"The LTRO has been a successful attempt to defibrillate the bank-funding market, and now we have a body lying on the floor with a heartbeat," says one banker. "But we still have a big problem and there are very few things that can be done at this stage that would make a difference. Allowing ABS into the liquidity buffer is one of them." One ABS specialist told Euromoney this month that such a move would transform European ABS from a 100 billion market this year to an LTRO-like 400 billion.
The exclusion of highly rated asset-backed securities from the liquidity coverage ratio under Basle III is perhaps the biggest challenge facing ABS as its buyer base is so bank dominated. Regulators in Europe have long resisted the industrys pleas that triple-A securitizations are safe and liquid despite considerable evidence to support this. For liquidity purposes regulatory support has firmly backed government securities and covered bonds ever since the financial crisis began. And while the European securitization industry is adept at trotting out impressive statistics as to the markets performance default rates across the board of just 0.7% the product is by definition not as liquid as the covered bond market: ABS in Europe is now a 100 billion market, while covered bonds are approaching a 400 billion market.
"Securitization may be very robust but there is a difference between the liquidity of a 1 billion covered bond and that of a securitization. It may be no less robust but it is likely to be less liquid," says one observer. Certainly all the RMBS held in bank liquidity portfolios when the market crashed turned out to be not very liquid at all.
But those in the market argue, not unreasonably, that current liquidity is a fait accompli of regulation rather than an indication of appetite. "If regulators decide that covered bonds are eligible for all sorts of liquidity or capital benefit and that securitization will be harshly punished, then of course covered bonds will be more liquid," says Robert Plehn, managing director and head of asset-backed solutions at Lloyds Bank. "For prime UK and Dutch RMBS as well as other asset classes such as credit cards and auto loans the credit quality has been exceptional, and if you look at spread volatility as a proxy, over the last two years arguably securitization is as liquid as many covered bonds."
Mark Hale, chief investment officer at Prytania Group, a London-based asset manager specializing in structured credit, warns that the regulators bias towards government bonds in liquidity buffers adversely affects more than just liquidity. "By pushing investors to buy government bonds the regulators are pouring gunpowder onto a powder keg and throwing lit matches at it," he says. "They are doing exactly the same as the rating agencies did with the [structured investment vehicles] SIVs forcing everyone down the same route with the result that everyone is invested in the same way, raising the potential for an explosion that would leave few investors untouched."
As funding dysfunction persists, the shortcomings of existing liquidity coverage ratio (LCR) eligibility will likely become ever more apparent. "One of the jobs of a bank is to effect maturity transformation," says Jeremy Jennings-Mares at law firm Morrison Foerster in London. "There should therefore be a limit on how prescriptive liquidity measures should be."
Diversification of secured funding sources is sorely needed in Europe especially following large LTRO volumes and securitization is the obvious alternative. "Even at more modest levels of LTRO take-up, it is hard to imagine how European banks can be weaned off reliance on official liquidity if the European ABS market does not revert to a meaningful semblance of its pre-crisis dimensions," says Allen Appen, head of European financing solutions at Barclays Capital. "This is unlikely to occur unless a subset of European ABS becomes eligible for inclusion in bank liquidity buffers."
Indeed, many believe that stimulating ABS issuance is, in fact, the markets last chance. The banking system in Europe cannot work on emergency liquidity for ever and it is fanciful to think that senior unsecured will bridge the yawning gap. In comparison with ABS, covered bonds are undeniably inefficient from a collateral perspective. "Allowing ABS in the liquidity buffer is inevitable," says one banker. "If this is not done soon, we could have a macroeconomic environment that would make the scenario that the regulators are so worried about actually happen. The regulatory recession will become self-fulfilling."
Thanks to the hit TV drama The Killing, Denmark has become a byword for cool in many European countries over the past year. It has not, however, become a byword for cool in Europes securitization market. The Danish financial regulator, Finanstilsynet, caused uproar among ABS market constituents when the latest draft of CRD IV was released in early January.
