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The synthetic solution

Newly created hybrid asset-backed securities are helping Europe's ABS market surmount its growing pains. Being a lawyer in Paris does have its perks.

Newly created hybrid asset-backed securities are helping Europe's ABS market surmount its growing pains. Being a lawyer in Paris does have its perks.

By Jeanne Burke
January 2001
Institutional Investor Magazine

One of Richard Parolai's clients, Nomura International, won a mandate in 1999 to lead-manage the first securitization of champagne revenues for Groupe Marne & Champagne, the world's second-largest producer. Fittingly, the postsigning celebration included a tasting from a selection of Marne & Champagne's most coveted vintages. "This deal had some extremely pleasant moments," Parolai recalls.

Besides enjoying the bubbly, the Clifford Chance lawyer had a more serious brief: to find a securitization structure that would protect bondholders in the unlikely event that 200-year-old Marne & Champagne lost its fizzle. During a tour of the champagne maker's production facility, Parolai couldn't help noticing that "the bottles don't really move very much," since they have to be cellared for proper aging and to meet the French government's strict standards for qualifying as champagne. The rows of bottles captured his attention. As he puts it, "Your ideas become clearer after some wine tasting."

Upon his return to work, Parolai began his legal research and came across the gage avec d,possession, a law from the Napoleonic Civil Code of 1804 governing the use of goods as security for a lender. If Marne & Champagne were to utilize the statute, it could transfer control over the 60 million cellared bottles to a third party, which would represent the bondholders' interest. In effect, the bondholders could be secured against any future bankruptcy by the cash flows from the champagne as it came of age and was sold.

Parolai took his idea to two rating agencies, which, after a couple of months' deliberation, agreed that it could work. And so a company was hired to guard the champagne stores day and night, with instructions to lock the cellars if the bankers advised them to. Investors could thus rest easy, confident of a claim on the company's future revenue streams. And Marne & Champagne completed a successful E396 million (about $380 million at the then-prevailing rates) securitization in March 2000, ten months after the champagne tasting.

Although his client and bondholder protection scheme is unique, Parolai's experience in the European asset-backed-securities market isn't. Because of the lack of uniform - or, in some cases, of any - legal standards, investment bankers, attorneys and rating agency analysts must test their intellectual mettle on almost every deal. It's quite a contrast from the U.S. cookie-cutter process that enables issuers to tap the markets in a matter of days, if necessary. Says Sami Tabbarah, a director in the European securitization group at Schroder Salomon Smith Barney in London, "Securitization is just a lot more fun in continental Europe."

The downside to all this fun for the European ABS market, particularly on the Continent, has been uneven growth since its 1995 launch (see graph). After about $9 billion in new deals that first year, the market surged to $33 billion in 1996, before easing to $31 billion in 1997. Volume rose again in 1998, to $40 billion, and then, boosted by the introduction of the euro, rocketed to $62.5 billion in 1999, creating expectations of another huge gain in 2000. These bullish forecasts fell short of the mark: Volume posted a respectable but unspectacular rise to about $72 billion.

More troubling than unpredictable growth is the uneven geographical spread of securitization. Nearly half of all public ABS deal volume still comes from the U.K., where bankruptcy and securities laws most closely resemble those of the U.S. Elsewhere, as Parolai experienced in France, much time and ingenuity are required.

There are signs, however, that securitization may yet take a more dominant capital markets role in Europe, as it has in the U.S. It just may not happen in exactly the way many have envisioned.

Not included in the European public volume totals is the market's newest wrinkle: the synthetic security. First developed in 1997, synthetics effectively sidestep the legal quagmires, because most of the assets are never sold. Instead, by utilizing a credit default swap in which a counterparty agrees under specific parameters to cover the losses on a pool of loans, synthetic securitizations transfer the risk rather than the assets themselves. If a sale doesn't occur, many of the bankruptcy and other securities laws become moot.

