The Trojan Horse of Europe’s Capital Markets Union, Part IV

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Securitisatie Capital Markets Union CMU


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Ewald Engelen watched the livestream of last week’s hearing on the European Commision’s Capital Markets Union and concludes that Paul Tang, rapporteur on the proposal to kickstart the European market for repackaged mortages, has upped the ante after his initial response, has thereby seriously annoyed bankers and their political backers, faces an uphill battle in learning the lessons of the crisis seriously and therefore deserves all the support he can get.

This week the battle of Europe’s Capital Markets Union (CMU) moved to the chambers of the European Parliament Building at the Rue Wiertz in Brussels. The hearing, Monday afternoon, on the Commission’s proposal to construct a market for Simple, Transparent and Standardized (STS) securitizations marked the start of weeks of extensive negotiations (until July 20th) between the different political fractions of the Committee on Economic and Monetary Affairs of the European Parliament. And, after that, between the European Parliament and the European Council, with the Commission as an observer, in the so-called ‘trailogues’. Over the course of this, financial lobbyists as well as ngo’s will use every opportunity they get to influence the outcome — especially financial lobbyists, who outweigh ngo’s in terms of resources and connections by a ratio of ten to one.

Financial lobbyists outweigh ngo’s in terms of resources and connections by a ratio of ten to one

Monday’s hearing started with a short keynote by Commissioner Jonathan Hill, who, in his own inimitable way, laid down the main arguments for the STS proposal. Hill’s speech was followed by two panels, interspersed with questions from the Committee members and responses from the two rapporteurs responsible for collecting and drawing up amendments to the two legal directives dealing with the STS proposal: Mr Paul Tang for the Social Democrats and Mr Pablo Zalba for the Christian Democrats. Strikingly, Mr Hill was unwilling to take questions from the floor, as is the norm in national parliaments, and fled the room right after his speech — so much for democracy in what is arguably the most transparent of the European institutions.

The two panels included two critics of the Commission’s proposal: Daniela Gabor from Bristol University and co-initiator of a letter signed by 86 academics warning European parliamentarians not to let the proposal pass unamended, and Christophe Nijdam from Finance Watch, one of the few Brussels-based ngo’s critically tracking European law making in the field of financial regulation. The other panel members were either industry representatives (Santander, the Spanish lender; Prime Collateral Securities, an industry initiative to standardize securitizations; LBBW, a German state bank) or work for European regulators (ESMA, the market regulator; EBA, the banking regulator).

"Strikingly, Mr Hill was unwilling to take questions from the floor, as is the norm in national parliaments, and fled the room right after his speech — so much for democracy in what is arguably the most transparent of the European institutions"

My aim in this fourth episode of our series on the Capital Markets Union (part 1, part 2, part 3), is not to give an extensive summary of what was being said or not said, but to focus on the main tropes and bones of contention that this first series of broadsides between proponents and opponents of the Commission’s proposal delivered, and conclude with a brief comment upon the draft reports of Mr Tang and Mr Zalba that will provide the basis for the upcoming negotiations.


The main argument for kickstarting securitisation again, as laid down by Commissioner Hill, runs as follows: default ratios on European residential mortgage backed securities (RMBS) were a fraction of those of American securitisations, which implies that European RMBS were safer than American ones and should thus come with different (read: lower) capital requirements, allowing banks again to free up credit space and help ‘jobs and growth’ in the EU. Capital requirements should become ‘more risk sensitive,’ is the widely used euphemism, meaning that they should be ‘significantly reduced,’ as the Commission’s proposal explicitly states.

This trade narrative was swallowed hook, line and sinker by most of the panellists as well as parliamentarians except for Nijdam, Gabor and an MEP for the Green Left. Nijdam countered that default ratios are only one performance metric and that by other standards of measurement European RMBS did no better than US ones; European securitisations, like US ones, lost 30 per cent of their market value during the crisis, which is the main reason the market broke down and the Commission is making this proposal in the first place. Gabor, in her Q&A session, convincingly showed that the European securitisation market before the crisis consisted predominantly of Spanish, British and Dutch mortgage securitisations, and that they spawned homegrown real estate bubbles in the respective countries which wreaked great macroeconomic havoc from which citizens are still hurting – a fact that is systematically erased from memory by speaking of ABS (asset backed securitisies) in the context of the Commission’s proposal, instead of RMBS (residential mortgage backed securities), what it is in fact all about. The argument, made in the second of our instalments on the CMU, that low European default ratios had nothing to do with the quality of the securitizations per se but were the result of a legal context of full recourse instead of non-recourse, as was the case in the US, was not broached.

