Over the last five years, European RMBS has proved to be good as gold for investors, especially in the U.K. market where the most trading happens. Some investment bankers have heralded this era as an age of unprecedented prosperity, with one calling triple-A U.K. RMBS "bulletproof." But is the magic coming to an end?
While there is a general consensus that U.K. RMBS issuance will continue to draw investors in droves, some market pundits doubt whether growth will continue at the same pace or begin to plateau. In the U.K., speculation abounds about all things residential, and RMBS is no different. The recent sale of Foxton's, a leading London-based real estate agent, to a private equity firm grabbed headlines with declarations of a forthcoming housing slump.
Such dispatches are not uncommon on the British Isles, and yet the real estate market continues to grow. As a result, so have U.K. RMBS volumes. According to a report by Deutsche Bank, U.K. prime RMBS master trust volume has increased sharply in 2007. Lloyds Bank, for instance, recently printed its GBP4.3 billion ($8.4 billion) Arkle trust. Both Abbey and the Royal Bank of Scotland are believed to be in the market for similar size issuance. Deutsche Bank analysts projected first half volume to be 120% above issuance for the comparable period in 2006, with the majority of U.K. prime RMBS issuers, particularly the newer trusts, looking to securitize assets at a faster rate than net originations, thereby increasing the share of mortgages funded through RMBS.
The Arkle trust is of particular interest to securities experts at Societe Generale, being that the primary currency is dollars. Of the $8.4 billion value of the deal, only 62 million ($83.2 million) is in euros and GBP175 million is in pounds.
According to SocGen analysts, U.S. dollars continue to gain more popularity in U.K. RMBS deals, with multicurrency tranching becoming somewhat of the norm in current issues. For U.S. investors looking at European RMBS, these dollar-denominated bonds offer less currency risk in the investment. And dollars help attract American investors who are hungrier for riskier deals, such as those involving nonconforming RMBS, than the more traditionally conservative banks, which prefer to steer away from such opportunities.
"It is sometimes easier for an underwriter to embed a currency swap in a deal and construct a USD tranche than for an investor to buy a sterling or euro tranche and enter a currency swap themselves," explained Ben Logan, managing director of structured finance at Markit. "With U.S. mortgages moving around, RMBS in Europe is a more stable investment that appeals to more diverse investors."
Over the past five years, RMBS structures have also continuously proven they can withstand the economic mini storms that have passed through. But the U.K. RMBS market has yet to be really tested, by an economic recession, for instance, which is cause for some concern. "There are a couple of things that may affect U.K. RMBS," said Dave Colling, director of structured finance at Markit. "The number of first-time buyers entering the market is diminishing, but the continued demand for buy-to-let [BTL] properties, up 21% in 2006, masks this trend," he said. He added that with rising rates and falling rental yields, he's not sure how much longer BTL investors will be willing to continue investing. Without the continued expansion in BTL demand, it is possible the property market will need to find a new dynamic to sustain continued price rises, Colling said.
On the nonconforming side, Fitch Ratings maintains its stable outlook for the ratings of U.K. nonconforming RMBS, based on the sequential paydown and certain conditions that are met to amortize the reserve fund despite expectations of some deterioration in the performance of the underlying assets.
But Gregg Kohansky, head of U.K. RMBS at Fitch, warns of potentially darker times ahead. "There are reasons why we believe asset performance for U.K. nonconforming RMBS will get worse before it gets better," he said, adding that the combination of recent and prospective interest-rate rises and a loosening of lending criteria - in particular, higher loan-to-value ratios and self-certified rental cover requirements for buy-to-let loans - on the back of competitive pressures to originate high volume in the sector has yet to filter through.
Looking to the Continent
If there is ever a time when U.K. RMBS becomes undesirable, investors need only look to other European nations. More and more, anecdotal evidence is pointing to the U.K. reaching the end of the yellow brick road, at which point investors will have to turn to the rest of Europe as an RMBS safe haven. According to one investment bank, investors have inundated the bank with requests for European RMBS, willing to take it on, no matter the form. So where one type of transaction may start to dip, another is expected to rise.
