What has grown into a €250bn market place now faces immense challenges in the form of new regulations, while coming to terms with what many see as the end of a remarkable bull run. All sides of the ABS market should really now grow beyond RMBS flow product. Alex Chambers explores the medium-term outlook for a structured finance market at a crossroads.
Europe's securitisation sector is at a crossroads, and not just because the end of the reliance on residential mortgage backed securitisation – especially of the UK variety – could be in sight. That the credit cycle may have turned is being espoused in many quarters.
Once, all that syndicate officials needed to predict a new issue's spread was to deduct a basis point from secondary market comparables. Primary market execution is now much more than simply working out how to scale back allocations on order books. Structurers and origination officials have to develop new tactics to cope with this new environment.
"The most important thing for the market [to take on board] right now is that we are probably at the top of the spread cycle. That means that despite the potential for some tightening, we have reached the end of the cycle – the downside is bigger than the upside," said Alexander Batchvarov, head of structured finance research at Merrill Lynch.
The de-coupling between corporate and ABS secondary market spreads seen in recent years is now a re-coupling, particularly lower down the credit curve. While the wall of money is still standing and is getting incrementally taller, the perception now is that it is not as stable as it was even a few months ago. What could stop the wall of money?
"It's the realisation that the level of risk has changed," said Rob Ford, head of ABS trading at Barclays Capital. Or perhaps the downgrading of a monoline insurer could undermine faith. "For the first time in 24 months we are suggesting that ABS spreads will be wider this time next year," agreed Ron Miao, structured credit trader at Citigroup.
Unlike the plain vanilla bond market, the known structured finance pipeline has continued to build during the second quarter, a function of the long time-span inherent within structuring ABS deals. ABS supply is not easily curtailed in the face of lessening demand – the question is how participants deal with a slower market.
Batchvarov argues that, "Investors need to think about how to react to potential spread-widening … this coincides with the introduction of IAS39." He elaborated that this dynamic could be magnified by regulatory change: new accounting regulations which introduce marking to market for investment portfolio positions.
The haven-like qualities of asset-backed securities were proven the last time the credit market turmoil took place in 2001-02, and there are few reasons to think that these virtues have altered. Nevertheless, the buy-side will still need to embark on strategies in view of the fact that the three-year bull market now seems at an end.
Where is the new flow?
Investors in Europe's securitisation market have been over-reliant on UK RMBS for paper and benchmarks for the best part of a decade. Similarly, investment banks have depended on this sector for fees and a means to build market share. But it seems that those looking for substitute flow product will need to cast their net far, and cleverly.
"The speed of mortgage origination has declined, and that will inevitably lead to less RMBS – and there is also the covered bond effect," pointed out Batchvarov, "but Italy and Spain have been fairly busy."
While recent issuers such as TdA CAM and Bancaja have shown their ability to print deals substantially larger than had previously been the case, there seems little chance that Spain will become the new UK. There is no equivalent source of the substantial supply that made Abbey, HBOS and Northern Rock a core element of the European and US securitisation market in the past years.
"Will it be the case that new asset classes will fill the gap? Will investors be more willing to do the credit work?" asked Jason Russell, of SG's securitisation syndicate desk. "For investors, new assets are the way to get paid," he added.
The factors that support a yes answer could include the fact that RMBS spreads are so tight relative to supras, sovereign and covered bonds. Mortgage product no longer offers substantial spreads over and above other Triple A rated credit product.
"We are excited about the property sector. If you are a bank with a huge origination team, the ability to keep assets on balance sheet and a command of the techniques and resources to shift risk off-balance sheet, you should be a market leader," argues Philip Basil, head of securitisation market at Royal Bank of Scotland.
Basil argues that banks have to be multi-product, with the expertise to manage and organise in this fast moving market.
"We've already seen significant growth in CMBS volumes," Batchvarov adds, adding that there is a good chance that volumes will increase further.
"It's clearly driven by where [CMBS] spreads have gone to," said Basil, who ventured that the economic rationale for securitising commercial real estate has never been stronger.
"Of course there is a risk that an event or a turnaround in the property market will change the current conditions," cautioned Basil. "Investors can be fickle." He added that diversity away from the UK will become an imperative.
"The European CMBS market is where the US was in 1997 – we could end up with European CMBS driving real estate financing in the same way it does in the US."
Consumer credit is another area for potential growth as banks have vastly upped their origination.
"Consumer credit risk-weightings under Basle 2 are higher than for mortgages, which means that in addition to funding, originators will have extra benefits of regulatory capital relief," Batchvarov said.
Everyone is predicting residential mortgage backed paper to fall as a result of Basle 2, but the fact is that borrowers may continue to issue in this form for investor diversity, suggests Basil.
"Clearly, government ABS is going to be increasingly important as an off balance sheet financing tool," said Basil. "The UK and Italy will still be there but France and Germany are also coming to the fore."
"Property is still hot and Germany is fascinating," enthused Ellen Brunsberg, head of European securitisation group at Morgan Stanley.
The economic tribulations of Germany are notably apparent in the banking sector, where domestic banks are estimated to be creaking under up to €350bn of non-performing or sub-performing assets. While many Germans have lost their appetite for real estate risk, the same international investors have filled this vacuum, creating a potentially vast market for securitised term refinancings.
“Germany is currently an inefficient market. The restructuring of the financial markets has seen a massive shift in the last three or four years. With so much change taking place, there are real opportunities to acquire some very attractive assets," said Brunsberg.
Securitisation provides an ideal vehicle to take advantage of market opportunities; real estate lenders are spending in Germany,” said Arvind Bajaj, managing director and head of European CMBS origination and distribution at CSFB
Regulation
Both borrowers and investors remain focused upon regulatory issues. One major question that needs to be addressed is whether Europe's central banks/regulatory bodies are going to create a level playing field?
The potential issues arising from the implementation of Basle II and IFRS have occupied the industry for years – it is now crunch time. At the European Securitisation Forum's recent conference in Nice, some 59% of conference delegates said that Basle II was the biggest factor confronting the European ABS market; IAS 39 and the interaction between covered bonds and RMBS were joint second most significant with 16% of the vote.
There is potential for further spread-tightening as the market enters implementation of Basle II, and if they have not done so already, investors will start to position themselves for lower risk-weightings. Even in view of the current spread-widening, some commentators argue that the new capital accord could drive Triple A rated RMBS as tight as Euribor plus 5bp by the end of 2005, once the market starts to eye lower risk-weightings for investment-grade risk.
Furthermore, the incentive for bank originators to remove at least part of the first-loss piece of RMBS transactions from their balance sheets has seen the development of a putative market for sub investment-grade RMBS product.
European policymakers had previously rejected the idea of US GAAP, but are now getting accounting convergence by the backdoor with IASB, according to Paul Rutterman, secretary general of European Financial Reporting Advisory Group (EFRAG). IAS 39 continues to be the most important and difficult area of the new standards.
While IAS 39 does allow for some element of off-balance sheet treatment,
the number of ambiguities as to whether it is a rules or principles-based system has resulted in ongoing calls for clarification. In the short-term, at least, the European ABS market will most likely respond with a pot pourri of ad hoc, one-off structures until a consensus emerges.