Nearly 70% of existing Dutch RMBS deals include early call options. However, only deals that include a call date in 2012 from larger securitization originators are likely to be called through, according to Societe Generale.
When a call option is included in the bond structure, any degree of risk transfer is calculated as if it will cease at the date of the call option. The degree of risk transferred will gradually decrease until the date of the call option.
Chris Ames, head of ABS and MBS at Schroders, wrote in a report that call options structured into Dutch RMBS are very efficient for the originator, because they allow new mortgages to be substituted into the pool as others prepay.
"There is absolutely no economic reason for the originator to call these deals, yet they all continue to trade to their call dates," he noted.
But in the current economic environment, concerns are mounting that banks might not call on their ABS deals. At the end of January, market reports indicated that Fortis Bank might not call through on its Dutch RMBS deal Delphinus 2004-1, with a step up call for Jan. 25. Although the bank finally announced it would call the outstanding notes on the deal, worth E1,163 billion ($1.5 billion), market analysts have not ruled out the possibility that other issuers might not call on their bonds.
"Extension risk is likely to remain a major theme for the ABS market through 2009," said Jean-David Cirotteau, head of ABS research at SocGen. "It is very difficult to predict if a large entity may be forced to maintain its structures beyond the call date."
Because these deals have legal final maturity dates in the 2090s, the downside of not exercising a call coupled with a slow prepayment environment would mean these bonds would have long average lives of 10 years or more. With call options not being executed, investors in first loss piece or mezzanine tranches face the problem of finding an adequate fair value for their tranche exposures.
To date, only one second-tier lender, Dutch DSB Group, has announced it would not exercise its call on consumer ABS, Chapel BV series 2003-1, on November 17, 2008. The next call dates for the structure are Feb. 17 and Aug. 17, but it is very unlikely that the lender will exercise the calls on these dates, Cirotteau said.
Ames said that one argument as to why bonds might continue to be called even in the current economic environment is that issuers plan to replace these called bonds with new bonds that will then be repo'd with the European Central Bank (ECB) at more attractive rates than the step-up coupon on the existing bonds would provide.
Larger issuers, in particular, are expected to continue to use the call option in order to avoid damaging their investor base for future refinancing needs.
"Despite the recent amendments of the ECB repo scheme on ABS (ASR, 2/2/09), these lenders still have good access to the funding facility from the central bank in order to refinance, despite the closure of the RMBS markets," Cirotteau said.
He estimated that call options will peak in 2013, but this is primarily due to the existence of at least two large balance sheet deals by ABN Amro and Rabobank.
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