Exceptional conditions recently seen in the global capital markets have virtually halted the refinancing by banks of their loan books through CDOs, CLOs, CMBS, RMBS and other forms of securitisation. However, many EU regulated banks and EU regulated branches of overseas banks have taken advantage of the repo facility (or window) made available by the European Central Bank (ECB) to obtain short term financing for their holdings of certain asset backed securities1 and have begun to arrange securitisations specifically for the purpose of accessing this funding.
In September 2007 it was estimated2 that € 215 billion of asset backed securities had been repo-ed with the ECB with up to € 485 billion of bonds being eligible for such finance. More recent figures are difficult to obtain but anecdotal evidence indicates that both these figures have increased substantially and some commentators have gone so far as to suggest a doubling of volumes. The picture is further complicated by indications3 that many banks are creating substantial portfolios of asset backed securities which are eligible for repo finance with the ECB in order to improve the liquidity of their loan pools but, for the time being, not actually repo-ing them with the ECB so as to provide a source of funding if and when the need arises.
Banks obtain two principal benefits from structuring their securitisation transactions to produce ECB eligible collateral (i.e., securities which are eligible for repo finance with the ECB).
- Securities which are ECB eligible collateral held by a regulated institution are treated as liquid securities for the purposes of Basel II. Depending on the regulatory capital arrangements agreed by an institution with its regulators, a regulated institution can obtain up to 24 per cent. regulatory capital relief by holding assets in the form of ECB eligible securities as opposed to holding the assets directly.
- The holders of such securities can obtain short term finance by repo-ing such securities with the ECB. The discount applicable to such finance is currently 2 per cent., a figure that compares favourably with the terms currently available in the wider credit markets and that available under the Bank of England’s Special Liquidity Scheme (where the discount ranges4 from 13 per cent. to as much as 25 per cent.).
The ECB offers repo finance for securities which are included on a list of eligible marketable assets maintained by the ECB and published and updated daily on the ECB’s website5. In order for asset backed securities to be included on the ECB’s list of eligible assets they must comply with criteria set out by the ECB. In places the ECB has deliberately drafted the criteria in the form of broad general principles in order to enable it to react to changing market conditions and to avoid becoming obliged to finance securities which meet the letter but not the spirit of its scheme.
At their most basic, the criteria require that asset backed securities to be included on the ECB’s list of eligible marketable assets must be:
- denominated in Euro;
- rated at least “A-/A3” by least one of S&P, Moody’s and Fitch;
- the most senior ranking securities issued by the relevant issuer;
- issued by an issuer incorporated in an EEA member state or, subject to assessment by the ECB, the United States, Canada, Japan or Switzerland;
- listed and admitted to trading on a regulated market for the purposes of MiFID6 or one of the limited number of non-regulated markets specified by the ECB;
- either (i) in bearer form and use the New Global Note (NGN) structure7 or (ii) in registered form;
- cleared through Euroclear and Clearstream, Luxembourg (or an acceptable EEA domestic clearing system); and
- either be based on a “true sale” structure or be covered bonds meeting the requirements of Article 22(4) of the UCITS Directive (i.e., covered bonds issued under a statutory framework).
There are no restrictions on the types or sources of collateral which may be used to back these asset backed securities. In particular, asset backed securities backed by assets situate outside of the EU are within the scope of the criteria. However, potential issuers may wish to consider recent statements from the ECB warning that the ECB may need to reconsider its rules so as to ensure that the ECB repo window does not become a substitute for a functioning ABS market and to maintain the high quality of securities being financed by the ECB8. In response to this, commentators have noted that even a partial closing of the ECB repo window could cause serious damage to already fragile international ABS markets which the ECB is presumed to want to encourage fully to re-open.
On a more specific level, issuers of securitised product wishing it to be eligible for the ECB window will, among other things, want to consider the following potential issues:
1. “True sale” is specifically defined in the ECB criteria as a “...[legal acquisition] in accordance with the laws of a Member State...that is enforceable against any third party, and be beyond the reach of the originator and its creditors, including in the event of the originator’s insolvency...”. Synthetic transfers through credit-inked notes, credit derivatives or similar mechanisms are expressly prohibited. This presents particular issues for transactions involving portfolios of CDO or CLO securities which themselves may be backed by synthetic interests.
