SPOTLIGHT KEY POINTS  The liquidity crisis of summer 2007 reversed the growth trend that the European Spotlight securitisation market had enjoyed from the beginning of the decade.  Why have Asset-Backed Commercial Paper (‘ABCP’) conduits played a key role in the growth of the securitisation market and in its recent crisis?  What market trends for the near future can be advanced based on recent events? Is there a hope for recovery? Author Carlos Echave Securitisation: the end of the beginning

SECURITISATION: FEATURES, This article takes a close look at the European securitisation market before and RATIONALE AND TYPES OF through the liquidity crisis. What is the future of this market in the light of recent TRANSACTIONS events? Although it is very difficult to make predictions, one thing is certain: the The term ‘securitisation’ normally same forces that caused the success of this product in the past will shape its future. refers to a broad array of structured finance transactions with different features, purposes and participants. diversification of portfolio by asset Spain, The Netherlands and Italy, were A paradigm securitisation structure (see class and structure, rather than simply by also significant contributors. In recent figure 1 overleaf) however, normally includes corporate issuer name, and normally higher years, however, an increasing number some basic features such as: (i) a portfolio of spreads as compared to non-ABS securities of countries were beginning to see some illiquid assets/debts transferred via true sale of comparable rating. issuance activity, including certain (bankruptcy remote) by its original holder For the financial market as a whole, nascent markets in Eastern Europe (originator) to a special purpose vehicle securitisation is beneficial insofar as it (Russia, Ukraine and Kazakhstan). (‘SPV’); (ii) the SPV finances the acquisition increases the capacity of the overall market by by issuance to the market of securities backed providing an alternative source of funding, in While issuance in the third quarter of by the portfolio (asset-backed securities particular necessary for amounts of funding 2006 amounted to €113.5bn, it declined to – ‘ABS’); (iii) the ABS are tranched into layers and tenors (in some cases up to or more than €89.5bn in the third quarter of 2007. It is of securities with different risk profiles and 20-25 years) exceeding the capacity of the well known that the US ‘subprime mortgage’ rating, so that junior tranches absorb losses banking system. crisis of last summer caused an ‘investor without interrupting the flows of payments to strike’ in the financial markets which led to a the senior tranches. MARKET PERFORMANCE: liquidity crisis and, ultimately, to this issuance Though not strictly securitisations, other GROWTH, DIVERSIFICATION AND slowdown in European term securitisation. structured products share some of their LIQUIDITY CRISIS As market turmoil continues, it seems now features. For instance, synthetic securitisations From the beginning of the decade and that these new credit market conditions hedge, rather than transfer, the credit risk until July 2007, European securitisation characterised by reduced investor risk using credit derivatives. In collateralised debt issuance had enjoyed spectacular growth tolerance, global repricing, increased volatility obligations (‘CDOs’) and repackagings, the and increasing diversification in asset and funding costs and lower liquidity are here portfolio is normally comprised of tradable classes and originators’ jurisdictions. to stay for some time. securities or debt instruments. ABCP According to data published by the What is the future of European conduits have certain distinctive features European Securitisation Forum, European securitisation under these market conditions? which are described below. securitisation annual issuance rose from Although it is not possible to ascertain how The objectives of the originators are the €78.2bn in 2000 to €474.5bn in 2006. precisely securitisation will evolve, as many main drivers of securitisation business. For In the second quarter of 2007, issuance uncertainties remain, some market trends may instance: reached €164.8bn, of which: be predicted with the appropriate caution. But  It is a good economic capital management  a majority, €102.8bn, consisted of we must first examine the role and importance tool, insofar as it improves Return on mortgage-related assets (residential of the key ABCP conduit sector to understand Equity (‘ROE’) by reducing the cost of and commercial mortgage-backed such trends, as it was the first to be hit by the capital. securities, ‘RMBS’ and ‘CMBS’), liquidity crisis.  For regulated institutions such as banks but other asset classes such as CDOs or insurance companies, securitisation (€40.9bn), collateralised loan obligations ABCP CONDUITS AND STRUCTURED further allows for regulatory capital relief. (‘CLOs’) (€8.2bn), auto loans (€6bn) INVESTMENT VEHICLES (‘SIVS’)  For originators with low ratings, and corporate receivables (€2.9bn) were Main features securitisation aims to improve their all-in beginning to take a significant share of ABCP conduits normally have the following cost of funds or the amount of funding the issuance volume; characteristics: that they can raise.  excluding CDOs (€123.9bn), roughly  They are SPVs often incorporated as half of issuance volume was originated limited liability companies with very little But it also provides benefits for in the UK alone (€62.1bn), whilst other capital base in tax-friendly jurisdictions. investors. In particular, they achieve credit Western European countries, notably These conduits issue ABCP in the money

