Overview
Even though the U.S. economy appears to be on a path toward recovery (albeit a slow one), Fitch Ratings expects weaker collateral performance across all structured finance sectors next year. Fitch expects the pace of downgrades to slow in areas such as RMBS, CMBS and CDOs given the magnitude of ratings downgrades and the prospective stresses built into the actions taken to-date. At the same time, sectors that have remained resistant to the downturn (consumer ABS) will likely see more negative pressure on collateral and, potentially, ratings on a relative basis, as fundamental improvement to key aspects of consumer health remain elusive.
U.S. ABS
Even with escalating delinquencies and losses in the face of persistently elevated unemployment, the ABS sector will continue to demonstrate a higher level of rating stability with limited downgrades, largely in lower rating categories. This relative rating stability is the result of structural features that enable rapid deleveraging, conservative loss expectations and stresses derived from prior recessionary environments, consistent collateral attributes, straight-forward transaction structures and ongoing involvement or retained interest by the originators.
ABS sectors directly correlated to the U.S. consumers will experience the most stress in 2010. In addition, new challenges for the ABS market in 2010 will center around recent accounting, legislative and regulatory developments. While not necessarily credit-related, these changes will shape the future of the market and its participants.
Ratings on credit card ABS remained stable in 2009 as issuers stepped in to support the trusts to mitigate steadily declining collateral performance. Although ratings in 2010 are expected to be stable, performance will be strained due to regulatory and legislative changes which will limit issuers' ability to employ dynamic risk based pricing strategies. Additionally, based on its expectation that unemployment rates will hover above 10%, Fitch expects chargeoffs to re-approach 12% in 2010. As a result, excess spread will continue to narrow, with three-month rolling averages hovering between 4% and 5%, causing intermittent spread account trapping. With that said, early amortization risk will remain remote.
Poor consumer health will continue to put a strain on loss frequency for auto ABS in 2010. On a positive note, Fitch expects the wholesale vehicle market will remain more balanced going into 2010. As a result, Fitch expects 2010 annualized net losses will be between 2.0% and 2.25%, below the levels witnessed between 2007 and 2009. This forecast is within Fitch's current ranges. Therefore, 'AAA' auto ABS ratings will remain stable. Any negative rating migration will be limited to the lower, subordinate tranches of notes.
Fitch expects continued deterioration in performance for private student loans as delinquencies continue to climb and losses increase. In general, transactions backed by direct-to-consumer originated collateral and those with premium proceeds structures are most vulnerable to downgrades. Private student loan transactions backed by school channel origination collateral and those issued by state related entities are less like to see ratings actions in the coming year. Also, private student loans are facing the prospect of increased legislative intervention. For example, Congress recently held hearings to determine if there should be more circumstances under which private student loans could be discharged in bankruptcy court. Such a decision would affect ratings.
The ratings outlook is stable for senior classes of FFELP collateral as a result of the U.S. government's guarantee of at least 97% of principal and interest. The outlook for subordinate class ratings is more negative as parity levels came under pressure throughout the crisis and will be slow to recover going forward, leaving less of a cushion for those tranches.
U.S. CMBS
Protracted illiquidity in the debt markets remains one of Fitch's primary concerns for CMBS. Refinance risk across all CMBS property types remains elevated, making even stabilized, low leverage fixed-rate loans less likely to repay in a timely manner.
Loans securitized in 2006-2008 vintage transactions will continue to reflect higher levels of loss than pre-2006 transactions However, due to the prospective nature of its rating actions taken on these deals in 3Q09, Fitch does not expect any additional widespread near-term negative rating migration for the 76 recently reviewed transactions. Over 80% of the bonds were affirmed in this review.
Fitch expects that operating cash flows will continue to decline across all property types for the next 18 to 24 months, which will result in negative rating actions for pre-2006 fixed rate transactions. Large loan floating-rate transactions, pre-2000 vintage transactions, and deals originated in the latter half of 2005 will be most susceptible to downgrades in 2010. However, the magnitude of the downgrades are not expected to be as significant as those taken in the 2006-2008 vintage conduit transactions due to seasoning, defeasance and loans generally not underwritten at the peak of the market.
