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COMMENTS

European Structured Finance Outlook 2020: Steering A Steady Course


European Structured Finance Outlook 2020: Steering A Steady Course

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Greater Regulatory Certainty To Support Steady Securitization Issuance

Investor-placed European securitization issuance recovered from a slow start to end 2019 at €102 billion, down only 5% (see chart 1). While uncertainties surrounding implementation of the EU's Securitization Regulation stifled supply early in the year, the new rules have increasingly bedded down and should not hold back activity in 2020, with securitization volumes set to remain steady at about €100 billion. European benchmark covered bond issuance remained strong in 2019, rising by 8% to €132 billion. In 2020, an increase in scheduled covered bond redemptions could support a further rise in volumes.

Continued modest growth in underlying lending to the real economy should provide a supportive backdrop for wholesale funding issuance. The approaching maturity of some issuers' borrowings from cheap Bank of England funding schemes could further spur a rise in bank-originated securitization and covered bond issuance in the U.K. However, the European Central Bank's (ECB's) equivalent scheme re-opened to new drawdowns in late 2019, potentially suppressing any similar effect in the eurozone.

Chart 1

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The diversity of European securitization issuance arguably took a step backwards in 2019, with less activity in niche areas and volume growth mostly confined to what were already the largest sectors--leveraged loan collateralized loan obligations (CLOs), U.K. residential mortgage-backed securities (RMBS), and German asset-backed securities (ABS). While CLOs recorded a fourth successive year of issuance growth and continued to be the highest-issuance sector in 2019, we expect volumes to dip in 2020, given increasingly challenging transaction economics and a decline in new underlying loan originations. Among smaller sectors, Spanish securitization was a bright spot where investor-placed volumes grew by 60% to reach a new post-crisis high of nearly €4 billion, as more originators began to print capital relief transactions. In the benchmark covered bond market, the U.K. and Spain saw strong growth, with €20 billion and €7 billion of issuance respectively, up about 60% in each case compared with a year earlier.

With interest rates now set to remain "lower for even longer", the floating rate nature of most European securitization products is less likely to spur marginal investor demand. However, another effect of continued accommodative monetary policy may more than compensate, with the ECB's recent re-start of net purchases under its quantitative easing program bringing a large buyer of both securitizations and covered bonds back to the market.

In addition, the long-running regulatory uncertainty that has caused a drag on securitization issuance continued to lift through 2019 and should no longer represent a significant hindrance in 2020. Market participants have had to comply with the EU's new Securitization Regulation since the beginning of 2019. As well as introducing preferential treatment for so-called "simple, transparent, and standardized" (STS) transactions, the regulation also included a revamp of rules regarding risk retention, investor due diligence, and disclosures, which apply to all securitizations. However, significant elements of the market infrastructure envisaged in the regulations--as well as drafts of various technical standards providing implementation guidance--were still under development in early 2019, despite the new rules already being in effect. This kept many originators and investors on the sidelines.

Now, however, the key technical standards are all but finalized and likely to enter into force in the first quarter of 2020. Confidence in the new STS regime already improved throughout 2019 as third-party verifiers received regulatory approval and began to opine on transactions' STS compliance. By the end of the year, more than 35% of all investor-placed European securitization issuance had come to market with the STS label, and originators have also begun to apply the label retrospectively to outstanding pre-2019 issuance. The significance of the label will likely rise further in 2020. From April, only STS-labeled securitization exposures can count as high-quality liquid assets in EU banks' calculation of their liquidity coverage ratio--a key regulatory test.

Opposing Effects From Central Bank Funding Schemes In The U.K. And Eurozone

While annual growth rates of underlying bank lending to households and nonfinancial corporates remain only in the low single-digits, they are still close to post-crisis highs for both the U.K. and the eurozone. This provides a supportive context for growth in net issuance of wholesale funding, potentially including both securitizations and covered bonds. That said, the role these products play in the funding mix will partly depend on the availability and cost of issuers' alternatives. Bank-originated European structured finance volumes have been depressed for several years given the availability of cheaper funding options offered by the ECB and Bank of England.

