Market pros see chance for ABS to rebuild Europe’s economy
GlobalCapital and Afme convened a virtual roundtable to tackle the biggest issues facing securitization as the pandemic crisis continues. While other capital markets and the wider economy are reeling from the economic fallout stemming from Covid-19, European securitization is undergoing a regulatory rejuvenation, as the European Commission turns towards structured products as a solution to the coming wave of NPLs. Meanwhile, the market for synthetic ABS is being given a second look to help free bank balance sheets across Europe and spur lending to the real economy. Over the summer, the market saw the report from the senior forum on the Capital Markets Union, which included a number of recommendations on regulatory adjustments to improve the functioning of securitization in Europe. More recently the European Commission put forward a capital markets economic recovery package including measures related to securitization. The Commission has proposed extending the STS framework to synthetic securitizations or on-balance-sheet securitizations. The Commission has also put forward proposals to remove regulatory obstacles to the securitization of NPLs including changes to the regulatory capital treatment.
Participants in the roundtable were:
Anna Bak, associate director, Afme
Alexander Batchvarov, head of international structured finance research, Bank of America
Steve Gandy, managing director and head of private debt mobilisation, Santander
Simon Long, managing director, HSBC
Janet Oram, managing director, BlackRock
Pablo Portugal, managing director, Afme
Neal Shah, co-head of EMEA structured finance, Moody’s
Damian Thomson, managing director, NatWest
Moderator: Tom Brown, GlobalCapital
Pablo Portugal, Afme: The mood in Brussels and the policymaking world in general is dominated at the moment by the effects of the Covid-19 pandemic and the need to establish conditions to promote economic recovery. It is clear that the regulators took a number of steps this year to support the financial sector and the economy in managing the crisis, but the focus has turned towards policies and measures to support businesses and market participants in a crisis that is not yet over. So in that context, the EU will be putting forward a new action plan for the capital markets union, which is expected to be published in the autumn of this year. We at Afme certainly think that the CMU agenda will be essential to promoting a long-term recovery and supporting businesses in the years ahead. Securitization is very much expected to be part of that new action plan. As we know, the establishment of the STS framework was identified early on as one of the building blocks of the CMU. And our view remains that policymakers need to do more to support the STS framework and fully reflect the strength of the STS concept across the various sectoral regulations that affect securitization.
I think it is important and helpful that these two proposals on synthetics and on NPL securitizations have been presented as measures related to the recovery and the management of the crisis. Securitization is therefore being seen by the Commission as part of the solution to current challenges.
Damian Thomson, NatWest: From a non-performing exposure point of view, I think this is recognition of the increasingly important role that securitization techniques played in resolving the NPL overhang from the global financial crisis, particularly across southern Europe and some of the peripheral economies. It was absolutely crucial to be able to use those techniques either publicly or privately to enable banks to clean up their balance sheets and move towards a safe and stable place where they could become active supporters of a growing economy. So, to formalise that to try and facilitate that is a really positive sign.
GlobalCapital: To expand on that point about there being more to be done with the quick fixes, Steve, do you think the proposition is extensive enough?
Steve Gandy, Santander: Well, I certainly agree with Damian’s comments: first of all, that it’s an expression of confidence, which is great compared with the stigma that was attached to securitization during the last crisis and gratifying that the regulator recognises the need for banks to be able to mobilise assets and recycle capital in order for us to continue lending in this kind of environment. So the STS for synthetic proposal is particularly welcome. In my opinion, the NPL proposals address a lot of the concerns laid out by the market. In terms of the timing, it seems that the political winds seem to be aligned in favour of getting the deal done as soon as possible, potentially even this year, which is great. There are two key points on the list that we will be submitting with Afme, where we think the way the wording is phrased could lead to an outcome that wasn’t intended.
There are two things: one is that, obviously, when we discussed the proposals for STS for synthetics with the EBA in various roundtables before the Covid crisis going into the beginning of this year, there was a question from the market around if STS were granted to synthetics with the capital relief, would the preferential capital treatment go along with that? We are pleased to see that it has been established at least with regards to the senior tranches which are retained by banks. Generally, when we do an SRT deal, we sell the first loss or the mezzanine or a combination of the two and we retain the senior tranche. It is the bank’s ability to gain preferential capital on that retained senior tranche that can make a very big difference on the economics of these deals.