It is, however, notable that the ECB guidelines do not limit “true sale” to the narrow concepts of traditional English law-type legal and equitable assignment or outright transfer. As such, insolvency-proof structures which are fully effective to transfer all risk and reward from the originator to the issuing SPV may be sufficient to satisfy the requirements for ECB eligibility. Note also that “true sale” must be confirmed by appropriate legal opinions and these need to be available (usually on a non-reliance basis) to the ECB and the national central bank of the jurisdiction where the securities are listed.
2. The wording in the criteria for “true sale” contains a reference “...[legal acquisition] in accordance with the laws of a Member State...”. Although technically “Member State” in this context is confined to Eurozone countries, various regulators have confirmed that in practice it is taken to mean EU member states. Furthermore, this wording has been interpreted to require the central sale or transfer document relating to asset backed securities to be governed by the laws of an EU member state. This can present particular difficulties when such asset backed securities are backed by assets situate outside of the EU as under conflicts of laws principals the lex situs of an asset is key to determining the effectiveness of such a transfer and, depending on the nature of the assets in question, the lex situs, may be outside of the EU. In such situations, the arrangers of the transaction will have to seek compromise solutions and produce transfer documents which are effective under and meet the mandatory provisions of a number of different legal systems.
3. As mentioned above, the asset backed securities must be denominated in Euro to be eligible marketable assets. This means that any securities backed by assets the cashflows from which are received in a different currency will have to arrange appropriate currency hedging for the mis-match. The minimum ratings requirement of “A-/A3” for ECB bonds will assist many banks as the minimum rating requirements for hedge counterparties imposed by the rating agencies at this level is “A-/A3” which can be met by a very wide range of banks and so the currency hedge can be provided by the bank itself. However, a bank whose current rating is close to “A-/A3” will have to accept the risk of finding a replacement hedge counterparty if it is downgraded.
4. Potential issues may arise when issuing ECB eligible securities which are backed by repackaged assets (i.e., bonds or securities which are backed by other assets). Arguably, such bonds may not meet the “true sale” requirements. However, there is helpful wording in the criteria relating to the use of intermediaries and so far the regulators have taken a flexible approach on this. However, this approach may be predicated on the availability of full “true sale” opinions at all levels which may not be achievable on deals where the “repackaging” has been completed some time in the past.
5. Finally, a further implication of the “true sale” requirement is that CDO-style investment management cannot be a feature of the bonds. This arises due to the difficulty in arranging “true sale” opinions in respect of assets bought in the market. As such, it is relatively difficult to arrange an ECB bond issue as a fully “managed deal”. A possible solution to this is to adapt traditional RMBS and CMBS asset substitution provisions so that the originating bank could acquire assets and then sell them to the ECB bond issuer delivering the required opinions as a condition of such substitution. More generally, substitution provisions can be a useful feature for banks arranging ECB bond issues as a liquidity tool as such bond issues to co-exist alongside more traditional publicly offered ABS transactions by allowing assets to be taken in and out of the structures as and when market conditions allow.
The national central bank of the Eurozone member state where the asset backed securities are listed is responsible for assessing whether the asset backed securities comply with the ECB’s criteria and can be included on the ECB’s list of eligible marketable assets9. The national central bank will only carry out that assessment after the securities are issued and it has received the following documentation: (i) rating letter and new issue report from the rating agency(ies) rating the securities, (ii) final prospectus for the security approved by the listing authority, (iii) ISIN code and Reuters/Bloomberg page codes for the security and (iv) if the security is issued in bearer form, confirmation that it is in New Global Note (NGN) form.
Although the ECB repo window has existed for some time, recent events in the credit markets have focused attention on it. Regardless of the form that the markets will take when they fully re-open, it is clear that banks will no longer be willing or able to rely principally on any one method of refinancing their loans. Accordingly, it seems clear that in the future, all European banks will wish to ensure that any bond issue they arrange is capable of being funded through repo finance with the ECB as well as any alternative sources of finance that may become available in the capital markets or from other regulators and guardians of the markets.