Since mid-2007, the European securitization primary markets have been living in a state of suspended animation.
The availability of attractive financing terms through the Central Banks relative to that offered in the market caused companies to stop issuing in the primary market, delaying its orderly recovery.
How much is on repo with the European Central Bank (ECB) is uncertain. Barclays Capital analysts said that the bank's reluctance to reveal volumes has raised questions, so much so that some investors now reckon that the ECB's facility must contain nearly all ABS bonds retained by European banks.
According to Barclays' estimates, the total current outstanding notional of all retained European ABS bonds amounts to roughly €1.1 trillion ($1.58 trillion), but the combined size of the ECB's repo facilities is only €648billion.
"Even if every single bond in the Bank's facility was an ABS bond, only about 61% of all retained bonds could possibly reside at the ECB," said Reto Bachmann, Barclays co-head of European ABS research, in a report.
Finding the Asset Overhang
Bachmann believes that investors are interested in knowing how much ABS is on repo because this could provide a gauge for how much the ECB might unload on the market.
"As far as we can tell, their underlying concern is that the ECB could, on purpose or by mistake, force the ABS bonds currently on repo out of its facility, which in turn would force the banks owning the notes to sell them on the secondary market," Bachmann said in the report. "This wave of forced selling would then cause a collapse in secondary valuations."
He added that this is why ABS investors might be interested in the repo'd amount in the hopes that the figure is small, from which they would draw some comfort. This could possibly mean that even if all the repo'd ABS bonds came to market all of a sudden, it would not cause too large of a decline in valuations because the market could digest the additional supply.
"Alternatively, investors may reason that if it is small, banks could afford to lose the funding caused by loss of access to the ECB's repo facility via ABS and consequently only a few would be selling the returned notes," Bachmann said.
Not all of the eligible ABS assets have been used to withdraw liquidity from the ECB. Many stronger banks with cheap funding channels have structured retained ABS but have not repo'd these with the ECB - instead funding them more cheaply on balance sheet.
Deutsche Bank analysts said that, based on the limited data available, the greatest reliance on retain-and-repo funding in the euro zone would appear to be in Spain, Ireland, Greece and Portugal.
Central Banks Aim to Revive ABS
The ECB has shown that it is ready to begin turning off the liquidity stream it was providing to the market and with an announcement the Central Bank made, came a sprinkle of the first real primary issuance from the U.K.
"The ECB will be taking some initiatives to help catalyze the re-launching of securitization on a sound basis in the context of its collateral framework policy related to the implementation of monetary policy," said Lucas Papademos, vice president of the ECB, in a Dec. 12 announcement where he outlined the upcoming changes to the repo program.
In February of this year, the ECB raised haircuts significantly for ABS. The ECB currently applies a 16.4% haircut (12% standard, 5% on top of this for theoretical price assets) to the market value of eligible assets.
In November, the ECB further tightened rules governing ABS eligibility criteria. From March 2010 for new issues and from March 2011 for legacy bonds, the ECB will require at least two triple-A ratings on every eligible ABS asset.
The announcement also refers to deals already in existence and provides an indication that the ECB may be starting to consider their longer-term support of the ABS market.
From March 1, 2011, all deals must comply with these new dual rating rules - the rating for deals issued post March 2009 must be triple-A at issuance; deals issued prior to March 2009 must be rated at least single-A. Many of the repo'd deals currently have only one rating and would become ineligible if a second rating agency does not agree with the original rating.
Securitization may pick up an important role in terming out much of the recent injected liquidity.
"Although at face value the move is designed to limit rating agency arbitrage, it also represents the first steps in a broader ECB campaign directed at issuer reengagement," said Deutsche Bank analysts. "The latest rule changes will put further pressure on advance rates and along with a broader removal of the extraordinary market stimulus should give rise to greater issuer market reengagement."
The U.K. Treasury's pre-budget report also noted the important role that RMBS would play as a funding channel to support future lending.
U.K. Liquidity Solution Draws to a Close
The U.K. special liquidity scheme (SLS) is currently set to expire slightly later than the ECB's more severe rating rules come into full force.
The Bank of England (BoE) has reportedly lent £185 billion ($295 billion) under the scheme, secured by bonds to a nominal value of £287 billion, the majority of which is RMBS.
Deutsche Bank analysts said that banks using the U.K. scheme still have the option of one year loans for a further two years, which means that the SLS funding will expire between April 2011 and Jan 2012.
"However of the €648 billion accessed from the ECB window in [December 2009], a large fraction is likely to have been secured through retained ABS," analysts said. "Notably, in the case of the U.K. however, it would appear that the majority of retained ABS has found a home in the SLS."
Crystal Ball Analytics
Alternatives to the repo financing window will play a key part in reestablishing pricing equilibrium in European ABS.
The sheer volume of bank financing needed over the next few years is such that securitization most likely cannot avoid playing an important role. European ABS primary markets should be significant.
