More investors required as European securitization looks to step up

There’s an unfamiliar sentiment pervading the world of European securitization as it gathers for IMN’s 27th Global ABS conference in Barcelona this year. A market that for years has felt rather downtrodden is allowing itself to feel a creeping sense of cautious optimism.

Yet this would not be simply a revival of the market of the early 2000s; the understanding of the purpose of securitization has moved on fundamentally since then. Rather, the industry appears to have carefully, cautiously, reinvented itself. And as lenders wean themselves off cheap central bank liquidity, securitization has a chance to show off its wares as an excellent financing instrument.

“There was a perception after the GFC that European regulators wanted to reduce the securitization market,” says Matthew Moniot, co-head of credit risking sharing at Man GPM. “I think that was wrong. From very early on, 2012 or 2013, the regulators were busy creating an architecture for a sustainable securitization market, which I think they have largely achieved.”

If those in the risk transfer segment of the market tend to agree (see box below), others have a rather dimmer view of regulatory measures.

“As well as cheap central bank financing, the single biggest problem to the growth of the market is the regulation that has come in since the financial crisis,” Matthew Jones, commercial head of structured finance EMEA for S&P, says.

“If that regulation was moved to a fairer and more appropriate place, it is very easy to see how you could start to see significant volumes of ABS and RMBS across Europe.”

There are plenty of green shoots that suggest reasons to believe the use of securitization as a funding tool is picking up. But the market is likely to encounter several potential obstacles in its bid to fully realise its promise.

Since 2008, the once-big players in the market have largely scaled back how much they use securitization for funding. Yet this has created an opportunity for specialist lenders to use securitization to finance a new business model, and the industry in Europe is arguably as diverse today as it has ever been.

Consider Kensington Mortgages, which became a securitization issuer in 2015. The specialist UK mortgage lender supported itself primarily through the securitization market until Barclays bought it for £2.4bn in March this year.

“When we started, there was a question about whether securitization was even feasible as a robust funding model,” Alex Maddox, capital markets director for Kensington, told GlobalCapital in March after Barclays acquired the company. “We proved that it was and showed we could maintain the levels through some pretty challenging conditions.”

According to Bilal Husain, BNP Paribas’s head of securitized product group and real assets syndicate, the expansion of specialist issuers has only been possible because bigger issuers have had less of a presence.

“The market has been so used to liquidity that when you only had UK prime issuers there was little room for [specialist lenders] to grow,” Husain says. “When the central bank funding was announced it created the window where investors had to focus on what they could actually buy, rather than what they wished they could buy.

“The nature of the issuer base has changed quite a lot. For me, that is driven by the fact that the market is not completely obsessed with only buying the [likes of] Rabo, Santander or Lloyds. They’ve been forced by their absence to go and buy other names.” 

However, those central bank schemes are, it seems, finally winding down, and those large banks will need to replace much of that funding. The securitization market would appear to be an obvious place to go.

There are plenty of reasons for optimism that that is happening. In May, there were four UK prime RMBS deals in two weeks, including — on May 17 — the return of Lloyds’ Permanent shelf after more than three years away.

Yet if securitization is truly on the cusp of some kind of golden age, the two universes of issuers must be able to coexist: the market must again become a reliable source of funding for big lenders, while continuing to allow smaller issuers to thrive. Rising to this challenge will require achieving something that has been hereto elusive: significant growth in the investor base.

Owen Muller, director private client syndicate at NatWest, believes the increase in prime issuance could be the catalyst that is needed.

“An increase in prime issuance could actually be a really good thing,” Muller says. “Maybe it brings in some investors who weren’t prepared to play because there wasn’t enough liquidity. Maybe over time they start investing in non-prime, as we’ve seen with some other accounts.”

The return of the big prime issuers raises the question of whether those specialty finance companies could find themselves squeezed out by larger issuers. But Kensington’s Maddox believes a more established market should be beneficial for all.

