The outlook for the securitization market in 2009 is bleak. Problems related to ABS are manifold and a recovery of the securitization market is not yet in sight. On the one hand, the future prospects of the securitization business highly depend on a stabilization of the financial industry overall. On the other hand, the credit cycle downturn will clearly test the solidity of European structured finance notes. Uncertainties related to ABS are high. An apparent example for the current market dislocation is the CLO sector - European leveraged loan CLOs are on the radar screens as undercollateralization is imminent.
The European ABS market has seized up. This is mainly due to three reasons: a) the fundamental deterioration of assets, originators and investors, b) the ongoing secondary market dislocation and persisting imbalance in terms of demand and supply, which is impacting spreads and c) uncertainty related to the rapidly changing rules of the ABS game.
Consequently, securitization prospects remain dim for 2009.
Currently, the securitization industry is undergoing significant changes, e.g. related to regulatory and accounting changes or with respect to the various stakeholders in the securitization market. For example, changes to the Basel II framework or the European Central Bank collateral framework, the introduction of public market support and/ or restriction schemes as well as the impairments and/ or related nationalization efforts of important players (Northern Rock/ Granite as the most popular example) are reshaping the securitization market. Uncertainty is also high in terms of adherence to call dates of the bonds outstanding. Moreover, rating agencies are changing their methodology inputs and modeling criteria has become much more conservative, which eventually influences rating performance and also questions rating reliability. The rating drift in European structured finance has become record negative: The number of downgrades of tranches and the negative watch status assigned by Standard & Poor's in 4Q08 included 3618 single actions, roughly five times higher than at the end of 2007.
Given the uncertainties with respect to the securitization market, the demand-supply imbalance still persists. While deleveraging continues, investors are solely concentrating on high-quality senior benchmark bonds and firm bids remain rare overall. Pricing assets especially for lower parts of the capital structure has become a tedious task. Projections for justified future ABS spread levels are only a best guess at present. ABS spreads have widened disproportionally, e.g. when compared to other credit instruments (e.g. covered bonds) or compared to the capital structures (triple-As) and various ABS asset classes (e.g. the prime RMBS Euroland universe). Current senior spread levels in high-quality assets are quoted in the 400 basis point area and volatility remains high as evidenced by the spread moves since the beginning of 2009. ABS spreads will definitely tighten in the long run. The initial tightening trend in January and February proves that spread widening throughout 2008 was exaggerated. Nevertheless, the path toward a sustainable spread stabilization will be characterized by many ups and downs. Furthermore, secondary spread gaps between various European ABS asset classes and jurisdictions are also expected to widen further. In the end, there will be no sustainable spread stabilization before the financial industry as a whole has managed to recover somewhat.
Current spread levels disqualified securitization as an efficient instrument for originators to refinance debt and the options to place securitized debt also remain limited. New asset classes such as government-guaranteed bank bonds are meeting investor demand and are crowding out ABS primary issuance activity. The primary market still remains closed and new transactions are 90% structured for originate-to-retain and repo purposes. This trend is expected to continue as the originate-to-distribute approach has failed.
Overall, the environment is highly vulnerable. A stabilization of the ABS sector is not in the cards yet. Therefore, investments in the ABS universe can only be recommended on a cherry-picking, deal-by-deal opportunity basis. While European structured finance paper outstanding is offering value (at least from a fundamental perspective) and the majority of the notes can withstand enormous fundamental credit stress, technical pressure on the market remains very high. Although the worst may already be behind us in the securitization universe in terms of bad surprises, the million dollar question in the foreseeable future is: How will the economic downturn and the subsequent structural changes in financial markets impact securitization? How effective is the structural support for the European notes and how sufficient is the level of credit enhancement across European capital structures? While the economic downturn has just started, the majority of European securitization exposure is put to the test for the first time ever. Fundamentally, the deterioration will continue during the next few months and will further drive write-downs on credit exposures and as such negatively impact the financial industry and credit spreads in return.