In the U.K., however, these central bank schemes have been closed to new drawdowns since early 2018 and the maturities of past borrowings are on the horizon. We estimate that about £17 billion will mature in the second half of 2020, but with more than £75 billion to come in 2021 (see chart 2). As a result, U.K. bank issuers are increasingly likely to once again tap debt markets as they plan for the gradual run-off of this official sector term funding.

Chart 2

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However, the ECB's equivalent scheme of targeted longer-term refinancing operations (TLTROs) has re-opened to new drawdowns, potentially suppressing any similar effect in the eurozone. While issuers' renewed access to TLTRO funding may substitute for some covered bond issuance in particular, ECB asset purchases and ongoing negative yields could help spur supply. Also, according to our data, scheduled covered bond maturities are set to rise in 2020. Even assuming flat net issuance, gross volumes could therefore increase modestly, by 5%-10% in our view. Another positive is that the European Commission's project to better harmonize the region's covered bond markets cleared the European legislative process in 2019. Although it will take some time for different national covered bond frameworks to align with the new rules, much of the uncertainty surrounding the project has now lifted.

Our issuance figures here do not include the volume of CLO refinancings and resets, which accounted for about €11 billion of further activity in 2019. Senior CLO tranche liability spreads are currently similar to their levels of two years ago, though trending lower. Collateral manager and equityholder incentives to refinance or reset transactions that exit their noncall periods in 2020 are therefore finely-balanced and sensitive to future spread movements.

Ratings Show Continued Stability, Though CLO Pools Are Weakening

Although European economic growth may remain sluggish in 2020, strong labor markets and accommodative monetary policy mean household finances should remain resilient, with little sign of credit deterioration among securitizations backed by consumer risk. Declining credit quality in CLO collateral pools is an area to watch, however.

On most measures, we expect aggregate European structured finance credit performance to be positive in 2020. For most asset classes, the 12-month trailing average change in credit quality has been positive for at least three years, indicating aggregate upward ratings movements (see chart 3). In the commercial mortgage-backed securities (CMBS) sector, where credit performance has been weakest, legacy transactions are now largely wrapped up, with most of the expected losses already crystallized. In fact, the sector's average change in credit quality turned positive in October 2019 for the first time in more than a decade.

Chart 3

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Although the eurozone economy has been slowing over the past two years, unemployment has also been trending lower--a credit positive for the assets backing most European securitizations and covered bonds. We expect eurozone GDP growth to slow further to 1.0% in 2020 from 1.2% in 2019. However, we believe the risk of recession is declining, thanks to strong labor markets that are supporting consumer spending. The unemployment rate is now at 7.5%--the lowest in over a decade--and we expect it to fall marginally further in 2020 (see chart 4). In the U.K., the outlook is still partly dependent on Brexit-related developments. Although the decisive outcome of the recent general election means the process has moved forward and may lead to a bounce in economic activity in the short term, there remains a risk that the U.K. could leave the EU without a free trade agreement at the end of 2020.

Chart 4

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Despite some concerns over the length of the current credit cycle, there are so far few signs of deterioration in underlying collateral performance for transactions backed by lending to consumers. However, one area of focus is the gradual deterioration in credit quality of CLO collateral, with more recent transactions backed by loan pools with lower ratings and recovery prospects on average than earlier vintages. That said, a lower quality collateral pool is generally reflected in higher credit enhancement for tranches of a given rating, all else being equal. Other effects are countered by structural features. For example, a growing concentration of loan collateral rated 'B-' puts CLO structures at greater risk of eventually breaching their 'CCC' concentration limits--and subsequently junior overcollateralization tests--in the event of a corporate downturn. However, such a breach could actually be credit positive for senior noteholders, as these CLOs would then pay down their liabilities and de-lever earlier.