The EBA also recognised that the kinds of investors who buy the first loss and mezzanine tranches are not regulated investors and are not capital constrained themselves, so the capital treatment for them is not as important as it is for the banks. But we think that the way the proposal is worded is such that the preferential treatment would apply only to the most senior tranche. That’s fine for banks that are so-called advanced-IRB banks — the way that capital formula works for advanced-IRB banks is that it is easy to just retain a single tranche that attaches right above the tranche which is sold to investors. But for standardised banks, or banks that have standardised portfolios, the rules are different. And they don’t have the ability to use the formula approach that allows them to retain just one senior tranche. And, therefore, if a bank has to use the so called ratings-based approach — the ERBA approach — generally what you find is that the banks would have to divide up that retained portion into two or more tranches and therefore it would be useful if this preferential capital treatment could apply to a series of contiguous senior tranches that are retained. That would have a dramatic beneficial effect on the capital economics of the deal.
It is a rather technical point, but the devil is in the detail, and that technical point can make a big difference. This is why we are asking regulators to consider allowing this contiguous senior tranche to qualify for the preferential capital.
The other point is on the so-called ratings limits — the CQS 1 ratings limit for allowing cash to be deposited with a protection buyer. So, in a typical deal, a bank will sell the first loss mezzanine tranche, and maybe some other tranches to investors and will receive cash from investors, and the bank then has the cash in-hand, which allows us to give a zero risk weight on the tranches which have been sold to them. According to the European Commission proposal, it would appear that only banks which have a rating of single-A or better would be able to receive this cash from investors, and if you don’t have that rating then the cash would have to be deposited with a custodian and invested in high-grade securities. That immediately presents a different playing field for stand-alone banks or smaller banks which don’t have as good a rating as some of the larger ones. And we think that this is not the aim of the provision for the CQS.
Neal Shah, Moody’s: I think there’s clearly a recognition that there’s an alignment between dealing with NPLs and the benefits of securitization. It is really a positive compared with what we have seen in previous cycles. We did a representative look at a portfolio of banks across Europe, and, between 2018 and 2019, the NPL levels have gone from €714bn to €617bn, principally through securitization techniques. So there’s a recognition among policymakers that solving the NPL question is important to get this part of the market into a good and stable condition. And to the point you just made, as we go through the pandemic, and as we come out the other end of it, you’re going to see an escalation in NPL levels and setting proposals so that the banks can manage their capital allocations to allow them to mitigate the cost of these portfolios, I think it is going to be critical among that community.
Now, from the proposals that come out, some of this is trying to address existing issues with the securitization frameworks. They are trying to solve some of the gaps that did or do exist vis-à-vis the NPL market.
As with everything, having standardisation and addressing gaps is clearly a positive for the market. There are additional benefits that are coming through with this standardisation of how this process would work, how the allocation would work, risk retention, etc. I think all these things would provide some clarity into what was perhaps an unclear space. So that is certainly a positive.
There are potentially areas which might be more challenging, such as concerns the floors to the risk weights might create some issues that weren’t seen previously. A lot of these deals are somewhat complicated and to try and find a one size fits all for all types of securitized NPLs may be a little bit challenging as well. So I think most of the things we have seen are going to be positive for the NPL market; some may bring forward transactions to this year rather than pushing them out. But it is really planning for the future and trying to mitigate some of the long-term challenges that would have otherwise been seen as the NPL portfolios start increasing on bank balance sheets.
Thomson, NatWest: I guess the great unknown is, as the previous financial and the NPL issue was southern European driven, it just remains to be seen whether we see the NPL portfolios developing in the different parts of the European banking market, different jurisdictions, different client types. We just don’t know. But I think a lot of it will depend on the shape of the recovery. There are a lot of unknowables around that at the moment. But again, it is very forward‑looking of the Commission to make sure the tools are in place to be able to manage that because they know how important it is for the overall health of the economy for banks not to be weighed down with a significant part of their balance sheet as NPLs.
Alexander Batchvarov, Bank of America: I will step back a bit with the EU NPL proposal to raise one particular point which is: EBA did detailed work on assessing NPL securitizations, and its consultation report came up with, in my view, a very detailed analysis with great ideas and proposals about what can be fixed. We see that some of these ideas have been transferred into the Commission’s proposal. However, many of the EBA’s proposal were not taken on board, it appears, because the Commission is directly taking the recommendations of Basel, especially on capital treatment. In that regard, I think that this is a missed opportunity to really open up the market for NPL securitizations — let’s not forget that this is predominantly a European product. And, in my view, all the work which EBA did with all the proposals and well-justified recommendations should go into the European Commission’s quick-fix proposal. Unfortunately, that’s not the case and, depending on how the EU final document comes out, we may have a bigger or smaller impact on the NPL securitization market in Europe. But in my view, not to apply the broad set of recommendations — well justified and well-argued recommendations — from EBA, is a missed opportunity.
