Sometimes central bankers have to play paramedic and perform emergency resuscitation.
Since the 2007 US subprime mortgage crisis revealed the dangers of slicing and dicing increasingly dodgy loans, Europe’s market for asset backed securities has been lifeless. “You have to consider that the ABS market is dead and has been dead for a long time,” Mario Draghi, European Central Bank president, admitted bluntly last week.
But now ABS are suddenly back in fashion among European policy makers scrambling for ways to finance an economic recovery. ABS pool loans into marketable securities; they can include residential and commercial mortgages, or car or credit-card loans. At his monthly press conference, Mr Draghi launched an initiative to revive the market for ABS backed by loans to businesses.
With European bank lending still chronically weak, ABS are no longer seen as dangerous instruments capable of blowing up financial systems but as an alternative source of finance for job-creating small companies, especially in southern Europe where credit conditions are harshest.
Mr Draghi even hinted ABS could be target purchases if the ECB ever followed the US Federal Reserve, Bank of Japan and Bank of England in launching a large-scale asset buying programme to boost economic growth.
Reports of the death of European ABS have been exaggerated. The ECB sustained the market during the crisis years by allowing banks to use ABS as collateral when taking out cheap loans in its liquidity providing operations.
But Mr Draghi admitted ABS “have a very bad name” and wants to revive private sector involvement. “You want real money, long term capital investors in these products,” says Jim Ahern, global head of securitisation at Société Générale.
That, however, will depend on policy makers rethinking attitudes towards ABS, regulators rewriting rules drawn up since the subprime mortgage crisis – and possibly changes in the way the ECB helps fund banks.
The ECB has already secured improvements in the transparency of ABS it accepts as collateral. Investors have become warier about financial instruments rated as triple-A. Lessons have been learnt since the crisis – including by rating agencies, argues Marjan van der Weijden, head of European structured finance ratings at Fitch. “We can analyse these kinds of transactions well, and feel that SME loans are good assets for securitisation,” she says. “Investors are looking for yield, and ABS give you yield.”
Salim Nathoo, securitisation partner at law firm Allen & Overy, adds: “It was not securitisation per se that caused the crisis – it was the way securitisation was used.”
However, the economics of ABS have changed since the crisis. Bank lending to SMEs is capital intensive; regulators demand adequate cushions against possible defaults. In the post-crisis world, capital requirements are proving even more strenuous when SME loans are packaged up into ABS.
Proposals currently being considered by bank regulators for capital charges related to ABS are based largely on the default performance of the worst-performing parts of the market, including US subprime mortgages. Regulators “need to appreciate it is just a financing technique and does not change the credit risk of the underlying loans”, says Mr Ahern.
ABS should distribute risk across the financial system. But banks have to keep some “skin in the game” rather than offload ABS risks completely on to the market – and investors are interested in only the highest-rated parts. To make ABS backed by SME loans work, bankers say, small businesses would either have to pay higher interest rates – or investors in such ABS would have to accept lower yields.
“It is no longer a scalable proposition – and there is nothing the ECB can do to make it scalable,” warns one banker working on securitisation deals. “Pre-crisis, the ABS market provided capital relief [by spreading risk] as well as funding for banks – now there is no capital relief. Regulators, meanwhile, are doing their best to ratchet up the capital pressure.”
The ECB’s initiative faces other problems. Small business loans are not easy to standardise. Entering the ABS business entails high initial costs for banks. Germany and France, meanwhile, have well established markets for covered bonds, which are similar to ABS in that they bundle together loans but are enhanced by bank guarantees. An alternative would be for the ECB to promote traditional European covered bonds, rather than US or UK-style ABS.
Mr Draghi made clear he expected other European institutions to shoulder any financial risks associated with his initiative. The European Investment Bank could provide guarantees, although bankers warn its capacity is limited.
But the ECB will not escape an examination of its own role. By accepting ABS as collateral in its liquidity providing operations, the ECB is, in effect, underwriting the market. Like private investors, however, it accepts only the highest-rated ABS; it has stuck firmly to the principle of minimising risks and lending only against “adequate” collateral. Even outright purchases by the ECB might well fail to revive the patient – unless more risk came on to its balance sheet.