Europe’s Lending Machine Fuels ABS De-leveraging
One of the legacies of Europe’s post-crisis lending landscape was a huge retrenchment in risk appetite, amplified by a lack of bank capital and in some instances funding for an extended period of time. This double whammy of restricted ability and willingness to lend proved to be a major drag on restarting economies and took years to unravel. As a result, in some areas non-banks increased market share and picked up the slack to cover traditional bank clients.
This fed through into European ABS in several ways, but we will focus on two. First, asset prices took some time to recover, so while pool defaults were modest, loss given default was higher. Second, and in part linked to asset prices, the lack of available financing across many prominent ABS sectors (mortgages, consumer lending, commercial real estate, SME lending) left borrowers unable to refinance into lower cost debt, and as a result prepayment rates in ABS deals fell dramatically.
Wind forward to 2020 and the COVID-19 crisis has been very different. Banks and lenders were not its root cause, far from it, which has helped to remove the stigma around new policies aimed at maintaining orderly lending to the real economy across the bloc.
Regular readers will know that we closely monitor central bank lending surveys to keep track of credit conditions, but just as important is the experience of our ABS team, which is in frequent dialogue with lenders across the continent. Since COVID-19 hit we have seen only a modest tightening of standards and a temporary period where funding was limited, a dramatically different picture to the environment post-2008.
To give a couple of examples, banks by and large responded by lowering the maximum loan-to-value (LTV) they would allow mortgage borrowers, though with no real increase in nominal rates (falling swap rates helped maintain banks’ net interest margin). The big UK lenders cut LTVs to 75% for a period, though some have certainly relaxed this, while the Netherlands saw no meaningful change from its tightly regulated lending guidelines. Non-bank lenders meanwhile had a tougher time of things as warehouse funding lines were for a period inaccessible, but this situation was easing along with credit market liquidity by May.
We also think European lenders were more willing to lend in part because of less fear of loose credit standards leaving numerous ticking time bombs on their balance sheets, with tighter regulation also meaning fewer borrowers trapped with products that were deemed obsolete or worse, banned.
For ABS, the importance of a normal lending market in this new economic cycle is that we expect prepayments to operate at a much more normal level, in contrast to the global financial crisis. Prepayments reduce the size of the pool backing an ABS deal, de-levering the bonds and consequently increasing loss protection for bondholders. This structural protection is often overlooked when considering ABS, but it is effectively our ‘counter cyclical buffer’. It is also an important anchor for ratings and tends to add positive rating momentum over time versus other asset classes.
To give an example, the BBB bond from a recently issued Dutch buy-to-let RMBS, DPF 2020-2, was issued with 6.5% loss protection. By its scheduled maturity in 2025, assuming a 5% or 20% prepayment rate would grow this to 8.8% and 18.3%, respectively. Put another way, with a 20% prepayment rate, the loss protection grows to a level more typical for AAA bond, and we would expect the BBB bond’s rating to follow it up (though maybe at a slight lag).
This organically built protection is one reason why the drivers of prepayments matter to ABS investors. As we move into 2021, where we think fundamental loan performance will weaken, having functioning lenders is not only good for economic recovery, but also for ABS credit quality.