Treasury Notes

 Examining Changes in Non-Residential Asset-Backed Securities Markets

By: Jake Liebschutz and Amyn Moolji
9/1/2016

This blog post is the sixth in a series on fixed income market dynamics by the Department of the Treasury to share our perspective on the available data, discuss key structural and cyclical trends, and reiterate our policy priorities. This post examines the non-residential asset-backed securities markets.

Vibrant, responsible securitization has constituted an important financing tool in the U.S. economy in recent decades.  In these asset-backed securities (“ABS”), a group of traditional credit instruments, such as consumer or business loans, are pooled together to create tradable securities.  While ABS represents just one of the many sources of credit for the economy, its role in expanding the availability of capital can have benefits for both businesses and consumers.  It can also benefit the financial system by diversifying the credit risk inherent in the underlying assets and enabling risk to be more efficiently allocated to capital providers. Unlike Treasuries, however, the ABS market is not one homogenous asset class. It encompasses securitization structures backed by a variety of asset classes, from consumer debt to commercial real estate mortgages.  During the financial crisis, after a period of abundant liquidity financed with high degrees of leverage, some ABS asset classes experienced stress, the most significant examples being in the private label mortgage market and asset-backed commercial paper. Key reforms have since been enacted to bolster the structure of securitizations and increase transparency. 

In this blog post, we focus on the non-residential ABS market, namely commercial mortgage-backed securities (“CMBS”), collateralized loan obligations (“CLO”) and consumer loan ABS (“Consumer ABS”).  These securities generally had more modest impairment during the credit crisis and continue to serve as an important financing tool for originators of consumer and business loans. While the data remains somewhat limited, we explore how this market has evolved in recent years, current issuance trends, and structural factors that bear continued monitoring.  Our focus as we evaluate this sector is on the stability of liquidity and market functioning, even when broader market conditions are stressed. 

Trends in Non-Residential ABS

Issuance in the non-residential ABS market, particularly CMBS and CLO, increased significantly in the years leading up to the financial crisis in 2008 – similar to the rise in residential mortgage securitizations.  In certain ABS markets, a lack of incentive alignment and information asymmetry contributed to loosening lending standards and the eventual stress that the market experienced.  Since the crisis, issuance of non-residential ABS has generally rebounded (Figure 1). Liquidity, however, continues to be a topic of concern for market participants. Underlying trends differ by asset class, with significant transitions occurring in certain market structures. Below we examine these recent trends, particularly in the CMBS and CLO markets, in greater detail.

Figure 1: Historical US Asset Back Securities Issuance (Source: Standard & Poor’s)

 

Commercial Mortgage-Backed Securities

​Private label CMBS issuance of $36 billion year to date is down approximately 45 percent from 2015, the post-crisis peak. In addition, both CMBS trade volume (Figure 2) and average trade size (Figure 3) have declined in recent years.

Figure 2: CMBS Trade Volume (Source: Federal Reserve, TRACE, J.P. Morgan)

 

Figure 3: CMBS Average Trade Size (Source: J.P. Morgan)


CMBS is just one of several funding vehicles for commercial real estate, and some have pointed to the relative attractiveness of other financing sources, in terms of certainty of execution and pricing irrespective of prevailing market conditions, as at least partially driving the decline in CMBS issuance. As Figure 4 shows, small and large domestic banks, international financial institutions, government agencies, insurance companies, and public market vehicles (included here in “other”) such as real estate investment trusts (REITs) have all stepped in as viable funding alternatives. 

Figure 4: US Commercial Mortgage Market (Source: Federal Reserve, Trepp,    Goldman Sachs)

 


The CMBS market is also undergoing transition as participants evaluate different structures to comply with the Dodd-Frank Act’s risk retention rule that goes into effect for non-residential ABS in December 2016. The risk retention rule is intended to align incentives between securitizers and investors by requiring that securitizers maintain “skin in the game.” The first conduit CMBS transaction compliant with the new risk retention rule closed in early August 2016 and generated significant investor interest, pricing at levels that were considerably tighter than that of other recently issued conduit deals. While the effect that the risk retention rule will have on the CMBS market remains unclear, some market participants suggested that investors were favorably inclined towards the transaction in part due to expectations of more prudent underwriting, as demonstrated by the lower loan-to-value level in the transaction, and greater liquidity support from the securitizer banks that are required, per the risk retention rule, to retain a 5-percent interest in the securitization until the loans backing the security are fully defeased.

