With the safe harbor from the Federal Deposit Insurance Corp. (FDIC) and Term ABS Loan Facility (TALF) in place until March, there are near-term positive expectations for the ABS market going into the New Year, market sources said.
"For the first quarter, there's still new issuance guaranteed under TALF, spreads remain tight and there's good opportunity out there particularly with investors a lot more comfortable with transaction fundamentals," said Douglas Long, executive vice president for business strategy at Principia Partners. He added that new-issue offerings without leverage are also coming in at really good pricing.
However, Long said that there is unease in the regulatory accounting changes that are expected to bring up the cost of doing a securitization for issuers, making the market for ABS more challenging. "The sooner we get this sorted out, the better it is for the market," he said.
"I partially think that the financial markets are going to work with the regulations - in line with what the new world is laying out," he said. But the key thing, he said, is people's view on the overall economy, which he expects to get reasonably worse before it gets better. He added that these expectations are included in the rating agencies' triple- A assumptions. "The agencies are assuming the worst-case scenario and therefore have a degree of conservatism in their view of the overall performance of transactions," Long said.
"TALF proved very successful in the consumer loan market - we need to preserve what we've seen for the last three to six months," Long added. There's a good amount of TALF-eligible collateral, Long said, that is being picked up by the market. "How much that will continue depends on whether TALF is extended." However, aside from the scheduled removal of TALF, there is the accounting treatment of securitization that the ABS market has to deal with. "There's the fundamental problem of capital and how loans are getting their funding."
Because of TALF, Long said there are more products that are leveraged, the impact of which is not only for triple-A tranches but for mezzanine and subordinated tranches as well. "When TALF finishes, the great thing about it is it gives a lot of leverage - you still have good return on investment in the triple-As, which will widen from where they are now. However, investors won't get the same return, and those who are looking for yield will need to move down the capital structure," Long explained.
Additionally, the mezz and subordinated tranches have been conservatively underwritten given the negative events that have occurred over the past two years. The rating agencies' stress tests and the very low rate environment over the last year and a half have also affected valuations on these tranches.
Michael Wade, managing director and head of asset securitization for the Americas at Barclays Capital, pointed to Treasury Secretary Timothy Geithner's recent letter to Congress that hinted strongly about the possibility of extending TALF.
"There are pros and cons to extending TALF," he said. "Some asset classes would likely be able to stand on their own without TALF. Most notably, prime auto loan and credit card ABS have been pricing near or through the 100-basis-point cost of the TALF loan, and these asset classes need TALF the least. However, even for auto and card ABS, if TALF were not extended there could be a spillover effect in terms of wider secondary spreads."
Christopher O'Connell, senior vice president at DBRS, said that taking TALF away would be a mistake based on three main reasons: the lack of stability in the mortgage market, the absence of a consistent subordinated market and market volatility.
O'Connell said that for frequent issuers such as Nissan Motor Corp. or Honda Motor Co., TALF is not as necessary, but other companies might not fit into the common pricing floor without TALF around.
"The reasons TALF is going away as of March 2010 is the presence of cash buyers and good spreads," he said. However, he cited the volatility in the market present before November 2008 to illustrate the need for the government program.
The pricing floor that TALF provides has been beneficial to non-TALF deals as well. O'Connell cited the three subprime deals that were sold without TALF this year, with the subordinated pieces sold as well. DBRS rated two of these transactions, which were from issuers Credit Acceptance Corp. and DriveTime Automotive Group. "The big story was that these deals priced nicely and the sub buyers bought the subordinate notes offered," he said, adding that these speak well of auto paper, auto investors and auto performance.
Indeed, there was some ABS activity outside TALF, but market players said that the program still had a lot to do with the success of such offerings.
"From a distance, there are large portions of the market that are selling their bonds outside TALF," said Stuart Litwin, co-head of the structured finance practice at Mayer Brown. "This might mean, at least on the surface, that the market can function without TALF."
However, beneath the surface, once TALF goes away, it could be like pulling the rug out from under the market. "What I'm trying to say is there have been non-TALF deals because spreads have tightened," Litwin said. "Part of the reason spreads have come in was that TALF was there."
