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

Part I & II

30Sep 2015

 

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 €

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.

2. 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.

3. 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.

4. 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 1^st 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.


Part II


Ewald Engelen and Anna Glasmacher call upon members of European Parliament to wake up and block the return of bankers’ paradise before it is too late. The ‘Capital Markets Union’ envisioned by the European Commission only reproduces the status-quo of an unsustainable financial oligopoly that sustains the few at the expense of the many.

Late September, European Commissioner Jonathan Hill presented his long awaited plan for the creation of a European Capital Markets Union (CMU). A key priority 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 (STS) products.
In an earlier article on this issue, Ewald Engelen and Anna Glasmacher, both from the University of Amsterdam, critically discussed a draft proposal to that effect. The authors argued that the proposal was based on faulty assumptions, was dangerous in that it furthers financialization and was falsely sold as being about enhancing the access to credit of Small and Medium Sized Enterprises (SME) whereas it was actually a ploy to lower capital requirements for securitized mortgages.
Below, the authors do the same for further proposals that are currently being pushed through the law making sausage machine that is the European Union in record speed. The expectation is that the European Parliament will give its blessing somewhere in the next six months, which nicely coincides with the Dutch presidency. As the British Bankers Association noted in a recent policy brief on the Dutch presidency:
‘Pragmatism and economic liberalism are the lenses though which the Dutch see the business world. And this is how we expect them to conduct their Presidency in the field of financial services. […] The Dutch intend to be realistic in their goals, and focus on what can be achieved. They will move forward with files such as the Bank Structural Reform and the securitisation proposals when and if the European Parliament concludes a position.’
The authors warn that the proposal has been stretched to such an extent that the securitizations endorsed by the European Commission are the spitting image of pre-crisis industry practices and as such are anything but STS. Hence, they call upon members of European Parliament to wake up and block the return of bankers’ paradise before it is too late. The ‘Capital Markets Union’ envisioned by this proposal only reproduces the status-quo of an unsustainable financial oligopoly that sustains the few at the expense of the many.
By: Ewald Engelen & Anna Glasmacher, University of Amsterdam, December 20, 2015
http://www.ftm.nl/exclusive/the-trojan-horse-of-europes-capital-markets-union-part-ii/

Introduction

December 2, 5:44 CET. The Twitter account of the European Council’s Press Office informed the world that the Council had given its formal consent to the new legal framework for a European securitization market, proposed by the European Commission (EC) and to be ratified by the European Parliament (EP). Its approval, brokered by Pierre Gramegna, Finance Minister of Luxembourg, comes ‘just nine weeks after the Commission made its proposal,’ as its website proudly stated, ‘enabling the incoming presidency (the Netherlands) to start talks with the European Parliament as soon as possible in 2016’. It must be a legislative record in the history of the European Union (EU) and its legal predecessors: from draft to proposal to approval in less than four months.

It must be a legislative record in the history of the EU and its legal predecessors: from draft to proposal to approval in less than four months

Commissioner Hill, responsible for the Capital Markets Union (CMU) of which the securitization framework ‘is the first major building block’, was quick on the uptake. A mere fourteen minutes later, Hills official Twitter account sent his thanks and congratulations to the Luxembourg presidency in general and minister Gramegna in particular for such a speedy processing, noting with obvious glee that the securitization proposal was ‘agreed in record speed’.
His next tweet read: ‘Welcome agreement by @EUCouncil on proposals to relaunch #securitisation. Good basis for discussions with @europarl.’ Followed two minutes later by what is arguably the main marketing ploy with which securitisation is sold to an electorate traumatized by financial malfeasance: ‘#Securitisation an important early step to boost capital markets, investment and economic growth in EU.’ A meme that is reiterated on the website of the council, where securitisation is presented as ‘an additional source of finance, particularly for SMEs and start-ups… that would encourage integration of EU financial markets and by (sic!) make it easier to lend to households and businesses.’
In the earlier article published on this website on the Commission’s plan to set up a Europe-wide CMU, and specifically on its securitization framework, we focused on the discrepancy between the official storyline of the CMU being all about facilitating non-bank finance in Europe and the actual content of its policy proposal, which is prioritising the construction of a European market of standardized securitizations, which is mainly a funding tool for banks and as such has nothing much to do with non-bank or market-based finance.

we continue our critical deconstruction of the storyline weaved by the Commission in close collaboration with the banking industry

