The investor base for European ABS has grown exponentially. With 90% of all ABS product rated Triple A, much of the attention has been focused on senior product. However, the dawning of a new regulatory and accounting era has created the pre-conditions for a growing market in the lowest echelons of the capital structure. Joti Mangat reports.
While the effect of CDO managers playing in subordinated tranches is well documented – and so too the emergence of B note investors in commercial property financings – the development of a market for unrated cash securitisation is a newer phenomenon.
The last 18 months have seen a raft of changes to the ABS environment, the broad intention of which has been more accurate assessment of risk – and a more complete transfer of that risk into the capital markets. This has driven issuers and investors to partner up in the creation of a new tradable ABS asset class: low-investment grade and unrated ABS tranches.
"In Europe, the market has been built on the conventional Triple A, Single A, Triple B capital structure: we should begin to see the issuance of more deeply subordinated notes or equity as liabilities are restructured to sell off more risk," said Ganesh Rajendra, head of European ABS research at Deutsche Bank.
Firstly, the implementation of the new Basle 2 Capital Accord has made it prohibitively expensive for bank originators of consumer loans, leases, credit cards and mortgages to retain first-loss, or equity tranches, on-balance sheet.
First-loss or equity classes are entitled to all the cashflow left over at the bottom of the payment waterfall, that is, all the cashflow not needed to pay for the administration of a deal, for the credit support of a deal, or for the principal and interest payments due to rated bond holders.
Depending on whether the originating financial institution follows the Standardised or Internal Ratings Based Approach (IRB), Basle 2 will penalise originators proportionately much more than they do today for retaining first-loss investments. In short, subject to certain exceptions, first-loss positions must be deducted from capital, equivalent to a 1,250% risk-weighting under the Standardised Approach and ranging from 250% for (Double B) to 1,250% (unrated) under the Internal Ratings Based Approach (for long-term ratings).
"The reason why Europe hasn't seen more issuance of deeply-subordinated ABS notes is primarily because the largest issuer constituency – the European banks – are generally well capitalised, highly rated institutions which have not been under any economic pressure to optimise their capital and funding management," said Deutsche's Rajendra. "In the European case, regulatory and accounting changes should compel some issuers to re-think the way in which they securitise."
The second term in the equation is the advent of IAS. They key concepts here are the transfer or pass-through of cashflows, and the transfer or retention of risks and rewards. Again, the new rules offer incentives for originators to sell as much risk as possible into the capital markets in order to achieve off-balance sheet treatment, which under regional general accounting practices had been much easier to achieve.
IAS 39 states that even if an SPV has transferred its right to receive cashflows, that SPV must consolidate accounts unless the subsidiary has transferred substantially all the risks and rewards associated with the assets in question. If an SPV retains substantially all risks and rewards of ownership of the financial asset, then IAS continues to recognise the financial asset as consolidated. In effect, the assets remain on-balance sheet.
Clearly, IAS encourages originators to transfer – or sell into the market – all parts of a capital structure, which increase the likelihood of recognition for the purpose of accounting.
Finding a match
Of course, investing banks face an equivalent capital charge increase under Basle 2, so the end-user of any low or sub investment-grade first-loss ABS tranche will have to occupy the non-regulated space; potential buyers come from the seasoned ranks of CDO equity investors, namely insurance companies, credit hedge funds and special ABS funds established – as non-accounting and regulatory constrained entities – precisely to take advantage of this new opportunity.
"This market is developing," explained Rajendra. "Generally, I would say that the non-bank investor base such as specialised credit investors – and certainly hedge funds – is increasingly looking at alternative asset classes within the structured finance space. These are investor constituencies which could potentially be very interested in this market."
One such specialist is Ocean Capital Associates, a London-based fund launched three years ago with the sole purpose of investing in unrated ABS. The investors behind Ocean are mostly former bankers who understood the significance of the changing market paradigm and spotted an opportunity.
"We are a dedicated investment firm focusing on non-rated residual pieces of securitisations; we prefer transactions where the rationale is driven by Basle 2 and IAS 39 where we can partner with issuers seeking favourable treatment under these regimes," said Pedro Errazuriz, a partner at Ocean Capital.
"We used to work for banks in the past where we saw these equity pieces flying around, and sometimes banks were buying them in order to cement relationships with issuers, and we saw a space for a dedicated investment firm," said Errazuriz.
According to Errazuriz, the market has been developing for the last three years, albeit at a slow pace. However, with many regulated bank originators now beginning to structure transactions in order to meet Basle 2 requirements, the market is beginning to expand more rapidly.
The last 18 months has a seen rapid growth in unrated pieces backed by financial assets, for example equity pieces of RMBS trasactions and equity pieces of bank ABCP conduits.
These transactions take two generic formats: the "residual" trade and the "coupon" trade.
The former refers to the residual tranche of a securitised portfolio, a commonplace business line in the US where investors get to participate in any upside in the overall collateral performance. Pricing reflects a number of risks associated with the portfolio.
"Coupon" trades, meanwhile, are somewhat more nebulous, proprietary transactions and are less transparent. In essence, investors bid for a specific risk which affects a pool of assets. Coupon trades tend to have limited upside because they, in effect, underwrite a specific risk.