For instance, he said that if there were two auto deals that had very similar credit profiles - one TALF-eligible and the other not - the TALF-eligible deal would likely price at a tighter spread. "But the other non-TALF deal also would benefit from the general tightening of spreads," Litwin said. "What will bring in spreads from the non-TALF transaction once you pull away TALF?"
Players agree that the program has taken away market volatility. "Before TALF, investors were concerned that market volatility could lead to abrupt changes in prices for ABS, which could result in write-downs on newly acquired positions," said Reed Auerbach, the practice leader of the structured transactions group at Bingham McCutchen. "Even after a deal has priced, the spreads could gap out and investors would have to mark to market the bonds that they bought, and they could be priced out."
Auerbach added that if you look at the number of TALF-eligible bonds relative to the total issuance in consumer finance, it's really not that much. "It's not the direct effect of TALF, but the indirect effect of providing a floor to the market," Auerbach said.
Wells Fargo Securities analysts expect TALF to expire as planned, citing the return to normal levels of spreads and market confidence. With spreads tightening and volatility declining, analysts said that traditional cash investors have reentered the market in a more meaningful way. This is why at this point, they believe that the government program's removal won't have a devastating effect on the market.
"I don't think it's going to have much of an impact just because the cost of getting a TALF loan is currently around Libor plus 100 basis points, while the spreads on most deals for most issuers are inside of that now," said John McElravey, senior ABS analyst at Wells Fargo. "The arbitrage from the leverage or the economics is not as compelling. You're still going to have a few issuers that price at wider spreads, and maybe the removal of TALF might remove some of the demand that might have been there."
According to McElravey, cash investors are likely going to comprise most of the ABS buyers post-TALF. Some of these cash investors have put together separate funds to utilize TALF, so some of these funds might also still be around after TALF is discontinued.
However, in terms of buyers such as private equity firms and hedge funds who simply came in because they had the opportunity to get funding and leverage, these types of investors will probably leave the market once TALF is gone, McElravey added.
McElravey cited some of the deals that were done in the latter part of November away from TALF. "The program has been providing some support to ABS, although it's not obvious to me that some deals couldn't get done without TALF at this point. Some transactions could probably get done without TALF, but they might price wider."
For instance, Citibank's deal that priced on Dec. 2 had its five-year tranche coming in at 255 basis points over swaps. "Most of the deal was financed with TALF money, and I don't know where it would have priced without TALF," McElravey said.
ABS Volume Projections
Wells Fargo analysts project approximately $150 billion issued in term consumer ABS next year with $65 billion coming from autos and $50 billion from credit cards, with off-the-run issuers probably making up an above-average proportion of the total. According to McElravey, the total that they are expecting is close to what was issued this year.
The lack of increase could be explained by several factors. In autos, for instance, although the automakers are starting to get their legs under them again, there's also the issue of unemployment rising from 5% to 10% and new car sales dropping by a third.
Overall, McElravey still thinks that the ABS market in 2010 will be a story of recovery. "I think it will continue to stabilize and improve," he said. "In 2009, we went from a market completely dysfunctional to where liquidity has returned. Currently, the market is just dealing with the impact of the recession and how the economy performs."
In terms of credit cards, DBRS' O'Connell said the volume in the sector would depend on how much consumers are willing to borrow and how much is maturing in issuers' portfolio. "There a lot of factors at play, but I don't think it's going to be a huge year next year," he said.
He mentioned that in 2009, the major story was that the large credit card issuers except Capital One increased credit enhancement in their portfolios. These issuers included American Express, Bank of America, Chase Bank USA, Citibank, Discover Financial Services, GE Capital, HSBC and National City.
"That was a huge story in 2009, and it hasn't changed; they increased the enhancement to maintain their ratings," he said.
Barclays' Wade said that on-the-run assets will continue their momentum, at least in the near term, but 2010 volumes will be dependent on macroeconomic factors, most notably unemployment. "If consumers limit their purchases of cars or spending on credit cards due to job worries, the new-issue ABS volume likely will not expand materially," he said.
