EUROPACE ABS Monitor

19 June 2008

Monolines may split or stop writing new business on downgrades

Over the past two weeks the global ABS market has been digesting the news of the downgrades by Standard & Poor’s from Triple A to Double A of monoline insurers Ambac Financial Group and MBIA.  

With Moody’s also putting them on ratings watch negative the future looks difficult for the two monolines, who had hoped that fresh capital already raised ($2.6bn for MBIA in December and $1.5bn for Ambac in March) would allow them to maintain their Triple A status.  

One analyst suggests that S&P may have been over cautious with these latest downgrades. But clearly the rating agencies are under a lot of pressure from regulators, and do not wish to be seen to be too lenient on companies, and then get caught out by more bad news. S&P said that the monolines’ business models had been damaged, which outweighed the positive effects of any new capital raised so far.   

As Double A rated entities they will be severely constrained in writing new business, and could even go into so called run-off mode in some business lines, which means collecting payments and making claims on existing policies but not writing new business.  

Another possibility is that they may be split into two separate businesses, one wrapping securities such as municipal bonds and the other specialising in structured credit. Given the problems in the RMBS sector it is the municipal sector that is likely to be more attractive.  
 

Regulatory pressure on rating agencies to get structured finance methodology right

In the wake of the debacle in the subprime mortgage market and the knock-on effects on Collateralised Debt Obligations and Structured Investment Vehicles, the rating agencies are currently under attack from politicians and regulators for not assessing risk properly, and thus contributing to the current crisis.  

There have been calls for the regulation of rating agencies, and for them to develop a totally separate scale of ratings for structured finance.  

However the latter seems unlikely, since global fixed income investors have incorporated existing rating scales as an important element of their risk management and reporting systems, and there are still many advantages to having a rating system where a corporate Double A is supposedly similar in risk profile to a structured Double A.  

The rating agencies are currently consulting extensively with ABS market participants, with proposals that may help head off intervention by regulators.  

S&P has publicly reaffirmed its commitment to the goal of comparable ratings across sectors, though it has proposed adding an identifier to signify that the rating is on securities that have been issued out of a securitisation structure. This might entail adding the letter ‘s’ to all existing and new ratings on securitisation transactions.  

S&P also has plans to complement traditional ratings analysis by highlighting non-default risk factors such as liquidity, volatility, correlation and recovery. Both Fitch and Moody’s are also consulting market players and regulators about changes to methodology and transparency.  

Banks retain structured deals for prudential collateral

Meanwhile, in the primary market in Europe, most structuring activity continues to be associated with banks needing collateral for European Central Bank or Bank of England liquidity facilities.   

The Arkle Master Issuer 2008-1 RMBS transaction from Lloyds TSB was a case in point. Around Pounds11.5nbn worth of bonds were structured in twenty tranches, but the deal was retained, with the subordinated tranches used to enhance the Triple A tranches which can be used as collateral with the Bank of England.  

There was also a Euro1bn retained RMBS deal for Bankinter in Spain.  

Primary market activity focuses on leveraged CLOs

Ironically, given the higher level of risk in the leveraged loan market than in prime mortgages, it is CLOs backed by leveraged loans that are providing much of the primary market activity. The Euro372m Jubilee CDO deal from Alcentra featured a Triple A tranche priced at Euribor plus 125bp. And the Euro300m Puma CLO transaction from M&G Investments featured a Euro211m Triple A tranche priced at Euribor plus 100bp.  

Both deals featured much more sizeable lower-rated subordinated tranches and unrated first loss pieces than would have been the case a year ago, as the rating agencies demand more protection for the senior notes.    

Lack of liquidity driving higher bank funding costs

Right across the financial markets, access to liquidity continues to be the overriding theme. In the bank lending market, the malfunctioning of the London Interbank Offered Rate (Libor) is causing great difficulties.  

There is plenty of evidence that banks funding costs are considerable higher than the published Libor rate. This is one more challenge to banks trying to get back to lending, since they may have to charge higher margins over Libor to reflect their true cost of funding.    

But though lack of liquidity and mark to market losses continue to dominate the market, at least there is more discussion taking place about the underlying credit fundamentals. Triple A prime RMBS are still viewed as a buying opportunity, though few accounts seem inclined to add to their exposure because of possible mark to market losses.  

UK BTL tranches widened, yet underlying property location key to performance

One of the hardest hit asset classes in recent weeks has been UK Buy To Let (BTL) RMBS. Over the past month Triple A rated BTL tranches have widened out by 50bp to 350bp, and Double A tranches by 100bp to 550bp. And at the Triple B level spreads have widened out by 200bp to 900bp.   

Investors need to look carefully at the regional distribution of mortgage loans in BTL pools. Even though apartment prices may be falling in London, unemployment remains low and owners have a good chance to find tenants to substantially cover their monthly mortgage loan payments.   

But outside of London the rush to build ‘lifestyle’ apartments in smaller cities was not underpinned by strong local economic activity or tenant demand. Owners were simply placing a bet on rising property prices, and the ability to refinance at lower interest rates as the Loan To Values (LTVs) fell.  

That game is now over. Many buy to let apartment investors are highly leveraged individuals with multiple properties, who do not have the resources to ride out long void periods with empty apartments. And the building societies and banks, which were so aggressive in the BTL sector over the past few years, have recently re-priced their BTL products in a move designed to reduce the volume of applications.

Archive EUROPACE ABS Monitor

Disclosures