The Trojan Horse of Europe’s Capital Markets Union (CMU)

Today European Commissioner Jonathan Hill presented his long awaited action plan for the creation of a Europe-wide Capital Markets Union in Brussels. A key plank of this Union is the attempt to resuscitate the market for securitized mortgage loans, which, due to its role in igniting the financial crisis, has been moribund since the outbreak of the crisis. The aim of the Commission is to create a new market for safe securitizations based on simple, transparent and standardized products. In the article below Ewald Engelen and Anna Glasmacher, both from the University of Amsterdam, critically discuss a draft proposal to that effect, that they have obtained through wikileaks. The authors argue that the proposal is based on faulty assumptions, is dangerous in that it furthers financialization and that it hence should be stopped.

Comments on the draft ‘Proposal for a Regulation of the European Parliament and of the Council on a European Framework for Simple, Transparent and Standardised Securitisation’ By: Ewald Engelen and Anna Glasmacher, University of Amsterdam, September 30, 2015   Europe’s Capital Markets Union (CMU) is rapidly gaining traction. Announced in November last year, the new European Commission under Juncker has quickly capitalized on the more buoyant economic mood among its member states to kick-start a series of ‘public’ consultations on what it deems to be the key priorities of the panoply of proposals included in the original Green Paper, written under supervision of Commissioner Hill. The premise underlying the CMU is that the striking economic performance difference between the US and the Eurozone is caused by the overreliance of European economies on bank lending rather than market lending, as is the case in the US. An insight that the Commission took straight from the private industry report ‘Bridging the Growth Gap’, that Boston Consultancy Group, commissioned by the main Brussels-based financial lobbyist, Association for Financial Markets in Europe (AFME), had produced. And since European banks are still rebuilding their balance sheets after the shock of 2008, their ability to finance the real economy is impaired. Hence the perceived need to open up an alternative financing channel, which is what the CMU is about. To do so it aims to integrate European capital markets, including countries which so far have been saved from the excesses of financialization, diminish administrative burdens and restart European securitization markets to increase the accessibility of new funding for European banks. The official legitimation is that this would predominantly serve the credit needs of Small and Medium Sized Enterprises (SMEs). This abbreviation appears no less than 49 times in the Green Paper, surpassing by far any other term, illustrating its importance.

Funding tool for banks

The surprising thing to note is that since the launch of the CMU, the Commission has redirected its efforts mainly at the securitization part of the proposal, which appears only at page 11 of the Green Paper and is formally not about constructing an alternative credit intermediation channel to bank finance anyway but serves mainly as funding tool for banks and as such only reinforces the dependence on bank finance. In other words, securitisation helps banks to find alternative sources of funding but is not in and of itself an alternative to bank lending. Nevertheless, the ‘public’ consultation on this part of the CMU has already finished, has been worked into a revised proposal by the European Commission and can now be downloaded from wikileaks as a draft legislative proposal, including an explanatory Memorandum laying out the rationale behind the draft. The aim is to get it through European Parliament as quickly as possible in order to be able put it in force as of the first of January, 2016, which, we surmise has everything to do with the need to refinance existing securitisation which, in general, have a maturity of five to seven years.
The aim is to get it through European Parliament as quickly as possible
The document we discuss below is revealing in that it betrays the major extent to which the thinking of the European Commission has been infected by the interests of banks and as such bodes ill for the willingness of the Commission to keep momentum in its reregulatory effort after what was arguably the biggest financial crisis since the 1930s. Below we critically discuss a number of key passages of the Memorandum preceding the draft proposal to demonstrate that. We do so by first looking at ‘Claims’, then at ‘Aims’, and, third, at ‘Means’. Under the heading ‘True aims’ we finally say something about the extent to which the Commission has been ‘captured’ by the banking industry.  
  1. Claims: feeding the real economy

