The European Central Bank is talking up securitization as a way to boost lending to small and medium sized enterprises (SMEs), which are the backbone of the region’s economy and have few alternatives to bank funding.
Loans to small companies are capital-intensive, and Europe’s banks are under pressure to deleverage in order to meet stricter capital requirements. Securitizing these loans would get them off banks’ balance sheets, freeing up capital to make more loans.
Yet the market for SME securitization, once an important funding vehicle for small businesses in Spain and Italy in particular, remains virtually shut. A major reason is that spreads on bonds issued by SME securitizations are much higher than spreads on SME loans. It’s simply not economical for banks to bundle these loans and sell them to investors; the interest they earn on the assets is not enough to pay the interest investors are demanding on the liability side.
As a result, most of the deals completed since the financial crisis have been used as collateral in borrowing from the ECB through sale and repurchase (repo) agreements.
There are other disincentives, such as regulatory requirements that deal sponsors hold on to 5% of the risk in securitizations. Capital requirements, proposed under Basel III, which give the senior-most tranches of securitization the same risk-weighting as subordinated tranches, also make SME securitization less attractive to some investors. But this is also true of all kinds of asset-backed securities, including sectors like auto loans and credit cards that have been fairly active.
Despite these hurdles, the ECB believes that securitization could be the key to jump-starting Europe’s economy, which contracted by 0.6% in the fourth quarter of 2012, and to bringing down its intractably high unemployment rate, which stood at 12.1% in March, on a seasonally-adjusted basis. (The unemployment rate ranges from 4.7% in Austria to 27.2% in Greece.)
The central bank is therefore looking for ways to make the process more attractive to both issuers and investors. On May 2, ECB President Mario Draghi said the central bank’s governing council would begin consultations with other European institutions on initiatives to promote a functioning market for ABS collateralized by loans to non-financial corporations.
Draghi’s remarks came after the ECB cut interest rates by 0.25 percentage point to a historic low of 0.5%. The central bank president noted that this accommodative monetary policy has failed to stimulate lending to SMEs.
“Our non-standard monetary policy measures have, therefore, the task of removing these stumbling blocks to ensure that our single monetary policy in fact reaches all parts of the euro area. This is crucial for fulfilling our mandate,” he said.
What would it take to revive SME securitization? Many market participants believe that the ECB, or some other regional institution, would have to either provide a guarantee on the securities or take the first-loss position in deals in order to make them more attractive to investors.
Another option would be for the ECB to purchase SME securitizations in the secondary market, which could drive down spreads just as the U.S. Federal Reserve’s purchase of mortgage-backed securities has driven down spreads on MBS. ECB executive board member Joerg Asmussen recently confirmed that the central bank has discussed this option.
SMEs to the Rescue
SMEs are incredibly important to the European economy; between 2001 and 2010, they contributed to an estimated 85% of new jobs in Europe, according to a report published by the Prime Collateralised Securities (PCS) Secretariat in March. “The biggest problem in Europe now is unemployment,” said Ian Bell, head of the PCS Secretariat. “The deleveraging of banks is going to hammer these smaller companies and, by default, unemployment rates in Europe.”
PCS is the securitization Kitemark launched last June; it is designed as a simple measure to identify securitizations that meet predefined best practice standards with regard to quality, transparency, simplicity and standardization.
The need to boost capital makes lending to capital-intensive assets, like SME loans, which often have terms of five years or longer and are below investment grade, less attractive to banks.
“These are smallish companies with an overall credit quality of maybe double-B or even less than that,” said Richard Hopkin, managing director in the securitization division of the Association for Financial Markets in Europe (AFME).
Securitization of these loans would enable banks to get them off their balance sheets and recycle the capital into new loans, though they would have to hold on to a piece of each deal in order to meet risk retention requirements.
“If you are doing a securitization to manage your capital base, which is relatively uncommon in today’s environment, then there are more efficient assets to securitize than residential mortgages because typically other assets, like SME loans, have higher capital requirements on balance sheet than residential mortgages,” said Hopkin.
He believes that the fact that an institution like the ECB is taking an even greater interest in SME financing, is very encouraging. “They have always been very focused on securitization and they hold many billions of euros of ABS paper on their books through their repo arrangement, which helps support the market,” he said.
Some questions how strong the demand for credit is right now from the SMEs themselves. “If you are in the shoes of a small entrepreneur and your economy is not that solid, you are not going to take big risks, you are not going to try and leverage yourself up,” said Marjan van der Weijden , head of EMEA securitization at Fitch Ratings.
On the other hand, van der Weijden said that these companies might be willing to take on more risk if they could access funding more cheaply.
