The ABS hangover, Eurosystem-style | FT Alphaville

The ABS hangover, Eurosystem-style

The ECB announced some updates to its General Documentation on Wednesday. The item on ABS modifications caught our eye:

Seventh, a new information requirement for counterparties has been established (Section 6.2.3) which places the onus on the counterparty to inform the Eurosystem (i) one month in advance of any planned modification to an asset-backed security which it has submitted as collateral and (ii) upon submission of an asset-backed security, of any modification made to that asset in the six months prior to its submission, if the asset-backed security is own-used.

The move was first announced last April, and it represented a toughening up of the rules around ABS collateral for borrowing from the ECB. The update therefore isn’t so much a surprise as a reminder of one of the ongoing, but less spoken about, hangovers of the crisis.

Let’s remember that it was only six months ago that the potential scale of the problem was made potentially worse:

The Governing Council has reduced the rating threshold and amended the eligibility requirements for certain asset-backed securities (ABSs). It has thus broadened the scope of the measures to increase collateral availability which were introduced on 8 December 2011 and which remain applicable.

The ratings thresholds were lowered with haircuts of 16, 26, and 32 per cent used to mitigate risk to the ECB depending on the type of ABS. We’re less worried about any residual risk to the ECB (after all, these are large haircuts) and more worried about the crutch allowing this collateral gives banks with duff assets. It no doubt makes them appear healthier than they are.

Over to an ECB paper (from 2009), entitled “The collateral frameworks of the Eurosystem, the Federal Reserve System and the Bank of England and the financial market turmoil” to clarify what the term “own-use”, as referenced above, is referring to:

Specifically, the Eurosystem accepts only ABSs that are based on true sale and are bankruptcy-remote from the originator. Because these requirements should in principle ensure remoteness between the issuer and the originator, the Eurosystem allows counterparties use ABSs that they have originated themselves and retained on their balance sheet (so-called “own use”) and counterparties have made active use of this possibility.

That is, the assets underlying these securities come from the originating bank — not unusual. But then rather than the ABS being sold to investors, the bonds are used as collateral for borrowing from the ECB. This is also became something of a norm after the crisis struck and authorities circled the wagons.

The update to the ECB’s General Documentation helps with the information asymmetry and conflicts of interest with this type of collateral, as the banks know a lot more about the ABS (than the ECB) and may have certain rights to swap the underlying assets in and out of the issuing vehicle — it being in the banks’ interest to put the worst possible assets in there. The underlying assets themselves might also be modified, e.g. loan terms renegotiated.

The same 2009 ECB paper that defined “own-use” points out the different stances of monetary authorities on the eligibility of ABS as collateral pre-crisis:

Once the crisis struck, the Eurosystem’s more accommodating stance on ABS was particularly handy — this is the where the “crutch” comes in — but it isn’t risk-free:

…the ability to use “own use” ABS as collateral allowed Eurosystem counterparties to mitigate their funding liquidity risk effectively when ABS markets closed up. At the same time, this “own use” has been a source of high risk for the Eurosystem, and, going forward, is complicating the task of getting the euro-denominated ABS market to function properly again. The Federal Reserve does not allow “own use” of ABSs as collateral in its TAF and PCF operations.

The stance was so darn useful that ABS issuance in Europe actually went up in 2008 and 2009, increasing the amount of eligible collateral of this type:

A lot of it was duly pledged to the ECB:

The above are the most up-to-date graphs we could find. The effect of the second three year LTRO won’t be in there, so we don’t know what it did to “own-use” ABS issuance, but it should be interesting given the loosening of credit standard requirements for the securities in June.

As a reminder, here are the latest ECB liquidity providing operations, where the last column is in millions of euros, and the second to last column is the maturity in days of the operation:

Another related trend is increasing home bias in collateral, but this will include loans and sovereign bonds too (from an August 2012 note):

What’s going to happen to all these ABS that were made-to-order as collateral? Can they be sold in private markets? What we wouldn’t pay to know the weight-average life of the ABS in the Eurosystem collateral pool, let alone the weight-average rating… sigh.

Related link:
Another ECB collateral BBBackstop – FT Alphaville