The African

Securitisation is booming in South Africa, with issuance reaching record levels in 2006 and further growth expected this year. But there are signs that the local market may be reaching saturation point. Mark Pengelly reports

Securitisation in South Africa has come so far in such a small time that it has left many in the market wondering where it can go next. Until recently, the practice was not widespread: just five years ago, transactions were sparse and regulatory ambiguity clouded the status of special-purpose vehicles (SPVs) set up to facilitate securitisation deals.

Ever since the country's authorities made clear these SPVs would not be regulated as banks under reforms made to the Banks Act in 2001, securitisation issuance has climbed. According to a report by Moody's Investors Service published in January, issuance reached R31.7 billion ($4.4 billion) in 2006, 44% up on 2005 and more than 25 times the level of 2001. While changes in the regulatory environment are partly responsible, there are other structural reasons for the rise. Decreased government bond issuance has left the country's well-developed investor base looking for alternatives. South Africa's post-apartheid government is also now beginning to reach its ambitious economic growth targets - real GDP growth has nudged 5% over the past two years. This is fuelling the rise of an emergent black middle class in the country, a phenomenon that is also evidenced by rising consumer spending and retail lending.

"Retail assets on bank balance sheets have grown, retail portfolios have grown significantly, and securitisation has provided another source of funding those," says Richard Hayne, head of securitisation at Nedbank in Johannesburg.

The supply-driven nature of the market is underlined by the dominance of certain asset classes. New middle classes need homes, cars and consumer goods - and this explains why residential mortgage-backed securities (RMBSs) accounted for EUR13.4 billion, or 42%, of issuance in 2006. Meanwhile, asset-backed securities (ABSs), backed mostly by vehicle loans and store card receivables, made up another R14.3 billion (45%), according to Moody's.

Securitised notes have been snapped up by asset managers, pension funds and, in the past three years, South Africa's asset-backed commercial paper (ABCP) conduits. These vehicles have been buying up securitised notes and issuing ABCP of up to 90 days' maturity - effectively enabling shorter-term investors to put money in long-term assets. They have proved particularly effective in South Africa, due to the relatively weighty proportion of investment in money-market funds.

"Those conduits require large scale to become economical, and we've seen a number of them bulking up," says Nick Job, head of securitisation at Investec in Johannesburg.

This strong investor interest has had a dramatic effect on prices across all classes of securitised paper. Spreads on AAA rated tranches of five-year RMBSs have fallen from around 60 basis points over the Johannesburg interbank agreed rate in 2002 to 30bp by early 2006. However, spreads widened in the latter half of 2006, with five-year AAA rated RMBSs reaching around 40bp by the end of last year. Job attributes this, in part, to a drop-off in ABCP conduit demand - a result of many vehicles reaching sufficient economies of scale. The largest, sponsored by FirstRand Bank, issued more than R12 billion of ABCP in 2006.

In fact, bankers are beginning to question the ability of local investors to swallow greater and greater volumes of securitised notes. Megan McDonald, director of securitisation at Standard Bank, believes market capacity is certainly an issue: "We had a little bit of uncertainty in terms of the interest rate and inflation outlook in the middle of last year, and we also got to the stage where the market had really achieved critical mass."

It is this kind of sentiment that has left all South Africa's major banks considering placing securitisation deals offshore. The first international transaction was by FirstRand Bank in November 2006. Called Nitro International Securitisation Company 1, the EUR200 million transaction was a single tranche of floating-rate ABS notes, repackaged from an earlier auto loan deal. The notes achieved an Aaa rating from Moody's.

While international transactions such as these are largely free from investor capacity constraints, they bring other problems of their own. Boshoff Grobler, senior transactor at Rand Merchant Bank, a division of FirstRand Bank, explains that investment-grade European investors are often unwilling to take currency risk on the South African rand: "The market for South African risk offshore is quite bifurcated, so for the guys taking the pieces lower down the capital structure, it's a currency trade as well. At the higher end, they want the risk in euros."

To avoid complications and obtain an investment-grade rating for Nitro, FirstRand entered into a currency swap with counterparty Morgan Stanley. At the close of the deal, the bank paid Morgan Stanley EUR200 million, which the counterparty returned to the bank in rand as principal. Similarly, rand coupon payments on the underlying notes are routed through Morgan Stanley and paid to investors in euros, hedging the transaction against both interest rate and currency risk. In the event a moratorium is placed on rand assets leaving South Africa, coupon and principal payments will be transferred between the counterparties within the country and Morgan Stanley will pay European noteholders' coupon and principal.