In an April survey by the ECB, euro area SMEs reported an increase in external financing needs for bank loans between October 2012 and March 2013. (The different between the percentage of firms reporting and increase and the percentage reporting a decrease was 5.0 percentage points.)
They also reported a deterioration in the availability of bank loans.
Poor Deal Economics
Although banks have a bigger incentive to get SME loans off their books than they do to unload residential mortgages, the latter are much more attractive to investors. In a report published in early May, Fitch said that investors are demanding higher yields on SME loans than on residential mortgage backed securities (RMBS) because the SME loans are perceived as riskier. And because there are fewer SME securitizations outstanding, these deals are also less liquid than RMBS.
The credit rating agency said the last “significant” placement of an SME securitization in the primary market was Sandown Gold 2012-1, which was sponsored by Lloyds and closed early last year. The deal’s ‘AAA’-rated tranche yielded 200 basis points over LIBOR. Spreads have since contracted significantly: Based on investor meetings and roundtable discussions, Fitch estimates that the minimum primary market spread for ‘AAA’ rated SME securitizations would be between 80 and 100 basis points over EURIBOR, at least for core European jurisdictions.
By comparison, spreads on SME loans that could serve as collateral for new deals currently range between 120 and 250 basis points, depending on jurisdiction, but have been increasing slowly. (Surprisingly, the asset spreads in Italy and Spain, considered peripheral markets, are at the lower end of the range.)
“As a result, for SME securitizations to be economically viable, either the spreads demanded by investors have to decrease further or asset spreads charged by lenders will have to rise,” Fitch said in the report.
It is no surprise, then, that banks prefer to use SME loans to access ECB liquidity, which is significantly cheaper. Fitch said it is aware of 27 SME securitizations that were completed in 2012 totaling €35 billion; all but one were retained for ECB repos.
The spread on the rated tranches was around 50 basis points lower. “This is significantly below the level demanded by investors, especially considering the ratings of retained tranches were typically in the ‘A’ category,” Fitch said.
It is interesting to compare SME securitization with Europe’s collateralized loan obligation (CLO) market, which has been enjoying a revival. CLOs are backed by loans to much larger below-investment-grade companies, and they are typically sponsored by non-banks that acquire the collateral in either the primary or secondary market. Sponsors have been able to place the entire capital stack with investors, including equity. The ‘AAA’ rated tranches of CLOs with a similar level of credit enhancement as SME securitizations have recently priced at 140 basis points of EURIBOR. However, asset spreads on the underlying loans are on average 400 basis points.
The ECB’s Options
One of the options the ECB is thought to be considering, setting up a pan-European vehicle that could securitize SME loans from various places, could prove quite challenging, according to Van der Weijden. A deal’s domicile is an important consideration in Fitch’s ratings, so “your structure will be more complicated, your portfolio risk assessment will be more complicated – it would be challenging,” she said.
Nevertheless, “in general we feel that SME CDOs [collateralized debt obligations], while not as granular and homogenous as mortgage portfolios, if composed of a sufficient number of small loans they tend to certainly behave like large homogenous portfolios, and are a good fitting asset for securitization.”
Van der Weijden said that regulators must realize that they can’t heavily penalize securitization on one hand and on the other hand look at it as a way out of the region’s funding problem. Regulators must therefore find a way to make the proposition less expensive.
One way to do this would be for an EU institution, like the European Investment Bank (EIB), to guarantee the whole or part of the capital structure of securitizations of SME loans originated by banks. “This would have the effect that the credit risk of the portfolio is taken by the EU institution, and not by the investor, and the required spread on the product is likely to be lower than for SME CLO tranches,” Christian Aufsatz an analyst at Barclays, said in a May report.
Because the bonds would be guaranteed by an eligible institution, those placed with investors would not fall under the definition of “securitization” under the European bank and insurance regulations, Aufsatz wrote in the report. “As a result, the punitive regulatory requirements and capital charges currently in place or proposed would not apply, reducing the spread required by regulated investors further.”
This would be a familiar role for the EIB, which already supports SME lending through a €3.621 billion initiative labeled the Competitiveness and Innovation Program (CIP). Under the CIP, which was launched in 2007 and winds down this year, the European Investment Fund (EIF), an arm of the EIB, provides low levels of credit enhancement for both cash and synthetic SME securitizations. In exchange for this, the originators create a new portfolio of SME loans during an agreed period known as the Additional Portfolio. The size and composition of this portfolio depends on the size and the seniority of the EU guarantee, but it must be at least 50% of the original portfolio. The Additional Portfolio must only contain medium- or long-term financing to SMEs.
