PART I: ABS market suffers a record number of downgrades in 2001
There is an old saying in the asset-backed securities market that was once a rallying cry but has recently become more of a haunting mantra: "Good assets in good times fare well."
Needless to say, there is very little of either commodity to go around these days, and that bittersweet motto begs the question of how ABS market participants will hang on during what looks to be the roughest ride in the market's history.
As consumer credit continues to deteriorate and unemployment spikes to alarming levels in the midst of recession and the events of September, the 16-year-old asset-backed sector - for the first time as a mature, diverse and large capital market, reaching a record-breaking supply of $350 billion in 2001 - has been swiftly kicked out of its comfort zone.
More than any other fixed-income sector, ABS is extremely vulnerable right now; perhaps no other area of the bond market is as directly linked to the consumer's ability to repay his or her debts as the securitization universe. Indeed, with mortgage-related loans, auto loans and credit card debt collateralizing most of these securities, the viability of a large portion of ABS hinges on the health of consumer credit and confidence.
"I don't even think we've seen the worst of it yet," says Thomas Sontag, an ABS investor at Strong Capital Management, which manages more than $1.5 billion of asset-backed securities.
Indeed, consumer credit problems are only half of the dilemma. No structured finance cash flow model or stress test could have adequately predicted the terrorist attacks and their repercussions on several sectors of the ABS market or how that would affect timely payments to investors. Nonetheless, analysts are confounded because, for all intents and purposes, their models - which the entire securitization market relies upon and nearly swears by - flat-out failed.
Add to this the record number of corporate defaults in 2001, which pummeled collateralized debt obligation (CDO) and ABS-related credit derivative structures, and the Enron scandal, which reflected badly on all off-balance-sheet endeavors, and you have a recipe for disaster.
Yet, most ABS players are not panicking yet. After all, most of the largely triple-A-rated asset-backed market weathered the storm of 2001 quite well. In large part, that's because asset-backeds have always been known to be staunchly protected by their structure and by guarantees. But there is no doubt that the current negative credit environment, which is expected to extend well into 2002, is of particular concern for the subprime, non-performing, manufactured housing and non-investment-grade areas of asset-backeds, as well as for the beleaguered aircraft, rental-car and other travel-related asset classes, which were walloped by the terrorist attacks.
The numbers exemplifying the new rough environment speak for themselves. According to a study released last month by Standard & Poor's Corp., annual downgrades of ABS credit ratings proliferated to a record high last year and significantly outnumbered upgrades. Even more disturbing, 2001's downgrades were unique in that, for the first time ever, they were triggered primarily by the poor credit performance of the underlying collateral. According to the S&P ABS surveillance group, a record-breaking 111 downgrades occurred during the fourth quarter 2001 alone, across 69 ABS transactions. Further, the group lowered 247 ABS ratings for the entire year-a 31% increase from 2000, and a record number in comparison with any previous year.
The result of this new reality for ABS, unfortunately, is that many investors who previously diversified their portfolios with the bottom tranches of deals or non-prime paper have recently shunned non-investment-grade and so-called "off-the-run" ABS amid fear of unemployment rising even further.
The pain is just beginning. "There has been no significant deleveraging of consumer balance sheets yet," says Strong Capital's Sontag. "I think that if there is a day of reckoning for ABS, it is coming in the future, as unemployment creeps higher. The biggest factor is how high it will manage to go. I have been avoiding subordinated consumer credit-related ABS. At this point in time, I think the risk is kind of one-way; it doesn't seem you're being compensated for the risk of the unknown."
The seeds of this risk can be traced to consumers' behavior over the last few years. As consumers' access to credit ballooned in the late nineties, subprime lending increased and borrowers with less-than-pristine credit were given loans, which were then securitized. Now that the economy has hit a wall, statistics on the delinquency and default behavior of these borrowers and their loans during a recessionary environment are sketchy at best.
"Borrowers that might not have had credit ten years ago have it today," says Anthony Thompson, ABS and CDO researcher at Deutsche Bank. "These borrowers and the models that underwrote these borrowers are not really what we would call recession-tested' at this point. Their performance may be different from what the rating agencies expected, especially for portfolios that are skewed to subprime. Non-prime ABS might have been a product that generated attractive margins, but it is unpredictable when the economy softens."
Different this time
If you ask ABS pros who have been involved in the market since its inception, however, they are quick to point out that the sector has survived a recession before, in 1990-91, among other downturns.
In fact, the ABS market fared worse ten years ago, and the recession was deeper, at least in terms of downgrade-upgrade ratios: out of 366 ABS credit classes outstanding at the beginning of the 1990-91 recession, there were 35 downgrades and two upgrades-a more than 15-fold ratio, according to S&P. In 2001, out of 3,600 credit classes outstanding (a much larger market), there were only 247 downgrades and 75 upgrades, a considerably smaller ratio. At first blush, at least, it appears that ABS has survived difficult economic environments before.
But the picture is more complicated than that. During the last recession, the underwriting of consumer credit-related sectors was more "one size fits all," says Deutsche's Thompson. Besides a few exceptions, most lenders viewed the consumer as one animal and priced their deals accordingly; there was not as much fine-tuning of subprime' vs. prime.' As a result, the performance of most portfolios was relatively similar in 1990, and there was not as pronounced a difference between one issuer and another, and therefore not as much tiering among issuers as there is now. "For off-the-run, non-prime names, even two or three years ago, there was a differentiation in prices," says Scott Davidson, the co-head of North American ABS at J.P. Morgan. "But now investors may say I'll buy it or I won't.' Another 25 or 30 basis points may not get some investors comfortable with a real concern about an issuer."
