‘Sell in May and go away’ is much quoted market-tested wisdom, but this hackneyed phrase certainly does not apply to the global asset-backed securities (ABS) market. Thousands of thought leaders and market participants gathered in Barcelona from 14 to 16 June 2022 for the Association for Financial Markets in Europe and Information Management Network’s (AFME/IMN) annual Global ABS conference. This article provides an overview of key themes, drawing on insights from Deutsche Bank’s panelists covering auto ABS, European CLO structures, and other issues from a trustee perspective. In summary these are:

1. The auto ABS sector is a prism through which to view the challenging supply-demand dynamics of the ABS market.
2. The discussion of CLO structuring enables an examination of deal and portfolio construction considerations in light of regulatory changes, as well as the current market dynamics.
3. The discussion regarding trust and agency trends (ranging from the latest developments in collateral and cryptocurrency through to fraud prevention) aids an understanding of the vital ‘plumbing’ and ‘policing’ that make everything in the ABS market possible.
   

The market in general is, noted speakers, “not going great”. Having “turned the page” on quantitative easing, it is now facing stagflation due to resurgent inflation, the possibility of recession, and a deterioration of credit, added to greatly increased geopolitical instability. This has resulted in ‘huge spread increases and very weak deal supply’.

1.1 Widening spreads

One panelist disagreed with the prognosis of market fragmentation made by European Central Bank (ECB) President Christine Lagarde earlier this summer,¹ and instead viewed an asymmetry developing between a European core and its periphery. For example, prior to recent escalating geopolitical tensions, transactions for Finnish companies might only have paid a two basis points (bps) concession above that paid by their German counterparts, but subsequently that gap has now widened to 20bps or more, with some Spanish and Portuguese companies facing even wider spreads and transactions that are partially retained and/or placed well below par with “tremendous concessions”. A gradual withdrawal of stimulus from the ECB’s Asset Purchase Programmes has been a further contributing factor.

1.2. Deal flow: supply chains and borrower demand

Colin Parkhill, Head of European ABS and CLO Syndicate at Deutsche Bank, observed that supply chain challenges for original equipment manufacturers (OEMs) did feed through into securitisation origination challenges, and reported that the disruption in semiconductor supplies had led to a lower volume of auto ABS issuance in 2021 and 2022 than had been expected.

While deal flow might have been – and still is – less than anticipated, that does not mean that borrowers do not wish to borrow or are faring badly themselves. From a performance perspective, the borrower profile within the auto ABS space specifically has largely come from captives/banks and has been very strong. This is reflected in delinquencies being at their lowest level since such records began in 2004. However, as one panelist noted, it also means that “there was only one way up [for delinquencies] from here”.

1.3 Investor demand

“In a rising rate environment, investors want short-dated floating rate notes in their portfolios”
Colin Parkhill, Head of European ABS and CLO Syndicate, Deutsche Bank

However, there were shifting dynamics in terms of investor demand. One consequence of the ECB’s long-running quantitative easing (QE) programme, Parkhill noted, was that it had crowded out “real money” asset managers. With the stimulus of QE now being withdrawn, this is making markets especially volatile from the demand-side too, he added, while also noting that in such an environment (rising interest rates and rising inflation) short-dated floating rate notes (of the type found in the auto ABS sector) are precisely what investors should want in their portfolios. Yet they are, to some extent, sitting on the sidelines, while they grapple with what “relative value” for such paper should be; given the new environment resulting from several current trends.

For example, EU definitions of investment products were ‘moving’, with some investors holding off until they see a more settled regulatory landscape. While the taxonomy regarding investment products might be in the process of becoming more settled (generally and regarding auto ABS specifically), both the definitions and the implications of developments in the space of environmental, social, and governance (ESG) matters – upon both asset allocation and relative value – continue to be finessed by the ABS market.

1.4 ESG

A report published in March 2022 by the European Banking Association (EBA) was commended by one panelist for clearly mapping both the current market landscape and novel ideas – including that market participants should securitise brown assets to invest in green assets.²

Given the quantum leaps in their technological development, there was widespread concern about the residual value of electrified vehicles. Ascertaining residual value becomes more uncertain as the “pathway to electrification” (as one panelist observed) also relies upon heavy regulation and governmental incentives. Such residual value considerations obviously impact the relative value investors ascribe to the paper that relates to them.

2.1 Adaptive and resilient structures

European CLOs have, noted panelists, faced a “constantly evolving regulatory landscape”, yet have successfully adapted their structures to market trends ranging from the growing focus on ESG credentials, the LIBOR-SOFR transition, new risk retention guidance, the EU’s blacklisting of Cayman Island special purpose vehicles (SPVs), through to anti- tax avoidance regulation. Regarding the first, panelists concurred that ESG is a rapidly evolving area, noting that CLOs were “ahead of the curve” vis-a-vis other asset classes. As for regulation, one panelist highlighted the EU’s current Anti-Tax Avoidance Directive (ATAD), which seeks to tackle tax mismatches within CLOs; for example, the so-called anti-hybrid rules and interest limitation rules. The latest version is ‘ATAD 3’, known as the ‘unshell directive’,³ and could enter into force on 1 January 2024. A recast of the EU’s Securitisation Regulation also looms on the horizon.

Despite this flux, one panelist now saw “some stability on that front”, citing the December 2021 report by HM Treasury into the functioning of the UK’s CLO regime, which concluded that it was “happy”.⁴ But, noted another panelist, however closely the UK regime currently mirrors that of the EU there was always the prospect of a divergence between the two over time. On the subject of geo-arbitrage, panelists flagged developments in Luxembourg, which since February permits actively managed CLOs – a reminder that the market is characterised by such innovation and appetite for business with new opportunities always popping up.

One panelist observed a ‘weakening’ of CLO documentation over the last five to six years market-wide, noting that one-third of CLO deals in 2020 were “weak”. However, one person’s “weak” is another person’s “flexible” and indeed most panelists commended the adaptability of CLO documentation, for example now widely:

1. Incorporates negative and/or positive screening regarding ESG;
2. Permits new types of assets to be included, like work-out loans; and
3. (Right on cue for a cautious market) – Offers a shorter reinvestment period.

2.2 An innovative market awaiting its next opportunities

Yudi Liu, Vice President covering European CLOs at Deutsche Bank, considered the current market to be “very challenging” generally, and that warehouses specifically presented a “mixed picture”, depending on when they were put together. “Issuance has been very slow, and year-to-date figures are roughly 30% down compared to that of 2021,” she reflected. The hunt for (dwindling) assets will be exacerbated with around 10 new CLO managers looking to make a debut issuance in the EU, resulting in more managers chasing fewer loans or high-yield bonds.

“Asset diversification and credit enhancement help mitigate any risks regarding market volatility”
Yudi Liu, Vice President, European CLOs, Deutsche Bank

Despite this adversity, asset diversification and credit enhancement that help mitigate any risks regarding market volatility, and CLO ratings, Liu added, have been “resilient” so far. Indeed, the consensus was that investors can expect “more ESG and more innovation regarding CLO assets”.

Trustees and agents play a vital but often unsung role in facilitating both debt and equity capital markets. From agency, custody, escrow, through to trustee roles, the range of services and solutions such teams provide has been highlighted by game-changing events such as the Covid-19 pandemic and the LIBOR transition.

3.1 No pause for the pandemic: facilitating stakeholder interactions

Early in the pandemic, trustees and industry bodies both debated whether virtual and/or hybrid meetings could be held in lieu of in-person physical meetings. Trustees were particularly concerned with the impact these new format meetings might have on stakeholder dynamics and on the ability to resolve situations arising between the various parties involved in ABS deals and structures.

Olufemi Oye, Head of Special Situations in the Trust and Agency Services EMEA team at Deutsche Bank, recalled how during the disruption, “trustees stepped up and made regulations relating to noteholder meetings being held virtually as it was not possible to do in person meetings. As a result, trustees were still able to facilitate meetings of noteholders – albeit virtual – and enable noteholders to vote on issues affecting them.” Now the pandemic has abated, he believed the position going forward should be:

• Trust deeds – as presently drafted – do permit trustees to make regulations regarding meetings and are sufficiently flexible. There is no need to include language in the Trust Deeds relating to virtual meetings.
• Physical meetings as the default position, although the trustee has flexibility in appropriate circumstances to make new regulations concerning virtual meetings.
• The current market standard – namely that it is for the issuer to decide whether to hold a virtual meeting – is sub-optimal and places the trustee under immense pressure. Unless there is an overarching reason to hold a virtual meeting, we should have physical meetings.

3.2 Safeguarding collateral

Digital assets (including cryptocurrencies⁵) were discussed as potential collateral. Deutsche Bank’s Oye noted that “every trust house is looking at this”, but that it is “definitely something for the future”. In the interim, Oye reflected, the unregulated nature of cryptocurrencies and challenges regarding cybersecurity meant trustees faced a legal grey area regarding their ability to safeguard the assets. Until the challenges around lost and stolen cryptocurrency are resolved, it is difficult to see how this can be used as collateral.

3.2 Protecting investors

Continuing with the theme of criminal behaviour generally, panelists observed an increase in executive impersonations, which are used as a way of obtaining control of SPVs – and then diverting assets. However, they praised the courts of England and Wales as helpful and “very quick to quash these actions”. Nonetheless, the time and money required for such litigation is considerable, and Oye reminded noteholders that all costs of trustees defending such actions will come out of the pool of assets.

3.3 LIBOR transition

Trustees across the ABS sector helped drive the LIBOR to SOFR transition. This was a ‘mammoth undertaking’ in ‘scale and complexity’, given that around US$350trn of financial transactions were underpinned by LIBOR. Trustees stepped up to the challenge and were proactive in educating the marketplace, helping clients avoid bottlenecks in refinancings. Praise was heaped on vehicles for this industry-wide cooperation, like AFME⁶ the trustee sub-committee of the International Capital Market Services Association (ICMSA)⁷, and the latter’s IBOR Working Group. However, the process of educating the marketplace continues: one panelist noted that synthetic LIBOR is not guaranteed beyond the end of 2022 and also that the US dollar book has to transition over by mid-2023. In addition, ATAD 3 is an incentive to market participants not to delay their refinancings.

3.4 Digitalisation of data

Another ongoing mega-trend in which trustees will play a key role is the dematerialisation and digitalisation of data, which will, noted panelists, “revolutionise the securities industry”. This trend is already evident, with an increasing use of platforms for a variety of ABS-related activities, such as KYC, transaction execution, onboarding, and virtual noteholder meetings (including voting and processing of consents). Further use of such automated platforms is anticipated, although this could, noted one panelist, take a further 10 to 20 years to fully play out. How banks and their trustee teams embrace the technology that facilitates this will be a critical factor.

In addition to simply increasing process efficiency for parties, data digitalisation also helps ABS management. With real-time data access round-the-clock, and with an expanding range of technology-based tools, parties will increasingly be able to visualise a variety of matters relating to their portfolio, such as exposures, KPIs, pending transactions, and cybersecurity.

The three sessions covered here can only provide vignettes of a conference bursting with around 40 panel discussions and more than 200 speakers. While the event was held back in June, the discussion provides helpful insights into an ABS sector that is resilient and ready to rise to the challenges posed by any further market downturn.

The AFME and IMN 26^th Global ABS Conference took place 14–16 June 2022 in Barcelona, Spain

Sources

¹ See omfif.org
² See eba.europa.eu
³ See home.kpmg
⁴ See assets.publishing.service.gov.uk
⁵ See „Is the crypto party over?“ at flow.db.com
⁶ See afme.eu
⁷ See icmagroup.org