Europe's reenactment of last summer's sovereign debt crisis heated up as talks of a Greek debt default intensified once again this July.

Round two of bailout talks for Greece stalled the gathering momentum in Europe's primary securitization pipeline and also put pressure on spreads across global markets.

This time last year - when talks of the Greek credit crisis also caused contagion risk concerns across the European continent - the securitization market seemed immune as it continued to launch and price public deals.

However, in July the market showed that it was not totally insulated from the crisis. Two deals that had been actively marketing - Anglian Water's tender offer and refinancing deal called West Bromwich Kenrick 1 and Santander Consumer Bank's German auto loan ABS named SCGA 2011-1 - were pulled because of increased market volatility.

Other deals went underground such as that from Banca Etruria, which retained its Italian RMBS rather than facing the execution risk of bringing a new issue to market.

Private placements have also once again emerged as the market's choice for executing deals as demonstrated by the two prints from Lloyds Bank last month.

Lloyds launched a new deal from its SME CLO shelf called Sandown Gold and another issue from its Arkle RMBS master trust. Both transactions were pre-placed and/or were subject to reverse inquiry. Despite the two BWICs, market analysts said it is still difficult to get a real sense of where the market is going since prices are softer and investors are remaining on the sidelines.

It is unlikely that public market issuance will resume this summer. Instead, when issuance does pick up, issuers are likely to continue to opt for the private placement route.

"All of the deals cited deteriorating market conditions as the main cause for delay," Barclays Capital analysts said. "At best, we interpret this as the ABS market being shut for the summer, and unless there is a resolution of the macro concerns, we could be in for a longer shutdown."

They said that the lockdown has not only been felt on the primary front but that secondary market trading also remained relatively quiet with little client involvement and low street volumes traded.

"Eurozone politicians can't agree on an effective solution to the sovereign crisis," said Suki Mann, a credit strategist at Societe Generale. "They don't - or don't want to - understand that the eurozone as we know it is on the precipice. In our view, Greece appears beyond repair, Italy is on the brink and chances are that the euro might be no more very soon."

This fear of contagion has been equally dominant over U.S. price and spread action in securitized products.

"No one wants to sell and leave money on the table if in fact this is the start of something bigger," said Jesse Litvak, a managing director at Jefferies & Co. "Bid offer spreads are still pretty bad. We still need a resolution to the debt ceiling in the immediate future, and I think Europe is going to be a longer-term issue. But rest assured, if 1400 SPX starts becoming a reality (corporate earnings so far have killed it this earnings season) non-agency prices will melt higher."

In fact, Bank of America Merrill Lynch analysts said that the euro sovereign crisis has been entirely dominated by agency MBS spreads relative to the U.S. debt ceiling.

"This conclusion might surprise a number of market participants, given the widening of MBS spreads as the market [last month] awoke to GSE conservatorship risk in the event of a U.S. default," they said.

Greek Options Weighed

Eurozone leaders met last month to discuss the three options that could save Greece.

The options included a bond buyback of Greek debt and public-sector credit enhancement; a second option that included the issuance of new, 30-year Greek bonds that would replace existing debt in a swap operation and a third option that is based on a tax imposed on the financial sector that would involve an agreement with private banks that have large holdings of Greek debt to maintain exposure.

What's ensued from the talks is an agreement to grant Greece a bailout that includes public money from both the International Monetary Fund (IMF) and European Union (EU) that covers €109 billion combined with a contribution from the private sector that amount to approximately €50 billion ($72.5 billion).

The plan stated that future European Financial Stability Facility (EFSF) loans to Greece will be extended from the current 7.5 years to a minimum of 15 years and a maximum of 30 years, and loans will be provided at lending rates close to those of the Balance of Payments Facility (now roughly 3.5%) without going below the EFSF funding cost.

Already existing Greek loans will receive a maturity extension from 7.5 years to 15 years. In addition, the interest rate on the loans will be lowered to 3.5% and this cut will also be applied to the loans Ireland and Portugal have received from the EFSF (meaning a cut of 100 basis points and 200 basis points, respectively, according to figures reported by BofA Merrill analysts).

