Green Shoots of Recovery in the Securitisation Markets?

Across Europe and a number of other regions bank recapitalisation pressures have led to a reduction in business and project lending - and thus reduced renewable energy lending.

This is a problem because the bulk of project finance (95% globally) comes from bank lending.

The development of a market for securitized renewable energy and energy efficiency assets and loans, allowing banks to quickly recycle limited loan capital, is going to be vital to ensuring banks deliver the project finance needed as we “green” energy systems.

This guest report by guest contributor Tadhg Molony explores the current state of the securitization market and its prospects going forward.

Introduction

Securitisation markets remain stubbornly subdued since the 2008 Lehman Brothers collapse, however speckled signs of recovery can be observed, for example increased residential mortgage backed securities (RMBS) are being issued in the UK.  This report reviews significant recent activity in the securitisation markets, identifies possible signs of recovery and potential implications for the clean energy sector and climate finance.  The analysis focuses on Europe and America - the two largest securitisation markets – which have been hit the most by the financial crisis and as a result, have seen significant changes to their structured finance market dynamics. Regulatory changes, which will generally place further restrictions on supply, are also examined.

New securitisations such as UK RMBS are being increasingly issued despite government led market intervention and it is speculated that these issues signal a thaw in the securitisation market or ‘green shoots of recovery’. Recovery at the established investment grade end of the market pre-empts an eventual recovery in the market dynamic of all asset classes, which would include climate finance /renewable energy assets.  Already recently issued Climate Bonds by public sector institutions, such as $500M by the IFC and $148M by the EIB (both in April 2012), have been snapped up by investors.

The Climate Bonds Initiative aims to further increase confidence in climate finance among both investors and originators through establishing a widely recognisable and reliable standard for clean energy assets, which investors are generally less familiar with.  The Climate Bond Standard identifies quality and environmentally sound investments, which can be used as part of an organisation’s Corporate Social Responsibility targets.  The Prime Collateralised Securities Initiative (PCSI), a similar standard for established investment grade assets, also hopes to benefit from introducing a recognisable standard and is campaigning to gain regulatory concessions such as a reduction in the ECB Repo haircut, concessions which possibly could also be claimed by the Climate Bond Standard.  However both supply and demand in the securitisation markets must continue to grow before the benefits of standardisation can be fully realised.

Market Developments

Europe

Europe did not suffer the same systematic problems of toxic sub-prime mortgage securitisation, as did the United States; between 2007 and 2010 only 0.95% of structured finance issues defaulted compared with 7.7% of those in the US.  However sovereign debt fears, investor caution surrounding regulatory reform and continuing uncertainty about the risk profile of certain assets led to a contraction in European securitisation markets by 4.3% to €367.2bn in 2011, compared with a peak of €481bn in 2006.

In the Eurozone new issues are being restrained, as highly rated banks access cheaper funding without securitisation and poorly rated banks in Italy, Spain etc. use their loan portfolios as collateral to access cheap ECB funding.  Figure 1 shows that 77% of 2010 overall European securitisation issuance was ‘retained’ by the banks i.e. held as ECB collateral and this only decreased to 76% in 2011.  Market analysts are cautious about the growth of private issue Eurozone securitisation in 2012 whilst ECB intervention continues.

Figure 1 European Securitisation Issuance 2002 – 2010 € bn (Source: AFME)

There are more recent positive signs of recovery and investment is returning to the secondary markets from the USA and Asia, as investors see that RMBS are outperforming other asset classes, whilst generating good yield, see Figure 2 below.  UK and Dutch markets are the most active and there is actually a shortage of new investment products.  In response, UK lenders such as Santander and more recently building societies such as Skipton, have announced additional RMBS issuances in the past three months, see Table 1 overleaf.  Additionally whole business securitisation (WBS) has picked up in the UK since 2010; Centre Parks’ recent holiday parks WBS was more than 2X oversubscribed.

Figure 2 Credit Spreads volatility by asset class, Jan – Oct 2011 (Source: AFME)

 

Bank Amount Date Announced
Santander  

$1,254M

 

May 2012

Skipton Building Society  

£550M

 

May 2012

Coventry Building Society  

£1,100M

 

April 2012

West Bromwich Building Society  

£410M

 

April 2012

Nationwide Building Society  

£1,500M

 

March 2012

Table 1 Selected UK RMBS deals announced over the past three months

 

Another interesting development in Europe is the Prime Collateralised Securities Initiative (PCS), led by the Association for Financial Markets in Europe (afme) and the European Securitisation Forum, which is going to be launched later this year.  The PCS is not unlike the Climate Bonds Initiative, and it has been designed to boost investor confidence and market liquidity, through labelling high quality assets and therefore reducing adverse selection risks.

