Monday, 22 October 2018

IFR Securitisation Roundtable 2015: Part 1

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IFR: Welcome to IFR’s Securitisation Roundtable, which I’ve called “The Great European Securitisation Debate”. I wanted to touch on two broad areas: how the policy area is evolving in Europe and where the market is today in terms of where the flow is, touching also on the differentials between issuance in the US and Europe. Alex: what’s your read of the market in Europe today?

Alex Batchvarov, Bank of America Merrill Lynch: The European securitisation market is gradually declining. We continue to see net negative supply as a result of low issuance and the amortisation of existing product. There are a few bright spots here and there, such as the revival of UK issuance, but we haven’t seen a significant pick-up in European issuance. In that respect the European Central Bank’s ABS Purchase Programme has not really initiated or prompted more supply in the European market.

In terms of spreads, the market has contracted materially from last year and the year before, which is more related both to where other sectors are and limited supply. The relative attractiveness of the market remains; to a large degree that was enhanced by the distortions introduced by the ECB’s Purchase Programmes, which significantly compressed spreads on covered bonds.

The next wave is compression of spreads of multinationals, agencies, and regional governments, leaving the European securitisation market behind with quite attractive spread levels.

We are seeing some crossover with the US, where with the exception of private-label mortgages all sectors of the market have recovered and we are seeing very active developments. Pricing in the European securitisation market is influenced by where the US is because a large portion of the European buyers are US investors. It’s also influenced by dynamics within Europe hence driven by the ABS Purchase Programme, by all the other QE initiatives which the ECB has initiated.

When we talk about spreads and issuance, we cannot forget that there are other funding sources and in that respect ABS in Europe is not the most advantageous funding source for banks. Actually, if you want to use ABS, you’ll probably use it for the TLTRO where you can get funding at 5bp and a very advantageous advance rate, and then fund the rest with deposits or other forms of a debt.

From that perspective, we are probably not going to see material recovery in eurozone securitisation until some of these other funding sources – and the lack of a level playing field across funding instruments – are addressed. The main stumbling blocks continue to be the regulatory framework in Europe.

IFR: Oldrich, what’s the key essence of this product? Is securitisation about funding or risk transfer?

Oldrich Masek, JP Morgan: During the crisis: it was very focused on funding. To Alex’s point, I agree that you can never look at securitisation in isolation; the other markets just make it much more favourable as issuance forms.

The one bright spot has been the re-introduction of risk transfer as seen in full capital structure securitisations, where you’re getting capital relief, real economic risk transfer and funding. That’s playing well into the wave of raw material disposal. If there’s any unique source of volume for the next 12 to 18 months, it’ll be the repackaging of portfolios that are becoming unstuck.

IFR: The other point that Alex made is the fact that ABS spreads in look very tight but on a relative value basis they look quite attractive. Is that how people should look at this, Arun?

Arun Sharma, Credit Suisse: In a perfectly functioning market that’s the way it would work but regulations around the capital investors have to hold and bank liquidity buffers prejudice ABS in the way that skews that equation towards covered bonds and away from even prime ABS products. We are in all honesty suffering from that. Clearly there have been some moves to level that playing field, but I think that in an ideal world they would go further.

IFR: Scott, when you go to dinner parties, are you allowed to say that you work in securitisation? Has it been rehabilitated conceptually?

Scott Dickens, HSBC: It’s a work in progress but we’ve made massive progress in the last two or three years. Immediately post-crisis it was certainly a very difficult topic to bring up but we’ve spent many years trying to educate people on what good securitisation was and the role that it can play.

As to your point around whether it’s funding or risk transfer, it’s both of those and it’s not about capital arbitrage. All of the negative elements that had become apparent in the market have now disappeared. People are very focused on its real use as a tool, and now there’s a lot more positive sentiment about exactly what it can be used for.

IFR: Pat, how would you summarise the mindset of potential putative issuers coming and looking at this marketplace against the backdrop of the alternatives against the backdrop of the stimulus we’ve had from the ECB? It’s a difficult backdrop to assess because there are lots of moving targets.

Alex Batchvarov, Bank of America Merrill Lynch: It’s a pretty interesting time in the primary issuance space in Europe. Coming from the US, where it’s more of a specialty finance market, you have a lot of issuers that need the securitisation market to survive. When I came to Europe, I was trying to find those specialty finance companies but I would inevitably end up at a bank.