However, Wade still sees things looking up in the New Year, with appetite for subordinate tranches and esoteric asset classes increasing.
"In the New Year, for on-the-run prime auto loan and credit card ABS, it's likely we will see greater demand for subordinate securities." He explained that spreads screamed in so much on senior tranches of on-the-run ABS during 2009 that investors will need to look at double-A and single-A tranches to find yield. He also noted that rating agencies are as conservative as they ever have been in determining credit enhancement levels, thereby increasing investor comfort with investing in subordinates.
In terms of actual issuance, Wade expects 2010 to continue some of the same themes as this year, with autos and credit cards dominating the volume numbers - these two asset classes comprised approximately 73% of ABS issuance in 2009. "Auto issuance was very strong in 2009 even with the problems that various issuers in the sector faced," he said.
Bingham's Auerbach said that the increase in the amount of assets that need to be retained and the rise in regulatory capital requirement raise the price of issuing an ABS deal. However, securitization still has a role "as a means to provide liquidity to portfolios and a cheaper form of financing. I think the unsecured debt and bank deposit markets are just not big enough."
He added that regardless, he thinks that capital-constrained banks would not have securitization in their tool box to finance growth. "When there's no need to finance loans, it would dampen the need to hold capital against the deal," he said.
There might be players, he said, that have an extremely high margin who might fall out of the market - like the triple-A- and double-A-rated issuers. But for the others, they would not have an alternative avenue to finance themselves. If they have securitizable assets, they will have to continue accessing the ABS market, although these high-cost issuers are more at a disadvantage to finance themselves.
For banks, when you are looking at accounting changes, the most important is the effect on their very low unsecured cost of funds.
"If banks can't get regulatory capital relief because they don't have the accounting benefit, and it's less expensive for them to fund their portfolio through deposits and unsecured borrowings, then they wouldn't have as strong a reason to securitize," Brown's Litwin said. "It's not so much issuers shying away from the market, but the economics to securitize are not as attractive."
However, Litwin noted that there will still be a need to securitize, particularly for credit card ABS that have maturities that will need to be refinanced in 2010." It would probably make sense for these firms to use some ABS, in addition to different types of unsecured debt, to refinance the maturing debt.
Changes to the accounting rules do not necessarily have a negative impact on all asset-backed issuers. Litwin said that for auto ABS, for instance, these issuers have not done off-balance-sheet financing for the most part. As a result, the accounting rules don't affect these securitizers, particularly because these entities fall under their finance subsidiaries. Securitization also happens to be a good way to match-fund their assets.
FDIC Safe Harbor
According to Auerbach, there are two aspects to the FDIC issuing an advance notice of proposed rulemaking on securitization safe harbor.
One aspect is that for credit card issuers, whether or not a securitization was off-balance-sheet under FAS 166 /167, the safe harbor disappears.
The advance memorandum issued by the FDIC also gives additional preconditions in lieu of giving assets the off balance sheet treatment. The FDIC is, "in a way, throwing stuff against the wall to the industry," he said.
One fear that some ABS market players have is that there will be separate regulations governing banks and nonbanks, because of potential differences in the preconditions for safe harbor that the FDIC put out and the securitization regulations pending in the Senate.
Mayer Brown's Litwin does not believe this is a likely occurrence since the proposed legislation on securitization will be administered by bank regulators, including the Securities and Exchange Commission and the FDIC. "Though it's way too early to tell, it would be surprising if, in the long term, the financial reform regulation and the requirements for the FDIC safe harbor wind up with dramatically different requirements."
The FDIC obviously doesn't want to get ahead of Congress on these issues for bank securitization versus nonbank deals.
Auerbach believes that there's going to be a convergence between the FDIC's regulations for banks and the rules for banks and nonbanks. "The proposals in the Senate hopefully won't be much different from the FDIC preconditions to the safe harbor," he said.
The FDIC preconditions, he said, are very RMBS focused. "The safe harbor for securitizations applies, for example, to mortgage loans," he said.
The preconditions for RMBS deals include, among other things, limiting RMBS transactions to six tranches; prohibiting external credit enhancement and for deals to be internally enhanced; requiring that mortgage loans be held for 12 months before being securitized; and requiring that loans be fully indexed before being securitized.