Rediscovered  investor's appetite for securitised products at investment grade in Europe is a sign of recovery and increased normalisation in the market will eventually benefit all asset classes, including those climate finance related assets such as renewable energy.

United States

The American securitisation market continues to shrink and 2011’s $1,784.9bn issuance represented a contraction of 14.3% on 2010.  As Figure 3 shows the American market is heavily dependent on the federal mortgage agencies; 92% of US issuance originates from Fannie Mae, Freddie Mac etc.  Government backed agency intervention is crowding out private sector activity and there has only been one private issuer of RMBS in the past three years, California based ‘Redwood Trust’, which has made four issuances; most other non-agency loans have been confined to auto and student loans.

Activity in Q1 2012 has been more positive with RMBS deals attracting plenty of demand from investors and Q1 2012 issuance growing 4.4% on Q1 2011. The announcement made by the giant insurance AIG about being interested in returning to the MBS market later this year can be interpreted as another sign of a return of confidence. It is widely recognised that intervention by the federal agencies will have to be reduced before the US markets recover.  Only after private sector investment for investment grade asset classes occurs, will investment return for new asset classes, such as those related to climate finance.

 Figure 3 American Securitisation Issuance 2002 – 2010 US$ bn (Source; AFME)

Trade Finance

Recent dollar liquidity shortages, combined with Basel III changes related to the reclassification of short term loans as one year liabilities[1] , have made commodity / trade finance less attractive for banks.  French banks and other leading trade finance institutions are now seeking to reduce their trade finance exposure and asset securitisation is seen as a solution to maintain liquidity in the market.

Banks are already using securitisation to offload trade finance balance sheet liabilities.  Four out of five of Standard Chartered’s recently disclosed securitisations in Q2 2011 were trade finance related, see Table 2, and JP Morgan is exploring using more complex securitised products such as CDOs.  The success of trade finance securitisation shows that securitisation remains an option for banks to offload their balance sheets and also that there exists investor appetite for new asset classes.

Table 2 Standard Chartered Q2 2011 Securitisations

As it has been shown in the case of RMBS and trade finance, there is evidence of increased investor demand for securitised products and an appetite by Banks to issue newer asset classes. These are positive signs of recovery in the securitisation markets; a recovery in which Climate Finance could be expected to emerge as a mainstream asset class in the capital market.

Regulatory Developments

An overview of current and forthcoming regulatory changes is detailed in this section; these regulations impact most asset classes and not just those related to climate finance.

Banking Sector Capital Requirements - Basel & FAS160

Basel II amended the treatment of securitised investments in the calculation of bank’s regulatory reserve capital requirements: capital requirements on secured investment-grade transactions were reduced, but requirements for non-investment grade ones, which would include the cleantech / renewable energy sector, were increased.  The impact of increased capital requirements will be greater felt in Europe than in the US, as European banks generally hold more ABS on their books than US ones.

Basel III regulations, which are to be implemented from 2013 to 2019, will also serve to discourage banks from originating loans, as the calculation of a Bank’s Tier 1 capital will limit the inclusion of Mortgage Servicing Rights, and other specified indirect balance sheet assets to 10% of a bank’s common equity component.  When these defined assets combined exceed 15% of a bank’s common equity, the asset will be deducted from common equity Tier 1 capital.  This change will make issuing new securitisations less attractive for banks, which currently dominate securitisation markets, and will make it more attractive for other capital markets institutions to originate securitisations.

Additionally the US based Financial Accounting Standards Board has changed its rules related to off-balance sheet financing structures.  FAS160 requires many securitised structures; previously accounted for as sales, to be accounted for as secured financings.  This change makes securitisations less attractive for US banks, as impacted issuances will be subject to regulatory capital allocation.

Insurance Sector Capital Requirements - Solvency II

Under Solvency II the EU is currently revising insurance industry regulations to include minimum regulatory capital requirements.  The proposed regulations, published in February, would create a 7% capital requirement for securitisations, compared with 0.9% for corporate and 0.7% for covered bonds (discussed in next section).  These charges have been deemed excessive by the insurance industry, which claims the EU is using a flawed methodology as it currently takes into account US sub-prime RMBS and Europe did not have the same problem of RMBS defaults.

A recent ASME survey found that there would be a major withdrawal by insurance investors if Solvency II regulations were passed under their current form.  All asset sectors, including those related to climate finance, would suffer from any reduction in investment by the insurance sector; the insurance sector will also become more important for future market liquidity due to the other Basel III changes in the treatment of originators holdingMortgage Servicing Rights.  Due to the increased importance of the insurance industry to financing the future green economy, the EU has recently signalled it might not subject climate finance investments to Solvency II regulatory capital requirements.