I would ask: “who are the equivalent leasing companies; who are the auto lenders?” And the answer was: “it’s the banks that do it all”. The banks form such a larger part of the economy in Europe. But what I’ve found over the last 18 to 24 months is things are becoming more interesting now because banks are getting smaller, so all the points that have been raised about how for banks securitisation isn’t as attractive as other options are right.

There’s this whole growing specialty finance segment that’s happening. We obviously cover the banks and that’s a big part of our business, but where we also spend a lot of our time are on the new fincos that are starting to pop up, the peer-to-peer lenders, and the platforms that have been bought by credit funds out of banks that are starting to either securitise the portfolios that they’ve bought or are starting to do new originations off them.

They all need securitisation to survive, so it’s an interesting time; probably the most interesting time since I’ve been here. Even among the UK issuance that you’ve seen this year, a lot of that is the Kensington issuances and the new platforms that are issuing non-conforming mortgages. You’re starting to see more of that and I think that’s going to continue, given where the banks eventually need to go.

Marjan van der Weijden, Fitch Ratings: When Alex said issuance is going down year-on-year, that’s clearly concerning and needs to be turned around. The lack of issuance by the big prime lenders is really driving that.

On the upside for the market is the emergence of specialised lending. We actually rate more transactions now than we did in the past few years but the transactions are smaller. That’s an indication of the more specialist niche areas – CLOs, bought portfolios, new originators. These are all smaller pockets of securitisation that are coming back and finding an investor footing, so that’s maybe a glass half full scenario - so more transactions even if at smaller sizes.

IFR: Let me stay with you, Marjan, because securitisation ratings have played a very important part in how the market has evolved. Everyone around this table has been re-regulated including the credit rating agencies, so I was curious to understand, when you look at rating securitisation now, what are the key essential differences today versus pre-CRA and other regulations?

Marjan van der Weijden, Fitch Ratings: There have been two drivers of how things have changed within Fitch in how we rate transactions. A large part of that we initiated ourselves many years ago. We’re in 2015 now but the problems were in 2007, 2008, 2009.

We overhauled some parts of our criteria, especially in the US but also in Europe, but I think more recently, in line with a lot of the policy initiatives, there’s been a big focus from the regulators – and it’s ESMA in particular for Fitch – around data quality and transparency. These are areas we’re still working on improving, and enhancing, in line with what the market is doing.

IFR: Andrew, let me come to you, then. Given that we’ve seen a shrinking market in Europe, what is your perspective? Are you bullish on where the market is going, and how do you play the market today? How do you get the best bang for your buck?

Andrew Dennis, Aberdeen Asset Management: The first thing to point out is that I’m probably the only person round the table who isn’t getting paid on the basis of the volume or growth of the market. We look at securitisation or structured finance as an asset class as a bond, which is ultimately what the end-product is. Then we have to make decisions about where that fits into the myriad investment strategies that we have determined by the managers we have.

I would say that we’ve seen securitisation in the last couple of years as a good source of Alpha. There are some fundamental problems for a lot of asset managers in the format of the bonds that securitisation produces – first and foremost, the fact that 80% of them are floating-rate notes. That, immediately, for an institutional asset manager, makes the mandates where you can place those securities quite specialised.

The second thing, which is very difficult to structure away from, is the uncertainty about the repayment profile, so we also see that as a risk characteristic of the asset class i.e. you never know when it’s going to mature; by-and- large, they’re not structured as bullets and they do have pre-payment and call risk in them and that adds a layer of complexity for which we think we need to get rewarded differently from a vanilla bond of an equivalent credit-risk profile.

The one word that makes my toes curl in securitisation is ‘innovation’. One of the areas, I think, where the US has been quite successful is the degree of homogeneity within asset classes.

You can see certain issuing programmes in Europe where the originators and the sponsors work very hard – and I’d point to the auto issuers as probably the most successful at this – at producing something that looks like the previous deal and the deal before that, and you know the next deal will broadly look the same.

You may not like the spread but you know precisely how the deal works. When somebody walks into the office and says: “we’ve got exactly the same as the last deal, but it’s got a different set of triggers this time, and by the way, it’s over one month rather than three months because that arbs us a couple of basis points on credit enhancement”; I cry inside.

