What securitisation for the future? - The collapse and revival of ABS markets
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB
at the ECB-CFS Research Network Workshop on "The structure of the euro area market for banks' debt financing and implications for monetary transmission and financial integration"
Frankfurt am Main, 18 May 2011
Securitisation is an important feature of the financial markets. If properly regulated and supervised, it can fulfil a key role by redistributing risks and completing the financial system. In particular, for sectors that cannot access capital markets on their own, mainly households and SMEs, that often include the youngest and most innovative firms, securitisation is a particularly attractive tool, acting as a bridge between these borrowers and investors that could not otherwise directly gain these types of exposure. It can also help overcome credit supply constraints by taking concentrated credit risks off bank balance sheets and distributing them to a wider investor base. All in all, if properly used, as I said, securitization can be a powerful facilitator, if not a factor, of economic growth.
Moreover, considering the large volume of bank debt maturing in the coming years, a well functioning wholesale market including asset-backed instruments will be important. The covered bond market is gaining ground as a funding tool, and hopefully will be able to replace some of the maturing debt. For this purpose, among others, the ECB has launched in 2009 the Covered Bond Purchase Programme (CBPP). Under the programme, over the 12-months from July 2009 to June 2010, the Eurosystem made outright purchases of covered bonds for a nominal value of €60 billion, as originally announced.
Let me comment briefly on this program. It had four objectives:
(a) facilitate a decline in money market rates,
(b) ease funding conditions for credit institutions and firms,
(c) encourage credit institutions to maintain or expand their lending to clients,
(d) improve liquidity in the private debt market.
During the months preceding the introduction of the program, activity in both primary and secondary markets for covered bonds in the euro area had been very subdued. In 2008, there was a clear trend towards smaller deal sizes and shorter maturities. Subsequently, the issuance volumes have returned to the levels observed before the crisis. Gertrude Tumpel-Gugerell in her presentation yesterday showed evidence on the effects of the programme on the primary and secondary market. The program was also effective in lowering the overall funding cost for banks. At the same time, anecdotal evidence suggests there were positive effects also on the supply of bank credit, a key objective of the program. A more detailed analysis of these effects is presented in a recent ECB occasional paper.
Going forward, the CBPP is not expected to be prolonged or expanded. However, the ECB and the Eurosystem will continue to work with the aim of revitalising different segments of the wholesale market, also by performing a catalyst role of privat initiatives (STEP, ABS, covered bonds).
Having said that, it is important to consider that banks do not have an infinite capacity to issue covered bonds; therefore, covered bond and ABS issuance must complement each other. For this to happen, we need to reactivate the ABS market and regain investor confidence. Three leading principles should guide us in this respect: quality, simplicity and transparency.
Let me start with transparency. Increased disclosure, either encouraged by the authorities or market-driven, should be combined with increased standardisation, where possible. In this respect, the Eurosystem has, as you know, launched a project on loan level data on ABS transactions, should these assets be used as collateral with us. ABSs represent 20 to 25% of the total collateral deposited by counterparties with the Eurosystem; the Eurosystem should thus be able to perform a proper assessment of risks. Also, loan-level information will allow rating agencies to improve their surveillance reports.
Concerning simplicity, in the context of the loan level project we have developed and published different templates for ResMBS, ComMBS and SME CLO and are developing further templates on other asset classes. This is to my knowledge the first effort to standardise the ABS market in Europe, which will also bring a substantial increased amount of information to market participants.
Let me emphasise that, independently of the market functionality and the consumer protection aspects, the ECB has a clear institutional interest in an efficient securitisation market, due to its links with the implementation and the transmission of monetary policy. In order to reach our objective of price stability, the Eurosystem deals with a broad range of counterparties, using a broad range of assets. Our experience suggests that this operational “style”, that over time as become typical of the ECB, helps steer interest rates and signal the stance of monetary policy in an effective way, especially when market do not function perfectly. An ABS “sector without market”, that is one resting mainly on retained issuance, would not be consistent with an efficient transmission mechanism.
Let me now move on to the four questions addressed to the panellists.
Why did the ABS market collapse so suddenly and indiscriminately? Was there an information failure?
Several factors explain the sudden stop we have observed. First, rating downgrades, backed by revised rating criteria and adverse credit trends, contributed to the negative sentiment. Second, SIVs and conduits, large investor in this market, virtually disappeared and are unlikely to re-emerge as in the past. During the crisis, investors concentrated more on their current portfolio and less on purchasing new assets on the primary market. There is still a large overhang of ABS assets on banks balance sheets today. In addition, credit risk concerns, price volatility and other risks have raised market skepticism towards ABS products. This is surprising, to some extent, because despite price volatility, higher spreads and rating downgrades, the credit performance of the underlying securitised assets in Europe has generally been good.