Denmark holds the presidency of the Council of the European Union for the first half of 2012 and as such Finanstilsynet was instrumental in preparing the draft CRD IV documentation. The 496-page document is littered with amendments and alterations, one of which looked like the answer to the securitization industrys prayers: it seemed to suggest that ABS would be eligible for the LCR. Denmark has a keen interest in this as its government bond market is so small. The draft CRD IV wording stated that "asset-backed instruments of high liquid and credit quality" were to be included in the liquidity coverage ratio, so the industry put the champagne on ice and prepared for volumes to soar. Closer reading of the document, however, revealed a specific exclusion for instruments issued by special purpose vehicles rather than credit institutions.
The strange wording seems to have been designed to ensure that Danish mortgage bonds are eligible for liquidity buffers, which are due to be introduced in 2015. The use of the term asset-backed instruments was not referring to ABS as a whole. When it became apparent that the statement did not refer to securitization the optimism that had sprung up in the market began to unravel faster than one of Sarah Lunds Fairisle sweaters. Descriptions of the Danish regulators drafting ranged from "extraordinarily poor execution" to "idiotic".
"No one is that situationally unaware," storms one ABS banker. "The wording should have referred to asset-covered securities not asset-backed instruments. The use of the term ABS in this context is almost negligent." This is clearly a market on the edge and it is not hard to see why.
According to Dealogic, total securitization issuance in 2005 was $2.6 trillion, with the product accounting for 43.6% of all DCM activity. Fast forward to 2012 and year-to-date global securitization volumes stand at just $50 billion a mere 6% of total DCM activity. In Europe, where securitization as a percentage of DCM activity peaked in 2006 at 22.5%, it now stands at 2.8% for 2012 from a total of just six deals. And the $11.2 billion raised from those six transactions is accounted for almost entirely by UK RMBS master trust issuance. The balance comes from Dutch RMBS, UK credit cards and auto receivables deals.
Allen Appen, Barclays Capital
According to Dealogic, of the six deals so far in Europe three have been UK RMBS, which between them account for more than $8 billion of issuance or 61.6% of the market. UK RMBS dominates European securitization more now than it ever did: in 2005 it accounted for 23.6% of the market and in 2009 28.2%. The deals that are taking place in Europe are doing so because of the US dollar bid.
"UK RMBS issuance was always driven by the US dollar investor base before the crisis this is nothing new," Tom Ranger, head of structured funding at Santander in London, explains. "Prior to 2007 it was market folklore that four guys in Newcastle and four guys on the west coast of the US controlled 25% of the UK housing market."
Those days are long gone, but the market is still heavily reliant on between five and 10 US dollar buyers. The imbalance between a super-liquid US banking system and a funding-deprived European banking system is thus manifesting itself in this recycling of US liquidity into Europe.
|Global securitisation DCM volume and activity|
|By deal type|
|European securitization DCM volume and activity|
|By deal type|
The extent to which euro-denominated appetite for the asset class might grow is unclear. Euro tranches have been small and illiquid, but Santander, which has issued £20 billion equivalent RMBS in the past two years, issued most of a recent £2.2 billion trade in non-dollar tranches. However, this was primarily to take advantage of pent-up euro demand following a lack of euro issuance during the second half of last year rather than any surge in euro-denominated appetite.
The LTRO might, however, make a difference. "The LTRO is putting a lot of liquidity into investors hands," says Mike Slevin, managing director in debt capital markets at RBS. "Additionally we have also seen a spate of liability management in euro-denominated ABS, that puts more liquidity into the hands of investors, and both factors could increase appetite for euro denominated ABS further."
But it is the US buyers that dominate and, with the economics of the trade as they are, UK mortgage banks will continue to tap into them in size. "For certain issuers and jurisdictions the headline margins of RMBS and covered bonds are getting quite close as some issuers are willing to pay up on covered to get access to the larger investor base," says Plehn. "A UK issuer with a wider senior unsecured benchmark spread can issue a US dollar RMBS deal at a lower headline margin than a covered bond (albeit the all-in cost could be higher because of the basis and the cost of the swap). With both products the issuer needs to take into account the contingent liquidity cost as well as the basis cost, which is especially relevant if they are issuing cross-currency." The three-year basis swap cost is around 45 to 50 basis points.
