On 4th September Mario Draghi announced that the Eurosystem will go ahead with purchases of certain simple and transparent Asset Backed Securities (ABS). The announcement comes more than two months after the European Central Bank (ECB) unveiled plans for its outright purchase of ABS but the detail remains elusive. Mr Draghi confirmed that the details relating to the proposals will be set out after the Governing Council meeting on 2nd October 2014 and will be based on the preparatory work previously described as being “intensified”. It was also reputed that Blackrock has been approached to act as asset manager. It is also proposed that the Eurosystem would start a euro area covered bond purchase programme again with details to follow. There remains however significant issues with regard to the success of implementation of the programme, not least due to the ECB’s own contradictory policies. This article outlines some of the policies employed by the ECB to kick-start the European economy and explores the ECB’s rationale for supporting a revival of the ABS market.
On 5th June 2014, the ECB announced a package of measures that it hoped would support lending to the real economy and in doing so spur European economic growth. Some of the key measures included:
- The introduction of a series of targeted long-term refinancing operations (TLTROs) aimed at encouraging bank lending to euro area households and non-financial corporations over a four-year period1. Similar to the Bank of England’s Funding for Lending scheme (although focussed primarily on lending to businesses rather than households), TLTROs allow participants to refinance eligible lending by borrowing money from the ECB2 at low fixed-rates3;
- Decreasing the rate that the ECB pays to banks on overnight deposits to a negative rate of -0.1%. Effectively this results in a charge on excess reserves and penalises banks for not lending their deposits into the economy; and
- The “intensification” of preparatory work relating to the outright purchase of ABS.
The Eurozone economy is recovering slower than was forecast. In Q1 2014, the Eurozone economy was more than 2% smaller than in 2008 and year-on-year growth stood at just 0.2%.4 This was even before Russia’s economic sanctions on the Ukraine started to take effect.
By July, Eurozone inflation had also fallen to 0.4% on an annualised basis – the tenth consecutive month of sub-1% inflation, the level perceived by the ECB as creating a risk of deflation. A deflationary environment would exacerbate existing problems as it typically leads to an economic slow-down or contraction as people postpone spending, incur less debt and prices and wages fall.
Euro area annual inflation and its main components, August 2012 to July 20145
RECOGNISING THE NEED FOR REVIVAL
Against this backdrop the importance of reviving the ABS market is now recognised by the ECB. “There is growing consensus that an instrument once seen as part of the problem could in fact be part of the solution”, said Yves Mersch, Member of the Executive Board of the ECB during his keynote speech at the ABS Conference in Barcelona.6 From the ECB’s perspective, a well-functioning European ABS market is central to its long term objectives of price stability, financial stability and the stability of its own balance sheet7.
To date, the ECB’s direct support for the European ABS market has involved accepting certain ABS as eligible collateral for its intra-day Eurosystem credit operations. However, only certain meeting high credit and disclosure standards and denominated in US dollars, Japanese yen, pound Sterling or Euro are currently eligible. Although details of the proposed purchase programme are scant at present, the scheme will involve the outright purchase of claims against the Euro area non-financial private sector under an ABS purchase programme (ABSPP). In parallel the Eurosystem will also purchase a broad portfolio of euro denominated covered bonds issued by MFIs domiciled in the Euro area. Detailed modalities will be announced after the Governing Council meeting at the beginning of October as a means of generating liquidity in the market.
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Like many of the policy initiatives launched since the financial crisis it is not clear that the programme would have the result the ECB intends and may be neutralised by other initiatives already in place or proposed. The availability of an estimated €450-€850 billion of cheap credit to banks from September through the TLTROs, for example may make other funding techniques like securitisation less attractive further impeding the development of liquidity in that market.
As well as potentially hampering ABS activity, the TLTROs seem likely to miss the intended objective of spurring lending to the real economy. Whilst cash will be made available to banks and availability tracks net lending to euro area households and non-financial corporations, the TLTRO framework does not stop participating banks from using the fungible proceeds to buy government debt (attractive from a capital adequacy perspective) or repay existing LTRO loans that mature in February 20158 – both of which are less risky than lending to SMEs. The only penalty is a requirement to repay the TLTRO loans two years earlier – by September 2016 rather than the scheduled repayment in September 2018. Rather than filtering down to the real economy, counterparties are likely to use the allocations for yield enhancement by investing in government bonds.
OTHER INITIATIVES UNDER REVIEW
The European Commission has been holding informal discussions with member states and stakeholders regarding the expansion of the range of ABS assets eligible for inclusion in reaching banks requirements under the liquidity coverage ratio (LCR). This would involve the inclusion in the LCR of ABS backed by auto, SME and consumer loans. Under the LCR to be implemented in 2015, financial institutions are required to hold sufficient “high quality liquid assets” (HQLA) at any time to meet their liquidity requirements over the following 30 days. Including a wider range of ABS to count towards Level 2B buffers which would certainly represent a step in the right direction.
Further changes to capital and liquidity requirements for ABS are still under consideration (with a final decision on the LCR delayed until September).
THE NEED TO REVIVE THE ABS MARKET
In Europe, aggregate issuance has been notably lower since the crisis with only €174 billion issued in 2013, equivalent to roughly 40% of the pre-crisis annual rate. Only a few asset classes have bucked the trend such as auto loans and consumer loans.”9
The total available amount of primary issuance is reduced further if one deducts those securities retained by originators to be used as collateral for Eurosystem operations. In 2014, 70.43% of European securitisation issuance was retained, compared to 58% in 2013 and almost 0% before the crisis. The table below compares current retained issuance to 2007.
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This is not to say that most European structured finance products have not performed well through the financial crisis with S&P reporting default rates on ABS, RMBS and SME CLOs between July 2007 and Q3 2013 at 0.04%, 0.1% and 0.4% respectively.
It seems that the ECB is serious about implementing the proposals. “If we were to work on things that don’t happen, we wouldn’t spend our time well”, said Mario Draghi in his August address on the issue of whether the ECB would end up buying ABS. The ECB is reported recently to have hired Blackrock as a consultant to help design the programme.
The ECB is de facto the largest investor in European ABS and so is as keen as any private investor to see an effective and well-functioning market in ABS.
With the announcement of the implementation later in 2014 however we will have to wait to see the detailed structure after the October meeting. This should allow time for regulators to determine the size of the programme and refine their capital and liquidity standards for ABS.
The risk of deflation remains real for the Eurozone. Economic data for Europe through the summer was not good and Draghi and Company need to use every opportunity to drive growth in the European markets.