The European Commission’s proposal that securitizations carrying the ‘Simple, Transparent and Standardised’ stamp should qualify for spread risk regulatory capital treatment for insurance companies aligned with that of covered bonds finally gives the label benefits that justify its existence.
STS was introduced by the EU at the beginning of 2019 as a kitemark for securitizations deemed structurally sound. The requirements are lengthy, but the aim is to make absolutely sure investors know what they are buying.
That doesn’t mean making it impossible for STS ABS to default, but ensuring that when defaults do happen, the bonds behave in a predictable way.
In other words, from a supervisor’s perspective, all the bad stuff that caused the financial crisis has been regulated out of the picture.
The STS label creates an irony: the safest bonds in the securitization market require the most work from issuers and investors.
But the idea was that this price was worth paying, so that safe sectors of the market could be clearly identified and attract plenty of investment, under regulators' blessing and encouragement.
Unfulfilled potential
STS has not enabled the safe tracts of the market to thrive, for a few reasons.
Shortly after the introduction of STS, Covid brought a fresh wave of cheap central bank liquidity, which very often made it pointless for banks to issue securitizations.
The extra work involved in doing STS securitizations has also deterred issuance.
Arguably most important, though, is that despite all the extra work, the regulatory capital treatment for STS securitizations — though better than for non-STS paper — was still much harsher than that for comparable non-securitization products.
Putting it right
As far as EU insurers are concerned, that wrong will be put right by the Commission's proposals to reform Solvency II, its prudential framework for the industry.
The proposed changes, released on July 18, are generally favourable for securitization.
A particular improvement is the capital weightings required of insurers when they invest in senior tranches.
For example, the minimum capital required under Solvency II for a triple-A five year senior STS note would be lowered from 5% to 3.5%. Analysts have said that is the same as for covered bonds.
As Bank of America’s researchers said in a note last week, that is “welcome and justifiable (as we have argued for years), but nonetheless a very positive surprise”.
Interestingly, the Commission has taken quite a different approach with bank capital, where securitization also has its own enormously complicated rules on capital requirements.
The EC has made some significant cuts in capital charges for banks, too, but it has not done a simple recalibration. Instead, it introduced the concept of 'resilient' ABS on top of existing STS requirements, further increasing complexity.
Mezzed up
When it comes to insurance companies, the Commission’s generosity does not extend so far for non-STS deals and the mezzanine tranches of STS deals.
Mezzanine tranches have been treated particularly harshly. A five year triple-B bond used to bear a capital charge of 39.5% if STS and 98.5% if not. Now that has been reduced to a still extortionate 35.3% and 94%.
Then again, in recent public deals, those tranches are normally heavily oversubscribed, suggesting that the market is managing without insurance demand.
What is hardest to find for issuers is demand for senior notes, so the Commission's Solvency II reforms may prove useful.
If the market grows substantially, the Commission may want to consider again easing the capital treatment for mezzanine tranches, but this part of the capital structure doesn’t seem like an immediate pinch point.
Beyond the pale
For senior non-STS deals, there are some big cuts in absolute terms to capital requirements, but from an extremely high starting point. That means many notes still will not offer an attractive return on regulatory capital to insurance companies.
Hence, one would expect lower insurance participation in non-STS sectors like non-confirming or buy-to-let mortgages, CMBS or CLOs than STS sectors like prime mortgages or car loans, but there are reasons why the Commission would want to tread carefully.
Non-STS deals can include anything from an almost clean pool of buy-to-let residential mortgages paying 80bp over the benchmark to commercial mortgage-backed deals secured on just a couple of properties paying nearly 200bp over.
If you calibrate capital requirements for the risky end of that spectrum, the low risk mortgage pools will struggle to offer an attractive return on capital. That is an unfortunate feature of the way the rules work.
It is sometimes argued that a reason to cut regulatory capital requirements for non-STS deals is that the cliff risk might put insurers off investing altogether. As things stand, if a position were to lose STS status an insurance investor would effectively have to liquidate it because the capital charge would increase vastly.
However, it is extremely hard to lose STS status without some kind of fraud or breach of contractual obligations. This suggests that, on closer inspection of the rules, insurers might be able to get comfortable with the cliff problem.
These reforms bring the unfinished project of STS — to create a vibrant, active securitization market within regulatory guardrails — another step towards completion.
There are other challenges for European insurers considering returning to investing in securitization, but this is undoubtedly the most encouraging moment of the decade so far.