Regulation blocks allocators from useful ABS market

Europe’s asset-backed securities (ABS) market suffered significant damage to its reputation by being linked to the US sub-prime crisis in 2007. Three years on, practitioners are warning of more damage at the hands of European regulation.

The industry has improved itself, they say, partly in the standardisation and transparency of securities.

Despite much bad press around the asset class, as many instruments imploded in 2007-08, alternatives long/short investors in ABS have fared remarkably well. Hedge Fund Research data shows ABS is this year’s best hedge strategy to August, up 10.5% after 6% gains last year; 13% in 2010; and 24% in 2009. It fell just 3.4% in 2008, and made 1.1% in 2007.

Credit quality curve

But regulated investors such as insurers could be scared off by capital reserving rules, under Solvency II. These are ten times harsher for holding top-grade ABS than for equivalent covered bonds, and over eight times harsher than some AAA credit (see table).

Specialist credit investor ECM argues this is unjustified: “Returns on ‘high-grade core vanilla’, such as UK or Dutch prime, or autos and credit cards, offer Libor plus 50bps-150bps, so almost a cash-replacement product,” says Andrew Lennox, ECM’s lead portfolio manager for ABS.

Lennox acknowledges Europe is “tarred by the US non-agency mortgage problems. Ratings agencies and regulators use what happened in US sub-prime to inform their model on how much capital is required, and to ensure insurance companies and banks are not squeezed or have inadequate capital bases. I believe that makes no sense when the bank is holding UK or Dutch prime.”

The EMEA structured finance market had actual and expected default rates of just 2.6% in four years to July 2011, and just 0.8% for AAA securities. Comparables for US markets were 10.6% and 6%, says Fitch. From mid-2007 to March 2012, European default rates were 1%, but 13.1% in the US.

Even with these differences, the market in Europe has changed markedly since the crisis. This year, Prime Collateralised Securities (PCS), an industry-monitored ‘stamp’ for instruments meeting pre-defined standards of simplicity, transparency and standardisation, will be introduced. This could reduce investors’ reliance on ratings agencies, attract more investors, and possibly encourage better treatment from regulators, Lennox says.

Prime assets attract healthy bids. Recent UK prime deals attracted more than 80 investors, including Americans and Japanese. Lennox thinks the market can absorb a bank holder making a multi-billion dollar sale, without discernible price impact.

Prime issuance and outstanding volumes of investable bonds have lowered. Banks conducted tender offers, and central banks effectively offered themselves as alternative mortgage financing sources for banks.

The market is also moving to more transparent, ‘loan-by-loan reporting’, Lennox adds. “People could pull apart the data and performance, and the market has started to require this more and more. It is starting to become a more standardised market. We want as much granularity as possible, in a standard format.”

Central banks are supportive of extra transparency and standardisation. Lennox says a more consultative approach now exists between ABS issuers and investors. Banks may come to ECM to discuss what terms and attributes it requires on securities, for example.

In addition, a European data warehouse is opening this year for the market, driven by the ECB.

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