Post-crisis, regulators of the insurance sector have taken a dim view of commercial mortgage-backed securities.
The European CMBS market has experienced a faltering recovery this decade, although Bank of America Merrill Lynch’s £347.9 million (€389.3 million) UK last-mile logistics CMBS last November demonstrated that there is investor demand.
However, many argue that penal capital charges on insurers’ CMBS holdings under the European Union’s Solvency II regulation, since 2009, has impeded the sector’s potential.
“Solvency II doesn’t make it easy on insurers, who are natural investors for high-grade investment product,” says Clive Bull, a director within Deutsche Bank’s CRE finance team.
“But, like every other investor, insurers are faced with a shortage of product so even if they are penalised in terms of capital treatment, they are still desperate for product.”
A tabled review of Solvency II has raised hopes that the treatment of CMBS will be re-evaluated. Before the end of 2018, the European Commission is conducting a review of the methods used when calculating solvency capital requirements with the so-called standard formula.
Some in the industry feel it is overdue. Most major UK insurance companies have had their internal models for calculating capital charges approved by the Bank of England, meaning they are likely to be subject to significantly lower capital requirements for CMBS bonds.
However, for most European insurers, capital charges are more onerous. They must hold capital of 12.5 percent per year against five-year, AAA-rated CMBS bonds totalling 62.5 percent over the life of the notes versus 25 percent for owning direct property. Regulation has contributed to European insurers gearing themselves towards the direct loan market, originating debt or investing in debt funds, attached to which is a much lower capital cost.
“For a small and specialised asset class like CMBS, it’s vital to be able to access the large, natural pool of investment capital that continental European insurers represent,” argues Peter Cosmetatos, chief executive of the Commercial Real Estate Finance Council Europe.
“[Regulators] decided in a knee-jerk way after the crisis that securitisation is bad,” continues Cosmetatos. “The starting point was thinking that we need to stamp out this terrible outgrowth of the financial sector that used complicated products suffering from misaligned interests and informational asymmetries by going back to good old-fashioned bank lending supported by a covered bond market.”
Cosmetatos argues that securitisation took the flak for wider failings in the financial world. “The broader structured finance industry wanted to show regulators that at least parts of the market need to be protected. That could only be done by throwing other parts of the market under the bus,” he adds.
Efforts to add nuance to the treatment of securitisations have not benefitted CMBS to date. Alongside collateralised loan obligations, CMBS is designated a ‘type 2’ securitisation and is subject to higher capital ratios than most asset-backed securities in the ‘type 1’ bracket.
Also, CMBS looks likely to be excluded from what will be labelled ‘simple, transparent and standardised’ (STS) securitisation. STS requires, for instance, no borrower to account for more than one percent of loans underpinning a securitisation, which is not a likely scenario in CMBS deals.
CALL FOR CHANGE
CREFC Europe has long campaigned for lower capital charges and has made a new submission to the European Commission. For the first time, it has been able to present quantitative analysis to support its long-held view that current capital charges are unjustified.
CMBS may have performed less well than other ABS asset classes but numerical analysis by Bank of America Merrill Lynch shows that the losses suffered by CMBS investors have not been as high as first thought.
BAML’s analysis looks at all CMBS to have been issued in Europe, the level of losses from triple AAA notes, and volatility during that 22-year period. It found the level of losses suffered by AAA CMBS to date have been just 0.3 percent of aggregate AAA issuance.
The main focus of the standard formula under Solvency II is not credit risk but price volatility, on the assumption that an insurer may be forced to sell at the worst time. Yet BAML’s analysis shows that the volatility of CMBS pricing is comparable with that of REIT bonds and corporate bonds in general. In a structured finance note last September, BAML proposed CMBS issuance by corporates be granted the same regulatory treatment as corporate bonds.
Based on informal dialogue with the European Commission, Cosmetatos notes “a growing recognition of the problems with the treatment of CMBS under the Solvency II standard formula, and a technical, if not political, willingness to explore possible solutions.
“There are a number of components we need policymakers to understand before we get them to turn their oil tanker. It’s a long, hard slog. The chances of getting real movement in our favour are very slim as part of the current review, but we are slowly making headway,” he says.
Investors remain pragmatic about the industry’s prospects. Speaking in December, Patrick Janssen, an ABS fund manager at M&G, told Real Estate Capital: “We’ve learnt to accept you’re not going to see much out of Europe. Capital charges and definitions of which type of deals warrant favourable capital treatment are all over the place; unless we see standardisation, there won’t be a big ABS market. CMBS will remain a small, bespoke market for years to come.”
Of more immediate concern for investors would be the impact of spreads tightening if CMBS issuance volumes were to rise. “There is enough capital in the institutional investor base at the moment but if spreads tightened further in the bank lending market and the CMBS market tried to follow suit, would they still be buyers, with the return on regulatory capital getting lower and lower?” asks Bull.