As securitization closes in on, arguably, its most event driven year to date, several sectors are experiencing new rounds of growing pains, while others continue proving their resiliency, despite the global economic deterioration. Last week, researchers at "Securitization Research Outlook 2003," a conference hosted by Deutsche Bank Securities, predicted the slump could last another two years.
Close up, DBSI views some sectors as faring better than others, though all will apparently experience some level of change.
For example, some significant changes could be in store for CDOs, predicts DBSI's Anthony Thompson, speaking on the inherent conflicts of interest between equity and debt holders that have culminated as the structure continues to be stress-tested. Thompson envisions a future in which managers take both equity and debt positions in new transactions, and concessions are made by both sides to prevent inefficient manager activity.
"A CDO should operate like a well-run company, with careful consideration paid to the interests of both equity and debt holders," said Thompson, citing some of the negative consequences to debt holders in deals where managers cater disproportionately to the interests of equity holders. However, he warned debt investors to be careful what they wish for, as stipulations to allocate greater seniority of management fees - to protect debt holders - can lead to situations where a manager has limited incentive to run a deal; it also makes it difficult to attract a replacement manager if the compensation economics are too unfavorable.
As a result, in the coming 18 months, deal structures and collateral types should be more conservative and equity return expectations should be more modest and more realistic, Thompson notes. "We want to avoid situations where a manager holds on to losing positions too long in order to keep money flowing to equity holders at the expense of the long-term credit quality of the deal," he says.
Thompson thinks "manager risk" has been significantly undervalued by the market. Also, too much emphasis had been placed on collateral diversification, which often forces managers to take bets in sectors where they have limited expertise. But he concedes that a number of unforeseen blowups, particularly in the formerly red-hot technology sectors, made it difficult to see trouble coming.
"We have never seen this extent of downgrades in the early years of any asset class," says Thompson. "It took almost a decade before manufactured housing finally unraveled."
Value in the secondary market can be found in the more stable recoveries of U.S. loan collateral and the ratings stability of structured product CDOs. The senior secured status of loans makes this the most attractive collateral of the pre-2000 CDO vintages.
U.S. arbitrage loan-backed CDOs from the boom-year vintages of 1997-1999 saw an average of just 10% of tranches downgraded, versus an average of 39.6% for high yield bond CDOs over the same time period. A miniscule 1% of 1999-vintage loan CDOs have seen downgrades.
With the CDO primary market slowing in 2003 as non-ABS collateral supply has decreased, Thompson believes the secondary market is where investors will turn. He thinks specialty investors will evolve and trading will increase in triple- and double-A tranches by structured product experts, rather than debt experts.
Seller scrutiny continues
to be theme
Coming off a year that nobody could have expected in asset-backeds, the outlook for 2003 remains fairly bright to DBSI Head of Global Securitization Research Karen Weaver. Weaver, speaking to the investor audience last week, reiterated that ABS, on a relative basis, will remain more stable than corporate debt and that the fundamentals of consumer credit remain strong.
Weaver spent most of her time on mortgage-related assets, which she dubbed "the country's biggest asset," arguing that home prices have risen on sound fundamentals rather than irrational behavior. Additionally, while home prices have soared, low interest rates have kept affordability in check, even in regions hit hardest by the demise of the dot-com boom, such as San Francisco.
Noting that the low interest-rate environment has led to origination growth that fueled ABS issuance this year, supply should remain strong. In what could be an ominous prediction, Weaver thinks originators will reach down in credit to maintain loan originations.
This bodes well for the subprime mortgage market, due to the fact that lower-priced homes retain their value better than high-priced homes in an economic downturn.
But, Weaver conceded the playing field has changed, and offered some New Year's resolutions for 2003. Due to scandal, analysis of ABS has changed. Weaver thinks that going forward investors will need to look not just at the structure of a deal or the surety wrapping it, but also do more complete "equity-type" due diligence on all aspects of the business model - including the involvement of servicers and trustees.
Any issuers with baggage will need hot backup servicers in place, and trustees will need to be more defined in their roles. Using the NCFE scandal as an example she said, "two different deals, with two different trustees each with completely different results." Investors should remain cautious of esoteric assets, the structures for which she claims "the rating agencies got wrong."
Also recommended was for investors to exit a position at the first sign of trouble: "the best out of a credit event is often the first one," she said. Weaver advises avoid credit cards that focus on deep subprime borrowers. She also notes that student loan ABS will be "hit by increased supply" next year.
