Buckle up: European ABS braces for bumpy ride in 2023
Despite a fast start in January, with deals printing ever tighter, 2022 ended up being a tough slog for the European securitization market. Looking to the year ahead, there is a feeling of cautious optimism among market participants. By Tom Lemmon.
Bankers do not usually need an excuse to be bullish. And those in the European securitization market probably have a more convincing reason than most to think conditions are going to get better in 2023. Surely, surely, it can’t be this bad again?
Volatility caused severe headaches in 2022, giving syndicate bankers, issuers and investors only brief windows of opportunity to execute deals. On occasion, these slammed shut without warning — as Yorkshire Building Society and Crédit Agricole found out, thanks to former UK prime minister Liz Truss’s now infamous mini-budget in September.
However, Christian Thun, chief executive of European DataWarehouse, tells GlobalCapital that, after the volatility that followed Russia’s invasion of Ukraine in February, there is now a sense that the market is in fact slowly getting used to this “less benign environment”.
Starting from a low base is driving Thun’s broader optimism for the European market. “I don’t think it can get worse after all the uncertainty the market has experienced in 2022,” he says. “It will not be a stellar year for securitization, but, hopefully, 2023 will be a better year.”
That sentiment was reflected in GlobalCapital’s survey of market participants, undertaken in October and November, with nearly two-thirds (61%) of respondents expecting greater issuance volumes in 2023. There is also a general expectation of tighter spreads.
Standard & Poor’s head of EMEA structured finance research, Andrew South, says he is hopeful that tranche spreads and pricing on the underlying loans will “eventually find a level” where securitization can work again, and adds that the pullback in central bank funding could also encourage more issuance.
“I’m conscious that I have said this every November or December for the past several years,” South adds. “But maybe more banks will come back to the market as originators next year. There is a stronger argument for that than there has been for a while.”
The terms of the ECB’s Targeted Longer Term Refinancing Operations (TLTRO) have been made “harsher”, South says. This could push banks towards more traditional funding channels sooner and make securitization more appealing.
In recent decades, the “sick man of Europe” tag was chucked at various national economies in their moments of crisis. France, Finland, Portugal, Greece and Italy have all been denounced as such since the turn of the century.
Not since the 1970s has the label been attached to the UK. However, as Brexit drew few dividends and killed off four prime ministers, there is a new sick man, and this could lead to challenges in UK RMBS, which is by far the largest RMBS market in Europe.
UK chancellor Jeremy Hunt said during his autumn budget statement that the UK was now in a recession, while the Bank of England’s base interest rate rose to 3% in November, a 2.75% increase from December 2021.
As a result, one banker tells GlobalCapital, the RMBS market is under pressure next year.
Following the Truss administration’s disastrous mini-budget, which led to extreme volatility in swaps markets, mortgage borrowers on standard variable rates are now “not far off the top” of their original stress tests, while those with refinancing needs coming up will soon feel the pinch, he says.
Meanwhile, hedging strategies used by originators are proving costly too, eating into their excess spread.
The banker says that, when Russia’s invasion led to greater instability in early 2022, many issuers began hedging underlying mortgages from the moment terms were offered to borrowers and at the point the transaction was completed.
Issuers typically hedged 50%-70% of their mortgage offers, because many don’t complete for a variety of reasons. Then, as conditions worsened, issuers became prudent and began hedging in the pipeline as well.
However, as rates rose even more rapidly in the autumn, the odds of completion shifted sharply too. A potential borrower who was offered a 2% interest rate in early summer now had a 95% likelihood of completing, as they knew rates would soon be closer to 6%. Some issuers may have 50% of their mortgages unhedged, taking a huge chunk out of the excess spread and potentially losing money on each of those deals.
Some 47% of survey respondents forecast that Europe-wide RMBS issuance will increase in 2023, whereas there is an expectation that consumer loan, auto and credit card ABS deal volumes will stay the same. However, further trouble in the UK could stop progress in its tracks.
Indeed, unless retail banks return to the UK RMBS market, having been absent for many years — as covered bonds proved a more cost-efficient funding route — a big increase in RMBS issuance is unlikely.
Rahni Soliman, head of capital markets Europe at National Australia Bank and with a particular focus on UK RMBS, says optimism is probably too strong a word to describe market expectations. But he does say that, eventually, some issuers will have to “bite the bullet”.
“I think there will come a time when the market will just say ‘enough is enough’,” Soliman says. “We need to create capacity. We need to re-open public markets.”
Shaun Baddeley, Afme’s managing director of securitization, tells GlobalCapital that, at the very least, the securitization market is proving resilient.
“We have seen that the structures are very robust and portfolio performance on the whole has been unaffected, aside from some marginal upticks in delinquencies,” he says.
As has so often been the case for the European securitization market in the past 15 years, success or failure will to a large extent be driven by regulatory changes.
