Since the onset of financial market turmoil in August 2007, the European Central Bank (ECB), in line with other major central banks, has significantly expanded its term liquidity management operations.
More recently, the Bank of England (BofE) introduced its Special Liquidity Scheme (SLS). With the wholesale markets closed, these central bank programs have offered a viable alternative for banks looking to shift paper and provided some much-needed liquidity at a critical time in the market.
But among structured finance market participants, there is a concern that the extra funding with lengthening maturities made available by the ECB could be slowing the recovery of the wholesale markets. At this month's Information Management Network and European Securitization Forum Global ABS conference in Cannes, some concern was voiced that banks are becoming too dependent on the central bank-sponsored programs.
"The facilities are a useful tool in this crisis, as they have reduced systemic risks and provide stability within the banking system," said Markus Ernst, a senior ABS/securitization research analyst at UniCredit Markets & Investment Banking. "In our view, the enlargement and introduction of these repo schemes initially had a big influence on recent - significantly rapid - spread tightening across prime triple-A assets in Europe. But indeed, what is quite interesting to see is the spike in volume of securitized debt receiving funding via these central bank facilities."
What deals have been done in the European primary market since last August have been primarily structured for ECB repo collateral. For example, according to data from the Bank of Spain, Spanish bank use of the ECB window rose to a record high in April, which is consistent with what has been seen in terms of primary retained securitization deal flow.
In May, ECB repo funding to Spanish banks (including foreign entities with offices in Spain) had risen to 47.88 billion ($74.1 billion), from 20.28 billion a year ago, according to the Bank of Spain. The ECB estimates that the annual average share of ABS pledged as collateral for its repo facility increased to 16% in 2007, up from 12% in 2006 and 6% in 2004.
"These are record high levels," Ernst said. "Retained transactions in Europe make up more than 85% of the primary market at present. A volume of at least 140 billion has so far not been issued publicly; therefore, the biggest stake represents bonds eligible for ECB and Bank of England facilities. Also, the SLS by the Bank of England is said to be massively used."
Credit analysts estimate that in the past 10 months the equivalent of 70% of the primary publicly distributed volumes issued so far are being retained for central bank liquidity purposes.
Chris Greener, a senior analyst at Societe Generale, estimated that the central banks have absorbed a meaningful proportion of the ABS market with around 215 billion placed with the ECB as of September 2007; newer figures have not been published. He added that the Bank of England's SLS is likely to absorb more, in excess of the GBP50 billion ($97.5 billion), with some reports indicating that more than GBP90 billion of securitized bonds might be placed with the Bank of England facility.
"The securitize to repo' format has become almost pervasive in the European structured finance market as issuers continue to engineer asset-backed bond volumes in order to readily access the central bank financing window," Deutsche Bank analysts said. "Banks naturally continue to dominate such securitize-and-repo' exercises in building up internal liquidity positions, but recent weeks have also seen the first leveraged loan CLOs to be constructed as ECB repo-eligible, namely by excluding any synthetic buckets from the managed portfolio."
Potential Downfalls of Repo Madness
Jose Manuel Gonzalez-Paramo, member of the executive board of the ECB, said in a speech at the Global ABS event that the central bank program should not be considered an alternative to the restoration of a well-functioning market that offers true secured funding possibilities. He added that the industry needed to make serious efforts to revive the interest of third-party investors.
Repo activity was intended to create support in the short to medium term. The longer the current situation continues, the greater the doubts on the sustainability and effectiveness of the support will become.
Ernst said that if transactions are solely structured for the use of repo facilities, this creates a type of regulated shadow market that is less effective in terms of kick-starting public issuance, and any longer-term refinancing operations will only continue to detract risk appetite from real investors.
With a lack of spread transparency, a spread benchmark from public placements is missing, which Ernst said would also support and be needed to find a fair equilibrium based much more on fundamental credit risk considerations for the secondary market. "As a consequence of the retained issuance, the quality of the documentation underlying issuances, such as pre-sale reports by rating agencies and prospectuses, seems to have deteriorated," he said. "Hence, contrary to expectations that issuers would enhance transparency to restore investor confidence, we witness signs or indications of the opposite development toward ever more opaque markets."
In addition, ECB eligibility criteria have left the door open for some banks to structure riskier transactions, both in terms of lower credit enhancement and riskier collateral profiles than were seen pre-credit crisis. There is a potential risk that banks will hold on to liquid collateral, which can then be pledged with other counterparties, while using more illiquid structured finance assets and riskier collateral in ECB repo transactions.
"It is the case that deals have in some cases been more lightly structured than a public offering would require," Greener said. "However, the assets may well become available for sale restructured into new transactions as demand dictates. Given the significant, circa 20%, haircut required by the BofE, it is unlikely to absorb meaningful credit risk. The ECB is more at risk, with a typical 2% haircut; however, defaulting on central bank debt is a last course of action."
