Europe reveals its weakness as it tries to flex its ABS

The world still remembers how the global financial system almost blew up in 2007 after dodgy US subprime mortgages were "sliced and diced", then sold to unwitting investors. Fewer remember how more recently, policy makers hoped similar loan "securitisations" would boost Europe's economic fortunes.

It is more than a year since the Bank of England and European Central Bank launched an initiative to revive asset-backed securities, which bundle up loans for resale. The objective was to turn a much maligned financial product into a force for good. Last November, the ECB even started buying ABS itself, inflating prices.

Unfortunately, the alchemy has not worked - at least not yet. ABS issuance has spluttered, and figures this week showed the ECB has quietly scaled back its purchases. Instead, it has switched to full-blown quantitative easing, including large scale government bond purchases.

But the lessons central bankers have learnt about their limited ability to affect activity in the real economy are instructive, especially in the post 2007 regulatory regime. They also highlight the challenges the EU faces with its plans for a European "capital markets union" to boost economic growth.

Properly designed and regulated, ABS should spread risks, increase banks' lending capacity and encourage healthy capital markets. Some European policy makers talked about ABS bypassing weak banks to provide crucial finance in the most stressed parts of the eurozone.

Such ideas, of course, have proved hopelessly optimistic. UK issuance of asset backed and mortgage-backed securities last year was a ninth of the level in 2006; in the rest of Europe it was about a fifth as high, according to Dealogic.

The pace has picked up a little this year - but not by much. There has been no rush to bundle up loans to job-creating small businesses in Greece or other crisis-hit European regions. With evident shortages of stuff to buy, and perhaps worried about driving out other investors, the ECB has bought less than €6bn of ABS.

What went wrong? An early disappointment was a failure to persuade European governments to guarantee ABS tranches; the revival of the US market is largely due to public support, for instance from Fannie Mae and Freddie Mac, the government-backed mortgage companies.

A bigger setback has been the failure to ease significantly the regulatory costs of ABS, which proponents argue reflect outdated perceptions of their riskiness. Official initiatives have not even agreed on terminology for the new generation of high quality ABS.

An initial ECB/Bank of England paper talked about "qualifying securitisations", the European Banking Authority refers to "simple, standard and transparent" products; the European Commission switched to "simple, transparent and standardised". The International Organisation of Securities Commissions preferred "simple, transparent and comparable".

As a result, European banks remain reluctant to use ABS for funding. By slashing its lending rates to historic lows, the ECB has undermined its own initiative; it is cheaper for banks to borrow from the central bank than go to the trouble of creating ABS for sale to investors.

The danger now is of squandering the moment, warns Richard Hopkin, head of securitisation at the Association for Financial Markets in Europe: "If you are an insurance company and not investing in ABS, why would you start now? We can't go on like this. Investors will lose interest."

A recent JPMorgan research note argued a less bureaucratic ECB purchase programme with a clearer purpose would lead to "improvements in real economy funding flows that a successful eurozone securitisation market can bring".

But the problem may simply be that economies remain too weak to generate sufficient loans that can be repackaged into ABS, especially from small and medium sized companies. To succeed, Europe's initiatives require a pickup in growth. "They are about being ready when that happens, rather than making it happen," says Ian Bell, head of the Prime Collateralised Securities initiative, an industry body.

The ECB's focus has, anyway, switched to its much bigger €60bn-a-month quantitative easing asset purchase programme - which has already had a far larger effect in inflating financial asset prices. But will it be more successful in stimulating the real economy?

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