Butterworths Journal of International Banking and Financial Law March 2008 115 Spotlight SPOTLIGHT

markets to invest in long-term, highly normally set up by their sponsoring banks conduits, leveraged ten to 15 times through rated receivables/loans and/or securities. to provide off-balance sheet funding to their the issuance of ABCP and Medium Term  ABCP has short maturity (typically customers with lower capital costs. For Notes (‘MTNs’). SIVs are required to up to 270 days in the US and 365 days European banks, the introduction in the mark-to-market their assets and monitor in Europe), like ordinary commercial EU of International Accounting Standard their performance regularly to determine paper, but it is secured by the conduit’s (‘IAS’) 39 forced a number of sponsor banks compliance with specific tests in order to assets. to recognise their sponsored-conduits’ limit their exposure to the different risks  Unlike term securitisation SPVs, their assets on balance sheet. On the other hand, that they face (investment risk, hedging risk liabilities are not tranched. All ABCP is regulatory capital costs of liquidity and and funding/liquidity risk). How a SIV’s pari passu, although subordinated credit credit enhancement providers in ABCP assets perform relative to its benchmark enhancement in the form of a letter of conduits are expected to increase as a result will determine its operating state, from the credit, a loan or a financial guarantee of the implementation of the 2004 Basel ‘normal’ operating state to ‘the below normal’ policy is normally provided to protect Accord (‘Basel II’). states (restricted investment, restricted investors and liquidity providers against Up until the second quarter of 2007, the funding and enforcement) which the SIV losses in defaulted assets. size of outstanding European ABCP had will fall into if its Net Asset Value (‘NAV’)  Their key feature is the liquidity support grown to $281bn (source: Merrill Lynch) declines below certain thresholds. These provided by one or various highly rated issued by an increasing diversified conduit features are specially designed to preserve the banks designed to cover the maturity base which included: (i) single seller and ABCP and MTN holders’ interests, as losses mismatch between short-term assets multi-seller conduits; (ii) arbitrage conduits, will be absorbed first by capital note holders, and long-term liabilities. The liquidity which invested in rated securities and other and, crucially, have made it possible for support is normally sized to backstop marketable debt, rather than customer- SIVs to operate without 100 per cent bank 100 per cent of the conduit’s maturing generated receivables/loans; (iii) hybrid liquidity support. debt, excluding defaulted assets, so as to conduits, which invested in a combination allow the conduit to continue purchasing of receivables/loans and securities; and (iv) The importance of ABCP conduits assets and repaying the maturing ABCP repo/TRS conduits, which funded their for securitisation. in a scenario of liquidity shortage within assets through repo and total return swaps. Future prospects the structure. In recent years, up to 25 SIVs and ABCP conduits and SIVs have been integral three SIV-lites, a subset of ABCP issuers, to the growth in securitisation insofar ABCP normally gains the highest had emerged in the liquidity-rich credit as they have reinvested in securitisation short-term ratings thanks to a combination markets. SIVs have a capital model which bonds the proceeds raised in money of liquidity support, credit enhancement allows them more flexibility than conduits markets which money market investors and good-quality underlying assets (AAA- to vary their mix of assets and liabilities could not have invested directly due to rated ABS among them). These conduits are over time. Their capital base is greater than legal constraints. In doing so, the overall liquidity in the European securitisation Figure 1: Paradigm securitisation structure markets was greatly enhanced. According to data published by Merrill Lynch, in First loss 2006 58 per cent of investors in European piece ABS were either banks, ABCP conduits or SIVs. ABCP conduits and SIVs had True sale of assets/debts Senior notes invested mainly in AAA tranches, while hedge funds, insurance companies and Originator SPV Investors monolines invested in mezzanine tranches and, more recently, even in first loss pieces Purchase price Note proceeds of transactions which previously were normally retained by originators. Exchange of current and/or As investors concerned about ‘subprime’ interest rate cash flows losses retreated from ABCP conduits and SIVs in summer 2007 and these became Swap unable to continue rolling over commercial Underlying counter debtors paper, banks came under pressure to advance party funds under the liquidity lines that they had committed to their conduits. This