In this second article, we continue our critical deconstruction of the storyline weaved by the Commission in close collaboration with the banking industry, this time focusing on its attempt to discursively separate crisis-ridden US securitizations from European ones, and especially the simple, transparent and standardized (STS) ones now proposed by the Commission from the complex, opaque and bespoke securitization produced and traded pre-crisis.
To do so, we will delve deeper into the legal text of the latest legislative proposal; as they say, ‘the devil is in the detail’. A close reading of the proposal shows that once you enter the details of the proposed securitization framework, nothing simple, standardized or transparent remains. That is in our first section. Next we show how the proposed regulation would give the EC unprecedented powers to fill in legal blanks at a later moment without any democratic control from either the European Parliament or the member states. We finish with a note on the marketing of it all. The headings above these subsections read ‘details’, ‘powers’ and ‘ploys’ respectively.

Details

As we described in the first episode, the aim of the EC is to carve out a new market niche of STS securitizations to differentiate safe securitization practices from unsafe ones in order to rewards banks that do safe securitizations with lower capital requirements and to help foreign investors get over their post-2008 trauma. The storyline being that STS securitizations should not be confused with the instruments that stood at the cradle of the Great Financial Crisis that broke that year. The overall aim stated in both the official regulatory proposals as well as in numerous industry reports on the matter is to give SMEs and households better access to credit.
Our first episode tried to debunk that larger story: securitization has nothing to do with alternative channels of credit intermediation; European securitizations were responsible for massive housing bubbles and therefore cannot be called safe for society at large; and the low default ratios in Europe compared to the US had nothing to do with better types of securitizations or underlying assets but everything with legal differences in bankruptcy law for private persons, i.e. full recourse versus non-recourse.
The new proposal published on the website of the European Council on December 2 gives further detail to what is meant by STS securitizations. As its title reads, it sets ‘common rules on securitisation’ in the EU and spells out the criteria of what is simple, transparent and standard. A second, related document which was published at the same time at the same site then proposes new capital requirements for buyers of such securitizations, thereby aiming to provide ‘a more risk-sensitive regulatory treatment for STS securitisations’, read: lower capital requirements. Our goal here is not so much to debunk the larger story of how a Europe-wide securitization market is going to result in jobs and growth but to critically assess the regulatory bite of the proposed legal directives for STS securitization.

Our goal here is to critically assess the regulatory bite of the proposed legal directives for STS securitization

The first thing to note is that the STS criteria spelled out in the proposal are only about the ‘quality’ of the securitization process and have nothing to say about the ‘quality’ of the underlying assets, which, as the events during the Great Financial Crisis have demonstrated, are crucial. As the proposal explicitly stipulates: ‘the satisfaction of any STS requirements does not indicate anything about the credit quality underlying the securitisation’ (Section 1,14b; page 8).
Moreover the minimum standards regarding the ‘quality’ of underlying assets that are specified in the document, are minimal indeed. For example, even loans of debtors who have gone into default within the past three (!) years are acceptable in STS securitizations, as long as the respective debtors have been able to fullfill their obligations under a new debt servicing plan, which is typically one that reduces monthly burdens by extending the maturity of the debt; in brief, this means that even the European equivalent of subprime borrowers can be included in STS securitizations.
Our second observation is that claiming that it is possible to make securitization simple, transparent and standardized at all is highly misleading since it negates the fact that securitization is even by the proposal’s own (implicit) definition inevitably complex. To illustrate the point, take Article 5 of the draft, from page 31 onwards, which stipulates the types of documents that the different parties in any securitisation (originators, sponsors, and managers of special purpose vehicles) have to make available to investors in order to fulfill the transparency requirements of STS securitization.
This adds up to a long list, covering more than four pages of the draft, suggesting an ultimate file that could easily add up to 1000+ pages, and which would inevitably contain contestable assumptions about risks, returns and macroeconomic conditionalities as well as open legal clauses that make a joke of any notion of simplicity, transparency and standardizability.

swaps make contracts less simple and less transparent, which begs the question why they should be part of STS securitizations.

