For European ABS market participants, it's a new year in name only. They have returned to work to deal with the same problems the sector faced in 2H07.
While there are lingering concerns about how the future of European ABS will pan out, no one seems to doubt that RMBS and CMBS will make it out of the turmoil intact, eventually.
"I'm just doing my best to get back into the groove of things," said one market observer who works in European securitizations at Unicredit. "This year it is going to be harder than others, but we have to get this thing going again."
The European economy was booming last summer when the first ripples of the U.S. subprime crisis began to reach the Continent's shores. That, and the summer's liquidity crunch, crushed the adventurous spirits of some investors.
Although Europe's once robust economy is slowing at this point, its performance in the past months has possibly prevented an all-out disaster stemming from the subprime crisis. Furthermore, some investment banks are saying that European ABS is alive and well, and now is the time to go for some of the best deals the market has ever seen. But can investors be lured back?
Many private investors who took a hit on ABS in 2007 are unlikely to return in 2008. Instead, new investors must be sourced, most likely from hedge fund companies, said a Merrill Lynch research report.
"ABS confidence-building took many years, only to be shattered in a matter of weeks over the summer as spreads gapped wider," Societe Generale analysts said. "With money markets, SIVs, ABS funds and banks all holding reduced cash, few were able to buy the paper being dumped on the market."
They added that the crisis likely will be seen as a positive for the ABS market "when we retire to don slippers and smoke pipes and the history books
are written."
If leverage had built further, analysts said that the market would have had much farther to fall, especially had the crisis occurred under a recession. They expect leverage to return and to be provided by banks, although to a limited extent through liquidity provisions from central banks, they said.
According to SocGen, outstanding European ABS amounts to just over GBP1,000 trillion ($1.982 trillion). Therefore, the GBP35 billion mark-to-market losses that have happened so far equate to just 3.5% of the total market.
RMBS Uncertainty
The rating agencies, which took a substantial hit for their perceived failure to predict problems with ABCP, have all revamped their rating criteria and announced better monitoring systems.
Fitch Ratings has declared that the 2008 outlook for European RMBS remains more uncertain than in prior years as a result the credit crunch. The sentiment is that European RMBS can grow stronger, but there are still pockets of geographical risks to be considered.
"In the U.K., house price inflation seems to be coming to the end of its long upward run as past interest rate rises and the influence of the credit crunch takes effect," says Stuart Jennings, head of RMBS Europe, Middle East and Africa at Fitch. "Earlier nonconforming transaction vintages will have built up a large degree of equity protection through house price inflation."
However, more recent vintages, specifically 2007 deals, will have less protection through this route. The protection might even diminish completely if house prices start to decline more rapidly. "While 2007 vintage transactions will not yet see extensive teaser expiry, those mortgages that do default can expect to see lower recoveries and higher loss severities than have been seen in the recent past," Jennings said.
A saving grace for the U.K. is that defaults on loans tend to remain at low levels, even during troubled times. "You can't underestimate the value of the generational subsidy,'" said one source at another rating agency, in reference to a younger mortgage holder being bailed out by his or her parents when repayment troubles arise. "In the States, people are more than willing to walk away from a property just like that, but in the U.K., such behavior is considered an embarrassment, culturally speaking."
Interest rate increases from late 2006 and through the early part of 2007, both in the U.K. and across the euro zone, will put pressure on borrower affordability, especially as teaser rates begin to expire, Fitch said. The rating agency also criticized U.K. mortgage intermediaries for declining underwriting standards. Both variables are likely to factor in future rating actions.
Some areas in Europe have solid outlooks for the residential market, such as the fixed rate sectors in Germany and the Netherlands, as well as in the currently stable Italian market.
Others, such as the Republic of Ireland, Portugal and Spain, are falling under the microscope as RMBS cracks begin to emerge.
"Deteriorating affordability owing to Libor-linked mortgage products in jurisdictions such as Ireland, Spain and the U.K. prime markets poses risks to credit performance, in our view, explaining also some of moderate weakening in payment behavior seen recently," Deutsche Bank analysts said. They think that seasoned, higher-quality vintages of U.K. nonconforming and Spanish triple-A RMBS are currently oversold.