The number of US dollar buyers looking to get into this market is set to grow they are comfortable with the credit story of the UK mortgage banks and are making a far better return than they can investing in the US market.
JPMorgans decision essentially to underwrite the return of the European ABS market after 2007 is one of the most contrarian and successful investment strategies the market has ever witnessed. Through its chief investment office, a global prop trading and cross-asset-class asset manager for JPMorgan Chase, the US bank acted as keystone investor in all of the first deals to emerge after the Lehman collapse and the implosion of the market. Committing billions, JPMorgan has seen a handsome return on this strategy as asset prices have recovered and confidence returned.
The US bank has always been tight lipped about its CIO investment strategy but given the performance of triple-A European paper throughout the cycle and the amount of liquidity that many US banks have to put to work it is surprising that more shops have not followed its lead.
More and more US dollar buyers have committed to the UK RMBS market consistently and in size in recent months, including US banks such as Citi and Wells Fargo, Japanese houses such as Norinchukin and Japan Post Bank, as well as Canadian buyers.
Euromoney has learned that at least one Citi is now following the JPMorgan model and setting up a new asset management business devoted to investing in ABS. The bank has confirmed that the strategy will be run through Citi Treasury Investors but declined to comment further. It might seem a late move given the extent of recovery that has already taken place in this asset class, but rumours persist that other big buyers will likely follow suit. Bank of America might be one, but this has not been confirmed.
|David Covey, Nomura|
It is this issue regulation that has dogged European securitization since 2007 and could now be set to make or break the market. "The securitization industry in Europe is in danger of becoming irrelevant if nothing changes on the regulatory front," Covey continues. "If CRD IV and Solvency II go through as they currently stand, securitization in Europe could become a niche market of limited importance and relevance for investors." And that point is inching ever closer.
The stark difference between the regulatory response to the sub-prime securitization crisis in the US and Europe has led to this. "The US policy response to dislocation in the ABS market was to find ways to promote its early restoration," says Appen at BarCap. "European officials, by contrast, through their rhetoric but equally through adopted policies, were consistently disapproving of the financing technique, and contributed to its lasting stigmatization."
The finer detail of the various proposals that have been put forward to rein in the excesses of the industry is exhaustive, but it boils down to issuers being required to have skin in the game, a far higher risk weighting or in some cases a complete ban being applied to securitized instruments on the balance sheet and the ineligibility of ABS for certain bank risk metrics such as the liquidity coverage ratio.
The need to address the shortcomings in the securitization process exposed by the US sub-prime crisis is unquestioned, but the severity is not. Many argue that Rule 122a, whereby you have to have skin in the game, kills sub-prime alone no further regulation is needed.
"No-one in the industry wants to see a US subprime-type scenario emerging again, but its important that the regulatory changes that do occur do not damage viable and sustainable securitization markets," argues Covey. It certainly seems perverse that Solvency II will encourage insurance companies to buy raw loans that have very little information available and penalize them for holding loan-backed ABS, which is transparent and public.
|Global securitization DCM revenue ranking|
|Top five ranking in 2011|
The securitization market itself has responded to these initiatives not only with righteous indignation the capital requirements for an ABS can be up to 13 times those of a similarly ranked covered bond but also with a drive for transparency to head off the kind of justified criticism that the technique attracted after the market first crashed.
Ranger at Santander argues that the market is now as transparent as it can be. "I have no fear that the regulators are going to ask me for more information because I have given them everything that I have got," he says. "We are providing loan-level data, cashflow modelling, total transparency there is nothing else that I can give them."
In what many see as a last-ditch attempt to persuade the regulators of the merits of securitization, the Association for Financial Markets in Europe (Afme) and the European Financial Services Roundtable have backed a proposed label, or kitemark, system for European ABS dubbed the Prime Collateral Securities (PCS) scheme.
