The European Central Bank (ECB) is continuing to develop and adapt the criteria1 which must be satisfied for asset backed securities to be included on the ECB’s list of eligible marketable assets which can be used as collateral by banks or bank branches established in a Eurozone member state in obtaining repo financing from the ECB to meet the needs and realities of the post credit-crunch capital markets.
The latest changes were announced in a press release from the ECB on 15 October 20082. Technical details of the new regime are to be set out in a series of “Technical Specification” to be issued by the ECB in coming weeks. To date, one such Technical Specification3 has been issued. The 15 October changes are stated to be a temporary relaxation of certain of the ECB’s criteria for the period from 30 October 2008 to 31 December 2009.
Some of what, on first reading, seem to be the most important changes (such as the relaxation of the requirement for a minimum credit rating of A-) apply narrowly and, for example expressly do not apply to asset-backed securities (ABS). The most important of the changes which are relevant to ABS are:
- ABS denominated in Sterling, U.S. Dollars and Japanese Yen will be eligible collateral for the first time. However, such securities must be “issued in the euro area”. This wording is not particularly clear. It seems likely that it means that the issuer of such securities must be formed in a Euro area member state.
Furthermore, such non-Euro denominated ABS will be subject to a “uniform haircut add-on of 8%”. Again, it is unclear how this will operate in practice. The ECB has indicated informally to us that this 8 per cent. will be added to the percentage valuation haircuts for ABS set out in the existing criteria4 “in absolute terms”. Under the existing rules, floating rate ABS that is valued on a theoretical basis is subject to a haircut of 12 per cent. plus an additional haircut of 5 per cent. Because the 12 per cent. haircut is applied after the 5 per cent. haircut, the effective overall haircut is 16.4 per cent. rather than 17 per cent.. In the case of non-Euro denominated ABS, if the new additional 8 per cent. haircut is to be added to the exiting 12 per cent. creating a 20 per cent. haircut, this would result in an effective overall haircut of 24.4 per cent. Alternatively, if the ECB were to choose to apply the new 8 per cent. haircut in a staged way (either before or after the existing haircuts), a slightly lower total haircut would result. Given the feedback so far from the ECB, it seems that the first of these approaches will be taken. Further details will be available through the Technical Specifications.
The concession granted by the ECB for non-Euro ABS overlaps to an extent with some of the changes announced by the ECB to its repo facility last September5. The September changes (which seemed to be motivated by a desire to maintain the quality of the ABS which was eligible for repo finance with the ECB) effectively prohibited originators from providing currency hedging for their ABS. The cost and scarcity of third party currency hedging in the current market significantly hindered efforts by originators to arrange transactions backed with non-Euro assets that would be eligible for ECB finance. The latest changes reopen the ECB repo window to such originators albeit at the cost of a higher haircut.
- Credit claims governed by “UK law” (which is taken to mean English, Scottish or Northern Irish law) will be eligible collateral for ECB purposes giving rise to the possibility of Eurozone banks directly repo-ing loan assets with the ECB. However, this concession may not be as significant as it first appears as a range of complex tax and practical issues arise in relation to repo transactions in such assets the solutions to which can lead to recharaterisation risk for such transactions6. Additionally, the requirement for the credit claims to exceed € 500,0007 has not been altered and uncertainty remains as to whether this requirement applies to the whole amount of the credit claim or only to the part for which ECB eligibility is sought. As a result, in practice, it is likely to continue to prove easier to repackage loan portfolios into rated bonds than to repo loans directly with the ECB.
The ECB’s press release uses the word “syndicated” when describing these assets. The ECB has confirmed informally to us that this is intended to exclude bilateral loans governed by “UK law”. However, it remains unclear what the ECB means by “syndicated” (in particular whether the credit claims need only to be capable of syndication or whether they must actually have been syndicated to third parties) and what the rationale is for excluding bilateral loans. No such rule applied under the existing regime to Euro denominated credit claims governed by the laws of a Eurozone Member State. The ECB has indicated that further guidance will be provided on this through the Technical Specifications.
In addition, some clarification of the existing ECB rules would seem to be needed as these could operate to effectively prevent “UK law” governed credit claims from being eligible collateral. In particular, the current rules8 require that the agreement between the counterparty and the national central bank mobilising the credit claim as collateral (“mobilisation agreement”) must be governed by the law of a Member State belonging to the euro area. Additionally, at present the total number of different governing laws that are applicable to (i) the counterparty, (ii) the creditor, (iii) the debtor, (iv) the guarantor (if relevant), (v) the credit claim agreement and (vi) the mobilisation agreement may not exceed two.
- Subordinated debt instruments which are backed by a suitable guarantee9 will be eligible collateral subject to an a haircut add-on of 10 per cent. with a further valuation markdown of 5 per cent. is such instruments are valued on a theoretical basis. The ECB’s rules clearly intend this category of securities to be limited to those which are guaranteed by public sector entities. However, some of the extraordinary measures taken in recent weeks to alleviate the credit crunch such as the Irish government’s bank guarantee scheme (under which certain Irish bank debt and securities are guaranteed by the Irish state) may have the unanticipated effect of making assets such as residual, subordinated, unrated ABS eligible for repo finance with the ECB (particularly if the same is guaranteed by the relevant originator).
So far there is no definition of what is meant by “subordinated debt instrument” and so the scope and extent of the subordination that will be allowed is not clear. Existing ECB criteria provides that the guarantee must be for at least one year, be unconditional and irrevocable, cover all payments of both principal and interest, be payable on first demand, rank at least pair passu with the guarantor’s unsecured obligations, be governed by the law of an EU member state and be supported by a legal opinion as to, inter alios, its enforceability.
While it seems clear that further clarification will be required in the Technical Specifications to make these changes fully operable, it is notable that the ECB is taking a pragmatic and flexible approach to its repo facility and is taking steps to increase its ability to provide liquidity to the capital markets in this way.
In an increasingly uncertain world, further developments in this area can be expected in the future. The nature of these are impossible to predict but based on developments to date, it seems likely that the ECB can be expected to adapt its repo facility as and when needed to encourage a reopening of the global financial markets.