Bankers are holding out hope for a last minute 'fix' to new capital requirements that will make it much less attractive for European insurers to hold ABS. Insurance companies have become important buyers of European ABS since the financial crisis.
The outstanding volume of European ABS is just under £2 trillion ($3.08 trillion), approximately half of which is retained by bank issuers and the remainder sold to third parties such as insurance companies.
Currently, the amount of reserves insurers are required to set aside is determined only by the amount of risk they insure, but starting in January 2013, they will also be required to set aside capital for the market risk they take on through their investments.
The European Commission's (EC) Solvency II Directive to harmonize insurance regulations across the region has been in the works for nearly a decade. The current draft, which was leaked in October 2011 but has yet to be officially released, treats ABS less favorably than government bonds and covered bonds that carry the same ratings.
The new regulation is expected to result in a plunge in ABS investments by insurers that would likely lead to a widening of spreads and reduced liquidity. But perhaps more importantly, a bowing out of the ABS market by insurers would reduce the ability of Europe's troubled banks to transfer risk by securitizing loans on their balance sheets and selling them — mostly residential mortgages followed by credit cards and auto loans .
"Surely it makes sense for a stable banking system to have the capacity to transfer that risk, especially longer-term risk," said Richard Hopkin, managing director at the Association for Financial Markets in Europe (AFME).
AFME, which was formed in 2009 through the merger of the London Investment Banking Association and the European arm of the Securities Industries and Financial Markets Association (SIFMA), believes that the European ABS market has been unfairly tarnished by some of the worst practices that took place in the U.S. subprime RMBS market.
"The point is that the rules should not be about solving for the last crisis but rather the next one," Hopkin said. He believes the EC erred on the side of caution in drafting the proposed capital requirements. In fact, the draft uses U.S. subprime RMBS as a benchmark to calibrate risk across the array of securitizations issued by European institutions. The trade group director said using this benchmark is unwarranted, given the structural differences between the U.S. and European ABS markets and the fact that most of the European ABS market held up much better during the financial crisis than U.S. subprime MBS.
In an April 30 report, Fitch Ratings estimated total losses for the 'AAA'-rated tranches of RMBS in the U.S. to be 6.5%, far higher than 0.8% in losses for 'AAA'-rated ABS in the rating agency's Europe, Middle East and Africa portfolio since the end of July 2007. Losses on European RMBS have been even lower; according to AFME, only 0.7% of European RMBS outstanding before the crisis started in 2007 has defaulted.
Hopkin attributed the lower default rate to tight regulation of mortgage underwriting and origination in Europe. In addition, he said, European mortgage originators did not immediately sell those assets to fund new originations and transfer the risk. Those banks retained the subordinated portion and so had "skin in the game."
The low loss rates for European RMBS contrast dramatically with the capital requirements imposed by the draft. Fitch reckoned that capital charges under the draft are 7% for 'AAA'-rated securitizations with durations of one-year, jumping to 35% for durations of five-years and 42% for 10-years. That is a huge change from insurers' current capital charges for investing in ABS. "Under Solvency I, there are virtually no capital charges, as capital was based mainly on [insurers'] liabilities, though there were a couple of caveats on the type of assets" they could hold," said Krishnan Ramadurai, managing director at Fitch's credit policy group.
"The calibrations [in the current draft] are way too high and don't reflect economic risk, and they will severely damage the European securitization market," Hopkin said. He added that despite strong credit and price performance, the market "still needs to shake off the negative perception that emerged from the difficulties it has acquired as a result of the financial crisis."
In a survey of 27 European insurance companies and asset managers investing on their behalf that AFME conducted early in 2012, one third of respondents said they would stop investing in ABS if the higher capital requirements went into effect. The remainder of respondents said they would "dramatically reduce" their investments in ABS.
Just over a fifth said that if the rules were imposed, as currently proposed, they would never return to the sector, even if the capital requirements were eventually reduced; of those that might return, 65% said it would take them a year or more to return.
John Jay, a senior analyst at Aite Group, said that Solvency II's high capital charges are a direct response to the inadequacies of credit ratings that became apparent during the financial crisis. He noted that other regulatory initiatives, including the Basel Accords and the Dodd-Frank Act, are similarly seeking to wean banks and investors away from the credit-rating system.
The goals, Jay said, are to shift the responsibility for credit analysis to the market participants and require them "to put more capital on their balance sheets during the good times to buffer the bad times." He added that earlier versions of the Solvency and Basel regulations didn't account for extreme market volatility."Regulators want to de-leverage the system," Jay said, but they must also be wary of "knee-jerk responses."
Market participants argue that Solvency II is just that kind of response. Its ABS capital charges far outweigh the capital charges it prescribes for 'AAA'-rated covered bonds, which for one, five- and 10-year durations, respectively, are 0.7%, 3.5% and 6%, according to Fitch.
The impact of Solvency II's capital requirements are compounded by other new regulations coming into effect over the next few years. For example, "Solvency II couples with the Basel III rules, which also give covered bonds a favorable capital position compared to ABS," said Peter Green, a partner at Morrison & Foerster focusing on structured credits and products. "Although it's to a lesser extent, the discrepancy will likely further focus issuance on covered bonds as opposed to ABS."
The ABS market wasn't expecting such tough treatment. An earlier alternative to the current Solvency II draft, referred to as Quantitative Impact Study (QIS) 5, recommended ABS carry capital reserve requirements similar to those for covered bonds.
The burdensome requirements in the current draft are almost certain to reduce the appeal to insurers, which were minor players in the European securitization market before the financial crisis, when spreads were narrower, but have become important buyers now that spreads are well above 100 basis points for 'AAA'-rated RMBS. Fitch estimated that insurers now purchase approximately one fifth of European ABS. AFME is concerned that the new capital requirements will "encourage insurers to invest in significantly riskier pools of 'raw' loans with no credit protection (but more favorable capital treatment), rather than highly rated securities," according to a "briefing note" the trade group published on April 11.
To avoid those "damaging consequences," AFME recommends in the letter that the EC "seek further technical assistance" from the European Insurance and Occupational Pension Authority (EIOPA). Hopkin said that once directives such as Solvency II are drafted and approved by European Union authorities, amending them becomes nearly impossible. However, before that happens, adjustments can be made to some provisions, and the note calls for "further technical consideration by EIOPA, on both methodology and appropriate calibration."
Industry participants say its unclear when such technical changes could be made to the still non-public draft, and the EC did not respond before press time to inquiries. Solvency II is currently slated to be finalized by June 1, 2013, and to be implemented by regional governments by Jan. 1, 2014.