Credit market meltdown - let the chaos begin

This was the week the credit crisis began. The level of the Australian iTraxx index I quoted (blowing out from 25 to 44) is laughable. Its now around 285 (out about 1000%!) and has been at high as 400. 

 

Insto Bond Diary

***Credit market meltdown (27 July 2007) ***

A chaotic week in global credit markets has shown no signs of abating. Credit indices globally are blowing out and the Australian Itraxx CDS index of 25 corporate names continues to widen. The last quoted price was 44.5/45.5 basis points, out from 38.5 this morning. At the start of June the index traded at 25 basis points.

“It's a case of pure panic as investors try to reduce risk as quickly as possible. There has been a rash of protection buying, and the indices as a liquid source of exposure have gapped wider,” said Mark Bayley, director - credit and structuring, ABN AMRO.

'Credit fundamentals remain sound, so negative sentiment is driving the spread widening. There is a circle of fear of the unknown,” said Craig Saalmann, credit strategist, JPMorgan.

Primary markets throughout the world remain shut with investors hesitant to buy and issuers hesitant to raise funds.

The nervousness stems from the narrow confines of US sub-prime lending sector. Its weakness had already triggered a fall in credit markets and an S&P report has revealed that sub-prime losses have exceeded expectations.

“There's a concern that sub-prime may have far reaching implications for the US economy and households, and investors are running for the exits,” said Saalmann. 

Earnings have remained strong with US banks Merrill Lynch and Citi posting strong results. Investors, however, are not interested and equity prices and credit spreads are being hit hard.

Markets are also concerned with the exposure of some of the investment banks with over US$300 billion of leveraged buyout financing still remaining on their books. Bear Stearns CDS spreads widened by 20 basis points, while Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley were all out by about 10 basis points.

Another fear lies in the black hole of CDOs, and with limited pricing, the extent of the fallout is not clear. Bear Stearns' hedge fund losses have been well documented but ABN AMRO’s Bayley feels that most of the CDO risk ultimately rests with investors. Where investment banks will feel most of the pinch, he says, is from a decline in new issue and M&A fees.

Liquidity remains an issue with bid only prices being quoted for most assets. According to a nabCapital report some larger dealers offshore are not providing prices to lower value clients until market liquidity picks up.

In domestic cash markets spreads of HSBC Finance, the first major lender to reveal sub-prime losses, widened significantly.

Investment grade credits are being dragged along in the sweeping tide. The four major banks have all seen their senior spreads widening and sub debt CDS spreads are out by about 10 points.

“The whole credit spectrum is being repriced as a result,” said Bayley.

Signs of shift in sentiment and risk valuation are being seen in other asset markets.

Equity markets have tumbled on the back of credit concerns with The Dow and S&P 500 down 2.3 per cent and the FTSE 3.1 per cent lower. The ASX opened 150 points weaker at start of today's trading.

A textbook flight to quality also drove a rally in US Treasury bonds, and hedge funds that have been riding the carry trade (borrowing in low yielding currencies to invest in high yielding currencies), are finally seeing an unwinding as the Yen spiked against other currencies.  

“The Japanese are still buying today but within the US and European investor community, lots of wounds are being licked,” said a currency trader.

“We expect to see more volatility in the coming weeks. The market will be thin due to the northern hemisphere summer holidays and opaque, with cash prices difficult to obtain. All investors can see is the indices and elsewhere there won't be much liquidity,” said Bayley.  

Bond investors thoughts on a torrid year

As 2007 drew to a close, I surveyed some shell shocked Australian fixed income to get their insights on the credit crunch. Little did they know 2008 would be a whole lot worse... 

Insto Bond Diary

***2007- A challenging year (20 December 2007)***

As 2007 draws to a close, Insto met representatives of the fixed income investor community to reflect on what was an extremely unsettling year for global bond markets.

