The European Securitization Forum (ESF) has remained steadfast about its belief that the European securitization market will return. However, as the credit turmoil intensifies, the beleaguered market looks less likely to be fixed in the short term.
Rick Watson, managing director of the ESF, said there are still three key points that need a resolution before the economics of securitization begin to make sense again.
"What we are hearing is that there's quite a bit of interest from investors to buy new securitization transactions, but at spreads that don't make economic sense as compared to where they are in a stable environment," Watson said. A large bank, according to Watson, can originate and hold assets on balance sheet at spreads reasonably close to where securitization makes economic sense.
"What this will come down to is how each lender calculates its return on capital and how it's funding every one of those assets," he said.
Large global institutions like big U.K. banks can opt to fund through deposits, covered bonds or unsecured debts. The spreads on all these options are very different numbers these days, and it makes an enormous difference on how mortgage loans for potential securitization fundings are priced.
Watson estimated that many mortgage products in the U.K. for the prime borrower sector are currently priced at 80 basis points to 90 basis points above Libor. That is tighter than where triple-A spreads are trading on the secondary market, at least for older production.
"If you add in a new pool with low LTV and conservative underwriting standards, an investor may have a different pricing decision," Watson said. "The reality is that there are still bonds outstanding in the secondary market that were originated a year or two ago."
He added that many investors are comfortable with the credit quality of bonds in the prime and nonconforming level. The challenge is that, in some respects, secondary market supply is still sensitive to the timing and property price dynamics of the U.S. subprime resolution, which means there are still macro risks that will affect the timing of secondary market recovery.
After the U.S. subprime problem is resolved, the next question will be when will investors return to the market? The third question is when will the triple-A buyers, primarily banks and money market funds that were buying a year ago, come back?
Watson said that thus far, bottom-fisher investors, which are typically funds-of-hedge funds, have shown resiliency. It's the triple-A buyer that has been more reluctant to bite. "The policy issue that is raised is will securitization return to economic levels for the originators so that it remains a viable funding exit," Watson said. In Europe, a good 50% of the investor base, particularly for triple-A ABS, are banks and money market funds. This triple-A base had broadly needed leverage, not over-leverage, but some level of leverage, Watson said.
"If you create a low-risk, low-profile asset like a triple-A tranche of a mortgage pool, fund managers that are driven by a total rate of return performance will buy it only as long as it will perform no worse than an index or roughly better, which means that it will not widen and might potentially tighten," Watson said, adding that without any form of government intervention, it is not clear how long it will take to create a scenario where spreads on triple-A paper revert back to levels so that when origination comes back, the economics work.
Working Toward a Solution
Sir James Crosby from the HM Treasury last month published his interim report addressing mortgage finance issues for the U.K. that included a discussion of options for improving the function of the U.K. wholesale mortgage funding markets, particularly RMBS and covered bonds. Watson said that the ESF is working closely with the Crosby team to review solutions that could revive the U.K. mortgage market.
The members of the ESF have a slightly different perspective than other market participants. Because its members are basically people who get involved with securitization transactions but don't necessarily originate loans or do other types of financing opportunities, the question that many members have is similar to what Sir Crosby outlines in his report. Watson said the ESF members question whether there should be a public sector response required to the declining mortgage markets or if it can come back on its own.
"What we are trying to do is to take a bigger picture overview of what is needed to actually create the right type of long-term equilibrium between mortgage origination and mortgage funding," Watson said. "Most people would agree that funding has declined in the U.K. by 50% to 60%. There is a risk that long-term mortgage funding will be cut off permanently to sectors above very conservative LTV borrowers, which could cause ever higher defaults and delinquencies on both prime and non-conforming assets."
From the ESF perspective, Watson said there are three important observations. In the U.K. and Europe, there is no Fannie Mae nor Freddie Mac, nor a Federal Home Loan Bank system that has been underpinning the recovery in the U.S., where Watson estimates that approximately 80% to 90% of new mortgage origination is still going through the government programs. In Europe, some of the slack is being taken up by the covered bond market, at least in continental Europe, but less so in the U.K.
The U.K. Treasury has ruled out the possibility of creating a U.K. Fannie Mae or Freddie Mac, but Watson said there are other options that can be implemented to create a temporary bridge that covers the supply of borrowers that can't obtain a mortgage now.
One option may be the development of a direct guarantee program, which has both advantages and disadvantages. On the one hand it would simplify things; however, while not necessarily expensive, it would have budget implications for the U.K. Other interim solutions, such as the Council of Mortgage Lenders proposal that asks for an expanded repo program that would be eligible for newly originated mortgages, could also work to stimulate origination. Watson suggested that programs that warehouse certain tranches, like the triple-A mortgage tranche where the natural buyer base for this low-risk low-return asset has undergone serious dislocation, could also be put in place.
The decision, however, will be both political and economical. It's likely that the U.K. will have to look at these programs as a business transactions and consider the loss in present value in tax revenue to the U.K. government, quantifying it in terms of a drop in GDP that could happen. "The question is: How much loss could be avoided if an interim bridging action were taken?" Watson said.
Marco Angheben, director of the ESF, said that in continental Europe some strides are already underway to revive their mortgage markets, including loan modifications. An example of this is under the Italian Tremonti decree in Italy, a new legal decree negotiated between the Italian Ministry of Finance and the Italian Banking Association.
It is not yet fully clear how the new decree will affect mortgages that are securitized since these loans are sold into an SPV, which isn't subject to the terms of the new decree. However, since the transfer of the asset should not mean any change of household conditions, the originator usually provides the possibility to terminate the mortgage and, at the same time, to originate a new one. Borrowers of securitized mortgages would then have the possibility of renegotiation.
The decree allows Italian borrowers, at the moment that their mortgage resets and if there is a sharp increase in rates, to apply for the cheaper rate under the decree measured on the rate of 2006 plus certain Libor. That basically leaves the bank or the SPV to provide the cushion to make up for the difference in rates.
"The big issue is what the impact of the decree will be on the current mortgage pool that has been securitized and what percentage of mortgages within this pool will be affected by the decree," Angheben said. "It will affect excess spread and some of the reserve, which will diminish current cushions. It's hard to say what the true impact will be; nevertheless, the spreads for Italian RMBS have widened because of this level of uncertainty." He thinks that, over the next month, banks will come out with an exact number of mortgages that have been impacted by the new decree.
In Spain, the government has created a fund to build new social housing. Additional measures that have been used in other countries include offering first-time buyers some discounts or fiscal benefits in terms of the interest that they pay on the mortgage, as is the case in Holland. "We have to look at the problem from various points of view; from the originator you have to consider the economic perspective," Angheben said. "From a borrower's perspective, these countries are looking at what can be done to continue to grant the opportunities for people to increase home ownership and affordability."
But with the facts so clearly outlined, Watson said it's now easier to understand what the economic impact will be. Now it isn't a question of whether the market will come back, because as Watson and the ESF see it, it's in the commercial interest for it to come back. The question is how big will that market be?
"The biggest challenge for us over the next 6 to 12 months is working with people like the Crosby team on harder bridging solutions and on the implementation of what we committed to deliver to the European Commission," Watson said. "If we can deliver on that, it will be helpful toward restoring investor confidence, but it will take work."
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