Monday, May 6, 2013

ECB continues to do everything it can, except require transparency, to restart structured finance

The Wall Street Journal reports that the ECB is continuing to do everything it can, except require transparency, to restart structured finance as it sees structured finance as crucial to reviving lending to small and medium size eurozone companies.

Regular readers know that in the absence of observable event based reporting on the performance of the underlying collateral, buying or selling structured finance securities is nothing more than gambling on the contents of a brown paper bag.

Leading up to the financial crisis, this gamble did not work out to well for buyers.

The realization that Europe’s troubled economies are faced with long and protracted weakness has encouraged European Central Bank President Mario Draghi to suggest a long-term solution to unlock credit to their cash-starved businesses.... 
Mr. Draghi on Thursday said the ECB was working to promote a funding market for asset-backed securities, which allow banks to pool together shorter-term debt they have sold–such as auto loans, credit cards, and residential or commercial mortgages–and sell those pools as a single package to investors.
The ECB wants ABS to be a sizeable source of bank financing that will encourage lending to small-to-medium sized companies, or SMEs....
Your humble blogger thinks that there is a significant role for structured finance to play in supporting the lending to small-to-medium sized companies not just in the eurozone, but globally.

The issue is what does it take to restart the structured finance market?

I have been saying since the beginning of the financial crisis that what it takes to restart the structured finance market is disclosure that allows investors to know what they own or know what they are buying.

The only way to achieve this level of disclosure is by having observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the beginning of the next business day.

With this reporting, investors have access to current collateral performance so they know what they own or know what they are buying.

Without this reporting, investors are simply guessing at what is a readily knowable fact.  A knowable fact that the sell-side knows and uses when it trades against the buy-side (see WSJ article on Goldman and Senderra Funding).

Your humble blogger predicted at the beginning of the financial crisis that the buy-side, except for hedge funds who charter is to gamble with their investors' money, would stay away from structured finance until this informational advantage was eliminated.

To date, despite 5+ years of zero interest rate and quantitative easing monetary policies, this prediction has been accurate.
At the moment, banks aren’t lending to SMEs. Without financing, these companies can’t grow: can’t hire employees, can’t invest in new projects. This is a serious problem in Europe, especially in the southern countries facing multi-year recessions and unemployment at depression levels. 
The ECB cut its main interest rate to a record low 0.5% Thursday, with the idea that cheaper money will help encourage a greater flow of money, eventually boosting the economy. 
But getting this extra cash to the real growth engines, i.e. companies, is not as easy as cutting rates. This is where ABS comes in. 
“Securitization can play a key role in funding Europe’s growth since it provides funding which matches the cash flows of the securitized assets and carries little or no refinancing risk, which is an important component of Basel III capital requirements,” said Rick Watson, head of capital markets at the Association for Financial Markets in Europe. 
But at the moment, these products still suffer from an association with bad deals sold before the financial crisis, like U.S. subprime mortgages, a type of ABS that catalyzed fears across the banking system. 
Since then, investors, especially those in Europe, have yet to regain confidence in the product....
Investors staying away from structured finance securities isn't a question of confidence, but rather the result of a costly lesson.  Investors know that while the product retains its information asymmetry it is good for Wall Street and bad for them.
“We’re seeing a market that is slowly grinding to a halt. The market isn’t going to disappear, but the risk is that it becomes small, bespoke, and reverse-inquiry driven. That is, not a real solid market for funding the European economy,” said Ian Bell, head of the Prime Collateralized Securities Initiative.
PCS was launched in November with the aim of labeling ABS deals that comply with a set of standards relating to quality, transparency and simplicity. Mr. Bell noted the good news was PCS labels have been granted to 12 of all qualifying ABS transactions. The bad news was this is 75%-80% of what has been sold to investors.
As noted earlier, a PCS label is nothing more than sticking lipstick on a pig.  The label is awarded to structured finance securities with the same transparency as opaque, toxic subprime mortgage-backed securities.
The first step for ABS is restoring confidence....
Confidence in the financial system has always been associated with transparency.

Confidence is the result of investors having access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Confidence results because investors trust their own assessment.
The ECB said did not say how close it was to activating any program. If they do launch one, it wouldn’t be the first crisis-era plan to buy collaterized bank bonds. ... 
“The experience with the first covered bond purchase program can be useful. It was the announcement there that produced the most effect. The implementation was indispensable; without it, the effect would have been undone. But if the ECB were to announce something similar for ABS, it could also have a positive short-term impact,” said Francesco Papadia, former director general for market operations at the ECB....
General expectations are that this will not happen soon. Rabobank analysts summed up the gist of opinions: “We would still view such action as some way off if it does indeed take place at all.” 
But Mr. Draghi’s publically sounded what other officials have been stating for four months. Something needs to happen, and this is a realistic path. 
“It would be a big disappointment if nothing comes of this… I’d be surprised if nothing material develops,” Mr. Papadia said.
What is likely to result is the ECB becomes the gambler of last resort and takes onto its balance sheet more opaque, toxic securities.

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