The deadlock regarding securitization activity in Europe still persists. While pressure on credit markets eased significantly since March, ABS spreads did not follow suit! Given the rapid pace of spread tightening and sentiment changes in the credit universe during the last couple of months, the jackpot question this spring from a credit risk perspective regards timing: Will the credit crisis fade sooner than anticipated or do markets face another bull trap? And will the ABS market keep its outcast status or will there be a rehabilitation?
Asset backed securities have been impacted more than any other sector by the crisis. Having been at the center of the storm, this market has changed significantly during the last two years. First of all, public placements have practically become non-existent: This is due to unattractive issuance spread levels (average 'AAA' RMBS spreads over 2009 were quoted in areas above 300 to 400 basis points) as well as a prevailing lack of investors, especially for lower parts of the capital structure. As banks hardly had realistic alternatives to relatively attractive central bank repo refinancing, a flood of repo transactions occurred (E912 billion ($1.25 billion) 2008-2009 year-to-date). However, outstanding ABS volumes which were retained for central bank repo windows have started to flatten out.
Since the beginning of this year securitization repo capabilities may have reached a natural limit, i.e. central bank repo accounts of originators are increasingly filled with ABS exposure and assets from bank balance sheets that qualify for repo transactions are not as readily available as last year anymore. Moreover, no turning point in terms of increasing lending activity (increasing underlying exposure being financed via wholesale activity) is apparent at this point in time, with one exception being the covered bond market. Covered bonds will clearly benefit from the European Central Bank's (ECB) announced plan to purchase E60 billion in covered bonds. Overall, it is interesting to see how debt market financing patterns for financial institutions have been shifting since 1Q09 - retained ABS outstanding has been gradually stagnating while senior debt volumes are increasing, as will covered bond activity! For the time being, the ABS primary market remains in deadlock mode.
This is also the case on the secondary ABS market. Activity since the beginning of the year has been extremely low. European sellers are unwilling to accept distressed prices for paper that they assume will repay in most cases at par, while at the same time buyers still demand huge liquidity premia. Thus, bid and offer levels often diverge significantly. Liquidity risk is high and actual trades are rare. On the synthetic side, activity also remains poor. Low volumes are traded, for example, in PERMA CDS on ABS, which is one of the most liquid references. Any quotes in the CDS universe are often limited to sizes of E5 billion only. The difficulties to source paper in attractive sizes on the secondary market prevail and liquidity risk is unlikely to improve at the present stage as market impulses are missing and incentives for short positions are low. The reclassification of ABS paper from trading to banking book exposure as well as the fact that numerous assets have not been revaluated to realistic levels yet is one of the reasons why market activity remains subdued. In contrast to Europe, securitization activity in the U.S. improved, which to a large extent is due to the fact that in the US public support for ABS debt is high. After initial hurdles, the TALF program is taking off (loan requests rose to $10.6 billion eligible assets account in total for $24.6 billion), which also positively impacts secondary spreads. Moreover, the ABCP sector is supported by the Federal Reserve's CCP and Asset-Backed Commercial Paper Money Market Fund Liquidity Facility or AMLF facilities while in Europe ABCP markets remain in the doldrums. Restrictions from Basel II and the European Union side as well as a devastating downgrade wave (negative structured finance 12 months rating drift at S&P below 80% in 1Q09) related to much more conservative approaches by rating agencies lead to further negative momentum.
With the deadlock mode ongoing, spread levels of European securitization markets are stagnating and stand in clear contrast to the mainstream credit market. Since March, credit spreads in cash and synthetic indices have tightened rapidly, i.e. iTraxx spreads tightened by roughly 40%. On a year-to-date basis the iBoxx non-financial gained 6.2%, the financial senior 2.8%! From a strategic point of view, tightening has been triggered by better-than-expected corporate and financial earnings (with banks leading the way) as well as numerous "green shoots" (e.g. PMI Indices, freight indices, production orders) which are fueling reflation hopes, i.e. expectations that the bottom of the crisis has already been reached. Government support measures are finally bearing fruit in terms of financial stabilization. While in March the potential risk of a systemic threat was still imminent (e.g. U.K. banking act, nationalization, etc.), these fears seem to have vanished into thin air. Money markets have eased and the U.S. mortgage market is not showing signs of further destabilization. Interest rate cuts finally arrived at mortgage borrowers and Case-Shiller futures contracts imply an end of the recession in the U.S. housing sector in the foreseeable future. Moreover, the U.S. housing market inventory cycle has come to an end, e.g. the inventory to sales ratio (=average duration to sell a house) has fallen below 10 months again from four to five months before the crisis. Last but not least, also fears related to collapsing economies in central and eastern Europe have abated as implied by country CDS levels, e.g. Ireland where five-year CDS levels tightened from 400 basis points to the 200 to 250 basis points area. The improved credit sentiment is reflected in the huge amount of European paper that was placed on primary markets in E110 billion benchmark bonds in March and April.