GlobalCapital: Would you agree with that, Simon?
Simon Long, HSBC: Yes, I would agree and I think a number of people in the industry, including Afme on behalf of their members, have made no secret of the fact that the capital piece of this package on NPLs is probably the most significant disappointment. I think a lot of people are concerned the capital requirements will actually go up from what is already quite a high base, frankly. It’s already quite rare to see a situation where risk weights are below 100% for a senior tranche in an NPL securitization, but under these proposals, it would actually become impossible.
During the Covid recovery, you might hope to see NPL securitization provide a significant part of the solution for the NPL problem that we expect to see in many more countries than we have over the past several years. At the moment, it’s largely peripheral Europe that has been using NPL securitization. And that may be the same going forward, but it could have a role to play in other countries which have historically not had so much of an NPL issue. In many of those other countries, because of their quicker resolution processes, higher rated sovereign, and so forth, you would expect those deals to be more highly rated, and to be deserving of lower capital charges. But with these proposals, you won’t get that reflected and therefore you’re potentially constraining a piece of the market that could make an important contribution in helping banks to preserve their capital base, and be able to go out and make new loans, without being weighed down by the dead weight of an NPL portfolio which has accumulated because of Covid.
Batchvarov, BofA: I totally agree with Simon, and I want to add one point here: the one thing the new risk weights may potentially encourage is a connection with the sovereign. In other words, bringing in the sovereign guarantee, bringing in the GACs format, which currently exists only in Italy and Greece, is potentially one of the ways to go in order to address the significant increase in capital requirements, as proposed by Basel and the European Commission. That is not really what we should be aiming at. Actually, the regulation should be aiming at reducing the interlinkages — the connection between the banking system and the sovereign. Unfortunately that’s not what might happen in this particular case.
Long, HSBC: I suppose the point about this is you are making it harder for the private sector to deliver private sector solutions. And therefore, as Alex said, you are pushing people in the direction of government sponsored solutions like the HAPS proposal, where you’re linking your rating with a government rating, or government-sponsored asset management companies and those kinds of solutions. And I think in general it’s considered a very healthy thing to try to find private sector solutions to these kinds of problems wherever you can, and make government support the last resort. There’s a danger that we make that much more difficult to achieve if we don’t get the right framework.
GlobalCapital: Pablo, when is the review coming and how will it take place?
Portugal, Afme: We expect a broader review of the STS framework and the securitization framework to take place in 2021. We may see a new set of proposals next year or in early 2022, depending on how the European Commission decides to proceed. We hope that the future review will address a number of elements that are not included in the quick-fix package. Referring again to the helpful report from the CMU high level forum, there were recommendations that we very much agree with: for example, improving the HQLA-Level eligibility of STS under the LCR, which is an area that we have been flagging for a while. We don’t think enough has been done to reflect the strength of the STS framework in the LCR as there was no real material upgrade in terms of the liquidity categorisation of STS. So from our perspective that is one of the key areas to look at.
Improving the process to achieve Significant Risk Transfer is another major area where Afme and the industry have been in dialogue with EU authorities. Securitization with SRT is vital as capital planning and absorption of regulatory pressure becomes more urgent with the implementation of Basel rules. Looking beyond NPLs, the regulatory capital treatment of securitization across the board is critical. The high level forum recommended considering a recalibration of capital charges for banks under the CRR and also for insurance company investors under solvency 2. We very much support work in that area as capital requirements remain overly conservative in our view. We hope that the review will not come too late as the market needs a well-functioning and proportionate framework. It will hopefully be an ambitious review to support the STS framework and facilitate the scaling up of the market, while maintaining prudential soundness.
Long, HSBC: There are two important issues with the LCR to be looked at. The first is the apparently unintended change that we saw, effective from April this year, where it used to be that the securities down to AA- could have LCR-eligible status, and now it’s only AAA securities. This isn’t just an issue for securities which are not AAA in the first place, it’s an issue even for new AAA tranches, because investors have to look at that and ask if it is always going to be AAA. Obviously nothing can be guaranteed with respect to downgrades, but you have this risk of a cliff-edge effect where even a single notch of downgrades that could have nothing to do with the deal itself — it could be a sovereign downgrade dragging all ABS in that country down, for example — could cause securities to be kicked out of LCR, and in some contexts that makes some banks who bought them a forced seller, at precisely the wrong time.