One apparent example for the prevailing adverse environment is the European leveraged loan CLO sector, where negative feedback mechanisms are evident. As fundamentals in the high-yield leveraged-loan universe are deteriorating, CLOs backed by leveraged loan pools are threatened by negative rating migration within the underlying portfolio. Thus, overcollateralization triggers are increasingly being tested. Mounting defaults and a higher portion of triple-C rated loans will lead to a switch to m-t-m evaluation which, in turn, will lead to a reallocation of cash flows. In a vicious cycle, under collateralization is imminent.
Default rates for high-yield leveraged loans (LevLoan) exposure are surging, while recovery assumptions are weakening. European speculative grade default rates are expected to reach 9-11% (S&P) and 12.5% (Moody's Investors Service) in 2009. Before the crisis, rates were 1.55% and 1.51%, respectively. Portfolio managers expect average high yield default rates of 10% up to 15%. Expectations regarding recoveries (which are typically higher than for senior unsecured bonds) have at the same time declined to an average of 57% and could fall to as low as 44%, according to S&P's Leveraged Commentary & Data. Implied secondary market expectations are even worse: Discounted spreads for first lien LevLoans stood at 1540 basis points in January. Assuming a worst-case default rate of 15% and a recovery of 44%, credit losses would total 840 basis points, leaving a gap of 700 basis points. Moreover, 21 companies requested covenant amendments in 2008 compared with only five in 2007. Thus, LevLoan-CLO related credit risk has taken off. This is especially true for lower-ranked bonds in the capital structure and aggressively structured deals from 2006 and 2007 vintages. The fundamental deterioration does also have direct structural implications. Cash flow CLOs can be negatively impacted by the breach of overcollateralization (OC) tests leading to a potential market evaluation of the respective underlying loan portfolios.
For leveraged loan CLOs an OC test applies to all notes outstanding (with specific limits in each class of notes). It compares the available cash and par value of the assets to the outstanding amount of notes. Assets are evaluated at net of eventual haircuts for m-t-m evaluated exposures and at net of defaulted exposures which have to be evaluated either m-t-m or at their recovery value. Before the crisis, m-t-m issues for cash LevLoan CLOs had been negligible: if assets were purchased above a specific discount level (usually 85%), they were booked at par value. However, in case of a higher purchasing discount, the value applied for cash CLO related OC tests will be the lower of the purchased price and the expected recovery value.
Most leveraged CLOs feature rating-related portfolio thresholds. Portfolio stakes rated triple-C or below are usually limited at 5% to 7.5% of the underlying pool. Any excess will also have to be marked to market (or at expected recovery value if lower). With deteriorating portfolio ratings due to weakening fundamentals, CLOs are increasingly in danger of breaching their OC tests. A breach of the OC test might prompt a partial or full cash flow (excess spread) reallocation e.g. from equity "noteholders" to senior debt repayments. Also junior note support may be triggered, according to documentation. This redistribution of cash flows can only be cured if OC test values return to compliant limits. Moreover, cash might be allocated to reinvestments in order to "cure" the OC trigger. But reinvestment opportunities are limited nowadays. LevLoan exposures to be newly included are predominantly trading below the original predefined (85%) discount limit; hence, such loans would have to be evaluated at market value. Also triple-C exposures are unlikely to increase in market value in the future. Consequently, undercollateralization has become an imminent danger for LevLoan CLO structures.
In our view, triple-A LevLoan CLO notes remain more or less safe in the current crisis scenario. But depending on the severity of a downturn, theoretically also OC tests related to senior LevLoan CLO notes might be threatened. In the end, any breach of a class A related OC test could trigger an event of default and a liquidation of the CLO. A vicious cycle is evident: The higher the pressure on the LevLoan market and the more LevLoan exposures turn into a workout problem for banks, the more adversely affected are Levloan CLOs, while at the same time financial institutions will suffer further credit losses.
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