Themes for 2015: Securitization – paying its debt to society
ABS has been on trial since 2007, when abusers of the technique conspired to set the global economy back a decade or more. Regulators now hold the keys to securitization, and it is they who will ultimately decide whether the asset class has served its time, writes Tom Porter.
A key tenet of any justice system is that the punishment fits the crime.
In 2007 tiny German Landesbanks started taking billion dollar losses because homeowners in the US could not pay their mortgages. A year later the world was entered the worst recession since the Great Depression. For that crime, securitization received a slow death sentence in Europe. Regulators threw the book at the product, seemingly intending to stop banks, the main players in Europe, becoming involved in the practice to the extent they were.
In the rush to bring the appropriate retribution, the fundamental benefits of proper securitization structures were forgotten and an industry crucial to shifting credit on the continent was put at risk.
“I do think there was an overreaction, which is natural in extreme volatile times,” says Antonio Caçorino, managing principal at StormHarbour Securities in London. “Negative headlines, combined with deficient knowledge from some regulators, drove an emotional reaction against the fundamental tranching of risk. Any form of risk tranching was seen as a way to package something that looked bad in a way that looked good.”
The ill feeling towards securitization may have been broadly equal on both sides of the Atlantic in the immediate aftermath of the crisis, but if you look at cold, hard numbers the US has got off much lighter.
Annual US issuance runs into 12 figures annually and issuers have a variety of buyers to choose from. In Europe distributed volumes will struggle to hit €60bn ($74.5bn) this year, versus more than €300bn in 2007, as issuers compete for the attention of 50 or so active investors.
The US capital market infrastructure was better set up to recover from the shock. Around 70% of US debt is financed via capital markets — in Europe it is virtually the opposite.
To paraphrase European Central Bank president Mario Draghi, whether you like banks or not, they take care of 80% of credit intermediation on the continent. In the context of the total debt market that difference is trillions of dollars. The two regions have completely different capital market cultures.
“In the US investors have been groomed for decades to buy bonds,” says Jim Ahern, head of Moody’s Americas securitization in New York, “and you have mechanisms that proliferate that, such as the way they set up retirement savings.
“A lot of the 401k plan money in the US flows into asset management firms, which have huge amounts of capital they need to invest and are generally looking for stable value, long term products. Securitization plays well into that fundamental.”
With such a large pool of ready capital, banks are not necesary as liquidity providers. Collateralised loan obligations (CLOs) and commercial mortgage-backed securities (CMBS) are both $100bn a year markets in the US. Asset managers or other sponsors provide liquidity, service providers facilitate transactions and a deep investor base buys, with minimal input from the regulated banking sector. The European versions are lifeless by comparison.
Forgive the SIVs?
In 2007 €307bn of European ABS was placed with investors, according to JP Morgan figures, including €40bn of CMBS. So where have all the buyers gone?
One hole is where asset-backed commercial paper conduits, or structured investment vehicles (SIVs), used to be. Before the crisis, European banks had over $500bn invested in these vehicles, which were borrowing short and investing long in ABS, using eye watering levels of leverage.
“The structure of the SIVs and the conduits proved weak to support stress conditions,” says Caçorino. “Restructuring and regulating those differently is an absolute necessity after the crisis, to set a maximum leverage level, ensure stable capital structures and less or no mark-to-market triggers.
“But lessons were learned. Now we should be incentivising new asset managers and new entities like SIVs to be fundamental buyers of the top rated part of the capital structure.”
One place Europe should have a nice pool of deployable capital is with insurance companies. But even without the new capital charges insurers are required to hold against securitizations, which are multiples of those for like rated covered and corporate bonds, the market would still be fragmented and dominated by national champions like Allianz in Germany or Axa in France.
Regulation is a high barrier indeed. Under the insurance industry’s incoming Solvency II regulations, insurers have to hold more capital against securitizations than other forms of debt with the same rating. The banking sector’s Basel III regulations and the Liquidity Coverage Ratio also penalise securitizations relative to competing products.
“This is where the overreaction may have come,” says Ahern. “There is still an entire policy sentiment towards securitization that is biased relative to other like forms of debt. In and of itself that is going to seriously hold back securitization in Europe over time.”
The familiar refrain from ABS representatives is that the entire product is being regulated based on the losses experienced in US subprime market, despite the fact that top rated European ABS performed admirably even during the crisis.
The ECB gets this point. It began purchasing senior tranches of euro area ABS in November, the firmest signal possible that it sees them as reliable instruments. It has also put pressure on regulators to address securitization’s treatment.
But while the ECB’s public backing is welcome, the idea that buying ABS will produce much more of it may be more in hope than calculation. For years banks have been told to de-lever and get their houses in order for Basel III, and they have done it by lending less. Growth in Europe is non-existent and if banks are not creating new assets, then they won’t be selling more ABS and covered bonds.
“Where we may see a reaction is in the peripheral countries,” says Ahern, “where they have mortgages or other assets that have historically gone into a securitization but today are maybe being pledged for liquidity purposes.
“That is some of the low hanging fruit, but I just don’t see the ECB having much impact on liquidity in the ABS market because there aren’t enough pools of underlying assets sitting around.”
Missing the target
It is not the ECB’s job to revive European securitization, nor is that its intention. Draghi’s rhetoric has shifted noticeably since his first hint of a purchase programme, from SME funding to balance sheet expansion.
The ECB wants nothing more or less than €1tr of quantitative easing. It just so happens that ABS and has been chosen as one transmission mechanism for it, as it bears some connection to the real economy. The target was quickly widened beyond SME ABS and then on to covered bonds in pursuit of size. If that is not enough they will move on to sovereign and corporate bonds.
But here lies another telling difference between Europe and the US. Draghi and team do not possess some of the tools available to their American cousins.
The US has undergone an unprecedented balance sheet expansion since 2007. But it has funded the real economy directly through government-sponsored enterprises like mortgage lenders Fannie Mae and Freddie Mac, and funded over $1tr of student loans. The ECB is trying to provide the same type of liquidity to the market, but it is doing it by stimulating the end product rather than the inputs.
“What the ECB has done is good, but it has to be only step one,” says Caçorino. “They need to be working on step two now if they ever want to leave this market. It is much more important that they give direction, and try to create and incentivise new players. As an example, insurance companies should not be penalised under Solvency II for buying asset backed securities.”
It is the velocity of asset rotation from bank balance sheets that provides fuel to the real economy, he says, as long as they are not creating bad assets.
“If the cost of carry decreases then banks can either lend at lower levels or make more margin, and if they have more capital they can lend more. There was a lot learned during the crisis. Rating agencies are significantly tougher and have smarter people. A lot of things have improved.”
Time for parole is now
ABS may have a great deal to contribute to keeping the European growth engine running. But if regulations remain as they are, it will be more capital intensive for insurance companies to buy the triple-A portion of a securitization than buying the entire loan pool. There are meagre incentives for European originators to securitize.
“The securitization industry argued for capital neutrality and they didn’t get it,” says Ahern. “That in and of itself is the biggest constraint around securitization. If regulators want to promote securitization make it favourable from a capital standpoint, if they want it to have its natural role in the markets, make it neutral. If they want to restrain it, make its capital treatment less favourable and therefore more expensive.”
Bankers arguing for weaker regulation may look like a grizzly brown animal defecating in a forested area. But in this instance they are merely asking that securitization’s sentence comes to an end, that its negative bias be removed and its performance recognised by regulators, investors and the industry. Then it may prove useful to the European economy.