The European Central Bank (ECB) has been one of the few advocates of asset-backed securities (ABS) over the past several years. Not only has the central bank verbally supported the usefulness of asset-backed financing, but also it has done so through initiatives to increase transparency of the product or to allow a reasonably broad use of ABS as collateral in the ECB’s monetary policy operations.
The ECB speaks and acts on its conviction that ABS could act as a new transmission channel from corporate lending to the broader capital markets. In a world of bank deleveraging and reduced willingness to lend, especially to small and medium-sized enterprises (SMEs), the ECB advocates asset-backed issuance not only as a funding instrument, but also as a way to transfer risk to other capital market participants and relieve banks from having to use expensive capital for their lending business.
By announcing a dedicated purchase programme for asset-backed securities (ABSPP), the ECB moved one step forward in its support of this asset class. The programme is designed to buy investment grade senior and guaranteed mezzanine tranches of “simple and transparent” eurozone ABS. The eligibility criteria broadly match the collateral rules used under the ECB’s monetary instruments, though asset classes like commercial mortgage-backed securities (CMBS) are excluded from the programme.
Reviving Europe’s ABS market
Revitalising the frozen European ABS market to support lending to the real economy was one explicit aim of the ECB when it first published the idea of directly purchasing ABS. However, when speaking about the ABSPP and its companion covered bond purchase programme, along with the ECB’s targeted longer-term refinancing operations (TLTRO) funding to banks, ECB President Mario Draghi explicitly highlighted a “sizeable” impact for the ECB’s balance sheet. One could easily conclude that the ECB would use both purchase programmes primarily to provide liquidity to banks, ease credit spreads and support the central bank’s goal to anchor inflation expectations in an environment where eurozone inflation rates are edging closer to zero as opposed to the ECB’s target of close to 2%. Although Mr. Draghi has not specified what exactly “sizeable” means for its asset purchases, he recently made it clear that the ECB plans to increase its balance sheet back to March 2012 levels, i.e., lifting it by approximately €1 trillion to €3 trillion.
Another programme objective complicates matters
Since the take-up of TLTRO cannot be actively managed by the ECB but is rather a decision of participating eurozone banks, the only way to achieve a balance sheet increase is for the ECB to buy assets actively in the market. However, the key risks associated with sizeable purchases in the European ABS market are the possible crowding out of established investors and suppressing of interest in the asset class from potential new entrants. Aggressive and sizeable buying in Europe’s relatively small secondary and primary ABS markets could compress spreads to levels where investors are no longer compensated adequately to invest in such a research-intensive asset class. Participating in a particular transaction with large volumes could also lead to even lower liquidity for individual ABS bonds, assuming that the ECB does not intend to trade actively in the market but rather holds the securities over the long term.
With that in mind, the volume of eurozone ABS bonds that qualify for the ECB’s ABSPP, are placed currently with investors and are traded in the secondary market is rather low (see Figure 1). Even if the ECB participates in upcoming new issuance, the volumes available for purchase are limited.
The only way to achieve large buys without crowding out other investors is to buy currently retained ABS from banks. For such purchases, however, the ECB requires that at least parts of the retained issuance need to be placed with investors. This might hinder buying of such deals as many ABS deals were not originally structured for a broader placement and require a more investor-friendly restructuring before selling can be considered.
At the same time, the incentives and the willingness for banks to sell these tranches outright to the ECB might be limited, as the option to fund these tranches cheaply ‒ through either deposits or the ECB itself ‒ is considerably more attractive. In cases where banks currently use retained ABS as collateral with the ECB to obtain central bank funding, the ECB’s balance sheet impact would be neutral as it essentially would be a transfer from one balance sheet item to another.
We believe that the ECB will not likely be able to accomplish the two divergent goals of reviving the ABS market and buying ABS in size at the same time. At this stage, it is unclear which direction the ECB will take and where priorities will be set.
A possible road map
We believe reviving the ABS market is the better near-term goal, and that the primary target of the ECB’s buying programme should be the new issuance market. Purchases in the secondary market might be a small add-on; however, the volume of ABS traded in the secondary market is too small to achieve reasonable amounts without drying out the liquidity in this market segment. Participating in new issuance should be limited to 20%‒30%, rather than the 70% limit defined by the ECB. With such a limited investment, the ECB could ensure that public demand and investor appetite for a particular ABS bond would determine the price, rather than the ECB acting as a price setter.
Given the temporary nature of the ECB’s involvement in buying ABS, we believe that the focus of the ECB should be on establishing and supporting an environment that ensures frequent issuance and healthy investor appetite over the long term. Over the secular horizon, this goal could be supported by promoting a regulatory environment that ensures a more neutral treatment of ABS relative to other asset classes, such as covered or corporate bonds, and attracts both issuers and investors to the ABS market. This may include not only funding, i.e., the senior part of the market, but also investor participation in mezzanine/subordinated tranches, which would help ensure risk transfer and capital relief for banks.
The balancing act
For the ECB, the ABS purchase programme might be a suitable next step for credit easing and for preparing a potentially broader quantitative easing programme that includes the more liquid government bond markets; however, buying ABS in any meaningful size would debilitate the market, rather than revive it. We believe that the ECB should use the ABSPP specifically to support the transmission channel from corporate lending to the broader financial markets, and should show ways not only for funding, but also for risk transfer in a reasonable regulatory environment.
By not crowding out existing ABS investors, but rather making the asset class more attractive for issuers and investors, the ECB has an opportunity to reach its ultimate goal to spur lending. In our view, if the ECB follows this route, Europe’s ABS market has a good chance to grow in size, improve in liquidity and find market-determined clearing levels for spreads that ultimately match ABS issuers’ and investors’ interest.