Fitch Ratings is keeping a closer eye on late-cycle behavior
Heading into the new year, the outlook for U.S. structured finance looks very similar to what we were seeing at around this time in 2017; stable overall with some pockets of concern.
Some notable differences as we approach 2019, however, are more peripheral in scope. The macro environment is still favorable and will continue to drive stable rating performance. That said, the fact that we are deep into an already extended credit cycle is a clear indicator that we are moving further past peak performance or past cyclical lows across sectors/asset classes. Given the old adage “bad loans are made in good times” - market complacency and late-cycle behavior among select asset classes is another risk that we’re focused on heading into 2019.
The pockets of concern are largely unchanged from last year,ABS backed by subprime auto and unsecured consumer loans.. This year, however, we’re adding aircraft ABS as a potential problem spot for 2019.
Normalization will continue for consumer bedrocks like credit cards and prime autos with performance still strong and coming in well within our expectations. Elsewhere, subprime auto and unsecured consumer loan ABS performance will remain more vulnerable to volatility due to weaker borrower profiles and acute competition. Aircraft ABS is another sector that we will actively monitor given rising asset valuations and transaction exposures to emerging market lessors, which are more exposed to both macro and local currency risks. With that said, Fitch’s presence in the subprime auto, unsecured consumer loan, and aircraft ABS is more limited due to the agency’s tighter credit standards.
Fitch will continue to participate in the growing aircraft ABS selectively. Growth in new issuance has been quite rapid with many of the deals coming from less established originators with little to no performance history to speak of. A possible broader economic slowdown, particularly in regional or emerging markets, could reverse that trend rather quickly and result in newer originators jettisoning the space in much the same way we saw with subprime auto originators in recent years.
The evolving face of retail has been well documented and is still problematic. We’ve likely seen the worst of the performance issues as it pertains to CMBS, though deals with underperforming malls may be subject to rating downgrades.
CMBS 2.0 special servicing volume will continue to increase in 2019 while delinquencies will remain steady. We are not likely to see widespread defaults on mall loans that are still performing because the properties are still cash flow positive and can cover current debt service until loan maturity. However, the first of those maturities occur in 2020 and we expect special servicers to extend loans that reach maturity, and cannot refinance, rather than foreclose on them and have the trust own the property. There’s uncertainty around the depth of the market that will be available to refinance ‘B’ and lower quality malls at maturity – CMBS is unlikely to be a source.
Performance remains very strong for U.S. RMBS. The potential issues we are seeing for 2019 have less to do with loan credit quality and more with new structures that provide less protection for investors. Some issuers have tested structures that distribute a greater share of cash flow to the subordinate classes (at the expense of senior classes), while others have introduced weaker rep and warranty frameworks.
The U.S. housing market is still very healthy, but price growth momentum is slowing. As interest rates rise and lenders compete for volume, the expected expansion of RMBS credit adds importance to transaction structural features. We expect the gradual recovery in new issuance to continue in 2019.
Fitch-rated U.S. CLOs have a continued stable outlook headed into 2019, though risks are building. We’ve been seeing signs of late cycle behavior emerge in the form of spread compression, higher leverage and looser documentation on underlying loans. As a result, leveraged issuers experiencing stress are likely to have long runways due to looser documentation and pushed-out maturities. The leveraged loan default environment is still quite benign; Fitch’s leveraged loan default index forecast for 2019 is 1.5%, down from 2% expected for 2018. We expect performance issues to be idiosyncratic.
Rui Pereira is head of Fitch Ratings’ North American Structured Finance Group.