“More supply helps investors build dedicated funds and that momentum will be good for specialty finance companies,” he says.

However, Husain believes that, although old investors could return, regulation will continue to be a barrier for new investors.

“One of the problems this market has is that investor appetite is not unlimited, unlike the US markets, which are quite deep,” says the BNPP banker. “We might see a return of investors who have been staying away from European markets because they focus on big names. We might see the return of old investors, but new investors are driven by regulation.”

One option that UK issuers have to uncover a new set of investors is the dollar market, where there is a vast ABS investor base but where there has been limited dollar activity from European issuers recently.

“There’s definitely demand for [dollar UK RMBS],” says Rob Ford, partner and portfolio manager at TwentyFour Asset Management. “But obviously issuers have then got to put swaps inside the structures.”

Given the rapid rise in interest rates over the past two years in both the US and the UK, the basis swap has been “very volatile”, notes Ford, making the cost of those swaps “prohibitively expensive”.

“[This] is probably why we’ve only seen a handful of deals,” he says.

If interest rates stabilise, allowing cross-border activity to pick up, there should be benefits for all issuers.

“The big guys can borrow in Asia, borrow in Australia or borrow in the US or in euros,” Husain says. “The smaller guys today can’t, but they will eventually have access, the more [that] overseas markets are used by the larger firms again.”

UK prime RMBS should be the lowhanging fruit of any potential securitization issuance revival, because many banks are already issuers.

“The UK is a different story [to the rest of Europe],” says Gordon Kerr, head of European research at KBRA.

“A lot of UK banks have set up master trust programmes and once they’ve been established it’s hard to justify collapsing them and putting them into a covered bond programme.”

However, expanding the hobbling euro RMBS market would represent a bigger prize. Over the past decade, around 2.5 times more European RMBS has been issued and retained each year than has been publicly placed, with lenders largely retaining deals so they can use them as collateral with a central bank.

While the UK accounts for around 75% of publicly placed volume, it only accounts for around 25% of retained volume. Coaxing more European issuers into the public market could therefore potentially be a major boon to overall volumes.

“It really doesn’t take much,” Ford says. “Even if it’s only a 10% change, that’s 10% of a number that is 2.5 times more than what is currently being distributed.”

Ford believes that Spain, France, Portugal, Italy, Belgium and the Netherlands all have scope to increase the size of their RMBS markets. However, even once central bank funding has disappeared, these markets will still face stern competition from covered bonds, which usually offer a better deal to issuers than securitization.

Although certain UK prime RMBS issuers — most notably Permanent — did manage to price deals slightly inside covered bonds in May, there remains doubt as to whether that can be sustained. Moreover, it could remain strictly a UK phenomenon.

“[Lloyds and Virgin’s] pricing was driven by significant demand from bank treasuries,” says Jones at S&P. “Most investors in covered bonds are bank treasuries in the EU, which will lead to less demand for sterling paper [in covered bonds than RMBS].”

In other words, EU covered bonds will remain relatively tight versus UK covered bonds, and they will thus likely retain their competitive advantage versus RMBS.

“I asked two heads of funding at [major European banks] whether they’d be coming back to publicly distributed RMBS funding any time soon,” says Ford. “They both said no, because central bank funding and covered bonds are both so much cheaper and simpler.”

Market participants note that covered bonds also have a significant regulatory advantage. Insurance money, which should be a natural fit for RMBS and CMBS, is kept out of the market because of the high capital charges associated with holding securitization paper.

“Regulation is a major factor [in the size of the securitization market],” Kerr says. “In particular, Solvency II is an issue. Changing that should be the priority because it would bring a big investor pool back in. Insurance money could help take bank risk out of the banking system.”

Muller at NatWest concurs that Solvency II is a hindrance.

“It still feels like there are pools of untapped capital that the market can’t really access at the moment,” Muller says. “Solvency II is probably the major cause of that.”