Securitisation 2007: Every cloud . . .
As the US sub-prime industry imploded this year at least one other industry saw some benefits. Under pressure from spread tightening and new entrants, the financial guarantors have seen sub-prime lenders beating a path to their door. But the monolines' problems will need more than a little spread widening to be resolved. Paul Farrow reports.
The financial guarantor industry is one beneficiary from the US sub-prime market's current problems. As spreads have widened out, the guarantors have found sub-prime lenders rather keen to renew their acquaintance with the monoline product.
"The sub-prime meltdown is the big event of the year," said Stanislas Rouyer, senior vice president in the financial institutions group at Moody's. "The guarantors had been pushed out of that market, so this is a big opportunity for them, and a reminder to the rest of the market of the value of committed, long-term players."
That optimism is shared within the industry. "Often the best opportunities come after a period of stress, when the quality of assets being originated improves. In that sense, adversity can bring opportunity," said Nick Proud, managing director, structured finance Europe at Assured Guaranty.
According to Thomas Abruzzo, managing director of Fitch's financial guarantors group: "The sub-prime blow-up has led to a widening of credit spreads, so there could be opportunities to write protection. Prior to the blow-up other forms of execution were simply more efficient, such as hedge fund participation in mezz tranches which made senior-sub execution, as an example, more efficient."
However, the key may be getting exposure to sub-prime business being written from now onwards, without getting involved in business written during more careless times.
"Spreads on sub-prime have widened out in 2007, but you have to balance returns with taking acceptable credit risks," said Howard Pfeffer, president of FGIC.
Fitch believes that the monoline industry is well protected against the sub-prime sector's problems given that historically financial guarantors have only been involved at the Triple A level.
According to Chris Weeks, head of international at MBIA, that company has been underweight sub-prime exposure for some time.. First quarter production consisted mostly of HELOCs (home equity lines of credit) and CES (closed end second liens) made to prime borrowers. MBIA is understood to have written US$3.3bn of business with Countrywide in Q1 2007 alone, which consisted of HELOCS and CES made to prime borrowers
"We have set ourselves strategic limits with US players that we see as long-term viable," said Weeks.
A revival of business with sub-prime lenders is certainly a welcome development for the industry after several years during which tightening spreads have excluded the guarantors from several sectors, and at a time when there are seven firms fighting for international business.
One reaction has been to develop more private business as the number of big, public deals has declined in relative terms. "The vast majority of Assured Guaranty's business is private," said Proud.
These private deals can take the form of wrapping long-dated index-linked debt from UK regulated utilities. The primary paper is bought by term, cash investors that approach the monolines to get it wrapped. In this way the monolines are enabling primary issuance, because these investors buy with the specific intention of getting the debt wrapped.
A lot of the private market, secondary wrap business is for capital relief purposes: "Basel II has encouraged this," said Fitch's Abruzzo. "We would question the long-term viability of the industry if this is one of the few sectors the industry makes inroads in".
So where else can the monolines look for growth? FGIC's Pfeffer lists as opportunity-drivers M&A-related transactions, companies using monolines to boost their debt capacity, and the greater use of the product internationally.
The development of UK-style PFI projects in the US is also potential area for growth, according to Pfeffer.
"The Chicago Skyway and the Indian toll road are both examples that got a lot of press coverage in the US. They were newsworthy in terms of the amount they raised for the cities in question," he explained.
FGIC is active in the long-tenor, project-finance related aspect of the industry outside the US as well. It recently did a railcar deal for New South Wales in Australia, and a Canadian road transaction.
There is also potential for more infrastructure business in Continental Europe, but there the monolines have to contend with tough competition from banks as well as formalised government programmes.
Still, FGIC is aiming for one third of its total business to be non-US. Three and a half years ago, when the company was sold, it solely focused on US public finance, so attaining this target will take time, according to Pfeffer.
In the emerging markets two main factors determine a monoline's willingness to write business: the perception of political risk and legal/regulatory constraints.
"If the legal and regulatory systems don't work, then whatever the asset class may be, it will be difficult to get comfortable. A jurisdiction needs to operate within reasonable tolerances. In Eastern Europe it is the legal/regulatory angle that is most constraining," said Pfeffer.
It is certainly telling that while no monoline has yet written business in Russia, all seven are active in the neighbouring emerging market of Turkey. Moody's Rouyer sees the monolines' refusal to get involved in Russia as evidence of discipline in the industry.
"The guarantors have a good sense of how bad things can get when they get bad. And given their high level of operating leverage, they can't afford to make a big mistake," he said. On that basis he sees the recent EU accession countries as a more likely hunting ground for the guarantors.
But Assured Guaranty's Proud denies that there is a herd mentality among the monolines. "It is simply that there are certain risk characteristics that are monoline friendly, while others are not," he said.
"Turkey is a low-rated country, so it is expensive for domestic banks to finance themselves. But the political and economic situation is improving and the DPR flows are quite varied," explained Proud. Those DPR flows include exports, remittances and tourist credit cards.
"In Kazakhstan, for example, the politico-economic situation is less well known, and the DPRs are more concentrated in oil. But at Assured Guaranty we are growing our market share in Western Europe, so we don't need to chase exotic deals."
