American politics took center stage last week, but the message President-elect Barack Obama had for U.S. citizens could be applied across Europe as well.
It took nearly a decade to create the market dynamics that have resulted in the present economic situation, and it will, consequently, take some time to get out of this mess. Obama, on the campaign trail, has said that Americans will have to tighten their belts in the meantime.
In Europe, the message is the same. As regulators carefully sift through the wreckage, the long process of correcting the market is already in play. However, despite some encouraging signs, observers remain unsure whether the market has reached its bottom, or if Europe has more unpleasant surprises in store.
European governments thus far have hoped to support their banking sectors via either capital injections or by promoting government guarantees for unsecured banking paper. There are still very few measures for direct asset purchases.
Governments also amended the IAS 39 reporting requirement under the International Financial Reporting Standards to allow European banks to transfer assets from held-for-trading into held-to-maturity accounts, which alleviates write off losses on assets, including ABS, if secondary market prices have fallen without actual declines in credit. And market confidence looks to be improving.
This doesn't change the fact that Europe stands amid an unfolding recession, and that household financial expectations have deteriorated sharply, especially in highly levered credit economies such as Spain and the U.K. Looking at the fundamentals, the housing crisis appears to be worsening. Take the U.K., for instance. Fitch Ratings last week reported that it expects U.K. house prices to decline by approximately 30% from their October 2007 peak. And non-investment grade notes, which are designed to absorb the losses generated by the increase in mortgage arrears and possessions, are likely to suffer more significantly than higher rate notes. Fitch said the potential default rates on the 'BBB', 'BB' and 'B' tranches as a proportion of total 'BBB', 'BB' and 'B' tranches outstanding are 40%, 78% and 100% respectively.
"With evidence suggesting that the U.K. is in the formative stages of a recession and the ongoing distress in the global banking system restricting the availability of mortgage credit, we are likely to see house price declines to the extent last seen in the early 1990s," said Rodney Pelletier, managing director in Fitch's Structured Finance team.
European investors look set to base their decision on fact, not hope. The Bank of England has observed that prime U.K. RMBS are severely undervalued in the market at present, even if a relatively gloomy scenario for mortgage arrears is assumed. The BoE said that investors are demanding a significant premium for uncertainty - far exceeding any premium that might be demanded on any rational performance prognosis.
"We continue to find it frustrating that, in the U.S., poor credit quality caused the funding crisis, whereas here in the U.K. the funding crisis has been a major cause of the worsening credit picture," said Michael Coogan, director general of the U.K.'s Council of Mortgage Lenders. "Underlying U.K. mortgage credit quality has never been the primary issue, yet the reduction in funding to support new lending has had a detrimental impact on the credit quality of existing mortgages, through house price falls, a narrowing of options for borrowers, and the prospect of rising unemployment."
Now the government will join the rest of Europe and employ aggressive rate cuts, but it's uncertain how far these measures will go to restitute the deteriorating housing market.
In the meantime, all remains quiet on the securitization front, and it is likely to stay that way well into 2009.
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