On the 26 of October the European Parliament plenary will vote to confirm new rules on complicated financial instruments, and before long, the Council is set to agree as well. ‘Securitisation’ – loans that are bundled and sold on – is to become easier in order to support economic growth, proponents say.
Yet there are rumblings of trouble in the financial press. Eyes have been on the trade in financial instruments linked to car loans to private customers, particularly in the US. Large numbers of loans have been granted to people with poor credit ratings, often without even looking into their financial situation, and the loans have been repackaged and sold on with little transparency and oversight from the authorities. The dreaded ‘sub-prime bubble’ could burst and affect significant parts of the financial system.
This scenario brings back memories.
The type of loans supplied, the way they are repackaged and sold on, and the lax oversight were seen as a principal ingredient of the 2008 financial crisis. Then it was residential mortgages in the spotlight; today, the 'subprime bubble' is made up of car loans. Though the bubble is smaller in size, you would expect European legislators to take precautions against financial crisis and instability, and to protect the poorest against predatory lending. You would expect them to avoid the worst practices of the US financial markets that caused the 2008 crash. And you would expect European lawmakers to be extremely vigilant when asked for less strict rules by financial lobbyists.
Yet, the EU seems set to embark on more favourable rules for bundling and reselling of loans, ie securitization, mainly thanks to effective lobbying of governments by the financial industry and some non-financial sectors, not least, car makers. This has been done with apparently little concern for the worrying signs of a coming 'carmageddon' across the Atlantic, not to mention the signs in Europe of something similar at play.
Carmageddon: from the US to Europe
The message from the US seems clear: over the past year, both rating agencies and hosts of analysts have been warning repeatedly that a bubble has built up in financial markets that could burst. Loans or leasing contracts have been awarded to thousands of private citizens for car purchases, with little regard to their credit standing. One of the major players in the US market for car loans, Spanish Santander, has admitted it only checked the income of eight per cent of those awarded a loan for a car. ‘Carmageddon’ has become the standard expression for this state of affairs. Defaults are shooting up in the lower loan quality areas, and even in high quality loans, one credit reporting bureau said in August this year.
Already in Europe, there are signs that similar trends are at play. The UK's financial watchdog the Financial Conduct Authority (FCA) is looking into car loans, while the Bank of England have asked banks to increase their capital buffers in the face of rapidly increasing pools of consumer loans, including car loans. The FCA appears uneasy and has turned to the US financial authorities for advice. With all the complicated instruments at play on financial markets, getting a grip on what is going on is not easy, not even for an official regulator. And the market in securitized car loans is not an open book.
How securitization works and doesn’t work
When you got to buy a car, you could be offered several funding options. The car company itself, VW or Renault for example, could provide you with a loan, or it could be granted by a consumer lender such as Santander. Those lenders would then bundle the loans – put them together in one package – and sell them on. From then on they would be ‘originators’ of the loan, but they would have removed the risk of lending you money from their books. At the other end, your repayments from the original loans would go to an investor, for instance an institutional investor, that has bought the package. For the future, then, repayments would go to them, and broadly speaking, the ‘originator’ such as VW, would have a smaller stake in the transactions. The proceeds would go to those who have bought the loans, often by buying a bond from a special entity set up to administer the bundled loans. If you stop repaying your loan, and others do too, the bonds become worthless.
If this procedure is easy, ie if it is easy to give the loan and pass it on, and if there is fierce competition, then the originators of the loan, in this case the car industry, will be more inclined to give out loans that are risky. It boosts their profits as they sell more cars, and they carry a smaller risk of default in case of non-repayment. In the case of the car industry, this procedure is particularly important.
The financial arms of car companies are called ‘captives’. They are crucial to the economy of corporations such as Volkswagen, Daimler, Renault, and others. Car corporations earn their money via their financial arms. When the ‘captives’ give a loan, they have to take special measures to secure their finances. As long as they still own the loans, they will have to have capital within reach in case of loan defaults as a precautionary measure, called capital requirements. If they sell on the loans, they can take on more new loans. This process is key to the auto industry in the US as well as in Europe. Fundamentally it helps car companies to make apparently attractive finance packages to consumers so as to be able to sell more cars, while passing on the ultimate risk to other financiers.
But more and more, what was perhaps the most prominent lesson from the financial crisis, becomes relevant: if the regulatory architecture is weak, if excesses are either allowed, or easy to hide, then two problems arise. It can become all too easy to give predatory loans, ie with initial conditions that appear tempting at first, but are difficult to meet for some borrowers in the long term. After all, in the long term, it won't be the car company's problem: the loans are sold on – off the books, out of sight. The second key problem is that if applied on a large scale, this can lead to broader problems in the financial system, because bad assets can be piled up. Sooner or later the bubble will burst.
