The rapidly growing collateralized debt obligation (CDO) market in Europe can pay thanks to the ever-popular securitization of small and medium-sized loans (SMEs), an asset class that since its inception in 1998 has contributed sizeable volume to the structure.

According to Fitch, SME loans are defined as loans made to companies with an annual turnover of less than EURO250 million, and they represent one of the main pillars of the growth of issuance in European CDOs. In 1998 the volume of issuance accounted for 7% of total European ABS that year. By 2000 SME CDOs made up almost 15% of the total volume and as the need for banks to free up cash from the balance books continues, so should the popularity of this asset class. "The main motivation for these securitizations is to provide regulatory capital relief and cover potential capital relief in the future; it is very much likely that other banks will continue to incorporate this tool," said one analyst familiar with the situation.

The market, to date, has been dominated by issuers based in Spain and Germany. While the number of deals this year has risen to12, the majority of the transactions have been partially funded, meaning that the amount of notes actually issued has not increased.: "The limit to how much can be securitized is dictated by the what the capital markets are able to absorb, and what we have seen up to now are fully unfunded or partially funded deals," said Dr. Stefan Bund at Fitch.

The SMILE CLO

However, the popularity of this asset class has thrived in a last-minute example this year that saw the asset class evolve to include a new issuer, the EURO5 billion SMILE 2001 securitization for Netherlands-based ABN AMRO. Not only is it the largest European securitization the market has seen this year, but it is also one of the only fully funded SME CLOs to come to market since 1998. Because of its size and reception the offering has proven that the capital markets are ready to absorb these deals.

Last week ABN AMRO closed the transaction, which was backed by a portfolio of mid and long-term loans granted by ABN AMRO to Dutch small and medium-sized enterprises. "We wanted to open up securitizations as a tool and we have more to go," explained Mike Nawas, head of ABS at the bank.

To date the issues originating from Spain and Germany have predominately come as synthetic securitizations. According to Fitch, while the first SME CDOs transferred both the assets and the risk embedded through a true sale, synthetic structures with only a transfer of the credit risk have become the preferred structure for the later transactions. "SMILE breaks the flow as being both fully unfunded and a true-sale," said one analyst. "Why ABN chose a true-sale is still unclear," he added.

The true-sale structure

Historically the market has done little by way of true-sale securitizations, explained Nawas. The driver for synthetics in the German market has markers that are driven to avoid the taxing on true-sale structures. "In the Netherlands there is no such incentive; both structures are treated equally," he said. "A synthetic structure is good for a small number of asset pools, whereas if you have a portfolio of 30,000 loans you know that there will be a substantial number of defaults and valuation for each individual loan would be too time consuming."

The SME loans are transferred to SMILE 2001 through a true sale. The purchase of the loans is funded through the issue of nine tranches of notes which are composed of five classes of floating-rate pass-through notes rated from triple-A to triple-B. The portfolio of 30,000 loans backs the notes to almost 20,000 companies in the Netherlands.

"One of the challenges of this transaction was to articulate a ratings view with the ratings agencies," Nawas added. The ratings on the notes for SMILE were based on ABN AMRO's historical recovery rate and the servicing and underwriting capabilities of the bank's consumer and commercial business unit.

In its rating of the notes, Fitch also included the available credit enhancement from subordination, the reserve account and the transaction's sound financial legal structure. Typically, the agency has employed its CDO rating methodology for past synthetic transactions but the fact that the underlying obligors are not publicly rated prompted the agency to vary its approach.

"The levels of credit enhancement are very close to RMBS structures and it's caught the market by surprise," said Nawas. According to Fitch, the credit enhancement provided by the subordination of the class A notes would total 10.37 class B at 4.8%, the class C at 3.45% and the class D notes at 2.12%.

Nonetheless, notes Dr. Bund at Fitch, because this is such a relatively new asset class that has yet to suffer an economic downturn it will be imperative to monitor its progression as Europe enters into the throngs of a recession. "We have to watch these deals," he said. "Issuers may struggle to manage assets in adverse economic conditions and it has to be proved that [SMEs] are robust enough to endure such a situation."

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