Structured finance works. It works because losses since 2007 on European consumer ABS are only 0.3%, according to Fitch. We know it works because in the latest round of sovereign crisis, with stock markets and credit indices sinking, senior ABS in core Europe slipped all of about 20bp wider. And stayed there.
Robert Plehn, head of structured securitisation at Lloyds Bank Corporate Markets, says: "The crisis weve seen this summer should put the relative quality of the securitisation product in a better light."
But to the consternation of structured finance bankers, politicians and regulators arent getting the message, adding a series of punishing requirements that apply only to securitisations.
In the EU, CRD II added a 5% risk retention requirement for any structure that tranched risk through Article 122a.
CRD III slammed re-securitisations, slapping on an indiscriminate 1,250% capital charge. The new regulations boost capital requirements for trading all ABS from December this year. Holding inventory for trading attracts the same capital requirements as holding ABS to maturity closing off one route of reg cap arbitrage. However, banks wishing to game the system will still be able to do so using any other fixed income product they please.
CRD IV, the European implementation of Basel III, is only out in draft form. However, the best guess from those that have devoted time to the 600 page document seems to be that ABS will not count for regulatory liquidity. This means banks, which make up around 40% of ABS primary order books, will have less incentive to buy.
Amador Malnero, global head of structured securitised finance at ING, says: "Its still not clear how ABS will get treated in CRD IV. If there was an exception in the liquidity ratio for labelled securitisations, that would encourage banks to invest."
Demand from bank treasuries also creates self-fulfilling liquidity. More buyers in the market, taking down larger sizes with less concern for concentration in a particular issue, helps the experience of liquidity. Bank buyers are more likely to repo their bonds, to trade in the market, and to roll their portfolios.
Indeed, the Basel draft suggests that banks regularly sell large pieces of their regulatory liquidity buffers to reduce "signalling effects" the logic being that markets would believe a bank must be in trouble if it starts to liquidate its asset portfolio.
"If regulators make ABS eligible for the liquidity buffer, by definition, ABS will become more liquid," says Plehn. "It is unlikely to become more liquid on its own, without regulatory support. Indeed, one of the reasons covered bonds are so liquid is due to such support, whether it is direct or indirect."
The central bank is, of course, the liquidity provider of last resort, and quasi-regulation from the European Central Bank has also hit securitisation.
The ECB has added tougher rating and transparency requirements for using ABS as collateral, while adding to the haircut up from 12% to 16%. ABS of all varieties sits in the highest haircut Category 5, below even senior unsecured bank debt.
New issues must be triple-A for presentation to the ECB, and have required two ratings from March onwards. Loan-level data is set to come in for RMBS and other asset classes from next year.
A lick of paint?
Under this regulatory onslaught, market participants have been seeking a solution.
The Prime Collateralised Securities (PCS) initiative, which the European Securitisation Forum is promoting, is the flagship move. It is a label that could set apart securitisations that meet certain quality, disclosure, and standardisation requirements.
Issuers and investors alike agree in private that it will do little to change how they see securitisations, with most in the market happy with the transparency and disclosure they receive. Issuers in particular grumble about the proposed system, arguing that it will be like satisfying another rating agency.
But insiders say this is not really the point of PCS. The initiative is a political move to demonstrate to politicians (ultimately the bosses of regulators) that the securitisation industry is happy to move in the direction they want.
It allows regulators and politicians alike to draw a line between pre-crisis securitisation, tarnished by US subprime lending, and post-crisis, clean, transparent low LTV lending. Market participants already know this line exists, but they are not the ones that need convincing.
It could also benefit the existing investor base, although there is some disagreement.
"Demand for PCS is coming from the investor side," says INGs Malnero. "A quality label and the transparency and standardisation it brings makes it easier for fund managers to convince management and credit committees to let them buy ABS."
However, Colin Fleury, head of ABS at Henderson, thinks otherwise.
"Were not fans of the PCS initiative to us it seems to run counter to a lot that regulators have been trying to do since the crisis," he says. "We dont think a label that says its OK to buy something and we dont need to do our own due diligence is helpful in the long term we need investors to do their own credit work and take responsibility."