The official story is that securitization is good for the economy. That is what the first sentence of the Memorandum states: ‘The development of a simple, transparent and standardized securitisation market constitutes a building block of the Capital Markets Union and contributes to the Commission’s priority objective to support job creation and a return to sustainable growth' (p. 2). Without any empirical evidence this causal claim is repeated over and over again in the document: securitization would help economic growth and job growth, with ‘sustainable’ being meant to refer to real economic growth in contrast to financialized growth. It pays to look a bit closer at this causal claim since before the crisis securitization in Europe was predominantly used to finance mortgage loans. SME-loans were only a marginal source of assets used to back securitizations. Of the total stock of securitizations in Europe at the end of 2008 to the tune of € 1700 bn, over € 1000 bn were mortgage securitizations, while asset-backed securities (ABS) made up less than € 200 bn of that total; securitised SME-loans are somewhere in there, but so are car loans, student loans and credit card debits.   Total stock of securitizations ultimo 2008, in billions € afbeelding Ewald 1 Source: European Securitization Forum 2008, p. 9.   The reason is that mortgage loans are much more prevalent, much more standardized, much better known among end investors and hence much more profitable than SME-loans. Since these differences are not addressed in the proposal, mortgage lending will post crisis again be the main beneficiary of the sanitized securitization market the Commission aims to construct, implying that most of the extra funding will end up financing already existing assets (real estate), resulting in asset inflation and, ultimately, the very same housing bubbles that, during the crisis, proved to be such a drag on economic activity in many Eurozone member states. In other words, the causal argument for securitisation is not only weak but the empirics actually suggest the reverse of what the Commission claims and intends: not sustainable economic growth, but Ponzi-like financial instability. This raises pressing questions about the true intentions of the Commission as well as its timing, on which more below.
Empirics actually suggest Ponzi-like financial instability
Similarly, the memorandum talks of securitization... ‘providing banks with a tool for transferring risk off their balance sheets (...) and free up more capital that can then be used to grant new credit including SMEs’ (p. 11). Again, it is hard to take those claims seriously after a crisis that clearly demonstrated that, despite endless assurances from bankers, regulators and financial economists that securitization has dispersed risk among a much wider array of financial institutes and had thus made the overall financial system more robust, risks were instead highly concentrated raising the issue of banks being too-interconnected-to-fail. Seven years after the crisis one would have expected any proposal to again allow banks to transfer risks from their balance sheet to at least demonstrate why this time it is different and how the issue of interconnectivity is solved. Nothing of the sort is to be found here. Further to the unsubstantiated claims made for securitization in the memorandum is the expectation that standardization would reduce ‘operational costs’ for the buyers and sellers of securitization, which ‘should have an especially beneficial effect on the costs of credit to SME’s.’ This too beggars belief because even when one accepts that standardization would lead to lower operational costs on the side of the securitizer (standardization would lead to a less complex and hence more industrialized and cheaper securitization machine) as well as that of the ultimate buyer (standardization, simplicity and transparency would diminish search and assessment costs), it doesn’t follow that these cost gains work their way through to the ultimate borrower. Banks have proven to be well able to pocket those sorts of gains themselves instead of passing them on to customers. In other words, without more invasive legislation in place to force banks to do so this is mere wishful thinking.  
  1. Aims: removing stigmas

The explicit aim of the framework is to remove the ‘stigma of securitization’ by constructing a legally certified market segment called Simple, Transparent and Standardized securitization (STSS) that differs in some key respects from regular securitizations. The argument behind it consists of two steps. First, that the current ‘stigma’ of European securitizations is undeserved. Second, that the ‘stigma’ nevertheless exists and that it is thus of the utmost importance to create a new securitization label to signal to end investors that European securitizations have nothing in common with US sub prime securitization. The Memorandum as well as the draft Act stress several times that European securitizations have performed much better than US securitizations but that, nevertheless, US securitization have recovered in terms of transaction values whereas European ones have remained subdued. Here is a typical quote to that extent: ‘Since the beginning of the financial crisis, European securitization markets have remained subdued. This is in contrast to markets in the US which have recovered. This is despite the fact that unlike the US, European securitization markets withstood the crisis relatively well with realized losses on instruments originated in the EU having been very low compared to the US' (pp. 2-3; see also p. 7, p. 10 and the CMU Green Paper). The memorandum next presents some data points on default rates of some of the different tranches to demonstrate the fact that indeed default rates on European securitizations have been much lower than in the US. But what the memorandum fails to give, is an explanation for this observation. The suggestion is that it is due to superior risk management by European banks, higher quality of the securitization process itself, or better regulatory supervision.
Banks again have succeeded outsourcing their credit risks to the taxpayer
Actually, the difference between the US and the EU in terms of defaults on home mortgages, because that is what we are dealing with here, can be explained by legal difference between mortgage loans in the US and the EU. Whereas in the EU all mortgage loans are full recourse loans, meaning that the contract gives the creditor full legal protection against payment shortfalls, in the US most mortgage contracts are non-recourse contracts, meaning that the owner-occupier can simply walk away from his mortgage obligations, resulting in a factual default and a quick decrease in value of the mortgage security in question if the scale of default is widespread enough. As it apparently was in 2007, 2008. Add a higher level of livelihood protection in the EU through a more inclusive and more generous welfare state, and the picture that arises is one where banks again have succeeded outsourcing their credit risks to the taxpayer in the form of the court system and the welfare state. Moreover, claiming success for European securitizations is committing the fallacy of composition. That individual European securitizations upheld their value throughout the crisis is not to say that securitization as such did not severely harm the long term interests of households, SMEs and national economies. The real estate bubbles it helped create in countries like Ireland, Spain and the Netherlands have, when they came undone on the backdrop of the credit crunch caused by widespread distrust in interbank markets due to the bankruptcy of Lehman Brothers, forced a substantial proportion of Dutch, Irish and Spanish households to cut back on consumer spending to contain the increasing discrepancies between the nominal value of their mortgage and the market value of their collateral. Together with misperceived and mistimed austerity policies, this has unnecessarily extended the recession and has substantially hurt the long term earning capacities of citizens and economies alike. It beggars belief that a mere seven years after the crisis, an official document of the European Commission would fail to perceive the huge externalities of housing booms and busts sharpened by widespread securitization and would willingly reproduce the industry-meme that there never was anything wrong with European securitizations. Worse, would even attempt to roll out securitizations to member states which have up until now succeeded in avoiding such a fate. From an individual investors perspective the claim that securitization is safe may well be true, but from a citizens’ perspective it definitely is not.  
  1. Means: creating a new market