A quality label with a subsidy
The European Parliament will vote on rules that regulate exactly these types of loans, on 26 October 2017. This is about boosting securitization in Europe by loosening the regulatory ties, provided certain conditions are met.
Securities trading in the EU has not recovered as fast as it did post-crash in the US, and the majority of law makers believe that giving them a boost by loosening the regulatory ties will lead to growth. For some industries, securitization is crucial, and the boom in car sales over the past years are often attributed to the use of financial markets to trade in car loans converted to ‘asset backed securities' (ABS), called Auto ABS.
The EU proposals up for adoption come in two parts: changes to the Capital Requirements Regulation, and a proposal for ‘Simple, Transparent and Standardised’ securitisation. They are about the conditions a given security must fulfil in order to qualify for beneficial treatment.
‘Capital requirements’ are the buffer of funds that financial institutions are required to have readily available. The amount is measured according to how risky their investments are. The Capital Requirements Regulation will be amended to allow for favourable treatment – lower capital requirements – for securitization that fulfils certain conditions. These conditions are listed in the regulation for ‘Simple, Transparent and Standardized’ securitisation (STS). Bundled loans described as STS have lower capital requirements. “STS is a quality label with a subsidy”, says Frédéric Hache, a former senior analyst for FinanceWatch who has followed the case from the beginning.
However, the big problem – as FinanceWatch has stressed on countless occasions – is that in fact, the securitisations that are to be given preferential treatment do not have to be simple, transparent or standardized. This is mainly due to ‘tranching’. Tranching means a security is divided into separate slices, each with its own characteristics, and of different qualities and risk characteristics, which makes it very difficult to assess for an investor – and makes it an arduous task for regulators to monitor the market. It is a massive contradiction that the EU's proposal allows tranching for securities described as ‘simple, transparent and standardised’, as has been pointed out by researchers at the Bank of International Settlements.
The two legislative acts – the regulation on ‘Simple, Transparent and Standardised’ securitisation on one hand and the changes to the Capital Requirements Regulation on the other – are the outcome of negotiations between the parliamentarians and the Council since early 2017. They were first tabled by the Commission in the summer of 2015 as a key part of broader EU project for free movement of capital - the Capital Markets Union - and were pushed heavily by the Council, not least by the UK government and by the now former Commissioner for financial services, Jonathan Hill, as part of the political manoeuvring ahead of the UK referendum on EU membership in 2016.
Umbrella groups and trade associations
As a result of Brexit and the departure from the EU of one of its key backers, there were fears in the financial community that the Capital Markets Union would suffer a fatal blow. Whether or not this turns out to be true, one of its cornerstones, liberalization of securities trading, still has powerful supporters. Though the persistent pressure from the UK government has vanished, the financial lobby has plenty of heft to push the agenda forward, and has invested lots of resources to support the new initiatives.
The main players are in many ways ‘the usual suspects’. They are the main lobby groups on most dossiers on financial regulation. At the top we find the most powerful lobby group of them all, the Association for Financial Markets in Europe, mainly a vehicle for the biggest banks in Europe and on Wall Street. AFME has played a key role on securitization as well. But as for car makers, they have taken care of their own interests.
|Name||Declared annual lobby spending||Full-time equivalent lobbyists||Passes to the European Parliament||Elite Commission meetings since Nov 2014||Elite Commission meetings on securitisation since Nov 2014|
|Prime Collateralised Securities UK Limited (PCS)||€200,000 - €299,999 (2016)||1||0||6||6|
|The Alternative Investment Management Association (AIMA)||€800,000 - €899,999 (2015)||5||2||6||2|
|Association for Financial Markets in Europe (AFME)||€4,500,000 - €4,749,000||26,25||5||32||2|
|Bank of America Merrill Lynch||€1,250,000 - €1,499,999 (2016)||2,75||2||18||2|
|EuroABS Limited||less than €9,999 (2016-17)||0,25||0||2||2|
|Bundersverband Deutscher Banken e.V||€2,500,000 - €2,749,000 (2015)||18||2||34||2|
|BNP Paribas||€900,000 - €999,999 (2016)||6||3||31||1|
|British Bankers' Association||€1,750,000 - €1,999,999 (2015)||7||1||1||1|
|Daimler Aktiengesellschaft||€2,500,000 - €2,749,000 (2016)||7,75||5||33||1|
Broadly the car industry and the financial sector have seen eye to eye on securitisation, although they have prioritised their own particular issues. For instance, at an early stage of the negotiations on the STS file, the car industry managed to insert an exception to requirements for short term securities (Asset Backed Commercial Papers, ABCP) through its work in the European Parliament. In the final agreement between the institutions, short term investments will get special treatment, if they are associated with “auto loans, auto leases and equipment lease transactions”. As the car industry was successful early on, it was left to AFME to fight for similar terms for other types of ABCP, for instance other kinds of consumer loans, as can be seen from a position paper obtained by Corporate Europe Observatory.