Finance Watch has argued for risk retention ratios of at least 20 per cent, claiming that it is best practice among the most sophisticated end-investors 

These counter arguments made little impact on the believers in the functionality of securitization for the ‘real economy’ among the parliamentarians. These seemed especially well-represented in the largest fractions in the European Parliament, with the Social Democrats showing a divided front.

Bones of contention

The issue that seemed to divide the sides more than any other was ‘risk retention’. This is trade speech for ‘skin in the game,’ meaning that parts of any securitisation issuance should be kept on the balance sheet of the originator to ensure that what is being sold is not rubbish offloaded by knowledgeable insiders to gullible outsiders. While the principle of risk retention as such was not at stake, its size was. The Commission’s proposal suggested a 5 per cent risk retention ratio to overcome asymmetric information. Instead, Finance Watch has argued for much higher risk retention ratios, to the tune of at least 20 per cent, claiming that it is best practice among the most sophisticated end-investors such as PGGM. This matters hugely, because high risk retention ratios and higher capital requirements for RMBS post crisis eat into the profitability of securitisation for originators, even after capital requirements are ‘significantly reduced,’ as is the aim of the Commission.

Apparently, Finance Watch has succeeded in convincing Mr Tang. In contrast to his earlier response, which didn’t give a precise figure, his latest amendments to the Commission’s proposal (more details below) now suggest a threshold of 20 per cent, although Mr Tang is willing to consider exemptions. While legal loopholes in financial regulation have a tendency to be lobbied into gateways if the sector has its way, the mark of 20 per cent has seriously annoyed the industry. According to a Reuters report it is on tenterhooks, although Mr Hill is expected to ultimately prevail.

The response from the industry insiders on the second panel was similarly vociferous. Both Santander, LBBW and PCS countered that with such levels the market would remain moribund, hurting the growth prospects of European economies. The employee of PCS used the analogy of pasteurization, stating that bacteria that don’t survive 60 degree Celsius will not be more dead when heated to 240 degrees. It’s analogies like these, conflating the social with the biological, that were at the cradle of the ultra low capital buffers from before the crisis. Price shocks in housing markets are not like bacteria and do not behave the same universally. To push the limits of the analogy: finance is a world where not all bacteria die at 60 degrees. One of the lessons of the crisis is thus that capital ratios should not be neatly calibrated to quantified risk measures, but should instead be sufficient to withstand shocks that are in a very true sense immeasurable. Yes, that hurts profitability, but for citizens it would be a small price to pay to ensure financial stability and prevent a banking meltdown on the scale of 2008.

Price shocks in housing markets are not like bacteria and do not behave the same universally

One would have expected the two regulators on the panels, the one from ESMA and the one from EBA, to make precisely this point. They are the carriers of our collective crisis experience. Instead, the first only conceived of stability concerns from a small investor-based perspective, proving Gillian Tett’s point of finance consisting of silos with no-one feeling responsible for the whole, while the second betrayed a level of identification with the industry that brought back bad memories from the pre-crisis era. Elsewhere, we noticed that EBA in its report on securitization whitewashed the industry origin of PCS, an industry attempt to set up a European label for securitizations which was one of the main sources of inspiration for the Commission’s STS proposal. Here, the representative of EBA on the second panel took the industry position, arguing that there is no good academic evidence that a risk retention ratio of 20 per cent produces more financial stability than one of 5 per cent, quoting Mr Hill that we ‘should be cautious but not paralysed,’ without even mentioning that 20 per cent is the best practice in the industry. Again, one would have expected regulators to argue that it is better to err on the side of caution than allow banks again to sail close the wind, especially after a meltdown of the scale of the 2008 one.