The way the Commission wants to resuscitate the European securitization market is by cordoning a market for simple, transparent and standardized securities off from a market for securities that are not simple, transparent and standardized, suggesting that that is what was the norm for securitizations before the crisis. What is quite crucial is thus the way in which the legislative draft operationalizes simple, transparent and standardized. Starting with the latter, standardization means a uniform format of the legal prospectus and ancillary documents, in order to roll out the securitization technique across Europe and to lower administrative costs. No more, nor less. Trickier are the requirements for transparency. Here the document speaks of ‘all relevant information’ that should be made available to end investors. It is spelled out as information regarding the prospectus, cash flow data and credit assessments. Moreover, these data should be provided in the form of standardized templates, again meant to reduce the administrative burden and to increase comparability across jurisdiction. Striking about these requirements is that they deal predominantly with the quality of the structure and not with the quality of origination, let alone the quality of the underlying assets. It is as if the flow of knowledge within the securitization chain is cut in two, one part dealing with the creditworthiness of the ultimate debtor (the household), and another part dealing with the reliability of the securitization desk that does the structuring. STSS does not force banks to provide end investors with a full see through of the complete securitization chain including origination and the underlying assets nor does it empower end investors to demand those data from banks.   In light of our earlier comment that individual European securitizations may well have held their value during the crisis but that in aggregate they had caused substantial unintended external damage, the ‘relevant knowledge’ for end investors to adequately assess the future valuation of the securitization at stake should also have included second order requirements, for instance information on the quality of data used by banks to do internal risk assessments. During the crisis it appeared that overly optimistic risk evaluations could be traced to datasets which included only periods of rising house prices. Nothing along these lines is even considered here, turning the open clause into an empty requirement.
The STS definitions give huge leeway for banks to provide their own, minimalist interpretations
Overall, the STS definitions only exclude the worst tricks (hidden ‘reverse seniority’-clauses) and excesses (‘refilling’ RMBSs with worse MBLs) from before the crisis, whereas the information requirements for sellers are overly lenient and give huge leeway for banks to provide their own, minimalist interpretations. Most of the € 1700 billion worth of European securitizations from before the crisis would easily have scaled this threshold.  
  1. True aim: lowering capital charges

