ABS market forges ahead
Europe’s asset backed market enjoyed pretty good health in 2004 – fewer downgrades than upgrades, hardly any defaults, and narrowed spreads. And, says Denis Badalucco, manager of HSBC Asset Management’s Asset Backed Securities (ABS) funds, liquidity also improved over the course of the year. “For our money market asset backed funds, we invest only in the floating rate issues in order to deliver a Euribor-plus return. We get 1 basis point spread-widening on our monthly mark-to-market pricings. And I believe that the liquidity will remain sufficient this year as we see even more supply.”
Supply was good in 2004, with around E250bn of issuance. That supply, however, was still not enough and lagged behind demand: in the primary market the mezzanine tranches of some deals have been 10 times over subscribed, and the senior tranches three or four times over subscribed.
As far as Badalucco is concerned, the attractions of asset backed securities are clear. He explains: “The spreads in ABS are higher than for an equivalently rated corporate credit bond, the stability of credit ratings in ABS is also better and there is a significantly lower probability of downgrade in ABS than in corporate credit.”
Jonathan Sissen is a senior analyst for Fixed Income Advanced Active Strategies Group at Barclays Global Investors (BGI). “Securitisation is fundamentally a good idea,” he asserts. “If we consider a special purpose vehicle (SPV) set up with 100,000 mortgages, for example, this is a readily analysable pool of assets with known or assessable characteristics. The ratings agencies are able to make good predictions on the overall behaviour of the pool under a variety of conditions. Banks know how the agencies create stress tests for the SPVs and will know how to package the security for it to obtain the AAA-rating. The ABS market is a rating agency driven world.
“One very important feature of each ABS is that it will have its own transaction model of how it performs under a range of different economic scenarios. A mortgage-backed security will have a group of different borrowers, in different geographic areas with different types of property. This diversification reduces the two key factors determining the credit enhancement for a transaction, namely the probability rate of default and the size of loss.”
The limited purpose nature of the SPV gives ABS one significant advantage over corporate credit – given the pooling of the collateral, ABS is virtually free from event risk something which, for investors in corporate credit is often unforeseeable but also potentially very damaging.
But investors in the complex asset backed market are the first to admit that they work in a very labour intensive area. At HSBC , for example, the managers have access to 14 credit analysts over the world with three dedicated just to ABS. That investors have access to all the information is vital.
Participants in Europe’s securitised market place have been working hard to ensure that the flow and accessibility of information is good enough. The European Securitisation Forum was created by a group of investment banks involved in ABS deals. One of its tasks has been to push for “the development of better reporting standards which give both issuers and investors greater confidence in, and understanding of, asset securitisation market operations and disclosures”.
ABS Reports, established in 2001, is also aiding the drive to clarity of information exchange via the internet. At the time of writing the service was carrying data on over 1,000 European ABS, MBS and CDO issuers with a combined issuance total of E750bn. Product director Dave Colling agrees that the growth in the European securitisation market continues to surprise on the upside. He also points out how the market innovation has also been increasingly rapid and complex. “The synthetics arena is where we have seen the really fast growth. In fact the securitised market and credit derivatives are growing closer and closer together. Synthetics are opening up the field to allow many more investors to get exposure to asset backeds through the use of derivatives.”
Colling suggests that the impact of Basel II capital adequacy requirements, which is being gradually implemented over 2007/9, is forcing the market to remain on its toes and to be willing to adapt. “There is justification for the originators and banks to be trying so many variations, as they are probing their markets gauging investor appetites.”
As in corporate credit fixed income, it really has been a pretty good time for securitised market, although the way to the decent performance (in all markets) was often fraught with difficulties over the year. Spreads have been declining in virtually all types of collateral, residential or corporate mortgage backed, consumer loans, credit cards, corporate and infrastructure, aircraft finance and whole business.
The outlook for capital markets, and fixed income ones in particular seems to be reasonably benign overall. According to Badalucco, global growth will be rather slower this year than last year, but will remain sustainable.
The ESF recently surveyed players in the market for their views in 2005. The majority believed that both supply and demand should continue to rise. Respondents cited relatively favourable credit spreads and a volatile equity market as potential boosts to investor demand for securitised products. And there was a consensus that the largest segment of the market, UK RMBS, could very well see a decline in issuance as the UK housing market cooled off.
Sissen of BGI adds: “We have to tread carefully. Part of the challenge is to recognise when a deal has been pushed too far, to identify situations where too much leverage might have been achieved or non-financial risks not properly assessed. There is a huge amount of financial, legal and industry specific analysis to sift through the complexities of each deal.”
How European ABS works
In 2004 the European securitisation market saw E243.6bn of issuance, over 10% up from the E217.2bn issued in 2003 and the market’s sixth successive annual record, according to figures from the European Securitisation Forum (ESF). 2004 marked a real milestone for asset backeds, with net issuance exceeding net corporate bond supply for the first time. Mortgage backed securities represented more than half of total issuance of E138.5bn.
Within Europe’s mortgage-backed sector (including the UK), residential mortgage backed securities (RMBS) represent the largest collateral type within the European asset backed securities (ABS) market and accounted for nearly half of last year’s issuance. This is the most liquid and actively traded asset class in the European securitised market. RMBS are bonds that are backed by (or referenced to) a pool of residential mortgage loans. In traditional structures, the pool is sold to a bankruptcy-remote special purpose vehicle (SPV), which pays for them from the proceeds of a note issue. The cash-flows from the mortgage pool are used to pay the interest and the principal on the notes.
In 2003, it was significant that European RMBS overtook German mortgage Pfandbriefe volumes for the first time. 70% of European RMBS were purely euro-denominated. ABS that are not backed by property loans take the next largest share, although remain significantly smaller than the RMBS sector. Collateralised debt obligations (CDO) are defined as ABS and now have around 10% of the securitised market share last year. commercial mortgage backed securities (CMBS), although now overtaken by CDOs, still represent a significant portion.
The UK maintains its position as it was the main issuing country with E93.4bn issued in 2004, three quarters of which is RMBS, according to the Structured Finance Research team at Commerzbank Securities. Spain, Italy, and the Netherlands together accounted for just over one-third of Europe’s securitised issuance in 2004.
Although residential mortgage backed securities remain the dominant class in Europe; there has been very rapid growth in other classes. Some of the fastest growing are trade receivables (mainly leasing) consumer loans, half of which are autos, and (CMBS). And as the eastern European capital markets continue to grow, it is more than likely that securitisation will be a feature of these markets too.