The European Central Bank is facing large potential losses arising from exposure to €10.3 billion of assets left behind from defaulting bank counterparties to the Eurosystem last autumn. In addition to Lehman Brothers, three Icelandic banks – Glitnir, Kaupthing and Landsbanki – and Dutch bank Indover have defaulted.
Among the assets that the ECB has been left holding is a massive collateralized debt obligation containing deteriorating commercial real estate assets. The €2.17 billion note was the senior part of a two-tranche transaction structured by Lehman Brothers in the spring of 2008 – when the firm was desperate for liquidity – precisely for the purpose of gaining access to the central bank’s generous repo facility.
Despite being rated at single A, and that by only one agency – Standard and Poor’s – the CRE CDO still passed the ECB’s eligibility tests as acceptable repo collateral and the ECB advanced cash to Lehman against it. S&P has since downgraded the deal to BB+, citing the various key roles Lehman played in the transaction.
S&P’s presale report for Excalibur Funding No1 contains no mention of LTVs but, according to one banker, the issue was backed by assets of relatively low quality. He believes many of the assets were of 90% LTV at the time of issuance in May 2008. He suggests that the ECB will struggle to get back more than 60 cents on the dollar, given the performance of generic commercial real estate assets.
“It is not an uncommon structure. There is a great temptation for banks to take assets that are not eligible for repo, securitize them and repo them with the ECB, said one commercial real estate investor with knowledge of the transaction.”
Because of the minimal due diligence conducted at the time of repo, the ECB is now holding paper for which it has no way of determining how much it will receive. The average life of this deal is 2.4 years; the legal final is 2054.
In a statement published on March 5, the ECB said: “The monetary policy operations in question were executed on behalf of the Eurosystem by three NCBs, namely the Deutsche Bundesbank, the Banque centrale du Luxembourg and de Nederlandsche Bank. The Governing Council has confirmed that the monetary policy operations in question were carried out by these NCBs in full compliance with the Eurosystem’s rules and procedures, and that these NCBs had taken all the necessary precautions, in full consultation with the ECB and the other NCBs, to maximise the recovery of funds from the collateral held.
“The counterparties in question submitted eligible collateral in compliance with the Eurosystem’s rules and procedures. This collateral, which mainly consisted of asset-backed securities, is of limited liquidity under the present exceptional market conditions and some of the ABSs need to be restructured in order to allow for efficient recovery. Under current market conditions, it is difficult to assess when the eventual resolution will be achieved by the Eurosystem.”
“We were amazed that they were allowed to get away it. A US bank taking advantage of the European system and European banks couldn’t tap the Fed,” says one syndicate official. “We knew the loans would blow up. It was one thing for the ECB to lend money against triple-A RMBS for the Spanish, but this stuff? The Bank of England never let CMBS through its facility.”
The ECB has said that any potential losses will be shared by the NCBs and has provisioned for €5.7 billion.
