European regulators take a step in the right direction in the treatment of securitised credit.
We have long held the view that the post Global Financial Crisis (GFC) regulatory environment in Europe has been overly penal to asset-backed securities (ABS) relative to other fixed income asset classes. This has impeded the re-establishment of the European ABS market, thereby limiting funding to the real economy and reducing investment opportunities for institutional investors.
The latest in a number of steps to address the asymmetric regulatory treatment of ABS was announced on 17 April 2018, with the proposed revision of the capital charge requirements for insurance companies investing in ABS, as set out in the Solvency II regulations. This, coupled with the new Securitisation Regulations approved last autumn, to be effective 1 January 2019, detailing the requirements for compliance with the ‘Simple, Transparent, and Standardised’ securitisations (STS), will make European securitisations more attractive to European insurance company investors.
First, a few more details…
The Solvency II regulations currently in place for European insurers divides the ABS universe into Type 1 (senior most tranches of high quality assets such as prime residential mortgages or auto loans) and Type 2 (everything else). The capital charges related to these two types of ABS range from penal (for Type 1 ABS) to very penal (for Type 2) compared to other fixed income asset classes, the underlying securitised exposures, and capital requirements for bank investors.
Under current regulations, the capital charge on a five-year weighted average life (WAL) AAA-rated, UK prime residential mortgage-backed security (RMBS) with 10-12% of credit enhancement, which classifies as a Type 1 ABS, is 10.5%. This is broadly comparable with a BBB-rated corporate bond or covered bond with the same duration, both of which have a capital charge of 12.5%.
Similarly, a AAA-rated European collateralised loan obligation (CLO) with 40% credit enhancement or a AAA-rated UK non-conforming RMBS with 18-20% credit enhancement, which classify as Type 2 ABS, attract a capital charge of 62.5%, which is greater than either a corporate bond or covered bond rated single B or lower (37.5%).
The new proposed regulations will replace the Type 1 designation with ‘senior STS and non-senior STS’, and the Type 2 designation with ‘non-STS’, as well as significantly reducing capital requirements for senior and non-senior STS, as shown in the chart.
Chart: capital charges on the ABS universe for European insurers
Source: Nomura, Janus Henderson Investors, as at April 2018. Charges are for securities with five years of duration. Capital charges relate to those under the Standard Formula of Solvency II regulations.
By incorporating certain Solvency II requirements related to the structure and quality of ABS into the Securitisation Regulations, the burden of proof for those provisions and compliance with risk retention requirements shifts from investors to issuers (although prudent investors will still want to complete appropriate due diligence to ensure they are comfortable such provisions are being met). We believe this will likely increase the number of issuers meeting all Solvency II requirements as they will now apply to all investors, via the Securitisation Regulations, rather than just insurance companies.… some market participants were hoping for more
The new proposed Solvency II regulations, along with the Securitisation Regulations and a related update on bank capital charges are important steps in the post-crisis redevelopment of the European securitisation market. However, it does not go as far as, perhaps unrealistically, some market participants had hoped.
While the new capital regulations certainly make STS securitisations more attractive to insurance company investors, the breadth of their impact is open to debate. The new capital charges for STS transactions are more in-line with other fixed income instruments, but remain marginally penal and non-STS transactions are still significantly disadvantaged.
To illustrate, when applying the new proposed capital charges, the UK prime RMBS mentioned above would attract a capital charge of 5.0% if it qualifies as an STS transaction. This is less than half of the current capital charge (10.5%) and much closer to AAA-rated corporate bonds or covered bonds at 4.5% and 3.5%, respectively.
Under the proposed regulations, capital charges for non-STS transactions will be calculated in the same way as they currently are under Solvency II. As such, the capital charge for the AAA European CLO and UK non-conforming RMBS, which will be classified as a non-STS ABS going forward, will remain at 62.5%.Absolute returns not high enough
There are two main methods an insurance company can use to calculate the amount of capital they need to set aside against their investments: the Standard Formula and the Internal Model Formula.
The Standard Formula calculates capital charges based primarily on the rating, duration, perceived liquidity and seniority in the capital structure of an investment. The capital charge applied under the Internal Model Formula is based on the results of running an investment through an internally developed model, not surprisingly.
Although ABS investment now appears relatively more attractive to insurance companies, the absolute return on capital remains in the low to mid-single digit area for insurance companies using the Standard Formula and is substantially lower than the return on capital that banks can earn from ABS investment (see table).Table: absolute returns on capital still fairly low for insurance companies
Source: JP Morgan, EC, Janus Henderson Investors, as at April 2018. Note: STS compliance and Solvency II Type are assumed. Summary thoughts
Although a step in the right direction to the full normalisation of the European ABS market post-crisis, the combination of new regulations still leave ABS disadvantaged compared to other asset classes. The new Solvency II regulations will make STS securitisations more attractive to insurance company investors, particularly for non-senior STS tranches (which are currently classified as Type 2), but non-STS transactions will continue to attract significantly penal capital charges. This will contribute to liquidity and pricing differential between STS and non-STS deals once the new regulations go into effect in January 2019, and is an area of the market that we will be watching closely in the coming months and years.These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. The information is based upon our understanding of the current regulations, which may be subject to change. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.