EUROPACE ABS Monitor
16 August 2007
Accurate pricing in volatile markets
Against a background of the turmoil on global financial markets, primary ABS issuance has dried up for the traditional summer break, and issuers and arrangers are hoping that the markets will have settled down once the pipeline fills up again in September.
In the meantime, in thin and volatile markets, it is proving extremely difficult to accurately price ABS assets, and this volatility is causing problems for investors needing to mark their portfolios to market. Indeed some analysts are identifying mark to market as the main concern at the moment in most areas of the ABS market, since it is even impacting asset classes which look fundamentally sound.
On 9 August, BNP Paribas froze three of its funds with US sub prime exposure, stating that it could not fairly value them due to the complete evaporation of liquidity.
In the absence of primary offerings, secondary bid lists are the main source of activity, and funds are adding to the pressure on spreads because they need to offload ABS assets in order to meet redemptions.
Irrational price movements are being seen across many asset classes, from bonds to equities, and the events of summer 2007 will result in radical changes in assumptions about how markets behave during a crisis.
The widening out of spreads
In the equities sector, the big hedge funds with so called market neutral strategies have been trying to unwind long and short trading positions by buying and selling the underlying shares. Poor quality stocks that they were shorting have needed to be bought, and so have seen their prices pushed upwards. But the stocks that they liked needed to be sold, causing sharp falls in the price of some blue chips.
The result is not just a malfunctioning market, but one in which prices are behaving in exactly the opposite way in which they are supposed to. And a similar phenomenon is to be found in the ABS market.
Many fund managers who need to raise cash urgently for redemptions are finding that there are no buyers for Triple B tranches, so instead they are offloading whatever they can sell at knockdown prices. These saleable assets tend to be the Triple A tranches of the largest and most liquid RMBS and CMBS deals.
This is having the effect of sending Triple A spreads shooting out wide in secondary, with even Dutch and UK RMBS tranches trading at 23bp or 24bp, and Spanish paper now seen changing hands as wide as 35bp.
Triple A spreads have widened out by as much as 15bp in little over a month, which has come as a bigger surprise than Triple B tranches widening out by 35bp.
Analysts argue that such levels are way out of line with the fundamentals of prime mortgage portfolios, and reflect distressed selling rather than liquid trading prices. Nonetheless, investors marking their portfolios to market are having to deal with the effects of a drastic widening in Triple A spreads.
Continued volatility in thin trading is expected during August, and it will not be until primary issuance resumes in September with some multi-billion Euro deals that it will be possible to see how the market has been re-priced, and the kind of spreads that investors will be willing to accept in a more risk averse climate.
And jitters in lower quality RMBS deals are spreading through into the prime sector, as investors question whether Triple B prime mortgage tranches could withstand the stress test of a major property market correction. Even at the prime Triple A level, tiering is becoming very pronounced, with top UK prime issuers selling at 10bp and Spanish deals at 20bp, with the Portuguese in the middle at 15bp.
Results of the current lack of issuance
Certainly at Triple B level, both prime RMBS and CMBS issuers are going to have to pay much more generously, as investors re-assess the extreme spread tightening seen since 2005. At the Triple A level, big and well capitalised issuers such as Dutch and UK mortgage banks will simply put deals on hold if Triple A spreads are too wide, so issuance could be pushed back to later in the fourth quarter.
Even of the market does settle down again in September, going forward there is likely to be much greater tiering between different countries and issuers. And issuance volume may fall in some sectors, with a possible slowdown in the origination of non-conforming mortgages in the UK, and a lower volume of leveraged loans to put into CLOs, as global M&A activity has ground to a halt.
In the European ABS market, primary issuance totalled Euro51bn in July, which was ahead of 2006 levels, but August issuance looks certain to be lower than the Euro11bn figure in 2006, particularly since a sizeable number of deals were pulled at the last minute.
This lack of issuance could result in some pent up demand from funds when the market re-opens in September, though there are questions about whether fund investors will now want to avoid ABS for the rest of the year, and continue with redemptions. Another drop in demand may come from the Asset Backed Commercial Paper conduits, which have been big buyers of ABS.
More news from the Alt-A RMBS market
The problems at the Rhineland Funding conduit run by IKB, which prompted the intervention of KfW to take over as liquidity provider, have placed ABCP conduits under scrutiny, and many bank liquidity providers to conduits are likely to block further ABS investments until the markets calm down.
Meanwhile in the USA, there is still bad news coming out of the so called Alt-A RMBS market, backed by second lien mortgage loans. On 7 August Standard & Poor’s announced that it was putting 207 Alt-A RMBS tranches on creditwatch negative.
Summer 2007 as turning point in the credit markets?
Summer 2007 has turned out to be a turning point in the credit markets, and it is a sign of the rapid growth of the securitisation market in recent years that the ABS market has for the first time ever sparked a global financial crisis.
The much heralded theory that spreading mortgage lending risk around via securitisation will bring stability to the financial markets has taken a hit. And the stability of Triple A rated asset backed securities for mark to market investors will also have to be re-examined. Come September, there will be a lot of re-modelling being done to try and predict the future behaviour of markets in a stress environment.
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