The currency swap embedded in the deal was instrumental in the notes achieving an Aaa rating from Moody's. However, a lack of agreement among rating agencies meant the European repack did not score universally highly - it was awarded just an A rating by Standard & Poor's (S&P). Bankers say the methodologies of both S&P and Fitch make it near-impossible for South African transactions to obtain an AAA rating. Chris Such, an S&P analyst who rated Nitro, says there was insufficient credit enhancement on the underlying transaction to achieve a rating above A. "If the credit enhancement had been higher on the underlying deal, it would have been down to the sovereign issues, which would have constrained the deal to around the AA level," he explains.

Standard Bank is among those looking to follow the trail blazed by Nitro, with Blue Granite International ABS. The single-tranche EUR250 million deal, the first South African international RMBS transaction, is a repack of another R2.2 billion local RMBS issue. Like Nitro, it too will involve a currency swap agreement, with Royal Bank of Scotland. The notes have been granted an AA- preliminary rating from S&P.

McDonald is eager to target mainstream European ABS investors. However, Rand Merchant Bank's Grobler says international investors are often uncertain whether to place South African debt under an emerging markets category or a pure international securitisation category. This dilemma, he believes, may have prevented fixed-income investors unfamiliar with South Africa from investing in Nitro - despite its Aaa rating from Moody's.

As such, education may be key to attracting more offshore investors - and that's something McDonald intends to focus on when marketing the Blue Granite International deal. "It's a question of educating and informing European investors about South Africa, about the economy and about how mortgages work here. It's a new asset class for them, so there's probably a lot more work involved than if we were to market to South African investors," she says.

Should offshore issuance ultimately prove fruitful for South African issuers, exponential growth in retail loan books will see ABS and RMBS transactions continue to dominate the market in 2007. But commercial mortgage-backed securities (CMBSs), which Moody's says accounted for R4 billion (13%) of issuance in 2006, are also likely to grow. The market for CMBSs was first tapped in South Africa in 2003, and so far all transactions have been originated by commercial property companies. However, Investec's Job says his bank will launch the first multi-borrower transaction soon. Private Commercial Mortgages is expected to be a R1.6 billion securitisation of loans secured mostly on South African shopping malls and office buildings. It will form part of a R10 billion programme of CMBS issues by the bank, and Job believes more deals may follow from other arrangers as well. "We're certainly aware of other banks that are thinking along the same lines as we are at the moment," he says.

With further issuance expected both onshore and offshore, there is little doubt the South African market as a whole will continue to grow in 2007. Job cites a recent survey that estimated Investec has securitised around 10% of its securitisable assets, while some of the country's larger banks have securitised as little as 1-3% of their total securitisable assets: "What that means is there are potentially another 98% of securitisable assets out there," he remarks.

Basel II will also add impetus for banks to remove some assets from their balance sheets. The revised capital framework, due for full implementation in South Africa in January 2008, will impose less favourable regulatory capital requirements on some types of consumer borrowing. The same will apply to the equity tranches of large securitisation programmes, which South African banks have so far tended to retain. Local investors, however, are not known to be big takers of risk at the bottom end of the capital structure - possibly exacerbating any domestic capacity problem.

There is debate, though, about what the effect of other new regulations might be on the underlying market. The final stage of South Africa's National Credit Act will be introduced in June 2007, and aims to offer greater protection for the country's growing community of borrowers. For banks, it means foreclosures on loans may be delayed while borrowers seek debt counselling. If they are thought to have engaged in irresponsible lending, authorities will have the power to suspend, rearrange or even annul credit agreements. Depending on the way this legislation is implemented and how banks react to it, delinquencies or even losses might increase. However, Reynold Leegerstee, general manager at Moody's in Johannesburg, points out it might also lead banks to tighten their underwriting standards: "At this stage, it's too early to see which one will outweigh which."

This suggests there will be changes, as well as growth, for South African securitisation in the year ahead. But McDonald of Standard Bank thinks it is now poised at an interesting stage: "We've got a mature, sophisticated market but we're also now experiencing some of the issues that come with being a sophisticated market."