Last year we wrote about the forthcoming "STS" (Simple, Transparent and Standardised) regulation for securitisation, designed in part to harmonise eligibility and capital charges for ABS across the wider regulatory landscape. Late last month, as part of the 2018 review of the Solvency II regulations, the European Commission launched a consultation proposing revisions to the Solvency II capital charges to incorporate STS.
We have seen some research suggesting these proposals could be game-changing in re-opening the ABS market to insurance investors but while they are certainly a positive step, on closer inspection they are not quite so encouraging.
Regulators unfairly (although perhaps understandably) tarred European ABS with the same brush as their US counterparts in the wake of the financial crisis and imposed punitive capital charges for insurance investors under Solvency II. The 2018 review is a chance to put that right, and to recognise that whilst covered bonds, corporate bonds and securitisations are not the same, their relative merits should be fairly calibrated and reflected in their regulatory treatment, and the timely introduction of the new STS regulations present the perfect opportunity and framework to do just that.
Similar to other asset classes, the new proposed capital charges can be seen as a grid with progressively higher charges for bonds with lower ratings. The good news is, the proposed capital charges for senior STS bonds are now similar to those for covered bonds, though still at a small premium. This probably correctly reflects the greater level of cash flow analysis required for securitisations, but recognises the similar default and liquidity risk. So far, so good.
Solvency II Capital Calibrations
|Credit Rating||AAA||AA||A||BBB||BB||B and Below|
|Proposed STS Senior||1.0%||1.2%||1.6%||2.8%||5.6%||9.4%|
|Proposed Non-Senior STS||2.8%||3.4%||4.6%||7.9%||15.8%||26.7%|
|Senior STS vs Covered Bonds||1.4x||1.3x|
|Non-Senior STS vs Corporates||3.1x||3.1x||3.3x||3.2x||3.5x||3.6x|
|Non-STS vs Corporates||13.9x||12.2x||11.9x||7.9x||18.2x||13.3|
However, insurance companies are not typically significant buyers of senior, mostly AAA rated, securitisations, or indeed of covered bonds. They simply don’t yield enough, and are often too short dated. A representative insurance company’s credit fixed income portfolio will be concentrated towards the mid-to-lower end of the investment grade spectrum, which covers most of the corporate bond market, and perhaps with a bias to longer maturities, where the yields and duration match their risk/return and the asset/liability matching investment needs.
Unfortunately, the authorities have seen fit to add an extra row in the grid for the non-senior parts of STS securitisations, despite the fact that the lower credit ratings of non-senior bonds already naturally lead to a higher capital charge. Whilst the new proposals are much lower than those currently in place, they are still between three and four times the equivalent charges for corporate bonds! This effective ‘double-counting’ creates a large cliff effect between senior and non-senior bonds, which is likely to be very off-putting for potential investors as it directly affects the effective ‘sweet spot’ for insurance buyers.
Practically speaking, yields in ABS are nothing like three or four times those in corporate bonds. The current Euro BBB corporate bond index (Barclays Euro BBB Corporate Bond Index ) has a yield of around 1%. Over the last two years, average BBB securitisation yields have been around 0.5% to 0.75% higher than corporates - nowhere near enough of a pick-up to attract investors who will suffer a three to four times higher capital charge.Non-STS securitisations (such as CLOs and CMBS) are even more harshly treated – in fact, they have basically have been ignored as their capital charges will remain unchanged. Possibly the most baffling part of the proposals is the treatment of the AAA senior part of a CLO, where something like 35%-40% of the loans in a transaction could default with 100% write-off before AAA noteholders might lose any money. These notes will incur a capital charge almost three times higher than a typical BB-rated constituent loan, and of course yield far less, so insurers have zero incentive to buy them. This forces them into other investments, such as whole pools of mortgages, which are completely illiquid and where they will take the first and every subsequent loss on each and every loan in the pool that defaults. In fact, this is exactly what insurers are currently buying, because they carry a lower capital charge! Utterly bizarre.
If insurers are to invest significantly in securitisations again, revisions to their capital treatment need to be ambitious and realistic, reflecting the real risk and return; not just for senior STS, but for non-senior and ultimately for non-STS securitisations as well – where we would expect insurers to concentrate their investments. The huge cliff effects of the current proposals mean insurance investors are unlikely to embrace the new STS framework, meaning there is unlikely to be any significant effect on participation and therefore pricing.