By Anthony Thompson, director of ABS research, Goldman, Sachs & Co.
As the second quarter draws to a close, the asset-backed securities market is experiencing its usual supply pressures; spreads across many sectors have softened. In the weeks ahead, investors will digest the latest FOMC meeting and form their spread product views for the second half of 1999. We thought now would be an appropriate time to answer a few questions we've recently been asked.
What effect will higher rates have on my ABS portfolio?
Higher interest rates have little to no relative impact on the majority of fixed-rate ABS. Unlike mortgage securities, which can be prone to extension risk, cards, autos, student loans, stranded costs, collateralized bond obligations, and collateralized loan obligations demonstrate virtually no correlation between average life and changes in interest rates. On the margin, securities with embedded early amortization features (such as credit cards) can actually benefit as rates rise because premium securities trade closer to or below par.
For those assets with higher loan balances and more refinancing opportunities, such as home equity loans, we think a higher rate environment will put some downward pressure on the level of prepayments. However, this will not be enough to ease the many servicing concerns that continue to challenge the sector.
There is one obvious strategy for those investors anticipating a higher rate environment for the remainder of the year: Buy floaters. While over the near term, spreads on LIBOR product will come under pressure along with fixed-rate spreads, floating-rate ABS offer an attractive opportunity to take advantage of rising short-term rates.
What should I be worried about on the credit front?
Collateral performance in the ABS sector has been mixed. By and large, consumer assets have stabilized. As shown in the table below, the trend for most credit card issuers has been positive over the past three years. Issuers can be commended for tightening underwriting standards and taking a more disciplined approach to lending after the excesses of the mid-1990s.
Congress is contemplating bankruptcy reform, which should also have a positive long-term effect on consumer portfolios. But in the short term this could push filings higher, as attorneys encourage borrowers to file before any new law is passed. There is no specific timing on when this legislation will be approved by both houses of Congress.
By contrast, the CBO/CLO sector has been dealt some unpleasant surprises on the asset quality front. While the vast majority of deals have performed as expected, a few isolated ones have left behind some unexpected watch listings and downgrades. Following the deterioration in emerging markets last summer, a drop in ratings on numerous emerging market CBOs was inevitable.
But the actions taken recently by Moody's Investors Service on the Excelsior and Triangle deals indicate that emerging markets aren't the only cause of asset quality problems. While subordinated holders have been the most affected, we expect investors even in the senior classes to place greater emphasis on disclosure in light of these developments.
How should I position myself with respect to the BIS proposal to lower risk weights on certain high quality ABS?
Take the longer view ... this isn't a monthly employment report. Currently, triple-A ABS supported by guaranteed student loans (e.g., Sallie Mae) are the only securities that qualify for a 20% risk-weighting when purchased by U.S. banks. All others are subject to the 100% weight. BIS is considering lowering risk-weights to 20% from 100% for all triple-A securities, and to 50% from 100% for single-A securities.
Less burdensome capital charges make ABS a relatively more attractive investment for banks (significant buyers of this product); we would therefore expect spreads to tighten if and when new rules become final. Yet over-weighting paper based only on this possibility could be a poor strategy over the short term. Regulatory changes come slowly and unpredictably.
The good news is that the Federal Reserve has been considering its own set of changes that would benefit bank investors in ABS. The bad news is that they have been considering this since 1994! While the regulators agree that some allowance should be made for these high quality assets, this involves ceding a fair amount of control to the rating agencies (which are essentially unregulated).
The best advice for investors is to realize that there is a pervasive view among the regulatory community to lower the weights for single-A and triple-A ABS. There are likely to be some changes, perhaps later this fall. But there is a high likelihood that this could be delayed into 2000.