There may be, therefore, an informational problem negatively affecting ABS reputation – a point raised also in the preceding panel. This is why increased disclosure and standardisation will be important. It could alleviate the asymmetric information between issuers and investors and also facilitate the distinction between good and bad products, also in the interest of better pricing.
Why is the ABS market taking so much time to recover?
I think it is important to distinguish between the primary and the secondary ABS market. Looking at indicative spreads, it seems that the secondary market has recovered slightly better than the primary market. Since the peak in spring 2009, spreads have narrowed considerably and many asset classes enjoy spreads below those before the Lehman Brothers collapse.
The primary market, conversely, is lagging behind. At best, the recovery is fragmented across asset classes and jurisdictions in the euro zone. Over the last 18 months we have seen few newly issued ABS sold to investors, in few countries and concerning few assets classes, based mostly on auto loans and ResMBS. However, the trend, while still slow, is positive.
Besides macroeconomic factors and general risk aversion towards ABS instruments, institutional factors could also play a role. Anecdotal information suggests that there is still a degree of uncertainty regarding the final outcome and effects of EU regulations. The current regulatory program in Europe [Capital Requirements Directive II or CRDII on retention rules and due diligence, CRDIII on re-securitisation and related higher risk-weights, along with the removal of trading book treatment for ABS assets, the Liquidity Coverage Requirement that treats ABS as illiquid products, and the revised MiFID], is often regarded by market participants as following a piecemeal approach, that may undermine incentives to long-term investments. The complexity of the issues that regulators are called to address can be a partial explanation. As the regulatory program continues to unfold in the coming months, it will be important to focus, on the side of regulators and market participants alike, on its overall logic and on the interconnections between its various sectoral components.
Why did such efficiently enhancing innovation cause so much damage? What are the lessons?
If financial innovation alwayd worked as textbooks tell us, then ABS would undeniably be one of the most efficient tools in the financial industry. By transforming illiquid assets to liquid or at least tradable ones, based on credit to borrowers typically without access to capital markets, selling and distributing risk to investors more capable of bearing it, the functionality and also the stability of capital markets should increase, almost by definition. But some of the basic premises of this reasoning proved wrong in light of experience. Risk transfer weakened a fundamental banking function, that of screening and monitoring credit risks. Complexity did the rest. The end result was not a better allocation of risk, but a generalised, or al least a widespread, unawareness of the existence of risk.
What was also overlooked is that risk-transfer markets, however sophysticated, cannot eliminate risk, only diversify it and transfer it. Fundamental risks remain in the economy, regardless of financial engineering, and they may even become more systemic. This is the lesson we learned from the turmoil. In the future, it will be important to approach securitisation in a way that the welfare-improving and stability-enhancing aspects are better understood and attained.
This leads to the final question:
What securitisation for the future? What design, regulation and supervision?
Some recent developments in the euro area over the last 18 months might indicate a viable securitisation design. We have seen securitisation activity mainly in countries with low sovereign credit risks. Investor demand has focused on prime, high quality collateral that exhibits low risks and good credit performance on the underlying assets. Only simple transaction structures with significant credit enhancement from originators with proven issuance experience and good reputation could be placed in the market. In addition, transparent structures regarding the allocation of cash flows seem to be preferred.
Let me be clear: there is no single-bullet or magic solution to revive the securitisation market. Structured finance sums up a combination of diverse features such as different asset types, coupon profiles and interest rate determination techniques, and diverse maturity profiles. Securitisation can be used as a funding tool or as a credit risk transfer tool. Not least, it is built around a variety of legal regimes and market arrangements. Attaining a successful mix of all these elements requires steady action and a combination of initiatives, by both the private and the public sector.
In order to restore sound securitisation markets, a broadening of the investor base in Europe will be needed. Restore investor confidence and potentially also “rebrand” securitisation will be key, in particular to attract new investors. As I argued, and as the recent trends demonstrate, more transparent, comparable and simple securitisation structures, including high quality underlying assets, will be needed. This will contribute to improve internal evaluation processes within investor firms, helping overcome the reputation risks that surround the ABS markets.
This area of work should become a high priority also for the industry, as it is for us monetary authorities and for the European and national regulators. I am confident that our loan level data initiative on ABS will contribute to this. Industry initiatives with similar aims would also be very useful.