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The Trojan Horse of Europe's Capital Markets Union, Part V

The securitizations saga continues. After months of negotiations, the European Union has brought out two compromise proposals, supposedly addressing concerns about public rationale and entry requirements. But do they really? Ewald Engelen and Anna Glasmacher are not impressed.

Our last episode of the continuing saga on the attempt of the European Commission to set up a market for 'simple, transparent, standardized' (STS) securitizations — repackaged mortgages — under the umbrella of a so-called 'Capital Markets Union' (CMU), was published on this plaform just before the summer. It described the public hearing held in the European Parliament, presented the main bones of contention (ie. the amount of 'skin in the game' originators should hold on their balance sheets) and briefly discussed the two draft amendments that were set up by the two 'rapporteurs' on this issue, Mr. Tang and Mr. Zalba, before concluding that Mr. Tang was the only one approaching the topic from a public interest perspective and could hence use all the support he could get.

Six months later, the negotations between the political parties in the European Parliament and the so-called trialogues between the European Council, the European Parliament and the European Commission have resulted in two new compromise proposals. One deals with the STS securitization market as such and the other with the amended capital requirements related to the ownership of those STS securitizations. There is a good chance that both documents will be passed today (December 8) to ensure their activation as of January 1, 2017.

In this contribution, we will not be able to do full justice to all the legal compromises that have been hammered out by the different parties involved. Instead, we will zoom in on only those parts of the texts that deal with the three main issues we have raised in the earlier episodes. These issues are: first, that there was no good public rationale for setting up a market for STS securitization in the first place; second, that it was all about lower capital requirements; third, that 'skin in the game' requirements were too low.


Our main bone of contention was that there was no good public rationale for a European market for STS securitizations — although we did of course acknowledge that there were excellent private reasons for such a market. Lower capital requirements, for example; higher profite; the chance to do monetary 'normalization' for the ECB and to further the financialization of homeownership in those parts of Europe which have so far escaped it.

There was no good public rationale for a European market for STS securitizations — of course, there were excellent private reasons

On paper, it was all about the construction of a Europe-wide market based system to diminish the bank dependency of the European economy for the allocation of capital — and was thus meant to kickstart growth and employment again. In practice however, the first element of the CMU that the commission chose to realize was all about constructing an inter bank market to aid the mortgage funding of large European banks. Hence, the market would only serve to reinforce European dependence on the banks.

This issue is only cosmetically addressed in the two compromise texts. The text on capital requirements, for instance, begins by noting that:

'Securitisations are an important constituent part of well-functioning financial markets insofar as they contribute to diversifying institutions' funding sources and releasing regulatory capital which can then be reallocated to support further lending...'

The trialogue resulted in the addition: 'provided that financial stability is guaranteed and that the capital is used to fund the real economy rather than for speculative activity.' Sentences like these, which return at the end of the document, indicate suspicion on the side of at least some MEPs concerning the background story behind the CMU, while at the same time relying on the ability of financial insiders to 'guarantee' that the extra funding sources generated by STS securitization are used to fund the 'real economy' and not 'speculative activity', a notoriously hard to make distinction.

In the other document, the one dealing with the establishment of the STS label, the following clause was added to the original text to address this concern:

'The originator and sponsor shall publish information on the long-term, sustainable nature of the securitisation for the investors, using environmental, social and governance criteria to describe how the securitisation contributed to real economy investments and in which way the original lender used the freed-up capital.'

The compromise 'addresses' public concerns by means of a toothless administrative requirement

Instead of simply outlawing large-scale mortgage securitisation, which, as we argued in the earlier episodes, merely leads to the misallocation of scarce capital in the form of asset inflation (housing bubbles) and the structural dislocation of national political economies, this compromise in essence gives banks what they want. That is to say: it provides them with a political blessing of large scale mortgage securitization — while at the same time 'addressing' public concerns by means of a toothless administrative requirement. The returns on securitizations simply end up on the liability side of the banks' balance sheets, allowing them to pick any corresponding assets to claim that it fed the 'real economy' — and was not used to fund 'speculative activity', whatever that may be.

Capital requirements

As we demonstrated in our earlier episodes, the real goal of the STS proposal — lower capital requirements for residential mortgage-backed securitizations (rmbs) — was not only deeply hidden in layers upon layers of complicated legalese; it was also something that directly went against the grain of the reregulatory initiatives that were taken after the Great Financial Crisis. As such, the STS proposal clearly was the high-water mark of the post-crisis wave of re-regulation and hence required an open and democratic discussion among all interests involved. Instead, what we got was an obvious example of backroom deals, occluding storylines and extensive lobbying.

