As the turmoil in global financial markets continues to affect financial institutions around the world, it is increasingly evident that the asset repurchase facilities provided by central banks have become a lifeline for banks struggling to raise capital in the current climate. In a market devoid of its traditional investor base, originators and arrangers of securitization transactions within the Eurozone have come to rely heavily on the European Central Bank's (ECB) asset repurchase or "repo" facility which allows (among other assets) ABS to be used as collateral for funding.
In contrast to the various U.S. facilities designed to restart the U.S. securitization market, the ECB facility is intended to allow financial institution holders of ABS access to short-term finance at (until recently) attractive rates, and has led increasing numbers of originators to structure, issue and retain their "own-name" ABS specifically for the purpose of accessing the ECB's repo facility. Unsurprisingly, originators have flocked to the ECB in droves with newly-issued ABS over the past two years as funding conditions have deteriorated, creating a de facto "lender of first resort" position for the ECB within Europe. This heavy reliance on the ECB's repo facility has inevitably led to a gradual tightening over the past eighteen months of the criteria by which the ECB assesses the eligibility of assets submitted as repo collateral and, in particular, the criteria applicable to ABS as "eligible assets".
These eligibility criteria are set out in Chapter 6 of the ECB's The Implementation of Monetary Policy in the Euro Area (known as the General Documentation). While the eligibility criteria apply to a wide range of assets, known as "marketable assets", ABS comprise a distinct class of marketable assets and are subject to some specificities within the criteria. The eligibility criteria for ABS may be summarised as follows:
* True sale: the transaction must involve a "true sale" of the underlying assets from an originator (or an intermediary) to a bankruptcy-remote SPV, with supporting legal opinions to be made available on request. The true sale must be governed by the laws of an European Union (EU) Member State, to ensure the issuer's rights to the assets are enforceable against any third party, including any creditors of the originator. Some recent attempts to submit ABS backed by non-EU assets as repo collateral (albeit issued by an EU SPV and utilizing a double-SPV structure as specifically contemplated by the General Documentation) appear to have been unsuccessful, suggesting the ECB has concerns about certain non-EU (particularly emerging market) collateral. A further restriction introduced in early 2009 that the underlying assets must not represent "tranches of other ABS", limits the use of riskier "resecuritizations", such as CDOs of ABS and CRE CDOs, as repo collateral.
* Non-subordination: the relevant tranche of securities must not be subordinated (in the post-enforcement priority of payments) to any other tranche of notes issued, whether in respect of principal or interest. It has become increasingly common in ABS transactions structured to achieve ECB-eligibility to include a single rated tranche to eliminate subordination issues.
* Credit standards: the ABS must meet the ECB's high credit standards, which now require, for all ABS newly issued as of March 1, one 'AAA' rating from an accepted external credit assessment institution (i.e. a rating agency). ABS issued (or already eligible) prior to March 1 must be rated at least 'A'. In all cases, the ABS must maintain a minimum 'A' rating until redemption. Further, ratings on ABS must be explained in a publicly-available credit rating report and regular ratings reviews/surveillance reports must be published, reinforcing the general trend toward greater transparency of ratings in ABS markets.
* Place of issue: the ABS must be issued in the European Economic Area (EEA, which includes the EU Member States and Iceland, Lichtenstein and Norway) with a central bank or securities depository that meets the ECB's minimum standards (e.g. Euroclear or Clearstream). All ABS issued in global bearer form must be in the form of New Global Notes in order to be eligible.
* Settlement procedures: the ABS must be transferable in book-entry form and must be held and settled in the Eurozone through an account with the Eurosystem that fulfills the ECB's standards (e.g. Euroclear or Clearstream), to ensure that perfection and realization are subject to the law of a Eurozone country.
* Acceptable markets: the ABS must be admitted to trading on a regulated market as defined in the Markets in Financial Instruments Directive (Directive 2004/39/EC). This includes the London, Irish and Luxembourg Stock Exchanges (the most commonly-used regulated markets for European ABS), but not the so-called "professional" markets established in those jurisdictions.
