Structured Credit: Wrong to buy?

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Europe’s key RMBS markets remain subdued. Lynn Strongin Dodds reports on whether the lack of activity is just about bank stresses – or a more fundamental economic malaise

The European residential mortgage backed securities (RMBS) market may have recovered but it is still a shadow of its pre-crisis self. Investors are drawn to the relatively attractive returns but ambiguity over the final versions of Basel III and Solvency II, combined with the Bank of England’s Funding for Lending Scheme (FLS), is casting a pall over issuance.

Banks and insurers are traditionally the biggest sellers and buyers of RMBS, but the new rules could cramp their style. As it stands, under Basel III, financial firms will have to hold higher quality capital against more conservatively calculated risk-weighted assets, while the capital charges for senior securitisations in the draft Solvency II rules’ standard formula are up to 10-times higher than those for similarly-rated covered bonds. This would make the latter a much more appealing prospect.

“There is a significant appetite but investors do not want to buy into the regulatory uncertainty,” says Rob Koning, director of Dutch Securitisation Association, which was set up by banks and insurers last year to increase transparency in Dutch securitisation transactions. “I think the market will stay that way until there is more clarity. The Dutch market has had decent levels of issuance and spreads but placed amounts are clearly lower than 2008.”

Menno van den Elsaker, European head of structured credits at Dutch pension fund manager APG Asset Management, agrees that regulation has been the biggest concern of investors over the past three years. “There is not much clarity and if, for example, Solvency II goes ahead in its current form insurance companies will drop out because it will make less economic sense to invest in RMBS,” he says.

Before the financial crisis hit, the Netherlands, along with the UK, Spain and Italy were the main European RMBS contenders, but in today’s torpid market it is mainly the Dutch that stand out. The country’s banks typically rely on sales of the securities to help fill a €450bn funding gap between deposits and loans. In addition, much of the recent issuance has ended up on their balance sheets, rather than placed externally, to be used as collateral to borrow from the Dutch central bank.

This is a reflection of the wider asset-backed securities market, says Ope Agbaje, senior vice-president and a European structured products specialist at Neuberger Berman. “On average, of all the issuance across the asset classes in ABS, about 30% have been placed publicly, while the rest has been retained,” he says.

So far this year, the two biggest deals in the Netherlands have been conducted by ING – the €3bn Orange Lion 2013-8 and €1.365bn Orange Lion 2013-9 transactions. It is not clear how far these issues represent genuine diverse demand rather than the actions of a single large account. They comprised more than half of the €6.27bn of total issuance in Q1 2013, and industry estimates show that the final tally for the year could reach around €14bn. This is only slightly higher than last year’s total, and little more than half the €26bn seen in 2010.

Despite the Netherlands’ reduced activity, it has outpaced the UK, which had historically been the largest market. The UK has been conspicuous by its absence, mainly due to the FLS, which offers cheaper funding to UK banks in exchange for their lending to the real economy. UK banks have also had reduced funding requirements than those faced by their Dutch counterparts. Earlier in the year, analysts expected the UK market would reach €10bn in 2013, but many believe that figure was overly optimistic. There has been a flurry of deals in April and May as the cost of funding between FLS and RMBS narrowed but the pace is not expected to accelerate.

Investec and West Bromwich Building Society kick-started the market by re-launching the securitisations they postponed in 2012 due to renewed fears over the euro-zone. The building society brought its £380m (€445m) senior tranche of prime RMBS, from the Kenrick No 2 deal, to market; while the fund manager debuted Gemgarto 2012-1, which is backed by a £202m pool of non-prime mortgages originated by its specialist lending subsidiary, Kensington Mortgages.

Santander UK is also poised to issue £1.35bn (equivalent) of sterling- and dollar-denominated notes via its Holmes Master Issuer PLC, increasing its total size to £15bn. The notes will be indirectly collateralised by a pool of first-ranking mortgages secured on properties in England, Scotland, and Wales.

“The FLS has had an impact and there is much less supply of RMBS in the UK,” says James King, ABS fund manager at M&G. “That is helping to drive the secondary spreads tighter. For example, if you look at the differential between the two countries, AAA-rated paper in the UK is trading between 30 and 40 basis points, while in the Netherlands it is 80-90 basis points. The question of whether it is fair or not is another story. It probably isn’t but in some ways it reflects the expectation of further stress in the Dutch housing market.”