Private-sector involvement can be done via four options that include a par bond exchange into a 30-year instrument, a par bond offer involving rolling over maturing Greek government bonds into 30-year instruments, a discount bond exchange into a 30-year instrument and a discount bond exchange into a 15-year instrument. For the first three options, the principal is fully collateralized.

"The temporary rescue facility will be given substantially more flexibility as it will be able to intervene in secondary markets for government bonds in the future (on the basis of ECB input and a unanimous decision by EFSF member states) and also be able to help recapitalize financial institutions," UniCredit analysts said.

Although the exact amount of aid remains unclear since it depends on the fully voluntary participation of private debt holders, the estimate is that private-sector involvement would combine buybacks for €12.6 billion and rollover and debt exchange solutions for €37 billion, reaching a total of €50 billion for 2011-14. The expectation is for the program, over the longterm into 2019, to deliver €106 billion.

Under the terms of the agreement, recapitalization of Greek banks will be provided if needed - the IMF sets the recapitalization needs at €20 billion - and liquidity flows will be ensured through the provision of credit enhancement to underpin the quality of collateral so as to allow its continued use for access to Eurosystem, should it be needed.

"Overall, the main financial conclusions of the summit look set to reassure the markets and avoid contagion through the reassurance that private-sector involvement will be restricted to Greece, although further details on the PSI will be needed to confirm this positive feeling," BofA Merrill said.

From an ABS perspective, investors welcomed the decisions by EU leaders last week, given the significant interference of sovereign risk with originators and structured finance.

According to BofA Merrill, sovereign CDS tightened massively with Italian five-year CDS trading down at 260 after reaching a high a week prior to the debt package resolution of 350, Spain was down at the 300a, Ireland at 890 basis points and Portugal at 936 basis points (before the debt package CDS traded at above 1200 basis points).

Europe Still Hits

First Default

Although the Greek bailout package has helped restore some market confidence, it hasn't completely reassured the ratings agencies.

Moody's Investors Service downgraded Greece's debt rating from 'Caa1' to 'Ca' "to reflect the expected loss implied by the proposed debt exchanges. Once the distressed exchange has been completed, Moody's will reassess Greece's rating to ensure that it reflects the risk associated with the country's new credit profile, including the potential for further debt restructurings."

Moody's warned that, in spite of reducing contagion in some ways, last week's set of measures to shore up the eurozone could lead to downgrades of the creditor countries because of the precedent its sets for future bailouts. "For creditors of such countries [Greece, Portugal and Ireland], the negatives will outweigh the positives and weigh on ratings in future," Moody's said.

For countries not rated triple-A such as Italy and Spain, which have seen bond yields soar in recent weeks, the risk of contagion remains very much a possibility.

Fitch Ratings also said that because of the private-sector involvement in the new financial program to support Greece, it would consider the country in "restricted default." As such, Fitch placed the Greek sovereign rating into 'Restricted Default' and assigned 'Default' ratings to the affected Greek government bonds on the date that the offer period for the proposed debt exchange closes.

Fitch will assign new post-default ratings to Greece and to the new debt instruments once the default event is cured with the issue of new securities to participating bondholders. The new ratings will likely be low speculative-grade.

Eurozone leaders restated their stance that "reliance on external credit ratings in the EU regulatory framework should be reduced." As such, the debt package agreement does provide credit enhancements to underpin the quality of collateral to allow it to be used for access to Eurosystem liquidity operations by Greek banks.

Still, it is unlikely that the market will see further tightening potential for the rest of the summer, said analysts at BofA Merrill. "The fact that the European authorities agreed to ignore any 'selective default' ratings does not necessarily mean that they will not come and that they will not have negative implications for sentiment and structured finance assets, which are still massively held at European banks," the analysts said.

Getting the Market

Going Again

Despite the lack of clarity, market traders are hopeful that this first step toward addressing the sovereign debt crisis in Europe will get investors interested in participating in the market again.