Draft amendments

It is striking to see the difference in mind set with which the two rapporteurs have approached their task to amend the two pieces of legislation for which each one was made responsible. While Mr Tang’s mandate covers the STS proposal as such, Mr Zalba’s concerns the related proposal for the capital requirements. Mr Tang’s earlier report already stirred up some criticism, though not enough to our taste, as we explained in our last contribution on this issue. The latest series of amendments proposed by Mr Tang clearly suggests that he has taken to heart the concerns voiced over the last couple of weeks, for which he must be applauded. The risk retention ratio should be 20 instead of 5 per cent, a public register is required, originators must be made legally responsible for the quality of their securitisations, synthetic securitisations should be excluded and the Commission will be forced to check whether the freed up credit ends up in the real economy and serves sustainable goals. This seems to address most of the concerns raised in the open letter of Mrs Gabor as well as those phrased by Finance Watch. The tone of Mr Tang’s amendments is nicely captured by the following sentences, taken from the explanatory statement at the end:

Securitisation, in theory, serves a more stable financial system through risk sharing. In practice, however, the securitisation market has been prone to the twin problems of asymmetric information and moral hazard and has been extremely unstable. In order to solve these problems, your Rapporteur puts forward amendments to the (sic) make securitisation market more reliable, even during times of crisis by:

  • making the market more transparent and by better aligning interest of market participants;

  • making the STS securitisation support the real economy and a sustainable environment;

  • to empower the supervisors, including at the European level, to prevent any threat to financial stability through the revival of the European securitisations market.

Paul Tang

"Securitisation, in theory, serves a more stable financial system through risk sharing. In practice, however, the securitisation market has been prone to the twin problems of asymmetric information and moral hazard and has been extremely unstable"

Mr Tang accepts the theoretical case for securitisation, but questions its practical application, which, in the light of the crisis is the correct kind of skepticism vis-à-vis financial innovations like securitisation. Moreover, he rightly questions the easy, uncorroborated claim by Mr Hill and others that the freed up credit would automatically serve the goals of jobs and growth and doesn’t feed real estate bubbles instead. As of yet, the Commission’s proposal does not contain any mechanism to steer credit into the former and away from the latter.

This contrasts sharply with the draft produced by Mr Zalba on capital requirements. Here the Commission’s proposal is further softened up, by bringing requirements down even further than the Commission suggested, by giving originators more leeway in deciding how to construct their securitisations and by specifying that the 100 per cent loan-to-value threshold for RMBSs is applicable not to the date of origination but to the time of inclusion in the securitisation, a point of considerable concern to Dutch mortgage banks which have a substantial share of mortgages with original loan-to-value ratios above 100 per cent in their portfolios. And where Mr Tang argues against the inclusion of synthetic securitizations, Mr Zalba is strongly in favour. The tone of his amendments is strikingly different from that of Mr Tang:

It is the dominant trade narrative in almost undiluted form, coming from a parliamentarian from a member state

Before the financial crisis which took place in 2007 and 2008, the securitisation market had been a steadily-growing channel of funding for the European economy. European securitised products performed well before and during the financial crisis, generating minor losses. However, the reputation of those products has since then been severely damaged by the revelation of the abuses and frauds that had taken place elsewhere, mainly in the US. [...] The rapporteur defends that creating a common high-quality EU securitisation framework will lead to further development of EU financial markets, help diversify funding sources and unlock capital which is currently unused, making it easier for businesses and households to borrow from credit institutions.

It is the dominant trade narrative in almost undiluted form, coming from a parliamentarian from a member state, Spain, which, like Mr Tang’s home country, has suffered extensive macroeconomic, political and social damage from fifteen years of oversupply of credit to the housing market. Where Mr Tang sincerely tries to apply the lessons of the crisis, Mr Zalba has already forgotten that there has been a crisis at all, let alone that there were obvious lessons to learn from it. Given the imminent consensus in favour of the Commission’s proposal, it seems Mr Tang will need all the support he can get to win the uphill battle against a powerfully regrouped industry with co-opted politicians and captured regulators on its side.

Ewald Engelen
Ewald Engelen
FTM-columnist van het eerste uur, financieel geograaf aan de UvA en actief voor de Partij voor de Dieren.
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