Even more important is the fact that the ABS market has grown by leaps and bounds over the last 10 years, and a good portion of that growth was in subprime mortgage, subprime auto loans and manufactured housing loans. "The ABS sector hasn't been tested with a deep downturn," adds Andy Dym, also an ABS co-head at J.P. Morgan. "We haven't had a recession in over 10 years, and now our market is bigger, with more players. On the non-prime side, consumer credit may get worse before it gets better. So people are interested to see how the market reacts."
Other market participants agree. "The market has grown considerably, both in variety of underlying assets and sophistication in cash flow structures," adds Joseph Hu, an ABS analyst at S&P. "The test of ABS rating stability therefore goes far beyond simply the downgrade-upgrade ratio. The development of non-prime ABS during the nineties meant that these loans were going to people with poor or less-perfect credit scores."
And how did that happen? The rise in consumer activity during the last few booming years of the nineties may be to blame. While consumers all but dominated the expansion of the U.S. economy during this time - racking up a record amount of indebtedness during a record-long economic expansion - the ABS market waited in the wings to reap the benefits. It extended itself into riskier consumer-related collateral, and expanded as a result. Lenders devoted their systems and technology to the targeting of a wider variety of customers, and capital became extremely easy for consumers to get. Subprime lending took off, and loans were made to people with poor or spotty credit profiles.
Those loans, in turn, were securitized and the ABS market grew with year-over-year record-breaking supply and a deepening interest on the part of bankers to get involved in riskier, off-the-run asset classes. The ability of the consumer to rack up debt and live beyond his means, it would seem, fueled big profits for securitizers and dealers. Everything looked rosy.
But the honeymoon is long over. The majority of the specialized, stand-alone finance companies offering such loans have either dissolved or fallen by the wayside; underwriting standards, particularly for subprime home-equity loans, have become stricter. The ABS market's extension into non-prime territory developed hand-in-hand with the nearly out-of-control access that consumers had to credit during this time. However, that era has been over for more than a year.
The subprime and non-investment-grade bonds - which had been of particular interest to investors in recent years because they are used as collateral for CDOs - are still out in the market in a fairly sizeable quantity. "For speculative-grade securities, like double-B's or single-B's, the performance of the underlying assets is heavily influenced by the unemployment rate, which is a lagging indicator," notes S&P's Hu. "So it is reasonable to expect that downgrades in ABS will continue."
This is especially true if the unemployment rate keeps on going up, and some ABS participants fear the worst. In the opinion of Dan Castro, the head of ABS research at Merrill Lynch & Co., the unemployment rate, which bottomed at 3.9% in Oct. 2000 and is now at nearly 6%, may get as high as 7%. According to Castro, for every 1.1% rise in unemployment, there is a 2% increase in credit card defaults. Despite the more-than-adequate cushioning provided by excess spread, which is the difference between the cost of funding and the yield on a loan portfolio, the economic downturn has significantly increased both delinquencies and charge-offs of bank credit cards for most of 2001.
For instance, in December, Moody's Investors Service found that delinquencies for securitized pools of U.S. credit card loans rose to their highest level in over three years. In the Credit Card Index report for October 2001, the analysts also found that more account balances were written off as uncollectible.
Similarly, despite the fact that stresses are still nowhere near worst-case scenarios, even prime auto loans are beginning to exhibit negative trends. Net-loss rates in securitized pools of U.S. prime auto loans rose in the first nine months of 2001 versus year-ago levels, according to Moody's. This was due primarily to a surge in personal bankruptcy filings in 2001. "Rising unemployment rates may lead to further negative trends in loss rates in 2002," says Kumar Kanthan, a senior vp at Moody's.
While the home-equity loan sector has held up quite well during this recession so far, Merrill's Castro warns that a rise in the unemployment rate can change that. "If we go from a rate of 3.9% in Oct. 2000 up to a possible 7%, the default rate on home-equity loans would rise between 80% and 100%," Castro says. "Still, with the excess servicing, the triple-A classes would be okay, but the triple-B's would have a problem. They would come under rating pressure and maybe even downgraded."
No asset class is more at risk than manufactured housing loans. Even prior to the current recession, the sector took a drubbing, with 90 downgrades in 2000. There were another 16 downgrades in 2001, and at the tail end of 2001, issuer GreenPoint Financial Corp. announced that it was leaving the already shrinking manufactured lending business. In September 2001, Bombardier Inc. exited the sector as well. In January 2002, the president of one of the last national players left, Conseco Finance, resigned only one month after several of the company's bonds were downgraded to CCC by Fitch Inc.
Analysts predict that rising unemployment may damage the sector even more. Given that borrowers for manufactured homes tend to have lower incomes, the flailing economy is sure to impact them hardest. "Manufactured housing is not well positioned for a recession," says Chris Flanagan, the head of ABS research at J.P. Morgan. "And that won't turn around until defaults decrease."
Please see next week's ASR for "A Rough Ride: Part II", which covers the trend of tiering in the market and the effect of the economy on the ability to carry out inventive or marginal deals in 2002.