116 March 2008 Butterworths Journal of International Banking and Financial Law SPOTLIGHT Spotlight

led to a dramatic disruption of the AAA- structures not adequately robust’ (11 ABCP market. Indeed, the basic features tranche ABS investor base with the well- per cent). of the ABCP conduit business model do known consequences: spreads widened to  The most likely to assist in the return of not seem in question, as investors point historical maximum levels for both ABCP investor confidence and growth in ABCP: to external causes rather than to intrinsic and term securitisation; primary market in this case, ‘limitation on types of features of conduits as the reason for this closed for new issues; secondary trading vehicles’ was chosen by 51 per cent of the crisis in the market. froze; the European ABCP conduit market respondents, whilst 19 per cent chose However, substantial changes will occur outstandings declined to $198bn in the third ‘better disclosure by issuer’. as anticipated by the respondents with the quarter of 2007 and to $153bn in the fourth  ABCP reporting: in relation to current reference to the ‘limitation in the types of quarter; and the decreased value of financial pre- and post-issuance reporting in vehicles’. In practical terms, this means assets forced almost all SIVs into restricted conduits (info memos, pool reports, that the conduit market will probably operating states. rating agency reports, investors undergo a restructuring and concentration It follows from Merrill Lynch’s data that the recovery of European securitisation issuance levels is interlinked to the recovery "How a SIV’s assets perform relative to its benchmark of ABCP conduits and banks as investors. will determine its operating state from the ‘normal’ A recent survey by the International Capital Markets Association (‘ICMA’) operating state to ‘the below normal’ states ..." among investors in ABCP provides some indications as to the potential prospects for presentations and conferences), a process with a preference for multi-seller the ABCP conduit market recovery: majority of respondents (52 per cent) conduits and for vehicles with 100 per cent  Reasons for the decline in ABCP said that ‘it needs some refinement’, liquidity support from bank sponsors. The outstandings: a majority of respondents although a significant minority (27 per surviving SIVs will likely be restructured (60 per cent) pointed to the ‘overall cent) opined that ‘it is adequate’. into arbitrage conduits with 100 per cent uncertainty in the credit and money liquidity support. The ‘Year End 2007 markets’, over ‘lack of availability The ICMA survey results suggest ABCP & MTN Global Market Update’ by information’ (11 per cent) and ‘some valuable conclusions for the future of the Merrill Lynch forecasted that ‘after losing

Figure 2: ABCP conduits

Equity Equity Expected owner owner loss investor Cash & credit risk Cash

Assets ABCP Asset Seller 1 ABCP Issuer Investors Purchaser(s) Cash Cash Cash

Seller 2 Cash & some risks Swap Cash payments Counterparties Seller 3 Services Fees Liquidity

Credit Sponsor / Enhancement Administrator Provider

Butterworths Journal of International Banking and Financial Law March 2008 117 Biog box Spotlight Carlos Echave is an associate in the London offi ce of Mayer Brown International LLP, specialising in securitisation and structured fi nance transactions, debt and equity securities off erings, banking transactions and in providing regulatory advice. SPOTLIGHT Email: [email protected] Th is article was fi rst published in Butterworths Journal of International Banking and Financial Law

