The European securitization market looks set to keep on the same track it traveled throughout 2008. Government-sponsored programs are at the forefront of primary activity going into 2009.
Until the market overhang dissipates and pricing issues are addressed, it's unlikely that the primary market will see any real activity, market sources said. Throughout the year, the central banks have made moves to accept a wider range of products as collateral to fund banks' balance sheets holdings.
Across Europe, governments have made direct equity injections to help recapitalize banks. "Widespread bank systemic crises have been averted by the recent actions announced by governments across Europe," said Gerry Rawcliffe, managing director, EMEA financial institutions at Fitch Ratings. "The newly introduced measures are expected to allow banks to better address the extremely challenging economic situation over the remainder of 2008, 2009 and into 2010."
While the various government-backed initiatives drawn up across Europe have staved off a complete collapse of the European banking system, part of the industry continues to deleverage, resulting in limited potential for a rebound in ABS asset prices.
Societe Generale analysts said that one approach that could greatly benefit the ailing market would be a direct asset buying option under the national plans. "The limited means governments are offering for the purchase of assets, which we think could have pushed up prices, means the measures will only slightly relieve the markets," said Jean-David Cirotteau, a SocGen analyst, in his outlook report for 2009. "What is increasingly evident is that only new assets or structured portfolios (recently originated loans) are being directly purchased."
For now, those traditional players that have fallen away are likely to be absent in 2009. The market has only been seeing privately placed deals. Issuers have been arranging deals, but there has been no distribution. The primary market in 2008 was marked by the launch of a large number of structured deals, most of which were retained. These transactions were structured so that the originator can use them to borrow cash at the central banks' repo facilities. These structures are very simple, with just one rating agency and few details on expected weighted average life. The coupons on the bonds are well below market spread levels, but were established to set an excess spread sufficient to serve as an extra layer of credit enhancement.
"They haven't gone away. The problem is that there is no wholesale market, so these traditional players have had to work through a variety of different means, such as syndicated loans, deposit banking, the Bank of England Special Liquidity Scheme (SLS) or the European Central Bank repo funding," said one market source. "At the moment, it seems every financial institution in the U.K. is borrowing under the SLS." Market analysts said these retained deals may end up being restructured when the market finally reopens, and banks will have to make coupons more attractive to find buyers for the structures.
SocGen analysts said appetite for ABS products has diminished considerably, and they expect no recovery before the second half of 2009. "This could imply a loss of nearly 50% of investment capacity compared to pre-crisis levels, as banking accounts/arbitrage conduits have decreased significantly," Cirotteau said. "However, banks' structuring capacity remains almost intact, which may bring some demand, based on activity from specialized investors."
One market source predicted that new entrants such as distressed funds will become the likely buyers throughout the first half of 2009. Beyond this, the market will most likely see much simpler structures such as consumer and simple prime ABS deals at the end of 2009, although these are unlikely to be placed publicly. "The market will come back when the overhang dissipates and when pricing reaches bottom, and distressed investors will be key in this process," the market source said. "That could happen in first and second quarter.... It doesn't mean that that is the actual bottom of the market, but it will be the key catalyst to rid the market of the overhang. Only then will new issuance become effective."
Over the short term, another market source said that the expectation is for more of the same government guarantee schemes. The source added that market participants are finding ways to manage their balance sheets via conduits, infrastructure deals and synthetic CLOs. These players are also looking at restructuring existing deals without monoline support. More restructurings, particularly in the CMBS area, are also expected.
SocGen's Cirotteau said that the ABCP market is expected to make a significant recovery. "The short-term market should be less expensive despite spreads remaining high, as rapid rate cuts from central banks ensure that lower interest rates will offset the higher cost. Our analysis also relies on the bottoming out of the CP market," he said.
Primary Market Revival Not Likely
The volume of deals structured for central bank repo - which, according to SocGen, has reached E400 billion ($567 billion) this year - is expected to decrease as a result of banks and financial institutions having already structured a large chunk, if not the whole of the loan books on their balance sheets, making them repo eligible. Furthermore, these banks and financial institutions now have alternative structures, such as the French Societe de Financement de l'Economie Francaise (SFEF), which provides a faster and simpler way of funding assets. The cost linked to the sovereign guarantee will drive the development of these solutions, Cirotteau explained.
