Last week, European market players focused on developments in the U.S. subprime market. They were concerned about the possible contagion risks resulting from the recent problems in this sector - whether the U.S. subprime woes will negatively impact European market performance.
"The one dark cloud [that] remains [for the European market] is the U.S. home equity ABS market, where negative lender headlines in the past week looks to have accelerated the sell off, with for example the ABX.HE.07-1 triple-B minus index trading down to around 85 mid, from near par levels just four weeks ago," explained Ganesh Rajendra, managing director and head of securitization research in Europe and Asia at Deutsche Bank. "There is no observable spread contagion as yet to other ABS sectors, including of course the European mortgage / ABS market."
HSBC's announcement earlier this month (ASR, 02/12/07) of a 20% increase in its expected provisioning levels is also not expected to affect the bank's non-U.S. operations, Societe Generale analysts said.
But this short-term immunity might not last long if Europe doesn't heed the warning signs, these market analysts said. Rising interest rates in the U.K., for example, have already begun to impact mortgage performance. Overly tight spreads on non- conforming issues have resulted in rising arrears and loss levels that ultimately lead to softening bond prices.
According to SG analysts, U.K. borrowers who have up to now relied on rising house prices to either release equity through selling at these high levels or through refinancing could be in a jam if prices were to suddenly fall. "If house prices cool off in the U.K. this will result in a significant deterioration in performance," SG analysts said. "[In the] U.S., house prices have been broadly static, with only modest declines witnessed, yet losses on repossession have proved problematic."
The reassessment that is happening in the U.S within its subprime lending business comes amid a U.K. lending growth spurt. New lenders continue to emerge, adding pressure to already aggressive lending techniques. Some U.K. subprime lenders have revised lending tactics to incorporate more aggressive and riskier techniques that sometimes offer up to five times a borrower's income multiple or in some cases, advances based on repayments as much as 53% of gross income, which leave very little squeeze margin for borrowers in a rising interest rate environment. U.S. lenders are scaling back on the LTV available to customers, whereas U.K. lenders are advancing higher LTVs to lower quality borrowers.
Ron Thompson, head of ABS and structured finance research at the Royal Bank of Scotland, said that many U.K. lenders have already begun scaling back these riskier lending techniques, adding that there are very few lenders in the market who will lend to a borrower with more than a 95% LTV. Lenders have also started establishing a moratorium on piggyback loans - where a borrower who does not have the 20% deposit turns to the mortgage lending bank for a loan to cover that cost. Thompson said that lenders are looking at the U.S. and decidedly taking steps not to let the situation repeat itself in the U.K.
But, for now, junior note spreads remain immune to U.S. travails. Thompson said that in the U.K., it's still very much a supply and demand scenario - with an awful lot of demand for this paper. Spreads are likely to stay at tighter levels, although analysts at SG said these recent events should serve as a cautionary tale to this growing U.K. market segment.
"U.K. lenders are chasing even more stretched borrowers, increasingly using affordability models to lend greater amounts, at a time when there appears little prospect of significant house price gains especially given the interest rate environment," SG analysts said. "Furthermore, increased LTVs, especially for heavy adverse and buy-to-let loans, may reduce borrower motivation to repay in a downturn, increasing repossession rates."
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