Edward Panek, Head of ABS Investment London, shares his thoughts on the recent European Commission amendment to its asset-backed securities regulations in Europe.
Back in May 2018, we published a note on new regulations impacting the European asset-backed securities (ABS) market and what was thought could become a regulatory reprieve for European ABS investors (A view from the ABS desk — regulatory reprieve for European ABS investors).
In July, the European Commission released its amended requirements for ABS to be used by banks as part of their holdings in liquid assets, which are required by regulators to ensure that they can cope with periods of stress.
A brief background
The amount of liquid assets that banks are required to hold is determined by the liquidity coverage ratio (LCR) and represents the amount of highly liquid assets needed to meet each bank’s short-term obligations. Currently, certain higher quality ABS (generally senior, prime AAA rated ABS and RMBS) qualify as ‘Level 2B’ LCR assets, the lowest of the three LCR levels. Other Level 2B assets include publicly traded common stocks and non-financial A+ to BBB- rated corporate bonds. For comparison, covered bonds, which are structured similarly to, and exhibit many of the same risk characteristics as ABS, are generally classified as either Level 1 or 2A LCR assets.
Following the publication of the requirements for ‘standard, transparent and simple (STS)’ securitisation transactions in December last year, market participants expected STS ABS would see a status upgrade in the LCR regime, in line with the more favourable capital treatment put forward under the amended Solvency II (for insurance companies) and CRR (for banks) regulations.
The latest development
In the event, the standards for ABS were actually tightened, with only senior tranches of STS-registered ABS qualifying. As a result, fewer AAA rated ABS transactions will be eligible. While it is not overly surprising that the focus was on STS ABS, it was hoped that non-senior STS ABS would also be eligible. Further, LCR eligible ABS will remain as Level 2B assets, subject to a 25-35% haircut while it was hoped that senior STS ABS would be upgraded to Level 2A, which feature 15% haircuts. For comparison, Level 1 covered bonds have a 7% haircut.
Additionally, there are no grandfathering provisions that would allow ABS currently in compliance with the rules to continue to be held as LCR assets following the implementation of the new directive. As these transactions were structured prior to the STS regulations becoming known, this may lead to banks suspending purchasing ABS or even looking to liquidate current holdings which may not comply once the regulations change.
We believe this is a setback for the ABS market. It makes ABS significantly less attractive to bank treasury investors (a significant portion of the market). It will lead to greater bifurcation of the market between senior STS eligible ABS, non-senior STS and non-STS, resulting in substantial differences in spreads and liquidity for what may otherwise be very similar securities.
Looking ahead, we expect the greater demand for senior STS may change issuance patterns as issuers that are able to fulfil STS qualification will skew issuance in that direction. However, we also expect that issuance from institutions without the resources to offer STS securitisation may fall off as they might be incentivised to access alternative forms of funding, such as issuing covered bonds.
For Janus Henderson as a non-regulated entity (neither a bank nor an insurance company), we believe it will create new opportunities (and for any of our clients not impacted by the regulations) to improve returns by investing in relatively cheaper non-LCR or STS eligible transactions.
Asset-backed securities (ABS) are securities collateralised by a pool of assets such as loans, leases, credit card debt, royalties or receivables.
Residential mortgage-backed securities (RMBS) are a type of ABS created from residential debt, such as mortgages, home equity loans and subprime mortgages.
Senior, prime AAA rated ABS refers to the highest quality tranche of an ABS.
Liquidity coverage ratio (LCR) refers to highly liquid assets held by financial institutions to meet short-term obligations. The ratio is a generic stress test that aims to anticipate market wide shocks.
STS refers to simple, transparent and standardised securitisation transactions under EU regulations.
Capital Requirements Regulation (CRR) aims to decrease the likelihood that banks go insolvent and reflects Basel III rules on capital measurement and capital standards.