German SME CLOs: the maturing of an asset class
This article provides a performance update on German SME CLOs and tries to answer the question whether German small-to medium-sized enterprise (SME) loans have become an accepted asset class.
Five years ago, KfW launched the PROMISE platform to facilitate the development of a (then virtually non-existent) liquid secondary market for SME credit risk in Germany. PROMISE was motivated by the insight that securitisation of SME loans would eventually lead to improved access to finance for SMEs. This was based on the facts that securitisation helps to ease the capital and funding constraints of their primary lenders, encourages banks to use standardised, more efficient origination and loan pricing processes, and – as ‘the gateway to capital markets’ – attracts new investors with previously limited exposure to SME risks.
A central theme revolving around KfW’s strategy was to establish German SME loans as an acknowledged asset class. We believe that the relatively small secondary market mainly resulted from the high degree of uncertainty associated with SME loans. In contrast to other assets such as prime mortgages or credit card receivables, where mature secondary markets exist, SME portfolios have some characteristics that make them more difficult to securitise.
SME loans are not homogeneous (very different sizes, legal forms, diverse collateral);
underwriting is often relationship-based and less standardised; and
long-time series data on loan performance and loss data are not easily accessible.
To overcome these obstacles it was important to make more information available to potential market participants. The rating agencies as well as investors must be able to assess the risks of SME loans, anticipate a stable performance and devote resources to research and monitoring.
Moreover, a continuous deal flow is important, because it helps to broaden the investor community and thus improve market liquidity. Over time it may also stimulate the securitisation of other sub asset classes such as SME mezzanine loans. Once investors are familiar with the specifics of SME securitisations, have built up corresponding research capabilities and have accumulated positive experiences with originators, they will be prepared to invest in more ’exotic’ assets.
Development of the German CLO market
There have been 28 public German SME CLOs to date, 25 of them currently outstanding (including 11 PROMISE deals by six different originators). Most of the transactions are synthetic partially-funded structures, and the total initial risk transfer amounts to approximately €39 billion.
Since the publication of the 2004 Guide we have seen six new transactions, three of them sponsored by KfW (Nationalbank’s Symvonie 2004, IKB’s SEAS 2005 and PROMISE-I-Mobility 2005) and two true-sale PREPS deals originated by the Capital Efficiency Group and Deutsche Bank´s GATE 2004.
GATE is noteworthy because its sole motivation is economic capital management. Therefore, the originator only transfers the unexpected losses of the portfolio, while retaining the expected losses (‘First Loss’) and the catastrophe risk (‘Super Senior’). The portfolio size for the transaction is €1 billion, while the amount of notes issued (a BBB and a BBB- tranche) was €30 million.
Deutsche Bank announced that it will bring similar transactions onto the market in 2005, and will regularly use securitisation as a risk management tool. This marks the beginning of an important trend. Other signs for the market’s positive development are the emerging securitisation of new sub asset classes (eg subordinated SME loans via PREPS) and the use of securitisation by smaller banks (in particular, Symvonie 2004).
We now also see the first originators actively originating SME portfolios with securitisation in mind (again PREPS, and more recently PROMISE-I-Mobility 2005). All these transactions pave the way for an ever closer link between the primary and secondary loan markets.
Difficult economic conditions for SMEs
Though economic conditions in Germany improved in 2004, the relatively optimistic expectations at the end of 2003 still had to be corrected. While the SME business cycle recovered from its low in 2002, the business climate and the order books have still not reached their long-term averages.
SMEs participated in the export-driven cyclical recovery, but to a much lesser extent than larger companies. While SMEs in the manufacturing and wholesale trade sectors benefited from the export push, the retail trade sector, construction industry and services sector are lagging behind. Most observers and SMEs themselves expect recovery to continue its moderate pace in 2005.
Corporate insolvencies remained at a high level, with more than 39,000 insolvencies for the third year in a row (insolvency rate: 1.34 per cent). Unsurprisingly, insolvencies are more severe in East Germany. However, the gap to West Germany is closing. While insolvency rates in West Germany reached a new all-time high of 1.25 per cent (up from 0.71 per cent in 1999), the rates in East Germany dropped to 1.85 per cent, marking a substantial decline from their 2002 record of 2.14 per cent to the lowest number in a long time.
The main problems for German SMEs are weak capitalisation and high dependence on domestic demand. Since equity ratios will only increase slowly over time and given the modest recovery. Most observers assume that corporate insolvencies will – at best – decrease slightly in 2005.
Rating stability and spread tightening
Notwithstanding the difficult business environment, most German SME CLOs have proven to be stable investments. So far, only two transactions (Promise-A 2000-1 and CAST 2000-2) experienced downgrades, while several deals were upgraded (eg the CORE deals and PROMISE K). The relative stability of the asset class is corroborated by the spread development (see figure 1).
After the spread widening in 2003, German SME CLOs recovered significantly in 2004. Obviously, the main reason for the spread tightening is the strong demand for ABS in general. Also, German SME CLOs are still trading at somewhat higher spreads than, eg their Spanish counterparts (probably reflecting an illiquidity premium for synthetic issues and perhaps the more negative perception of the German economy). However, the spread tightening also suggests that investors have more confidence in a favourable development of German SME transactions now than they had in the past.
