Despite recent optimism among many European investment bankers and analysts, the Euro market has not been weathering U.S. subprime woes as well as anticipated. Their recent contention that there is room for growth in non-real estate asset classes may not dovetail with the current scenario of jittery investors, negative news coverage and questionable ratings changes.
"Lurid headlines emanating from the subprime fallout in the U.S. are impacting ABS trading and the perception of risk in European MBS bonds," said Dave Colling, Markit's director of structured finance. "During the summer holiday season, it's easier for a junior trader to do nothing than take on a risk position in a product that continues to attract negative media commentary."
Indeed, the European summer lull is in full effect, with only a trickle of deals done in the past weeks and little activity expected for the rest of August. Market players hope that after this much-needed break, primary momentum will revive.
Colling said that the widening in RMBS is fuelling the perception of a possible crisis and perpetuating the spiral of declining value. "In Europe, we have not seen the degradation of structural protection available to investors or deterioration of the quality of MBS pools in either prime or nonconforming issuance," he added.
Aggressive traders may have overplayed their hands in the last month or so, according to Fitch Ratings. "Since Barcelona, a time in the market when leveraged finance bankers were pushing cov-lite, cov-loose, toggles and PIKs, the market has changed," said Ed Eyerman, head of European leveraged finance at Fitch. "Now they're having a hard time selling anything." But this development is clearly a technical market correction and not a reflection of a fundamental credit directional downturn, Eyerman said. He added that the outlook for default rates, at least in the near-to-medium term, remains the same as it was in June.
Eyerman's words, however, simply cannot compete with the mainstream press, whose headlines blare: "hell-bent on doom and gloom," as one analyst put it. The negative news related to investor write-downs and/or liquidity retrenchment continues to mount, a Deutsche Bank report said. "Funds are wrestling with substantially wider mark-to-market valuations on portfolios," Royal Bank of Scotland analysts said. "Several ABCP programs may face increasing pressure and likely will liquidate portions of their portfolio, if the commercial paper market proves difficult to roll. Several ABS specialists have unwound portfolios, and more are expected."
Other Factors Hindering Issuance
Another rising complaint is with the type of investor that is drawn to the ABS market. European ABS is a victim of its own success, by attracting a whole class of newer, less experience investors looking for yield.
"The ABS market is not for the retail investor, and you won't be opening The Wall Street Journal to track these bonds," said Jim Savitsky, director of structured finance at Markit. "ABS investors need to fully understand the risks in terms of both the underlying collateral as well as the deal structure, [as] investor concern over recent subprime underwriting standards is one of the factors behind slower deal issuance recently."
European ABS has gone from swim to sink rapidly. KfW earlier this month announced the bailout of IKB (ASR, 8/6/07), and DECO 2005-UKC1's small, GBP2.9 million ($5.9 million) Class E notes defaulted on a portion of interest due, causing a downgrade to D' from an initial BBB-'. Furthermore, Markit's Colling said that according to market sources, Windermere 12 has been postponed and Deco 16-UK 5 was said to be no longer in active marketing. In addition, news broke Thursday morning that France's biggest listed bank, BNP Paribas, froze 1.6 billion ($2.2 billion) worth of funds, citing the U.S. subprime mortgage sector woes that have affected financial markets worldwide.
"Current liquidity is driven by the banks [and] CLO managers depending on the banks for warehousing, but there is little appetite to warehouse loans when the same bank may be sitting on large, unsyndicated primary loan exposures," Fitch's Eyerman said. "Moreover, many banks and brokerages are pulling back lending to hedge funds who are compelled to unwind leverage on loan positions. The banks need to sell unsyndicated exposure, yet they're also pulling liquidity from the traditional buyers."
The pullback in liquidity is happening at a time when few leveraged deals need to be refinanced out of necessity, either to meet amortizations or to finance broader restructurings. However, that day will come, and the market will punish credits that remain overleveraged or exhibit even modest underperformance. "Most market participants believe we have passed the peak in the cycle," Eyerman concluded.
