Debtor's Prison

Greetings fellow inmates:

Last week, Fitch Ratings published a report, which you can download here, on the state of European securitization markets. As we might well expect, it isn’t pretty. As you are well aware, we greatly deride rating agencies for their central role in creating this credit catastrophe. Nevertheless, it is important to keep track of the rating actions and outlooks since they directly impact not only prices but also the ability of certain investors to even hold the paper. In general, though the report echoes many others in noting the tentative signs of macroeconomic improvement, the outlook remains very negative for most asset classes in European securitization. As the report states, even if the economy does improve, unemployment is expected to continue to rise throughout 2010, hitting 11.7% in the euro area and 9.8% in 2010. The unemployment effect is expected to outweigh the ameliorating effects of cuts in interest rates thus extending the negative rating bias currently in place. Again, nearly every single class has both declining asset performance and/or declining ratings outlook, and this is expected to continue.

RMBS:

As we know, the single most important factor in the performance of this asset class is housing prices. Though substantial house price declines of 19% have already been observed in the UK, this is still below the expected 30% peak-to-trough decline. This decline has only recently begun to feed through into higher loss severities. In the euro area, house price declines have not been as steep, but the report claims that this could be due to the fact that the indices are lagging actual developments in the market. Even more concerning is that the losses have not begun to get realized as foreclosure procedures are not yet complete. In general then, what we are noticing is the great lag that has taken place between declining house prices, which still have a long way to go, and realized losses. This is true not only due to the structure of securitization, but endemic features of the European market. Banks, insurance companies and mutual funds can still be expected to take substantial losses.

The other two factors greatly holding down this sector are the rising unemployment levels and the tight credit availability. While this is true for all asset classes, it is especially so for the RMBS market since unemployment and refinancing capacity play a greater role in asset performance. Notably, Spain, Portugal and Italy have some major concerns remaining over new defaults. Moreover, there is still a great amount of uncertainty regarding the actual recovery rates on these loans, versus the expected recovery rates embedded in the ratings. If we were to take a guess, the actual rates will turn out to be worse than expected.

Below is a table of the outlooks in both asset performance and ratings for RMBS securities in a variety of countries. Notice that every single country, except for the UAE, has either a stable/declining or declining performance outlook. The ratings look a little better with a few countries showing stable outlooks. However, we expect these to be downgraded, especially for Greece and Ireland and UK prime.

CMBS:

Much like in the US, this is a completely battered market whose deterioration is not only happening very fast, but has much more to go. The main factors weighing on this class are uncertainty surrounding future rental income, falling market rents and rising vacancies. This has led to a great rise in yield premiums demanded on individual properties over “risk-free” rates. These of course are in turn very dependent on the state of the economy and corporate defaults, retail in particular. The higher capital intensity of investments in this market is also restricting demand.

Even as the report states, downward pressure on rents will persist for some time and even significant signs of recovery will take time to translate into actual improved performance. We expect European corporate defaults will continue to rise, placing greater downward pressure on CMBS. The table below is much shorter, but does portray the negativity in the sector, with both the UK and the Pan-European regions showing negative outlooks in both categories.

Consumer ABS:

Naturally, this sector is extremely sensitive to the macro-economic conditions, which in spite of showing signs of slowing contraction, continue to deteriorate. In particular, unemployment is a heavy factor, as are confidence-linked factors such as house prices and new car sales. As we have said several times, these will continue to deteriorate. Fitch does see a reduction in credit card balances, which could indicate that some borrowers are using their lower mortgage payments to pay down unsecured debt. However, in spite of low interest rates, the high unemployment figures render these palliatives null. As possible signs that could foretell an improvement in this sector, the report lists increased manufacturing orders, stabilisation of unemployment, stabilisation of GDP, increase in credit availability, stabilization of house prices, increased new car sales and a fall in early stage delinquencies. This is quite some wish-list and we are a long way from having these come to fruition.

Corporate ABS:

Weak consumer confidence and subdued foreign trade are mentioned as those most heavily weighing down on the corporate ABS sector. The latter in particular is leading to rising delinquencies and the subsequent defaults. Falling asset prices are also hurting recovery rates, as they should. A big part of this sector are small and medium enterprises which have been especially hard-pressed to find financing in this tight credit environment. In this segment, the effects of low interest rates have helped more than in others due to the greater proportion of floating-rate debt that has become cheaper to service.

Below is the table for the outlooks for both consumer and corporate ABS. As before, most countries show a negative outlook.

Structured Credit:

This category refers mostly to CDOs and CLOs, which as you know are structured securities of other structured securities. Naturally, the performance of these assets depends on the portfolio composition of the underlying basket of assets. Structured credits may compound losses, as mechanisms in the structure itself allow for the unwinding of the security if the performance or the ratings of the underlying deteriorate. CLOs are being particularly affected by the diminished recovery prospects due to reduced equity valuations, access to funding and high leverage ratios. Below is the table for the outlooks for European structured credits. The performance of every single country and asset class is declining, and only two rating outlooks are stable.

May your capital be safe and your investments prosperous,

MAAA