The summer months have brought a more positive sentiment to the European securitization market. However, market sources believe that the winter could bring some discontent, adding that Europe has yet to make some lasting moves that would indicate the market's true revival.
Corporate high-yield and leveraged loans have taken a strong rally over the last month, and ABS has rallied along with these sectors. Market sources said they expect continued tightening in most European ABS sectors, although the price rally has come with no real new securitization issuance to speak of.
The two deals that came to market were done as long-term fixed-rate sterling, with one having the backing of the government. Away from that, Europe has not really seen any new issuance.
The U.S., by contrast, has seen more meaningful issuance, although that activity has been driven mostly by the Term ABS Loan Facility or TALF.
"In Europe, we continue to see a big amount of securitize-to-repo, so there is a huge amount of structured product issuance but it hasn't ended in the hands of investors," said Colin Fleury, a portfolio manager at Henderson Global Investors. He estimated that year-to-date retained issuance volumes in Europe have been around $280 billion.
The market's rally could therefore be explained because there presently aren't as many active sellers around. Most axed sellers in the European space that are now able to take a longer-term view might be feeling better about their financial positions and so are not looking to exit their positions as aggressively.
According to data from Henderson Global, spreads for tranches at the top of the capital structure (triple-A rated) prime RMBS have come in from approximately 300 basis points in May to the low 200s at the end of August.
Most sellers in the European space who are more long term might be feeling better about their financial positions and aren't looking to exit the market any longer.
"The market now has limited paper, and the securitized volume spreads are being chased in the back of lack of supply," he said. "It's a strange feeling, and it's uncomfortable seeing a rally on the back of such limited volumes."
Rajan Dosanjh, who a few months ago started the ABS trading desk at Evolution Securities, said that, at the moment, the team has been focusing on illiquid CMBS, CLOs and mezzanine paper. However, he said that clients are holding on to paper and that the market is generally seeing smaller ticket loans of less than Ã¢Â‚Â¬20 million ($28.6 million).
The lack of supply, he said, has led to a supply-and-demand imbalance and a very technical market where a lot more money needs to be put to work.
"If you think about it, the market blew up because of the availability of paper," he said. "There was so much paper at the beginning of this that investors could name a price, but the situation now sees clients outbidding each other. But the fundamentals remain weak; this rally that we have seen of late has been very technical."
Overhang? What Overhang?
At the beginning, investors' expectations that the market faced a major asset overhang left many players sidelined. Three separate stories developed that would theoretically flood the market with paper.
One came from failed structured investment vehicles (SIVs) that would create forced sellers with bonds being auctioned off en masse during bankruptcy proceedings. However, while in the process of restructuring, people holding on to bonds just held them; when the paper eventually sold, it was a longer process than anticipated, and in some cases the bonds just paid down.
"When some of these bonds did eventually come to market, they traded at reasonably good levels because by that time, the auction volume was not that large and there were not that many other bonds being offered," explained Reto Bachmann, co-head of European ABS research at Barclays Capital. "The fear of large fire sales from SIVs that weakened investor confidence for so many months in the end never really materialized."
The European Central Bank's (ECB) repo operation is the second situation that investors fear might represent an ABS asset overhang that could collapse, but in that case too investors are finding that they might have overreacted.
"Investors' concern was that the ECB may decide to make all or most ABS ineligible as repo collateral, and thus banks would become forced sellers of their ABS holdings," Bachmann said. "But one has to keep in mind that the ECB only ever modified its ABS eligibility criteria with care and that when it did tighten its criteria, its intention never was to make all ABS ineligible overnight. While further tightening of ABS eligibility criteria cannot be ruled out, it's likely that it would be done only in small steps."
"No one believes the ECB will force sales of assets - the train is going in the opposite direction," Fleury said.
The third situation that investors feared would add to an oversupply of assets in the market was the ever-changing stance of rating agencies. To be sure, at this year's London location of the European Securitization Forum's/Information Management Network's Global ABS conference, many of the panels discussed the uncertainty that the rating agency criteria changes had placed over the market and partly blamed this uncertainty for holding back the revival of the market.
CMBS has seen paper hit with regular rating action across the capital structure. The worst case to date, according to Henderson analysts, has been EPIC Industrious, which has seen even the triple-A classes downgraded to triple-C minus or below investment grade, with more downgrades likely and ultimate impairment a real possibility.