The plan, announced at the start of the year, is to certify the transparency, quality and standardization of certain high-grade ABS instruments, essentially a guarantee of quality. This might sound like another rating to you and me but its backers have emphasized that it makes no attempt to judge the collateral or credit quality of the instruments.
Quite how a stamp of quality can be made without this is unclear, but the impetus behind the scheme is clearly to boost liquidity in the market with a view to persuading the regulators that certain ABS instruments should be eligible for liquidity buffers.
"In and of itself the PCS will not change the market," admits Plehn. "But if it allows the regulators to easily refer to a category of securitizations that are eligible for liquidity or Solvency II benefits then it is quite useful." There has been no indication that PCS-compliant instruments would be eligible for liquidity buffers, but the industry is pinning its hopes on positive noises from Brussels the initiative has received letters of support from the European Commission, the European Banking Authority and the European Central Bank.
Eligibility for the liquidity coverage ratio is so important for ABS in Europe because the buyer base is dominated by the banks. The rapid rise in securitization volumes in the years before 2007 was accompanied by a rise in levered vehicles such as SIVs to invest in them. These buyers suffocated the development of a large real-money investor base as they kept spreads suppressed.
"One of the reasons that the European securitization market withered so quickly is that it did not have time to develop roots when compared with the US," muses Hale. Thus the treatment by regulators of securitizations held in bank-trading books is of such crucial importance.
"ABS is naturally a buy and hold product with a lot of bank-based buyers," says Slevin at RBS. "Some banks, such as DnB Nor, for example, have gone public, stating they will no longer buy ABS as it is not eligible for the liquidity buffer. There is a need to build out the investor base before the summer last year you would see 60-odd investors in large deals but now we are back to 30 or 40."
European securitization experts lobbying the regulators over treatment of their product is something that has been taking place with almost monotonous regularity since 2007 and has produced monotonously few results. So one wonders why the industry perseveres with initiatives such as the PCS when it has been faced with overwhelming indifference for so long? The answer seems to be that the bank-funding market in Europe is now so dysfunctional that instead of viewing securitization as a pariah product that needs to be suppressed at all costs, the regulators may be realizing that any form of secured funding that can improve liquidity in the bank-funding market is something that should probably be encouraged. The ABS market is, therefore, hoping to seize its chance.
One securitization veteran tells Euromoney that he senses signs of change in his trips to Brussels. "People are starting to get it," he says. "A couple of regulators have said to me: Dont confuse regulators and politicians. Regulators get it even if politicians dont."
But will getting it lead to any real change?
Key to this is the ECB. Thanks to the almost complete freeze in the ABS market after mid-2007, staggering volumes of ABS were pledged with the ECB. Indeed its annual report for 2010 shows that 24% of all collateral pledged with the bank was ABS the largest class of asset pledged. By comparison, unsecured bank bonds accounted for 21% and central government bonds 13%.
So much ABS was being pledged with the central bank that it introduced a series of stringent changes to its eligibility criteria, limiting the types of ABS that were eligible and trying to discourage banks from pledging these assets.
But after the bank-funding freeze of last year all that has now changed. Last December, ECB president Mario Draghi announced drastic changes to loosen ABS eligibility the minimum rating required was slashed to single-A and the bank will now accept deals backed by both residential mortgages and SME loans. This is a complete about-turn far from trying to dissuade banks from pledging ABS the ECB seems almost to be encouraging it.
"In September last year I was not optimistic that the ECB would move quickly on loosening the criteria for repo market eligibility to single-A and offering long-term funding in scale, but by December they had done both, which was surprising and reassuring," says Hale at Prytania. "There are grounds for optimism. This is, however, not because of a sensible reassessment by the regulators of the situation but was forced because of the intensification of the crisis since June last year." The combination of the ECBs relaxation in ABS repo eligibility and its introduction of the three-year LTRO has triggered a wave of tender offers in the ABS market as banks assemble as much collateral as they can to pledge against cheap central bank lending.