Furthermore, the draft explicitly calls for the use of interest and FX swaps in STS securitizations. On page 44 it reads: ‘Interest rate and currency mismatches arising at transaction level shall be appropriately mitigated and any measures taken to that effect shall be disclosed.’ In essence, this means that swaps are mandatory for any securitization to be eligible for the STS label. However, derivatives hugely complicate the risk-and-return profile  of any financial contract, increasing counterparty risk, and creating strong incentives for big financial players within the system to actively try and manipulate money markets, either directly (see LIBOR scandal), or indirectly by lobbying monetary policy makers, especially central banks. All in all, swaps make contracts less simple and less transparent, which begs the question why they should be part of STS securitizations.
As such, the proposal reads as if STS securitization has been stretched so far as to include again all  the standard industry practices that had developed before the crisis. The draft even opens up the possibility for particularly risky types of securitizations to receive the STS label in the future, despite explicit acknowledgement of their danger. And here it is necessary to quote the passgae in full:
‘In securitisations which are not ‘true sale’, the underlying exposures are not transferred to such an issuer entity, but rather the credit risk related to the underlying exposures is transferred by means of a derivative contract or guarantees. This introduces an additional counterparty credit risk and potential complexity related in particular to the content of the derivative contract. To date, no analysis on an international level or Union level has been sufficient to identify STS criteria for those types of securitisation instruments. An assessment in the future of whether some synthetic securitisations that have performed well during the financial crisis and are simple, transparent and standardised are therefore eligible to qualify as STS would be essential. On this basis, the Commission will assess whether securitisations which are not ‘true sale’ should be covered by the STS designation in a future proposal. The Commission should present a report and if appropriate a legislative proposal to the European Parliament and to the Council on the eligibility of synthetic securitisations as STS securitisation by one year after entry into force of this Regulation’ (Section 1(16), Page 9). [our italics]
Not only synthetic securitizations using credit default swaps, but also ‘re-securitizations’, which is the Commissions euphemism for ‘CDOs-squared’, that is collateral debt obligations backed by tranches of other securitizations, could in the near future get the STS stamp (e.g. Section 1(12), page 6; for definition of ‘re-securitisation’, see Article 2(4), page 20). Both of these variants of securitization had been in heavy use in the US in the years leading up to the crisis but had not made it yet on a sufficiently large scale into the repertoire of European securitizations due to their extreme in-transparency and hence the difficulty to adapt them to national jurisdictions. The mere fact that the proposal considers to give synthetic securitizations and re-securitizations STS status in the future signals to banks and investors today that conducting and investing in those kinds of securitizations will be allowed and facilitated; a blatant contradiction to the declared goal of the proposal.
This brings us to what is on our view the key (albeit undisclosed) goal of the new securitization framework (see also the first episode) which is the lowering of capital requirements for (STS) securitizations as specified in the second document. The proposal uses the well known level playing field argument to justify the granting of lower capital requirements for STS securitizations throughout the entire financial sector, including asset managers, insurance companies, pension funds as well as banks (Section 1(27); page 14).

The proposal uses the well known level playing field argument to justify the granting of lower capital requirements for STS securitizations throughout the entire financial sector

However, proposing lower capital requirements for STS securitizations means denying the inherent contradiction between the key objective of creating a safe and transparent market on the one hand and the additional risks generated by any securitization, whether STS or not, on the other; and the document reveals that the proponents of the proposal do so knowingly. On page 5 it states:
‘Investments in or exposures to securitizations will not only expose the investor to credit risks of the underlying loans or exposures, but the structuring process of securitizations could also lead to other risks such as agency risks, model risk, legal and operational risk, counterparty risk, servicing risk, liquidity risk and concentration risk.’
Here we have an explicit recognition on the side of the Commission that securitization is inevitably a funding technique that increases risk in the financial system compared to a situation in which securitization is forbidden, which hence would require more, not less, overall capital reserves. But that is clearly not the direction the Commission has chosen to head. Instead, as the second document shows in length, it is the intention to set capital requirements for STS securitizations considerably below the capital requirements that apply if the underlying assets were not securitized. This runs counter to all (economic) logic.
Last but not least, the proposal reveals that the Commission plans to again strongly rely on self-regulation by banks in this new STS securitization market, instead of introducing stricter oversight which would have been the logical lessen to draw from the crisis. The procedure for acquiring the STS stamp for a securitization is such that banks merely have to notify the European financial market regulator, ESMA, of its emission of an STS conforming securitization, upon which ESMA will simply post the emission on its list of STS compliant securitizations on its website without even checking whether the bank assigned the STS label correctly:
‘The inclusion of a securitisation issuance in ESMA’s list of notified STS securitisations does not imply that ESMA or other competent authorities have certified that the securitisation meets the STS requirements’ (Section 1(20), page 12).
Hence, ESMA will help to signal to investors that a given securitization is “simple, transparent and standardized” without even checking whether that is the case and without taking any (legal) responsibility for its future performance. Instead, ‘the compliance with the STS requirements remains solely the responsibility of the originators, sponsors and SSPEs. This will ensure that originators, sponsors and SSPE’s take responsibility for their claim that the securitisation is STS and that there is transparency on the market’ (ibid).
This formulation could not be more at odds with reality. Despite complete reliance on banks’ more than doubtful ability to conduct ‘due diligence’, investors will be allowed ‘to rely on the STS notifications and on the information provided by the originator, sponsor and SSPE on STS compliance’ (see Section 1(22), page 12).

