The European Central Bank (ECB) is gearing up to buy “simple, transparent, and real” asset-backed debt. The success of its bid to breathe life into the market will depend on how regulators from Basel to Brussels define those terms.
President Mario Draghi said last month that ECB purchases of asset-backed securities (ABS) “would lead to a reconstruction of a market that has disappeared with the crisis,” and that’s why they will focus on products that are easy to price. The ECB, whose Governing Council meets this week, may start buying ABS as part of a quantitative-easing (QE) program aimed at shoring up a euro-area economy that’s edging closer to deflation.
As the ECB’s push to revive the European Union’s 1.4 trillion-euro (US$1.8 trillion) ABS market builds momentum, EU and international standard-setters are working on as many as 19 measures that could affect demand for securitized debt, according to a draft EU document obtained by Bloomberg News. Many will be rolled out in the next year.
“I can’t see how you get an exit from QE if you haven’t really got the market going again,” said Patricia Jackson, head of prudential advisory at EY in London. “Defining simple, high-quality securitization, and then pushing these securities, is a key part of that.”
When it comes to asset-backed securities, “simple means readable,” Draghi said. “Transparent means that you can actually go through and price them well. And real means that they are not going to be a sausage full of derivatives.”
Yet the ECB has “intensified preparatory work related to outright purchases” of ABS in the absence of clear European or international standards on what constitutes a high-quality, transparent product worthy of preferable regulatory treatment. The ECB has hired BlackRock Inc., the world’s biggest money manager, to advise on developing the program.
Within the EU, the lack of a common definition of high-quality ABS, and the various timetables for individual bits of rule-making, mean the only blueprint so far has come from the European Insurance and Occupational Pensions Authority (Eiopa), as part of technical proposals on applying capital rules to the industry.
Eiopa’s draft criteria for identifying “less risky” securitizations cover areas such as the structure of the product, the quality of the underlying assets, the underwriting process, and transparency.
They include that the underlying securities come from one of several categories on a “closed list,” such as residential mortgages, small business loans, and auto loans. These assets must not include “swaps, other derivatives instruments, or synthetic securities.”
Other European measures in the works include bank liquidity requirements, investment rules for money-market funds, and a more general review by the European Banking Authority.
The EU should conduct a review toward mid-2015 to “take stock of the progress made” and consider whether further measures are necessary, according to the EU document prepared by a group of officials known as the Financial Services Committee. This review “could inform a discussion on whether an overarching EU legislative framework is needed for securitization instruments, as views currently diverge.”
The “careful coordination and sequencing of work streams at EU level is crucial,” according to the document. Failing to do so risks “regulatory arbitrage across financial sectors and financial instruments.”
The European Commission, the EU’s regulatory arm, wants “securitization products to be part of the toolbox that will unlock additional sources of funding to the real economy, but only in ways that raise no financial stability concerns,” said EU financial-services chief Michel Barnier.
“The first step is to define criteria by which we can identify safe, high-quality securitization structures and products, thereby differentiating between good and bad securitization,” he said.
At the international level, a task force co-led by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions will “develop criteria to identify and assist in the development of simple and transparent securitization structures.”
The task force will report on its findings on high-quality ABS to the Group of 20 leaders’ summit in Australia in November. A final report will follow by March, according to the EU document.
The Basel committee is also in the process of overhauling rules on the capital banks must have to back purchases of asset-backed debt.
For securitization, the plethora of regulatory initiatives “has been identified as causing confusion and uncertainty in a component of the financial system seen as crucial for sustained economic recovery,” said Richard Reid, a research fellow for finance and regulation at the University of Dundee in Scotland.
“My guess is that the pressure to support ailing economies in Europe will mean that some steps to boost securitization will be introduced in advance of finalized global standards,” he said. “This again will demonstrate the difficulty of reaching international agreement when national and regional priorities differ.”
The timing differences between EU and international work mean that “the EU standards may end up diverging significantly from what emerges” at a global level, possibly creating complications further ahead, according to the EU document.
Some governments “have already flagged the existence of a discrepancy between the emerging definitions” of high-quality securitizations in EU and international discussions.
In addition to the regulatory questions, another open issue that may affect the market revival is whether governments will step in to guarantee at least some of the debt.
“Europe is facing a very fundamental choice if it wants to move to an ABS market that is as deep and liquid as the U.S. market,” ECB Executive Board member Benoit Coeure said last month. “To reach this goal, the securitization market will require a significantly different amount of public sponsoring than is currently the case.”
The European market for ABS, like that in the U.S., was brought close to extinction in the financial panic of 2008, which was fueled in part by banks taking heavy losses on securitized U.S. subprime mortgage debt even though the tranches they held had been considered high-quality. It has been slow to recover.
About 181 billion euros of bonds backed by everything from auto loans to credit-card payments were issued in Europe in 2013 compared with a peak of 711 billion euros in 2008, according to data from the Association for Financial Markets in Europe. U.S. issuance totaled 1.5 trillion euros, down from a 2003 peak of 2.9 trillion euros, the data show.
Draghi said in July that the “outstanding amount of securitizations in the European Union at the end of 2013 was about 1.4 trillion euros, which is one-fifth of what’s in the U.S.”
“We aren’t going to build a long-term viable market unless we avoid the pitfalls that happened last time—the hidden deterioration of quality,” said Jackson, a former U.K. member of the Basel committee. “This time, regulators have got to put a stake in the ground when it comes to quality.”