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IPE special report May 2018

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Structured Credit: Still to gather steam

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Joseph Mariathasan finds investors ready to buy ABS, but the markets frozen by regulators still fearful of their role in the financial crisis

Chris Redmond, an investment consultant at Towers Watson, makes the case pretty unequivocally: “We think pension funds should have a strategic exposure to the RMBS markets as it gives them direct access to consumer risk, which diversifies their credit exposures away from purely corporate risk.”

Given this type of endorsement from leading pension fund advisers and the importance of housing finance to the overall strength of Europe’s economy, one would have thought the future of Europe’s securitisation markets would be looking rosy.

Nothing could be further from the truth. The European asset-backed securities (ABS) market is like a chronically sick patient hoping for a miracle to restore it to its previous vigour. And the cause of the European ABS malady is not a single pathogen that can be found and destroyed to effect a cure.

Instead, the European ABS market has been cumulatively weakened by a number of separate afflictions: the loss of key investors in the form of special investment vehicles (SIVs); regulatory regimes for banks and insurance companies that penalise investors in ABS; actions by authorities to stimulate bank lending that have undercut borrowing rates available through ABS issuance by banks; the lack of growth in the mortgage market and lack of good collateral in general; relatively tight spreads; heavier due-diligence demands on investors; the unwillingness of banks to run large trading books and a lack of liquidity in general; and perhaps most pernicious of all, the lingering perceptions of the market caused by the catastrophic US sub-prime RMBS defaults of 2007-08. Despite a resurgence of the US ABS market itself, this trauma may still be embedded in the consciousness of Europe’s regulators.

New issuance in the ABS market has declined dramatically since the financial crisis, challenged by competition from the much fitter covered bond market, which has been heavily favoured by regulators.

“Exactly opposite to the ABS market, covered bonds attract favourable treatment in terms of capital charges under the new regulatory regimes of Basel III and Solvency II,” Redmond says. “This makes them extremely attractive to insurance companies. We think this gives rise to captive buyers and a technical support such that pricing appears less attractive to less constrained investors such as pension funds.”

However, it also means that pension funds can and have benefitted from investing in ABS sold by ‘distressed’ owners facing uneconomic capital charges. Towers Watson even went so far, in 2009, as to set up a ‘dislocation trade’ in collaboration with a US and European ABS specialist, recommending to its clients to take on global ABS exposure.

“It was structured as a drawdown structure with cash flows like a private equity investment, as there was no liquidity,” Redmond recalls.

Spreads have come in tremendously since then, but Towers Watson still sees RMBS as having a strategic weighting in their clients’ portfolios of around 1-3%. There are problems to be faced, though. Excessively complex and opaque structures can put off many potential investors.

“Jargon is endemic and over-used,” Redmond complains. “Some of it could be distilled down to more fundamental ideas. A securitisation is just a capital structure with debt and equity – like every corporate has.”

The trigger for the European ABS market’s decline in health was, of course, the global financial crisis, itself triggered by those US sub-prime RMBS defaults. From a high point of €711bn in 2008, European ABS new issuance all but halved to €372bn in 2011. But even those figures give a more positive view than the reality, since as Shammi Malik, ABS trader at StormHarbour Securities, points out, the vast majority of recent new issuance has been retained by the issuer. The supply available for placement with third-party investors has declined even more dramatically.

“Total new-issue supply for placed European ABS in 2013 is projected to be €60bn – similar to that of 2012 and may be even lower, as UK prime MBS issuance is expected to decline on the back of the BoE’s funding for lending scheme,” he says.

This scheme, extended to 2015, gives banks cheaper funding than is available through the RMBS markets, leading to a lack of new issuance and a massive tightening in UK RMBS spreads – and even something of a knock-on effect in other core markets, for example, the Netherlands. The ECB’s long-term refinancing operation has had a similar, though much less pronounced, affect.

“New issuance will be even worse for peripheral ABS bonds where redemptions and tenders have significantly reduced amounts,” says Malik. “Since 2007 the volume of outstanding bonds in Spanish MBS has reduced by around 50% to €50bn, with Italian MBS down by almost 65% to €20bn or so.”

For existing investors, such as Luis Merino, Fund Manager at Invercaixa Gestion in Spain, limited supply can have advantages. “The scarcity of ABS is pushing prices up and spreads tighter,” he says. “I am very happy with the performance.”

Indeed, plain-vanilla ABS markets, such as European consumer loans, UK and Dutch prime RMBS, have performed well and provided a great value opportunity after the global financial crash. With hindsight, they were solidly structured and the economic crisis produced an extreme stress test from which these deals came out well.