ABCP access or fi nding cheaper fi nancing Given a reduced investor base, in the near backing the covered bonds remains on the alternatives, 128 programmes of the 295 future European securitisation issuance is bank’s balance sheet and they constitute active ABCP programmes at 31/12/07 are likely to remain weak and transactions size a direct obligation of the issuing bank. expected to terminate or permanently exit small, compared with previous years, and Covered bonds benefi t from a very the market by 30/6/08’. dominated by a risk-averse investor drive. favourable legislation in almost all EU It is also worth noting that investors Possible consequences of this could be: member states, with the UK expecting seem reasonably satisfi ed with the level of  Jurisdictions: investors’ fl ight to safety to enact its covered bond regulations in transparency in this market. Th is would might favour assets originated in certain March of 2008. challenge the allegations made by the press countries considered as safer, eg Th e  CDOs: issuance of arbitrage CDOs might and some regulators that the ABCP market Netherlands, the Nordic countries or remain weak, even if other products is opaque. Again, this does not mean that Germany, which might take a bigger recover. Th e main reason would be things will stay the same: as respondents share of issuance than previous years; the loss of investor confi dence as these to the survey demanded ‘some refi nement’  Asset classes: there may be a similar fl ight products have proven diffi cult to value in conduit disclosure and reporting, the to safety, which would also be a fl ight following the liquidity crisis. industry is formulating a Code of Conduct to quality, with the investors taking a which, once approved, will set forth certain much closer look at the features and In the long term, it is not possible to best practices for reporting and some basic credit risk of the portfolio than before. anticipate whether the growth trend prior to content for information memoranda and For instance, in RMBS this would mean the crisis of summer 2007 will resume. Th ere investor reports, which ABCP conduits that only prime mortgages with low are good grounds to hope for that, perhaps adhering to the Code will commit to comply loan-to-value (‘LTV’) ratios are likely to on a contracted market basis. On the one with. be securitised. hand, the business rationale for the various securitisation uses described at the beginning of this article is still robust from both "One thing is certain. The European securitisation originator and investor perspectives and will market will substantially change as a result of the continue to hold true after we overcome the current market uncertainties. On the other current crisis." hand, a glance at: (i) the above-described data of types of securitised assets and countries of origination as of the second quarter of SECURITISATION GOING FORWARD: Th ere may be greater opportunities for 2007, both highly concentrated in mortgage- SHORT AND LONG VIEWS alternative asset classes to access the backed assets and in a few jurisdictions in Th e ongoing restructuring of the ABCP market, in particular trade receivables Western Europe; and (ii) the overall size of market will make unlikely in the short and other corporate assets, and, subject the European securitisation market, roughly term a quick recovery of this part of the to repricing in the securitisation market, a third of the US market, will reveal an European securitisation investor base. there may be greater incentives for enormous potential for growth which still Further uncertainty for the conduit market corporates to use securitisation given the remained mostly untapped before the crisis. will be added by the new regulatory capital tightened lending criteria in the banking Whatever the outcome, one thing is calculations deriving from Basel II for market. certain. Th e European securitisation market banks as liquidity and credit enhancement  Structures: there may be a fl ight to will substantially change as a result of the providers. simplicity. Th is could benefi t certain current crisis. Th ere is no question that the Th us banks will, in the short term, asset-backed lending, securitisation lite securitisation industry must address some constitute the overwhelming majority structures (ie securitisation without issues regarding transparency and valuation of the investor base in AAA tranches of rating agency involvement) and whole of structured products. It is, in fact, already new transactions. On a positive note and loan sales. Furthermore, this and the rising to this challenge through various leaving aside other factors, investor appetite banks’ need of funding might favour industry-led initiatives, whose ultimate goal in securitisation from banks might be covered bond issuance, vis-à-vis RMBS. is to attain a more transparent and liquid encouraged by the Basel II rules, insofar Covered bonds are highly rated securities ABS market and, in the process, regain as they provide for a low regulatory capital issued by banks and other credit investor confi dence. risk weightings for AAA securitisation institutions secured by a ring-fenced pool To quote Winston Churchill, ‘Now this exposures (7 per cent for Internal Ratings of mortgages loans or loans to or secured is not the end. It is not even the beginning Based approach banks and 20 per cent for by certain public sector institutions. of the end. But it is, perhaps, the end of the standardised banks). Unlike securitisations, the pool of assets beginning.’ 

118 March 2008 Butterworths Journal of International Banking and Financial Law