The European asset-backed securities market now appears to be in tatters after a period of rapid growth that lasted until just over a year ago. Joseph Mariathasan investigates whether there is still life ahead for the market
Until not much more than a year ago the European asset-backed securities (ABS) market was increasing in size at such a rapid rate that it looked likely that it would overtake the corporate bond market in size. Today it is more akin to a train wreck, with the European Central Bank (ECB) and the Bank of England finding themselves in the role of the rescue services.
“The ECB now represents Europe’s single largest purchaser of ABS, ‘owning’ an estimated 60% of ECB eligible ABS - €715bn out of an estimated €1,256bn of ECB-eligible ABS,” says Shammi Malik, an ABS consultant. The primary market remains shut to end investors, with new issuance dominated by issuers using these in repo transactions for funding with the ECB and the Bank of England, he adds.
Should institutional investors see this as an opportunity for extracting value, or is the European ABS marketplace still a danger zone to be avoided? It has certainly had a bad press, and this has not been wholly justifiable.
“The epicentre of the global credit crunch was in the US mortgage backed securities [MBS] market, and as a result, the whole global MBS market has become tarred with the same brush,” says Malik. “The European ABS market has fallen victim to this despite benefiting from superior underlying collateral and performance.”
But the confusion and difficulty in the European ABS markets arises from a combination of factors. Malik lists them: “An inability to compare risks within structured products or true returns on a like-for-like basis; valuation methods that have evolved from mark-to-market to mark-to-model and are now currently ‘mark-to-myth’ as a result of low volumes and/or the desire to keep many valuations confidential to avoid write-downs across the whole book; the inability of rating agencies to keep investors fully informed about the real risks they were facing; and inappropriate skill and resources.
“The reality is that even most of the senior AAA notes sold, particularly the US sub-prime, were to investors who were unable or unwilling to do the analysis.”
“In Germany and France, the ABS market has had a bad press that was justifiable to a great extent because of the way that some ABS funds were run,” says Alex Veroude, head of credit at Insight Investment Management. “More than a dozen funds were frozen to outflows.”
But fortune favours the brave. Fund managers with European ABS expertise who are able to distinguish the valuable from the scrap in the wreckage are seeing opportunities that suggest there is still life ahead for the European ABS market, although it might look very different from the recent past.
Parts of the European ABS market are so interesting that Insight has set up a dedicated fund for AAA-rated tranches, says Veroude. “We are buying bonds at extremely attractive yields for extremely low risk,” he says.
And David Jacob, head of fixed income at Henderson Global Investors, admits to being in discussions with investors about launching an ABS recovery fund with a three-year time horizon. “There are very good opportunities but stock selection is very important,” he says. “You have to look at the ABS market with a three-year time horizon and you may be in for a bumpy journey.”
Scott Thiel, co-head of BlackRock’s fixed income team, says:”The credit crunch has affected European bond markets to a lesser degree than the US. You can see this in the nature of the spread widening in the ABS market. A lot is due to the fact that the ABS market is smaller and the structures are simpler, and consumers in continental Europe are less leveraged than in the US and UK.”
Pimco is also generally positive on the asset class in terms of credit worthiness of the underlying assets, according to Andrew Bosomworth, portfolio manager for fixed income portfolio management in Munich. “There are regional pools in Ireland, Spain and the UK that we are not comfortable with,” he says. “But plain vanilla MBS for the Netherlands, Germany and Scandinavia are pretty attractive securities with rates of swaps plus 80 to 160bps for AAA names.”
Meanwhile, Lehman Brothers Investment Management is expanding its resources for European ABS, according to John Lovito, head of fixed income. Lehman recently won a large mandate from Saxony in consultation with Landesbank Baden-Württemberg (LBBW) and a group of German banks, to manage a portfolio of structured finance securities formerly owned by SachsenLB, a German regional bank, although the objective is to substantially reduce the exposure.
Influence of rating agencies
Rating agencies clearly have played a key role in the development of the ABS market. For a number of years fund managers expressed the view that ratings on ABS structures were not comparable with those on corporate bonds and represented a different concept. And there may be a case for arguing that ratings on ABS structures should be recognised as such with a different nomenclature that would automatically ensure that institutions using rating guidelines for bond invest-ments would have to take an active decision in their investment committees to include ABS.
But it is not only the ratings that have attracted criticism. “The agencies were unable to keep investors fully informed about the real risks they were facing,” says Malik. “One cannot help but feel the inter-agency competition has on occasion exacerbated this and forced the market to take another leg down.”
Moral hazard and conflicts of interest are issues raised by many commentators. As Malik says: “The desire to generate fees by rating agencies has benefited issuers which have opted for the most economically profitable issue at the expense of investors by eliminating or excluding agencies that dictated higher credit enhancement levels or more onerous conditions. This is particularly so within CMBS.”
The market needs to have confidence in the role that the rating agencies play in the regulatory environment, says Jacob. “One outcome going forward will be a greatly increased regulatory environment. And while bank leverage will continue, regulators will need to have some comfort.”
After an indiscriminate sell-off, most fund managers seem to be focusing their attention on the high credit quality end of the spectrum. Veroude does not favour some commercial MBS and lower down the capital structure the BB and BBB tranches. “You need to be extremely cautious to distinguish good from bad,” he says.
“In general, mezzanine and subordinated MBS have more downside risks arising from higher losses than are reflected by current market pricing but, in particular, long duration assets such as Irish, Spanish and Italian MBS should be avoided,” argues Malik.
He is also pessimistic about some of the higher-rated UK MBS: “Except for seasoned UK buy-to-let MBS issues from non-headline risk names, the more recent MBS issues with originations post second-half 2006 should all be avoided as there is a high risk of negative equity. This is especially so where pool compositions are concentrated in the South East, in new build flats and apartments owned by non-professional landlords - a professional typically owns 10-plus propert-ies and income is cross collateralised.”
The situation becomes more risky further down the credit spectrum and at the extreme. Malik says: “While current spread levels of +500 bps and +750 bps for single A-BBB European CLOs may look attractive, defaults are expected to rise, with recovery rates likely to be significantly lower. This is especially so in the case of more recent issues comprising second lien loans.”
Given the current impasse does the European ABS market have a future? “Banks and SPVs will continue to securitise mortgages and use the market,” says Bosomworth. “The timescale for new issuance equates to the end of the deleveraging we are currently seeing, when volumes in the secondary market will pick up and there will be more of equilibrium between distressed sellers and buyers. Now we are beyond the midway point of deleveraging and are seeing the entry into the market of dedicated closed-end funds. We should see a turnaround in the next 12 months.”
“The ABS market is very quiet but the residential mortgage market will come back,” says Thiel. But he warns: “The prospects for other areas such as CMBS and the structured stuff is not so favourable and CDOs are also very tricky.
“The European structured products will return to the lower levels of a few years ago. In 2006, it was estimated to be €450bn of ABS products and this may shrink to €200bn.”
What is likely is that any renaissance of the European ABS market will entail a different style. “The SIVs [structured investment vehicles] have gone for good, they are now a history-book concept, says Jacob. “The new structures need to be simpler, with more transparency and able to be understood easily by investors.”
“If nothing else, the existence of ECB-eligible ABS has clearly helped the financial community to better weather the recent turmoil in the credit markets,” says Malik. “What is also clear is that this lesson will not be forgotten and virtually all new ABS securities issued in future will continue to be in this form.”