ECB. As easy as 1-2-3
What explains the dramatic reduction in the European securitised market in the period since the financial crisis?
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Prior to the Global Financial Crisis (GFC), the outstanding European securitised products market stood at nearly €1 trillion in current face value. The European securitisation market was dynamic and secondary trading was active. There was institutional investor engagement across many types of institutions.
Today, by contrast, the investor-owned European securitised market is only €267 billion1. This 70% reduction in market size occurred during a period when economic growth was positive, and while there was strong demand for spread product investments.
Why then is the European securitised market so much smaller today? The answer is as easy as ECB.
The beginning of the end
During the GFC liquidity in the bond markets dried up. European banks, and UK banks, that had traditionally used securitisation to finance their mortgage lending operations, were left with a substantial amount of loans on their balance sheets. These on-balance sheet mortgage loans were not efficient from a return perspective, without the financing from securitisation.
So, to provide relief, both the European Central Bank (ECB) and the Bank of England (BoE) created lending facilities to address the needs of the bank lenders. Banks would create securitisations, but instead of relying on investors to buy the securities the banks would retain the resulting bonds. The bonds were then pledged as collateral to the central bank (ECB or BoE) through the lending facilities, allowing the issuing banks to borrow at very, very low rates (cheaply) from the central banks.
At the time the facilities were created, the BoE set a limit so that only pre-GFC loans would fit within the financing framework. In other words, once a UK bank securitised loans originated post-crisis (2008), that transaction would be ineligible for the BoE emergency facility.
The ECB, by contrast, never set any origination date limitation; their facility exists to this day, just as it was more than 15 years ago in 2008.
Impact of the ECB
Astute students of asset-backed securities (ABS) strategy may ask why, over the past decade, our non-US ABS investment preferences have been skewed to transactions from the UK. Our answer has always been: “because we don’t like to compete with the ECB”.
Some may, mistakenly, assume that we are referring to another emergency ECB programme, the ECB’s ABS Purchase Programme (APP). But the ECB’s APP has never been large. At its largest point, the ABS in the programme amounted to only €31 billion, a small fraction of the market. We are, in fact, much more concerned with the impact of the lending facilities.
Eurozone banks receive very cheap financing from the ECB facilities when they retain bonds issued from their securitisations. This cheap capital explains why so much of the securitised “issuance” in the EU is issued by banks. But don’t confuse issuance with supply for investors - the banks are generally issuing, but RETAINING the bonds, and using the bonds to pledge as loan collateral with their central bank.
The current outstanding balance of European securitisations that has been retained and pledged is a staggering €679 billion. In 2023 alone, nearly €100 billion of securitisations were retained by the bank issuers, more than half of all bonds created. This retention really distorts markets.
As an example, prime mortgage securitisation in the UK totalled €10.7 billion in 2023 and €8 billion of that was distributed. By contrast, in the Netherlands, €12.4 billion was issued, but only €2.4 billion was distributed. France was even more extreme with €50 billion issued and only €0.5 billion distributed2. This retention severely constrains access to supply, and for investors constrained to EU securitised exposures, supply is very constrained and yield spreads are excessively tight as a result3.
The programme put in place in 2008 to deal with an acute GFC-driven bank problem, is now consuming nearly 75% of all issuance.
Subsidy…
Securitised markets are now characterised by strong and increased demand, and tight yield spreads, and yet banks are still retaining the lion’s share of issuance. In a recent Spanish mortgage, which issued several billion euros of eight-year weighted average life, AA rated senior bonds, the coupon on the issued bonds was a very, very low EURIBOR+15bp. In our view, a 15 basis points (bps) premium over government debt for this bond is extremely low.
Given the longer spread duration and the AA rating, this bond would likely require a risk premium between +100 bps and +150 bps in the secondary market. This would create a price discount of 6 to 10 points to the par issuance level, based on a market-driven risk premium. This discount seems to point to the banks charging loan rates that are inadequate and below what capital markets would charge. The ECB is not pricing for risk, they are subsidising the mortgage lending markets. Currently, the charge the ECB makes for financing is around 65 bps. This is not as low as 15 bps, but neither is it 100 bps or 150 bps.
The securitisation market imposes discipline on lenders to make loans at market clearing rates, and in general does a good job of risk-based pricing for those loans. Even in the US, the government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac are required to sell risk into the public markets, helping to establish the “validity” of the guaranteed fees they charge.
In our view, you have two issues here. First, the central bank lending facility for eurozone ABS looks a lot like a subsidy to the EU consumer. The below-market charge, which in effect supports below-market rates, could represent inappropriately priced risk, or potential loss for the ECB. It reduces lending discipline, which arguably makes banks riskier.
As well, the facility distorts the securitised market and reduces supply. This leads to questions about ability to scale, competition and, if the level of yield spreads and volatility today reflect the future, whether this facility should end. But, until the programme goes away, eurozone ABS will remain scarce and overvalued, and European borrowers will be receiving loans at more favourable rates than a disciplined, market-based approach would suggest.
The retention of 75% of the European securitised market suggests there is a strong financial or political incentive to do so. We believe there is likely an incentive to continue to provide this support to consumers, and that any material change would be economically stressful and would force a fairly material re-pricing of what is today a much less transparent market. But we also believe it’s prudent to be aware that markets do not reflect real clearing levels.
1 European ABS: What’s Left, JP Morgan Research.
2 European SF Weekly Data Addendum, 12 August 2024, BofA Global Research.
3 This is particularly acute for mortgage assets, which require less capital. European banks do sell ABS backed by consumer loans, but this is a much smaller asset class than mortgages.
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