Judging by the compromises reached, these issues have not been substantially addressed either, indicating that the critics of securitization have failed to withstand the massive lobbying on this issue by industry insiders. The document on capital requirements merely reiterates the point made over and over again in the earlier drafts that European mortgage securitisations.

'Exhibited better performance than other securitisations during the financial crisis, reflecting the use of simple and transparent structures and robust execution practices in STS securitisation which deliver lower credit, operational and agency risks.'

And hence should be rewarded with lower capital requirements for STS securitizations, including a ten percent risk weight for the "senior" tranches kept on the balance sheet of the originator to conform to risk retention requirements (see below).

Ewald Engelen & Anna Glasmacher

The STS proposal required an open and democratic discussion among all interests involved. Instead, what we got were backroom deals, occluding storylines and extensive lobbying.

While making lower capital requirements only available to STS securitizations was the intention of the lawmaker from the outset, what has been added over the course of the negotiations are the requirements to which STS securitizations have to conform in order to be eligible. Only synthetic securitizations (ie. securitizations that 'mimic' real securitizations through credit default swaps) are now legally excluded, as are re-securitizations. 

This state of affais suggests that the opponents have, in essence, bought into the narrative that there is nothing intrinsically wrong with securitizations; that European securitizations were in essence safe; that securitization cannot be causally linked in any way to the Spanish, British and Dutch housing bubbles; that they can play a beneficial role in the allocation of capital and can stimulate growth and jobs, provided that they are constructed in a 'simple', 'transparent' and 'standardized' way. 

As the sentence quoted above betrays, however, there is little difference in design and construction between securitization as envisioned by the European Commission in its STS proposal, and securitization before the crisis. As the compromise text claims, it was due to the 'simple', 'transparent' and 'standardized' nature of European securitizations before the crisis that 'credit, operational and agency risks' as well as defaults were so much lower than in the US. One would be hard-pressed to find a more explicit acknowledgement that STS securitizaion is basically a complicated charade allowing banks to do exactly what they did before the crisis.

STS securitization is a complicated charade that allows banks to do exactly what they did before the crisis

Skin in the game

The issue that drew most of the political flak in the hearings and subsequent negotiations was the amount of 'skin in the game' that lenders should have in the STS securitizations they sold on to external institutional investors. The opening bid of the European Commssion was five percent; meanwhile, ngo's such as Finance Watch wanted a minimum threshold of 20 percent. Amidst vehement protests from the industry, rapporteur Tang was willing to include exemptions. However, he did hold on to a 20 percent threshold, claiming that that was the industry practice among large asset managers — the main potential buyers of STS securitizations. 

Again, it seems the industry won the day. The key article reads:

'The originator, sponsor or the original lender of a securitisation shall retain on an ongoing basis a material net economic interest in the securitisation of not less than 5% or 10% depending on the retention modality chosen in paragraph 2.'

The very low opening gambit of the commission, itself reflective of the striking extent to which law preparation in the EU context is subject to lobbying and co-decision making by industry insiders through the expert system especially in the field of finance, has survived the lengthy parliamentary control process basically intact. The only additional compromise critics like Mr Tang and Finance Watch have been able to wrestle from the proponents of the STS proposal is that the European Banking Authority (EBA) together with the European Systemic Risk Board (ESRB), has the prerogative to set retention requirements at 20 percent in the light of 'market circumstances':

'The EBA in close cooperation ESRB shall take a reasoned decision on required retention rates up to 20% in light of market circumstances as part of the mandate given to them...'

It is as if the European Union is designed to disenfranchise citizens and enfranchise big corporations

Obviously, granting regulators the mandate to increase risk retention rates in the 'light of market circumstances' is incomparable to a twenty percent risk retention rate across the board as a minimum. The only reason the attempt to impose such a floor has failed is that it would have made securitizations too expensive for originators, even with 'substantially lower' capital requirements, given unchanged banking business models which still require two digit return on equity figures.

This says much about the strengths of the interests that are behind this proposal, as well as the inability of the European Parliament to block a proposal which has the unanimous backing of the commission and its experts. That is perhaps the most disconcerting conclusion to be drawn from this year long saga: once a legislative initiative has been launched from the bossom of the commission-centred and heavily lobbyist infiltrated expert-system, there is not much democratic representatives can do — neither in the field of finance and banking, nor in that of agrifood, Big Pharma and the car industry. It is as if the European Union is designed to disenfranchise citizens and enfranchise big corporations: from one (wo)man one vote, to one euro one vote. Frightening.