"Although the word is used extremely liberally, every crisis is different, and this is a liquidity crisis of sorts, not a credit crisis, in our view," said Suki Mann, senior credit strategist Societe Generale. "The liquidity refinancing tap has been turned off - for now - but the question is how long it will last, and whether it will eventually morph into a full-blown credit crunch."
Whether it does take a turn for the worse depends on how long the market takes to regain confidence and composure, thereby limiting any lasting impact on the economy. Mann said the current situation in some ways resembles that of LTCM, when the market rallied after the bailout at the back end of 1998 and into 1999, only to be derailed as the economy turned sour toward the end of 2000. But such ruminations were not really a worry. "We think we will emerge from the subprime malaise intact, chiefly as those fundamentals remain supportive - thus presenting a unique opportunity to add credit risk at very attractive levels," he said.
The Need for a Break
The August break will be a vital turning point in the market, according to a source at Merrill Lynch: If players really go on holiday and leave work behind, European ABS will face some real problems. On the other hand, if everyone takes a deep breath and has a rethink, September may be the start of some exciting new activity, she said.
"The current slowdown and repricing of risk assets is probably no bad thing, given that we had gone too far in favor of the issuer, and perhaps to the detriment of the investors, in terms of structuring and pricing of many transactions in the high-yield and leveraged loan market," SocGen's Mann said, adding that the current market situation was nothing to be alarmed about.
"We're still in the bull camp. We think we will emerge from the subprime malaise intact, chiefly as those fundamentals remain supportive - thus presenting a unique opportunity to add credit risk at very attractive levels," he said.
After the Break
Markit, which represents both the buy-side and sell-side of the market, said issuance has slowed dramatically, with investors becoming increasingly wary. But it was confident that the September launch of the first synthetic European ABS index, ECMBX, should result in increased activity in CDS of ABS, particularly among single-name CDS.
According to Markit, pool performance and delinquencies are mostly in rhythm with the economic cycle and reflect the quality of assets in individual pools. There is little evidence of a substantial decline in underwriting standards in nonconforming issuance. "Delinquency rates are increasing, but there is no spiking to indicate a coming cash crunch, even among deals containing teaser-rate loans," Colling added. "There is great value in senior European MBS bonds today, if investors can overcome their fear of the next headline."
Royal Bank of Scotland analysts said that the current market environment is beginning to form some unique opportunities, but investors need to remain "nimble and opportunistic." They recommended a series of short and long positions for the near term. "Typically, long positions are focused on higher-quality instruments, while short ones have weaker collateral characteristics, structurally weak, or performance has been worse than expected," RBS analysts said. "The CDS market has created opportunistic trades for portfolio managers, both when selling protection (i.e., buying credit risk) and when buying it (selling credit risk)."
Indeed, there is some decent action still happening. On Tuesday, Aug. 7, Brushfield Capital, an ABN Amro CDO issuing and management platform, closed its inaugural deal "with great success despite turbulent market conditions," the firm said in a statement. "This CDO of high-grade ABS is one of the few to close in this current volatile market, and due to excess demand, it was increased in size by 25%."
"In a market that some are saying is the most difficult we have seen in the past 10 years, the need for this issue to be upsized shows the trust that investors have in our asset selection ability," added Scott Eaton, head of Brushfield Capital, ABN Amro's principal financing group.
ABN Amro added that the thorough collateral selection process ensured that the underlying ABS was of very high quality, with a weighted average rating factor of 20, and made up largely of U.S. RMBS and CDO assets, and that there was investor interest from asset managers, banks and hedge funds. In terms of ratings, $62.5 million of the $1.2 billion deal was rated triple-A with a 1% spread, while $26.25 million was rated double-A with a 2% spread.
Moody's Investors Service also predicted growth in other areas come September, with the general feedback from sources at the rating agency believing that all EMEA asset classes are expected to perform well. RBS analysts have even bolstered their 2007 forecast on the back of a stabilizing market early in the fourth quarter, providing a window until year-end for new transactions. The bank raised its full-year forecast to 550 billion from 540 billion. "However, if investors remained concerned about fixed income, the refuge could be in covered bonds," according to one source. "CMBS is also expected to remain strong."
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