In the final balance, the car industry could only be happy with the final version. Both the car makers' lobby groups and the association of captives – financial units of eg Volkswagen, Renault, Ford and others – have been present in the corridors of both Brussels and their respective capitals all along, and seem to have managed to fine tune the text in their favour. Their influence, even in the final phase, has been significant, and shows that the car industry continues to have sway in Brussels. For a moment, it may have seemed as if Dieselgate – the scandal that showed car makers use fraudulent software to make the cars seem more fuel efficient than they were – had rocked decision makers’ faith in their lobbyists. With the securitisation dossier, we see once again, strong faith in industry at play.
Trilogue: it is not over until the car industry sings
When the long debates on these new rules were over in the European Parliament, and a compromise between member states reached in the Council in late 2016, there remained some issues to be settled. There was still disagreement on crucial elements between the two institutions. To lobby groups, including the car industry, a continued effort made sense. Corporate Europe Observatory filed freedom of information requests to the Commission and the Council to check the development of sensitive issues, and to see who were trying to influence negotiations in the final phase, particularly on auto ABS. These documents show that among others, the auto industry did advise the institutions on the questions of most interest to them, supplying the negotiators with very specific ideas on how to help the trade in auto ABS. In some cases, industry sided with the Council, in others with Parliament, and in others it opposed both institutions and suggested amendments outside the limits of the mandates agreed on in the two institutions.
In a document obtained from the Commission, dated 25 January 2017,12 three lobby groups, Banken der Automobilwirtschaft, Comité des Constructeurs Français d’Automobiles, and Verband der Automobilindustrie, representing German and French car makers, list eight separate queries over the texts from the EU institutions in a last-ditch attempt to tailor the outcome to their interests. Out of eight, five of their industry demands were met, partly or in full – including the most important ones.*
|Name||Declared annual lobby spending||Full-time equivalent lobbyists||Passes to the European Parliament||Elite Commission meetings since Nov 2014||Members include...|
|€100,000 - €199,999 (2016)||1,25||0||0||PSA Group, Renault|
|€2,500,000 (2016)||14||3||33||AUDI, BMW,BRABUS, Daimler, Porsche, FCA, Ford, HWA, Irmscher Automobilbau, IVECO, MAN, Opel, PINA, RUF, StreetScooter, Trasco Bremen, Volkswagen and many more|
|Not available (VDA is not registered in the EU Transparency Register)||Not available (VDA is not registered in the EU Transparency Register)||Not available (VDA is not registered in the EU Transparency Register)||Not available (VDA is not registered in the EU Transparency Register)||BMW Bank (BMW, MINI, Rolls-Royce), FCA (Alfa Romeo, Fit, Heep, Abarth, Maserati, Jaguar, Land Rover, Erwin Hymer), Ferrari Financial Services, Ford Bank, Honda Bank, Hyundai (Hyundai, Kia), Mercedes-Benz Bank (Mercedes-Benz, smart, Setra, Mitsubishi), MKG Bank (Mistubishi), Opel Bank (Opel, Cadillac), RCI Banque (Renault), Toyota Financial Services (Toyota, Lexus), Volkswagen Financial Services (Volkswagen, Audi, SEAT, Skoda)|
First and foremost, the worst fear of the industry lobbies didn’t materialise. Risk retention was one of the most disputed areas, about the extent to which the original organizers of securitization (originator, sponsor, lender), must retain a stake in the deal, and in that way bear part of the consequences if for instance borrowers default on their loans. The original proposal of the Commission was that they would have to retain a five per cent stake, but after much discussion in the European Parliament, MEPs opted for ten percent.
Actually, even 10 percent doesn’t amount to much. It is not unusual for investors – those who ultimately buy the package – to go for 20 per cent retention with those who put it all together in the first place, " to ensure that interests are fully aligned between the originator and the investor", as Frédéric Hache told Corporate Europe Observatory. That option was seriously considered in the European Parliament as well, but discarded.
Still, in the Trilogue – the tripartite meetings attended by representatives of the European Parliament, Council, and Commission – Parliament caved in and agreed to the five percent threshold. The financial lobby and the car industry came out victorious. This means that those who give the loans can pass them on even more easily, incentivised to take more risks and lower the quality as they will only have a little ‘skin in the game’.
