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Industry Voices

Commentary: Regulatory reprieve for European ABS investors

We have long held the view that since the global financial crisis, the regulatory environment in Europe has been overly penal to asset-backed securities 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 this asymmetric regulatory treatment of ABS was announced April 17, 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 securitization regulations approved last autumn and effective Jan. 1, 2019, detailing the requirements for compliance with the "simple, transparent, and standardized" securitizations, will make European secularizations more attractive to European insurance company investors.

A few more details

The Solvency II regulations now 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 securitized exposures and capital requirements for bank investors.

For example, under current Solvency II regulations, the capital charge on a five-year weighted average life AAA-rated, U.K. prime residential mortgage?backed security with 10% to 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 collateralized loan obligation with 40% credit enhancement or a AAA-rated U.K. non-conforming RMBS with 18% to 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 simple, transparent, and standardized securitizations, 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 Figure 1.

By incorporating certain Solvency II requirements related to the structure and quality of ABS into the new 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 assure 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 securitization regulations, rather than just insurance companies.

Hoping for more

The new proposed Solvency II regulations, along with the securitization regulations and a related update on bank capital charges are important steps in the post-crisis redevelopment of the European securitization market. However, it does not go as far as, perhaps unrealistically, some market participants had hoped.

While the new capital regulations certainly make STS securitizations 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.

For example, when applying the new proposed capital charges, the U.K. RMBS would attract a capital charge of 5% 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.

Capital charges for non-STS transactions, under the proposed regulations, 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 U.K. non-conforming RMBS, which will be classified as a non?STS ABS going forward, will remain at 62.5%.

Although, ABS investment now appears relatively more attractive to insurance companies, the absolute return on capital remains in the low- to mid-single digits for insurance companies using the Standard Formula, which calculates capital charges based primarily on the rating, duration, perceived liquidity and seniority in the capital structure of an investment, and is substantially lower than the return on capital banks can earn from ABS investment (see Figure 2).

Figure 2 Absolute returns on capital still fairly low for insurance companies
Insurance company investors
PROPOSED SIICURRENT SII
RatingWAL (years)Spread (bp)STSSII TypeCapitalReturn
on
capital
CapitalReturn on capital
UK Prime ABSAAA541Y15%8%11%4%
BBB5153Y240%4%99%2%
CLOAAA777N288%1%88%1%
BBB10250N2100%3%100%3%
Source: JP Morgan, EC, Janus Henderson Investors, as at April 2018.
Note: STS compliance and Solvency II Type are assumed.   

Summary

Although a step in the right direction to the full normalization 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 securitizations more attractive to insurance company investors, particularly for non-senior STS tranches (now classified as Type 2), but non-STS transactions will continue to attract significantly penal capital charges. This will contribute to liquidity and pricing differentials between STS and non-STS deals once the new regulations go into effect in January 2019, and is an area of the market we will be watching closely in the coming months and years.

Edward Panek is head of asset-backed securities investment at Janus Henderson Investors in London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.