The concept has caught on more quickly, particularly with major Continental banks, than even investment bankers had anticipated. Total synthetics issuance has more than doubled over the past 12 months, to about $40 billion, according to Merrill Lynch & Co. research. It took the traditional ABS market four years to reach that volume level. "I don't think anyone predicted the extent to which this would develop," says Alexander Batchvarov, Merrill's head of European ABS research.

The first synthetic was actually created in the U.S. in 1997, when J.P. Morgan applied the concept to the so-called collateralized loan obligation structure in a $697 million transaction, the first of its Bistro series. Deutsche Bank's inaugural synthetic in late 1999 legitimized the European market, setting the stage for 2000's rapid growth trajectory. The German bank began securitizing its corporate loan portfolio in 1998 with a conventional securitization. Last year it completed two more synthetics deals totaling E2.5 billion. "We prefer the synthetic transactions because by using a huge credit swap, we decrease the cost of the transaction, and we have more flexibility," says JÙrgen Bilstein, divisional board member for corporates and real estate at Deutsche Bank.

In a traditional securitization, a bank earmarks for sale a specific pool of assets - say, corporate loans. Normally, it would sell the loans to a legal entity known as a special purpose vehicle. That SPV would repackage them as securities and market them to investors. The loans would then be cleared off the bank's balance sheet completely, since classic securitizations are complicated by tax issues, says Bilstein, with SPVs having to be set up offshore.

A synthetics transaction differs in that the bank enters into a swap agreement that transfers only the credit risk from some of the loans, usually about 80 to 90 percent, to a counterparty. The remaining 10 to 20 percent is either held by the bank or structured into bonds. "There are two distribution channels: the bond market for subordinate tranches and the credit default swap market for the senior tranches," explains Tamara Adler, head of European securitization at Deutsche Bank in London.

Counterparties are OECD banks, which often then do swaps with insurance companies. Frequently, these swap partners are located in the derivatives departments of the same companies that buy traditional ABS and therefore have a reasonable comfort level with the product.

The big lure for the issuing bank is the resulting reduction in Bank for International Settlements regulatory capital requirements. Even though the assets remain on its balance sheet, the bank off-loads some of the risk to the counterparty by means of the swap and thereby cuts its regulatory risk weighting. Under current BIS guidelines, the risk weighting of corporate loans that are swapped to an OECD bank drops to 20 percent, from 100 percent. That means the issuing bank doesn't have to set aside as much capital to remain in compliance and can put that money to work elsewhere.

The entire process is also cheaper than a traditional ABS transaction; bankers say the fee for a swap ranges between 6 and 10 basis points, compared with several times that for a regular securitization. The issuers also save on technology outlays, since they don't have to spend nearly as much on the manpower, software and computers used to set up securitizations and track asset performance. "The key issue [with traditional securitization] is that regulators don't allow us to cherry-pick assets," says Deutsche Bank treasurer Detlef Bindert. The selection of assets, requiring substantial systems support and a long, involved process with the rating agencies, "is much harder than having a counterparty look at a swap," he adds.

Although the synthetics technique was pioneered elsewhere, European banks have expanded both the types of assets used and the structures. In Germany, for instance, banks have sometimes gotten rid of the SPV entirely, which eliminates any taxation concerns. They have also gone beyond the original corporate loans and bonds to include residential and commercial mortgages. The technique has safely crossed borders, most recently into the Netherlands, where last month ABN Amro Bank created its first synthetics deal, with a face value of E8.5 billion.

The catch is that the bulk of the deal, the senior tranche, does not raise money. But in some countries, freeing up capital is more important to many banks than raising new cash. "German banks have more need for capital and risk relief than for funding," explains Torsten Althaus, who coordinates structured finance for Standard & Poor's in Frankfurt.

Importantly, synthetics have jump-started the securitization process. In Germany bankers estimate that synthetics have produced more than $10 billion in volume in the past year, versus roughly $5 billion in traditional deals. "Suddenly, the whole German market is appearing," Althaus says.

