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We’re heading to Barcelona for FT Live’s Global ABS next week, along with most of the European market. If you haven’t sent Excess Spread a drinks invite yet, there’s still time. 9fin will also have a stand there for the first time, drop by for a sangria from 4pm Weds!

Resilient?

It’s nice of the European Commission to circulate some of its draft proposals for reforming securitisation ahead of the big conference, with enough of a window for everyone to have a read and chew over them.

But if your regulatory glass was half empty, one might consider the absence of agreed LCR and Solvency II proposals this stage as a sign that meaningful reform here will be much more difficult.

The big LCR question is really “should securitisations get parity with covered bonds”, meaning LCR 2A treatment rather than 2B (lower haircuts for a bank’s HQLA liquidity buffer).

Parity, actual or symbolic, with covered bonds is deeply controversial in covered bond-loving countries.

It’s bad, Anglo-Saxon synthetic CDO weapons of financial mass destruction vs good, prudent, Germanic, Frederick the Great no defaults in 250 years kind of energy. There are decent points to be had on both sides but there’s a lot of culture and tradition in the mix too, which might be giving the Commission pause.

Anyway, let’s talk about what we do know so far. Celeste has a great rundown for 9fin subscribers, and there’s another piece focused on CLOs here.

On of the big changes, floated first in 2022, is that the STS (Simple Transparent and Standardised) definition will be supplemented by another beneficial designation, that of “resilient” securitisation.

As per the draft, “the proposal introduces a new concept of resilient securitisation positions. The resilience securitisation positions are senior positions in securitisations which satisfy a set of eligibility criteria that ensure low agency and model risk and a robust loss absorbing capacity for the senior positions.”

“Aha!” you may say. “Just like STS.” And you would have a point.

The new ‘resilient’ designation borrows several elements from STS, such as amortisation structure and granularity. They are, however, only relevant with respect to securitisation positions retained by an originating bank or sponsor, not capital improving for third party investors in securitisation.

Overall senior capital floors will be lowered from 10% and 15% for STS and non-STS respectively, to a more risk sensitive measure.

The figure will be floored at 5% for deals which are STS and resilient, but derived from 10% of KIRB (the risk weight of the underlying under the internal ratings-based approach) or 12.5% of KA (risk weight of the underlying under the standardised approach). The floor will be 10% for deals which are non-STS and resilient, with the actual capital coming from 15% of KRIB, or 12.5% of KA.

The risk-sensitive floor concept sounds good — who doesn’t like being “risk sensitive” — but if you consider it for a moment longer, it’s actually quite weird.

Securitisation is a set of legal tools and techniques which allow you to carve a pool of assets into tranches of different risks. You can get triple-A out of almost anything, depending on the credit enhancement and other structural support; in a sense the whole point of the market is to turn diverse forms of lending into risk-insensitive tranches, using structure to abstract away from the credit quality of the underlying.

So it’s slightly curious to have a capital regime proposing to tie capital treatment for the senior tranche back to the overall risk weighting of the underlying loans.

I can see the argument for ensuring that a full stack of securitised bonds has some relationship to a full pool of underlying loans, but it’s not obvious to me at all why the capital for the senior tranche should be derived starting with 10%, 12.5% or 15% of the underlying loan requirement.

Still, the stated aim is basically to make it cheaper to securitise low-risk assets, and the big prize is mortgages.

Many banks already make extensive use of their consumer finance and auto books to do distributed cash risk transfer deals (May and June has seen about €3bn a week of this kind of supply). It’s concentrated among the largest banks, but the incentive certainly seems to be there, for banks with sufficiently large portfolios.

Pure cash risk transfer in mortgages is rarer. There are full deconsolidation deals, primarily among the UK challengers and for closed book portfolio sale purposes, and there are mortgage insurance deals, which are bigger than you might think. Santander, for example, discloses €11.57bn in synthetic SRT exposures relating to residential mortgages in its 2024 Pillar 3.

But there’s no first-principles reason why far more European mortgage risk can’t be distributed in cash securitisation format. Mortgage lending is much larger than any other consumer asset class, and capitalising this lending with bank equity has been the historic approach for most European countries. If a regulatory shakeup can allow more of it to be capitalised on market terms, perhaps that’s a good thing? It would certainly offer a more fertile investment environment for securitisation funds.

Other changes (covered in much more depth here) include changes to the much-criticised p-factor, and adjustments to the scaling factors. This all points in the direction of reduced capital requirements; the question is only whether it will be enough to move the needle.

