When the European Central Bank (ECB) unveiled its Ð
As Greece struggles to stay on dry land, the fragile state of the European securitization market begins to wash ashore.
The ECB and other national banks structured the European stabilization program and also launched a program to buy up debt of the most vulnerable euro zone countries. The rescue scheme will also be backed up to
On the news of the package, the yield on Greece's ten-year bond fell from 12% to 6.7% and mortgage nominal spreads rallied back up, partly in response to the extraordinary European Union measures to stabilize the region.
"The country seems to have narrowly escaped defaulting," Deutsche Bank analysts said. "The path to this agreement was long and winding for both political and financial reasons. At their peak, two-year Greek sovereign bond yields climbed to nearly 20%. Nor is it possible to declare an end to the emergency."
While the initiative led to the immediate revival of Greek government bonds, the Greek saga and the resultant market turmoil demonstrated vividly how securitized products performance has remained very sensitive to general market sentiment. Bids in the ABS/MBS market are vanishing as other credit markets and equities are softening.
At press time, UniCredit analysts reported that traded volumes have been rather low, with only a couple of bid lists circulating, mainly across European RMBS and CMBS paper.
They said that given the current situation, it is logical that players like real money accounts will remain particularly reserved regarding European securitization investments.
"Extension fears remain on the agenda and the fear of a return of technical pressure remains high, also from a sovereign risk perspective, with respect to potential concentrations in Spanish securitization exposure. Furthermore, the fundamental outlook looks set to remain challenging," UniCredit analysts said.
Market players said they expect the road to be bumpy, but mortgages will benefit from a tailwind of very strong technicals: low supply and increasing bank and foreign demand.
This tale of fiscal woes illustrates the challenges that many Western countries face. As a result of massive fiscal stimulus policies launched immediately after the Lehman Brothers shock in September 2008 and during the deep financial and economic crisis that followed, the G7 countries will collectively have increased their central government debts to a record high 120% of GDP by the end of 2010, according to Deutsche Bankestimates.
"Having the ECB come in and essentially throw money at the problem doesn't fix the fact that trust is no longer there," said Christopher Wasserman, president and founder of the Zermatt Summit, which is an independent business summit run by the Zermatt Foundation. "There will be more volatility ahead because the fundamental structural issue has not been fixed."
Was Europeon the Road to Recovery?
Even amid the Greek crisis, the Arkle 2010-1 RMBS transaction closed. This was the sixth U.K. RMBS deal placed with investors since the U.K. securitization market re-opened in September 2009, following a lack of activity after Lehman's insolvency.
Europe was clearly beginning to stabilize. The market saw an obvious reopening in the autumn of last year with the Permanent and Nationwide deals; albeit bespoke to investor concerns at the time, they were the first deals to depart from the securitize-to-repo format that had been so prevalent since the onset of the crisis.
By the new year the call option prevalent in those earlier U.K. RMBS deals began to be dropped as seen in more recent deals such as Santander U.K.'s Fosse deals and Lloyds Banking Group's most recent issuance instead containing a step-up and call feature to help address extension risk.
Things looked to be getting well on their way in Europe at least for the right credits. "People are very encouraged and Europe has gotten a lot better the fact that these recent deals have been executed without the call option has brought back some confidence in the market," said Salim Nathoo, a partner at Allen & Overy.
He said that it helped that the economic environment was also showing some encouraging signs of improvement. The level of unemployment remained low and the debt service ratio coverage remained at low levels, while the losses for banks did not fall outside what models initially predicted. This created more optimism and we began to see people buying into different asset classes and an increasing interest from a U.S. investor base.
The volume of RMBS placed with investors is still not comparable with pre-crisis levels, but there are signs of continual improvements in market conditions.
According to Barclays Capital analysts, around £6.4 billion was placed with investors in 1Q10, which is significantly lower than the £27.8 billion sold in 1Q07. Additionally, the currency denominations of recently issued U.K. RMBS paper seem less diverse; in 1Q10, 69.1% of issuance was sterling-denominated, compared with only 30.0% in 1Q07.