At the end of 2006, international business accounted for 20.8% of Assured Guaranty's par insured (the industry's measure of volume).
With the more exotic markets making headlines, it is easy to assume that there is limited scope for growth closer to home. But that might be a mistake, and Proud emphasised that it would be an error to see the US market as a mature one for the monolines.
"The US also has potential for growth, and a Moody's upgrade for us would boost our US public finance business a lot. Also remember that the US public business is all upfront premium," he said.
Pricing remains tight for the monolines, despite the recent spread widening. This is a result of an increasingly commoditised product in some sectors, competition from within the industry and competition from outside players.
"The more commoditised the product, the more competitive the price," said FGIC's Pfeffer.
According to Assured Guaranty's Proud, as of April this year, pricing was pretty similar to that in Q3 2006. "Pricing hasn't tightened since then, despite spread movements," he said.
MBIA's Weeks said that the pricing environment had improved, but it was important to take account of the product mix.
"MBIA has taken advantage of better pricing for Triple A tranches of risk within CDOs, CMBS and RMBS in the last six months. That may mean lower absolute premiums rates, but superior returns on a risk-adjusted basis," he said.
However, Fitch's Abruzzo still categorises the current market conditions as brutal: "Has the sub-prime turmoil halted that? A little, for a while. So spread tightening may have slowed, but spreads are still very tight. Sub-prime spreads are still at 50% of their 2001–2002 level."
For newer entrants an additional problem is the need to absorb in their fees the difference in their bonds' secondary market trading performance. Assured Guaranty's Proud said that in the secondary market investors look to buy Assured Guaranty paper 10bp wide of MBIA or FSA bonds, though that narrows to 2bp–5bp for structured deals, where the investor base is more sophisticated.
"And when AGC makes it to Aaa from Moody's (it is currently on Creditwatch positive), the differential should be further eroded," he added. It will certainly help in sectors like US public finance, which is very commoditised and very competitive.
"Any new player has to establish a liquid trading value in the secondary market. To do that, it has to buy market share, which means accepting lower profitability in the short to medium term," explained Fitch's Abruzzo. "These guys are writing a lot of business, and not getting sufficiently paid for it."
Moody's Rouyer also notes that there is evidence of more competition on the big project deals, the result of a combination of more guarantors chasing those deals and competition from other players, such as banks and big private equity groups.
And while international business is much more profitable than US business (with a PV of premium to par value of 1.2%–1.4% for the sector compared with 0.7%–0.8%), some of that is due to the product mix.
"Infrastructure is a relatively large proportion of the international business, while the low-risk municipal business is the core activity in the US," he said.
Then there is competition from other businesses trying to get onto the monolines' patch. Bank lenders' seeming indifference to low profitability is one problem; CDOs can represent competition for monolines – although they can be a source of business as financial guarantors insure CDO tranches – and the number of credit derivative product companies (CDPCs) is set to increase.
"We don't see competition from credit derivative companies," said Assured Guaranty's Proud. "They are typically involved in purely synthetic execution, whereas monolines focus on cash-market trades."
Fitch's Abruzzo agrees that so far the lack of scale in credit derivative companies means that their impact on the monolines has been limited. "However, if there were 10 or more such companies, the industry would have to take notice," he added.
Abruzzo also considers it erroneous to draw a line between cash market-focused monolines and synthetic-focused credit derivative companies."A lot of monoline execution these days is synthetic via pooled CDS," he said.
"CDPCs are not that important in terms of competition, but they could become so if they broaden their activities into areas of monoline activity, such as US municipal finance," said Moody's Rouyer. "And although for the moment CDPCs don’t compete in publicly traded cash securities, this could change, although it would take a long time."
MBIA's Weeks agrees. "Few of these CDPCs are up and running so far, and there is a question over how much counterparty risk investors will be prepared to take. But perhaps a more important factor is that the broader structured credit markets are growing, which provides scope for the CDPCs and the monolines to participate without necessarily competing head on," said Weeks.
As for consolidation within the industry, according to Fitch's Abruzzo there is no indication that the monoline sector is about to undergo consolidation, but such a move would not be a surprise.
"In the medium term, consolidation within the monoline industry is possible, but the market in which they are playing is much larger now," he said.
Moody's Rouyer agrees: "Unless their shareholders feel meaningful pain, the drive to consolidation among the monolines will not be strong. However, if the recent spread widening ends or reverses, and if international growth is below expectations, that could change.
"Compared with 1999, the industry has room for more than the four players active at that time. The industry is larger, thanks to international expansion, and financial innovation means that there is more use of securitisation in different areas, which gives opportunities to the financial guarantors," Rouyer continued.
"There has been a huge evolution in the way that credit risk can be hedged and transferred, and there has been tremendous growth in the markets. That combination may sustain the number of monoline players. The danger is not an increase in defaults – the industry has shown itself quite good at navigating defaults historically. The problem is if spreads flat line," said MBIA's Weeks.
"And that's when the established firms' advantages come into play," said Iain Barbour, managing director at MBIA. "They have an historic book, critical mass and diversity of business that together provide the strength to go through the cycle."