Wishlist

The big one for the SRT market is the introduction of STS for unfunded deals. This has long been on the industry wishlist, and was discussed earlier this year by EU regulators. This could cut out some of the more convoluted workarounds, such as funded repacks, but, in line with the discussion earlier in the year, the proposal limits the participation to Solvency II-regulated (and therefore EU-based) insurers.

One might think that it’s good for EU financial stability to transfer bank risk out of the EU entirely, but there’s a valid risk (given the protection is unfunded) that the failure of a non-EU supervised insurer could leave European banks undercapitalised.

SRT execution should also get a boost, from a planned new Principles-Based Approach test for SRT authorisation. This builds on EBA recommendations from 2020, and on a fast-track approval pilot that’s currently under way. Anything that serves to streamline the process would be welcome, but the proposal doesn’t lay out the details — it’s for the EBA to fill in the gaps.

Some of the other changes are a bit more pedestrian, and more disappointing. The Commission seems to accept the argument that the ESMA templates aren’t especially useful, and are overspecified and burdensome.

There are plans to cut this red-tape burden down. At the same time, though, more assets will fall in scope as “public” deals, notably CLOs.

In every practical sense, CLOs are already public deals, but what this designation really means is reporting to a Securitisation Repository. This is unlikely to improve transparency for any CLO investor, potential or otherwise, since comprehensive CLO information is already available through various proprietary services. But the paper says the lack of reporting to SRs “curtails supervisors’ ability to adequately analyse and supervise cross-border markets and might limited overall market transparency”.

On this point, we were struck by this piece from the Financial Times’ Alphaville blog, which strongly suggests that the European Banking Authority has only one Bloomberg terminal in the building. Perhaps the supervisors would be better able to supervise cross-border markets if they had access to one of the securitisation industry’s main information systems?

The CLO industry could club together and subscribe for a couple more, in the interests of providing regulatory transparency without having to report to the SRs? Heck they could probably use a 9fin sub as well. Got to be cheaper in the long run.

While the actual burden of reporting is eased slightly, there’s an ominous expansion in the scope of punishment for failing of investor due diligence, which will be formally brought within the sanctions regime of the Securitisation Regulation. That means the maximum fine for failings of investor due diligence could be up to 10% of consolidated global turnover. Compliance says no!

More useful would be a concept like the “regulatory sandbox”, which has been used in fintech, crypto and other fast-moving innovative spaces. Give firms a break while they get up and running; if the ABS book is some de minimis percentage of overall fixed income investing or below a certain value, go easy on enforcement for DD requirements until they’re big enough to matter.

Chicken and egg

Monzo Bank’s annual report was released on Monday (2 June), confirming what we’ve discussed here previously — the bank is now actively buying securitisations, to the tune of £484m in the year to 31 March 2025.

Given the interest income reported for these assets, and the likely spread on a triple-A RMBS tranches in sterling, we think the buying has been concentrated towards the latter half of the year. There’s not much other detail, but we would assume triple-A mortgage product in sterling is most suitable. STS deals are generally most attractive to regulated banks, but Monzo’s liquidity and capital ratios are so far in excess of where they need to be that it may not matter.

Perhaps most interesting is what happens to the rest of the balance sheet.

Monzo still has £11bn in cash and cash equivalents. Gathering current account deposits and posting these at the Bank of England is a valid business which will earn a positive spread, but gathering current accounts and investing them in ABS is much juicier, if the product supply is there. It reported an LCR ratio of 1,226%, so it’s got a lot of liquidity headroom.

Right now, deploying an additional £10bn into sterling RMBS is not an easy proposition, especially if you want a prudent and diversified book at a decent price.

At the same time, senior bonds remain the part of the capital structure which gives treasurers the greatest headache.

At the time of writing, the £240m seniors in Haydock’s Hermitage 2025 equipment finance deal are 1.3x done. Bank of Ireland’s Bowbell Master Issuer 2025-1 finished 2.5x done on a £350m tranche, Vida Bank’s London Bridge Mortgages 2025-1 was 2.8x done on a £204m tranche.

So depending on the deal type, there’s somewhere between £300m and £1bn out there for sterling seniors, when conditions are good and supportive. If Monzo chips away at its £10bn cash pile in £30m-£50m primary orders, even this is significant enough to drive a meaningful bit of extra price tension.

But it shows up the basic problem of market depth. There is simultaneously not enough product in sterling securitisation to easily deploy a sizeable new allocation, and also not enough demand (in tougher times) to consistently rely on publicly placed senior.

