In the past year or two the European Central Bank (ECB) has been vocal in supporting the European asset-backed securities (ABS) market and pointing out the benefits that a fully operational market can bring to the financial system.
However, this has been all rhetoric and no substance – until last month.
A joint paper from the ECB and the Bank of England set out a detailed explanation of how the two banks saw the ABS market working, how it could provide funding and capital benefits for banks, as well as appropriate investment opportunities for long-term investors. The paper then called for a normalisation of capital charges for banks and insurance companies that invest in the asset class, in comparison with equivalent charges against other low-risk asset classes, specifically covered bonds.
The following week, however, ECB president Mario Draghi went even further, announcing that it had “decided to intensify preparatory work related to outright purchases in the ABS market to enhance the functioning of the monetary policy transmission mechanism”.
No additional details were provided, so in the absence of any guidance, what do we think Mario should spend his money on, and how?
Firstly, we think he should focus on primary market, new-issue bonds only. The secondary market is well supported from the existing investor base, and if the ECB stepped in here in any meaningful way then it could easily dominate the market.
This would make it hard for other investors to find bonds, and in the long-term increase illiquidity.
This would also be at odds with its stated aim in the joint paper of a fully functioning market.
There would be little non-residential mortgage backed securities (non-RMBS) paper available that conformed to their reporting requirements, and it would also only provide secondary support for the transmission mechanism by tightening spreads, as opposed to actually passing any liquidity benefits through to the real economy.
The only guidance so far on which assets classes it would look to buy has been “real economy oriented, oriented towards non-financial companies of the private sector”.
We know Mr Draghi wants to focus on small- and medium-sized enterprises (SMEs) funding. However, this is not a material part of the market (¤87bn of more than ¤1trn) and to get significant volume he will have to look at auto loans, credit cards, other consumer debt but primarily, residential mortgages (more than 50 per cent of the market).
Unfortunately we can foresee an announcement that rules out RMBS to start with, which we think would be a significant mistake.
There’s also the question of whether the ECB should focus on senior bonds only. The banks do not need funding – they have had plenty of that already, and the aim here is to get that funding directly transmitted to the end user.
The banks do need capital, though, and a significant benefit of this programme could be to provide that by effecting proper risk transfer and capital relief.
However, it would be a big step for the ECB to go from funding senior bonds through repo to directly buying mezzanine and junior bonds.
That said, the market for these supporting tranches has performed well, and there would be a competitive external buyer base, particularly for deals where the ECB is buying some of the senior bonds.
So perhaps by buying senior positions only, the market can provide the rest of the appetite – though possibly this needs to be supplied initially by the ECB until enough demand has built up.
We should also reiterate that while this would have a material effect on the European ABS market, other initiatives such as lobbying for lower capital charges remain just as important, and that ultimately it is not the role of a central bank to own this type of risk in a normalised market.
Ben Hayward is a founding partner and portfolio manager at TwentyFour Asset Management