In a financial system dominated by banks, securitization has helped unlock significant amounts of capital and improved lending conditions for consumers and small businesses. In 2015, the European Commission estimated these amounts between EUR 100 and 150 billion if bond issuance in EU securitization could return to pre-crisis levels[1]. Mindful of the excesses of the last financial crisis, however, there have been significant efforts to ensure that the growth of lending is responsible and sustainable.

While the use of opaque ABS structures has already retreated, the European Commission is giving securitization a fresh push through the new comprehensive Securitization Regulation (“SR”), effective per 1 January 2019. This set includes the Simple, Transparent and Standardized (“STS”) securitization framework. It clarifies due diligence obligations between ABS originators, underwriters, and investors and brings existing rules on EU securitizations (for example in Solvency II, AIFMD and CRR) under a common roof. While compliance with STS framework is not compulsory, both issuers and investors clearly have an incentive to structure and invest in STS-compliant securitizations, as we will describe later.

The European Commission is giving securitization a fresh push through the new comprehensive Securitization Regulation (“SR”), effective per 1 January 2019

Securitization will become more transparent

The STS framework can be divided into three parts. Below the most important criteria of each part:

• Simple: The collateral must be a homogenous pool of loans, with residential mortgage loans fully verified and no other securitizations included in the asset pool. The debtors must have made at least one payment.
• Transparent: Investors must have access to at least five years of historical data on defaults, losses, and delinquencies from comparable loans. Issuer is to notify to European Securities Markets Authority (ESMA) about STS-compliance and ESMA shall publish STS notification on its website.
• Standard: Risk retention requirements must be fulfilled, interest and currency exposure must be hedged, and only experienced service providers must perform key functions.

The compliance with the STS requirements must be verified by an independent Third Party Verification Agent, authorized by the local financial authorities. That agent must ensure that issuers treat investors fairly and ensure that loans are placed into securitizations are of the same quality as those held on their own balance sheet (i.e. no adverse selection[2]). These requirements will likely increase both collateral quality and loan data quality for ABS investors, which will reduce credit risk and increase quality of investor analysis. While STS will also result in higher costs for issuers and not all ABS that our Fund invests in (such as CLOs and CMBS) will yet qualify for STS treatment, we are hopeful that this is the first step to more sustainable and responsible growth of the ABS market.

Reduced capital charges increase the attractiveness of the asset class

When the Solvency II Directive came into effect, capital requirements against investments in ABS soared, especially compared to other fixed-income asset classes and whole loan exposures. This resulted in the virtually complete retreat of the European insurers from the European securitization market[3]. As a result, banks and asset managers currently constitute a clear majority of investors in European ABS.

Under the new STS regime, the Solvency II capital requirement across the rating spectrum is lowered for STS compliant deals which will make investing in ABS more attractive and bring the treatment of securitizations more in line with other risk assets, such as covered bonds. This will strongly incentivize STS-compliant issuance, which will require insurance investors to hold significantly less capital coverage compared to non-STS compliant deals. The less capital the insurance companies need to hold for an investment, the higher the return on capital. In the table below, we display the improvement for two different types of securitizations. By bringing back a large portion of the pre-crisis ABS buyer base, this is a significant step towards attracting more originators and the issuance of more diverse types of ABS, but more importantly, it enables more funding for consumers and SMEs which drive the real economy.

Table 1: RoC effect under Solvency II

Source: JPM Research (2019), European Commission (2018)

A new morning for institutional investors

The introduction of the STS label by the European Commission, and improved capital treatment for banks and insurance companies should lead to a healthier, more efficient, and bigger securitization market and more investment in attractive alternative investments which fund the real economy. We enthusiastically endorse any developments that support our mission to better match savings and credit for a more prosperous society.

Sources

[1] http://europa.eu/rapid/press-release_MEMO-15-5733_en.htm?locale=en

[2] Guidelines on the STS criteria for non-ABCP securitization, EBA, 12 December 2018

[3] Opinion of the European Central Bank from 11 March 2016, ECB

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