Sloppy rules on selection of loans
What obligations should an originator have when putting together a bunch of loans for securitization? What should be investigated beforehand? Should an originator have information on a borrower’s liabilities elsewhere? What loans cannot be included in the package? On these points, the car industry was unhappy with the proposals of the Commission, Council, and Parliament, and sought a way to weaken the proposed obligations of the originators to investigate the liabilities and credit standing of the borrowers. According to the document from the three lobby groups (Banken der Automobilwirtschaft, Comité des Constructeurs Français d’Automobiles, and Verband der Automobilindustrie), industry feels it “would not add any value to the selection”, for originators to have to check credit information on borrowers.
None of the obligations were deleted in full, but the final outcome was the weakest possible mix of the suggestions from the European Parliament and the Council. This is most clear in the case of article 20, par. 11 c, where a proposal from Parliament to have originators compare the credit standing of borrowers to an average was deleted, whereas the Council version was adopted. According to that version, originators should assess a loan on the basis of ”similar exposures held by the originator which are not securitized”.
What does that mean? It means if the car dealer or the car company already has a habit of making risky loans, some of which have not been securitized, then they are in the clear to carry on.
Required number of borrowers cut in half
The car industry was unhappy with the minimum number of borrowers necessary to securitise loans (the short term version dubbed Asset Backed Commercial Paper, ABCP). In the proposal, the Commission, Council and Parliament all supported the demand that only one per cent of the value of a securitization could stem from a loan to a single borrower (or obligor). The car industry claimed this makes it very difficult for wholesale car dealers to enjoy the benefits of STS securitization, in that it will make it more difficult to sell cars to groups of dealers. Its suggestion: eight percent instead of one, bringing the required minimum number of deals for retailers in a securitization bundle down from 100 to 13.
In the end, the deal at the Trilogue was to change from one percent to two percent, thanks to a proposal from the European Parliament delegation, bringing down the required minimum number of loans from at least 100 to at least 50. Not a full victory for the car industry lobby, but a victory still, and one that leads to a greater dependence on fewer loans, and less diversification.
Besides these three substantial victories for the car industry, two other concessions came out of the Trilogue.
In its document, the three groups from the car industry complain that the definition of ‘originator’ as proposed by the European Parliament, would exclude leasing companies from securitizing loans. “Delete Parliament’s proposal”, they suggest. In the final version there is no trace of the Parliament’s proposal to limit the securitization market to specific players.
Industry is keen on getting their securities rubber stamped at the beginning. They would like to see “a competent authority or a third party” give the green light to the bundled loans before they are put up for sale. In that way, they are less responsible if it turns out they were actually in breach of the rules and had sold a package under the preferential STS terms when in fact it didn’t meet the conditions. This demand was met with an entirely new article, that allows third parties, authorised by competent authorities, to expedite rubber stamping (article 28).
On two points, which both relate to just how much preferential treatment should be given to STS securitisations, the Trilogue negotiators rejected the proposals from the auto industry, but in the final balance, when considering the context, it is quite astonishing to see the important changes that were made well after the two main negotiating parties, the Council and the European Parliament, had made their positions clear.
When the negotiations started between the Parliament and the Council, there was clear blue sea between them on key issues, first and foremost the level of risk retention required. However, the car industry (along with the financial lobby) pushed for the lowest number and with the Council holding its line, the final result was what they hoped for. Given the importance of the car industry in two of the most powerful member states, Germany and France, perhaps that is not so surprising. What is more striking, perhaps, is that even on questions where the EU institutions took the same line at the beginning, the proposals of the car industry were still able to shift positions and have some success.
Steering financial markets blindfolded
What is most remarkable of all, however, is the context in which the car loan and financial lobbies were able to score their successes. The Trilogue took place in the midst of persistent rumours of an imminent collapse of the market in Auto ABS in the US, and worried financial services authorities in the UK. Default rates are on the rise and a series of research units, rating agencies, and financial institutions are warning against the burst of a bubble that could cause disruptions far beyond the market in subprime lending. Still, there is no indication that this was a pressing issue at the negotiations. The texts and proposals were judged on the basis of their immediate effects on the car industry, and driven by the urge to liberalise financial markets. Predatory lending, or the risk that would entail for financial stability, was secondary at best.
That seems to be the only way to explain how proposals from the car industry to soften the requirements for loans, reduce risk taking of originators, and lower the amount of loans necessary to securitise and sell them on were adopted. It is difficult to say the scales of the impact these successes of the car lobby will have on markets. But they move the EU closer to the situation in US markets at the moment, shaken by subprime car loans tremors, and the memories of 2008.
Hopefully, a majority in the European Parliament will reject the package last minute. If not, citizens may have to pay for their lack of caution in the years to come.
* To track the changes the car makers managed to insert in the texts, it is necessary to use the three institutions' versions of the two legislative proposals and the agreed text after the Trilogue. Links to the four versions of the two texts: