TRUST AND AGENCY SERVICES
European structured finance remains resilient
20 November 2020
Securitisations are going through a volatile period, but markets have begun to stabilise. flow reflects on recent Global ABS and Creditflux discussions and examines Deutsche Bank Research findings to assess the major trends impacting the securitisation markets and the outlook
When two of Bear Stearns’ leveraged credit based hedge funds collapsed in July 20071, the fragility of subprime mortgage-backed securities (MBS) was laid bare. A louder wake-up call followed almost a year later when the housing crisis precipitated the collapse of Lehman Brothers. The former chairman of the U.S. Federal Reserve, Alan Greenspan, put the unfolding drama into perspective, calling it a "once-in-a-century type of financial crisis."2 But even he could not have anticipated that another crisis of similar magnitude would impact the MBS market a mere 12 years later. Thankfully, the circumstances are different in 2020.
While government and central bank support measures to boost liquidity have helped to reduce the systemic impact of Covid-19 volatility, changes to securitisation deal structures since the global financial crisis (GFC) have helped to minimise disruption. These include more sequential pay structures, which provide even greater protection to senior bondholders, and generally less leveraged structures3.
Held in September, the virtual Global ABS conference took stock on how resilient these structures have been overall. In addition to the impact of Covid-19 disruption on securitisation issuances, it provided a pulse check on the residential mortgage backed securities (RMBS), non-performing loans (NPLs) and asset-backed securitisations (ABS) markets. It also assessed the benefits of regulatory change, securitisations’ readiness for an alternative risk free rate (RFR) and how arrangers are incorporating environmental, social, and corporate governance (ESG) performance themes.
Separately, the Creditflux CLO Symposium held a week before Global ABS, assessed the recovery of the CLO market from Covid disruption, the durability of CLO 2.0 and the outlook for the next few years.
In this article, flow reports on the key findings of both events and summarises the latest Deutsche Bank Research reports on the health of the structured finance market.
Covid-19 disrupts new issuances
Generally, the pandemic is having a seriously de-stabilising impact on securitisation issuances. In Europe, S&P expects issuance levels will reach €60 billion to €70 billion by year-end, a sharp drop from the €102 billion issued in 2019.4
Unlike in 2008, Covid-19’s liquidity crunch was briefer owing to the responses of rapid government support and central bank liquidity schemes. Furthermore, the financial market infrastructure underpinning securitisations has withstood the volatility – partly thanks to post-2008 financial crisis regulations. In addition to support measures such as the European ABS Purchase Programme5, central banks have dusted off their tool kits implemented from the GFC and put them to work during the past six months.
An uncertain outlook for RMBS
The 2020 pipeline is quite sparse (see Figure 1), according to the Deutsche Bank Research team's European RMBS monthly report for November6. With November typically the last full month for issuance, and year to date RMBS issuance at €23.2 billion, down 35% versus a similar period last year, the pipeline remains thin as we approach the last six weeks (possibly four) of the 2020’s issuance window, according to Conor O'Toole, Head of European Securitisation Research & Global Head of CLO Research at Deutsche Bank.
Figure 1: Monthly RMBS issuance
Source: Deutsche Bank, Informa, Bloomberg Finance LP
The introduction of extraordinary fiscal measures in the form of furlough schemes and increased unemployment payment schemes has cushioned the immediate impact of the sharp falls in household income observed during this crisis, notes the research. Many of these schemes however will be wound down over the next year and if unemployment rates remain elevated, the impact of income decline will then be felt or could decline further, acting to reduce housing demand, and consequently prices.
Looking ahead, with renewed lockdowns in place, expectations are for underlying credit to turn south again across European RMBS. In the UK, the Financial Conduct Authority’s mortgage payment holiday extension (six months available with the proposal suggesting a last application date of 31 January 2021) allows for pushing back delinquency recording into Q1 2021, aiding households. The regulator allowed for applicants who were not in payment holidays to apply for six months, while existing borrowers in payment holidays would also be able to extend this by a further six months if they have not already done so.
Covid payment holiday impact review
Payment holiday data in October confirmed a continued decline in payment holidays in the UK across non-conforming/prime and buy-to-let as well as Irish prime RMBS, with stabilisation elsewhere, notes Deutsche Bank Research. The payment holiday median for UK prime RMBS is low at about 4%, following spike of 19% in April /May (see Figure 3). "What we'd expect to see is that the schemes get renewed as lockdown is renewed, and the number will likely go back up again as credit concerns remain," says O'Toole.
Figure 2: Covid % range across sectors since April
Source: Deutsche Bank, Intex, Includes all placed and retained deals, as of end October
Central Bank policies impact ABS recovery
Although the extraordinary central bank measures have helped reduce the number of defaults, the availability of cheap financing is suppressing the need for bank-originated securitisations. The Bank of England’s (BOE) Term Funding Scheme for SMEs (TFSME) was set up in the first weeks of Covid-19 to provide additional sources of cheap funding (interest rates are set near to or at the BOE’s current rate of 0.1%) to SMEs whose businesses are currently struggling. During the previous Term Funding Scheme – launched in 2016 – issuers scaled back on their ABS activity in favour of the low-cost financing available through TFS. Speaking at the virtual Global ABS Conference, a number of industry experts said that in addition to existing TFS users refinancing debt through the TFSME programme, ABS issuers will leverage the scheme moving forward. In addition, borrowers with TFS maturities arising from 2009 may choose to refinance under the new TFSME scheme due to the low-cost funding source available. “From past experiences, the mere presence of the BoE scheme means we don’t really see primary RMBS issuance as the types of sponsors that are issuing RMBS are predominantly non-bank lenders which focus away from high street primer borrowers,” says O’Toole. Volumes are down as a result, versus those forecasted (see Figure 3).
Figure 3: RMBS issuance versus forecast
Source: Informa, Bloomberg Finance LP, Deutsche Bank
Making securitisations safe, transparent and standardised through regulation
Introduced in 2018, the Securitisation Regulation (SR) is part of the wider Capital Markets Union package, aimed at bringing about more harmonisation in the EU’s securitisation market.
The rules aim to help invigorate European securitisation activity, which had already been waning before Covid-19 hit. It will do this by providing preferential risk weighted capital treatment on securitisations which meet the STS (safe, transparent, standardised) eligibility criteria. Regulators are also imposing new tough risk retention measures on lenders, originators and sponsors by requiring them to hold a 5% stake in their securitisation transactions. SR also demands investors conduct thorough due diligence to corroborate that lenders, originators and sponsors have this for skin in the game.
In September 2020, the European Securities and Markets Authority (ESMA) published its regulatory technical standards and details on implementing technical standards which originators, sponsors and SSPEs (securitisation special purpose entities) need to provide in their reporting templates. ESMA’s clarity on reporting has been widely accepted by the industry, especially as until September, there was much uncertainty about the disclosure obligations. Panellists at Global ABS were also bullish about the regulation’s impact in the EU, adding there were a growing number of diverse securitisation issuances coming to market with STS accreditation including RMBS, auto-loans, credit cards, non-ABCP (asset backed commercial paper) and ABCP.
However, the new SR reporting regime is not without its challenges. The regulation demands market participants report on any ‘significant event,’ which is defined as ‘an event that would be likely to materially impact the performance of the securitisation as well as have a significant effect on the prices of the tranches/bonds of the securitisation. For instance, if borrowers default on their loan payments owing to Covid-19 disruption, this could impact the securitisation’s income and performance, thus triggering the requirement for a disclosure to be made. This disruption, says Jason Connery, head of Trust and Agency Services, EMEA at Deutsche Bank “is forcing market participants to reassess their portfolio and risk characteristics and consider whether any event or anticipated future events require disclosure as a significant event under SR”.
“Covid-19 disruption is forcing market participants to reassess their portfolio and risk characteristics”
Under Article 77 of the Securitisation Regulation, significant events include: a change in the structural features that can materially impact the performance of the securitisation; a change in the risk characteristics of the securitisation or of the underlying exposures that can materially impact the performance of the securitisation; a material breach of the obligations provided for in the documents, including any remedy, waiver or consent subsequently provided in relation to such a breach; any material amendment to transaction documents (such as switching from quarterly to semiannual interest payments to manage liquidity, as we touch on further in the article).
Switching to RFRs
The transition away from LIBOR – as the interest rate benchmark of choice – in favour of alternate risk free rates (RFRs) – is one of the biggest market changes ever undertaken, according to one regulator, speaking at Global ABS. Securitisations will be affected by this transition, which is due to take place at the end of 2021. Accordingly, new securitisation transactions will now need to start leveraging RFRs if they have not already done so. The transition is likely to be harder for legacy transactions and will require counterparties to develop fallback language. Moreover, consent solicitation from investors might be necessitated to allow for benchmark changes to be made. A panellist at Global ABS concurred that consent solicitations can be cumbersome, adding that Covid-19 had resulted in serious delays to the process.
Incorporating ESG into securitisations
ESG investing is fairly ubiquitous in traditional equity and fixed income markets, but it is now taking hold in the world of securitisations, according to a panellist at Global ABS. Investors are pushing more aggressively on their ESG policies and inserting detailed questions covering sustainability into due diligence questionnaires. The growing enthusiasm for all things ESG does pose its challenges. Firstly, there is a limited supply of green loans, meaning it is not yet commercially viable to invest exclusively in such instruments.8 While a handful of industry bodies – such as the International Capital Markets Authority - and various credit ratings agencies have developed their own bespoke ESG standards, there is still no universal consensus on what constitutes as ESG.9 Regulators are developing an ESG taxonomy and framework in what should bring about greater clarity. Establishing how data will be reported in a consistent manner will be key as strong disclosures will be required by investors.
CLOs: a slow recovery
The collateralised loan obligation (CLO) market was totally disrupted by Covid-19. A slew of nominally healthy and profitable companies suffered unprecedented revenue shocks, leading to more than 300 credit downgrades in Europe alone since mid-March.10 Nonetheless, borrower defaults have been averted following interventionist government policies. Panellists at the Creditflux event also said European CLOs fared better than those in the US, as they typically hold fewer distressed assets, instead favouring companies with solid credit ratings. A number of CLOs (and RMBS) have fared reasonably well during the liquidity shortfall because they were structured in a way that insulated them from adverse market events. O’Toole notes that leverage loan defaults have risen to 4.8% this quarter11, but added that “we still expect the default rate to go up, it will just get pushed out for longer.”
The durability of CLO 2.0s
CLO 2.0s are a by-product of the 2008 crisis; they typically have strengthened credit support while the period in which loan interest and proceeds can be re-invested into additional loans is shortening.12 “The majority of CLO 2.0s are permitted to have a 7.5% bucket of triple C loans and breaching this threshold can lead to reductions in OC (overcollateralisation) ratios and after re-investment periods ends preclude CLO managers from investing further. Since the crisis began, a number of downgrades were instigated by ratings agencies, exerting a huge amount of pressure on managers to ensure that their concentration limits and collateral quality tests were at the appropriate levels,” says Connery.
OC test failures are a result of increased concentration of CCC and defaulted assets in European CLOs since the beginning of the pandemic.13 Thankfully, fewer defaults are occurring since the spikes seen in May and June (see Figure 4) and only a few European CLOs have diverted interest proceeds for reinvestment or notes paydown.
Figure 4: Deals failing OC test (by rating category)
Penta 2 CLO is the latest European CLO to report a coverage test failure in September and to switch its interest payment dates to semiannual (November and May) from quarterly. The frequency switch comes on the back of semiannual paying credits now constituting roughly 32% of the portfolio, up from 17% in January. Switching would allow the manager to not distribute all interest proceeds for semiannual paying loans, to service quarterly distributions on CLOs.
Yet if semiannual paying assets become material as a portion of the portfolio, some managers may find it easier to manage liquidity by switching to semiannual payments on the liabilities. In light of Covid-19 and the pressure on CLOs, it is possible there will be an increase in switching activity over the coming months. This could potentially put pressure on equity investors, who could stop receiving quarterly payments. Moreover, the transaction documents also make it incredibly difficult for managers to revert back to quarterly payments, although it is feasible through refinancing. The decision to switch must be made in full consultation with all impacted parties, although the alternative to not switching is for the transaction to potentially default.
The structured finance industry has remained resilient throughout 2020. This optimism remains tempered by the uncertainty of what lies ahead. In summary:
- Securitisations deal closings are picking up and spreads are now back at pre-crisis levels. Covid-19 is a very different type of crisis to 2008 as regulatory intervention enabled financial infrastructure to withstand the volatility.
- While payment holidays have caused stress in the RMBS market due to the reduction in collections, investors report that the structural features are doing what they are supposed to do (i.e. liquidity facilities are available to cover any coupon payments).
- While these structures have been effective, junior noteholders could be adversely impacted once payment holidays expire. Experts at Global ABS anticipate there could be an increase in principal being paid back as opposed to interest. This is not expected to impact senior noteholders though.
- In order to accelerate deals, originators and issuers will be carefully analysing the underlying structure and performance of the collateral in the asset pools they are originating.
- European CLOs have proven resilient during Covid-19, at least relative to US CLOs, with notably fewer OC test breaches. There appears to be more active CLO debt buyers, a lot of interest of which is derived from Asia. Additionally, demand for new CLOs is strong while supply is low, helping to tighten CLO liabilities further.
- However, Covid-19 uncertainty prevails and as a second wave triggers new lockdowns, the renewal of payment holidays and the extension of furlough schemes could push the credit quality of European RMBS south again. Similarly, while leverage loan defaults on CLOs have decreased this quarter, and the number of CLO downgrades has been lower than anticipated, default rates are expected to increase in 2021.
- The number RMBS impacted by Covid-19 payment holidays will likely increase due to the second wave as credit concerns remain.
1 See https://bit.ly/36U9Vzw at investopedia.com
2 See https://bit.ly/3nEtoLv at rferl.org
3 See https://bit.ly/3fdP26h at spglobal.com
4 S&P Global Ratings (July 21, 2020) Global securitisation 2020 issuance forecast trimmed by a quarter, now at $830bn
5 See https://bit.ly/36OUj0q at ecb.europa.eu
6 See https://bit.ly/36Q2REb at research.db.com
7 See https://bit.ly/3fdPjGl at esma.europa.eu
8 DLA Piper (October 25, 2019) ESG CLOs – a practical solution to cater for a growing demand
9 DLA Piper (October 25, 2019) ESG CLOs – a practical solution to cater for a growing demand
10 White & Case (July 30, 2020) Loan markets show signs of life after COVID-19 shock
11 In loans only, the lagging 12-month default rate based on issuer count in the S&P European Leveraged Loan Index (ELLI) shows a monthly increase to 4.84% at the end of October, from 4.61% in September, and 3.63% in the two months prior to that.
12 Pinebridge (September 19, 2019) Seeing beyond the complexity: an introduction to collateralised loan obligations
13 See https://bit.ly/3pJmNBi at fitchratings.com
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