Market analysts said that while U.K. RMBS pricing is becoming steadily more competitive, margins are still considerably wider compared with those seen at the peak of the market, when deals backed by prime mortgages would price within 10 basis points of Libor. However, the recent comparatively more positive sentiment is reflected in the Arkle 2010-1 transaction, which included the first P-1 rated note since the credit crunch, and with the one-year notes pricing at 20 basis points over three-month Libor.
The revival of primary securitization issuance has not come just from the RMBS space; Europe began etching details for a revival in other asset classes that saw auto deals come to market and a private market CMBS deal get done.
The CMBS space remained quiet, although it has also seen some bespoke deals from the bigger U.K. corporate borrowers like Tesco, which has been using up to date valuations ."There is some appetite but not the flow that was expected its more originator led deals," Nathoo said.
With Greece, Europe's positive growth trajectory may be falling off course. At press time, the Fosse 2010-12 transaction had been officially delayed until the end of May. The launch of Volkswagen's Driver One Espana Auto ABS was also put on hold as a result of the current market spread widening.
The dislocation of markets has also sent senior Dutch and U.K. prime RMBS paper for trading inside, and wide of, their respective senior unsecured markets.
"With market focus turning to the ability of European economies to participate in a recovery in growth in the face of future required fiscal austerity measures, it was noticeable that ABS transactions from European peripherals remain wide to senior sector benchmarks," Deutsche Bank analysts said.
The analysts expect senior European ABS spreads to take their lead from senior financials, with any prolonged elevation of interbank stress, indicating a potential further softening in pricing spreads. "In the event of a sell-off however, we expect senior ABS re-pricing to be muted relative to Lehman-like levels due to the absence of leveraged forced sellers (SIVs, conduits)," analysts said. "The honeymoon period of recent months of ABS acting in isolation to bouts of volatility in other credit markets looks to be at an end."
Still Doing Business
But the Greek crisis hasn't had as much of an impact on primary market issuance because simply put the originators that can get deals done are issuers that can tell a story. "At the onset the whole market reacted in panic mode that sent prices plummeting across the board but a week into the Greek crisis deals began to stabilize. Lloyds Arkle priced its deal among the chaos to some good investor appetite," Nathoo said.
And there are further signs of life. According to UniCredit traders, plans by Bank of America Merrill Lynch to issue £1.5 billion of U.K. nonconforming RMBS through Moorgate Funding 2010-11 have emerged. The deal will include £617.8 million of triple-A notes with a 6.5Y WAL.
Next to BofA Merrill, Kensington is said to be preparing two transactions. A new issue by Gracechurch Card Funding out of the existing Gracechurch receivables trust is also expected to come to market.
"The latest (Gracechurch) issuance, which has been assigned preliminary ratings, is to be denominated in USD but it still has to be confirmed whether Barclays will privately place or fully market the notes into the recently much-talked-about large pocket of U.S. dollar demand," UniCredit traders said. " It will be interesting to see if [BofA Merrill] can manage to place not only senior debt in order to achieve capital relief, but also whether the transaction will be placed publicly or more in a private club style."
Jean-David Cirotteau, a Societe Generale analyst, said that some accounts have also taken opportunistic positions on the recent BWIC lists traded because the amount of investment is small and the funding risk is small.
However, the trend is limited to a specific type of investor and is not reflective of the current risk aversion in the markets, which could become problematic in the future if it keeps the primary market closed.
He also noted that more interest in fixed rate and mezzanine tranches is a possible result of the current situation.
"Despite what we consider as relatively generous spreads to their variable index (Euribor or Libor), senior tranches in particular are not attractive in the current environment," Cirotteau said. "This will result in an increasing call for fixed rate tranches for senior liabilities, and potentially further interest in mezzanine distressed paper where the attractiveness lies in the discount not in the coupon. However, the sums involved and the number of players are limited in this segment, and the credit outlook is more difficult to measure."
Impact on the U.S.
Citigroup analysts said they estimated the exposure - including derivative receivables - of the five largest U.S. bank holding companies to Greece, Ireland, Italy, Portugal and Spain at about $190 billion.
"These banks appear to be well capitalized to survive on orderly restructuring of debt issued by the five sovereigns," Citigroup analysts said.