The other aspect is treatment ABS for LCR generally, particularly the fact that it’s a level 2B at best. It’s got higher haircuts and is less favourably treated than other credit products, which is what we see across the piece in terms of the regulatory treatment of securitizations. If you look, for example, at the capital charges for insurance companies, ABS, even for STS securitization, is penalised compared with other asset classes with similar credit profile, such as corporate bonds and so forth.
In terms of liquidity treatment, it’s the same. And as we have seen during the recent crisis, the eligibility of ABS for central bank support programmes, the PEPP and the various UK programmes, the support for ABS is much, much weaker, if it’s there at all, and that drives the impact on the product.
Batchvarov, BofA: I cannot disagree. I mean, we are still missing the realignment between central bank treatment and LCR treatment of STS and other securitization bonds. An alignment should help effectively expand LCR eligible assets based on a proof of historical performance and disclosure. As far as disclosure is concerned, there are large discrepancies. The simple standard, very detailed disclosure requirements for securitization do not apply to other asset-based instruments, and may not be appropriate for private securitizations and for synthetics. It is not about opposing the need for disclosure, it is a question about the degree of disclosure and the level of detail needed, and about realignment across asset-based capital market instruments.
Long, HSBC: I would certainly emphasise that. Sorry to interrupt, I wanted to echo the comments about private disclosure. We see this directly because we, as a bank, invest in private securitization transactions. In some of the transactions that we see, there are at most a handful of participants. We talk to our clients about the disclosures we will be asking them for under the new system. Many of them find it very burdensome to produce, and they are asking us why we need this information. And in some cases, in many cases, the honest answer is we don’t. We don’t even know what we would do with some of the data fields, or what we are going to use that information for. There’s nobody else who needs them. But we have to ask for them, it’s just legally mandatory now.
Anna Bak, Afme: I agree with the point about getting some more thoughts about the private arrangements for the private transactions on the templates. We have been flagging that to the Commission for a long time. The current framework does not cater well for the private transactions. We hope this will be addressed in the upcoming review.
GlobalCapital: ESG principles are becoming an increasingly important part of the market. I want to touch on what the challenges are there and whether ESG principles can fully be integrated within securitization?
Bak, Afme: As we are focusing on strategies to tackle the coronavirus pandemic, it is becoming more and more evident that the role of Environmental, Social and Governance (ESG) policies will certainly increase as the hoped-for economic recovery progresses. Policymakers across the globe have given strong indications that ESG considerations will be increasingly important in regulatory analysis and decision making in the coming months and years. And we have seen that especially in the EU, with announcement of Sustainable Finance Action Plan (back in 2018), then the EU Green Deal — which aims to make the continent climate-neutral by 2050, which is an ambitious plan, but we also understand that the EU is really determined to move on with it. So it is quite clear that ESG factors will stay with us for a while. And most recently, towards the end of August, the Commission signalled that the 2020 Renewed Sustainable Finance Strategy will go beyond the 2018 sustainable finance action plan and focus on a broader range of sustainability objectives, such as biodiversity and social aspects, particularly in light of the impact of Covid-19, as well as a stronger emphasis on corporate governance and corporate reporting. So we see the strong trend towards ESG there. Now, how do the ESG considerations work in practice and how do they translate to securitization itself? One of the key challenges we see is that there is a lack of a common standard of those ESG factors. It is not entirely clear what those principles mean; hence each firm may have a different understanding of what ESG means. What will mean ESG to one firm might not necessarily mean ESG to another. So that is one of the key challenges. Another is the lack of eligible assets to be securitised. There is often not enough of “green” or “ESG” assets that could form a portfolio big enough to be securitized.
Janet Oram, Blackrock: I completely agree with everything you just said, Anna. There is a range of approaches to implementing ESG in portfolios depending on investment objective — and this isn’t necessarily something that needs to be standardised – but it does underline the need to be very clear on the differences across approaches. Even within our own product set at Blackrock, there are multiple different approaches sitting under the broad sustainable investing umbrella. There are the funds that are essentially screening out certain sectors or companies; so tobacco, oil or gas, or whatever it happens to be — we call these “avoid”, and then you’ve got a set of products looking to “advance” — these are both portfolios tilted towards better ESG scores, higher than average in the market — not speaking about securitization I’m just talking generally here — and then there are those who are looking to have an impact, and so within that very broad umbrella we’ve got to work out how securitization fits. There are very obviously green assets where there is an opportunity for issuers to create products and transactions that meet not just the needs of the end customers, and attract ABS investors, but also the new market here that is looking to invest in ESG products — however they are defined.