Liquidity Requirements – Basel III, Covered Bonds

Under Basel III liquidity requirements, banks are required to hold enough liquid assets to meet cash flow needs for up to 30 days but securitised products have not been specifically designated as liquid assets.  Asset eligibility is subject to regional interpretation and the European Banking Authority has been tasked with reporting to the European Commission by mid-2013 to define liquid assets.  Banks are lobbying for the classification of these assets as liquid and if successful European banks could be expected to return as major RMBS buyers, but presently they remain cautious about holding these assets due to ongoing uncertainty about classification.

The extent to which demand is restrained due to this can be seen from the rush to issue ‘covered bonds’, which can be included in liquidity buffers.  In response to investor demand, a record £11bn worth of covered bonds was issued in Q1 2011, compared with £3bn the previous year.  Insurance companies are also attracted to covered bonds, as they will be treated more favourably under Solvency II.

Rating Agencies and Reporting Requirements

The role of rating agencies in assessing securitisations has been amended by recent Basel regulations and the 2010 US Dodd-Frank Act.  Under Dodd-Frank, US banks now rely solely on more complicated internal ratings which increase issuance costs for capital requirement calculations, while under Basel III the function of external rating agencies is retained, albeit reduced.

To avoid forthcoming increased capital requirements and as a cheaper alternative to capital raising, banks in some European countries, such as Spain which relies on internal ratings, have been exploring issuing securitisations using ‘optimistic’ internal ratings of structured products, whilst selling riskier chunks to outside investors. Regulators are scrutinising such deals closely and in the UK the FSA has introduced standardised models and retained the use of external regulators.

Increased reporting requirements have been adopted globally but are more demanding in the US, which has already adopted a more onerous supervisory formula approach. Further reporting requirements could be required in the US under an amended regulation AB, which would require greater securitisation disclosures such as:

  • Disclosure of data points about the loan such as the security property, the loan underwriting standards and the performance of other loans from the same originator
  • Computer based model of the securities cash flows
  • Monthly loan-level performance data reports

Regardless of whether external or internal ratings are used, increased reporting requirements will not improve the attractiveness for originators of issuing securitisation in any asset class.

 

Originator Risk Retention

European and US issuers are being forced to retain capital of at least 5% of the assets they sell as securities to ensure quality investments are sold.  In Europe risk retention requirements are being set by the Capital Requirements Directive and in the US as part of the 2010 Dodd-Frank Framework.  As risk retention serves to mitigate against moral hazard, it is widely considered a good thing and should help encourage a return of investor confidence.

Repos

The European Central Bank (ECB) and the Bank of England have become stricter on the securitized products they accept as collateral for their repo operations and in recent years have increased both reporting requirements and the haircut applied.  However the ECB has been supportive of the Prime Collateral Securities Initiative (PCSI) and it is speculated that they could reward PCSI labelled assets with a less restrictive repo haircut (which currently stands at 16%).

Conclusion

Increased rates of activity during Q1 2012 have seen encouraging signs of recovery in securitisation markets.  However growing demand for securities is countered by reduced supply; increased regulation and the prospect of further increases, combined with government agency intervention such as those of the ECB (purchasing 76% of 2011 Eurozone issues), Freddie Mac etc. (purchasing 92% of 2011 US issues), is reducing banks willingness to issue new securitisations and should not be expected to continue as economic recovery gathers pace.

Whilst much regulation has been necessary to correct the mistakes of the past, care must be taken not to limit future prospects for returning to sustainable economic growth, to which securitisation can contribute.  Amendments to proposed regulations such as the classification of structured financings as liquid instruments for Basel III liquidity requirements and a reduction in the reserve capital requirements to be held for securitisations under Solvency II and Basel III will help reduce uncertainty in the market and will hasten the return of investors, as evidenced by the recent surge in demand for covered bonds.  The special treatment of climate finance assets held under Solvency II could be expected to similarly attract increased investment in emissions reductions.

The recent increase in UK RMBS securitisations and global Trade Finance issues shows not only that investor demand for securitisations remains, but also that banks retain an appetite to continue issuing new and old asset classes despite new reporting requirements etc. This momentum can be maintained as global economic recovery inevitably returns, if balanced decisions by regulators are made and if government sponsored banking sector stimulus is appropriately withdrawn. Increased privately led climate finance issuances and investments can be expected to follow market normalisation.

The rollout of the PCSI should be closely monitored, as investor responses, as well as regulatory allowances made for PCSI issued securities could serve as a model for Climate Bonds Standard securitisations and any successes could be replicated.  In the face of reduced attractiveness for banks of issuing securitisations and continuing uncertainty of the potential for overall market growth, issuers and investors must be convinced of the greater attraction of environmentally related investments, which are untainted by the financial crisis and offer greater returns, CSR credentials, as well as the security assurances for those that will be covered by the Climate Bonds Standard.


[1] Basel III liquidity requirements are discussed further in the next section.