* The issuer: ABS issued by central banks, public sector entities, private sector entities, international or supranational entities will be eligible provided that the Issuer (or guarantor, if applicable) is incorporated in the EEA.
* Currency of denomination: the general rule is that eligible assets must be denominated in euro. However, the ECB announced in October 2008 that, temporarily from November, 14 2008 until the end of 2009, certain debt instruments including ABS may be denominated in U.S. dollars, pounds, sterling or Japanese yen, provided that they are issued and held/settled in the Euro area, the issuer is established in the EEA and the ABS meet all other eligibility criteria. In early May 2009, the ECB further extended this period of temporary eligibility, so that ABS denominated in these foreign currencies may be submitted as repo collateral until the end of 2010. One particular restriction upon ABS denominated in these foreign currencies is that they must not have a coupon payment falling due in the period for which they are used as repo collateral. To avoid the practical difficulties associated with repurchasing eligible assets prior to interest payment dates, ABS with monthly or quarterly payment dates have been repackaged into new securities with semi-annual payment dates, or repackaged as principal-only A tranches (to be used as repo collateral) and interest-only B-tranches, although either option will have cost and timing issues that will need to be carefully considered. Additional "haircuts" (see below) will also be applied to ABS denominated in foreign currencies.
In addition to the eligibility criteria summarized above, some other aspects of the general documentation that have been recently refined are relevant for ABS:
* Haircuts: significant increases in the haircuts (i.e. discounts in value) applied to ABS from 1 February 2009 mean that all ABS will be subject to a blanket 12% haircut (previously the haircut range was between 2% to 10% for all assets with a residual maturity of 0-10 years and 12% to 18% for assets with a residual maturity of over 10 years, depending on coupon structure). Additional (cumulative) haircuts apply if the ABS are given a "theoretical value" (i.e. the reference price is older than five days or has not moved for five days - in effect, where the securities are illiquid) and/or if the ABS are denominated in one of the non-euro currencies mentioned above. Further, there is anecdotal evidence that the ECB has applied additional, ad-hoc discounts in value to ABS over and above the valuation haircuts, resulting in originators shelving some planned transactions as economically unfeasible.
* Close links: even if the ABS satisfies all of the eligibility criteria, the party submitting the ABS for repo purposes (or any third party with which it has "close links") must not provide currency hedges for the ABS or liquidity support of more than 20% of the nominal value of the ABS. Close links arise, broadly, in situations in which the party submitting the ABS for repo purposes is linked to an issuer/debtor/guarantor of eligible assets by reason of the fact that the counterparty owns directly (or indirectly through one or more undertakings) 20% or more of the capital of the issuer/debtor/guarantor (or vice versa), or a third party owns (directly or indirectly through one or more undertakings) more than 20% of the party submitting the assets for repo purposes and more than 20% of the issuer/debtor/guarantor.
The ECB's gradual tightening of the eligibility criteria reflects its growing concern that increasingly risky assets are being submitted as repo collateral, exposing the ECB to losses - both potential and actual - running to billions of euros. With the quality of the underlying collateral in many ABS transactions deteriorating and potentially subject to rating downgrades, it is widely expected that the ECB will begin to demand greater disclosure by banks using the repo facility about the assets underlying the ABS submitted as collateral.
Despite the threat of greater scrutiny of ABS collateral by the ECB in future, the prospects for a return to more traditional, investor-funded transactions are, in the present market, slim. With around 95% of all 2008 European securitization issuance used as collateral for ECB repo purposes, there appears to be little appetite to test the public market, either on the buy or sell-side. Market participants are now calling for a Eurozone version of the U.S. Term Asset-Backed Securities Lending Facility (TALF) to help drive primary market issuance in Europe. Given that many member states (including the U.K.) are now developing their own TALF-like schemes, any further restrictions placed on access to funding through the ECB's repo operations may have the desired effect of kick-starting the ABS market in Europe.
McCaw could be reached at +44 (0)20 7919 1617 or katie.mccaw@bakernet.com. She is part of the structured capital markets team in Baker's London office, specializing in the regulatory aspects of securitization and structured capital markets transactions.
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