Investment Grade Credit: What’s next for ABS?
The last 12 months have seen a significant shift in the tone used by senior policymakers and regulators when discussing securitisation. For example, in April 2014 the ECB and the Bank of England issued a rare shared paper in which they argued that prudently designed ABS had “the potential to improve the efficiency of resource allocation in the economy”. They urged a revival of this moribund financing technique, which would lead to lower costs of capital, higher economic growth and a broader distribution of risk.
Despite these warm words, current issuance of securitisations is far below the level reached before the crisis. From 2001-06 issuance ranged from €153bn to €481bn, all placed with investors. It peaked in 2008 at €819bn. By comparison, in 2013 total issuance for the full year was only €181bn, down 28% from 2012, with less than half actually placed with investors.
AFME’s latest statistics show the declining trend continued in 2014. At the end of Q3 2014, issuance was €155bn, with only one-third placed with investors. Significant uncertainty remains regarding the future of this market, despite the very strong historical performance of European ABS. During and since the crisis, European securitisations never suffered the losses we saw in the US sub-prime mortgage market. The regulatory framework in Europe, and our different banking business models, helped prevent that.
While policymakers consider reviving the market to support economic growth in stagnating European economies, for investors it would mean the rebirth of a potentially attractive asset class. We now have seven years of data to show that securitisations of ‘real economy’ assets in Europe have performed extremely well both through and since the crisis. For example, since the middle of 2007 until the end of Q2 2014, Standard & Poor’s analysis shows that only 0.14% of prime European residential mortgage-backed securities have defaulted – for all rated tranches, senior and subordinated. Defaults on the senior AAA tranches were zero. This performance is sharply different from that of the US sub-prime market, and yet US market issuance has recovered much more than Europe’s.
However controversial the history, secur-itisation should be seen as no more than the process by which cash-generating assets, such as mortgages, auto loans or SME loans, created by banks and initially funded on their balance sheets, are funded instead by issuing bonds in the capital markets.
In our opinion, European securitisations suffer from an excessively harsh regulatory framework. This reflects initiatives begun in a very different environment, in the immediate aftermath of the financial crisis. European regulations continue to discriminate against ABS compared with other fixed-income instruments or direct lending with similar degrees of risk. This will hinder the revival of this market.
Today the market is at a crossroads. One road would lead us to a new, rebuilt and sustainable market based on a European regulatory environment which is balanced and evidence-based, and which protects against risks while recognising the strong credit and price performance of high-quality securitisations in Europe. The other road would take us to a world where all securitisations, even those that have performed very well, continue to be treated as sub-prime. This will cause issuance to continue to stagnate, investors to exit the market and bank lending to be even more constrained, impacting businesses and the real economy.
There are some encouraging signals. The ECB’s recent ABS purchase programme sends a positive message to new and returning investors that securitisation is a safe investment. The inclusion of a wider range of ABS in the scope of the liquidity coverage ratio by the European Commission was very welcome, and will help underpin bank investment in this market.
However, other important regulations remain discouraging. Under the recently finalised Solvency II rules, insurers are still required to hold capital amounting to 10.5% of nominal for a five-year AAA-rated prime RMBS – when the default level has been zero over seven years. This will continue to deter insurers from returning to this market at a time when we badly need non-bank investors for our capital markets to grow. We can only hope that this harsh calibration does not prove too damaging, that flexibility for lower capital allocations using internal models will be possible for at least the largest and most sophisticated insurers, and that a review of this outcome can be undertaken at the earliest opportunity.
For bank investors, the recently announced final rules from the Basel Committee for Banking Supervision have increased capital requirements significantly. This is disappointing. However, the simultaneously published BCBS/IOSCO paper on ‘Criteria for Identifying Simple, Transparent and Comparable Securitisations’ gives some grounds for optimism that, following further consideration, securitisations which meet app-ropriate criteria will be incorporated into the securitisation capital framework in a more positive way.
Both we as an industry and our regulators must continue to engage, and demonstrate our commitment to reviving the market for “simple, standard and transparent securitisation”. The EBA’s recent discussion paper on this subject highlighted, for the first time in a regulatory document, the inconsistencies and lack of a level playing field between securitisation and other forms of fixed income with similar risks.
Also, we should continue to support the good work done by the Prime Collateralised Securitisation initiative (PCS), set up by AFME and the European Financial Services Roundtable but now wholly independent. A not-for-profit initiative, it seeks to promote quality, transparency, simplicity and standardisation throughout the ABS market in Europe.
While much good work has already been done in transparency, AFME continues to work to standardise investor reports further, and will also continue to explore how to better exploit the significant investment already made in the European DataWarehouse.
We must also grow the investor base and persuade investors, both bank and non-bank, to return. Currently, the European securitisation market relies on only some 40 or so investors. This is too narrow a base, and needs to be broadened significantly. This is why sensible calibrations of capital requirements under Basel III and Solvency II are so important.
Securitisation needs to regain its function not just as a provider of direct funding, but as a tool for risk transfer. Prudently deployed and sensibly regulated, securitisation can free up capital on bank balance sheets, enabling it to be recycled to support further lending. Yet, in practice this has been hard for banks to achieve in recent years. National supervisory authorities have been reluctant to grant approvals even when the rules have been complied with, and many inconsistencies have developed between different national treatments.
So while we welcome the progress that has been made, for the markets to recover, it is not enough simply to define “simple, standard and transparent” securitisation. It must also be recognised in the key regulations outlined – so that policymakers’ high-level support can be translated into meaningful, co-ordinated action on the ground.
Richard Hopkin is managing director in fixed income at the Association for Financial Markets in Europe (AFME)