With six months of trading left in the year, European industry players are beginning to hammer out the trends that will define the second half of 2004. The obvious culprits remain the Basle II consultation paper, which was purportedly unveiled at a press conference last weekend, and the direction spreads are heading. The year promises to be busy with year-end levels expected to surpass 2003 volumes.
In the weeks preceding the release of the Basel paper, bankers were holding out hope that the committee would provide more detail on how the new accord would impact their securitization holdings going forward. Although the European market was somewhat preoccupied with the pending release, activity managed to maintain its upbeat pace despite the specter of regulatory change.
"I think we will be waiting for the end of the month to digest what the committee has to say," one market source said in anticipation of the release. "More importantly, what Basel has highlighted is the market's ability to come together as a collective force and lobby in the interest of the market in general to the point that we feel confident that the market is headed toward something suitable to be worked out."
Pricing scenario discussions also dominate the market as it enters the second half of the year. A will it or won't it' scenario has evolved regarding where the pricing scenario environment will move over the next six months. However, spread levels during the first half of the year did little to suppress appetite (see ASR 6/21/04).
Interest rates on the rise
The recent spate of interest rate rises between continental European and U.K. markets is a continuing concern. Industry players argue that housing market fundamentals should be paramount in pricing; that is not currently the case. "We should be seeing more tiering among the different deals based on housing markets differentials," said one source.
Over the past six months, the market has seen a convergence of triple-A rated RMBS spreads. Spanish and Dutch RMBS transactions have begun trading inside U.K. prime paper.
Within the U.K. market, the spread differential between U.K. prime RMBS and U.K. non-conforming RMBS is at an all time low.
The trend in the RMBS market has seen prime lenders increasingly introducing non-conforming product into prime RMBS portfolios. Yet it's difficult to assess how much these lenders really know about the product and how it behaves in a varying market environment (see ASR 6/7/04). "With rising interest rates, they might find it difficult and we could start to see a difference in performance for these prime RMBS deals," said one source.
Nonetheless, non-conforming does not necessarily equate to subprime, pointed out one industry source, adding that up until now self-certified portfolios had been performing quite well. "The press has probably exaggerated what problems could arrive with a change in the interest rate," he said. "The other sector in non-conforming is subprime and there we see a little more credit enhancement offered - spreads have contracted quite dramatically. But how long can non-conforming collateral be tighter than buy-to-let?"
At the moment, the market remains positive on market fundamentals. Interest rates would have to rise substantially before they begin to test consumer fundamentals. Analysts at Morgan Stanley estimated that there would have to be an 11% to 12 % rise in rates before borrowers' average spending on mortgage debt servicing - measured as a percentage of their income - reaches the level seen in the last downturn.
According to the Royal Bank of Scotland, U.K. house prices continued to increase. Nationwide's house price index increased 1.9% during May, representing a 19.5% increase over 12 months. Nationwide expects a 15% increase during 2004, which implies a 0.7% rise each month for the duration of 2004. Although income levels have not risen at the same rate as house prices, the reduction of LTVs experienced over the last five years is a positive sign. "While house prices have grown by 68% from 1999-2003, we find that the average advance has grown by 51% in the same period," said analysts at Morgan Stanley. "The average LTV in the U.K. has fallen from 70% to 63%. In contrast, the last downturn saw mortgage growth outstrip house price inflation."
The best way to evaluate the immediate effect of these interest rate rises is to view the credit card market as an indicator of what stress levels put on the consumer market, suggests one industry analyst.
High APR product may function well under a low yield, low interest rate environment, but how it reacts to the recent rate rises will be an early indicator on how the rate rises could affect the prime RMBS market.
More to come
Market players have predicted the entrance of new dealers to the market place during the next six months. Smaller dealers that have built up books may now be ready to enter the market in hopes that spreads will begin to lighten up. "Some of these dealers loaded up books in December as is customary and have booked a huge profit; they will be looking to lighten up books in anticipation of the summer lull," said one market source. "Going forward there is no real reason why spreads will necessarily gap out but they will certainly soften."
According to the latest data, spreads on triple-A tranches have begun to experience a slight softening.
Analysts at Merrill Lynch reported that spreads softened on the triple-A level and had also begun softening on the mezzanine level as the market began the week. "The next week or so will test the market's resilience - traditionally second quarter end brings a large volume of deals, some taking-stock-of the-books-with-related-actions occurs, and the market prepares for the summer lull," analysts said.
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