Increasing defaults …
In a standard German SME CLO, a default occurs if the originator calls a credit event (generally stipulated as bankruptcy or failure to pay, though the latter may be defined differently across the transactions). Losses are allocated after the collateral is realised and recoveries are determined.
In line with insolvency rates, in 2004 cumulative defaults increased across all transactions. However, some transactions (in particular PROMISE-G 2001-1, PROMISE-K 2001-1 and PROMISE-C 2002-1) performed much better than others with cumulative defaults still below 25 bp several years after the closing of the transaction.
Other transactions (namely the PROMISE-I, PROMISE-A and CAST deals) reported much higher defaults up to 3 per cent of the original pool balance. However, even in those cases, their performance seems to be in line with expectations at closing (in general, the initial average pool rating was BB+ or BBB-). Moreover, so far all of these transactions to a certain extent benefit from low levels of replenishment and/ or high recoveries (see below).
A useful indicator of future pool performance is the actual rating distribution. Unsurprisingly in view of the sluggish performance of the German economy, the average credit quality in most portfolios has somewhat deteriorated. However, in general the concentration of weaker assets has increased only modestly.
A helpful analytic tool that was developed in 2004 is Fitch’s Performance Tracker. The Tracker evaluates the actual performance of a deal against expectations at closing (ratio of actual defaults compared against the rating agency’s default expectations based on portfolio quality). As long as the actual development is in line with expectations the transaction is healthy, because the subordination is sufficient to protect the noteholders (provided, of course, that the assumptions regarding recoveries also hold true). Based on the Tracker methodology most transactions perform within expectations and some remarkably better (in particular PROMISE-K 2001-1 and PROMISE-G 2001-1).
… but recovery rates remain high …
With default rates increasing and losses slowly starting to eat into the capital structure, recovery rates become more important. German SME CLOs usually refer to high portions of secured loans, and recoveries on SMEs are often higher than for larger companies, because banks are usually more selective in extending loans to SMEs and require more collateral.
Obviously, the Bankruptcy Code of a country will influence the recovery rates for secured loans.
In a recently published Report on Security and Insolvency in the German Leveraged Finance Market, Standard and Poor’s concludes that the German insolvency regime ranks between the secured creditor-friendly regimes of the UK and the Netherlands and the secured creditor-unfriendly regimes of France, Italy and Spain. In particular, in Germany, secured creditors can retain security over substantially all the assets of a company and enforce their rights within insolvency proceedings.
The study confirms that the workout process in Germany takes about 24 months on average. Information about recovery rates in German SME CLOs is still limited. However, some data is available for the more seasoned transactions. At the end of 2004, CAST 1999-1 and CAST 2000-2 reported average recovery rates of 66 per cent and 74 per cent respectively on liquidated claims. PROMISE I 2000-1 and PROMISE I 2002-1 reported their first small losses of 1 bp and 2 bp respectively in 2005. Before this they had completed the work process for 43 and 24 loans respectively without suffering losses. PROMISE-G 2001-1, PROMISE-K 2001-1 and PROMISE-A 2002-1 have also realised very small losses between 1 bp and 3 bp.
Nonetheless, to date only a rather small fraction of the defaulted loans have gone through the entire workout process, so the caveats mentioned in the 2004 Guide still apply. In particular, banks may tend to declare a workout completed when they have achieved substantial recoveries and report these figures, while they keep the procedure open for as long as recoveries are low. Consequently, the average recovery rate is likely to fall later in the deal life when the losses from low-recovery defaults are included in the reported numbers. This qualification notwithstanding, most transactions are highly collateralised, and so far there does not seem to be a significant decline in recovery rates.
… and de-leveraging provides additional comfort
Several transactions have de-leveraged substantially, in particular those that experienced higher defaults and consequently hit a suspension trigger (eg in PROMISE-A 2000-1 the outstanding volume is only about 50 per cent of the original balance, and the time call is in 2005). Some transactions are static and de-leveraged as expected.
Reducing the pool size relative to the outstanding notes provides senior noteholders with a higher relative loss protection. Fitch reports that in some cases they were assured that portfolios will remain de-leveraged and thus affirmed the ratings of those transactions.
Over the last few years, loans to the German Mittelstand have become more of an asset class and have attracted a number of new investors. Obviously, KfW´s efforts to support SME securitisations by establishing a recognised brand name and a standardised structure have been effective. As a recent study concluded: “Investors have become comfortable with the PROMISE brand and are therefore more willing to assume risk at competitive rates.”
A proven track record in terms of performance is the key to strengthening investor confidence and is a major factor for positive development of the asset class. Despite difficult economic conditions for German SMEs, up to now the overall performance of German SME CLOs is stable and in line with expectations. Recovery rates, in particular, still look good. Further taking into account that some portfolios have de-leveraged considerably, subordination levels seem sufficient in all transactions (obviously, this generalisation cannot replace a careful analysis of individual deals and their relative value).
Germany is now a leading market for SME securitisations in Europe. However, the market is still in its infancy. We estimate that at the end of 2004, only 2 or 3 per cent of the SME loans in German banks’ balance sheets had been securitised. At the same time, securitisation gains in importance as a risk management tool for banks. A deeper and broader secondary market for SME loans will make it easier for originators to use securitisation for capital management and funding, and will also help to improve SMEs’ access to financing.