Collateralized Loan Obligations

​While there was record CLO issuance in 2014 and 2015, issuance is down nearly 50 percent year to date to approximately $36 billion.  Anecdotal reports have pointed to a decline in CLO liquidity; however, traded volume relative to the size of the outstanding market (i.e. market turnover) has been relatively flat over recent years (Figure 5), and although average trade size has declined it has been offset by increased trade count (Figure 6).

Figure 5: US CLO Secondary Market Turnover (Source: Morgan Stanley, Intex, TRACE)    


Figure 6: US CLO Average Trade Size and Trade Count (Source: Morgan Stanley)



​The recent decline in CLO issuance appears to have been driven in part by lower merger and acquisition and leveraged buyout activity (Figure 7), which is a key source of leveraged loans that CLOs securitize.

Figure 7: LBO/M&A as Percentage of New Loans Launched (Source: S&P LCD,  Morgan Stanley)



​The CLO market is also preparing for the year-end deadline for new transactions to include the required 5 percent risk retention.  Compared to the CMBS market, implementation of the risk retention rules began earlier in the CLO space, with a number of compliant deals being completed over the past year (Figure 8). However, market participants remain focused on how the remainder of the market will implement risk retention going forward and this will warrant continued monitoring.

Figure 8: Risk Retention Compliant US Deals (Source: Citigroup, LCD, Creditflux, Bloomberg)    



Consumer ABS

​Issuance in Consumer ABS is down approximately 12 percent year to date to $133 billion, with reduced issuance across asset classes. Market participants have pointed to lower liquidity as a result of the decrease in primary dealer inventory and, as Figure 9 shows, trading volume in Consumer ABS has trended lower. However, as addressed in previous blog posts in this series, the relationship between inventories and liquidity is not straightforward.

Figure 9: Consumer ABS Monthly Trading Volume (Source: Bank of America Merrill Lynch, TRACE)


​Issuances in auto ABS, which was least affected by the financial crisis, and credit card ABS are each down nearly 12 percent year to date, while student loan ABS is lower by over 20 percent. ABS has become a less significant source of financing for student loans in particular over the past few years, given that the direct federal student loan program, which does not rely upon ABS financing, has become the largest issuer of new student loans. As Figure 10 shows however, overall access to credit for consumers remains relatively robust.

Figure 10: Non-Mortgage Consumer Debt Outstanding (Source: Morgan Stanley, Federal Reserve)



Looking Forward

The non-residential ABS sector is currently in a state of transition, particularly as it relates to the CMBS and CLO markets. As a result of the financial crisis, important reforms were put in place to address the shortcomings that plagued certain securitization structures. The reforms, including the Dodd-Frank Act’s risk retention rule and the SEC’s amendments to Regulation AB to increase disclosure and reporting requirements for ABS, were designed to facilitate securitization as a viable source of credit in the economy while increasing incentive alignment, allowing investors to better understand the underlying assets and risks inherent in securitizations and reducing risks to the financial system as a whole.

Some form of risk retention was already prevalent in certain non-mortgage asset classes prior to the crisis.  Securitizers’ retained stake in credit card securitizations and the retained subordinated securities held by issuers of auto ABS are two such examples. Due in part to these structural features, both of these asset classes generally proved more resilient to stress during the financial crisis.  

In advance of December’s effective date on the risk retention rule for non-residential ABS, securitizers have been experimenting with a number of different risk retention compliant transactions, which will be critical to the successful transition of the industry to the new regulatory framework.

Given the likely impact of these and other reforms, we and other interested parties will need time to assess any longer term effects on activity in these markets. As a general matter, however, efforts that promote the efficient and dependable allocation of economic resources and risk taking should be a positive for resilient and liquid markets. Initial evidence from the emerging risk retention transactions indicates that the reforms are a significant step in that direction.

Securitized products remain an integral part of the diverse financing channels available to American consumers and businesses. It will be important to continue to monitor the ongoing changes in underlying collateral and deal structures to better understand any emerging risks.

Jake Liebschutz is the Director of the Office of Capital Markets and Amyn Moolji is a senior policy advisor in the Office of Capital Markets at the U.S. Treasury Department.

Posted in:  Fixed Income
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