In our Clients & Friends Memo titled “Creating ECB Eligible Collateral: Some Traps for the Unwary” (17 July 2008) we looked at the criteria which must be satisfied for asset backed securities (ABS) to be included on the list of eligible marketable assets of the European Central Bank (ECB) allowing them to be used as collateral by banks or bank branches established in Eurozone member states and which enter into financing operations with the ECB.
On 4 September 2008 the ECB announced changes1 to (i) the criteria which must be satisfied for ABS to be eligible collateral and (ii) the terms on which the ECB will provide financing in respect of such eligible collateral.2 The changes relate to the following:
- the valuation haircut applied to ABS provided as collateral;
- the ability of the provider of currency hedging in respect of ABS to use such ABS as collateral;
- the ability of the provider of liquidity support in respect of ABS to use such ABS as collateral; and
- the information to be provided by the rating agency(ies) in respect of the ABS in order for such ABS to be ECB eligible collateral.
The changes will not enter into force until 1 February 2009. However, they will have an immediate impact as they will influence the decisions of originators, arrangers and investors in originating, structuring and investing in ABS.
The Valuation Haircut
The first and most significant change announced by the ECB relates to the valuation haircut which the ECB applies to ABS used as collateral. Up to now the ECB has applied a 2% valuation haircut to all floating rate ABS, irrespective of the maturity of such ABS. Most issued European ABS is floating rate and therefore subject to this 2% valuation haircut. The valuation haircut applied by the ECB to fixed rate ABS varies with the maturity of the ABS and ranges from 2% to 12%.
From 1 February 2009 a valuation haircut of 12% will be applied by the ECB to all ABS used as collateral, irrespective of the maturity of such ABS or whether its coupon is fixed or floating. Where the value of ABS is determined on a theoretical basis rather than by reference to a market price an additional valuation markdown of 5% will be applied to the value of the ABS prior to the application of the 12% haircut. Even prior to the credit crunch most ABS was valued on a theoretical basis as market prices were not readily obtainable and this is even more the case today.
The effect of the ECB’s changes is that the total effective haircut applied to typical floating rate ABS by the ECB will increase from 2% to 16.4%. This increase will reduce the amount of funding that can be obtained by banks in respect of such ABS. Eurozone banks holding ABS investments may be more inclined to liquidate such investments in light of such reduction in ECB funding available.
The valuation haircuts which the ECB applies to covered bonds are only 1.5%, in the case of floating rate covered bonds, or 1.5 to 9% (depending on maturity and whether “jumbo” or “traditional”), in the case of fixed rate covered bonds. Consequently, we expect that the changes to the valuation haircuts for ABS will impact on the choice of mortgage originators between MBS issuance and covered bond issuance.3
The second change announced by the ECB is that a bank cannot use ABS to borrow from the ECB if such bank (or any third party that has “close links”4 to it) is the provider of currency hedges to the issuer or the guarantor of such ABS. Contrary to some comment, the change does not mean that ABS where the originator provides currency hedging will cease to be ECB eligible collateral. Such ABS will continue to be accepted by the ECB post-1 February 2009 from any entity except the provider of the currency hedging. The ECB’s approach in this regard is logical. The ECB is taking the ABS as collateral to protect it from the bank’s credit risk but if such bank is itself providing the currency hedging in respect of such ABS then the ABS is exposed to the bank and is likely to lose value at the time when the ECB most needs to be able to rely upon it as collateral.
Only ABS where the underlying assets are denominated in currencies other than euro and which therefore involve currency hedging will be effected by the change. It has been suggested that the ECB is seeking to reduce the amount of ABS backed by assets denominated in currencies other than euro and reduce the ability of banks to arbitrage between the different collateral requirements of the US Federal Reserve, the Bank of England and the ECB.
Originators or arrangers which provide the currency hedging in respect of ABS which they have retained themselves will be most immediately affected. If they have not had themselves replaced as currency hedge provider by unrelated third parties prior to 1 February 2009 they will become unable to use the relevant ABS in financing operations with the ECB. The entry into of back-to-back currency hedging between an originator or arranger and such third party hedge provider will not prevent the originator or arranger from using the relevant ABS as ECB collateral as it would not be providing currency hedging “to the issuer or the guarantor of such ABS”.
Investment banks which have been acting as third party hedge providers on ABS will also need to consider their positions and look at whether they hold on their books any ABS on which they are currency hedge providers. One longer-term effect of the change may be that more specialised entities which do not themselves trade ABS, such as derivative product companies, increasingly provide currency hedging on ABS transactions.
