Asset-Backed Securities: Shackled by history
The asset-backed securities markets across Europe struggle to recover from the financial crisis while the EU wavers on necessary regulatory reform, says Joseph Mariathasan
The European asset-backed securities (ABS) market is still shackled by the heavy chains of regulation and has received little help from its core supporters who have been attracted by alternative sources of funding. The market is also a fraction of the size it was before the global financial crisis.
Given the circumstances, the market will continue to shrink. In addition to the unfavourable regulatory environment, there are cheaper forms of financing available, including central bank repo and other facilities, as well as cheaper alternative debt.
Market participants may hope that at least the regulators and central banks are realising that in the ABS market they have an ally in providing greater liquidity. It could help in their aim of revitalising the European economy. Attitudes are different from a few years ago when the European ABS market was being demonised, but the capital charges remain punitive.
As an illustration, for arbitrage cash-flow collateralised loan obligations (CLOs) the AAA tranche is similar to a covered bond in terms of credit risk. However, the applicable capital charge is about 10 times higher. This prevents the asset spread from tightening to covered bond levels, says Renaud Champion, head of credit strategies at La Française Investment Solutions.
The European ABS markets are in limbo on the regulatory front, according to Edward Panek, head of ABS investment at Henderson Global Investors. Over the past few years authorities, particularly the European Central Bank (ECB) and the Bank of England, have said that capital charges are too onerous. But the seemingly negative perceptions of the ABS markets by other entities have offset that particular development, says Panek.
The regulatory discussion is making slow progress in the European Parliament, says Annemieke Coldeweijer, head of asset-backed securities and covered bonds at NN Investment Partners. The European Parliament needs to make a decision on simple transparent standardised securitisation before the market can expect any changes in capital requirements for banks and insurance companies. Intensive discussions are still taking place between industry participants and the European Parliament.
Coldeweijer argues that the European Parliament is looking for measures to assure transparency and liquidity by setting stricter criteria. This is despite existing initiatives such as the European Datawarehouse and the 5% retention requirement. One suggestion is that the risk retention figure should be increased to 20%. “That would severely impair the ABS markets, particularly given the more expensive nature of securitisation versus the government-sponsored funding schemes,” says Panek.
The frustrating aspect to the regulatory impasse is that the US sub-prime-induced financial crash was not reflected in the default experience of the European markets. Indeed, Jeremy Deacon, a portfolio manager in secured finance at Insight Investments, points out that there is a fundamental difference between the US and the European mortgage markets.
In the US, mortgages are non-recourse, which means that borrowers can walk away from debt without being pursued for it. That has a tremendous impact on their willingness to pay. In the UK lenders can pursue borrowers for years when they stop making mortgage payments. In the Netherlands they can be pursued for life.
In a credit crisis, says Deacon, the logical sequence of events would be to look at credit card delinquencies before looking at vehicles delinquencies and then housing delinquencies. In the US, that got turned on its head during the crisis. People kept their credit card payments going because they were using them for shopping. They then kept their vehicle payments going because they needed to get to work.
But what was not critical were mortgage repayments, as they were not going to be pursued if they walked away. “Home owners would have a large percentage of the value of the house but maybe they were able to rent next door for half the cost of the mortgage repayments,” says Deacon. “That drove a very different set of behaviours from what was seen in Europe.”
The obstacles facing European ABS have led to a two-tier securitisation market. Champion says traditional bank securitisation has almost shut down as a funding tool because of alternative funding methods. These include covered bonds and the ECB’s targeted long-term refinancing operations (TLTRO) are much cheaper.
The incentives for banks to launch securitisations (in a non-retained, broadly syndicated format) are therefore low, given the regulatory capital charges differential. That is even true for more plain vanilla transactions.
In contrast, the non-traditional securitisation market is more lively, with growing volumes – although starting from a low base. Many transactions are being used to finance trades for a whole portfolio (that is providing leverage to a non-bank buyer of a legacy or newly-originated portfolio). Others are risk-transfer trades either to reduce risk-weighted assets, or to improve leverage ratios by deconsolidating the whole portfolio from the ceding bank.
The onerous capital requirements imposed on insurance companies through Solvency II means that it is rare to see insurance companies participating in new ABS issuance, says Panek. However, there is hope that they may be relaxed in the future. The main purchasers of European ABS are banks and fund managers, and there is a healthy amount of central bank buying, too.
Publicly placed issuance is still low compared with the pre-crisis years. But in 2016 there could be the most issuance since 2011, says Panek. The primary market has become more concentrated in vehicle loans and leases, particularly in Germany. Residential mortgage-backed securities (RMBS) are dominated by the UK and the Netherlands.
Champion sees likely trades for 2017 including non-performing loans (NPL) in Italy. The total stock of NPL is about €360bn. Transfer pricing could be in the 30% range and only a fraction of nominal exposure is likely to be sold. “Overall volumes of issuance over the next few years should therefore be a fraction of the total, but could be decent, provided investors are comfortable with servicing, transfer pricing and foreclosure process enhancements,” he says.
But Panek says some investor scepticism remains, particularly concerning the duration of the recovery process and the internal rate of return, considering that only a handful of small private deals have been done. Other potential issuers Champion identifies could be non-bank finance companies which still need financing for origination or legacy portfolio purchases and cannot access ECB-sponsored cheap funding. These include buy-to-let, non-conforming and re-performing mortgages. A further possibility could be arbitrage deals on loans (CLOs) which could be a big contributor to volumes (€15-20bn a year) in Europe unless the risk-retention framework changes again. Such a shift is possible, given the legislative measures floating around.
Hopefully the ABS market will grow in importance as its strengths are recognised. But, Coldeweijer points out, the European Parliament has not yet been swayed to adopt a favourable stance. This is despite strong performance numbers from the European market and support from European central banks for the asset class.