EUROPACE ABS Monitor

19 July 2007 

Black Tuesday in the US mortgage market

The direction of the European ABS market has recently been dominated by events in the United States, with fears that problems in the sub-prime mortgage lending sector may be a foretaste of things to come in the UK non-conforming RMBS market.

On what one analyst described as Black Tuesday in the US mortgage market, last week Standard & Poor’s placed on credit watch 612 tranches that it had rated between the fourth quarter of 2005 and the end of 2006. This included the remarkable figure of 46.4% of all Double B sub-prime mortgage tranches that were issued during that period.

On the same day Moody’s downgraded 399 sub prime tranches issued in 2006, and placed another 32 tranches on review for possible downgrade. And two days later Fitch Ratings placed 170 sub-prime tranches under review for possible downgrade.

One US analyst notes that, while it was common knowledge that the 2006 vintage was the worst performing to date in the sub-prime universe, the sheer number of downgrades seems to have taken the US market by surprise.

Affects on vintage deals

Still to come are actions on 2007 vintage deals, which were issued very early on in the year before the scale of the sub-prime lending debacle began to hit the headlines. And also potentially affected are large numbers of Collateralised Debt Obligations issued both out of Europe and the United States, which were heavy buyers of lower rated sub-prime mortgage tranches in the search for yield pickup.

Funds of Bearn Stearns

Bear Stearns has finally released data on the two funds which were heavily invested in sub-prime mortgage tranches, and at one point had heavily leveraged investments totalling Dollar20bn. The High Grade Structured Credit Strategies (Enhanced Leveraged) fund has lost all its value, while even the less leveraged High Grade Structured Credit Strategies fund has left investors with only nine cents on the Dollar.

Narrow spreads for risky bonds

For European investors looking for clues as to possible contagion, there was one positive aspect of the downgrade news, since all the tranches were rated Double A or below. In spite of extremely high delinquency levels on mortgage loans, robust credit enhancement levels at the Triple A level have thus far done their job.

Not surprisingly, given the structure of RMBS deals, most of the downgrades were in the Triple B and Double B area.  Spreads on these tranches tightened in dramatically during 2005 and 2006, so investors are now finding that they were accepting very narrow spreads for risky bonds.

Downgrades too late?

A US analyst suggests that these latest rating agency actions have happened a bit late in the game for most investors. And another highlights the need for investors to do their own analysis of the underlying collateral in transactions before making investment decisions, and to monitor deal performance very closely, rather than just relying upon the rating agencies.

European primary spreads

With all this bad news blowing in from across the Atlantic, primary spreads have been edging wider on European deals, and the level of tiering is getting more noticeable. Triple A spreads on RMBS have generally widened out slightly, while the Triple B tranches are paying investors a much higher risk premium.

Credit news which would have been discounted a year ago is now having an immediate and visible impact on new deals, with investors at long last using their collective muscle to demand higher spreads across the capital structure of transactions. 

Contagion worries about the UK non-conforming market

The UK non-conforming market is the main focus of contagion worries. The UK has by far the most developed non-conforming mortgage market in Europe, and UK mortgage lending practices, though not as shoddy as those seen in the US sub prime sector, have loosened up in recent years, with poor documentation, lax checks on stated income levels of borrowers, and high LTVs.

Many loans have a one or two year introductory period with low interest rates, which are now beginning to shoot up and leave borrowers overstretched. The betting in the UK is that, in the face of rising core inflation, the Bank of England will soon raise base interest rates to 6%. And another raise later in the year to 6.25% is predicted by some economists.

Against this background, UK issuers are having to pay up heavily on subordinated tranches in order to get their deals away. Price guidance on Eurohome mortgages, the Pounds500m RMBS deal from Deutsche Bank’s UK lending platform, is in the 17bp area for the 3.1 year Triple As, and 140bp for the 4.3 year Triple Bs.

An interesting upcoming benchmark in the prime mortgage sector will be the UK RMBS deal Fosse 2007-1C, which is a Pounds2.5bn multi-currency offering from building society Alliance & Leicester. The Triple A tranches include Dollar, Euro and Sterling notes.

Non conforming mortgage lending has also developed quite fast in The Netherlands, and the Eurosail 2007-1 offering from Lehman Brothers’ Eurosail programme has price guidance at 18bp to 19bp on the 3.1 year Triple As, and the 120bp area on the 4.7 year Triple B notes.

Spanish RMBS deals

In Spain, the very heavy supply of RMBS deals has pushed spreads wider in this asset class, and there is noticeable tiering developing between issuers, with investors particularly keen on transactions with low Loan To Value ratios.

Bancaja 11, the Euro2bn prime Spanish RMBS deal, was in demand from investors, and tightened guidance on its 4.5 year Triple As to 17bp (which is still 3bp or 4bp wide of where such deals would have printed a year ago). The 9.5 year Triple Bs priced at 80bp. In contrast, Madrid RMBS III, a high LTV deal from Caja Madrid, printed its 3.7 year Triple As at 20bp.

The market in the summer holiday season

As the market starts to wind down for the summer holiday season, secondary market activity is thin, with high volatility. Primary volume has been quite heavy, though deals have got away with the help of wider pricing right across the capital structure. But bookrunners will be hoping for a pause in primary issuance during August, giving everyone in the market a chance to digest all the implications of rising interest rates in the UK and Eurozone, and how this might affect high-LTV or non- conforming securitisations.

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