The European Commission’s own survey of market participants found broad dissatisfaction with the EU Securitization Regulation (EUSR), while GlobalCapital’s survey found 80% of respondents do not think the regulation is helping to revitalise the market.
In 2023, regulatory developments will be critical for the market’s future. Two of the main aspects of the regulatory framework up for debate in 2023 will be the development of the private reporting template and the review of the regulatory capital requirements.
The European Securities and Markets Authority (ESMA) has been asked to review the reporting templates required under Article 7 of EUSR; in particular, it has been asked to develop a dedicated form of private template.
The European Commission acknowledged in its review of EUSR that EU investors would be at a competitive disadvantage when investing in deals outside the EU, mainly in the far larger US markets, because of the disclosure templates for third country securitizations. Private templates in third country transactions are being suggested as a route out of the problem, but more work is needed to ensure they are not so onerous on the originator that they maintain the complexity and competitive disadvantage.
“It’s essential that this is done in a way that works for everybody,” Merryn Craske, partner at Morgan Lewis, tells GlobalCapital. “Particularly for overseas (third country) securitizations, but also for private transactions in general.”
Making disclosure templates easier for EU investors in overseas transactions is also important because it can encourage a deeper investor base for domestic transactions.
Craske adds that the requirement to obtain the reporting templates in overseas transactions is a “real issue”, because EU investors are saying they need the templates and overseas originators may not be able or willing to provide them.
In many cases there is no local legal mechanism for providing the reporting templates to regulators in EU member states. There is also some discrepancy between what the Commission thinks supervisors need and what they appear to be reviewing in practice, although this is likely to change, Craske says.
“If they can come up with a workable template for private transactions, focused on what supervisors need to get an overview of the market and the main features of the transactions, it is likely to make it easier for EU investors to continue to invest in overseas transactions,” she says.
Furthermore, Craske says, regulatory capital requirements for securitization are “not proportional”. This makes it difficult for some investors to invest in deals and is probably restricting the growth of the market. She adds that securitization is treated differently from covered bonds, even though the underlying assets are the same. It does not make sense for securitizations to be subject to significantly more onerous capital requirements than covered bonds and other forms of funding for those assets.
“Tranching doesn’t inherently create more risk in the underlying assets,” Craske says.
However, Baddeley says that while there are “strong arguments” in support of favourable capital treatment, any changes to the Liquidity Coverage Ratio (LCR) rules are likely to be “off the table”.
Nevertheless, liquidity in ABS and RMBS transactions stood up well to the liability-driven investments (LDI) strategies crisis, often performing better than covered and corporate bonds, he says. “It’s a natural asset to preserve value and they have done that in spades in ABS.”
Securitization is an inherently diverse asset class, and while regulations have contributed to RMBS and ABS placed issuance volumes falling by more than half since the global financial crisis, significant risk transfer (SRT) deals have increased more than tenfold, Baddeley says.
However, in 2023 SRT will face a number of headwinds, with the European Banking Authority’s (EBA) imminent report on SRT expected to have a “significant impact on issuance volumes and outstanding volumes”, Baddeley adds. SRT will be “crucial” to banks in recycling capital, which in turn will allow them to lend more and fuel the real economy. A report on SRT is expected in the first months of 2023. GC
ESG in need of stability
Developing new sectors within an asset class typically requires stable conditions. After a strong recovery out of the pandemic in 2021, 2022 was supposed to herald growth of ESG. High volatility and uncertainty made that almost impossible, and Dutch mortgage lender Obvion’s Green Storm RMBS was the only ESG-labelled transaction in 2022.
But Merryn Craske, partner at Morgan Lewis, says that ESG is “not going away and will continue to be a significant area of focus for investors and those structuring transactions”. Some 24% and 21% of respondents in GC’s securitization survey, respectively, say that sustainability is becoming more important in a volatile world and that attracting ESG demand will be even more important in challenging markets.
But they are outnumbered by the pessimists. Some 41% of respondents believe that ESG is beginning to lose importance because investors have more pressing considerations.
The EBA recommended that securitization be permitted to take a use-of-proceeds approach (for now) in ESG securitizations, and this is expected to be ratified by the EU’s politicians in the next couple of months. However, the market is clearly in need of broader stability if it is to develop and become an integral part of the EU’s green transition programme.
A solar ABS market is often considered the great hope for ESG securitization, with market participants frequently telling GlobalCapital that a dam-busting deal is imminent. But the first public solar deal is yet to emerge from the continent, and market participants do not expect one until at least the summer of 2023.
GlobalCapital understands that a German solar company has received a securitization warehousing facility from Citi with the intention that once the facility is fully ramped up, it will be offered to investors in the public European ABS market, potentially as the first ever European solar ABS.
Ultimately, however, the development of a solar ABS market will need stability, a broad investor base and fit-for-purpose regulations — no different from other sectors of European securitization. As one banker says, to be in securitization is to be an optimist. There is hope that 2023 will be an improvement, but much remains uncertain.