U.S. structured finance is set for another stable year in 2016, with performance across most asset classes remaining strong by historical standards. Largely driving this trend is the U.S. economy showing steady improvement and housing market volatility diminishing.
Not surprisingly though, when you drill down further the picture isn’t as rosy. In fact, it’s safe to assume that for most asset classes, the best days are firmly in the rear view mirror. CMBS underwriting quality remains under pressure. Defaults on leveraged loans are on the rise. Auto lenders are becoming increasingly competitive. And new marketplace lenders are looking to disrupt the status quo in the consumer lending space.
So the big question is ‘What is the other side of the peak going to look like?’ With that in mind investors would be wise to look out for some early warning signs that could signal more significant credit issues in the future.
Irrational exuberance in CMBS, Subprime Autos, Marketplace Lending
Excessive or irrational competition is the most common pre-cursor to significant credit deterioration and three asset classes have a higher than average exposure to this risk: commercial mortgage-backed securities, subprime autos and marketplace lending
The steady decline in CMBS underwriting standards is not a new issue by any means, but one that continues to bear close watch. Fitch has done so through higher credit enhancement, with levels on ‘AAA’ CMBS roughly double (over 23%) what they were back in 2007 (over 11%). In particular, underwriting that includes pro-forma income is of particular concern. The good news is that some originators are beginning to show a higher level of discipline which could help slow or reverse some of the recent negative trends.
In subprime autos, there are a large number of lenders competing for a finite number of borrowers, and this has led to loan terms getting pushed out. This is an early sign that competition could be getting overheated. If car sales slow, life could become more difficult for some of these lenders.
Marketplace lending is another sector that warrants close scrutiny. While current practices seem rational, the sheer number of new players entering the market causes us to be wary. Excessive competition among marketplace lenders could create credibility and stability issues within this new space as well as in the broader, traditional consumer lending sector.
These early warning signs carefully taken into account, the outlook for U.S. structured finance is stable to positive. The vast majority (87.7%) of Rating Outlooks remains Stable or Positive in 2016 (with FFELP student Loan ABS a notable outlier). Transactions issued this year are expected to continue to exhibit high credit-quality collateral, solid performance metrics and robust structural protections. Continued tight credit discipline employed since the credit crisis will benefit transactions across most sectors, though it’s a foregone conclusion at this point that underwriting standards will loosen further in some sectors.
Low jobless claims and sustained job creation will further trim the ranks of unemployed while solid property fundamentals, rising home prices and equity valuations should continue to bolster consumer confidence and in turn consumption. Despite the favorable trends, overall growth expectations have receded as global uncertainties and higher rates threaten to dampen broader gains. Long awaited Fed tightening will impact all sectors albeit to varying degrees with CMBS most likely to feel the effects as refinancing needs loom.
Prime Autos, Credit Cards Stable
The outlook for auto and credit card ABS ratings and performance remains stable. Auto and card collateral performance measures are expected to ride high credit quality and ongoing strong trends into 2016. An easing of credit standards will continue in the auto sector and increasing consumer leverage is a concern across all sectors. Fitch expects performance trends will revert toward historical norms albeit at a measured pace. The aforementioned outlier is FFELP student loan ABS, the rating outlook of which has turned negative given the widespread maturity risk issues plaguing the sector.
Commercial property market fundamentals are still improving, extending a trend that began in 2010. Continued economic recovery, a lack of new construction so far, low interest rates and plenty of liquidity are the main contributors. Interest rate rises remain the key risk to stable performance. Potential headwinds to face CMBS in 2016 are higher interest rates, continued declines in underwriting, and the refinance wall made up of loans from 2006 and 2007.
Income growth for hotel and multifamily properties has been strong over the past five years with new revenue and net operating income peaks reached in 2015. Which begs the question- - How much longer can this trend continue? At some point growth will plateau, which explains Fitch’s conservative cash flow assumptions for these two property types to ensure that current revenues and incomes are sustainable over the long term. Multifamily is most at risk from new construction. Office properties continue to see mixed results. Major metropolitan markets continue to experience rental growth, although new construction will temper that going forward. Smaller and suburban markets still exhibit weakness though they are in better shape than a year ago. Retail continues to slowly stabilize with already-strong properties dominating weaker rivals.
Some CLOs Exposed to Commodities
Fitch's outlook for U.S. collateralized loan obligations remains stable, thanks to sufficient credit protection on the structures. That said, warning signs are emerging as leveraged loan credit deterioration surfaces especially in commodity-related sectors. Despite a small increase in defaults of energy and metals & mining loans, CLO exposure to these sectors remains limited and structural features and overall portfolio diversification are expected to insulate the rated notes from negative rating actions in the near term.
How big of an impact of leveraged loan performance will have on CLOs will depend on structure, the exposure to distressed credits and the manager's abilities in addressing those risks. Managers have been opportunistic in building par and overcollateralization with assets purchased at a discount. However, they still face risks of losing par and overcollateralization when exiting out of distressed credits.
The U.S. residential mortgage backed securities continues its slow and steady recovery from the financial crisis. The rating outlook for RMBS for the majority of new and legacy transactions remains stable. Issuance volume in 2015 was the highest on record since the crisis. The performance on legacy loans originated prior to 2008 continues to improve, supported by strong home price gains, while the performance on loans originated after the crisis remains the best in the history of the sector.
Despite the gradual improvement, the lingering question with regards to new issuance remains “Where is it?” Though reaching a post crisis high in 2015 of $15 billion, private label prime RMBS issuance is still a small fraction of pre-crisis volume levels In the mid-1990s, when annual issuance volume averaged around $40 billion per year. From 2000-2003, prior to the significant expansion in credit guidelines that led to the crisis, annual issuance averaged close to $100 billion per year. The short answer to the question is lack of investor demand and limited incentive to securitize high-quality loans. Until the shape of the yield curve changes, securitization volume of prime non-agency loans will likely remain limited and may even fall back from 2015 levels.
Overall, the early warning signs are still relatively modest and somewhat anecdotal. But now is not the time to get complacent.
Kevin Duignan is a managing director and head of Fitch’s global structured finance and covered bonds groups.
