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Structured Credit & Loans: Collateral damage

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Tarred with the same brush as the US securities that sparked the 2008 crisis, Europe's ABS are shunned by investors and regulators alike. Joseph Mariathasan finds that pension funds might be the key to bringing depth to the market again

The global asset-backed securities (ABS) markets are too important to disappear, but European ABS is struggling to survive under the new regulatory environment for banks and insurance companies imposed by Basel III and Solvency II, which favours covered bonds over securitised instruments. Despite this, there are still attractive opportunities in European ABS, even when compared with the US ABS markets, and a chance for European pension funds to diversify their portfolios by having direct exposure to the consumer.

The fact that the global financial crisis was sparked off by a crisis in the US sub-prime residential mortgage-backed securities (RMBS) market has entrenched misconceptions by investors towards the whole asset class, argues Ed Panek, head of ABS investment at Henderson Global Investors: "Amongst these are that ABS are risky securities which have experienced significant losses; that the performance of the assets underlying ABS has been poor; that ABS are illiquid securities; that ABS returns are highly volatile; and that ABS is a relatively small, niche market."

While some of these perceptions are accurate when applied to certain sections of the ABS market, dig behind the headlines and it becomes clear that, in many instances, they are not accurate in relation to many European ABS asset classes. The US securitisation marketplace certainly had significant flaws in specific sectors such as US sub-prime and collaterised debt obligations (CDOs), and although the European experience has been very different, it appears that regulators have tarnished it with the same brush.

"Auto loans have an average life of 1.5 years," says Shammi Malik, ABS trader at Stormharbour Securities. "They are rock solid and short duration. No one has ever lost money on them. But under Basel III, even auto loans will have as high a risk weighting as Spanish covered bonds, which represent a dynamic pool of assets on the balance sheet of the originator. It doesn't make sense."

A report issued in April by Fitch Ratings warns that these punitive capital charges will cause insurers using the standard Solvency II formula to shift out of securitised assets into more favourably treated asset classes. Why have regulators favoured covered bonds?

"I don't know the answer," admits Chris Redmond, head of global bond manager research at Towers Watson. "Perhaps it is because there has never been a default on covered bonds and they have seen defaults on ABS - albeit largely confined to more subordinated tranches. There is a feeling that regulators have looked backwards at the historical experience and covered bonds looked safe."

Struggling with an existential crisis in the euro-zone, authorities are driven to actions and decisions that are damaging ABS markets in ways that are either too complex to appreciate or too peripheral to consider. For example, the ECB's introduction of the long-term refinancing operation (LTRO) by the ECB has crowded out ABS, as potential issuers have been able to borrow more cheaply from the ECB. By contrast, US government and regulatory authorities believe that, even given what has happened, securitisation is a key long-term financing tool for banks and non-bank financial institutions.

"In Europe, there was a period when the feeling seems to have been that securitisation is bad and we don't want it any more," says Panek. As he acknowledges, that attitude has begun to soften as regulators realise that securitisation is a viable funding mechanism as long as it is not abused. But in Europe at least, the ABS market will likely function below pre-crisis levels for some time. "Many of the previous investors no longer exist - that is, almost anyone doing anything involving leverage," he notes.

But even real-money investors think twice at the moment, not least because of uncertainty around the future of the euro. Bryce Markus, senior portfolio manager at BlueMountain Capital Management, argues that elevated yields in European issues still do not compensate for that kind of risk: "We will go anywhere where the risk/reward trade-off looks attractive - but we are not currently active outside the US ABS markets."

Redmond acknowledges that things could get complicated in the event of a euro-zone break-up, and that Towers Watson does "probe fund managers" to make sure they have thought about issues of securities' domiciliation. But there is only so much you can do, he adds: "Otherwise you get so paranoid that you won't invest in anything."

As well as the uncertainty about another part of the investor community is willing to fill the void left by leveraged players, the future size of the European ABS market has a supply-side problem, too. ABS markets in peripheral euro-zone countries like Spain - historically a vibrant MBS market - are essentially broken. Today European ABS is focused around just three core areas: UK RMBS, Dutch RMBS and German auto loans.
Secondary markets do have liquidity. Jason Walker, ABS portfolio manager at CQS, argues that, in many respects, European investors see even more two-way markets across a range of names than US investors. "There are 160-180 outstanding CMBS issues and each has 5-6 tranches per deal," he observes. "There is an active market in 60-70 deals, with the senior AAA tranches trading the most."

But depth is limited. Charlotte Valeur, chair of the London-listed Credit Catalysts investment trust, which feeds into the Brevan Howard Credit Catalysts Master fund, says that its investment manager David Warren can find plenty of liquidity in the securities he trades - from credit card receivables to home-equity loans - but that is because he is moving blocks of $10-20m (€7.9-15.8m). "Maybe the market, in its heyday pre-2007, could trade $200m, but no bank could do that today," she says. "If JPMorgan wanted to get out of a large position, yes, they would take a hit and have to sell at a discount."

Moreover, that depth is getting shallower by the day, although it is easy to overstate this. "New issues are down for 2010 and 2011," says Walker. "The market is amortising away - but not very quickly."

The solution undoubtedly lies in opening the asset class up to real-money investors like pension funds, in the same way that non-bank participants have been enthusiastic takers in the US. Since the big-value opportunity of 2009, there certainly has been progress. Structures are likely to be simpler in future, says Panek: "The securitisation market had become very esoteric and highly structured, but now we are seeing more straightforward generic structures and there is good demand from real-money investors."
Future issues are also likely to offer stronger credit enhancements, catering to a more knowledgeable investor base and dramatically improving industry performance, suggests Markus.

"Having observed ABS asset managers pitching for mandates, there is a basic inability to put across the case for the asset class in simple, understandable terms," says Redmond. "People are too comfortable hiding behind acronyms and technicalities. ABS has more acronyms than any other asset class that we have looked at. However, 10 years ago no clients invested in the secured loan market, but now it is seen as a relatively plain-vanilla investment. We are proponents of ABS as a strategic asset class investment."

If efforts by Towers Watson and others do manage to persuade the European pension funds to invest significantly in ABS - and Towers Watson suggests that up to a 5% weighting is implied by the market's size and risk profile - then it could provide the lifeline required to support the European ABS markets long term. That's assuming, of course, that those pension funds don't get caught up in Solvency II-type regulation that punished ABS relative to less attractive - and arguably no less risky - alternatives like government bonds, investment-grade credit and covered bonds.
 

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