Credit performance for the U.S. securitization markets held firm in 2014 in the face of uncertainty surrounding the regulatory environment and numerous political issues. Flash ahead to next year and Fitch Ratings expects the outlook to remain stable across most sectors. An integral factor around Fitch’s continued stable outlook is long-awaited regulatory clarity.
Global regulators finalized many outstanding regulatory issues last year, chief among them risk retention, Reg AB II and Basel III. With finalized regulations now in place, Fitch expects issuers will spend significant efforts implementing processes to comply with the new regulations throughout next year.
One development that has not materialized yet looms large over the securitization markets in 2015 and beyond is the potential for rate increases by the Federal Reserve. With the close of QE, market attention has now zeroed in on the timing of Fed tightening and a higher rate environment in general. Fitch’s expected case is for rates to increase moderately over the next several years which would be unlikely to have a significant impact on structured finance performance. However, a more rapid or higher increase would be felt across all sectors, albeit to varying degrees. The effect of a spike in interest rates would be most pronounced for CMBS, where refinancing needs could pressure existing deals.
Across U.S. securitization, the vast majority (over 80%) of sectors have a stable rating outlook, with the likelihood of that number likely to increase in the coming months. Negative rating outlooks are down significantly from prior years and are tied to legacy RMBS and student loan ABS deals issued pre-crisis.
ABS Maintaining Consistency
Collateral credit quality and performance metrics are expected to remain stable and transaction structures robust through 2015. Although we expect some further loosening of credit standards in collateral pools, the rating outlook remains stable to positive for most sectors with an expectation for upgrades on auto and credit card subordinate tranches.
The ratings and performance outlooks are stable to positive for core sectors such as auto, credit card and student loan ABS. Collateral performance proved strong once again in 2014 and is expected to remain so into 2015. Absent any external pressures, Fitch expects performance trends will slowly drift back toward historical norms longer term, albeit at a measured pace. No doubt an area of focus from an underwriting standpoint will be on subprime auto ABS underwriting on new deals continues to drift. Fitch expects subprime auto ABS losses to rise to 8%-10%, though they figure to remain below peak rates seen during the 2008-2010 recession.
From a regulatory standpoint, one area of focus will be within the student loan ABS markets. The proposal for private student loan dischargeability in the event of bankruptcy is not gaining much momentum despite backing by the CFPB. The Bank on Students Emergency Loan Refinancing Act is not making make much progress either. If a larger number of borrowers qualify, potential prepayments could affect subordinate student loan ABS bonds that rely heavily on excess spread for a full repayment of principal. There could also be principal reductions in outstanding FFELP and private student loan portfolios and higher level of prepayments on outstanding student loan ABS if there was high participation.
CMBS Underwriting Pressure Builds
Fitch expects the positive momentum of U.S. CMBS since the beginning of 2010, as well as past rating actions, to continue to provide ratings stability in 2015, especially with respect to investment-grade CMBS. Fitch’s 2015 outlook for U.S. CMBS is stable, although continuing aggressive underwriting could pressure this view. Two other potential headwinds facing CMBS in 2015 will be the potential for higher interest rates and the ever encroaching refinance wall made up of loans from 2005 through 2007. A more rapid increase in interest rates than expected could prove especially problematic.
Like the last four years, property fundamentals continue to improve. Hotels and multifamily properties have shown strong income growth over the past five years. Rents are not expected to grow as much in 2015. Office properties continue to see mixed results while retail continues to stabilize, with already-strong properties dominating weaker rivals.
Two potential headwinds facing CMBS in 2015 will be the potential for higher interest rates and the ever encroaching refinance wall made up of loans from 2005 through 2007. Most loans remaining in 2005-07 deals are still performing, so their ability to refinance will be relatively smooth. However, an increase in interest rates more rapid than expected could prove troublesome. Also, given that a number of the loans that were originally scheduled to mature in 2015-17 have already refinanced there is the potential for adverse selection.
RMBS Still Facing Challenges
Fitch believes underlying credit fundamentals remain positive for U.S. RMBS performance in 2015. That said, the sector’s recovery remains anemic as the industry continues to face numerous challenges, among them the continued dominance of the GSEs and new mortgage regulations. Also, despite renewed efforts lead by SFIG to address missing post-crisis structural reforms, progress remains slow. Fitch expects many of these same challenges to be present in 2015, keeping RMBS a niche market with projected issuance in the $15-25 billion range.
A positive for the market heading into 2015 is improved regulatory clarity. Several mortgage and RMBS rules were finalized and implemented last year including the Ability-to-Repay and Qualified Mortgage’ standards, the SEC final Regulation AB II rule, Liquidity Coverage Ratio, and the Qualified Residential Mortgage’ definition and related risk retention rules. While it is too early to tell what the ultimate impact of these rules will be on the RMBS market, Fitch believes that their release is a positive in that they reduce market uncertainty for both issuers and investors.
Fitch believes rising interest rates and the unwinding QE program will not destabilize the global recovery or financial markets, although an increase in financial market volatility is expected. Fitch views any impact on RMBS rating performance to be modest. The impact of a rate increase is also muted to some degree as most servicers have adopted modification/loss mitigation strategies to help borrowers avoid foreclosure, particularly among those still in a negative equity position but with ability to pay a modified rate.
CLOs Stable Despite Growth
Fitch’s outlook for U.S. CLOs remains stable, driven by sufficient credit enhancement levels/overcollateralization and excess spread available to the CLO notes. Limited credit migration of the underlying assets in the CLO portfolios also factor in the notes’ stable performance. Fitch expects benign credit conditions to continue and default rates to remain below historical levels, reinforcing CLO performance in the near term.
This outlook is not without its caveats, however. For one, the leveraged loan market is showing some signs of frothiness. CLOs continue to fuel loan demand, although overall it has been damped by the decreased demand from retail funds. Leveraged loan issuance totaled $807 billion in the first 10 months of 2014, versus $951 billion issued in the same period last year. Leverage is also creeping back up to pre-crisis levels, while loan underwriting has become more aggressive in recent years, as seen with the continued issuance of covenant-lite loans.
The future of CLO issuance and performance may also be challenged by the changing regulatory environment. The Volcker Rule is already forcing many traditional CLO investors to the sidelines. Fitch also expects larger repercussions from the adoption of CLO risk retention rules under Dodd-Frank. CLO issuance will likely accelerate in 2015 before the rules take effect in 2016. However, CLO issuance in the longer term will likely contract or consolidate across fewer CLO managers as smaller managers with limited access to capital will find it difficult to comply with the rules.
Michael Dean is a managing director and head of Fitch’s U.S. consumer ABS group