what we have here is a clear case of legislator and regulator rubber stamping industry practices, while leaving responsibility for the future integrity of this market niche to the buyers and sellers

So what we have here is a clear case of legislator and regulator rubber stamping industry practices, while leaving responsibility for the future integrity of this market niche to the buyers and sellers, ie. to financial professionals who can profit greatly from using the STS stamp as generously as possible. Neither individuals personally nor financial firms have anything to lose when trying to stretch the boundaries of what falls within the STS label and hence can do with reduced capital requirements, since the proposal presents many second chances and protections for those who self-certify a securitization that does not actually comply (See Article 21, 5.; page 74). In the light of massive housing bubbles, massive bail-outs and an even more massive misallocation of capital, with huge consequences for households for decades to come, this kind of regulatory laxness and legislative ‘laissez-faire’ borders on callousness.

Powers

It gets worse. The proposal only spells out a broad legal framework for STS securitizations and their regulatory treatment. Much of the fine tuning still needs to be done. As a result the proposal is full inconclusive statements ending with the formulation that “power will be delegated to the Commission” to work out the details, meaning that they will be outside any democratic control, neither by the European Parliament nor by the parliaments of member states.
For example, concerning the details of risk retention requirements the Act states that ‘[p]ower is delegated to the Commission to adopt the regulatory technical standards referred to in the first subparagraph in accordance with Articles 10 to 14 of Regulation (EU) No 1093/2010” (Article 4(6), page 30).
Moreover, the proposal repeatedly stresses that the Commission should make use of the “expertise” of ESMA, the European financial market regulator, which in Brussels is even closer to the industry than regulators are at the national level, as well as financial professionals, when preparing those delegated rules. Even better, sector representatives are explicitly invited to participate in fine-tuning the law they will be subject to: “the views of market participants should also be requested and taken into account to the extent possible’ (Section 1(10), page 5; our emphasis).
If European Parliament approves this proposal  – which, it has to be stressed, is going to be the only public, democratic moment of political decision making in a long and complicated legal process – the Commission will gain full legal powers concerning the determination of not only risk retention requirements (p. 15, 30) (ie. the amount of skin-in-the-game originators need to have of any securitization [see below]), but also information requirements (p. 15, 36), the information flows between regulatory bodies of different jurisdictions (p. 15, 77), the template for STS notifications (p. 16, 59), the authorization of ‘third parties’ to be granted powers to certify STS compliance (p. 62ff), the downward adaptation of capital requirements for non-bank firms, notably pension funds and insurance companies (p. 80), any future changes in the regulation of covered bonds and Over-The-Counter contracts (p. 83-84), and more. In fact, it is impossible to tell at this point whether the proposed market for securitization will be simple, transparent and standardized because key points are not even clarified.

it is impossible to tell at this point whether the proposed market for securitization will be simple, transparent and standardized because key points are not even clarified

The interpretation of the Commission of what STS means, would automatically become law in all member states, since EU law automatically trumps national law – for reasons of efficiency as the proposal argues rather convolutedly:
‘Since the objectives of this Regulation cannot be sufficiently achieved by the Member States given that securitisation markets operate globally and that a level playing field in the internal market for all institutional investors and entities involved in securitisation should be ensured but, by reason of their scale and effects, can be better achieved at Union level, the Union may adopt measures, in accordance with the principle of subsidiarity as set out in Article 5 of the Treaty on European Union. In accordance with the principle of proportionality, as set out in that Article, this Regulation does not go beyond what is necessary in order to achieve those objectives’ (p. 35).
The proposal raises serious doubts as to whether the Commission would be particularly risk-averse when fine-tuning the details, as the proposed requirements concerning risk retentions mentioned above shows.The obligation that banks conducting and selling securitizations have ‘skin in the game’ in order to overcome pre-crisis abusive practices to sell customers extremely risky securitizations was, together with higher capital requirements, the crown jewel of the post crisis regulatory effort to address the causes of the crisis.
This effort is severely undermined by the current proposal since it stipulates that it is not necessarily the securitizing bank that has to retain parts of the security since the risk only has to be retained by either the sponsor or the originator (which need not be the securitizer); that banks can pick and choose with regard to which particular parts of the securitization are retained; and that there will be no risk retention requirements if there is any form of state guarantee on the underlying assets such as the National Mortgage Guarentee scheme of the Netherlands, which means that conflicts of interest are aggravated in cases in which tax-payers money is at stake (p. 28ff).

