Flight to simplicity
After years of growth in financial engineering, the structured finance market is going back to basics. Little of the 2008 vintage has yet emerged, but a few structural tweaks have allowed issuers to obtain vital funding. Jean-Marc Poilpre reports.
The structured finance primary market has in the past few months fundamentally consisted of transactions designed to clean up warehouses and to secure funding from the central banks. In the case of the three European auto ABS deals that came to the market in the first quarter, the leads pointedly signalled to investors that the euro-denominated Class A was expected to be ECB eligible.
"Issuers are focused primarily on meeting their liquidity aims in the short term, rather than focusing on what may be required when the market truly re-opens," said Lee Rochford, head of FI securitisation at RBS.
"Issuers are more concerned about funding efficiency than regulatory capital relief,” Rochford said. “We have seen features such as calls being incorporated at any time so that structures can be unwound and recreated once longer term funding solutions are available and AAA-only structures that provide enhanced protection to the senior notes but do not concentrate on maximising the advance rate in the deal."
Underground activity points to clean structures, in particular in CMBS, where leverage is expected to negligible or non-existent. "We think the CMBS as an asset class will not be as dominant a finance source as it used to be, but it will definitely come back," said Conor Downey, from law firm Cadwalader.
Cadwalader is looking into new structures where SPVs are created, either to warehouse commercial loans – which could ultimately be securitised or sold to third parties – or to attract new types of investors through fund structures. These would bring alternative players like hedge funds, private equity funds and sovereign funds together with entities able to originate loans.
The loans’ terms need to be flexible enough to allow them to be securitised, repo-ed with the ECB, sold on to private funds or on the loan syndication market or even put into a covered bond pool,
Downey said. He predicted some banks may set up covered bond programmes specifically to facilitate commercial mortgage lending, or become issuers for third parties.
In the non-conforming RMBS sector, coupons that reduce excess spread (DACs) have fallen out of favour, and look unlikely to return. But the most dramatic changes are expected outside plain vanilla securitisation.
The Bank for International Settlements (BIS) released a report at the beginning of March predicting the market for ABS CDOs would shrink dramatically – perhaps disappear altogether. Prospects for "one-layer" credit-risk transfer products, such as CLOs or corporate CDOs, were better as, according to the report, they "made economic sense".
Citi analysts concurred. The protection for ABS CDO Triple As (mainly collateralised by subprime RMBS bonds) "turned out to be woefully inadequate", they noted. But in the case of CLOs, the Triple A is usually the most senior tranche, with about 25%–30% structural protection below it. Diversification ensures that, in theory, the default of every individual instrument in the pool is extremely unlikely, they added.
Rating agencies are forcing issuers to adapt their structures in the wake of methodology changes, and may themselves become more conservative. According to one buy-sider, agencies are now highly unlikely to turn a blind eye to inadequate interest rate hedging – a common feature of UK non-conforming RMBS.
But overall, the current crisis does not fundamentally undermine the whole structured finance market, particularly plain vanilla deals. Almost one year into this crisis, structured finance professionals still believe transparency and structures did not cause the market’s collapse and many of them believe better investor education is the key to solving the market’s problems.
"European deals and their structures have held up well and it is too easy to make broad-brushed comments tainting the entire sector with the mistakes of a few exceptions,” said Rochford. “The current problems in the European RMBS/ABS markets are primarily liquidity driven rather than due to underlying credit or structural issues."
But there is a fact that cannot be ignored: the core investor base of the securitisation market for the past two or three years has vanished. SIVs are discredited and even unleveraged funds find it difficult to cope with volatile spreads.
Issuers must help investors to convince their credit committee that structured products are not toxic by simplifying their offerings. Changes in the underlying credit are needed, such as improved transparency in reporting the performance of the underlying assets and increased robustness built into the documentation. This will become increasingly urgent as fundamentals deteriorate, notably in the UK, which could replace technicals as a source of volatility.