Appendix: Sector-By-Sector Outlook Highlights In Charts

CLO

Chart 5

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  • New European CLO issuance grew 8% to nearly €30 billion in 2019, posting a fourth consecutive annual increase.
  • By contrast, refinancing and reset activity declined significantly, given little economic incentive for managers and equityholders.
  • CLO liability spreads are currently not significantly lower than those on legacy transactions whose non-call periods are coming to an end.

Chart 6

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  • The trend in new CLO issuance has historically been closely linked to the trend in underlying leveraged loan originations.
  • Annualized European leveraged loan origination volumes have fallen by more than 30% over the past two years, from a peak of €108 billion in early 2018.
  • This trend may foreshadow a decline in new CLO issuance in 2020, although CLOs can also source collateral in the secondary market.

Chart 7

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  • Spreads on senior European CLO tranches generally tightened during the second half of 2019.
  • However, spreads continued to widen at the bottom of the capital structure, possibly due to some credit concerns among the junior investor base.
  • Going into 2020, relatively low "arbitrage" between loan spreads and CLO funding costs means that transaction economics remain challenging.

Chart 8

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  • As of end-2019, our negative ratings bias for European speculative-grade corporates exceeded 20%.
  • This suggests a widening risk of downgrades among the high-yield issuers that are typically candidates for inclusion in CLO portfolios.
  • However, our data suggest that the negative bias among issuers included in CLO portfolios is lower than for the wider corporate universe, due to manager selection.

Chart 9

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  • On average, the proportion of CLOs' underlying portfolios that is rated 'B-' has risen significantly over the past two years.
  • This increases the risk that CLOs could fill their 'CCC' portfolio limits in the event of a downturn and corporate downgrades.
  • That said, most transactions that we rate have significant headroom in their 'CCC' allowances.
ABS

Chart 10

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  • While investor-placed European ABS volumes declined by 15% in 2019, the composition of issuance remains diverse.
  • About one-third of ABS issuance in 2019 was from Spain and Italy, up from less than 25% the previous year.
  • We expect ABS issuance in 2020 to remain widely spread across countries and underlying asset types.

Chart 11

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  • More than 20% of European ABS tranches (by count) placed with investors in 2019 were rated in the 'BB' category or lower.
  • Originators are increasingly selling the full capital structure of their ABS transactions, rather than retaining the higher-risk portions.
  • This could signal a return to the use of securitization for capital relief--rather than solely as a funding tool--spurring issuance growth.

Chart 12

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  • For consumer ABS, ongoing steady growth in banks' underlying lending activity could support issuance.
  • While the rate of net lending has recently been trending slightly lower, it remains close to pre-crisis levels.
  • Expanding loan books in this area reflect the current contribution of household spending and strong labor markets to economic growth.

Chart 13

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  • Our delinquencies indices aggregate credit metrics across the underlying collateral pools of transactions that we rate.
  • On this measure, fundamental credit performance on average remains steady for core ABS subsectors.
  • Given the forecast macroeconomic backdrop, we expect aggregate 90+ day delinquencies to remain broadly stable through 2020.
RMBS

Chart 14

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  • Investor-placed European RMBS issuance slowed by 6% in 2019, with growth mostly confined to the U.K.
  • Nonconforming and/or buy-to-let collateral accounted for more than half of U.K. RMBS issuance, with prime collateral-backed transactions in the minority.
  • Dutch issuance continued to wane, posting a multi-year low of only €5.4 billion, given the growing use of covered bonds and other funding alternatives in The Netherlands.

Chart 15

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  • Issuance from non-bank originators dominated the RMBS sector again in 2019, but 2020 could see a shift.
  • In 2019, less than 40% of RMBS issuance was from bank originators, compared with more than 90% in 2012, for example.
  • For some U.K. bank originators in particular, the approaching maturity of cheap legacy central bank funding could spur a return to capital market issuance, potentially including RMBS.