Spains CatalunyaCaixa launched a tender offer for two RMBS and two covered bond deals at the beginning of February worth 7 billion; in Portugal Banco BPI launched a fixed-price tender offer for one of its outstanding RMBS (with limited success); and Banco Popular Español recently launched a tender for ABS and lower tier 2 instruments.
Banks are also structuring retained ABS deals Barclays Bank and SNS Bank have both recently done so presumably to provide LTRO collateral. Lloyds Bank has also launched a tender offer for three series of Dutch RMBS notes that were due to be called later this year.
Robert Plehn, Lloyds Bank
The net result of all this activity is that the ECB already the largest investor in the ABS market by far will be further increasing its exposure to the asset class. "The ECB understands this market it is the largest investor in ABS in the world and it knows how these securities have performed. It also has a huge vested interest in the re-emergence of a scalable, efficient ABS market in Europe," says one banker.
This might prompt the central bank to assert more control over the treatment of ABS under CRD IV the market is certainly hoping that it will. Following the draft CRD IV release in January that caused such agitation in the market, the ECB has issued an opinion that inserts itself as expert adviser on liquidity rules, saying that "the ECB should contribute" owing to its "competence and expertise in the area", pointedly adding that "it is important to ensure that regulation does not lead to unintended consequences with regard to recourse to central bank funding and related financial markets."
It is a long way from comments such as this to a change in regulation, but it could be a start. "When banks lobby the regulators the result has been that their position becomes more entrenched," admits one ABS banker. "Now that the central banks are saying this, the regulators will have to listen. They will have to choreograph how they reverse their position."
The view that securitization in Europe will die unless ABS are eligible for the liquidity buffer is one that not surprisingly stirs some emotion.
"It is an alarmist, simplistic view of things to say that if the PCS fails then securitization fails," says one banker. "It will go back to no less than it is today."
And even hostile treatment under Basle III and Solvency II is unlikely to see it shrink from where it is now. "I would hope the European securitization market will grow even if the liquidity buffer rules are not changed," Ranger at Santander believes. "At some stage people will have to invest in this product. How many triple-A products are there out there that are going to pay you 150bp over Libor for three years?" Not many for sure.
Regulatory forbearance aside, the sheer collateral demands of covered bond and LTRO activity will soon become all too evident. "Asset encumbrance levels will soar, particularly if LTRO usage reaches the elevated levels which some commentators suggest are likely," says Appen. "Although LTRO liquidity has clearly been a contributing factor in the nascent revival of the senior market, resulting encumbrance and attendant structural subordination of unsecured creditors will eventually impede a full and sustained recovery of this market."
And as European governments struggle to stimulate growth from their moribund economies they might begin to see the stimulation of consumer credit as more of a priority than reacting to a US sub-prime mortgage crisis of five years ago.
"Europe needs ABS," states Covey. "There are few means through which banks can effectively transfer prepayment and/or credit risk. You cant do this via a covered bond and you cant do it via senior unsecured. There is strong investor demand for consumer assets, and well-performing credit and securitization is a great way to access it."
Update: New CRD IV wording ray of hope for European ABS market
The new wording was published specifically to address the confusion that the January drafting caused in the asset-backed security (ABS) market.
Interestingly, the most recent draft removes the language in the previous compromise proposal that specifically excluded securitizations from being eligible for liquidity buffers.
It also incorporates a requirement that the European Banking Authority (EBA) considers the appropriateness of allowing other categories of European Central Bank-eligible assets to count towards liquidity buffers.
Both of these amendments are extremely good news for the ABS market. The document specifically mentions high-quality residential mortgage-backed security as an example of the type of asset that the EBA should consider for the liquidity coverage ratio (LCR).
Although there are no assurances of the outcome of the EBA review, this is a welcome first step towards the recognition of the characteristics of high-quality ABS, says David Covey, managing director at Nomura in London. Hopefully, this will eventually lead to the levelling of the LCR playing field for senior prime European ABS vis-à-vis covered bonds and highly-rated corporates.
Such treatment is a long way away, however, and is still far from assured. That said, the level playing field for European ABS seems more plausible today than it has been for some time.