"Irrespective of what has worked, we are in a new world where when you structure new issuance, input and assumption will be very different since the rating process has had a fundamental shift and the economics of it means that future structures have to be different and safer," a market source said. "The default and correlation have changed. The result is quite different. But despite the shift in economics the consensus is that securitization will remain an effective and efficient tool for the capital markets."
In the second and third quarters, the market source said that a pool of mainstream investors buying into standard structured finance portfolios should emerge, and then a smaller group of more specialized investors will regain appetite for right risk return portfolios. "We need to see the liquidity in simpler stuff, you need vanilla and futures and the swaps market to gauge where rates are, then you can move on to more complicated structures," he said.
Cirotteau said CDOs and managed CDOs - which have been severely hit - are not expected to grow strongly next year. They may, however, benefit in the long term from a more stable investor base that is less dependent on the banking bid - insurers, for example, which represent roughly 15% of the global CDO market, according to the Bank of England figures.
"The whole asset management industry will need to reinvent itself and, in doing so, to differentiate between managers who have the capacity to take on risk (regulated or non-regulated investors - such as hedge funds) and those who do not or cannot do so," said Cirotteau. "We expect development of the new structures will mostly concern investors in the first category, as only high-level investors will be dealing with complex CDO structures."
The covered bonds market will be the first to show signs of life when the market stages a return. Dresdner Kleinwort analysts said that the significant spread widening of recent months, along with the liquidity collapse and the drying up of issuance, are the symptoms of a fundamental market weakness, which is likely to require a long healing process.
On the covered bonds front, French and German paper has been sold, but the rest of Europe has fallen away. However, changes in legislation that distinguish covered bonds from structured covered bonds, as have been passed in the U.K., could create a more level playing field and perhaps entice investors back to the market.
"If you can get companies comfortable with new rating methodologies, and management of price expectation of where investors want to pay and where issuers want to sell, then the market can return," said one market analyst. "But the dynamic of cost guarantee isn't a guarantee that it will stimulate the right investors to buy - that is another question."
The introduction of industry policy groups into enforced regulatory requirements is another item to watch in 2009. But while these regulatory changes could reduce the volatility of the market in the medium term, in the short term there remains uncertainty over which regulations adopted could actually increase market volatility.
"New regulation could increase demand for ABS, or the situation in the banking sector might improve," Cirotteau said. "Discussions are taking place at various levels between the authorities, banks and industry representatives on implementing regulatory changes in order to avoid a new crisis in the medium term, but ironically, the regulatory discussion could increase uncertainty in the short term."
Various jurisdictions are discussing an increase in originator participation in the structures. For example, regulators could oblige originators to maintain a minimum 5% exposure to an ABS transaction, and to increase information disclosure at origination and throughout the life of the underlying portfolio. Cirotteau explained that retaining exposure would make ABS products more like other funding tools - particularly covered bonds, where banks keep the assets on their books. It would also increase the cost of the whole structure, as the retained portion would be held unhedged on the originator's balance sheet, implying extra cost in regulatory capital, most probably 100% risk weighting.
There have also been changes in fair value treatment and IAS39 reclassification of existing assets. Cirotteau said that banks are still looking at the implications of reclassifications from trading books to either hold-to-maturity or available-for-sale (AFS).
The ratio of downgrades to upgrades has increased in European ABS. According to SocGen, in the fourth quarter 2008 there have been 1991 downgrades against 55 upgrades.
"2008 was a difficult year for structured finance in EMEA - issuance to investors was near zero, while bank failures heightened counterparty risk," said Stuart Jennings, group risk officer, EMEA structured finance at Fitch. "From a performance perspective, 2009 will be worse. As the predicted severe recession bites, delinquencies and defaults will weigh upon performance in all sectors, increasing the risk of downgrade."
SocGen said that there is also evidence that subordinated tranches are suffering more than senior tranches, but analysts anticipate relatively limited credit deterioration in the underlying pools of existing granular transactions, in line with their current ratings. The situation is more difficult for non-granular portfolios, especially U.K. CMBS portfolios, whose performance will be hurt by weak economic growth.
"It's important to keep in mind that we have not seen the end result yet - the initial long-term ramifications of the credit crunch haven't yet begun," a market analyst said. "We have really only seen the start of how the world will look."
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