Some pools and transactions constructed for central bank activity have been constructed to include elements of adverse selection. These are the deals that can cause problems as soon as central bank support is reduced, and these transactions need to find once more their right to exist.
Fitch Ratings reported that the ECB program was driving changes in Spanish securitization transactions. Since most Spanish ABS and MBS transactions are being retained by the issuer for liquidity purposes, banks are looking to maximize balance sheet liquidity and, as a result, have changed their asset selection criteria from what is used in a typical ABS/MBS transaction.
For example, Fitch said that recent retained RMBS deals have pools with higher LTV profiles. Additionally, in other asset classes, some pools analyzed carried elevated concentration levels to obligors and higher risk sectors, including real estate and construction. The trend, the rating agency said, has weakened credit enhancement in deals because originators need only to meet the credit enhancement requirement of a single agency, which is usually the agency with the lowest thresholds. Once the market reopens, the lower credit enhancement and weaker collateral profile of these deals could hinder these transactions' liquidity.
"We agree that this lack of more than one rating is a potential weakness, but not through lack of transparency," Greener said. "These structures are temporary and very often include early calls. We expect they would be called by their sponsors as soon as spreads return to narrower levels, when it would be economical to issue ABS paper."
UniCredit's Ernst said that pools of recently structured Spanish securitization transactions would have had no chance to be placed with investors publicly because of their LTV levels or regional concentrations. The credit enhancement levels of recently retained deals often fulfill only minimum requirements in order to lead to "eligible" tranches for the ECB program.
"Spanish originators have been dependent to a high degree on wholesale funding sources like securitization and multi-seller cedula structures in the past, and public RMBS issuance volumes of mortgage loans in Spain have risen tremendously over the past years," Ernst said. "These originators now have little alternative other than using the facilities provided by national banks because they still offer the rare opportunity to receive affordable funding."
He added that Dutch banks are also heavily using the ECB facilities. By contrast, German and Italian banks have not significantly increased their ECB funding activities, as they can rely on good retail funding opportunities.
Looking at Short-Term Benefits
Although the ECB had accepted structured finance assets as collateral for its liquidity operations long before the onset of the credit crunch, during this turmoil European banks have increasingly turned to these refinancing operation programs as a successful way to address the overhang of paper looking for a home.
"In our view, the key mechanisms of these facilities/repo schemes work, i.e., these repo facilities provide confidence to capital markets as they provide liquidity in the short run for a still very much distorted market," Ernst said.
Hans Vrensen, director and head of securitization research at Barclays Capital, said that even with the threat of problems arising over the long term once the market stabilizes, the short-term benefit to individual banks and the overall system is significant, and ratings are a significant requirement for eligible assets. The ECB requires that ABS used for repo follow certain requirements. Notes must rank senior in the capital structure, be denominated in euros, be issued from the European economic area, be considered true-sale, be enforceable against any third party and be structured to remain outside the reach of the originator and its creditors in the event of the originator's solvency.
The cash flows behind the ABS must not be backed by credit-linked notes or similar claims resulting from the transfer of credit risk via credit derivatives. The ECB has no minimum ratings requirement, but requires only that the bonds be senior in ranking.
The Bank of England's announced SLS allows banks and building societies that are eligible for the bank's standing facilities to borrow U.K. nine-month Treasury Bills against triple-A covered bond, RMBS and credit card ABS collateral. Eligible securities must have been held on balance sheet at the end of December 2007 or be backed by loans held on balance sheet at that date.
While the volume of transactions indicates a desire to increase liquidity on balance sheet, it doesn't necessarily indicate that all of this paper is being placed with central banks, only that it could be if it became necessary.
"There is a risk of over-reliance on repo funding, and we expect rating agencies are closely examining this topic," Vrensen said. "It is not clear which banks may be over-relying on repos, as this is not fully disclosed, but rating agencies will likely penalize them. We expect that the ECB is closely monitoring its positions given press and political pressures, with some restrictions to availability likely."
With hands tied, the central banks look almost forced to continue with their activity. The question for them to figure out is how to shut down the current liquidity program without causing further disruption.
"Smoothly unwinding current support in the long run is one of the trickiest questions at present," Ernst said. "If central banks cannot manage to do so, could this mean that in the long run central banks do support financial institutions with liquidity, which they would have to bail out anyhow, as the financial institutions do not manage to finance their portfolios efficiently without direct central bank support? In our view, short-term central bank funding at present is to some extent also taking over the role of missing ABCP investors in no longer functioning arbitrage conduit pools and SIV pools from the past. Hence, doubts in terms of long-term sustainability of the current actions are justified."
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