It means that if you’re running a portfolio with several hundred line items in it, you just have to remember: “that deal is the deal with the funky triggers that pays one month”. For us, I think a degree of standardisation would be helpful, but generally speaking we think that although spreads have tightened very significantly they do reflect generally a very positive relative value versus many other asset classes, particularly corporate and bank paper, which is our food and drink.

IFR: At the back end of last year, when the ECB’s ABS Purchase Programme kicked in, we did see a bifurcation between eligible and non-eligible paper, and the indications were that investors were being effectively encouraged or were going into the non-eligible paper offering better returns or down the capital structure. Can you just talk to that element?

Andrew Dennis, Aberdeen Asset Management: First of all, let me for the sake of disclosure say that we don’t buy an awful lot of euro paper; we do keep an eye on the market and occasionally dabble. I wouldn’t call the delineation between what is eligible and not-eligible entirely arbitrary, but If you’re an investor who doesn’t have to buy securitised bonds, you’re going to tend to gravitate to the point in the curve where your intellectual know-how and work will garner you the best return.

If that means not being in eligible paper, that’s what it means. I think a lot of firms have ridden the wave of the precursor to the Purchase Programme and what would be eligible, and spreads have tightened very significantly. But when we do our relative value analysis very few continental European RMBS markets come up as offering any real value to us.

It will be thematic when we come to talk about regulation: there are dangers inherent, potentially, in bifurcating markets and stamping one that’s good and one that’s bad. Ultimately, the investor side of the market, one would hope at least – will continue to be populated by experienced securitisation people who are capable of making value judgements, and that will mean they gravitate towards things that don’t necessarily get the seal of approval.

In terms of going down the capital structure, that’s a slightly different kettle of fish. I’ve been around a while and I visit the cemetery every week laying flowers at the graves of people who went down the capital structure because there wasn’t enough yield at the senior end.

The further you go down, the more you need to acknowledge that you’ve got a lot of thin-tranche risk, you’ve got a lot of liquidity risk, you’ve got a market that is not necessarily entirely populated by people like you; they’re populated with people with leverage and so forth. So, we’re reasonably cautious as a firm; hats off to the people that do it, but that’s not necessarily our reaction to tighter spreads.

IFR: On the capital structure point, how important is getting non-senior/mezzanine tranches out into the marketplace?

Oldrich Masek, JP Morgan: Coming back to what drives the issuer to choose, there is sufficient capacity up and down the capital structure. There are people who have different risk appetites and take different views. In a lot of ways, the mezzanine and junior is just leverage on an asset class.

What I always find challenging is, particularly at the lower part of the capital structure, it’s not so much a question of what the rating is or comparing bond-to-bond but at the end of the day you’re just putting on leverage on the raw asset class. Depending on how much thickness and how much leverage you put into it, it’s less about the securitisation mechanics; you’ve got to start with the underlying first.

To me, that’s very much at the heart of the crisis in the first place i.e. people just looked at the ratings and the bonds themselves on a superficial basis but they really didn’t dig under the covers and it was judgement around the raw asset class first that caused the difficulties, particularly in the US.

Alex Batchvarov, Bank of America Merrill Lynch: In our criteria for the recovery of the European securitisation market, we always considered not just the volume increase but also the placement of mezzanine or the full capital structure. Securitisation without full capital structure is purely a funding tool, and there are many other funding tools. Today there are even cheaper funding options for the banks than before.

The second point is that securitisation cannot fulfil its function if it does not place the capital structure. The whole point is to transfer assets, to reduce risk and disperse risk across the system. From that perspective, we have two issues around how to deal with the tranches.

The first issue is who is going to buy them; the second issue is what the tranching is, how it works and how it is rated. One of the key takeaways from the crisis was thin tranches are effectively digital, plus or minus. They can blow up very quickly; you can eat through the tranche very, very quickly.

The rating agencies have made quite a few changes already and we are seeing different level of attachment points and different thickness; some improvement in that respect is definitely there. But that will remain one of the key risks. You cannot have a 20% mezzanine tranche or double B tranche, so by definition the tranches will remain thinner.

Then the question is who buys them? The current set-up in Europe is not really conducive to distributing mezzanine tranches across the investor base. A natural buyer would be an insurance company, but we all know that regulatory capital under Solvency 2 is prohibitive.

Another natural buyer group would be pension funds; they will ultimately be subject to rules similar to Solvency 2. You would not want to have mezzanine tranches distributed to banks; that’s not the purpose of securitisation. You’re left with asset managers, and you have a big range of asset managers who have the risk appetite, the quantitative and qualitative analytical set-up to analyse these tranches.