But Merino, like most players in the European ABS market, is not entirely happy. “There is no new issuance in the primary market,” he says. “The scarcity is good for what you have but the market is contracting slowly and you can never reinvest. It means that we can’t expect to invest more in ABS next year, and the spreads are not competitive enough with other products.”

Merino is pessimistic about the prognosis for the patient. “If you mix the regulatory uncertainty arising from Basel III and Solvency II together with the funding for lending scheme in the UK, there is much less incentive for the securitisation of assets from banks,” he notes. “We do not have a good atmosphere nor a good regulatory regime for European ABS in general.”

The fact that the financial crisis originated in the ABS markets, and that securities in this sector with AAA ratings dropped like stones, has not escaped the notice of banking and insurance regulators. Perhaps understandably, they have taken the view that they will not be caught out again by the ABS markets.

But as Thierry Sebton, managing partner of Accola Capital argues, securitisation is just a tool. “There is a misunderstanding among regulators between the quality of the assets underlying securitisations and the concept of securitisation itself,” he suggests. “If the quality of the assets is not properly understood by banks and rating agencies, then as we have seen in the case of US sub-prime, you get into trouble.”

Richard Hopkin, managing director of the securitisation division of the Association for Financial Markets in Europe (AFME), points out that while total losses in the US sub-prime RMBS market have reached 12% and are rising, losses on European prime RMBS have totalled a mere seven basis points.

“As people realise, Europe needs funding if it hopes to generate growth, they will also realise that it makes no sense at all to inappropriately penalise an asset class as a result of misplaced perceptions,” he says. “The crisis was caused by bad behaviour, not by a bad product. The comparison between the US and Europe shows this. In France, for example, loan-to-value on mortgages has rarely been above 70%, compared with levels in excess of 100% in certain countries.”

The knee-jerk ‘covered bonds good, securitisation bad’ response from regulators has led to banks needing to set aside more capital to hold ABS than to hold a comparable loan to a corporate with the same credit rating.

“The capital required to hold a BBB-rated ABS tranche can be a multiple of the capital charge applied to a corporate loan of a similar rating,” says Sebton. “So we have arrived at the bizarre situation where a corporate getting cheaper, secured lending through securitisation is being penalised by the regulators compared to getting a straight unsecured loan.”

Solvency II has not been much kinder to the insurance sector than Basel III has been to the banks. Should the regulations on ABS investments not change prior to the implementation date, there would be little incentive for insurance companies to remain invested. Moreover, while insurers also face capital charges for investing in mortgages outright they are only about 3-5%.

“Capital charges for investing in RMBS which have a 10% credit enhancement are in the range of 30-35%,” says Hikmet Sevdican, managing partner at Dynamic Credit Partners Europe. “So imagine what this means. Investing in a five-year AAA RMBS security requires a 35% capital charge, while investing, not in the most senior part of the capital structure, but in the overall capital structure, requires a capital charge of only 3.5%. That’s one-tenth of the capital charge for an RMBS security, even though the risk is larger.”

Merino concurs: “Loans held directly by insurers are better treated than securitisations and there is no point in them getting involved with RMBS as it seems Solvency II will not be changed.”

Each symptom of the European ABS sickness can be treated, but for the patient to recover its vigour a holistic approach is required, directed at the fundamental cause of the malady – a lack of appreciation by regulators and governments in Europe that securitisation could have an essential role to play in unlocking the credit markets of Europe. A level playing field is essential.

“Securitisation, prudently deployed and sensibly regulated, has a critical role to play in the European and the global financial system, along with secured borrowing by banks, covered bonds capital and retail funding,” says Hopkin. “Banks need a range of funding tools.”

Redmond agrees: “The reality is that you need more than just the covered bond market to encompass what historically has been the preserve of Europe’s ABS markets.”

And Sebton notes that there may be little choice but to support securitisation in the longer-term. “The regulators are demanding that banks increase their capital in such a way that they have much less capacity to lend,” he says. “There is therefore little alternative to disintermediation through securitisation.”

As Merino points out, the US Federal Reserve, with its asset purchasing and quantitative easing programmes, is buying ABS, supporting the market. “There is optimism and US investment banks are trying to promote ABS products. But in Europe, the ECB prefers covered bonds, or Spanish or Italian government bonds,” he says.

Redmond is optimistic that attitudes are changing, albeit slowly. “The process of regulation includes an extended period of consultation and review of the impact of regulations on the market,” he reasons.

Indeed, in May, ECB president Mario Draghi announced an initiative to stimulate the market for ABS backed by loans to small- and medium-sized businesses. The supply-side may just be getting its act together – and we know that there is demand for this paper.
Perhaps the last step in the transition to a genuine real-money institutional market for securitised funding for the real economy in Europe is a transfer of staff with securitisation skills from banking to pension funds.

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