Is there sufficient transparency in the market?

Transparency has progressed greatly compared with even just three or four years ago, when any kind of report was seen as a bonus.

Today, there are a number of guidelines issued by rating agencies, trade bodies and the European Securitisation Forum. Launched last year, Fitch Issuer Report Grades (IRG’s) provide a further measure of the quality of reporting.

Although Fitch IRG’s reflect some wide discrepancies between asset classes and countries, since the grades have been published many issuers have been keener to improve the level of disclosure and update performance reporting. The EU Prospectus Directive will further encourage reporting at deal close rather than just as an afterthought.

How does an index contribute to market development?

Indices are crucial to the development of a deep, liquid pan-European structured finance market. Fitch is committed to market transparency and publishes many indices designed to provide market participants with frequent, objective, standardised analysis on the performance trends in a wide cross-section of market sectors.

In 2004, Fitch Ratings launched four quarterly indices to help investors monitor the performance of the Italian leasing sector. The indices provide an overall measure of Italian leasing performance for the market, based upon the four key measures used by Fitch in its analysis: delinquencies; gross defaults; net defaults and excess spread.

Fitch also publishes a number of other indices for European consumer ABS, credit cards, synthetic CDOs, UK non-conforming RMBS and a Pan- European SME tracker.

What do servicer ratings bring to the market?

Fitch’s servicer rating programme is designed to provide greater transparency to arrangers and investors concerned about servicing quality and operational risk. The process also gives servicers an independent analysis of their organisation identifying strengths and challenges as well as the effectiveness of their risk mitigation abilities.

In publishing its servicer ratings, Fitch conveys transparency to securitisation participants and helps to develop the industry best practices that are necessary for the advancement of the overall servicing market.

The analysis performed in conjunction with the rating process enables the agency to measure servicing quality, and determine how those organisations with highly skilled staff, proactive processes and controls and robust technologies positively impact the performance of RMBS transactions. This culminates in a numeric rating score that adds additional benefit to issuers of RMBS through improved credit enhancement levels.

As the market matures, so too will the rating process. The ultimate benefit to all industry players is the continuous mitigation of operational risk. Fitch, through its servicer rating product, is committed to achieving such a goal.

What is the basic approach to rating CDOs?

A CDO’s performance is linked, among other things, to the performance of the reference portfolio. The quantitative tools most frequently used to analyse CDOs involve a Monte Carlo approach which simulates the default behaviour of individual obligors in a CDO portfolio. Monte Carlo simulation is widely used in finance and allows Fitch to model the distribution of portfolio defaults and losses, taking into account the default probabilities, recovery expectations and correlation of underlying obligations.

CDO models tend to use a structural form methodology which holds that a firm defaults when the value of its assets falls below the value of its liabilities (or its default threshold). Fitch’s model simulates correlated asset values for each obligor, compared to the default threshold derived from the rating and its corresponding default probability.

What are the risks to the continuing health of the asset-backed security (ABS) market?

As with any market, there are a number of risks which we are actively considering with regard to the ABS market currently.

The ABS market has grown exponentially in recent years, both in terms of the number of borrowers and investors. We do believe that the ABS product will prove more resilient than other forms of fixed-income investments over the longer term, but inevitably there will be some transactions that underperform. One of the challenges that such a relatively young market faces is avoiding an overreaction to a negative event. Will the new investors panic because they had not foreseen the problem? Will established benchmark borrowers see their spreads widen if a second-line deal gets into difficulties?

One topical risk is always leverage. Recent commercial property transactions have benefited from the asset price inflation in recent months and would prove to be very overleveraged if the valuations in today's very low yield environment were unsustainable. Taking another perspective, the current tight yields mean that leveraged investors, such as CDOs and hedge funds, are only limited participants in the ABS market, outside of the less liquid, lower-rated tranches, so we doubt that any volatility in this segment of the investor base would have a material impact on the market in the event that the leveraged investors were forced to liquidate their holdings.
Another principal concern we have about the future of the ABS market lies in changing legal and regulatory regimes. Whilst laws and rules need to evolve to match changing times, in many cases we have seen substantial changes that threaten to hurt existing transactions, making investors more wary of purchasing even future ones. Consistency, and then stability, in regulatory and legal frameworks will help to develop global ABS markets. Grandfathering old transactions, as a principle, should be upheld wherever possible.

With many bonds currently priced above par, we believe the market is still paying insufficient attention to prepayment risk. Today's low yields are encouraging issuers to refinance transactions (e.g. UK whole-business securitisation) and prepay faster (e.g. non-conforming mortgages) than predicted. Perhaps the rising interest rate environment in which we now find ourselves will serve to alleviate this trend.
Some commentators are concerned about the ever-increasing levels of issuance. We see this as a positive development. The current high level of issuance is helping to fuel demand. The broadening market offers investors greater diversification, and investor understanding of the product is growing.