Chart 16

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  • The pipeline of outstanding European RMBS set to reach a call date is front-loaded in 2020.
  • To the extent that originators target a stable role for securitizations in their funding mix, the call pipeline could correlate with new RMBS issuance.
  • In the Netherlands though, the rise of alternative funding approaches may mean that called RMBS is not all replaced.

Chart 17

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  • On average, severe delinquencies in the mortgage pools backing RMBS that we rate are stable and lower than five years ago.
  • These delinquency trends are broadly correlated with movements in unemployment.

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  • Looking ahead, trends in many relevant macroeconomic and credit indicators appear favorable for most countries with an RMBS market.
  • For example, we forecast modest house price appreciation in 2020 for most RMBS markets, with the exception of Italy.
  • Similarly, we expect the unemployment rate in most markets to remain stable or continue declining.
CMBS

Chart 18

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  • Although CMBS volumes remained modest at less than €5 billion in 2019, it was the busiest post-crisis year for the sector in terms of transaction count.
  • Issuance was dominated by a few large transactions, but the average transaction size declined slightly.
  • Despite Brexit-related uncertainty, British pound sterling-denominated CMBS volumes held up well.

Chart 19

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  • The U.K. remains the dominant location for European CMBS, supported by a wide spectrum of commercial property types from retail via logistics to student housing and hotels.
  • New borrower-level structures ("double LuxCo") put France back on the map in 2019.
  • As in previous years, pan-European transactions look set to remain rare in 2020.

Chart 20

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  • In 2019, the average change in credit quality for European CMBS turned positive for the first time in over a decade.
  • This trend is largely due to the declining number of legacy "CMBS 1.0" transactions outstanding, which previously contributed more to downgrades than upgrades.
  • Given the prevalence of prorata pay and single-borrower structures, upgrades resulting from improved credit metrics following loan prepayments are now generally less likely in European CMBS than in other sectors.

Related Research

  • Global Structured Finance Outlook 2020: Another $1 Trillion-Plus Year On Tap, Jan. 6, 2020
  • Credit Conditions In EMEA Are Perched On A Fine Edge, Report Says, Dec. 3, 2019
  • Spanish RMBS Index Report Q3 2019, Nov. 28, 2019
  • U.K. RMBS Index Report Q3 2019, Nov. 28, 2019
  • Portuguese RMBS Index Report Q3 2019, Nov. 28, 2019
  • Dutch RMBS Index Report Q3 2019, Nov. 28, 2019
  • Italian RMBS Index Report Q3 2019, Nov. 28, 2019
  • U.K. Credit Card ABS Index Report Q3 2019, Nov. 28, 2019
  • European Credit Card ABS Index Report Q3 2019, Nov. 28, 2019
  • European Auto ABS Index Report Q3 2019, Nov. 28, 2019
  • Eurozone Economic Outlook: Consumers Won’t Give Up In 2020, Nov. 28, 2019
  • Global Outlook: Covered Bond Harmonization Set To Raise The Bar In 2020, Nov. 26, 2019
  • Rise In Repayments Expected For U.K. Legacy Borrowers, Nov. 13, 2019
  • Game Of Loans: The Nitty-Gritty Of Granular European CMBS Transactions, Sept. 3, 2019

This report does not constitute a rating action.

Primary Credit Analyst:Andrew H South, London (44) 20-7176-3712;
andrew.south@spglobal.com
Secondary Contacts:Alastair Bigley, London 44 (0) 207 176 3245;
Alastair.Bigley@spglobal.com
Sandeep Chana, London (44) 20-7176-3923;
sandeep.chana@spglobal.com
Antonio Farina, Madrid (34) 91-788-7226;
antonio.farina@spglobal.com
Mathias Herzog, Frankfurt (49) 69-33-999-112;
mathias.herzog@spglobal.com
Volker Laeger, Frankfurt (49) 69-33-999-302;
volker.laeger@spglobal.com

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