As European banks and the broader financial markets situate themselves for the impending implications of Basel II, market participants are noting - and speculating on - a number of changes to come within the growing CDO sector.
European CDO issuance had swelled to nearly $68 billion as of Oct. 6, compared to $48 billion a year earlier, according to JPMorgan Securities. CDO issuers are aiming to sell deals that will still be favorable to post-Basel balance sheets while banks are aiming to prune their portfolios of no-longer favorable assets - a phenomenon which is expected to bring fodder for securitization.
As January's implementation in the Europe Union of the revised regulatory capital requirements nears, sources anticipate a continuance of this year's growth in CLO issuance, as well as an increasing interest toward structuring CDOs backed by new asset classes, such as commercial real estate. Because of their much more favorable treatment under Basel II than sub-investment grade positions, CDO issuers are also anticipating demand for highly rated tranches.
"The Basel II impact on CLOs and other CDO markets will depend on the risk of the underlying pool of assets being securitized, as well as the ultimate structuring and tranching of the deal," says Martin Hansen, a senior manager at Algorithmics Capital Management Solutions, a unit of Fitch Ratings. Basel II securitization charges on a given CDO tranche will generally be the same across a given rating grade, meaning that a comparison of the capital charges on two different types of deals will ultimately come down to structure - a factor that could also cause tweaks in how CDO deals are put together. For example, per Basel II, a tranche backed by a so-called "non-granular" pool rated double-A is assigned a capital charge that is more than three times greater than an equivalently rated senior tranche backed by a more granular pool, Hansen said.
Changing risks create
Basel II, which affects all financial institutions within the European Union and U.S. banks with assets greater than $250 billion and more than $10 billion in foreign exposure, will set the framework for the amount of cash banks need to have on hand, based on the perceived amount of risk they hold in their portfolios. Banks in Canada and Japan, as well as parts of Asia, Latin America, South Africa and Australia are expected to also implement the new framework. How exactly asset risk is determined depends largely on whether banks choose one of the internal-ratings base (IRB) approaches to determining regulatory capital under the new requirements or the more rudimentary standardized approach.
While increasing demand for highly rated securities is anticipated due to a significantly lower risk weighting treatment for them under Basel II, whether more subordinated CDO pieces will fall out of favor or price wider remains unclear. Basel's ratings-based approach will require 2.5 times more capital for a double-B plus tranche, which carries a 20% capital charge, than a triple-B minus tranche, which carries an 8% capital charge, according to Fitch Ratings. However, banks that follow the standardized regulatory capital Basel implementation are generally expected to endure less risk weighting for the lower class bonds than banks implementing the more sophisticated IRB approach, according to Fitch. This is a factor that could help mitigate a flight to triple-A rated tranches. The rating agency found that IRB banks - expected to be the majority in Europe - will endure a 65% smaller securitization charge than standardized banks for triple-A rated securities under the new framework, and 76% less for single-A. On the contrary, double-B and double-B minus tranches will rack up 21% and 86% more in securitization charges for IRB banks, while unrated tranches will require a dollar-per-dollar capital charge for both entities.
more collateral for CDOs?
For those asset types that are expected to become more expensive for banks to hold on balance sheet, securitization is the expected choice. According to Kim Olson, co-head and managing director of Algorithmics Capital Management Solutions, "Basel II seems to establish fairly strong capital incentives for banks to securitize commercial mortgage and credit card receivables." CMBS in particular are beginning to make a debut within the European CDO market.
While at a slightly lower ratio than credit cards, capital charges IRB banks accrue for so-called medium risk unsecuritized CMBS collateral outpace securitized CMBS with the same level of risk by three-to-one, according to Fitch, with the ratio slightly lower for low risk assets and about 2.2 times for high risk CMBS.
Even though banks will eventually want to transfer the risk of lower rated or unrated commercial real estate assets, so-called specialist investors are already mopping them up in hopes of packaging them into CDOs. In some cases, the investors are renting bank balance sheets in order to launch CDO term-finance when the "pools have reached critical mass," Fitch reported last month, (ASR, 9/25/06). In other cases, U.S. issuers such as Wachovia and Blackrock Anthracite are expected to mirror their CRE CDO operations abroad. Investec in mid-September announced it was preparing a GBP200 million ($378.4 million) CRE CDO, and at least three more deals are expected. Market participants are forecasting that as many as 10 such deals could hit the market in 2007.
Balance sheet deals abound
CLOs are another Basel-inspired growth area, along with balance sheet deals. During the first half of 2006, balance sheet CDOs accounted for 52% of issuance, according to the European Securitization Forum. "It is expected that a number of bank balance sheet transactions will come with issuers motivated by economic and regulatory capital issues arising from Basel II," the ESF wrote in its biannual review of the European securitization market. Market participants are also expecting a continued increase in SME CLO issuance.
As of early October, balance sheet deals looked on pace to surpass arbitrage issuance for the second month. There were $3 billion worth of arbitrage CDOs issued in September, compared with $3.1 billion balance sheet deals; $1 billion in arbitrage CDOs had been issued in the early days of October, compared with some $2 billion worth of balance sheet CDOs, according to JPMorgan. Balance sheet deals constituted 33% of European CDO issuance in 2005.
High yield loans, by far, have been the collateral of choice for European CDOs this year, with more than 77% of issuance backed by them to date, compared with only 41% last year. Deals backed by high grade structured finance and investment grade debt have fallen out of favor in the meantime, with 20% and 10% reductions in issuance so far this year versus 2005.
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