U.S. CMBS issuance may further decline in 2003, according to DBSI's Rich Parkus, but the availability of terrorism insurance and decreased conduit issuance should buttress spreads. Despite deteriorating vacancy rates, loan performance has remained remarkably stable in some sectors of commercial real estate, but a stalled economic recovery represents a threat to the CMBS market in 2003.
The best stories for 2003 are the real estate fundamentals of the industrial and multifamily sectors, which will stabilize and may even see improvement. Also performing well is the retail sector, which
will hold up as long as consumer spending holds up. Office real estate fundamentals, by contrast, may see
continued deterioration, particularly in a further 2003 downturn, with a rebound through mid-to-late 2004, Parkus added.
Still, despite the weak fundamentals, loan performance in the office sector has been remarkably strong, boosted by short-term sub-leases. While vacancies are high at 16% nationwide, 25% of these vacancies are sublease space - making the vacancy rate appear more like 14%, at least for the moment.
On the positive side, spreads for conduit CMBS may hold firm. Parkus expects that forward supply pipeline for office space will remain light, a positive for real estate fundamentals.
The best performance is seen in seasoned pre-1999 transactions, with "seasoned conduit loans experiencing little credit deterioration," said Parkus. Credit performance for 2000 and later vintages will underperform earlier vintages in 2003.
With numerous downgrades in 2002 due specifically to a lack of terrorism insurance availability, Parkus expects most of those ratings be restored once insurance is purchased. This will have the most dramatic impact on the single-borrower CMBS transactions, expected to rebound from the 70% decline in issuance in 2002.
"Greater availability of terrorism insurance should lead to a surge in single asset deals by second half of 2003; moreover, as an alternative outlet to larger, fixed-rate assets, the market may move away from the fusion format," Parkus added.
While the hotel sector has staged a remarkable comeback in terms of collateral performance in 2002, it remains fragile. Within the hotel sector, high-end hotel properties have fared the best, relative to the low-end, something Parkus believes will continue. Throughout 2002, short-term delinquency rates improved drastically, and are currently at 0.65% and are approaching pre-Sept. 11 levels, in from highs of 2.70% in November 2001.
MBS a brighter picture
As for the MBS market, 2002 was a stellar year for performance, and the sector should continue solidly in the coming year, said DBSI director of mortgage research Alec Crawford. Crawford recommends an overweight in MBS, particularly in lower-coupon conventionals, where an expected increase in Treasury supply should make mortgage product more attractive.
Crawford predicts mortgages will outperform Treasurys, but likely lag corporates in 2003. "Rising Treasury rates will lead to declining swap spreads, lower options volatility and decreased mortgage supply in those coupons," he theorized. As for corporates, expect a rebound from a disastrous 2002: "If you pick the right names, it's going to be a home run."
Conventional 30-year 5.5s and 6s are the call for Deutsche Bank for three reasons. First Ginnie Maes, particularly 6.5% coupons, will lag as improvement is in store for both the agency and corporate debt markets. The 15-year sector is threatened by an expected flattening of the yield curve. Also 30-year conventionals have the most favorable carry dynamics.
Investor financing of MBS continues to be attractive with the dollar-role market "on fire." Currently, investors can borrow money for a month, for example, with no interest and park the funds in interest-bearing MBS. "If you believed that dollar rolls on 5.5s were 16/32 a month, you would be earning 7.25% a year on 5.5s by owning them and dollar-rolling them. We do believe the dollar roll will cool down, but not for at least three months. After that a lot of it depends on the direction of interest rates," Crawford added.
As this latest refi wave has shown, the call option has increasingly become more efficient for homeowners. Crawford expects this trend to continue in the future, driven by the possibility of e-signatures and electronic title searches. He describes a hypothetical "Internet refrigerator effect," where a homeowner will have the ability to get a refinance quote before even opening up the refrigerator each morning "and you can refinance your mortgage before you eat breakfast."
Investors should thus expect shorter hedge ratios. Currently, the DBSI mortgage index, benchmarked to 10-year Treasurys, averages just 1.7 years. Crawford joked that the next step for the mortgage market is for lenders to offer "no down payment, no payments until 2004" mortgages, and that Starbucks would begin staffing a mortgage broker in each coffee shop.