As such, this framework represents a move back from what in hindsight appears to have been the high tide of post-crisis regulation

As such, this framework represents a move back from what in hindsight appears to have been the high tide of post-crisis regulation, both with regard to risk retention requirements and with regard to capital requirements (see part 1).
All in all, this proposal for regulation of what is one of the most widely used alternative funding instruments of banks before the crisis, and is hence absolutely crucial from a macro-prudential regulation-perspective, is explicitly and intentionally put beyond the remit of democratic institutions and shifted to a technocratic realm where regulators in close collaboration with industry insiders do again have the opportunity to calibrate regulation in such a way that is least harmful to financial interests.
This is a return to the mode of ‘collaborative regulation’ from before the crisis, which has demonstrated in 2008 to let financial interests prevail over public ones, despite employing a language that plays on the importance of the commons, referencing efficient markets before the crisis and jobs, growth and the credit needs of SMEs afterwards. Whatever it is, it is a political program for which citizens as members of a democracy and as tax payers should beware.
Members of European Parliament better take heed: once they have signed it of there is not much any of us can do. The Commission’s request to get this proposal ratified as soon as possible might be a carefully designed trap, as the following section suggests.

Ploys

We have said it before and will say it again: it is hard to imagine a policy domain where discourse and policies are further apart. The policy, as we argued above, is one of extreme complexity, informed by highly specialized legal expertise, requiring excessively complicated legal interventions in a wide array of already existing pieces of legislation, to carve out a financial market niche that is way beyond the scope of the average citizen and the average firm to comprehend let alone use. In fact, the proposal explicitly stresses that STS securitizations are meant for professional investors only and are forbidden territory for financial laymen.

it is hard to imagine a policy domain where discourse and policies are further apart

An earlier draft gave as reasons for excluding retail investors from purchasing even STS securitizations that their ‘potential level of risk and their complexity [our italics]’ (page 7) made them unsuitable for investors who are not professionally involved in financial markets on a daily basis. Of course, these reasons were hastily crossed out in the version presented to the European Council, for it might raise awkward questions if securitizations that were meant to be ‘simple, transparent and standardized’ were in the same sentence described as ‘risky’ and ‘complex’. It is a telling illustration of how even within the text of the law there is a need to actively manage discourse in order to ensure that ‘the repressed’, in an almost literal Freudian sense, does not slip through the order of the official storyline.
However, the cognitive dissonance between discourse and policy comes nowhere starker to the fore than on the webpage dedicated to the Capital Markets Union. Under the heading Unlocking funding for Europe’s growth, the EC writes:
The Capital Markets Union (CMU) is a plan of the European Commission to mobilise capital in Europe. It will channel it to all companies, including SMEs, and infrastructure projects that need it to expand and create jobs. By linking savings with growth, it will offer new opportunities for savers and investors. Deeper and more integrated capital markets will lower the cost of funding and make the financial system more resilient. All 28 Member States of the EU will benefit from building a true single market for capital.

The official story is that the CMU is all about facilitating the bringing together of creditors with excess savings with potential debtors in need of credit