If you look at the fundamentals, your credit risk to that transaction from ESG factors is not always all that much, either because it’s not directly impacted by very many ESG factors or because they are mitigated through the structure. And so it becomes harder to differentiate the ESG-ness of some transactions, and that can lead to us being left behind if we are not careful, but actually it’s an opportunity for us to trumpet some of these features and say actually we are creating a conduit for lending to the real economy. That ticks social boxes. We have really strong structures and tried and tested frameworks. The one thing I am really worried about when we start talking about greater transparency and data on the assets, is that some participants start focusing on metrics. So, for example, I had a data provider who was ringing me up about ESG, who said: how about if I could get you the environmental scores for all the tenants in your UK RMBS portfolio? It sounds great, I can just filter out all the ones that have lower environmental scores and market that as a green bond. The problem with that is, unless I’m doing something to support the people that are stuck in lower quality housing, I have just created a massive social problem. So when we are looking at data transparency, we need to not be just looking at metrics we can measure; we need to be looking at the social impact as well.
Gandy, Santander: There may need to be a transition period. I’m 100% in agreement with what Janet has said, especially about the idea of standardising what the requirements are so that we are not dealing with five different varieties of what is ESG and trying to tailor a particular transaction. We may hit four of the five, and that means only three investors can invest in it because it doesn’t meet the other two or three requirements that other investors have, because it doesn’t have standardisation. The other very powerful incentive for getting ESG securitization up and running is to recognise, as you said earlier on, Anna, that we may not have a large enough and diverse enough portfolio of ESG-qualifying assets to be able to make a transaction work. So, an idea would be that we should be thinking in terms of potentially being able to securitize a group of loans that have some ESG loans in them, but could also be combined with a commitment by the originator to recycle the capital received from the securitization into new qualifying assets so the assets being securitized are not ESG, but they are going to be reinvested in ESG, and that would help move things along, just as a suggestion.
Bak, Afme: Yes, indeed. The transitioning is a very, very important point. When we were preparing our response to the Commission’s consultation on the Renewed Sustainable Finance, back in July, this point came up lot. We need to think carefully how to transition from the market which we have today to the ESG market which we would like to have in the future.
Oram, Blackrock: I think we have to be very careful when we do that, though. Because otherwise we run the risk of being accused of greenwashing or whatever the ESG-washing terminology is. I’ve seen transactions where a proportion of the transaction was green mortgages, for example, and so the issuer looked to make one tranche green, an equivalent proportion of notes as the pool. But the assets are fungible and we didn’t like that as a way of doing things. I think we need to have a long discussion as to what is the appropriate way of transitioning.
GlobalCapital: I would like to move to our final topic, which is Libor transition. How much more work needs to be done on this?
Oram, Blackrock: Before commenting on what else do we need to do, I do think we need to take a step back and go: wow, how far have we come in two years? Just over two years ago we published the template for Libor transition language to go into docs because we knew something was going to change. And now, the entire UK market is Sonia based. Even the last CMBS transaction was Sonia benchmarked. So we have already come to the point where we’ve got a whole load of new issuance in Sonia, tick. We’ve got active issuers, tick. We’re in quite a good place there. Now we are looking at transactions that don’t have fallback or replacement language, particularly those without active sponsors. This really brings us down to a core of non-transition bonds. And, I think, in the hardest transition bonds, one of the challenges, in the public market at least, is the fact that so many of them have Libor-linked mortgages in them. Actually that’s not just a problem for transactions with defunct originators, it’s a problem for some of the active issuers as well. It’s really not clear what’s going to happen to those mortgages, particularly where underlying contracts don’t allow for a switch. Absent further guidance from the FCA, if there is a legislative Libor solution, those mortgages are probably going to move on to what the legislative solution provides — and so any tough legacy bonds are going to have to transition to that too.
Neal Shah, Moody’s: I agree with Janet. I think the UK market has had some success and has done pretty well to support transition of the market. I think the support of the regulatory bodies clearly was very helpful here.
If you compare it with what you see on the other side of the pond, there is a lot more remaining for them to resolve. Particularly the legacy transactions where there has been a natural transition on our side. I fully agree with Janet where the asset liability alignment still needs to be resolved for some of the legacy pools, but that is a much smaller problem than I think we’re seeing in the US, where there’s a lot more legacy, a lot less interested parties necessarily involved in some of those transactions, and some ambiguity as to how the transition will work. So I think in particular the UK market has done well — obviously the European market is much more geared towards this, given Euribor will continue in some form. So I think in Europe, compared with a year or two ago, when this was one of the top risks we would have put on the agenda, I would see it as a more limited, perhaps a more transaction specific risk.