Some investors are more supportive Menno van der Elseker of APG is playing a big role in developing PCS but in either case, the ESF faces formidable challenges in getting the initiative off the ground in time.
If PCS is to influence liquidity policy, it may need to do so before 2013. Banks will have to run a full Liquidity Coverage Ratio from January 2015, but the European Banking Authority will start "observation" from January 2013, meaning that definitions will have to be almost settled.
The multiplicity of securitisation structures across jurisdictions and asset classes makes the job of drafting standard rules extremely challenging, even for core assets.
In the Dutch market, for example, originators reference the loan-to-foreclosure-value when expressing mortgage quality. Everywhere else, the figure is loan-to-value, though again, this means subtly different things.
"Its a huge challenge to get one standard for every asset class," says Paul Adams, vice president, FIG DCM origination at ING. "We probably cant do one single set of transaction documents across European securitisation. But we might look to the covered bond market there are agreed standards for each jurisdiction."
One element that it might seek to replicate is the market-making commitment for jumbo covered bonds. This means banks have to commit to making markets with a defined maximum spread and minimum dealing size.
A terrible thirst
Liquidity in the ABS market is still a controversial topic, which could prove decisive in tempting investors back.
"Investors are very concerned about liquidity in ABS," says Jean-Baptiste Thiery, European head of FI securitisation at Natixis. "Some asset managers look back to the crisis, remember being quoted irrelevant prices or no prices at all, while struggling to meet redemptions and are still prevented from buying ABS again."
Focusing on the credit quality of ABS will not tempt such investors back they need to have confidence in the liquidity of the market.
Lloyds Banking Groups Plehn argues that the credit quality of most real economy European securitisation products has never been an issue for most investors, and that the problem was forced selling during the crisis from leveraged buyers and mark-to-market volatility that this deleveraging caused.
"If these leveraged buyers had been buying covered bonds in similar amounts pre-crisis I suspect we would have seen much more mark to market volatility in this product as well," he adds. "With the disappearance of the highly levered, short term funded buyers I doubt we will see similar levels of price volatility in the future."
Through the most recent sovereign crisis, Plehn has largely been vindicated. Volumes have been thin, as is typical in August, but senior core ABS has displayed remarkable price stability. Dutch or UK prime is off around 20bp from its tights this year, while auto ABS has been even more stable.
In off-the-run, high beta or non-core assets, the spread story has been very different. Volumes have been tiny or non-existent and dealers have been reluctant to add risk, so have marked prices radically down.
The liquidity story also differs depending on which side of the market you look at.
Early this year market participants called a "bid-only" market, with a high and sustained demand for quality ABS assets. Buyers were not willing to pay up to get bonds, but could digest large volumes at prevailing spreads.
However, sourcing bonds was much harder. Dealers are not holding much inventory, and many investors are long-only real money accounts who rarely trade.
Thiery says providing liquidity isnt only down to bank ABS trading desks.
"If investors want liquidity to come back, they need to contribute to that turn over their portfolios, or make assets available for repo," he says.
Even if investors can get a green light for an ABS mandate, they may struggle to build a portfolio without a long investment period to pick bonds as they become available. Some sellers opt to use bid lists rather than market-makers to sell bonds. Many disposals come from CDO liquidations or legacy books, meaning sellers want to exit a portfolio all at once.
The buyers and sellers of primary ABS are sometimes, but not always, the same as those in secondary. Nowhere is the distinction between pre-crisis and post-crisis issuance more sharply drawn. European ABS had a two year issuance hiatus and market coupon for a new issuance is perhaps 15 times higher than pre-crisis.
Regulation has forced a divide between the two.
"The new market standards and Article 122a [risk retention] split the market between new and legacy assets," says Natixiss Thiery. "As final investors, banks and asset managers are reluctant to buy assets that do not meet the new standards, whether legacy assets look cheap or not."
This makes it hard to see how large the market is and hence how liquid. The usual figure for ABS primary books is somewhere between 20 and 50, but Lloyds gathered 70 orders for its market-re-opening Permanent 2009-1 RMBS.
Meanwhile, Santanders Fosse 2011-1, the largest RMBS all year, gathered 130 orders from 80 accounts this May, but that does not seem to have led to larger books on subsequent issues.
Lloydss Plehn says that a focus on investor numbers can be misleading.