Note that ‘banks’ and securitization do not figure here, nor do mortgages and real estate. The official story is that the CMU is all about facilitating the bringing together of creditors with excess savings with potential debtors in need of credit. A two-minute video with simple animations placed to the left of the introduction describes the functionality of the CMU using the fictional storyline of Anna, a brilliant entrepreneur looking for funding, and Paul, a saver looking to invest his money. In between them stand borders, rules and regulation, depicted in the video by dystopian walls, anathema in the bordeless world of the EU. In comes the CMU, to break down the walls. As the video explains: ‘it would help Anna and other businesses to raise capital more easily and it would help Paul and other savers to get more for their money. That’s the goal of the Capital Markets Union.’ The reality could not be farther from this sugar-coated fairytale.
We can only speculate about the motives and agents behind the current high-pressure regulatory push. But the speed of political decision making, the prioritizing of securitization over other policy initiatives listed under the CMU, the willingness to backtrack on earlier regulation and make a U-turn on its direction as well as the potential political risks of selling something as being about jobs and growth that is so obviously about something else all together suggests that the interests involved are not only extremely powerful and have excellent access to policy making circles but also that they have urgent needs which only kickstarting securitization again can fulfill.
Regarding the former, it is obvious that banks stand to win and lose most from this initiative. The proposal is tailor made to enable the continuation of a business model that has been hugely profitable in the past by creating huge amounts of debt without having to care about their sustainability since banks could – due to their ‘too-big-to-fail’-status – count on bailouts when the massive hidden risks explode. In any case, it is mainly bankers and other financial professionals who have contributed to the writing of this proposal. Records of the public consultations concerning the securitization framework reveal that it was predominantly bankers and investors that have used these opportunities. 110 out of 120 submissions originated from the financial sector, sell-side as well as buy-side. For a formal panel on the same issue the EC had invited a high ranking official from Deutsche Bank as well as a partner from a venture capital fund, next to a sprinkling of officials from the ECB, ESMA and the EIB. No representatives from NGOs, labor unions and or consumer organizations were invited.
Concerning the urgency behind the proposed regulatory change – and here we do enter speculative territory which is however backed by market data that allows us to draw some of these inferences – it may be driven by a very serious funding need of European banks due to the requirement to refinance securitizations which have been created during the “bonanza”-years from 2005 to the first half of 2008 and which have an average maturity of between five to seven years. Those were the years in which the growth of the European securitization market was finally gathering speed (see first episode) until – that is – the US crisis put a sudden stop to it. At the moment, negative (!) interest rates and “quantitative easing” solves any funding problems European banks may have had since the crisis. Obviously, this situation is not only economically unsustainable but also politically, as is evidenced by the growing unease of Bundesbank officials on the governing council of the ECB. Therefore, a new market outlet is urgently needed, or more in particular: new buyers, that are willing to buy those assets that banks want to – and have to – get rid of.
If this is true, banks have a powerful argument to blackmail politicians into accepting this new proposal to support and in fact enforce the growth and spread of the securitization market across Europe. As was demonstrated in the US in the Summer of 2008, the prospect of mass bank failures and their subsequent economic, social and political fallout can make politicians do what bankers want. Currently the European securitization-based debt-machine is not as powerful as it was in the US when the crisis broke. “Kicking the can down the road” by ratifying this law will allow the STS securitization market in Europe to quickly grow and penetrate countries where securitizations are as yet unknown, as is the case in many Eastern European member states, and thus make Europe ever more dependent on securitizations and hence more vulnerable to sudden stops in interbank markets. Now is the moment to pull the emergency break, and to start thinking about how to create a truly transparent financial markets, rather than blindly repeating the mistakes of the US.

this Act should be forcefully rejected and securitization should be forbidden

To conclude:

• this Act should be forcefully rejected and securitization should be forbidden. Instead, there should be a concerted European effort to re-install traditional, on-balance funding and full risk retention in line with the declared task of banks as professional financial intermediaries based on their expertise to handle risk and maturity mismatches: that would truly make banking transparent, simple and standardized again;
• the tentative efforts to establish higher capital requirements, which were spawned by the crisis, should be beefed up (we favour 15 percent of non-risk weighted assets), not reversed, as this proposal does;
• if we truly want to connect the ‘Annas’ and ‘Pauls’ of this world, it would make much more sense to safeguard the local (cooperative and savings) banks that still dominate the banking landscapes in many EU member states instead of making their live miserable due to the construction of a regulatory environment that puts a heavy premium in scale;
• finally, the Commission could do worse that to have a serious look into and foster the various non-bank initiatives for peer-to-peer credit intermediation which have sprung up in recent years. Modern information technology opens up possibilities for truely dynamic financial markets that would be real alternatives to “too-big-to fail” dinosaurs.

The ‘Capital Markets Union’ as envisioned by the current proposal only reinstates the pre-crisis ‘bankers’ paradise’. It reproduces the status-quo of an unsustainable financial oligopoly that sustains the few at the expense of the many.