"We expect U.K. nonconforming lenders, mostly now owned by large international investment banks, to look toward the continent for volume -Spain, Netherlands, Italy and Germany are likely targets," Fitch's Kohansky said.
Furthermore, a combination of factors over the past five years - such as originators utilizing assets built up over many years, mortgage origination growth, narrowing spreads, increasing awareness and familiarity with securitization and a benign economic environment - are fueling growth overall in Europe, according to Steve Curry, European head of FIG capital markets at ABN Amro.
"I do expect further growth of the RMBS market across Europe, although this may be slower than in the past [because now there] is slower growth in new origination, driven by higher interest rates and slightly lower levels of consumer confidence," Curry said. "Some of this slowdown will be offset by jumbo transactions undertaken to achieve regulatory capital relief squeezed in ahead of Basle II."
Curry added that there is continued appetite from investors for RMBS risk as historical performance has proven the asset class to be very robust to shocks. Barring a catastrophic event that would affect all markets across the board, such as "Iran lobbing a nuclear weapon at East Germany or Russia descending into complete chaos," as one European RMBS analyst put it, investor appetite in not expected to wane.
Mainland Europe in general has shown not to have a boom or bust cycle in its property markets. Such a cycle is embedded fearfully in the minds of British homeowners, by contrast. Recent events, such as troubles in the Spanish property development sector and the U.S. subprime debacle, have created nervousness. "This is bound to cause spreads to widen, but this is not unusual and will be isolated to the geography/asset classes directly impacted," Curry said. "I don't, however, expect such short-term wobbles' to slow down the pace of RMBS growth across Europe."
Beyond the U.K.
"The risk of deterioration in deal performance, following woes in the U.S. subprime market, should be mitigated by the strong fundamentals of the U.K. nonconforming market and the European RMBS market as a whole," said Nathan Kirk, director of structured finance at Markit, who said deals will continue to perform well because of tighter lending criteria than those found in the U.S. subprime market and because of structures that allow credit enhancement to be built fairly rapidly through amortization. Furthermore, the strong European RMBS primary pipeline is buoyed by an increasingly liquid secondary market, he said.
The recent equity market sell-off relating to construction businesses that were heavily exposed to the property market in Spain, for example, has not led to a massive RMBS downturn in the country. Instead, the only fallout seems to be that earnings growth will occur at a slower pace in the future. "In Spain, investors in equities in the building and construction sector lost their nerve with the ensuing sharp correction in share prices. However, in Spanish RMBS, there is not yet much evidence of any deterioration in performance," Colling said. "Cash flows are still very much in line with expectations."
There is also an interesting situation in Italy, in that there is no remarkable property price appreciation. It's relatively stable; bank structures are strong and lending conservative. The Bersani Decree, for example, should stimulate some prepayment rates favorable to borrowers. Anything that increases liquidity increases the RMBS market, as the economy is stimulated when people can afford more. "European RMBS deals generally are built with greater levels of credit support than those in the U.S., so with continued low delinquencies and losses for European RMBS as a whole, it is very much business as usual," Colling added. "However, continued vigilance is needed by investors to monitor pool performance within individual deals."
As the market continues to develop, segmentation of mortgage risk will continue, and it is likely that there will be greater growth of nonprime RMBS products outside the U.K., ABN Amro's Curry said. "We have already seen evidence of this market segmentation, with principal finance activity at investment banks buying mortgage portfolios and certain originators agreeing to use their networks to originate mortgage product for others but not retain the risk," he said.
However, there are no easy outs if the market, for some reason, begins to crumble. A likely option would be to make up shortfalls in old Europe by looking at new Europe, such as in Central and Eastern European markets. In those markets, originators are active, but the local banks are are still new to the RMBS game. While those markets have a voracious appetite for securitization to help them grow, they are still, broadly speaking, in the early phases of securitization development. A number of deals have already been done, but many originators are still exploring securitization and still digesting what it takes to get a securitization done, Curry said.
"Having said this, we anticipate continued growth," he added. "What distinguishes these markets versus Western Europe is the relatively small size of the mortgage markets, and this will of course impact the amount of securitization that can be done."
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