A picture of consistency for several years now, U.S. structured finance is once again set for mostly stable rating performance in 2017. That said, asset performance has peaked in many sectors with modest declines expected over the course of next year.
Last year, we said that investors need to be on the lookout for early warning signs that could signal more significant credit issues among various securitized assets. Fast forward to present day and very few warnings are flashing brightly. With that said, we do see signs of performance deterioration in some sectors though so far it has been limited and within expectations.
Asset performance continues to weaken for subprime auto ABS, with Fitch predicting annualized net losses to reach as high as 12% next year (similar to the rates we saw between 2005 and 2007). Used vehicle values continue to dip and recent securitized vintage ABS pools are producing higher losses. Driving the higher subprime auto losses will be securitized deals from newer, lesser established names in the space. Meanwhile, losses among the Fitch-rated AmeriCredit and Santander subprime deals will track within expectations with ratings to remain stable in 2017.
The road ahead is smoother for prime auto ABS despite Fitch’s expectation of rising losses, which will be well within Fitch’s base case scenarios. Estimates annualized net losses for prime auto are in the 0.80%-1.20% range, consistent with levels seen in 2005 and 2006. One area Fitch will continue to monitor closely is loans with longer terms. These loans tend to be associated with lower borrower equity and higher losses.
Multi-borrower CMBS deals issued in 2006 and 2007 are substantially winding down and figure to be the most volatile, as the last performing loans from these vintages face maturity.
Fitch expects elevated refinancing issues on the underlying loans in these pools and has accounted for these in its current ratings. As a result, it expects ratings actions to be limited for investment grade tranches.
However, thinly structured non-investment grade bonds will be more susceptible to rating changes, positively or negatively, as loan concentration is almost always very high in these pools, and can affect losses, or lack of, more significantly.
Legacy CMBS Winds Down
Helping matters for 2006 and 2007 vintage CMBS deals is that they are coming due against a much smaller maturity wall, as borrowers have spent the last twelve months taking advantage of low interest rates by refinancing or defeasing their loans.
CMBS is likely not the lead source of refinancing for 2006 and 2007 vintages, as its portion of commercial real estate finance fell this past year, and CMBS issuance may be further depressed by risk retention rules which go into effect in 2017. In addition to this, two other important questions arise: will risk retention rules cause shakeout among smaller originators and will they lead to the entry of new or re-capitalized B-piece investors?
The potential impact of risk retention will also play out next year for CLOs. With the flurry of new and refinanced CLOs coming to an expected halt, attention will turn to whether subsequent offerings will comply with the new rules. Meanwhile, some asset managers are still in the process of finding strategic options to fund the risk retention investment and even those who had no problems raising capital still need to fine-tune the legal and operational aspects.
As a whole, the commercial real estate financing market should be resilient, even with a small increase in interest rates. Similarly, Fitch’s legacy CLO portfolio is expected to exhibit rating stability as deleveraging offsets increasing concentration and adverse selection.
Bright Spots: CLOs, RMBS
Amid the cloud of risk retention, U.S. CLOs have been and will continue to be a bright spot in terms of asset performance. CLO investors benefited from diversification this past year in the face of volatile oil prices and commodity market distress. As such, Fitch either affirmed or upgraded all of its leveraged loan CLO ratings and maintained a Stable or Positive outlook.
Leveraged loan downgrades and a spike in defaults in commodity-related sectors continued in 2016, however, this has improved. Oil and gas prices have risen from their lows earlier this year due to the combination of a more robust supply response from U.S. producers and evidence of modest progress in reducing the inventory overhang in the market. In the metals and mining sector, the weakest issuers have already completed or are in the process of restructuring their debt.
Another bright spot for 2017 is U.S. RMBS, with Fitch holding a positive ratings outlook. Asset performance will remain positive thanks in large part to solid gains in home prices. Rating upgrades outnumbered rating downgrades for the second consecutive year thanks to continued recovery among legacy RMBS and the continued strong performance of post-crisis RMBS. In fact, Fitch has upgraded a number of classes in transactions issued since 2010, specifically for prime, reperforming loan, and government-sponsored enterprise credit risk transfer RMBS. Furthermore, no U.S. RMBS bond issued in the last five years has experienced a rating downgrade.
Another positive sign is the number of distressed mortgages remaining in private-label RMBS, which has now dropped to approximately one-quarter the figure that we observed during the peak of the crisis, the lowest level in over ten years. Collateral losses have been close to zero for Prime Jumbo RMBS pools securitized since the financial crisis. Early delinquency and loss trends in RPL and GSE CRT transactions also remain below initial expectations.
Also buoying the RMBS outlook is U.S. home prices, which continue on their gradually rising trajectory, although prices have not yet fully recovered to pre-crisis levels in most areas of the country. The rate of price growth has been uneven nationally, with areas in the Western regions experiencing much more rapid growth than areas in the Northeast. Prices in California, Arizona, Nevada and Washington, for example, have increased over 50% since 2012, while average prices in New York, New Jersey, and Massachusetts are up less than half that figure over the same period.
Some housing markets in the West appear to be over-heated and Fitch estimates prices in a number of major cities are now overvalued. Prices in Dallas, Phoenix, Riverside and San Francisco all appear to be 10%-15% overvalued and are increasingly vulnerable to a sharp slowdown or a price correction. Outside of these regional pockets, home prices in the U.S. appear to be on solid footing and are well-supported by the underlying demographic and economic trends.
Some of the early warning signs we spoke of 12 months ago have moved from anecdotal to visible, but U.S. structured finance should, by and large, withstand the road blocks that lie ahead in 2017.
Rodney Pelletier is a managing director with Fitch Ratings.
