By Dominic Griffiths (Partner) and Ela Zakaim (Senior Associate) of Mayer Brown Rowe & Maw's European securitization group
The Basel II Accord will profoundly change the securitization markets. Even though it is not expected to become effective in the European Union until 2007/2008, such changes are already under way.
The new rules will encourage banks to retain lower risk-weighted assets, such as BBB and higher-rated ABS as well as corporate exposures, on their balance sheets. Conversely, higher risk-weighted assets, such as some credit card ABS (due to the need to hold capital against investor interests), smaller bank and corporate exposures, commercial mortgages and other specialized loans are more likely to be securitized, balancing out any slowdown in the market.
As capital charges for securitization exposures become more burdensome for bank investors, particularly for lower-rated tranches attracting the highest capital charges, the securitization markets will look to diversify their investor base in the nonregulated sector. This trend is already visible in the recent surge in take-up of first-loss pieces by a new breed of boutique equity investors.
Big changes in the commercial paper conduit market are also expected. The principal effort will be to reduce or eliminate liquidity, which attracts increased capital charges under the new rules. We expect to see new conduits structured and existing conduits restructured to reduce traditional liquidity by greater use of extendible commercial paper, and by introducing forms of liquidity such as credit default swaps and market sale indemnities that attract lower capital. We also expect to see conduits shift to repo funding, which does not require as much liquidity as commercial paper funding.
Some ABCP conduit sponsors may question whether Basel II's higher capital charges will eliminate their incentive to hold assets in conduits. We do believe, however, that conduits will continue to be useful to banks for many reasons, even if there are no regulatory capital arbitrage opportunities (as under the existing rules). For example, conduits may help banks diversify funding sources, meet certain accounting objectives and generate nonlending income rather than on-balance sheet exposures for risk-based capital purposes.
Several issues must be resolved regarding the implementation of the new Basel II rules. First, the rules permit a significant amount of national discretion, which would create an uneven playing field if not rectified. Second, important terms (such as "significant risk transfer," which is a condition to qualifying for the securitization capital rules) have yet to be defined. Finally, synthetic CDOs are still not permitted "double-default" relief, which is an important change if synthetic CDOs are to avoid requiring more capital charges than are justified by the risks of the exposures. These and other issues are being discussed in meetings between national regulators and securitization industry representatives.
Securitization and a booming M&A market
Europe's booming M&A market has provided a fertile backdrop for a growing trend in more sophisticated acquisition funding packages, including post-acquisition securitization take-outs of the initial acquisition debt. This alternative financing has been used in numerous pan-European acquisitions over the last few years.
We have found that the challenge of this product is to structure and protect the cash flows such that the transaction is consistent from a credit standpoint with capital markets requirements, even though the target is usually below investment grade and invariably highly leveraged post-acquisition.
The advantages of securitization go beyond the ability to access less expensive funding. The detailed due diligence of the securitization sponsor on a target's cash collection and management processes enables the target and the sponsor to better understand those processes, and sometimes reveals inefficiencies (or even liabilities) in the target's business not known at the time of the acquisition.
European covered bond market to exceed 1 trillion
Covered bonds constitute one of the most dynamic segments of Europe's debt capital markets. Some estimate that the European covered bond market, which has experienced spectacular growth over the last five years, will exceed 1 trillion by 2010.
From their modest origins in the German pfandbrief, covered bonds are now issued in about 20 European jurisdictions. This proliferation reflects significant government action in Europe to facilitate their development. Over the last few years, several countries, including Spain, Ireland, Norway, Italy and Hungary, have passed specific covered bond legislation. In 2004, Germany extended the right to issue pfandbrief (previously reserved to savings and mortgage banks) to commercial banks. However, the absence of specific legislation is not a bar. The U.K. has no such legislation. However, since the inaugural U.K. covered bond was issued by HBOS in July 2003 (structured using RMBS technology), it has developed an active covered bond market.
RMBS issuers are increasingly moving into the covered bond market to diversify their investor base and access an alternative, stable and economical funding source. For investors, as well as having good liquidity, covered bonds allow geographical and asset-class diversification by providing a viable investment alternative to European government, agency and national bonds. Plain vanilla structures (fixed interest bullet bonds) dominate the market, but have given way to some structured covered bonds (including step-up bonds and callable bonds) introduced to meet investors' specific yield and risk needs.
Europe is watching the RMBS market, which is also enjoying strong growth, with interest in light of the competition posed by the covered bond market. This competition is expected to intensify with the impending removal, under Basel II, of the incentive to RMBS of regulatory capital relief through off-balance sheet treatment of the assets (with covered bonds, the pool of assets remains on the issuer's balance sheet).
Central and Eastern Europe - a hotbed of opportunity
The region encompassing Central and Eastern Europe, as well as the former Soviet Union and the Middle East, has seen an explosion in structured finance transactions.
The expanding membership of the EU (now at 25 member states), the development of member states' legal systems and the demand for funding to fuel their rapidly growing economies have contributed to the boom.
The most active sectors include securitization of consumer loans, Tier 1 and Tier 2 capital issuances and straight bond offerings. There is considerable room for additional growth as the volume of assets (particularly consumer assets) increases.
Transaction volumes in Russia, Turkey and Kazakhstan have been especially high, with Ukraine tipped to be the next hotspot.
The Turkish market has started to move beyond the ubiquitous future flow deals for which it is known, with the introduction of offshore securitizations of domestic receivables. Kazkommertsbank ended 2005 with a flurry of structured finance offerings.
In Russia, the first true-sale basis auto loan securitization was completed in July 2005 for Bank Soyuz. The basic legal structures underpinning that deal are expected to provide a good template for mortgage-backed and other bond offerings.
(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.