One thing that we still do not have as a good instrument or add-on is a hedging instrument for mezzanine tranches. The US has developed something but in Europe that virtually doesn’t exist, so from that perspective you have a whole set of issues that needs to be addressed and regulation is only the first step. Building up the investor base for mezzanine will be a multi-year process.

Alex Batchvarov, Bank of America Merrill Lynch: For some of the deals we’ve worked on recently, especially in the UK, the top of the capital structure is the hardest to move. The mezzanine has been the easiest thing to sell; the yieldier investors that are out there right now are looking for that paper.

How much of that is because they can get leverage from banks is an open question, so potentially it could go away pretty quickly but at least right now, from what we’ve seen and what you saw even on the Warwick full capital structure deal, was the middle to the bottom of the capital structure go very quickly and be multiple times oversubscribed.

IFR: It looks at the moment like there’s more demand for junior than for mezzanine. Because of the economics of both the junior and the senior, those two spaces are the most convenient. Do you see that changing any time soon in terms of the economics of the mezzanine space? Will it become more convenient if the spread dynamics change?

Alex Batchvarov, Bank of America Merrill Lynch: There is demand right now. For instance, the bottom of the capital structure when we sell CLOs besides the equity goes fairly quickly, the double Bs and the single Bs, and the triple Bs. The single A can be difficult at times, because you have people there that “If you’re going to buy single As, then I might as well buy triple Bs and pick up more yield.”

You have kind of an in-betweener type bond that can be difficult to place because you don’t have the senior buyers, and then you have the other buyers that would rather go to the bottom part of the capital structure, so it can be an issue to place that single-A type tranche at times.

But I think, given that right now there’s leverage out there for those bonds; at the end of the day you can sell them right now. If that leverage went away, then potentially those yieldier type buyers who buy that tranche go away.

Oldrich Masek, JP Morgan: It’s a very difficult question to answer because I think, to Alex’s point, the industry lacks critical mass. The number of investors is probably 50; there are no hedging mechanics, no indices, sporadic issuance …

Until we start getting the volumes back up where we can have more investors who can effectively pay for the infrastructure to look at junior parts of the capital structure more efficiently, we’re at a very funny point because until we get to that critical mass where people start re-investing and building asset allocations into this space, we’re never going to move beyond it.

In a lot of ways, we’re talking a lot about industry structure and regulation as if the industry was pari passu with covered bonds and unsecured. We’re a long way away from that, unfortunately.

Alex Batchvarov, Bank of America Merrill Lynch: We talk about a shrinking market, but one thing we should talk also about is the shrinking qualified investor base – qualified not under the securities rules but qualified in terms of having analysts and infrastructure in place.

One of the biggest damages, in my view, of the last five years was this constant and relentless association of securitisation with toxicity, with toxic assets, a disaster in terms of financial system and so on. We’ve seen many of the people who were securitisation specialists gradually leave the industry or move to other areas. For me, that’s one of the big challenges now for the market recovery.

Let’s say the regulation changes in the next 12 months or 18 months; it takes several years to build infrastructure. Many people who exited the market may not come back at all and it will be a very difficult decision for many of them to make. We have to address the issue of how we rebuild the infrastructure that existed in Europe. It’s a pity we destroyed it.

Scott Dickens, HSBC: We also need the fundamentals to work; that’s really important. If you look at the demand-supply imbalance, that’s really an issue of the funding that’s been made available by central banks that’s crowding out securitisation as a funding solution.

The lack of ability to hold ABS as a liquid asset has had a big impact. The withdrawal of banks as buyers is something the regulators could really look at in terms of how ABS can play a role on banks’ balance sheets.

Regulation has not helped and we’ve been left with a much smaller universe of potential buyers. I echo what Andrew said: auto ABS have been one of the stand-out asset classes because it is homogenous, they’ve continued to access the market throughout the crisis, and it’s at least given the European market an asset class that works.

We’ve seen the development of the leveraged loan CLO market, but the big missing piece has been the prime residential mortgage market, and I don’t see that recovering on any sort of scale soon. That’s a different market now. The securitisation market is not going to be the same as it was pre-crisis unless some of these key factors change.