"However, for the ECB and BoE to engineer an orderly and full transfer of the risk they have assumed via retained ABS refinancing operations back to the private sector (either through placed ABS, covered bonds, senior unsecured or retail funding) may be more protracted than dates for program expiry and criteria changes would imply," Deutsche Bank analysts said.
Indeed, the European public new-issuance market has already begun to show signs of reemergence with the ARENA 2009-1 Dutch RMBS deal marking the latest public deal to hit the market. ARENA sold its two senior triple-A tranches A-1 and A-2 to investors, and retained the more junior tranches. The publicly placed senior tranches priced at 110 and 140 basis points, and quickly tightened in secondary markets, demonstrating the generally positive sentiment in the market.
Friesland Bank publicly placed the Class A tranche of its Dutch RMBS, CIT11 4, which was originally printed in May 2008 as a retained transaction. The fact that the tranche had a high coupon of 140 basis points and step-up of 200 basis points makes this an unusual bond in the retained universe and no doubt aided execution (the deal was reportedly sold at above par to give a spread of 130 basis points).
Similarly, BBVA is looking to place the government-guaranteed A2G tranche of its BBVAP 8 Spanish SME CLO that was issued and retained in July 2008. High-coupon or government-guaranteed tranches may not be the norm in retained deals, but such attributes are likely to give them a head start in the post-crisis market.
Caixa Catalunya also syndicated a new government-guaranteed SME CLO tranche, GATGE 09-1 A1G, at attractive levels. Credit performance across many securitization sectors continues to mirror the improvement in the wider economy.
The new-issuance pipeline will continue to grow into the New Year and, if sustained, could usher in a period of revived issuance.
A portfolio manager said that, despite the relatively positive signs from U.K. banks entering the market, it is likely that the banks that can't readily access the covered bond market will be especially interested in securitization.
From Europe, the market is likely to continue to see some activity from the residential side, although there continues to be some uncertainty in this sector considering the number of deals that have high LTV or that have large extension risk.
"It clearly won't be a high volume of issuance because issuers will utilize another funding outlet that is more economical before they opt for securitization, thus the pipeline won't be what it used to be," the portfolio manager said. "Nonetheless we expect to see some deals from RMBS and credit cards and possibly CLOs. CMBS will be more challenging, but buyers still have appetite for low leverage, single borrower issues."
David Shearer, a partner at Allen & Overy, said that, despite the recent flurry of activity, the market remains fairly closed. "It's a small number of issues that got away, but not what was seen in previous years," he said.
And a return to pre-crisis ABS issuance levels is not in the cards;for the U.K., high currency swap costs mean ABS will likely be more restricted to domestic buyers, unlike before.
Shearer said that looking at the transactions that have closed recently, the deals needed to have a level of credit enhancement. "So while there are people willing to invest, the prices don't really make ABS economically viable for the arranger," he said.
The question is can the ECB drive the economics of doing ABS when the macroeconomic situation remains questionable and housing markets are still teetering?
The ECB is undoubtedly distancing itself and has always pointed out that it's not an investor, but whether it will successfully get banks to place paper directly into the market certainly also depends on what type of real money investor are willing to bite.
According to Henderson Global Investors analysts, there remains a substantial amount of "real money" cash looking for risk assets and with interest rate risk becoming an increasing focus for 2010, Libor-based ABS are gaining particular appeal.
Henderson said it estimates that potential third-party-placed new-issuance volumes for Europe in 2010 could be up to €50 billion, although estimates range from €20 to €100 billion.
Shearer also said that while the market could see similar previously retained assets being placed in public securitization, the word on the Street is that Dutch RMBS is seen as a special case among buyers that understand that it has not suffered to the same degree as its neighboring mortgage markets.
Looking Toward Sustainable Issuance
It's likely that lenders that are able to issue covered bonds will prioritize this funding tool given its lower cost. But a combination of investor demand, weaning of banks off central bank liquidity, and a return to the securitization arbitrage (asset yields supporting funding levels), should bode well for a sustained ABS market re-opening.
"Looking toward next year, European structured finance continues to offer strong pick up relative to other comparable credit markets and a continuation of the recent primary market revival in [the first quarter] looks likely," Henderson analysts said.
Citigroup analysts said that a combination of the European economies stabilizing and cash investors looking to put excess funds to work will help the rally to resume in European ABS spreads. "We think this should happen as market participants realize the benefits of having financing secured by assets that have been devalued during the long drawn out recession," analysts said.
Markus Ernst, a senior ABS analyst at UniCredit, said he clearly sees value in ABS assets for 2010. He expects that stabilizing fundamentals will ease price pressure and robust senior tranches will offer strong pick-up potential compared to other related asset classes such as covered bonds.
"ABS pricing is now at, or very close to, a level where most asset yields are able to support publicly placed bond spreads (at least where the senior part of the capital structure is placed)," added Deutsche Bank analysts.
However, junior bond spreads still need to tighten significantly for placement to be realistic. Ernst believes that less risk averse and specialized investors could also find value in mezzanine and subordinated classes within the capital structure in 2010, which have not yet experienced the same rally as senior assets and offer an attractive risk return next year.
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