Although August is typically a quiet month for European primary issuance, the period leading up to this summer's lull means that September and the rush to year-end issuance are both still uncertain.
Players are standing at the sidelines looking for more definitive measures to gauge where the market is headed. The primary pipeline for the rest of the year remains very uncertain.
"There are even fewer buyers out there than before September," an ABS analyst from a European investment bank said. "Everyone is sitting back, even though there is no fear of running into the same kind of problems we've had lately."
Indeed, according to market reports, several deals have already been rated and structured, but how the market unfolds is really up to investor appetite for new bonds in the current pricing environment. This uncertainty in the primary market stems from activity in the secondary market, Barclays Capital analysts said.
"On the back of continued concerns regarding U.S. subprime, a number of ABS investors have been forced to liquidate some of their European ABS holdings, including some structured vehicles and conduit programs," Barclays analysts said. "This occurred despite the fact that performance of European ABS assets has continued to be good, albeit slightly less so than in previous years." According to Barclays Capital, triple-A spreads widened to unprecedented levels in August. For instance, CMBS spreads went out 140% - from 25 basis points to 60 basis points - and more than 200% in U.K. nonconforming RMBS - from 23 basis points to 70 basis points.
The last time the market saw spreads widen to these levels was back in 2003, after which any widening that happened was sector specific. This summer has seen levels heat up across all asset classes - everything from overnight rates to ABCP to bank debt and ABS has experienced this unprecedented widening. As an example, Synapse Investment Management, a hedge fund created by former Barclays Capital executives, recently closed its High Grade ABS fund, citing severe illiquidity in the market. The fund had no exposure to the subprime market.
If the market is to take a lesson from history, then it's likely to be at least a year before levels normalize to precrisis levels. "[In 2003,] it took six months for confidence to return and a further six months to tighten back in - although this, in part, related to an improving economy and increased buying capacity," said analysts at Societe Generale.
Market players don't expect primary deal flow to pick up until late September or early October, and even then those volumes are predicted to be anemic by comparison to recent years. For a market perceived to be very liquid in times of stress, the European market is not showing very well, even at the triple-A level, Royal Bank of Scotland analysts said. "Now that dealers continue to show discipline to take bid lists off the tables, rather than liquidate at any cost, and several of the distressed funds are looking like they will have a slower unwind than many are suggesting, some of the real money investors may peek their heads out as values become too compelling to miss, even with more volatility expected," RBS analysts said.
But before the market starts to see any significant trading activity, Barclays trading analysts said that the market will need to see secondary spread widening cool, and at the same time, primary issuance will have to pick up at clearer and more attractive levels both for issuers and arrangers. Presently, the lack of demand has led to further price softening that has then led to forced sales and further reduced demand. "Despite the recent events, we are hopeful that the market will pass these tests and continue to thrive in the future," Barclays Capital analysts said. "We expect that when the market does stabilize, investors that are able to differentiate between strong and weak sub-sectors and issuers will be able to profit most from a potential recovery."
But for September, the landscape will remain dicey, with new primary deals expected to encounter limited buy-side appetite. Societe Generale analysts said they expected leveraged buyers to be a reduced buying force, thus reducing senior note placement capacity. "Our estimates suggest roughly 75 billion of annual buying capacity came from SIVs, or 15% of the market," SocGen analysts said. "Without this demand, senior spreads are unlikely to tighten beyond 20 basis points, where bank balance-sheet buyers have historically found more value. In the medium term, we expect new or restructured buyers will emerge, with significant value available to those with cash to invest."
Repeat issuers could give the primary market its lifeline. Analysts at SocGen suspect that some originators may be forced to come to the market. Northern Rock, for example, is slated to refinance around GBP8 billion before the yearend and may have to test the waters earlier than others. Northern Rock's Granite master trust could come into two different series, dependant on market appetite, and will likely be structured to tap pockets of demand. But if spreads remain too wide, Northern Rock could turn to its covered bond program, SocGen analysts said.
Barclays estimates that 80 billion to 120 billion is likely to be available from redemptions for investment in the primary ABS market for the second half of 2007 - the weighted average of investors' reinvestment requirements for the coming 12 months is approximately 13% of their current portfolio size.
If investors reinvest these redemptions from European ABS back into the sector, this could be sufficient for the primary issuance market to start up again in September and match primary issuance volumes of 2006, Barclays analysts said.
According to the European Securitization Forum, outstanding European securitizations stood at 1.28 trillion at the end of June. "If 13% to 20% of 1.2 trillion becomes available for reinvestment, this amounts to approximately 160 billion to 240 billion," Barclays analysts said. "If we assume this is evenly distributed over a 12-month period, this means that 80 billion to 120 billion is likely available from redemptions for investment in the primary ABS market for H2 07."
How the pricing scenario evolves depends ultimately on how issuers manage the supply volume for the second half of the year.
Barclays analysts believe that primary issuance for 2007 could exceed the 80 billion available from redemption, which in the short term could continue to pressure the supply-demand imbalance that has driven pricing spreads wider lately. Barclays analysts said that if issues do not exceed the 80 billion mark, spreads are likely to come back more to pre-July market pricing. But if issuers are unable to show restraint, spreads will probably continue to suffer.
"This willingness to limit supply will depend on banks' funding alternatives, such as their balance sheet or the whole loan or syndication markets," Barclays analysts said. "Therefore, we believe that redemptions from existing ABS investments will be a partial demand driver for recovery in the primary issuance market for European ABS during the remainder of the year."
The ESF said that global credit repricing, increased volatility and reduced liquidity in the third quarter have caused spreads to widen across the credit quality spectrum and limited investor risk appetite - and that is likely to remain unchanged until this month.
Market participants said a number of securitization funds halted redemptions in August due to the inability to value their holdings.
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