Consumer-related asset-backed securities have so far withstood the economic slowdown, both from a credit and spread perspective. But, as economists further revise their outlooks, and the threat of continued weakness and a longer-than-anticipated recovery looms, some investors are beginning to wonder if and when consumer ABS will start to feel the dregs.
Merrill Lynch's Alex Batcharov writes in a recent International ABS/MBS Weekly (8/30), "U.S. consumers must be doing relatively well these days, contrary to the corporates they are working for. Well, that's a paradox, which with the benefit of hindsight, will likely not be resolved in the first half or second half of year 2001."
According to most analysts, because the ABS structure was designed to withstand economic cycles, conditions would probably need to be substantially worse before even the subordinate pieces of deals were hit with economy-associated downgrades, or early payout events.
"Our economist is pretty negative. He figures we could sort of drag along another year or more with really slow growth, which isn't technically a recession but really stinks," said Mark Adelson, of the fixed-income research group at Nomura Securities.
"But that's not what would louse up ABS deals. What would louse up ABS deals is not a stagnant economy, but a really bad economy, where unemployment gets pushed up. The unemployment number is key, and it's still historically low."
The top indicators for rising defaults in ABS are bankruptcy filings, which are often predicated by a spike in unemployment. Currently the unemployment rate is roughly 4.5%, although some economists are expecting that rate to continue trending into the 5% range.
And though the wave of bankruptcy filings seen earlier in the year has slowed, the levels are still nearly 23% ahead of last year, on a cumulative, year-to-date basis, according to Michael Dean, a consumer ABS analyst at Fitch. If this continues, 2001 could be the worst year on record in terms of bankruptcy filings.
"I'm not as optimistic as some are right now," said Fitch's Dean. "I think there is still a lot of uncertainty in the consumer arena, particularly in the credit card arena as it relates to charge-offs. I'm not doom and gloom either. There's just a lot of uncertainty."
Sub bonds still well bid
Whether or not consumer ABS deals begin to suffer from the current slowdown, some investors believe the market is overly confident, which, coupled with the CBO bid for subordinates, has kept most ABS sub bonds expensive from a risk perspective.
"Unlike the corporate market, where credits have really cheapened up a lot in certain areas, you're not being paid at all to take on the risk in the subordinated part of the asset-backed market right now, or for that matter, in the mortgage-backed market," argues Thomas Sontag, ABS/MBS portfolio manager at Strong Capital Management. Strong has been staying clear of ABS below the triple-A level this year, as well as ABS backed by subprime consumer credit.
"These things haven't widened out due to, what I think ought to be, heightened concerns over consumer credit," Sontag added.
Currently, most ABS spreads are well inside their one-year averages, and several fixed-rate classes at the one-year lows. Even as most analysts feel a true credit event, or missed payment in an ABS deal, is rare and highly unlikely, one commented that "a downgrade is damn near the same thing as a default to an investor, because it is a question of value, whether or not the security ever misses a payment."
Another ABS investor dubbed the CBO bid as "not necessarily an economically rational investor bid."
To get hit first...
As analysts have been saying all year, the first deals to suffer, if unemployment and personal bankruptcies rise, would be those backed by subprime credits. Still, there's no real indication that consumer deals at any end of the spectrum are nearing trouble.However, there is an uncertain lag period associated with issuer reporting in ABS deals, which is currently a concern of some industry analysts. As has been an ongoing story over the last few years, issuers vary in the way they report delinquencies and charge-offs. The Federal Financial Institutions Examination Council (FFIEC) requires credit card issuing banks to recognize charge-offs within 60 days. That said, some issuers will report charge-offs immediately, while others will wait the full 60 days.
At currently reported levels, charge-off and default rates in credit card deals are well above their levels this time last year.
In JPMorgan's most recent ABS Monitor (8/31), the research group addresses the risk of early amortization in fixed-rate credit card deals, which do not benefit from a lower coupon tied to interest rates, that has kept excess spread robust on the floating rate deals.
Cited from the report: "We believe the risk remains low as structural features such as finance charge sharing or swaps in the trust alleviate the risk [of early amortization in fixed rate deals]. In addition, issuers have limited tools at their disposal to boost trust performance."
JPMorgan notes that most of the outstanding fixed-rate deals have the benefit of a master trust structure allowing the deals to tap excess spread from other series in the trust, to some degree.
Fitch's Dean notes that credit card issuers have the unique ability to reprice their assets to manipulate portfolio yield. For example, a credit card issuer could tinker with finance charges to increase overall yield and excess spread to avoid early amortization.
Meanwhile, in subprime home-equity deals, often the only thing protecting the most subordinated tranche is excess spread, although overcollateralization levels tend to build up over the life of the deal.
In July, Nomura's Adelson authored a report titled "Jumbo MBS: Where is the Credit Enhancement?" in which he argued that Jumbo MBS in recent years contains less overcollateralization than earlier vintages, even though the loans are no less risky.
Adelson argues that if the economic scenario worsened to the extent that unemployment began substantially hitting the broader population, these deals would not be properly protected by O/C.
Overall, most ABS players remain confident in the safety-in-structure that has been so beneficial to the industry this year, luring several issuers who might have otherwise tapped the corporate debt market.
"The consumer has been the one strong part of the economy throughout this slowdown, but we sort of view this slowdown as being somewhat protracted," Strong's Sontag said. "We think that economic activity is going to sort of bumble along at a slow pace for an extended period of time. Eventually, if that happens, layoffs will unfortunately rise and that's going to impact consumer credit."