How has the European ABS market evolved, and what's in store?

The ABS market in Europe evolved differently than in the US largely because of local, cultural and geographical differences, but also because of its issuer and investor bases. On the issuer side, the market has essentially passed through three distinct phases. First, through the late 90s, most securitisers used the markets to achieve capital relief. Second, as the new millennium began, with the birth of the master trust programmes, we began to see issuers using securitisation as an alternative financing tool, with the side benefit of achieving capital release. Now, we see more issuers using securitisation with risk transfer as the principal objective, but in addition to the other two goals. With implementation of Basel II around the corner, we expect to see a return to that first, capital release objective, though issuers likely will not miss securitisation's other benefits of tapping new investor markets and of risk transfer. Investment strategies too have evolved from nearly all buy-and-hold strategies. Now, with increased liquidity in secondary markets, we see more total-rate-of-return investors joining in the market, particularly from participants looking for off-benchmark yield plays. Whilst these types of investors have populated the sterling fixed-rate market, we now see euro-based investors using similar strategies, even in floating-rate securities.
How will Basel II affect the ABS market?This innovative regulatory regime change should have a fairly pronounced effect on the European ABS market for two reasons: European issuers are mostly banks or backed by banks, and nearly two-thirds of the European investor base are banks. Therefore, any significant change in banking regulation has a knock-on effect within the European ABS market. We see Basel II changing issuance patterns, migrating away from a market dominated by residential mortgage-backed security transactions towards one consisting of a broad array of new asset classes. Aircraft leases, SME loans and commercial real-estate loans should rise to prominence, whilst banks will likely securitise residential mortgages as a funding alternative, if at all. Bank capital will become more expensive for loans with high loss given defaults, even for those with low probability of default. Intriguingly, banks will likely become better buyers of securitised product over corporate credit, especially given the risk weights assigned within the internal ratings-based approach.Does current documentation and post-deal reporting require an overhaul or does it suffice?Current offering documents include about 90–95% of information investors would like to have. As the market becomes more sophisticated, information transfer needs will grow and that 5–10% gap will have to close. More investors are running scenarios on transaction cashflows, either to bolster analysis beyond rating agency methodologies or to match their own internal investment views. We have discovered that the few assumptions of several years ago were insufficient to match prepayment speeds we are experiencing today. With more total rate-of-return investors entering the market, pricing scenarios for structured pass-through securities will have to become more realistic. Several issuers have taken steps to create repayment ramps, for example, but more need to join. Finally, with every passing day, the market expects more, timely ongoing transaction reporting that comes closer to matching offering circular disclosure.How do you view the development in spreads until the end of the year?We expect that looming Basel II implementation will contribute to further spread tightening in the markets, but this trend has also been aided by larger asset allocations from portfolio managers seeking additional spread income. Adding spread duration with assets bearing more rating stability makes good sense in firming and steady markets, and we believe that ABS markets can ultimately trade tighter than equivalently rated corporate debt. ABS is subject to less exogenous risk, such as fundamental industry changes or shifts in rating agency views. Investors generally know exactly what they are buying in an ABS, and this market enables them to express a view on underlying collateral and its expected performance.

Asset-backed securities: what are they and what do they do?

Asset-backed securities (ABS) are the product of a financing technique known as securitisation. This involves using a financial asset to guarantee the issuance of bonds in the capital markets. ABS enables depositary institutions, finance companies and other corporations to ‘liquefy’ their balance sheets (i.e. raise cash by borrowing against assets) and develop new sources of capital. Assets such as credit cards, automobile loans and home equity loans are packaged as the collateral for securities and sold in the capital markets as either floating-rate or fixed-rate bonds.

Issuers reap many advantages by securitising assets rather than keeping them on their books. By packaging their portfolios of credit card receivables as securities, major commercial banks, for example, have been able to reduce the amount of capital they would otherwise have to maintain in order to be compliant with the guidelines issued by the bank regulators.

The fact that the process of securitisation involves an absolute cession, or ‘true sale’, of the financial assets means that an investor buying securities backed by these assets is not exposed to the credit risk associated to the entity originally responsible for the assets. Hence in the case of ABS backed by consumer credits (e.g. credit cards, auto loans), the risk taken by an investor is statistical in nature and strongly linked to the economic environment. ABS therefore lends itself to a quantitative analysis which is less subjective than the analysis to which corporate bonds are subject.

Is there an investor base for ABS-only funds?

