Top 250 2005 - Looking for direction
The international securitisation market has reached an interesting point in its cycle. The trend to ever-tightening spreads looks to have run aground and the regulatory environment is set to undergo a significant change. How is the market likely to respond to these issues? Joti Mangat and David Bentley report.
Europe's securitisation sector is at a crossroads and the end of arrangers and underwriters' reliance on residential mortgage backed securitisation – especially of the UK variety – is in sight. Evidence that the credit cycle is at a turning point is everywhere.
Primary market execution is now much more than simply working out how to scale back allocations on order books. Structurers and origination officials have to develop new tactics to cope with this new environment.
"The most important thing for the market [to take on board] right now is that we are probably at the top of the spread cycle. That means that despite the potential for some tightening we have reached the end of the cycle – the downside is bigger than the upside," said Alexander Batchvarov, head of structured finance research at Merrill Lynch.
The de-coupling between corporate and ABS secondary market spreads seen in recent years is now a re-coupling, particularly lower down the credit curve.
While the wall of money is still standing and is getting incrementally taller, the perception now is that it is not as stable as it was even a few months ago. What could stop the wall of money?
"The realisation that the level of risk has changed," said Rob Ford, head of ABS trading at Barclays Capital. Or perhaps the downgrading of a monoline insurer could undermine faith.
"For the first time in 24 months we are suggesting that ABS spreads will be wider this time next year," agreed Ron Miao, structured credit trader at Citigroup.
The haven-like qualities of asset-backed securities were proven the last time the credit market turmoil took place in 2001–02 and there are few reasons to think that these virtues have altered. Nevertheless, the buyside will still need to embark on strategies in view of the fact that the three-year bull market now seems at an end.
April and May were very significant for the development of the European MBS market: ongoing corporate bond volatility fed into the ABS sector as risk sensitivity increased. ABS spreads stalled, then widened as investors scented blood.
By late May, new residential deals from Germany, Greece, Spain, as well as German and Austrian CMBS trades offered sufficient spread pick-up to attract buyers back into primary market, with all deals notably oversubscribed. The dual impact of off-the-run jurisdictions and new borrowers, ironically, gave syndicate managers an opportunity to meet investor appetite for wider spreads, and win participation in a primary market which has been less than robust over May and early June.
Oversubscription and spreads achieved on the latest UK master trust transactions confirmed, albeit temporarily, that investors are indeed better buyers at wider levels.
"We have recently seen demand exceeding supply on the mezzanine side for a lot of deals, particularly for a strong issuer with good collateral," said Eva Kiendl, portfolio manager at UNIQA Alternative Investments. "It was interesting to see how the new Granite 2005-2 performed, because people might have had quite a lot of exposure already. Sterling demand is significantly lower – right the way down the capital structure - while Triple A paper in general appears harder for syndicate desks to place."
"It certainly seems that we have entered a new period of stability after a couple of weeks with new issues just scratching by the finish post," said a senior ABS syndicate official at the time.
Recent secondary market activity confirms a return to the tightening bias. Whether this will last or not is another question. Indeed, the Street last week successfully digested some €1.4bn of paper arising from client liquidation bid lists: "These lists were just sucked up by the Street, the levels looked good, as we are seeing strong demand from clients at the moment," said one trader. "€50m of Hermes XI As at a discount to par? I'll take those all day long," he quipped.
Are single-digit spreads around the corner?
Where is the new flow?
Investors in Europe's securitisation market have been over-reliant on UK RMBS for paper and benchmarks for the best part of a decade. Similarly, investment banks have depended on this sector for fees and a means to build market share. But it seems that those looking for substitute flow product will need to cast their net far – and to cast it wide and shrewdly.
"The speed of mortgage origination has declined, and that will inevitably lead to less RMBS – and there is also the covered bond effect," said Batchvarov, "but Italy and Spain have been fairly busy."
Indeed, issuance in the European RMBS market remains steady, with year-to-date volumes comfortably surpassing issuance over the comparable period in 2004. On a year-on-year basis, growth of RMBS has been strongest in Spain, followed by Italy and the Netherlands. Residential mortgages account for 58% of the European securitisation market year-to-date.
The first quarter of 2005 definitely belonged to the Australian RMBS issuers, which made an energetic start to the year.
“UK and Australian issuers have been first into the market and are likely to dominate throughout the year,” observed Allen Appen, head of FIG securitisation at Barclays Capital. “Outside these jurisdictions, continental European RMBS issuance in 2005 is shaping up to resemble 2004 – that is to say, only modest issuance volumes … and a huge amount of competition to capture this issuance.”
Although there has been a burst of offshore Australian issuance, it is unlikely that the sector can keep up the pace, in view of the relative benefits of domestic capital markets. “There are a couple of Aussie offshore bank RMBS deals in the pipe, but after these deals have been launched and priced we expect that issuance will taper off in the second quarter,” added Appen.
“The primary reason is that domestic A$ spreads have contracted to historic tights (Westpac at plus 14bp, CBA at plus 15bp), which makes the domestic Aussie dollar market more attractive to Aussie issuers. However, there is still a concern that there is insufficient demand from domestic investors to absorb deals larger than A$1bn. Hence, deals in this category are likely to continue to go offshore,” said one seasoned Australian RMBS specialist.