Since these instruments, by definition, are outside the remit of the rating agencies, the process of analysing, valuing and executing a transaction like this is especially credit-intensive. In Ocean's case, the team draws on structured finance, corporate finance and ratings agency expertise when making investment decisions.
While a pre-sale report makes a good starting point, specialist investors have greater access to the agencies, engaging analysts for specific advice on particular points on a deal-by-deal basis. "The agencies have the best overview of the market so they can provide more useful advice or opinion on a trade,"said Errazuriz.
The bulk of the work is necessarily proprietary. "We don't rely on ratings agencies in the way senior investors might, although we might work with them from time to time."
The unprotected, high risk nature of the investment means that credit work and modelling is exhaustive, including transaction modelling and asset pool modelling. Stress-testing goes beyond that required by credit enhanced, rated tranches to assumptions about different factors which could influence the performance of the portfolio.
The process is intensive in terms of both modelling and asset knowledge, but also requires knowledge of servicing and the servicer in any particular transaction. For these reasons, non-rated ABS investors prefer to work with frequent issuers so they do not have to do separate servicer analysis each time.
So which borrowers are offering these instruments? In RMBS, the frequent borrowers from the established jurisdictions are leading the market, as with the rated tranches. Equity tranches can come in notional sizes anywhere between 50bp to two percentage points of the overall transactional amount. The market is presently ticking over on about two such deals per month.
Bumper yield
In the absence of structural protection, non-rated investors are really taking a punt on performance, with most of the risks to the downside. As such, the rewards can be very attractive.
Because investors are buying a unique position each time they make the decision to invest, returns very much depend on the risk-profile of the pool in question and on the assumptions used to price. "For financial assets, taking the credit markets as a benchmark, investors look at equity pieces as a relative value play against Double B and other deeply subordinated pieces which are trading in the market," Errazuriz indicated.
With prices available on application only and tailored to specific risks, it is hard to estimate a generic risk premium offered by these investments. Some general observations can be made, however.
For example, the credit tiering seen – or not, depending on the point in the cycle – in rated securitisations between prime UK mortgages and a non-conforming pool is mirrored in residual equity spreads. Again, pre-payment risk is influential in residual equity price volatility, but not so significant in "coupon" trades.
"These are trades of opportunity, so it's difficult to give a general idea of yield or returns because you have factors other than credit factors which can influence more or less the rate of return," Errazuriz said.
However, Ocean Capital is in the business of generating near double-digit absolute returns. "We are trying to deliver market returns for each asset class: in corporate assets we are looking for returns similar to private equity yields – around 20% – and for financial assets in particular the double-digit/single-digit boundary."
Buy-to-hold or churn?
At present, there are two main investment strategies in first-loss ABS: buy-to-hold and trade. The former is far and away the most popular, with very restricted, almost negligible flows in the latter.
"There are some hedge funds which are trading these positions, but we know from issuers that they prefer partners working with them in these transactions," a source familiar with the matter said. "If they are going to be working on a regular basis, having some sort of partnership is important – and the buy-hold approach makes a lot of sense for them."
At least one hedge fund has been looking at unrated securitisation tranches, however. At this stage of the development of the market there is no liquidity trading: "This is not liquidity trading – it's directional trading: these investors are hoping that spreads will contract, and if you see a piece performing you take a view that you will be able to turn it around two, three years down the road," the source said. "It's still a proprietary strategy – you need to understand the position in the context of the other bets they are making. It's not a short-term play."
State of play
Recent examples of first-loss issuance in the unrated and low investment-grade rated space include Promise I Mobility €750m synthetic CLO via Deutsche Bank for IKB. The 100% German collateral included €695m of drawn and undrawn facilities, loans and guarantees.
Supporting the rated capital structure was a €21m unrated first-loss slice, which was sold to the market with a coupon of three-month Euribor plus 1,100bp.
"This is the first time in Europe in which the true first-loss piece from an SME CLO has been sold to the market," said Kevin Flaherty, head of ABS syndicate at Deutsche, at the time. "IKB has very strong name recognition in Europe and its previous Promise deals have performed very well in terms of losses. In the end, we were able to find a diverse group of investors wanting to participate at the first-loss level."
In addition to the dedicated equity investment groups, mortgage insurer PMI has taken first-loss pieces in the past from DZ Bank and Aareal Bank, and the interested accounts in this case were likely to be funds from Europe.
"In the current environment, there is a desire from both traditional first-loss buyers and newer buyers for anything with yield, so I am not surprised by this," said one investor.
While not unrated, recent issuance from Spanish RMBS stalwart Bancaja indicates the rate at which low investment-grade, deeply subordinated securities are proliferating in the Basle 2, IAS 39 universe.
Again, Deutsche Bank connected the sell and buy sides in this burgeoning asset class: Bancaja 8 saw €13.2m of 9.68-year Double B rated class Ds printed at plus 175bp after talk of plus 200bp–225bp, indicating a surplus of demand over supply the asset class.
However, as first-loss risk takers, sub investment-grade investors require a relatively greater degree of comfort before coming on board.
"Bancaja has issued over €10bn of ABS securities, making them one of the largest programmatic issuers in the European market. Its collateral performs extremely well and investors have become very confident in Bancaja's origination and servicing capabilities. This allowed us to build a diverse book of investors at the BB level and set a new pricing benchmark," said Deutsche's Flaherty.