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Shaping the conversation on sustainability
While ESG integration has hit the mainstream across multiple asset classes, focus on ESG factors in asset-backed securities (ABS) has been more limited. In the latest ‘Spectrum’ report, Andrew Lennox, ABS Portfolio Manager at Hermes Investment Management, looks at how ESG factors can be considered within the ABS market. Building a framework for assessing ESG within ABS transactions is the next step for investors to incorporate these factors into their credit analysis.
Are ESG factors making a difference in ABS assets?
Considering ESG factors within asset-backed securities does not require an entire rethink of how to analyse ABS, although there are challenges that are unique to the asset class. Investors are analysing structures that hold pools of collateral – the underwriting, origination and servicing of those assets is key to the performance of the ABS securities. The structure of the securitisation vehicles also needs to be reviewed to ensure it will support the performance of the assets and aligns noteholders interests.
There is currently a lack of quantitative evidence of the benefit to financial performance from ESG factors in ABS products. On the environmental point, an analysis from Bank Underground – a blog run by Bank of England staff – provides early evidence that residential mortgages on energy-efficient properties display lower arrears than energy-inefficient properties. However, it remains difficult to determine whether those borrowers are just more conscientious or whether this outperformance can be attributed to energy efficiency.
Until enough data becomes available which clearly demonstrates that these borrowers have a lower risk profile over housing market cycles, lenders are likely to be slow to incentivise green property improvements through lower rates; rating agencies will be unable to re-calibrate their models for energy-efficient lending; and investors are unlikely to accept lower yields as a result.
Improved oversight and assessment of ESG factors across ABS requires:
While the issue of a lack of data may deter investors from really tackling ESG factors in ABS, the framework by which investors can assess a broader set of environmental, social and governance risks to ABS warrants further consideration.
Many of the elements that already form a part of the credit analysis of ABS deals can incorporate ESG factors, even where issuers and investors have not yet necessarily highlighted them as specifically ESG-related. ESG factors can be assessed when analysing the underlying assets backing securitisations, how those assets are serviced as well as the structures themselves.
Looking at the S & G factors in ABS
Whereas the application of the ‘E’ factor in ABS is evident in energy-efficient mortgages and the financing of alternative fuel autos it has not always been quite so obvious how social and governance factors can be applied to ABS transactions and structures. The special purpose vehicles (SPVs) that hold the assets and issue the bonds of a securitisation are not analogous to corporate entities – they do not have boards of directors with corporate strategies – and so give rise to differing governance challenges.
Governance factors: from origination to documentation
The structural features of transactions, as well as the type of risk mitigants and noteholder protections are crucial aspects for investors to consider in any deal. The devil is in the detail, and sometimes the pivotal features that make a structure strong or weak can be difficult to find in documentation. It is, therefore, essential that investors have enough time and analytical capacity to thoroughly review the offering circulars and other transaction documents that govern how a deal operates. The introduction of risk retention prompted originators to look more closely at how to ensure the sustainability of their loan products. However, there are still ways in which risk retention can be structured that move away from the spirit of what the regulation intended, so investors need to look carefully at the details of exactly how the risk retention has been structured.
Social factors: Lending to the real economy
When looking at the social aspect of securitisation, the vast majority of securitisation is backed by assets that are financing the “real economy” – products to help ordinary consumers finance their everyday lives. To consider social factors that investors can use in a meaningful way, it is necessary to differentiate between the originators and the individual credit merits of individual transactions. It’s not enough to recognise that lending to consumers has a social aspect to it: the quality of the underlying lending also has to be considered.
It is vital to consider the sustainability of the lending – assessing whether borrowers can afford to pay, not only in the current environment, but in other economic conditions, including stressed scenarios – when we’re analysing the risks inherent in lending to consumers. As we saw through the pre-crisis sub-prime mortgage market, not enough consideration was given to the implications of what would happen to those borrowers who couldn’t refinance when their rates had reset in a housing market that had cooled and where valuations were under pressure.
Balancing social and financial interests
There is an obvious financial impact when borrowers go delinquent or default on their mortgages or loans, but social and governance factors come into play in the way that the lender deals with those borrowers. As investors, it is our responsibility to analyse the arrears, the collection, the debt management and the forbearance policies of those lenders as well as the recovery processes they use. There is a social imperative to allow a borrower to remain in their home or to continue to use their car (which they may need to get to work), even when they have ceased to service their debts on those assets. However, this also has to be balanced against what is financially prudent and what makes sense for the lender’s position in recouping the money they have lent.
While the application of ESG analysis to ABS has not developed as much as it has for other asset classes, there are plenty of potential ways for ESG analysis to be used when looking at securitisation which investors can consider. As we have highlighted, many of the elements that are already part of the credit analysis of ABS deals can incorporate ESG factors. We can draw out ESG factors when analysing the underlying assets backing securitisations or when we look at how these assets are serviced.
Building a framework for assessing ESG within ABS transactions is the next step for investors to incorporate these factors into their credit analysis. Increased data collection as well as quantifiable proof that deals with better ESG scores lead to better financial performance will ultimately encourage the expansion of ESG products and ESG investing in the asset class too.
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