Lehman Brothers' overnight collapse has left a heap of trouble in Europe, setting off an alarming domino effect.
It all happened over a span of three weeks: what began with the U.S. subprime problem has evolved into a dilemma of tsunami-like proportions. It has destroyed some of the most well-established names on Wall Street and taken down a number of large European firms, such as Fortis Bank, Bradford & Bingley (B&B) and Dexia.
As the outlook continues to darken, more European financial institutions are expected to stumble, forcing the counterparty issue center stage.
"As a number of originators are struggling, bailouts and default events are intensively being discussed," said Markus Ernst, a senior ABS research analyst at Unicredit. "Thus, the market is currently heavily involved in analyzing counterparty issues."
These counterparty issues have turned out to be complex and time consuming to investigate, and the damage caused by bank bankruptcies to the European structured finance market is growing.
ABS transactions benefit from contracts with swap and other counterparties incorporated to mitigate non-credit related risk including interest, currency and liquidity risk. However, if the originator and swap provider are the same, and that seller fails, not only does the transaction face potential servicing transfer issues but also concurrent swap novation risk. A swap novation is when a client does a swap with one party and then assigns the swap to another counterparty.
In the case of Lehman, for example, banks that have the capacity to provide replacement swaps on Lehman-originated deals are demanding costly fees, while trustees have been accused of being slow to react.
Because of Lehman's sudden collapse, no collateral procedure was set up in advance; such procedures are typically based on the rating triggers set off by the deterioration of a counterparty's credit. Lehman went from qualifying as a hedging counterparty to default overnight, and all of the entities that were involved in swap agreements with Lehman came under U.K. administration, preventing them from making any payments.
The implications of Lehman's fall span much wider than the small circle of its sponsored deals, according to Societe Generale.
The impact on existing structures of Lehman serving as a counterparty is expected to be negative, although originators might be willing to step in indirectly to avoid severe rating downgrades.
"The underlying assets may well be of decent quality, but the travails of issuers and swap counterparties like Lehman Brothers are still ramifying through the markets," said Jean David Cirotteau, a securitization analyst at SocGen. "Outcomes for the CMBS sector seem very difficult to assess, and are strongly dependent on the willingness and capacity of the sponsor to support the transactions. With financial operator confidence at its lowest level at the moment, financial constraints for the banking community as a whole, and for a number of big names in securitization in particular, remain high."
CMBS servicers and trustees need to clarify the issuer's ability to use the liquidity facility, said Barclays Capital analyst Hans Vrensen. The ability to bridge a temporary shortfall - between the unhedged fixed-rate interest received on the loans and the floating rate interest on the bonds - is crucial in the short term for investors working to determine whether interest will be paid on their bond class at the next interest payment date.
"It is not always clear from the offering circular whether liquidity is available to fund a shortfall as the result of either an issuer-level or borrower-level swap counterparty default," Vrensen said. "Investors would likely take comfort from confirmation that liquidity is available for that eventuality. Given that this information has become clearly material to the pricing of the bonds, in our view, it should be made publicly available. Selective disclosure to existing investors might limit their ability to trade the bonds in the future."
Trustees need to then determine the best course of action in the long term regarding the swaps, Vrensen explained. This might include replacing any defaulted swaps with new swaps, which might not be a contractual obligation under the transaction documents. Even if trustees request a bondholder vote, the ultimate outcome will depend on voting procedures.
"We would expect triple-A investors to press for a speedy replacement of the swap, even if current market costs are unattractive," Vrensen said. "But lower-rated tranche investors might be less incentivized to accept a replacement swap, as the costs of a new swap might cause a loss to their bonds."
The potentially vast swap shortfall has landed multiple tranches of various deals from Lehman's Eurosail nonconforming RMBS program on rating watch negative. Fitch Ratings put a number of CMBS bonds on Rating Watch Negative and Barclays said it expects interest shortfalls for the class C in the Windermere IX, classes E and F in Windermere X, classes D and E in Windermere XI, and classes D and E in Windermere XIV at each of their respective next interest payments dates, unless liquidity covers these shortfalls. Standard & Poor's estimated that 422 European bonds across all asset classes that include RMBS, CDOs, ABS and CMBS are affected, as a result of Lehman's acting as bank account provider, derivatives counterparty, guarantor, liquidity provider, issuer or seller.
"Given the fast-moving developments of financial markets these past few weeks, the requirement to pledge required collateral within 30 days (agency requirement) may be too long a time lag to adequately protect transactions from counterparty risk, unless highly rated counterparties suffer gradual, multiple-notch downgrades before defaulting," Conor O'Toole, a Deutsche Bank analyst, said.
Waiting to Fall
Lehman's sudden collapse has left many banks on the brink of failure. One of the latest causalities in the U.K. is B&B, which saw the government take over its £42 billion ($74.8 billion) mortgage loan book and its mortgage servicing operation on Sept. 29.
B&B will discontinue originating mortgages, according to the lender's Web site. Its branches and retail deposits were acquired by Spanish bank Santander's subsidiary Abbey National.
B&B has a £747 million structured finance portfolio that includes CDOs and SIV paper, which is expected to be positioned for sale. For its Aire Valley Master Trust, the bank's nationalization could cure some of the triggers that were activated following the bank's downgrade by Moody's Investors Service to 'Baa3'/ 'P-3' from 'Baa2'/'P-2' on Sept.16. The bank's downgrade meant its short-term rating-related trigger was hit. This effectively stops future additions of mortgages to the trust. Aire Valley's funding companies cannot further increase their share in the mortgage trust, which means that no further issuance out of the trust can be done at B&B's current rating level without a prior waiver of this condition by the trustee.
Another consequence of the loss of a 'P-2' is that the bank will have to ensure that the customer files and title deeds related to loans that were assigned to the Aire Valley trust are identifiable as distinct from other loans. Since B&B's ability to replenish the trust has consequently become limited, the trust becomes static. As such, the trust becomes significantly reliant on prepayments that can influence the scheduled maturity of those notes that have already been issued. In the case of a breach of the minimum seller share, which is set at 5%, repayment orders are threatened.
Additionally, Barclays replaced B&B as a basis swap provider in another transaction called Bowler Finance. The deal is a restructuring of a securitization backed by near-prime and buy-to-let mortgages originated by GMAC-RFC and Kensington. Bowler Finance closed in July. As a result of the nationalization, B&B's covered bond programs and securitization vehicles will continue to operate normally, now that their credit ratings will recover.
"The effect of government intervention in Europe has been credit-positive thus far," said Deutsche Bank analysts. "But the upside for ABS has been much more limited - while nationalizations, whether quasi or outright, have neutralized seller-related risks, there remain other threats."
The impact on ABS would be decisively positive only in the case of asset-level 'bailouts,' but any intervention at the borrower or lender (nationalizations and other capital rescues) levels are likely to carry more uncertain results. Deutsche Bank added that the asset overhang will prove more of a problem now, with the ABS portfolios of these rescued banks poised to be sold.
Northern Rock's nationalization earlier in the year, and B&B's last week, mean that the U.K. Treasury will now act as manager of two mortgage master trusts, effectively accounting for 27% of the market outstanding. The number of private sellers in the U.K. prime RMBS market has now fallen to just five from nine. It's likely that the European securitization market will continue to struggle with its asset overhang problem, since the ABS portfolios of these rescued banks are poised to be sold.
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