"The relative depth of the investor base in this market isnt as bad as people would portray it," he said. "Even pre-crisis, the investor base for securitisations was not extremely deep in terms of absolute numbers of investors."
The floating-rate format of ABS attracts big tickets from bank treasuries, while corporate credit appeals more to smaller asset managers.
Lloyds demonstrated the strength of ABS in a private format, placing a £2bn RMBS from its Arkle master trust in the teeth of the eurozone crisis this July.
While a full public market is a healthy sign, ABS issuers can get deals done while senior unsecured or corporate markets are closed.
"While we havent see a big vibrant public market this summer, deals were getting done in pre-placed/club formats, while other asset classes such as covered bonds and senior unsecured bank debt have been largely shut down for primary issuance," says Plehn.
Regis Lanove, vice president, high grade syndicate at ING, says: "The private or semi-private route is a good way forward, in difficult markets and for re-opening asset classes. I cant really see much of a public market in the more esoteric assets."
Securitisation struggles less with respectability from the issuer side.
Treasurers do not have to convince sceptical credit committees and battle headline risk in their own institutions. But the universe of willing issuers is also small. Institutions which might struggle to access capital markets with a credit-linked instrument smaller UK building societies, small Dutch banks, regional Italian banks might consider securitisation.
Dutch bank-insurers, which are not credit institutions that can issue covered bonds, but nonetheless have large mortgage books, are also in the market, as are UK issuers with uphill funding targets.
While the ECB is offering full allotment against retained ABS though, incentives to test the market remain limited.
"Constraints on liquidity right now havent been pushing people to diversify funding," says Thiery. "The deadline for the ECB to remove full allotment is a long way off, and people only want to move when there is immediate pressure or constraint. But its better to establish programmes and get the investor work done in good time."
INGs Lanove is sceptical about how broad the issuer case can get in Europe.
"Securitisation is likely to be more interesting for medium or smaller continental banks, as covered bonds will probably remain cheaper for the biggest banks," he says. "Securitisation may be complementary, but not competing."
Some of the markets that were largest pre-crisis are now engulfed in sovereign crisis. France and Germany never had ABS markets proportional to their size, but the product thrived in Ireland, Portugal and Spain.
Thiery says: "ABS is delinked in theory, it should be a safe haven. But its still a bit correlated, it is linked to the financial situation of the banks and linked to the macro environment. Investors are just not going to be willing to get involved in Spanish RMBS when theres a Spanish sovereign crisis."
Culture is important too. The UK has historically had the largest, most diverse and most vigorous securitisation market. But this is truer than ever, and the European primary market remains extremely narrow.
Lloyds Banking Group originated nearly 20% of all issuance in Europe this year, with Santander and its subsidiaries not far behind on 17%, with Santander UK delivering the vast majority.
Volkswagen covers another 10%, through its captive lender VW Financial Services, and no mainstream European bank appears until BNP Paribas (it did one RMBS, making up 3% of placed issuance this year). Rabobanks specialist mortgage subsidiary Obvion placed more than 3bn, accounting for 7%.
Nonetheless, the versatility of ABS and its delinked structures count in favour of ABS for issuers.
"Senior and covered both come up against credit limits," said Natixiss Thiery. "If banks have lots to do theyll want to look at alternative sources that arent connected to their own credit rating."
Getting investors on board
The ABS market is starting to work together and find the right ears to whisper into and figuring out where the levers of lobbying lie.
But this is happening too late. Regulation hitting the market now was conceived and drafted years ago. This creates drift and a momentum of its own, where an initiative starts to gain currency because it has been talked about. Few discussions strip things back to first principles, however flawed these principles might be.
The stories of US subprime mortgage broker shenanigans led to risk retention rules. But taking a step back, why would regulators want to hold more risk in the banking system? Wouldnt it be better to shrink bank balance sheets and let them act as middlemen rather than principals?
Maybe, or maybe not, but the argument got brushed under the carpet.
A better route to a flourishing market is working with investors. Not ABS investors (they know what theyre doing) but those that arent buying ABS. Fund launches or credit approval might be slow in coming, but they will be supersonic compared to regulatory change.Regulatory benevolence may be a worthy aim but buyers are what make a market.