Some ABS is backed by assets which themselves involve currency hedging. For example, asset backed securities backing a CDO of ABS may themselves have currency hedging. However, provided that it has not provided currency hedging “to the issuer or the guarantor” of the ABS a bank which has provided currency hedging at the level of the assets themselves will continue to be able to use such ABS as ECB collateral.
The third change announced by the ECB is that a bank cannot use ABS to borrow from the ECB if such bank (or any third party that has “close links” to it) provides in respect of such ABS liquidity support of more than 20% of the nominal value of the ABS.
In this regard “liquidity support” must be taken as including a liquidity facility, a liquidity asset purchase arrangement or a swap the terms of which are intended to provide liquidity, but the extent of its breadth has not been demarcated by the ECB and originators and arrangers will need to be conscious that the term could encompass other structural features such as revolving notes.
The meaning of “the nominal value of the ABS” is unclear. It could refer to:
- the face value of all of the ABS issued by the relevant SPV, both that which is senior and ECB eligible collateral and that which is not;
- the face value of the senior ABS issued by the issuer that is ECB eligible collateral; or
- the ABS which the bank is providing to the ECB as collateral.
If (1) is the case, the impact of the change is likely to be limited as only a very small number of ABS transactions have liquidity support features which exceed in size 20% of the nominal value of the ABS. If (2) is the case, the impact is still likely to be limited but it will become relevant to more ABS transactions as the calculations will be based on 20% of the nominal value of the most senior rated class. In the case of (3), however, the impact may be greater as the notional amount of ABS against which the 20% test is measured may be must less. We are currently seeking clarification from the ECB on this point.
The change in relation to liquidity support is only relevant where a provider of liquidity support in respect of ABS itself holds some of the ABS. As with currency hedging, this is most likely to arise where an originator or an arranger has provided the liquidity support on ABS which it has retained.
Rating Agency Information
The fourth change announced by the ECB is the only one of the four changes which relates to whether or not ABS qualifies as ECB eligible collateral in the first instance and relates to the information available from the rating agency(ies) rating the ABS:
- A detailed pre-sale report or new issue report for the ABS must be publicly available and include a comprehensive analysis of the structural and legal aspects, a detailed collateral pool analysis, an analysis of the transaction participants and any other relevant particularities of the transaction.
- Rating reviews for the ABS must be published on at least a quarterly basis and contain an update of the composition of the collateral pool, transaction participants and capital structure and data on the performance of the ABS.
The national central banks in the Eurozone, which are responsible for assessing whether or not ABS meet the criteria to be ECB eligible collateral, already require that a pre-sale report or new issue report be provided in respect of such ABS before it will carry out such assessment. It is usual for such pre-sale report or new issue report to be made public by the relevant rating agency, but this will now be a requirement.
The ECB’s announcement on 4 September 2008 was keenly anticipated and there was a considerable amount of speculation as to the nature of the changes that would be announced. The ECB did not make some changes which had been mooted as likely. In particular, the ECB left untouched the minimum rating requirement for ABS of single-A from one rating agency and neither increased the minimum rating requirement nor added a requirement that ABS be rated by at least two rating agencies.
In announcing the changes the ECB stressed that it was making the changes in line with its previously announced practice of reviewing and updating every two years its collateral framework. Changes to the collateral framework were previously made in 2006. Consequently, some comfort can be taken that no further changes to the ECB’s collateral framework will be made before 2010.
The changes announced by the ECB in relation to currency hedging and liquidity support are logical in that they serve to ensure that the collateral being provided by a bank to the ECB is sufficiently independent of the credit of such bank. The change announced in relation to rating agency information may not represent a significant change to what is being done in practice at present or, to the extent that it does, may assist in improving the standard of rating agency information and reporting across ABS generally.
The change to the valuation haircuts and the introduction of the additional haircut of 5% for ABS which have a theoretical price clearly has the widest and deepest impact. An effective haircut of 16.4% rather than 2% will change how banks use ABS as collateral for ECB funding. The larger haircut will encourage banks to consider sales or alternative funding arrangements for ABS held by them. However, given the continuing liquidity squeeze, the larger haircut is unlikely significantly to diminish the preference of banks for holding ABS which is ECB eligible collateral and in respect of which some ECB funding can be obtained rather than the underlying assets backing the ABS against which no ECB funding can be obtained.