Two important questions remain to be answered regarding timing: I) Will the crisis fade sooner than anticipated, is the worst already behind us and how sustainable is the positive sentiment? II) Will ABS spreads follow suit and tighten and can ABS markets manage a potential turnaround in Europe?
I) Regarding the former question, cautiousness is recommended from a strategic point of view despite all easing. Market consensus is that we will see an economic stabilization at the latest next year, e.g. the IMF expects a decline of 1.3% in global economic growth while in 2010 a moderate expansion of 1.9% seems possible. In the U.S., economic growth is expected to increase to 1.8% in 2010 (2009: -2.7%) in Europe to 0.3% (2009: -3.4%). Nevertheless, so far most of the macro arguments still reflect non-hard data! Even if the worst, in terms of ugly macroeconomic figures, is already behind us, the worst regarding real defaults is yet to come. Moody's Investors Service expects high yield default rates to rise from currently 5% to 15% to 20% at year-end. Much of the default risk is already priced in, but the rally in credit markets remains mostly sentiment driven. It is not based on real fundamental improvement, and sentiment can easily deteriorate once some landmark defaults occur! Unemployment in the eurozone is expected to increase above 10%, which will be a burden for economic growth as well as for banks. Global IMF loss estimates have been revised upward to E4.1 trillion while so far around $1.35 trillion in losses have been revealed. Recapitalization needs of $375 to $725 billion are expected at European banks, according to the IMF. The future looks anything but rosy. While another bull trap in the medium term remains a realistic threat, the crisis is at least becoming more manageable and more predictable.
II) With respect to ABS markets, there are only little signs of improvement: Some initiatives in Europe are encouraging, e.g. the Bank of England's (BoE) guarantee scheme may have the potential to attract originators while investors are particularly welcoming the incorporated liquidity guarantee. Also initiatives like issuer principles for transparency/disclosure or retention rules for originators to minimize moral hazard in originate-to-distribute approaches will support investor confidence. If any of these initiatives prove successful, spreads will benefit, e.g. the BoE guarantee could support battered U.K. prime RMBS spreads, where extension risk is one of the key issues. But the most convincing argument for a rehabilitation of the primary market is derived from a sound performance of European securitized exposures: Only if transactions turn out to be structured sound enough to withstand the stress ahead (independent of rating agencies' revised assessments) and convince via reliable performance, i.e. pay back interest and principle on time, investors' concerns regarding credit or liquidity risk can be calmed effectively and broadly! Overall, European ABS spreads can be expected to at least stabilize on the back of the easing in credit markets. The trend of continuous technical spread widening has come to an end and spreads related to secured versus unsecured credit exposures will further adjust as fundamentals move center stage again! However, performance differences remain huge and downside potential from a fundamental point of view is high, especially in sectors with credit-adverse underlyings (e.g. U.K. nonconforming, high yield and mezz CLOs, CDOs) as well as for sectors subject to rapid fundamental deterioration (e.g. CMBS, Spanish RMBS). The downgrade spiral will continue due to ongoing reviews by agencies. While the overall deadlock mode will hardly be overcome in the short term, alternative funding methods will continue to crowd out the ABS market as long as no further support impulses by regulators, originators and central banks are forthcoming. Further efforts are needed to rehabilitate ABS in the short term. In the long term, however, the usefulness and effectiveness of securitized wholesale financing and risk transfer techniques can not be doubted.
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