EUROPACE ABS Monitor

22 October 2007 

Spread tightening in secondary market trading

There has been some spread tightening in secondary market trading of European ABS over the past two weeks, as more investors have put aside their nervousness and taken advantage of some of the cheap tranches on offer.

But tiering in Triple A rated RMBS tranches remains very marked, with Dutch RMBS moving in to 28bp, and UK RMBS to 32bp, while Portuguese tranches are at 39bp and Spanish Triple As still very wide at around 60bp.

Some analysts are forecasting that prime Dutch and UK Triple A spreads will tighten in to the mid twenties in the coming month, and that the Triple A end of the market will start to settle down. But at the Triple B level there continue to be real worries about credit quality, and more distressed selling may mean that high volatility could continue for some months. 

Structured Investment Vehicles (SIVs) still have large quantities of lower rated ABS that they would like to offload, so the market remains wary of a sudden flood of paper if pricing conditions temporarily improve. Triple B rated end prime UK RMBS have recently been trading around 190bp, and Spanish Triple Bs at 350bp. 

Investments in US subprime tranches

Even more problematic for European investors are their holdings of US subprime tranches, which were very heavily marketed within Europe during 2006. And in this sector, not even Triple A rated tranches are immune from the effects of poor mortgage loan underwriting standards and falling US house prices.

On 11 October Moody’s downgraded Dollar33.4bn worth of mainly lower rated subprime securities that were issued in 2006, representing 7.8% of the original Dollar volume issued. At the same time Moody’s placed on review for possible downgrade another Dollar23.8bn of 2006 vintage securities, which include 48 Triple A rated and 529 Double A rated tranches.

Moody’s noted that the securities placed on review were generally not expected to move by more than three notches, and that the most heavily impacted securities were originally rated Ba, Baa or A. Rating migrations have been much more severe for the more deeply subordinated tranches of 2006 subprime deals.

The US Treasury involved in setting up a superconduit

Meanwhile the US Treasury Department has been involved with an initiative involving the setting up of a superconduit which can sell Asset Backed Commercial Paper (ABCP) and use the proceeds to help fund distressed investors such as SIVs.

The Master Liquidity Enhancement Conduit (M-LEC) is backed by banks including Bank of America, JP Morgan Chase and Citigroup, and should enjoy the confidence of jittery commercial paper investors.

M-LEC will in turn invest in ABCP and MTNs issued by SIVs. This would help prevent the fire sale of more subprime ABS if financially troubled SIVs (who are unable to sell their own ABCP in the current environment) are forced to sell their investments as their ABCP matures.

Analysts note that fears of more large selloffs by the SIVs have pushed spreads much wider than the embedded credit risk would seem to justify. Thus the main aim of M-LEC is to avoid a massive amount of paper being dumped, further pushing down prices, and causing yet more problems for the SIVs as they mark their investments to market.

The plan is viewed as innovative, but the rumoured Dollar100bn maximum size is quite small compared to the both the size of subprime ABS holdings in the US market, and the ABCP market. Nonetheless, the involvement of the US Treasury should give confidence to buyers of ABCP issued by M-LEC, though no government funds will be involved. Final details are still being worked out.

The primary market in Europe

In the European ABS primary market, most transactions continue to be retained, with a few tranches privately placed. Most issuers would find current spreads too expensive to justify public issuance.

The Euro2.2bn Portuguese RMBS Hipototta plc 6 from Banco Santander Totta had all tranches retained.  And Cars Alliance Auro Loans Germany FCC 2007-2 from RCI Banque Germany involved private placement of two tranches, with two junior tranches retained.   

A big RMBS deal is still needed for price discovery, and analysts who expected some sizeably publicly offered transactions in October are now hoping that November will see some activity. Certainly there are hopes that some of the major UK mortgage originators will need to issue RMBS before year end.

Serious concerns about UK non-conforming RMBS

Although the market is slowly becoming more comfortable with the embedded credit risk in sectors such as Dutch and UK prime RMBS, there are serious concerns about UK non-conforming RMBS. 

UK non-conforming securities are trading at 90bp for Triple As, and 400bp for Triple Bs, and some analysts question whether that makes Spanish prime RMBS Triple B tranches look comparatively like good value at 350bp.

Of course the US subprime market was much more developed than in Europe, but there are large quantities of UK non conforming RMBS tranches which could hit trouble if the UK property market were to fall by 10%, as it has done in the United States.

Of particular concern are 2006 vintage RMBS, since underwriting standards become very sloppy in a highly competitive environment. There has since been a welcome tightening of underwriting standards. Industry figures show that the number of mortgage applications in the UK that were rejected by lenders has surged by over 60% in recent months compared to figures for 2006. 

News from Northern Rock

Earlier in the week Northern Rock executives found themselves in the uncomfortable position of being questioned in front of the TV cameras by a Treasury Select Committee in the UK Parliament. They defended their wholesale funding model, with its high dependence on securitisation, and criticised the Bank of England for not making emergency funding available to the UK banks, as was the case in the US and the Eurozone. 

There are currently a number of interested buyers for Northern Rock, including a consortium led by Richard Branson’s Virgin Money, and US private equity house JC Flowers.

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