Andrew Dennis, Aberdeen Asset Management: We talked about pension funds and insurance companies and so forth – between pension and insurance, they make a very significant percentage of the savings market that exists. The money that people like Aberdeen manage is broadly for those [buyers], with some mutual fund-like product as well.

If you look, for instance, in the UK the most significant guardians of pension fund assets are pension consultants. They are a universe that has not understood securitisation well, who have not read past the headlines and still to some extent regard it as something slightly to the left of anthrax in terms of financial engineering.

As a consequence, they’re not necessarily engaged. They’re beginning to be, but they’re not fully engaged and they see it as a specialist product, an alternative credit product. There needs to be an effort on the part of the industry to not necessarily see it as a rather geeky, slightly dangerous, “you’ll fall asleep before you understand what it is” part of the market and integrate it more fully into the mainstream, like government bonds, corporate bonds, bank credit, lower Tier 2, upper Tier 2, high yield and so forth..

As a firm, for instance, we have a very successful business running emerging market debt; we have a very successful business running high-yield, leveraged loans and things like that, all of which have a degree of risk associated with them that are specific to themselves.

There’s nothing particularly different about securitisation: it has a series of risks associated with it that are technically specific mainly to consumer credit. We mentioned the concept of a hedging product, a hedging index. I’ve never really fully got that or bought into it; it’s just another ‘no money down’ way of playing the market for hedge funds, as far as I can see it, and that was what was going on in the US pre-crisis.

But, for instance, to get securitised product more embedded within bond indices very commonly when firms like mine are awarded mandates they’re given mandates that are measured by reference to bond indices and because there isn’t a great deal of presence in a lot of those indices of our product or the product that we know and love, there’s a very good excuse not to invest in it, because it’s an off-index bet.

It’s that type of institutionalisation, as much as pushing on regulation that will get the product mainstream. If you look at the US market – you talked about banks playing a very important part in Europe and they hitherto always have – if you look at the US market, it’s by and large an institutional investor market, whether it’s triple As, or double Bs, or single Bs.

I always joke when we sit down with banking guys on regulation; my opening shot is we should make regulation such that it’s so difficult for banks to buy bonds that only I can buy them. That’s absurd, clearly, but there’s a level of seriousness about that that we do need to institutionalise our market.

Arun Sharma, Credit Suisse: I wanted to go to Scott’s point about the supply of mortgage-backed paper. I’m reasonably upbeat about the supply of residential mortgage-backed paper in Europe; maybe not in the immediate short term but in the medium term.

We’ve seen non-bank lenders – new lenders – start up and existing lenders grow their business on the back of financing they can raise privately to take out into the public markets. We’ve seen acquired portfolios (where if we rewind a few years, they were privately funded) being increasingly funded in the public markets with broadly distributed deals.

We will see – and we’ve seen the beginnings of this but no more – bank treasuries, as they figure out how to manage their balance sheets and leverage ratio targets, looking at securitisation of a way of getting assets off the accounting balance sheet.

That, in a way, echoes what we used to do pre-crisis, where banks would issue large top-to-bottom transactions in the capital markets because that achieved Basel I capital relief and they couldn’t achieve capital relief without issuing the triple As even though they were more expensive than other funding they could raise elsewhere.

The capital rules drove them to issue those triple As and leverage ratio regulation will require them to issue them again. That could be a source of large bank prime RMBS transactions.

Marjan van der Weijden, Fitch Ratings: But there are variances between the dynamics in each country in that respect. In the Netherlands, which has been one of the largest RMBS-issuing countries, there are different dynamics. The emergence of more conditional pass-through covered bonds, as well as the push for whole-loan portfolio sales to pension funds, which is actively supported in the Netherlands, will become a competing source of funding for issuers next to RMBS.

There I would be a little bit less optimistic at the moment in terms of the advantage for RMBS with those two options becoming more real.

Alex Batchvarov, Bank of America Merrill Lynch: You’re going to see more issuance because you’ve had so many assets that have been sold out of banks in the last couple of years, and you’ve had credit funds that have brought those assets and have quite frankly done pretty well subsequently securitising those assets. The light bulb has gone on to these sellers. Why don’t we just access that market immediately rather than sell it at 101 and if someone securitises it, at 103.

I think you are going to see more of this full capital structure, as banks try to get out of certain asset classes and shrink their balance sheets. How much of that is a one-off thing I’m not really sure; it’s something we’re just going to see over the next 24 months.

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