Happily, Monzo isn’t the only challenger boosting its securitisation allocations. Monument Bank has been buying, and Starling’s annual report, published last week, shows a £250m increase in RMBS holdings.

That’s enough senior bid for a whole extra specialist lender transaction!

Price and terms

SRTs and CLO equity look kind of similar, if you squint hard enough, and plenty of funds play in both; you’re looking at levered junior tranches in broad portfolios of corporate credit, and analysing individual names as well as correlations.

Partisans of each product have a standard suite of criticisms to level. The credit universe in CLOs is much narrower, especially in Europe. Active management might enhance safety, but at the cost of a fee-based drag on equity returns. Concentration in leveraged finance is unhealthy and higher risk. From the other side, CLO folk dislike the trust in issuers required by the SRT market, find the lack of transparency (and blind pools especially) shocking, appreciate the curative powers of the interest waterfall, and the liquidity both in leveraged loan trading and in tranche trading.

Still, in both markets the question of what can go in the pool is crucially important.

The bulk of the corporate SRT market is no longer static, and therefore has a replenishment period before amortisation. Unlike CLOs, though, this is not an actively managed flexibility, but an automatic process — bank credit portfolio managers are not allowed to cherry-pick good or bad loans.

Both asset classes have eligibility criteria, buckets, limits and replenishment rules, but despite the similarities, these are very different animals. CLO managers are incentivised by their subordinated fees and IRR kicker to pick the good loans, with the eligibility criteria and replenishment rules mainly serving to allocate payments to debt or to equity. Colour outside the lines too much and the main effect is to switch off cashflows down the stack.

For SRTs, meanwhile, the incentive structure runs the other way — banks would like investors to bear their losses — but the replenishment and eligibility structures serve to bind portfolio construction absolutely and ex ante, feeding through automatically to refill the portfolio.

Celeste has been digging into replenishment mechanics, as well as other major points of SRT negotiation, such as disclosure. As tariff concerns have reared their head, investors have sought clarity from banks on how exposed their portfolios might be, and have been less willing to accept replenishment terms which give banks broad optionality.

This hasn’t necessarily been reflected in price, though, with banks apparently willing to proactively flex on terms if they can keep the same headline economics.

Asset liability mismatch

We picked up a curious announcement from pre-crisis UK RMBS Alba 2007-1 the other day.

The Issuer hereby notifies Instrument holders that on the Payment Date falling in September 2024, the Master Servicer recorded a Principal Deficiency of £2,100,051.42 in the relevant report made available to Instrument holders. The Master Servicer subsequently confirmed the amount of £2,100,051.42 debited related to an asset liability mismatch identified in 2019 when Intertrust Financial Services B.V. were appointed as successor Master Servicer.

Stripping out the legalese, this notice is saying that £2.1m disappeared from the deal six years ago, and the remedy attempted was to put this through the principal deficiency ledger — effectively, to fill the hole by taking a huge bite out of the interest waterfall for the September 2024 payment date.

Interest collections have been running at £3m or so per IPD, and this money was taken out junior in the waterfall so, if it had not been for a drawing on the reserve fund, the PDL in question would not have been cleared.

That, in turn, would have tipped the deal into sequential amortisation (one of the triggers is an uncleared PDL) until it had fully worked through. Deal economics are improving now, helped by falling Sonia rates, but this is still a deeply odd affair.

Principal deficiency ledgers are supposed to be for recording principal shortfalls only — the mortgage repayment is less than full — not for curing a mysterious “asset liability mismatch” undiscovered for half a decade. Reserve funds can be drawn to remedy these shortfalls, not for any money which might go missing.

Presuambly, since there’s missing money, the “mismatch” is either not enough assets, or too many liabilities. Counting both of these accurately should be a core competence for securitisation counterparties, but sometimes things go wrong — perhaps the swap calculations were off base? Perhaps the currency mismatch (the deal used to have euro notes) was miscalculated? Those are the benign possibilities, perhaps there’s a suitcase full of used £50s somewhere?

Either way, enquiries are underway.

The Issuer had not been informed by the Master Servicer of the amounts identified in 2019 until queries in relation to the relevant report were raised following the Payment Date falling in September 2024. The Master Servicer is currently investigating the reporting irregularities and recording of the Principal Deficiency. The Issuer will provide a further update to Instrument holders once the Master Servicer has notified the Issuer of its findings.

When these investigations are concluded, it will be an ugly job to unpick.

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