While recent issuers such as TDA CAM and Bancaja have shown their ability to print deals substantially larger than had previously been the case, there seems little chance that Spain will become the new UK. There is no equivalent source of the substantial supply that made Abbey, HBOS and Northern Rock a core element of the European and US securitisation market over the past few years.
"Will it be the case that new asset classes will fill the gap? Will investors be more willing to do the credit work?" asked Jason Russell, of SG's securitisation syndicate desk. "For investors, new assets are the way to get paid."
The factors that support a "yes" answer could include the fact that RMBS spreads are so tight relative to supras, sovereign and covered bonds. Mortgage product no longer offers substantial spreads over and above other Triple A rated credit product.
"We are excited about the property sector. If you are a bank with a huge origination team, the ability to keep assets on-balance sheet and a command of the techniques and resources to shift risk off-balance sheet, you should be a market leader." argues Philip Basil, head of securitisation at Royal Bank of Scotland.
Basil contends that banks have to be multi-product, with the expertise to manage and organise in this fast moving market.
"We've already seen significant growth in CMBS volumes," Batchvarov says, adding that there is a good chance that volumes will increase further.
"Of course, there is a risk that an event or a turnaround in the property market will change the current conditions," cautioned Basil. "Investors can be fickle," adding that diversity away from the UK will become an imperative.
"The European CMBS market is where the US was in 1997 – we could end up with European CMBS driving real estate financing in the same way it does in the US."
Consumer credit is another area for potential growth as banks have vastly upped their origination.
"Consumer credit risk-weightings under Basle 2 are higher than for mortgages, which means that in addition to funding, originators will have extra benefits of regulatory capital relief," Batchvarov said.
Everyone is predicting residential mortgage backed paper issuance to fall as a result of Basle 2, but the fact is that borrowers may continue to issue in this form for investor diversity, suggests Basil
"Clearly, government ABS is going to be increasingly important as an off-balance sheet financing tool," said Basil. "The UK and Italy will still be there but France and Germany are coming to the fore also."
"Property is still hot and Germany is fascinating," says Ellen Brunsberg, head of European securitisation market at Morgan Stanley.
The economic tribulations of Germany are notably apparent in the banking sector, where domestic banks are estimated to be creaking under up to €350bn of non-performing or sub-performing assets. While many Germans have lost their appetite for real estate risk, the same international investors have filled this vacuum, creating a potentially vast market for securitised term refinancings.
“Germany is currently an inefficient market. The restructuring of the financial markets has seen a massive shift in the last three or four years. With so much change taking place, there are real opportunities to acquire some very attractive assets. Securitisation provides an ideal vehicle to take advantage of market opportunities; real estate lenders are spending in Germany,” said Arvind Bajaj, managing director and head of European CMBS origination and distribution at CSFB.
Both borrowers and investors remain focused upon regulatory issues. One major question that needs to be addressed is whether Europe's central banks/regulatory bodies are going to create a level playing field?
The potential issues arising from the implementation of Basle 2 and IFRS have occupied the industry for years; it is now crunch time. At the European Securitisation Forum's recent conference in Nice, some 59% of conference delegates said that Basle 2 was the biggest factor confronting the European ABS market; IAS 39 and the interaction between covered bonds and RMBS were joint-second most significant, with 16% of the vote.
There is potential for further spread tightening as the market enters implementation of Basle 2 and, if they have not done so already, investors will start to position themselves for lower risk-weightings. Even in view of current spread-widening, some commentators argue that the new capital accord could drive Triple A rated RMBS as tight as Euribor plus 5bp by the end of 2005, once the market starts to eye lower risk weightings for investment-grade risk.
European policymakers had previously rejected the idea of US GAAP, but are now getting accounting convergence by the backdoor with IASB, according to Paul Rutterman, secretary general of European Financial Reporting Advisory Group (EFRAG).
IAS 39 continues to be the most important and difficult area of the new standards, and while it does allow for some element of off-balance sheet treatment, the number of ambiguities as to whether it is a rules or principles-based system has resulted in ongoing calls for clarification. In the short-term at least, the European ABS market will most likely respond with a pot pourri of ad hoc, one-off structures until a consensus emerges.
While the regulatory and accounting debate is chiefly concerned with the potential negative impact of both BIS 2 and IAS 39, the new environment has created its own investment opportunities: issuers and investors are partnering up in the creation of a new tradable ABS asset class of low-investment grade and unrated ABS tranches.
"The reason why Europe hasn't seen more issuance of deeply subordinated ABS notes is primarily because the largest issuer constituency – the European banks – are generally well capitalised, highly rated institutions which have not been under any economic pressure to optimise their capital and funding management," said Deutsche's Rajendra. "In the European case, regulatory and accounting changes should compel some issuers to re-think the way in which they securitise."
Of course, investing banks face an equivalent capital charge increase under Basle 2, so the end-user of any low or sub-investment grade first-loss ABS tranche will have to occupy the non-regulated space; potential buyers come from the seasoned ranks of CDO equity investors – namely insurance companies, credit hedge funds and special ABS funds established (as non-accounting and regulatory constrained entities) precisely to take advantage of this new opportunity.
In the absence of structural protection, non-rated investors are really taking a punt on performance, with most of the risks to the downside. As such, the rewards can be very attractive. "This market is developing," explained Rajendra. "Generally I would say that the non-bank investor base such as specialised credit investors and certainly hedge funds are increasingly looking at alternative asset classes within the structured finance space. These are investor constituencies which could potentially be very interested in this market."