The Spanish mortgage sector is deteriorating as a result of affordability issues exacerbated by interest rate increases and a 97% variable rate market, which has led to increased arrears at early stages of loan repayments, Fitch said. "For these reasons, more recent vintage Spanish deals face a negative rating outlook," the rating agency said.
In the Republic of Ireland and Portugal, the situation is simpler. Property price declines and a slowdown in buying will likely weaken portfolio volumes. And, as in Portugal, a prepayment penalty reduction will likely accelerate the build-up of lower-rated notes as transactions amortize, leading to the deterioration of excess spreads, which normally could help absorb loses.
A European investment bank analyst described something much darker for Irish RMBS. According to the source, there are Irish firms dedicated to saving residential borrowers when they run into repayment troubles. Basically, these companies offer to take over the mortgage and put the original borrower on a fixed-rate tenancy agreement. However, while borrowers believe this tenancy will last only the length of their troubles, the typical company evicts their "tenants" after a six-month period to resell the home.
"While it sounds damaging only to the poor family that finds itself suddenly homeless," said the source, "we believe it may [also] cause wobbles further up the ladder in Irish RMBS."
CMBS Likely to Stay Stable
While the European RMBS market remains negative on the future, CMBS is poised to remain stable, performance-wise, when compared with 2007. Nonetheless, CMBS will not be without its share of changes in 2008. One of the more important factors for CMBS is based on solid overall fiscal forecasts. The countries that hold the lion's share of European CMBS are likely to remain economically stable, which means that office tenants, in particular, are probably going to stay put.
Furthermore, the introduction of Markit's ECMBX (ASR, 7/16/07), the first integrated pricing and performance monitoring service for the European ABS market, covering CMBS, RMBS and CDO transactions, "will, we think, provide for a quicker return to pricing levels which are reflective of the risks inherent in CMBS relative to the wider economy," a Merrill Lynch report said.
However, European CMBS is struggling to cope with spread levels that are around 20 to 25 percent higher than loan margins, and replacing the demand left over from the commercial paper dry-up remains a concern, also causing a massive dip in year-on-year performance.
"New issuance during 2007 reached 40 billion ($58.9 billion) before the crisis took hold and looked to be on target to reach 75 billion plus for the full year," Merrill Lynch analysts said. "We expect that 2008's issuance will be lower, and our forecast range for the year is between 25 billion to 35 billion."
Fitch has also predicted that endangered commercial property markets may be negatively affected if current liquidity conditions persist, the agency said in a report. "Fitch expects a general tightening in commercial mortgage loan credit terms and conditions to persist over the short term across much of Europe," said Rodney Pelletier, a managing director at Fitch. "This should create more equilibrium between debt and equity and cause higher leverage investors to be less active in the market."
And, despite the lower numbers predicted by other investment banks, Royal Bank of Scotland analysts believe that investment-grade CMBS in Europe is unlikely to realize any loses in 2008.
Also, the European valuations of commercial property are likely to remain flat. However, the U.K. market, particularly the city of London, may experience a downturn in overall value.
The analysts add that the biggest credit risk in CMBS for the short term is that of "loan-to-value covenant breaches" on those loans that were secured on U.K. commercial properties with dwindling values. This would leave B-note holders in a precarious refinancing position. During such a covenant breach, the note holders would have to choose either a cash or collateral solution, or partially repay the loan.
"A/B note structures could therefore be tested for the first time in Europe," said RBS analysts. "There is a further issue, even if sponsors do choose, and have the funds, to support loans, in that the number of times breaches can be remedied is usually restricted, suggesting that it will be impossible to support a loan indefinitely. In the absence of the ability to refinance the loan, this may lead to forced selling."
But despite the seeming abundance of risks associated with European CMBS and RMBS investors for 2008, SocGen analysts offered clear advice to these parties.
"Buy as much as you can while it is cheap," SocGen analysts said. "We expect solid opportunities will last well into the New Year; however, high-quality deals well understood by the market are unlikely to remain at their current wide levels. We expect prime-quality deals to tighten in the early months of 2008."
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