However, the rating action resulted from very specific circumstances in terms of the quality of the underlying collateral (secondary quality U.K. industrial properties with relatively short lease terms), high leverage (96% total debt to original valuation) and the structure of the deal.
"These specifics reinforce our belief that investment in CMBS requires caution and close attention to the quality of the underlying property and deal structure," analysts said. "We expect that many CMBS subordinate classes may ultimately impair, but there are some good opportunities still available in the senior-most classes that remain sufficiently well enhanced and in the position of control."
In RMBS, for instance, Bachmann said that there has been a relatively small impact on downgrades that would see a triple-A fall below investment grade.
"Another concern that the market had regarded is what would happen if large volumes of the triple-A-rated ABS bonds on repo with the ECB were downgraded so much that they would no longer satisfy the central bank's ratings-based eligibility criteria," Bachmann said. "The ECB has recognized this risk, and when it tightened its criteria it was careful to ensure that bonds already on repo at the time of a downgrade would continue to be eligible so long as they remain at least single-A rated. The end result has been that few if any ABS notes on repo where forced out of the bank's facility and dumped onto the secondary market."
The ECB has recognized this and, in turn, revised criteria so that you can keep the bond in repo as long as it remains a single-A, and the end result has been that no one is forced to take bonds out of repo and sell to secondary.
Banks have also secured a guarantee from their central government. This occurred in the U.K. and Spain, for example, against the risk of increased capital requirements.
Basel II's finalization has also impacted the market this summer. There are specific items introduced, despite some opposition from the industry, mandating specific operational criteria for securitization exposure. The new operational criteria for credit analysis may barely fill a single page, but they pose a very substantial risk for ABS.
Banks are now required to meet specific operational criteria so they can use the risk weights specified in the Basel II securitization framework. These criteria are intended to ensure that banks perform their own due diligence and do not simply rely on rating agency credit ratings. Failure to meet these criteria for a given securitization exposure would result in its deduction.
As a general rule, a bank must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of its individual securitization exposures, whether on balance sheet or off balance sheet, as well as the risk characteristics of the pools underlying its securitization exposures.
Banks must also be able to access performance information on the underlying pools on an ongoing basis in a timely manner. Such information may include, as appropriate: exposure type; percentage of loans 30, 60 and 90 days past due; default rates; prepayment rates; loans in foreclosure; property type; occupancy; average credit score or other measures of creditworthiness; average loan-to-value ratio; and industry and geographic diversification.
For securitizations, banks should have information not only on the underlying securitization tranches, such as the issuer name and credit quality, but also on the characteristics and performance of the pools underlying the securitization tranches.
A bank must have a thorough understanding of all structural features of a securitization transaction that would materially impact the performance of the bank's exposures to the transaction, such as the contractual waterfall and waterfall-related triggers, credit enhancements, liquidity enhancements, market value triggers and deal-specific definitions of default.
"The finalization of Basel shows that regulators have taken a strong line on having the right tools and the right people to run securitization," said Douglas Long, executive vice president at Principia Partners. "As an organization, in order for you to use the risk weights, you'll have to prove you understand investments on an ongoing basis and that you have the right systems and operations to support that."
In other words, failure to have access to up-to-date performance reports and deal models to run up-to-date stress tests would, in the case of a senior triple-A-rated bond backed by a granular pool, result in an explosion of the applied risk weight from 7% to 1250%, a multiplier of 179.
Long said that it's likely that the language will also be adopted by the European Union and the Financial Services Authority.
Bachmann said that it would be difficult for anyone to satisfy these requirements without receiving detailed investor reports on a regular basis and being able to run stress tests effectively on demand.
"It would appear that something as simple as the servicer failing to deliver timely investor reports, or reports at the required level of detail, could result in a drastic increase in capital that investing banks have to set aside for the corresponding exposure," Bachmann said. "Thus, rather than reducing the risks of investing in ABS, regulators are introducing a severe additional regulatory risk - a risk so big it has the potential to prevent the re-emergence of a large, liquid European ABS primary market."
He added that it becomes worse if the Basel II operating criteria amendments have a grandfathering clause for existing securitizations, which the market might have overlooked. Without this clause, Basel II's enhancements could cause considerable disruption in the fragile remaining secondary market, Bachmann said.