The Netherlands is currently facing its third recession since 2009 and its housing market is in the throes of a slump, with prices dropping by 6% last year and 16.6% from their peak. Unemployment just hit an 18-year high of 8.1% and the International Monetary Fund (IMF) is predicting the economy will shrink by 0.5% in 2013.

In addition, market participants are waiting with bated breath to see the outcome of the debate over proposed tax changes: the Netherlands is the only EU country where residential-mortgage interest is fully tax deductible – which explains the high loan-to-value ratios of 85-95%. Under the new regime, mortgage interest payments on new loans will only be tax deductible if the loan is fully repaid within 30 years at least on an annuity basis. Loans entered into before 1 January 2013 will be grandfathered.

“There is some uncertainty over how mortgages will be treated and there needs to be more clarification,” says Agbaje. “The impact is that if the incentives that people took for granted are not there then this may have an impact on the level of mortgage approval rates.”

Dutch authorities are also hoping to protect mortgage lending and generate greater interest from institutional investors. A government-commissioned group has proposed packaging state-backed portions of home loans in a national mortgage body funded through sales of covered bonds guaranteed by the government. The securities would yield more than government bonds and less than current securitisations, boosting their appeal to buyers and reducing costs for issuers.

“The uncertainty around regulation and the negative perception of the asset still prevents some investors from stepping back into the RMBS market,” says Van den Elsaker. “As a consequence, the RMBS market is still not as deep and liquid as other fixed income sectors. The idea of a government-backed scheme is an attempt to move these instruments from a credit to government bond allocation to attract a deeper and more liquid investor base.”

But, as Koning notes, the big question is how much pension funds would be willing to put into these government-backed assets: “They already have a sizeable exposure to the Dutch government and may be more interested in diversifying their assets.”

This point was made by the IMF in its latest Netherlands country report, published in May. It also noted that favourable tax treatment and generous loan-to-value ratios led to bank expansion via wholesale financing – the real source of the funding gap between bank deposits and mortgage loans – and a resulting sharp rise in household debt and house prices. Pension funds should be left to manage their assets “independently”, it warned, and a “natural” adjustment of house prices should go on unimpeded without the help of government taking on additional contingent liabilities.

Wouter Pelser, CIO at MN, adds that while the government-backed scheme would make RMBS more liquid, it would break the direct linkage with the underlying risk.

“In general, a possible investment in RMBS should always be viewed in relation to the already existing allocation to real estate,” he says. “That being said, RMBS could be of added value because of the extra liquidity and the loss protection in case of investing in the AAA tranche.”

Others share this confidence – but selectivity is the watchword.

“It is important to remember that the Netherlands has a very strong RMBS market from a credit, underlying collateral and rating perspective, and all within a very judicious, regulated lending framework,” says Rob Ford, ABS portfolio manager at TwentyFour Asset Management. “Although rising unemployment is one of the biggest concerns, if you look at the figures the most affected part of the population are under 25 and they most likely do not yet have a mortgage. I think there needs to be a period of extreme stress before we see significant foreclosures. The main benefits of RMBS are that they are floating-rate notes that offer downside protection against rising interest rates. In addition, they are generating a Libor+50 basis point return or more.”

Despite falling house prices, cumulative defaults on Dutch loans packaged into securitisations were 0.4% at the end of last September, according to Moody’s Investors Service. That compares with 2.85% on Spanish mortgages, where the average loan-to-value ratio is less than 80%.

Will Howard Davies, ABS portfolio manager at PIMCO, also believes it is essential to “look under the headlines” regarding the impact of tax changes on house prices, the deteriorating economy and rising unemployment.

“The propensity to default in Netherlands is lower than other countries for two key reasons,” he suggests. “First, they have strong borrower protection in terms of generous income support; and second, there is a big incentive to use all available means to pay one’s mortgage, because lenders have the legal right to go directly after a proportion of income at source and also after all assets. We caution that one must be very careful selecting originators as well as collateral, since Dutch RMBS bonds rely heavily on being called after around five years – choose a weak originator but good collateral and you may be left with a good bond, but for up to 15 years.”

As in just about all channels through which credit reaches the real economy in Europe, authorities are exploring ways to bring pension fund capital in to support mortgage and housing markets. To the extent that this is about relieving pressure on a stressed and de-leveraging banking system and spreading Europe’s credit risk more broadly, this could represent a genuine opportunity for those pension funds. But investors also need to be critical, and question the extent to which it is an attempt to maintain the unsustainable lending practices of the past.



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