This raises the question what the true aim of the draft is. While it is easy to loose track of that, given the weird brew of non-sequiturs and legalese from which it is concocted, the game is given away on page 9 where the document speaks of ‘broad support’ for a more ‘risk sensitive’ capital charge for European securitisations. This requires some explanation of what went wrong before the crisis and what was done about it afterward. In short, Basel 2 allowed banks to asses their own risk exposure and calibrate their capital accordingly. The gaming this made possible resulted in banks -- European much more than US banks -- being severely undercapitalized when the crisis struck and earlier risk assessments proved to be fairy tales. In order to strengthen the ability of banks to withstand market volatility, the Basel Committee of Banking Supervision (BCBS) post-crisis beefed up the capital charges for different assets and put constraints on the ability of banks to use in house risk assessment models. As a result the securitization market dried up in Europe: securitization was simply not profitable anymore. In other words, the flat lining of securitization markets has nothing to do with problems on the demand side, due to so-called 'stigma’s' being wrongly attached to European securitization, but are instead due to the supply side. The regulatory strings attached to securitizations make them simply too costly. Lowering those costs, and hence increasing the gains from securitization, by lowering the regulatory capital charges for securitization as defined by Basle 3, is the true aim of the proposal; ‘The methodology would result in a significant reduction of the capital charge for non-senior tranches of STS securitizations’ [our underlining]. To add, in the next sentence: ‘Technical improvements will also be made to the calibrations for the senior tranches.’ In other words, residential mortgage backed securities which stood at the cradle of the biggest and most global financial crisis ever are again going to be treated as low risk assets by the European regulator ensuring that banks can again kick-start their highly profitable securitization production lines. Hill was quite outspoken about this in his op-ed in the Financial Times: 'To help free up banks’ balance sheets, making it easier for them to increase lending, I am proposing a new EU framework, with lower capital requirements, to encourage simple, transparent and standardized securitization.' This is equal to the pope blessing a weapon of mass destruction. It raises pressing political questions about the nature of the public consultation surrounding this and many other, similar legislative initiatives in Brussels and elsewhere as well as about the extent to which the European Commission has internalized the frames provided to them by the extremely powerful, extremely wealthy and extremely well-connected financial services industry. Corporate Europe Observer has reported that the financial services industry through organisations such as EFSR and Association of Financial Markets in Europe (AFME) spends € 120 million annually on lobbying activities. The memorandum as such mentions the broad support from industry insiders through its public consultation for a series of measures which clearly serve the interests of banks, possibly those of investors, but hardly those of SMEs and citizens, even though the latter are referred to as the main beneficiaries and the ones for whom this is all done, as the opening sentence of the document quoted above makes clear.
This is equal to the pope blessing a weapon of mass destruction
The Memorandum briefly summarizes the outcomes of the public consultations on page 10, where it is, more adequately, referred to as ‘stakeholder consultation’. The text spells out that the Commission received 120 replies that indicated ‘that the priority should be to develop an EU-wide framework for simple, transparent and standardized securitisations’, based on the recognition that EU securitization have held up their value in the crisis and should hence, according to the key financial principle of ‘risk sensitivity’, be treated more lenient than US ones, both by regulators and by end investors. This, thus the Commission in its own summary of the stakeholder replies, apparently glossing over the critical replies by NGOs such as Finance Watch and Progressive Economy: ‘would help the recovery of the European securitisation market in a sustainable way providing an additional channel of financing for the EU economy [read: real estate] while ensuring financial stability' (p. 10). And if the similarities between the phrases summarized here and the ones used earlier by the Commission itself are not a sufficient giveaway for who is truly behind this initiative, data from Eurosurvey give the game away: 110 of the 120 repliers came from the industry itself, with an overrepresentation of British and Belgium-based organizations; the latter, of course, indicating the overrepresentation of the Brussels-based financial lobby. The Memorandum nicely continues with the following sentence: ‘On most issues the input from stakeholders was fully taken into account’ [our underlining] (p. 10). Not mostly, but fully. While under the heading ‘Collection and Use of Expertise’ it is stressed that: ‘Fruitful meetings and exchange of ideas with private sector representatives […] have enriched the debate and understanding of the issues at stake’ (pp. 10-11) To conclude: Hills CMU is a Trojan horse for the interests of a banking sector that is beyond control. For proofs go to the website of the AFME and have a look at their Annual Report, which so much as claims that they have booked a complete victory over their adversaries on the CMU and securitisation: ‘Since June 2015, we have undertaken an outreach program to meet with key policymakers and opinion formers on CMU – including Commission officials, finance ministries and central banks, MEPs and think-tanks. […] We will continue to be active and closely engaged across the CMU agenda, including in areas such as infrastructure, securitisation and SME funding, which are vital to promoting growth. In December 2015, together with Euromoney and ICMA, we will hold a conference in Brussels on CMU. Commissioner Hill is confirmed as keynote speaker, and this event should provide the opportunity for the industry to respond in detail to the Commission’s action plan’ (p. 4).
Hills CMU is a Trojan horse for the interests of a banking sector that is beyond control
Or what to make of the digital announcement of a so-called CMU breakfast in Brussels on the 1st of October, 2015, where the main figurehead of the financial services industry in the European Commission, Commissioner and former lobbyist for the City, Jonathan Hill, was to field questions from financial insiders. The main sponsor? Managed Funds Association: ‘the voice of the global alternative investment industry’, i.e. a lobby organisation for hedge funds. We urgently call upon the members of the European Parliament to stop this attempt to resuscitate securitization markets and further the financialization of Europe. This does not serve citizens through job growth and sustainable economic growth but merely feeds asset inflation, real estate bubbles and bankers’ bonuses. In our opinion, this is not the constituency the European Commission should placate.