The Capital Requirements Directive (CRD) already included similar language in an earlier draft that it later revised to include a grandfathering clause for existing securitizations. This means that under the CRD, these new provisions will be applied only to securitizations issued after January 1, 2011 (and after December 31, 2014, to existing securitizations where new underlying exposures are added).
Bachmann said that because the CRD transposes Basel II into legislation in Europe, the CRD's grandfathering clause is currently protecting the secondary market from the "enhancements" in Basel II.
"But for new issues, the regulatory risk remains, and it will be smaller under CRD than under Basel II only if local regulators decide not to impose the one-for-one deduction proposed by Basel II and permitted by CRD I," he said.
The International Organization of Securities Commissions (IOSCO) in July also issued its due diligence best practice guidelines for structured finance investment managers.
"Before the crisis these requirements were forced upon only the specialist investment managers and SPVs," Long said. "Now everyone investing in structured finance will need to have that level of sophistication to be able to prove that they really know their investments and that they are doing the right thing."
The real challenge for data providers will be to allow investors to get a clearer view of underlying collateral. "As an investor, you don't want to spend weeks and weeks going through each line of a CMBS - it doesn't always make sense," Long said. "You need to be able to understand how the data works and look at the overall performance of the pool, for example, by looking at summary information and being able to get a snapshot of performance indicators such as delinquency rates. You need to see what is going on in the broader picture and then, if deeper analysis is required, you need to be able to drill down into the loan-by-loan data."
Crystal Ball Predictions
As sentiment improves, at least in the ABS and RMBS space, the investors who stayed on are looking to get in on secondary trades that haven't yet materialized.
Some investors are seeing certain indicators - such as the halting of house price declines, reduced repossession figures and enhanced affordability through low-interest rates - which have fed into improved sentiment for the RMBS and ABS space.
"Government assistance to consumers across the continent may also be influencing thinking about expected RMBS and consumer ABS performance," said Stuart Jennings, managing director at Fitch Ratings. "While these are clear positives, we believe the lag in occupational markets with the recession will continue to push up unemployment through 2010, which will again cause deterioration in performance indicators for these sectors."
Fitch has therefore continued to have a negative outlook in ABS and RMBS generally, and Jennings said that negative rating actions will continue to outpace positive ones.
Primary Issuance in Sight
The European RMBS market could see some new issuance in the last few months of the year, possibly under the U.K. government's Asset Guarantee Scheme. But investor appetite for new RMBS issuance will be nowhere near the volume of retained transactions, partly funded via central bank repo facilities, that have been done since the closing of the primary market.
"Property prices remain stagnant, and that is coupled with the fact that joblessness is still rising," Dosanjh said. "The key data is still pointing south. Money needs to be put to work, and we are seeing the same game that put people here three years ago. The hunt for paper means that investors aren't really doing the credit work that needs doing, especially in the current market with so many variables that must be considered."
Even Barclays' rumored three-year RMBS hasn't been enough to heat up sentiment. The deal is expected to feature a bullet maturity, with a put option back to the issuer at par after three years. Investors would get security over the highest-quality collateral of any U.K. master trust as well as a pledge to buy back the bonds at par from one of the few U.K. banks not to have needed government help; this is possibly as attractive as this market will ever get.
"This is just one of the U.K. prime RMBS master trust deals rumored to come to market this fall," Bachmann said. "It looks like arrangers are sounding out the investor base to find out what structure might work, in particular whether a government guarantee is really needed or not."
He said that some are speculating that there might be a deal with some bonds having the guarantee and others not. Basically, everyone is trying to figure out how to get a U.K. prime RMBS deal placed this fall. "I think that some are overoptimistic on how strong the RMBS market will be going forward. The investor base looks small and the new regulatory rules affecting RMBS have affected healing rather than support it. Regulations are making it difficult and it is unlikely that it will come back with any major volume," Bachmann said.
If RMBS-based funding for mortgages goes away, funding will have to come from other sources such as traditional saving accounts, supported by consumers growing their deposits and complemented by banks shrinking their lending volume. "It's as if the market has gone backward in time with a larger fraction of private-sector funding coming from plain vanilla savings products," Bachmann said.
Another traditional funding option would be the covered bond market, which has recovered more quickly than RMBS and does not face the same future regulatory constraints that the RMBS market faces.
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