Analysts said that the U.S. financial system and economy are also better positioned to handle the shock much better than the European economy did after the Lehman Brothers bankruptcy because U.S. banks have less external exposure compared to European banks and are better capitalized.
"The main source of global contagion in the financial crisis post-Lehman was, of course, the financial linkages," Citigroup analysts wrote in a note. "A number of European banks held U.S.-originated mortgage debt and, as the performance of these securities deteriorated, these banks faced funding and ultimately capital problems. The reverse contagion risk is smaller, i.e., U.S. banks are less exposed to Euro peripheral sovereign risk than Euro area banks were to the U.S. housing market."
The overall foreign exposure of U.S. banks' loan and securities portfolios is only about 13% and the current exposure of U.S. banks to the four most vulnerable European peripheral countries - Greece, Ireland, Portugal and Spain - is even smaller at less-than 2% of the asset base.
European banks have a much larger foreign exposure (33%) and, particularly, had a 12% exposure to U.S.-originated assets at the beginning of the financial crisis.
Citigroup analysts said that U.S. banks are also better capitalized today relative to the situation of European banks at the beginning of the financial crisis.
"The IMF estimated that the Euro area banks had a Tier 1 capital to risk weighted assets ratio (Tier1/RWA ratio) of about 7.3% at the end of 2008," analysts said. "In contrast, the U.S. banking system today is sitting at a comfortable Tier 1/RWA ratio of 11.5%; capital ratios were helped by significant capital raising after the Fed's stress tests in April 2009 as well as general improvement in capital market conditions."
However, an area where the story could get ugly is derivative exposure. Sovereigns generally do not post margin on OTC contracts and it is likely that all large, global banks have receivables outstanding against the sovereigns, analysts said.
"It is likely that U.S. banks, which have significant derivative operations globally, could be quite exposed to sovereign default risk through this mechanism," Citigroup analysts said.
The fact that the Euro peripherals situation dominated price action so strongly - on the Friday before the ECB bailout was passed theDow plunged by 1,000 points and then climbed back up by 600 points - means that any positive views on securitized products should also consider the going sensitivity of the sectors to general market sentiment and macro events.
"This is a much bigger crisis than the Lehman one, but the market has yet to recognize it," said Suki Mann, a credit strategist at Societe Generale. "And just like the U.S. authorities before it, the European authorities are way behind the curve. In such cases, usually 'cash is king' while we ride out the storm - and yields are so low that the missed opportunity cost is reduced. But this is not quite the situation now, simply because the case for credit remains compelling given the wider sovereign-related situations."
Like the U.S., European ABS Faces Regulatory Overload
Europe may be still feeling out its reaction to the sovereign crisis. What is certain is that investor confidence won't be helped any by the regulation that keeps slamming the U.K. and continental Europe.
Banks and financial institutions have been prepping for the new liquidity requirements coming up in the Basel III Accord. The Basel Committee will issue new standards by mid-2010 to take full account of counterparty credit risks, the benefits of centrally cleared contracts and collateralization.
The market is also looking at a new set of regulations under the Capital Requirement Directive, CRD 3. At the same time, market sources said that another directive, CRD 4 was also being drafted. CRD amendments are expected to be in force in 2011.
The Committee of European Securities Regulators (CESR) is also regulating pan-European investment restrictions that money market funds have to satisfy. The new regulations were published on May 19.
These restrictions could lead to some limited forced selling but any resulting pricing pressures in the secondary market should remain minimal. The latest regulatory news to emerge affects a different investor base than the usual banks or insurance companies - money-market funds.
CESR's newly released guidelines on ABS investments for said funds will require money market funds across Europe to use legal final maturities instead of expected maturities (or weighted average lives) as their duration investment criterion for ABS.
Barclays Capital analysts said that the new rules could effectively prevent money-market funds from investing in any ABS with a legal final maturity longer than two years and would potentially further alter the remaining European ABS investor base landscape and hurt appetite for short weighted average life paper such as auto ABS bonds, which had been so successful with this type of investor until now.
Complying with this additional regulation will not come cheap and could push some banks to question whether they should be securitizing, say market source.
The changing regulatory landscape has also cause some jitters among sellers and buyers because it creates uncertainty over how today's structures will work once the overhaul is in place.