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CMA
May 31, 2019  

EU-Compliant Deals May Be Flash in the Pan

Asset managers that oversee European capital were pleasantly surprised when two recent conduit deals were structured to comply with the European Union’s risk-retention rules — but they may not see many more.

While the compliance authorized a broader range of European investors to buy bonds from the two “BMARK” commercial MBS issues, that wasn’t the motivation. Rather, the goal was to enable Deutsche Bank’s securitization program to continue to contribute loans to conduit deals while an error in European risk rules was being corrected. With that mistake now well on the way to being fixed, Deutsche is no longer likely to have the incentive to take the extra steps necessary to make its conduit deals conform with the European rules.

That’s bad news for Europe’s version of mutual funds, dubbed UCITS (for “Undertakings for the Collective Investment of Transferable Securities”). Under a sweeping overhaul of Europe’s securitization rules that went into effect Jan. 1, UCITS can buy bonds only from transactions that are E.U. compliant. Those investors have been grumbling all year about being all but shut out of conduit deals and other securitized products in the U.S.

The E.U. risk-retention rules differ in many ways from the U.S. version. Most importantly, they require lenders to retain 5% risk exposure to securitizations themselves, eliminating the option to pass off that responsibility to third-party B-piece investors. And they prohibit a single lender from assuming the full 5% risk unless it contributes at least 50% of the collateral pool. Otherwise, each lender must retain risk in proportion to its own contribution. In the U.S., the threshold for one lender to assume all the risk is much lower. Also, the E.U. rules have different disclosure requirements than the U.S. regulations.

Conduit dealers for the most part have said they currently have no intention of incurring the cost and structuring restrictions necessary to make their deals E.U. compliant. That’s why it was a surprise to investors when Deutsche and partners Citigroup and J.P. Morgan floated the two compliant BMARK deals, in March (2019-B10) and last week (2019-B11). Unlike in the BMARK deals floated before this year, one or more of the three lenders assumed the risk-retention responsibility, instead of turning to third-party B-piece buyers.

By making the deals E.U. compliant, Deutsche was able to continue participating in the conduit market. The bank presumably made some concessions to Citi and J.P. Morgan to get them to go along. In the 2019-B11 deal, Deutsche purchased loans from its partners to reach the 50% collateral threshold necessary to solely retain 5% of the transaction. In other cases this year, Deutsche sold loans to other lenders before securitization to avoid participating in noncompliant deals.

“The partners are not doing Deutsche Bank any favors economically,” said one investor. “They are just figuring out the economics so everyone is net neutral.”

But overall, the prevailing combination of tight conduit supply and solid investor demand is mitigating the need for dealers to take steps to attract European investors. Should conditions change, the dealers said they would revisit the possibility of making deals E.U. compliant, but they don’t expect that to happen for the foreseeable future.

“It sounds like we’re out of luck,” said one U.S. asset manager of a UCITS fund when told that Deutsche’s incentive to float E.U.-complaint deals seems to be waning. “Unless CMBS volume picks up and [issuers] need the incremental buyer, I don’t see why they would go through the effort.”

Although UCITS are domiciled in Europe, many have traditionally invested in U.S. bond offerings, which can offer higher yields and more liquidity. In addition to CMBS, UCITS have targeted certain asset-backed securities and CLOs. But this year, managers of UCITS have had to settle for secondary-market trades or synthetic purchases via IHS Markit’s CMBX index — investments that weren’t affected by the Jan. 1 rule overhaul.

“You are basically shut down,” said another asset manager. “It’s a huge and very sensitive issue for us.”

A banker at one U.S. issuer said part of the problem has been major uncertainty about Europe’s rules, with the European Securities and Markets Authority and the European Commission working all year on revisions designed to head off one unintended consequence after another. One major outstanding issue is a requirement that issuers conform to a standardized format for reporting monthly deal data to investors. That standard format hasn’t been finalized, even though the requirement took effect on Jan. 1. And it will differ from the U.S. version. That’s a big negative for U.S. conduit issuers, because complying with E.U. rules would require them to abide by two separate sets of reporting standards.

While the BMARK deals are the only E.U.-compliant conduit transactions so far, dealers have structured 10 single-borrower transactions this year to be compliant, including some that don’t involve Deutsche. Those transactions are generally smaller than conduit offerings, and the dealers presumably targeted some of the bond distribution to funds that require E.U. compliance.

The error in E.U. risk-retention rules that has stymied Deutsche occurred in the overhaul that took effect on Jan. 1. The changes inadvertently eliminated an exemption that long allowed U.S. units of European banks to participate in U.S. deals if they conformed with local laws. That mistake potentially affected four banks in E.U. countries that contribute loans to conduit deals: Deutsche, Barclays, Natixis and Societe Generale.

The E.U. then advised regulators in its member countries that the exemption would be reinstated. That gave three of the banks the comfort to go ahead with business as usual, but Deutsche opted to follow the rules to the letter and wait for the official reinstatement.

Two weeks ago, the European Council quietly approved the exemption language. Next, that action has to be published in Europe’s version of the Federal Register, called the Official Journal of the European Union. It’s unclear how long that will take, but one source estimated the paperwork should be completed by September at the latest.