European banks are issuing asset-backed securities in massive amounts and pledging them to the European Central Bank as collateral on its term repo funding. Since September, more than 50% of European ABS issuance has been used as ECB collateral. With banks bereft of other viable funding options pledging so much to the ECB for repo financing, it will become harder and harder to return those banks to a normal funding environment. "The ECB will keep taking collateral," says a eurozone banker. "It will be a long, hard slog to get out of this."
Around 10% of the ECB repo funding has been absorbed by Spanish banks. The total securitization issuance by Spanish banks last year was 143 billion, up 55% on 2006, and none has been seen on the public markets since August. Spanish banks use of ECB repo funding rose from 20 billion to 50bln in 2007. Clearly, these banks are using the ECBs term repo window for more than a little liquidity support. Some have suggested that the reliance on the ECBs repo window has propped up Spains nose-diving mortgage market and enabled the country to avoid its own Northern Rock-style disaster.
Spanish bank borrowing via main and longer-term repo
Source: Bank of Spain, Lehman Brothers.
But according to the ratings agencies, there is little cause for concern. Although issuing large amounts of mortgage-backed securities that cannot be sold in a stalled public market and ploughing them into the ECB in record numbers should interest the ratings agencies, for the most part the ECBs term repo window is not seen as being abused by its patrons. "What we have been observing is banks using the repo window as a secondary facility," says Carmen Munoz, senior director in Fitch Ratings fixed-income group. "Banks dont really need it, but are using it as an additional cushion."
Its an odd claim in light of the numbers, but Munoz insists that the banks have drawn so much repo funding because of uncertainty in the markets and the preference for extra liquidity even though it might not be needed. And other ratings agencies are similarly indifferent about any possible pitfalls. "We are keeping an eye on the number of assets that can be repod, the amount borrowed, and any changes in policy," says Johannes Wassenberg, managing director in fixed income at Moodys. "As long as the ECB doesnt alter its framework, there is no real risk."
As ECB/repo volumes increase, banks could use the repo window as an opportunity to grow their balance sheets rather than provide liquidity support. Aside from the moral hazard involved in such activity, if that is the case it will be even more painful when the ECB eventually decides to wind down the facility. It can hardly be considered appropriate for banks to rely on such short-term funding, as the asset/liability maturity mismatch will increase volatility in already volatile times. "The repos are not the basis of a viable business model," says Wassenberg. "It is normal for any bank to optimize funding, and very difficult to prescribe an ideal mix or a level not to exceed. Ultimately, though, banks need more reliable, cost-efficient funding."
With no other options available, Spanish banks will continue to pour collateral into the ECB. "There is not much promise in the mortgage and ABS markets," says Matthew Froggatt, executive director of European securitization at UBS. "It could be argued that it is the ECBs job to promote financial stability, to allow alternative liquidity support. But this should be used to roll funding, not to grow balance sheets."
While the ECB is unlikely to make any changes to its open market operations, it could privately discourage certain banks that it deems over-reliant on ECB repo. It could also increase its margin requirements for floating triple-A RMBS from the current 2% to a much higher percentage.