Although still low, delinquencies have risen significantly throughout 2009 for all property types. Fitch anticipates that delinquencies will reach 6% by the 1Q10 and could peak at 12% in 2012. With the expected increase in commercial real estate loan defaults, Fitch's outlook for U.S. CMBS is negative.
U.S. RMBS
The RMBS sector will face increased delinquencies and loss severities in 2010 as temporary government support programs expire and re-defaults on modified loans increase the supply of distressed housing inventory in the market. Fitch predicts that national home prices will decline a further 10%. Also, as modifications have focused on reducing monthly payments as opposed to addressing borrowers' negative equity position, Fitch expects re-default rates after 12 months will remain high. Based on re-default rates on similar modification performed prior to HAMP, Fitch predict that re-default rates will be approximately 50% for prime and 65 to 75% for Alt-A and subprime.
The number of severely delinquent borrowers remaining in non-agency RMBS pools has grown to approximately 1.7 million, the highest level on record. Fitch estimates that of the currently paying borrowers in pools issued from 2005 to 2008, approximately 50% owe more than their homes are worth. In 2010, the existing negative equity position of many performing borrowers combined with a further rise in unemployment is expected to prevent any material improvements in roll-rates from performing to delinquent.
While Fitch expects downgrades to continue to outnumber upgrades in RMBS in 2010, the magnitude and severity of negative actions will moderate substantially compared to prior years. This prediction is based on the extent of the downgrades to date and that the current ratings already assume further stress. Interestingly, subprime RMBS could prove to have the most stable ratings of the three major mortgage sectors next year. Actual performance has been in line with expectations since mid-2009.
Generally, high recovery rates are expected on the senior RMBS bonds downgraded to distressed rating categories due to a high likelihood of default. Average recovery rates for prime, Alt-A and subprime average 95%, 80% and 50%, respectively. To guide investors on the prospect of a distressed asset's recovery, Fitch provides Recovery Ratings (RR); to-date more than 22,000 RRs have been assigned to distressed RMBS bonds.
U.S. CDOs
Fitch expects continued declining asset performance for every major U.S. CDO sector in 2010. Recently reviewed CDO notes that have retained high investment-grade ratings maintain sufficient cushion to Fitch's portfolio loss expectations, while mezzanine investment-grade and speculative grade tranches will generally be more susceptible to rating volatility from variability in these loss expectations.
Corporate CDOs have performed relatively better than any of the structured credit asset classes even while corporate debt markets experienced elevated levels of default and softness in U.S. high yield corporate recoveries in 2009. Defaults are expected to remain elevated to historic averages in 2010 but lower than those experienced in 2009. As a result, Fitch expects total defaults will fall just short of its initial 2009 projection of 15% to 18%. The biggest challenge facing corporate debt markets, in the coming years, will be the availability of refinancing opportunities. It is unlikely the high yield bond market will have the capacity to refinance the volume of debt that is scheduled to mature in 2013 and 2014.
A significant percentage of the 142 U.S. banks that have failed since July 2008 are within bank TruPS CDOs, contributing to the rising trend in defaults and deferrals within these CDOs. With approximately $3.8 of $33 billion of bank TruPS issued in CDOs defaulted and another $4.7 billion deferring, Fitch anticipates at least $3 billion of additional bank TruPS defaults by year-end 2010.
Mortgage-related CDOs remain under significant stress. While delinquency and defaults are currently more prevalent in the residential real estate markets, this trend is accelerating in the commercial real estate markets. Fitch expects performance of CRE CDOs to follow that of SF CDOs, given the lagging nature of the underlying CRE assets.
John Olert is a group managing director and head of Fitch's U.S. ABS and global structured credit groups.
Huxley Somerville is group managing director and head of Fitch's RMBS and CMBS groups.
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