Credit performance remained strong across most U.S. structured finance sectors in 2013 and the outlook for 2014 calls for more of the same. High credit quality collateral is again expected to underpin solid performance metrics and ratings stability for new issues across the core structured finance sectors ABS, CMBS, CLOs and RMBS. These better optics, however, still need to be viewed in the context of legacy RMBS, CMBS, and CDO transactions, which account for the vast majority of negative Fitch Rating’s rating outlooks.
Structured finance rode the strong credit and performance and a favorable funding environment to issuance gains again in 2013. CMBS and CLO issuance reached post-crisis highs while ABS maintained a consistent pace. RMBS experienced modest growth despite constraining market and policy factors. Fitch expects the pace of structured finance issuance growth overall to moderate in 2014 given a number of external factors on the regulatory, policy and political fronts.
Consistent with recent years, regulatory overhang will pose a challenge in 2014 and beyond. Regulators have made progress on some outstanding issues stemming from legislation passed in the wake of the financial crisis, notably risk retention, Basel III and regulatory capital and liquidity issues. Fitch expects resolution on some fronts in 2014 with implementation likely in later years. While resolution could remove uncertainty, it could also act as a catalyst and pull forth issuance for certain sectors.
Fed tapering and a higher rate environment will be felt across all sectors, albeit to varying degrees. The longer term impact of a higher rate environment is expected to be most pronounced on CMBS, where refinancing needs could pressure existing transactions.
Repeated budget and debt limit standoffs have not directly impacted the performance or ratings of most sectors nor are they expected to. While any broader macroeconomic declines triggered by crisis-to-crisis governing could create some performance drags, rating actions are expected to be limited with the exception of FFELP-backed student loan ABS.
ABS Maintains Consistency
Collateral credit quality and performance measures are expected to remain strong and transaction structures robust throughout 2014. The rating outlook is stable to positive for most sectors, except for student loans where Fitch’s universe of AAA’ rated FFELP backed ABS remain on Rating Watch Negative pending resolution of the U.S. sovereign rating.
Fitch’s outlook for prime auto ABS asset performance in 2014 is stable, even as losses are expected to increase, driven by rising loss frequency and severity. Fitch expects annualized net losses to range between 0.50%-1% in 2014 (similar to 2005-2006) and up from approximately 0.40% through the third quarter this year.
The performance of securitized credit card receivables has consistently exceeded expectations since the recession. Delinquencies and chargeoffs remain at or near historic lows and monthly payment rates are at record highs. Fitch believes that this exceptional collateral performance will persist into 2014, before receding moderately toward year end.
Student loan performance remains highly correlated with the economic environment when students enter repayment. While the collateral performance will continue to reflect the macroeconomic environment, FFELP student loan credit quality will mostly reflect the reinsurance provided by the U.S. Department of Education. Fitch’s outlook for private student ABS is negative for legacy and stable for postcrisis transactions. Performance remains under pressure as unemployment is expected to remain elevated but significant increases in defaults are not anticipated.
CMBS to Stay the Course
Fitch expects the positive momentum for U.S. CMBS loans seen since 2010 and past rating actions taken to provide ratings stability in 2014, especially for investment-grade CMBS. Fitch’s 2014 outlook for U.S. CMBS is stable. Macroeconomic factors will provide the key risk.
Underwriting will be of continued focus in 2014. All of Fitch’s metrics, bar debt service coverage ratio (DSCR), worsened in 2013. DSCR improved due to the decline in interest rates and the increase in interest only (IO) loans. DSCR will worsen in 2014 as interest rates tick up. Of particular note was the substantial increase in full or partial IO loans in 2013; they comprised 49% of the pool on average through the end of September compared to 33% in 2012. If DSCR starts to decline and LTV continues to rise, the uptick in credit enhancement will be more substantial all other factors remaining constant.
Property market fundamentals continue to improve, a trend that started in 2010. Continued economic recovery and a lack of new construction are the main contributors. Macroeconomic factors continue to provide the key risk to positive performance.
Hotels and multifamily properties have shown strong income growth over the past four years, with many markets reaching previous revenue and net operating income peaks. Office properties will continue to see mixed results. Major metropolitan markets will continue to see rental growth, though new construction may be a concern in some. Smaller and suburban markets will continue to exhibit weakness. Retail has stabilized but will continue to be a mixed bag as already-strong properties will dominate weaker rivals.
As in 2012 and 2013, larger metropolitan areas will continue to outperform smaller cities, tertiary markets, manufacturing hubs, and markets still suffering from the housing industry downturn. However, as the housing market continues its improvement, the disparity in performance seen over the past four years will decline. The best properties in gateway markets will continue to be attractive to finance.
RMBS Recovery Slows
Fitch expects the U.S. RMBS market to continue its recovery in 2014, even if interest rate volatility and regulatory uncertainty may hinder progress. Delinquency trends continue to improve across all credit sectors, with the exception of the pre-2005 vintage collateral. While home price gains are well supported in most regions, the risk of overvaluation’ is increasing in some markets. Home prices are expected to climb further although higher rates may temper growth.
The combination of rising home prices, stable macro conditions and low interest rates has supported steady improvement in mortgage collateral performance in recent years. Most of these factors are expected to stay in place in 2014 albeit with interest rates inching up further. As of the latest distribution date, the total percentage of outstanding RMBS borrowers seriously delinquent has declined to 24% from close to 32% three years earlier. We expect these trends to continue albeit at a slower pace.
Fitch does not expect material changes in underwriting conditions in 2014 with new issue RMBS largely backed by high quality jumbo collateral. However, rising mortgage rates are expected to drive a decline in refinance volume, which could result in some incremental credit expansion with a slight deterioration in pool FICO and CLTV attributes. RMBS transactions will continue to have a high percentage of third party due diligence, in part due to the new qualified mortgage’ (QM) rules that become effective in January.
CLOs Keep Pace
Collateral performance and ratings will remain stable for U.S. CLOs as corporate loan defaults remain muted and the credit quality of most speculative grade corporate borrowers remains stable.
Stability of ratings on CLO notes are primarily a function of stable credit profiles on underlying loans, low leveraged loan defaults, and significant cash flows and credit enhancement compared to applicable rating stresses. The issuers of over 81% of loans held in Fitch-rated CLOs maintain stable outlooks indicating an expectation of stable rating performance over the next one to two years. Negative and positive outlooks for the issuers of underlying loans account for 9.3% and 8.6%, respectively.
Regulations for implementation of risk retention rules under Dodd-Frank for CLOs have not been finalized yet, with guidelines likely to be published in early 2014 and effective beginning 2016. The re-proposed regulations as they stand today could have significant consequences on the CLO market as we approach that date. The Loan Syndications and Trading Association discussed three potential outcomes of risk retention at its annual conference in October. In its “benign” scenario, over 80% of the current CLO manager base survives. A “moderate” scenario would see mid-sized and smaller managers withdraw from the market or consolidate and the largest 25 CLO managers survive. A “severe” scenario for risk retention is that it halts new CLO issuance altogether.
—Michael R. Dean is managing director, asset backed securities at Fitch Ratings.
