EUROPACE ABS Monitor

10 January 2008

Detailed analysis for value

Many traders only returned to their desks on Monday 7 January, after an extended Christmas break for the European ABS market, and the first bid lists are now circulating in the secondary market.

Liquidity concerns continue to dominate, and it may take one or two quarters to re-establish a decent volume of primary offerings. Nonetheless market participants have started to look beyond technical factors such as lack of liquidity and try to identify where value might be found. Detailed analysis of underlying collateral and performance data is being undertaken.

The underlying credit fundamentals of many ABS tranches remain sound, and have simply been caught up in the overall drying up of investor demand. Analysts are trying to differentiate between these asset classes, and those which will be adversely impacted by the credit crunch and writedowns across the banking sector.

The London commercial property market

One asset class giving cause for concern is UK Commercial Mortgage Backed Securities, since there is great uncertainty about the direction of London office property prices. 2007 was notably for some high profile commercial property transactions, including the sale by HSBC of its headquarters building in Canary Wharf. The Pounds1.1bn price tag made this the single most expensive building ever sold in the UK. Merrill Lynch and Swiss Re also cashed in on high property prices by selling their London headquarters buildings during 2007.

Now the banks are gearing up to lay off staff, and are cutting back on their requirements for office space. Citigroup alone is tipped by some analysts to lay off 10% of its global workforce, or 32,000 people.

Against this background CMBS spreads have been widening out in secondary trading have been widening out, with Triple As trading at around around 100bp over Libor, versus 65bp for UK RMBS. Investors want to get more information on the state of the London commercial property market before venturing back into buying CMBS.

The European prime RMBS market

In prime UK RMBS, barring a property crash of major dimensions, Triple A tranches are well protected and many analysts see value at 65bp spreads. Indeed there was some tightening to be seen in the first few trading days of the New Year.

There is an even better case to be made prime Triple A Dutch RMBS tranches, since the Dutch market has traditionally been very stable, with low delinquency levels. Dutch RMBS tranches are viewed as considerably undervalued at 65bp spreads, and Dutch issuers are tipped as most likely to re-open the European prime RMBS market with sizeable offerings once spreads move inwards.

In Spain the picture is less clear, since there are genuine concerns about a property price bubble. But French and German prime RMBS are viewed as attractive, while in Italy there is a sizeable backlog of RMBS deals waiting to price if conditions improve.

The impact of the liquidity crisis on fundamental performance of RMBS tranches

It is in the non-conforming and buy-to-let space, which is dominated by UK issuers (though some Dutch paper was also sold last year), that the liquidity crisis is feeding back into the fundamental performance of RMBS tranches.

Mortgage lenders were offering cheap deals at low introductory or teaser rates to borrowers, in the expectation that they could refinance after two years. But with liquidity drying up, new mortgage finance is no longer available to many buy-to-let and non-conforming homeowners, who are stuck with loans that will soon be reverting to much higher interest rates.

The Bank of England credit conditions survey for the last quarter of 2007 showed a big drop in mortgages loans, partly fuelled by a lower number of first time buyers who cannot afford to buy,  but also illustrating they way in which banks are scaling back lending, requesting larger deposits and setting generally tighter conditions for borrowers.

The evolution of delinquency data in UK buy-to-let and non-conforming portfolios will be one of the most closely watched themes during the first quarter of 2008. Already in late December Moody’s downgraded some junior tranches on Kensington Mortgages from Ba3 to B2, and put another thirteen tranches on negative ratings watch, including Single A rated tranches.  Various tranches from GMAC-RFC deals have also been put on ratings watch, including Single A rated tranches. Creditwatch typically lasts less than three months before deals are either confirmed or downgraded. 

Fundamental credit problems or just caught by the liquidity crisis?

As the market takes its first slow steps to recovery, this differentiation between asset classes with fundamental credit problems and those simply been caught up in the extreme liquidity crisis should some clear tiering patterns in the market.   

In the UK credit card asset class, where Triple A tranches can be picked up in secondary at 80bp spreads, there are general worries about the direction of the UK economy. However, problems in the card sector in 2005 and 2006 led to a tightening up of lending practices, which means that some of the underlying problems have already been addressed.

In continental Europe, auto loan deals will also be impacted by the broader economic picture, but senior tranches are well protected by subordinated tranches, and should offer good value at 65bp.

Highly diversified SME loan deals may also offer good value at 100bp for Triple A tranches, in spite of worries about faltering economic performance in the Eurozone. But German mezzanine loans have their own particular problems, since these deals suffer from lack of granularity, and a number of high profile bankruptcies have led to downgrades on issues such as PREPS and CB MezzCaP. Even worse, from an investor point of view, the same names tend to crop up in different deals, increasing their exposure to unanticipated events from single names.

The structured finance market in 2008

Excluding retained deals, which dominated the European market in the fourth quarter, estimates for total European securitisation issuance in 2007 come in at around Euro385bn, down from Euro456bn in 2006. There were another Euro60bn worth of retained tranches. The market is expected to shrink again in 2008, though structured finance remains an important source of funding for banks, and if investors prove willing to buy selected asset classes such as prime RMBS at acceptable levels, then primary issuance will bounce back rapidly.

But the demand side remains problematic, especially since banks have been taking ABCP conduit assets and putting them back on balance sheet, diminishing any appetite they might have had to buy ABS in either primary or secondary. 

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