Funding for small and medium enterprises and infrastructure became universally acknowledged as the solution to Europe’s problems somewhere around 2012. The sovereign crisis seemed to be receding, a banking union was under construction, and all that was left was job creation and enterprise.
So Europe’s financiers set to work, and soon the proposals were coming thick and fast.
The French central bank sponsored a state-wrapped SME bond; the Dutch did the same with mortgages. Italian and Spanish legislators overhauled covered bond laws to allow other collateral in. Commerzbank issued an SME-backed covered bond; NordLB one backed by aircraft loans. Goldman floated a wrapped dual-recourse instrument apparently to fund a chunk of its trading book. Public institutions including the EIB, the ECB, KfW, and ICO were mooted as possible guarantors for SME ABS.
The advent of Capital Markets Union in July 2014 upped the regulatory ante, and prompted the European Covered Bond Council to come up with its own proposals.
At first glance, these are underwhelming. It proposes two classes of instrument.
One is effectively a structured covered bond with SME collateral – just like Commerzbank’s SME-backed deal.
But the ECBC makes it clear that this shouldn’t be regarded a true covered bond, perhaps in an attempt to head off the vicious internecine fights over nomenclature that preceded and followed the Commerzbank deal.
The second is in all essentials a securitization, but with a guarantee from the originator for the senior tranche, thereby adding in the all-important “dual recourse” element which the ECBC values.
The question is, does everyone else value dual recourse as much?
Two banks, CFF and ING, have already sold full capital stack securitizations with no guarantee, and at least three more are working on such deals. These are essentially what the ECBC is proposing, but without senior guarantee from the originator – meaning without dual recourse.
Dual recourse takes away advantage
Adding a dual recourse feature actually undercuts two of the major advantages to such deals.
These are matched funding and the leverage ratio.
Regulators like securitizations because they introduce no liquidity risk. Even if they are refinanced every five years, in theory a bank can walk away from its securitizations and leave them to pay down over the next twenty – meaning no liquidity or refinancing risk.
Dual recourse to an originator reintroduces liquidity risk, since if underlying assets don't meet payment schedules the originator is on the hook.
On the leverage ratio, banks like the deconsolidation trades because it gets a book of loans off balance sheet. Other than the 5% they are required by regulators to retain, they keep the economics of originating the loans, and the spread between the securitization notes and the underlying loans, but improve their leverage ratio.
Selling only the risk of a transaction, but retaining the low-risk senior tranche (as in a balance sheet CLO, or the ECBC’s dual recourse proposal) throws this advantage away too.
Regulation changes the game
But what changes the game is regulatory treatment. Covered bonds have had exemplary regulatory treatment – justified, in the ECBC’s view, by their dual recourse to assets and to originator, as well as other features such as bullet maturities and a standardised legal framework.
If the ECBC’s two versions of dual recourse secured notes get starkly better regulatory treatment than securitizations today, even if it falls short of full parity to traditional covered bonds, that changes the economics drastically, and will create new demand for such structures.
But if regulators do not like dual recourse as much as the covered bond set think they do, it’s hard to see what the ECBC has brought to the table.