Yes, clearly in Europe today there is considerable appetite for ABS-only funds. There are now a number of funds domiciled in Luxembourg targeting institutional and corporate investors throughout Europe. We ourselves launched two ABS-only funds at the end of last year. Both funds have met strong demand in an environment which is not conducive to the strategies typically employed in short-duration money market type funds. Most ABS-only funds marketed in Europe currently restrict their investment universe to ABS. We expect fund providers to increasingly look further afield and include US and Asian ABS in their funds. This is the strategy we have followed. The drawback with ABS-only funds which limit themselves to investing in European ABS is that inevitably they have a large allocation to UK residential mortgage-backed securities (RMBS) which is the dominant collateral in the European ABS market. Enlarging the investment universe to include the US and Asia allows much better diversification and means we are far less exposed to the UK property market.

What are the current drivers in the increase in issuance?

Booming housing markets and the search for yield are the two main drivers of the increase in issuance. When one looks at ABS issuance in Europe it is dominated by UK RMBS. The UK banks and mortgage lenders make extensive use of securitisation in order to issue ABS backed by their mortgage business. Given the boom there has been in the UK residential property market and the competitive nature of this market, there has been no shortage of collateral.

If we look at the US, it is again the housing market which explains the increase in issuance over the last few years. Take last year for example: 66% of ABS issued in the US last year was backed by home equity loans (first-lien mortgage loans to sub-prime borrowers). The rise in residential property prices has allowed American consumers to cash in on the rise in the value of their property and fill their driveways and houses with SUVs and other consumer durables. Access to this sort of credit is one of the main reasons why the American consumer has held up so well over the last few years.

On the other side of the equation there is clearly greater demand for ABS. The search for yield has led new investors to the asset class. We believe that the investor base can grow further so the rise in yield will continue to meet strong demand.

How do you view the development in spreads until the end of the year?

ABS spreads have held in well after volatility returned to the credit markets with the bad news from GM in mid-March. We believe that there is room for a correction in the pricing of European and US markets which remain close to historical lows. Nonetheless we remain positive on the outlook for ABS for the rest of this year. Demand for ABS remains very strong, particularly from managers seeking to use ABS as collateral in structured securities such as collateralised debt obligations. We anticipate this demand to provide an important support to the market in coming months.

Why do new issues of ABS carry higher estimated yields than many corporate bonds of comparable maturity and quality?

In the past the excess spread offered by ABS over corporate bonds could be viewed as a premium available to those investors capable of undertaking the sort of analysis necessary to evaluate the structure of an ABS issue and the quality of the underlying collateral. Although the size of this premium is smaller than in the past, it still exists. In many European countries ABS remains relatively underdeveloped, those managers investing in ABS remain a minority. The extra yield is attracting new buyers but specialist skills are necessary to ensure successful management of an ABS portfolio.

What are the risks to the continuing health of the asset-backed security (ABS) market?

As with any market, there are a number of risks which we are actively considering with regard to the ABS market currently.

The ABS market has grown exponentially in recent years, both in terms of the number of borrowers and investors. We do believe that the ABS product will prove more resilient than other forms of fixed-income investments over the longer term, but inevitably there will be some transactions that underperform. One of the challenges that such a relatively young market faces is avoiding an overreaction to a negative event. Will the new investors panic because they had not foreseen the problem? Will established benchmark borrowers see their spreads widen if a second-line deal gets into difficulties?

One topical risk is always leverage. Recent commercial property transactions have benefited from the asset price inflation in recent months and would prove to be very overleveraged if the valuations in today’s very low yield environment were unsustainable. Taking another perspective, the current tight yields mean that leveraged investors, such as CDOs and hedge funds, are only limited participants in the ABS market, outside of the less liquid, lower-rated tranches, so we doubt that any volatility in this segment of the investor base would have a material impact on the market in the event that the leveraged investors were forced to liquidate their holdings.
Another principal concern we have about the future of the ABS market lies in changing legal and regulatory regimes. Whilst laws and rules need to evolve to match changing times, in many cases we have seen substantial changes that threaten to hurt existing transactions, making investors more wary of purchasing even future ones. Consistency, and then stability, in regulatory and legal frameworks will help to develop global ABS markets. Grandfathering old transactions, as a principle, should be upheld wherever possible.

With many bonds currently priced above par, we believe the market is still paying insufficient attention to prepayment risk. Today’s low yields are encouraging issuers to refinance transactions (e.g. UK whole-business securitisation) and prepay faster (e.g. non-conforming mortgages) than predicted. Perhaps the rising interest rate environment in which we now find ourselves will serve to alleviate this trend.
Some commentators are concerned about the ever-increasing levels of issuance. We see this as a positive development. The current high level of issuance is helping to fuel demand. The broadening market offers investors greater diversification, and investor understanding of the product is growing.

How has the European ABS market evolved, and what’s in store?