A more recent example of the work the EIF has sponsored under its program is the securitization agreement it signed in March with UniCredit, Federconfidi and FederAscomfidi to support SMEs in Italy. This program, also part of CIP, provides companies with easier access to an additional €120 million of new loans, according to the EIF.
CIP is set to expire this year, but the EIF has planned up a follow-up, €2.5 billion program called Competitiveness of Enterprises and Small and Medium-sized Enterprises (COSME), expected to run from 2014 to 2020.
Another option would be to have an EU institution such as the EIB take the first loss in SME CLO securitizations, ideally by purchasing the most subordinate tranche -- the one banks would otherwise be required to hold. The banks would place only the senior tranches with investors.
The EIF has acted as both investor in equity funds and as a guarantor, using its own capital as well as mandating the use of capital from third parties to amass resources for new SME funding, according to Alessandro Tappi, head of guarantees, securitization and microfinance. In remarks made at an April roundtable sponsored by European Association of Craft, Small and Medium Size Enterprises (UEAPME), AFME and the Association of Chartered Certified Accountants (ACCA) in Brussels, he said the bulk of the resources under mandate come from the European Commission.
“Somebody needs to step in and take some of the capital risk that is originated and taking the capital risk away from SME lending from banks is sort of a government job – like the SBA guarantees in U.S. SMEs – its why we have government,” said Bell, referring to the U.S. Small Business Administration’s guaranteed loan programs.
“We think that ultimately if the ECB is serious and the government is serious then at some point they need to say that some of that money that is already allotted to the SME programs needs to go somehow into buying some of the capital element of these deals so that buyers have a reason to do them,” Bell said.
SBA-guaranteed loans, available from both banks and non-bank lenders, aren’t the only options smaller U.S. companies have to bank loans. There are also business development companies, a type of closed-end fund that makes loans to specialized investment company that lends to middle market companies. Juan Alva, a partner at Fifth Street Finance Corp., says BDCs are “an ideal debt financing vehicle.” They have permanent capital, in the form of publicly traded stock, in addition to various kinds of debt financing, from bank lines of credit to convertible bonds and even ‘baby’ bonds sold in small denominations to retail investors.
BDCs also have the flexibility to invest in different parts of a company’s capital structure, first lien, second lien, or mezzanine debt, depending on the market appetite and the risk return profile, Alva said.
There is also an active market for middle market CLOs in the U.S.
U.S. ABLe Proposal
The ECB’s securitization push is part of broader effort to diversify the sources of funding to smaller companies. AFME, for example, submitted a proposal last year to the U.K. government to finance SMEs through an entity to be called the Agency for Business Lending (ABLe). Hopkin said that the proposal was “a little bit broader than just securitization” and looked at various ways to pool SME loans and fund them through a non-bank entity.
“The rationale behind that paper is that the problem we are having at the moment is a capital problem; it’s not a funding problem – there is plenty of cash sloshing around,” he said.
KfW as an Anchor Investor
In Germany, KfW, the government-owned development bank based in Frankfort, has two long-standing programs to facilitate securitization of SME loans, but regulations put in place since the financial crisis have rendered both largely redundant. The Promise program, launched in 2000, took the credit risk in portfolios of SME loans held by German banks, freeing them to make more loans. Another KfW program, Provide, transferred the risk way from residential loan portfolios held by German banks, also freeing up capital.
Markus Schmidtchen, first vice president for capital markets products at KfW, said that collectively the €125 billion of SME securitizations have been issued through the two programs. However, since the adoption of Basel II capital standards in 2008, the programs have been less attractive to issuers. Since then, only two deals have been completed a $1.2 billion deal via Promise in 2012 a $2.0 billion Provide deal in 2009.
The German agency has now assumed a role as an anchor investor in the senior tranches of German SME securitizations. “That means that we are willing to invest in SME transactions in Germany and this is important because there is definitely a lack of investors in the securitization market today,” Schmidtchen said.
He said that KfW continues discussions with policy makers and regulators on the role it can play promoting securitization.
Some kinds of SME loans appear to be particularly attractive to investors. In January, Société Générale issued Red & Black TME Germany, a securitization of equipment leases made to SMEs by the bank’s subsidiary, GEFA. The €513 million tranche of class A notes priced at 50 basis points over one month Euribor. That was almost as tight – or as tight -- as deals in the auto sector, according to Laurent Mitaty, Société Générale’s head of securitization for Europe.
“ABS investors now show some appetite for SMEs ABS, which may not have been the case last year that was dominated by auto ABS and U.K./Dutch RMBS,” Mitaty said.
--Allison Bisbey contributed to this article