"Between the tape bombs surrounding what is going on in Europe and the headlines from our fearless leaders in D.C., how can anyone price risk without having a good feel for what the outcomes are going to be?" Litvak said. "Sure, you could argue that's part of the game. But at this point, since we are at the mercy of what entities like Moody's and S&P think, you might as well go to Vegas and get a line of credit at the craps table and take your chances because that is a lot more fun."

To be sure, the level of uncertainty not only drove down new issue transaction volumes but it also sent bid offer spreads wide on the secondary front.

According to Societe Generale analysts, closure on the sovereign issue for the summer could bring a return of secondary market liquidity and a pickup in trading activity.

"The much-anticipated EU summit broadly delivered as positive an outcome as the market had dared hope, with a powerful rally in risk assets ensuing, lifting asset-backed prices noticeably," Royal Bank of Scotland analysts said. "Whether the measures announced are sufficient to draw the eurozone crisis to a definitive close is arguable, indeed our economists think not and see potential for renewed market risks. For now though, the more liquid ABS have shared in the relief rally, paring most of the losses seen over the past tumultuous weeks."

The firm tone of the debt resolution package has already drawn a line under the recent slippage in European ABS pricing and could pave the way for better pricing performance in European ABS if and when activity on the continent picks up.

If this recovery in the broader market holds, market analysts said it's likely that the primary securitization market will reopen after the summer lull, with deals resuming their public syndication formats rather than opting to be marketed as private placements.

"We think that the core primary markets will still see activity, subject to some adjustments - shorter maturities, established programs, high-quality collateral, i.e. the usual risk-off attributes, and a re-run of private placements and retained repo deals," BofA Merrill analysts said.

 

Portugal and Ireland Written into Greece Package

Greece isn't going to be the only country to benefit from the eurozone bailout package; Portugal and Ireland are also eligible to borrow under the new terms of the International Monetary Fund (IMF)/European Union loan extension, which will come in handy as these countries grapple with the European sovereign meltdown.

The three countries have together felt the sting and backlash of rating agency downgrades.

To be sure, Moody's Investors Service last month downgraded Portugal by four notches to 'Ba2' from 'Baa1' with a negative outlook on the back of the Greek drama. The rating agency also warned of the "increasing probability" that Portugal would not be able to access the markets at sustainable rates for some time after 2013.

The rating agency has also downgraded the ratings of 95 tranches of RMBS transactions as well as 18 tranches of 13 Portuguese ABS, which amount to roughly €29.8 billion ($42.8 billion) worth of debt securities. Moreover, 12 ABS tranches from seven transactions remain on review for possible downgrade.

The 'Aaa' rating of an ABS tranche guaranteed by the European Investment Fund (rated 'Aaa') has also been put on review by Moody's, as the benefit of the guarantee may be subject to the performance of transaction parties.

"The highest rating that can be achieved by Portuguese RMBS is now single-A," UniCredit analysts said. "The sovereign bonds are still rated 'BBB-' by both Standard & Poor's and Fitch Ratings and the linkage between the sovereign bonds and the RMBS bonds, while harder to predict recently, is generally believed unlikely to exceed a difference of 6 notches."

This means, analysts said, that any more downgrades by the rating agencies would result in these assets not being eligible for the ECB repo facility, unless the ECB made further changes in its rules.

For now the European Central Bank (ECB) said that the country won't lose access to its much-depended-upon liquidity program.

In a statement issued after the Moody's downgrade last month, the ECB said it would suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem's credit operations. This suspension, which will be held until further notice, applies to marketable debt instruments issued or guaranteed by the Portuguese government.

The ECB said that it based its decision on an approved economic and financial adjustment program, which has been negotiated with the European Commission, together with the ECB and the IMF. "The Governing Council assessed the program and considers it to be appropriate," the ECB said in a statement. "The approval was based on a positive assessment and the strong commitment of the Portuguese government to fully implement the program from a risk management perspective."

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