19.12.2019

Over the past years, public issuance has indeed been hindered by regulatory uncertainties (potential introduction of regulations that make transactions less attractive for originators), by the availability of cheap funding for banks driven by the ultra-loose monetary policy, as well as by the European Central Bank’s (ECB) eligibility rules under the repo-collateral framework that favour alternative instruments, such as sovereign bonds or secured or unsecured bank debt.

The first quarter of 2019 saw a drop in asset-backed security (ABS) issuance, predominantly due to the EU Securitisation Regulation, LIBOR/SONIA (London Interbank Offered Rate/Sterling Overnight Index Average) changes and Brexit uncertainty. However, we saw the primary market pick up in the last few weeks of the second quarter - particularly in the UK and the Netherlands.

The size of the overall European ABS market (including SME securitisation) was approximately EUR 34 billion in Q1 2019. The EU’s 2018 issuance of EUR 269 billion was significantly below its peak issuance of EUR 819 billion in 2008.

NEW FRAMEWORK FOR SECURITISATION

In 2015, the European Commission (EC) announced that it wanted to remove the "stigma" attached to securitisation and to revive the EU’s securitisation market by creating a framework for trusted securitisation. This resulted in legislation that laid down the framework for "simple, transparent and standardised" (STS) securitisation.

The EC thinks that if there was an increase in repackaging contractual loans and selling off the risk in a certified manner it would free up balance sheets, and the EC estimated that between EUR 100bn and EUR 150bn of additional credit would become available to the private sector - and that particularly SMEs would benefit.

The EC thinks that if there was an increase

The STS regulation has applied since 1 January 2019, but it was not until March that the European Securities and Markets Authority (ESMA) received its first notification of a securitisation product meeting the STS criteria. This is due to the fact that the market is waiting for some key implementing rules to be adopted by the EC.

Most people agree that the STS will become the standard in ABSs, and that the market will continue to grow steadily. We have started to see an upswing in deals issued as STS compliant, especially since some asset classes, such as residential mortgage-backed security (RMBS) and auto loans, were already familiar with the ECB purchase programme's stringent requirements, so the impact has not been too much of a shock. However, there are other asset classes that will not be considered as STS, but will still have to meet more stringent reporting requirements under the new framework.

THE DIRECTION OF THE SECURITISATION MARKET

It is important to note that European ABSs offer a higher risk-adjusted yield than most other fixed income asset classes. As an example, a high investment grade rated ABS strategy currently yields 130 basis points above the Euribor (the Euro Interbank Offered Rate). ABSs offer exposure to direct consumer risk, which is complementary to sovereign and corporate exposure, both of which tend to be well-represented in most investors' portfolios already. ABSs have a low, or even negative, correlation with traditional asset classes, and European Collateralised Loan Obligations (CLOs) have a very low default rate. All of the above qualities should make securitisation a more widely spread asset class among investors, unfortunately, this is not yet the case.

Whether STS securitisation will improve the market conditions remains to be seen, however, hope for European securitisation especially for SME financing could lie in the private debt market.

GROWTH IN THE PRIVATE MARKET

In recent years, we have seen substantial growth in the private debt market, which comes in many forms, but most commonly involves non-bank institutions making loans to private companies or buying those loans on the secondary market. A variety of investors, or private debt funds, are involved in the space. These include direct lending, distressed debt, mezzanine, real estate, infrastructure and special situations funds, among others.

The private debt market accounts for a substantial piece of the private markets; 10-15% of total assets under management with most private middle market companies having at least some debt.

Investor demand for debt funds is on the rise. Depending on factors like interest rates, regulations and business cycle, investors view private debt as a less risky way to dive into the market or diversify their assets. Because private debt investments are growing so rapidly, competition in the space is increasing, and therefore, these funds are facing overcrowding just like other asset classes.

THE IMPORTANCE OF INFORMATION ASYMMETRY

Another factor to note is called information asymmetry. This idea was formally introduced to economics by Nobel Prize winning research on the market for used cars. It was demonstrated how the existence of "lemons", or bad cars, in a population of otherwise good cars could create the conditions under which no one is willing to pay a good used-car price, even for a used car in good condition. That is because it is costly for sellers of good cars to credibly communicate their private information - that their car is in good condition - because buyers know that the sellers of bad cars have an incentive to represent their cars as "good", and because it is difficult for buyers to tell the difference.

Private debt funds invest considerable resources in due diligence and monitoring. To do so efficiently, they often focus on companies located nearby. The shorter distance facilitates the flow of both tacit and codified information, in other words, proximity reduces the costs associated with information asymmetry.

Overall, there are three central costs associated with asymmetric information in private debt investing. The first is general awareness of the deal. It is costly to learn about different deals, especially when ventures are prohibited from advertising private placements due to the general solicitation regulations. The second is transaction costs. The overhead associated with small, ad hoc debt transactions increases with added communication and delivery costs. Third, the due diligence necessary to address the information asymmetry problems discussed above requires face-to-face interactions between investors and founders; thus, the cost increases with distance between the investor and the venture.

Same is true in structured finance (capital) markets because private information about the credit quality of loans restricts the scale of securitisation in view of the way information asymmetries adversely impact on the market ability of such loans.

CREATING A STRONG EUROPEAN SECURITISATION MARKET

The key to a robust securitisation market in Europe is therefore reducing costs associated with information asymmetry and opening up the market to a broad base of non-traditional lenders and asset managers. This may be easier said than done, but the STS securitisation framework is a good start even though it may require some additional features to entice a broad base of investors into the market. The solution to his may lay in another trend gathering pace, which is marketplace lenders using securitisation techniques to fund their businesses with investors keen to profit from the lower loan origination at fin-techs.

Both marketplace lenders and crowdfunding platforms use the concept of syndicates to minimise costs associated with asymmetric information. These platforms operate as two-sided markets in which the platforms try to attract both investors and entrepreneurs. In order to succeed, there needs to be enough investors to make it worthwhile for investors. Although the various platforms are similar on some dimensions, they each have some unique market design features aimed at attracting certain types of investors or ventures.

Given the fixed-cost nature of sourcing and monitoring, particularly small and mostly local firms, capital market funding end lending by non-banks (direct or via funds) should have a complementary role alongside traditional bank lending channels.

Vladimir Petropoljac, Head of Structured Finance, OMNIA Global

 



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