The focus on mortgages is appropriate, according to Auerbach, given that the FDIC has taken over all these community banks and now they own their RMBS. The FDIC is simply looking at what they now own and figuring out how to get rid of these assets.
"I actually think they are not incorrect in focusing on mortgages; the losses incurred in the consumer market are miniscule, and the consumer triple-A bonds and ABCP paper have performed remarkably well - there have been very few defaults," Auerbach said. "They are focusing on where the disease started but are also aware not to throw the baby out with the bathwater, since the problems they are trying to solve exist mainly in the mortgage market."
The real concern is the effect of the FDIC notice of proposal to multi-seller conduits, Auerbach said. "There's a concern that the market will become very expensive to sellers as result of the regulatory capital requirements," he said. "How will conduit providers adapt to the differences in the price of credit for U.S.-regulated and non-U.S. regulated institutions? It would be very interesting to see how these institutions adapt, there's some success at least in traditional multi-sellers, depending on the amount of assets in the conduit."
Trends in the New Year
A big trend that Barclays' Wade suggested is the demand for esoteric asset classes in 2010. This would possibly include asset classes such as aircraft leases, and rental car loans as well as less frequently issued ABS like those backed by insurance assets. "We're working on a variety of opportunities in esoteric asset classes," he said.
Covered bonds, Wade said, could also gain more attention in the coming year. These deals, which are commonly issued by European banks, have been gaining ground in Canada as well.
Wade noted that the U.S. government has encouraged the growth of the covered bond sector by clarifying certain legal treatment of the underlying cover pools. He said that due to the current lack of a new-issue non-agency mortgage market, financial institutions might be more apt to fund their mortgage portfolios through the covered bond market.
"Prior to the credit crisis, covered bonds started very slowly with U.S. issuers; however, at that time, we had a very liquid non-agency new issue market," he said.
Now with the non-agency market not functioning, the government is attempting to help open up the market for covered bonds next year. Additionally, Wade noted, with the implementation of FAS 166 and 167 in 2010 both ABS and covered bonds in the underlying assets will remain on the balance sheet of the issuer, thereby eliminating a previous potential advantage of ABS versus covered bonds.
According to Wade, the 5% retention required under the regulatory reform bill is not overly onerous considering that this year most of the subordination under triple-A ABS issued was retained by issuers. Many issuers continue to find securitization to be their most cost-effective funding tool even after the cost of retaining subordinate tranches.
"Even though changes in accounting treatment for ABS issuers could certainly negatively affect ABS issuance volumes, for many issuers ABS remains a cheap source of funding, if not the cheapest. For a non-investment-grade, nonbank issuer for instance, whether securitization is on or off balance sheet, the ABS market still provides a low-cost, liquid funding source. Even some more highly rated investment-grade rated issuers fund tighter in the ABS market versus unsecured or issue ABS to diversify their funding sources," Wade said. "I would say that unemployment and the economy are bigger hurdles to volumes increasing than forthcoming accounting changes."
Mayer Brown's Litwin said that recent Canadian withholding tax changes may facilitate the inclusion of some Canadian assets in future ABS pools. He noted that finance companies that sell products in both the U.S. and Canada might take advantage of the deeper market in the U.S.
With Canadian regulatory changes, it has become possible to securitize Canadian and U.S. assets in the same deal. "I don't think this is going to be a huge amount, but we'll likely see some Canadian assets in U.S. term ABS deals," Litwin said, adding that this is despite the complexity brought about by the different laws governing Canadian transactions as well as the currency risk, which causes deals to be more expensive to hedge.
Meanwhile, Wells Fargo analysts are recommending the auto and equipment ABS sectors because of their solid underwriting, credit enhancement levels and structural robustness. According to them, Class A4 last cash flow bonds and subordinated ABS provide the best relative value. "We believe that there's value in terms of the yields investors would get relative to the risk that they are taking," McElravey said. "With TALF disappearing, the investors typically buying the subs will likely return. Credit risk has peaked and is not getting any worse." - KS
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