The dramatic growth has even raised the question of whether synthetics will soon eclipse the traditional market. Last year's 20 percent growth rate in the more typical transactions might have been higher if banks had not taken to synthetics so readily. "There hasn't been the growth that everyone had hoped for [in asset securitization], and that's largely due to the synthetic side," says William Young, head of European securitization at Schroder Salomon Smith Barney in London.

Still, most analysts and investment bankers don't think further synthetics growth will take a huge bite out of traditional securitization volume. Because synthetics don't provide much funding and don't reduce the balance sheet, many financial institutions would still prefer to use the older method.

Instead of competing, synthetics and traditional securitization could ultimately coexist to fit different needs. "Synthetics will always have a role to play, and securitization will always have a role to play," predicts Deutche Bank's Adler.

Limiting the growth prospects of synthetics still further are probable new capital requirements from the BIS. The proposed requirements, expected to take effect in about two years if approved, are likely to lower the amount of capital that banks must hold against their highest-quality loans. Thus banks will have less need for the capital relief that synthetics provide.

If the synthetics structure helps familiarize issuers with securitization while allowing European regulators and policymakers time to iron out the legalities, it will have more than served its purpose. A pan-European securitization framework, though the ideal solution, is not high on the European Union's list of priorities - other cross-border issues, such as taxation, are causing more controversy and have a greater effect on government revenues. And how quickly individual governments will resolve their issues is uncertain.

In the U.K., where securitization has become a healthy business, the bankruptcy system tends to give great power to creditors such as bondholders. "The U.K. is a very easy place to do business from a legal perspective," says Henry Cooke, co-head of securitization at Nomura.

Continental legal systems, by contrast, favor the issuing companies. "In Europe the priority is to keep a company running and to keep the employment," explains Alain Carron, S&P director of securitization in Paris. That makes securitization on the Continent inherently more difficult.

Every European country has either passed or is working on securitization laws, but even these are no cure-all. In November two serious legal obstacles arose. The Netherlands proposed a new tax on SPVs that inadvertently hurt the subordinate tranches of securitized deals. And in Italy a court reinterpreted the usury law in such a way that loans originated years ago in higher-interest-rate environments might be considered illegal. The Italian ruling, upheld on appeal, could mean that many mortgage loans, for instance, could not be packaged for securitization. Some existing deals would also be at risk if Italian borrowers file suit against their lenders.

Although the Dutch government scrapped its plans once it became aware of the problem, Italian financial institutions are waiting anxiously for some remedy from the government. "It's hard for investors to accept the fact that suddenly their investments could be in trouble because of regulatory and legal changes, as in Italy," Carron notes. "We need stability in the regulatory environment."

Ironically, with so many asset-rich banks, Germany has proved to be an especially tough environment for securitization. A new securitization law took effect in 1998, but off-balance-sheet treatment remains difficult in part because no uniform approach exists. Recently, the government began to discuss the taxation of SPVs. A regulation addressing the taxation issue is expected shortly.

Despite these setbacks, traditional securitization is being aided as laws change. In 1999, before the recent snafu, Italy's government passed a securitization law that led to a surprisingly quick flow of deals; the country was one of the most active in Europe last year. Spain, meanwhile, is hammering away at its laws to make securitization of nonmortgage assets more feasible. Portugal, already active in securitizing consumer loans, is revamping its mortgage laws to promote securitization in that area. And Greece made some legal changes last year.

The governments now have a selfish reason for getting their regulations right: They've become issuers themselves. Both Italy and Greece last year securitized government assets, including delinquent contributions to an Italian government insurance agency and future lottery receivables in Greece, to raise money off-balance-sheet. The transactions helped them stay within their debt limits under terms of the Maastricht Treaty. Of those governments' new role as issuers, Adler says, "We're pleased to see it."