EUROPACE ABS Monitor

20 March 2008

Investors hoard cash on the back of Bear Stearns bail-out

The emergency rescue of investment bank Bear Stearns by the US Federal Reserve and its takeover by JP Morgan Chase has added to the sense of crisis on global financial markets, and the knock on effects are being felt in the European ABS market.

In such an environment of uncertainty and at times panic, banks and other ABS investors are hoarding cash. There are very few buyers in the European ABS market, and the only deals being seen are firesales of the best quality Triple A tranches at knockdown prices, often by hard pressed hedge funds.

Even trading desks that see value are scared of short term mark-to-market losses if spreads widen out further, and prefer to sit and watch rather than do any buying- assuming that their credit oversight committees would let them.

Continued prime-grade spread widening making value buys uncertain

It is worth remembering that back in January many analysts said that there was good value and  buying opportunities with prime UK and Dutch Triple A RMBS tranches trading at spreads of around 70bp.

Those investors who were brave enough to buy at those levels probably still see long term buy-and-hold value in high quality prime mortgage backed product. But they are now having to explain huge mark-to- market writedowns to their senior management.

The latest set of secondary market spreads would not have been believed by anyone back in January. At the Triple A level, prime Spanish RMBS are being listed at 225bp, Portuguese at 200bp, German and UK at 180bp, and Dutch at 150bp. Among the Triple Bs, Spanish tranches are at 700bp, UK tranches at 600bp, and German at 550bp.

This is in spite of the fact that most analysts still view prime European Triple A RMBS tranches as well structured, with good subordination, and generally well placed to withstand a substantial fall in property prices. But it is lack of liquidity which is driving the market, and no one wants to listen the talk about the fundamentals of the Dutch or German property markets.

Outside of the prime RMBS space, where there are genuine concerns about potential problems in the mostly UK market in buy-to-let and non-conforming mortgages, secondary prices are much worse.

Triple A buy-to let tranches are listed at 300bp (out by 100bp in a week) and Triple Bs at 700bp. And non- conforming tranches are at 350bp (also out 100bp in a week) at the Triple A level, and 1000bp for the Triple Bs.

Bond spread also growing in UK and Spanish market, while German spreads remain tight

Interestingly, the carnage is also to be seen in the generally more stable covered bond market, which benefits from the fact that covered bonds are full recourse obligations of the issuer, with the mortgage cover pool acting as a back up in case of bankruptcy.

In this market there is much more differentiation between jurisdictions, and while German Pfandbrief are still pricing tight, spreads on Spanish Cedulas or UK issuers have moved out dramatically. Spreads over mid-swaps on Multi-Cedulas, which are packages of covered bonds from groups of smaller Spanish savings banks, have doubled to 60bp versus 30bp in January, and UK issues such as Bradford & Bingley are around the 70bp level. Only last June Bradford & Bingley was selling a ten year covered bond at mid swaps plus 4bp.

Banks continue market withdrawal: spread widening and the mark-to-market write down cycle

Given the vast holdings of ABS and covered bonds in the banking sector, the daily mark-to-market requirements are a vicious circle. The greater the mark-to-market losses are at the banks, the less willing they are to buy additional ABS even at spreads which look fundamentally good.

One analyst comment that few international banks would have strong balance sheets if full mark-to -market was applied right across their balance sheets. Banks are also sitting on hundreds of billions worth of leveraged loans from the Mergers & Acquisitions boom, and are at various stages in deciding what level of writedowns to make on these holdings.

Analysts see no rational end to the current spiral, and are simply hoping that if the markets can get through the next few weeks without another major banking collapse (and there are several rumours about both New York and London based banks) then fundamental analysis may begin to return.

Hedge fund collapse triggers more ominous banking sector pressures

Until very recently the collapse of hedge funds was viewed as the main problem for the ABS market. It had been concentrating upon the bankruptcy of the flagship ABS fund run by Peloton Partners in London, followed soon after by the collapse of Amsterdam listed fund Carlyle Capital Corporation (CCC), an affiliate of Carlyle Group of the US.

Banks acting as prime brokers and lenders to CCC (which had $20bn worth of loans to its highly leveraged fund which was heavily invested in Triple A rated RMBS) made huge margin calls as the price of securities they hold as collateral fell. Many hedge funds were unable to put up extra cash, and have gone under.
But the near-death and emergency takeover of one of the biggest investment banks in the United States has made the problems at the hedge funds a sideshow compared to prospect of more major banks going under.

The Federal Reserve liquidity injection: the Bear Stearns obituary

A week ago, the Federal Reserve pumped $200bn of liquidity into the system, leading to rumours that a major institution was in trouble. As one banker commented at the time, the smell of death was in the air, but no one could locate the corpse. But on Thursday and Friday other institutions stopped trading with Bear, and banks cut off all overnight credit lines, leading to the Fed intervention and high speed takeover by JP Morgan.

As one of the founders and most innovative players in the sub-prime securitisation market in the United States, there is a certain symmetry that Bear Stearns should be the first major casualty of the credit crunch on Wall Street. In fact one of the early signs of the seriousness of the sub-prime problem was the collapse last summer of two Bear Stearns ABS funds.

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