It was a year when the world turned upside down. The focus at the end of last year, when a QANTAS buyout loomed, was on event risk in the corporate sector. Twelve months later it is the chaos in the financial sector that is causing sleepless nights for fund managers.

The year will go down as the most turbulent in credit markets, and one from which Australia could not escape.

It presented a number of challenges that markets have taken for granted such as confidence and trust in the financial system.

"There are some bigger picture issues that the market had to do some thinking about,” said an investor.

The trouble in markets began in July and continued in waves throughout the end of the year. Despite showing signs of a recovery in November, the market was plunged back into despair as offshore banks announced massive write downs.

Many regard the crisis as more severe than any before as financial markets grappled with the uncertainty and complexity of the problems for over six months.

Australian credit and fixed income markets stalled during this period. Liquidity was by far the biggest issue for investors. The primary and secondary corporate cash market remained virtually shut throughout the second half of the year. Funds struggled to find bids as brokers retreated.

Once the credit crunch began, investors in general attempted to shed exposure to credit. They needed liquidity to ensure they could meet redemptions and avoid further mark to market losses as spreads remained volatile

Bids were hard to come by and those that were on offer were unpalatable. The era of free liquidity had come to an abrupt end.

Exactly what constitutes a liquid asset also has to be reassessed following a widening of swap rates. At times, only cash at bank could be deemed truly liquid.

The market was also reminded of many wisdoms it had abandoned – leverage is a double edge sword, liquidity is only there when you don’t need it, a AAA is not a AAA, don’t lend to people who can’t repay, borrowing short and lending long is fraught with danger, and history keeps repeating itself.

The market was also retaught the concept of “systemic risk” and the need to prepare for the possibility that things will go wrong down the track in every deal.

Some new risks were also introduced.

“CDOs allowed low quality credit risk to be enhanced through securitisation. The global chase for yield took the compensation for this risk to ridiculous levels. Complexity, liquidity and leverage have all been re-priced in a very short period of time,” said Fred Mellors, UBS Global Asset Management.

The role of the rating agencies has been scrutinised but investors emphasised that they do not rely on ratings as an assessment of credit worthiness.

Investors did, however, identify where the agencies had gone wrong.  Their models proved inadequate driven by a number of factors including a lack of historical data, poor assumptions, conflicts of interest and the ‘gaming’ of models by arrangers.

A few positives did emerge in 2007.

The repricing of risk has made credit an attractive sector again with abundant value and opportunity, although the severity of the process caused substantial pain. 

Credit quality is also likely to improve as banks tighten their lending standards and investors demand better ABS collateral and more robust structures.

Also, fund managers feel that there will be more tiering of their abilities and good performance will be more visible.

Another positive has been the credit derivatives market which has proved to be a crucial alternative or enhancement to the physical market. Credit Default Swaps was a critical tool to a number of managers looking to manage their risk when liquidity dried up. 

The extremities of 2007 are most evident in the RMBS market. The disparity between deals completed at different points in the year demonstrated just how much the credit environment had been altered.

“Comparing CBA’s Medallion 2007-1G which priced at the sweet spot of the year with Bluestone’s Sapphire 2007-2, which priced at the worst point. In just two deals you can sum up the entire shift in sentiment over the course of the year. One was huge, global and very expensive while the other was small, a struggle to be completed, heavily oversubordinated and at eye watering spreads. Complete complacency in early 2007 gave way to paranoia in December,” said Nick Bishop, Aberdeen Asset Management

The market faces critical challenges as many issuers struggle to fund themselves. An oversupply of paper due to an unwinding of offshore structured vehicles, which hold the bulk of outstanding paper, is keeping spreads at wide levels. 

A host of issuers are desperate for funding and are waiting for market conditions to improve. 

Investors are concerned that once markets show signs of a recovery, a rush to the gates will result in further oversupply.

“When they can issue, we will see a wave RMBS issuance and there might be an overhang of supply which makes us negative on any quick recovery in the market,” the market,” said John Sorrell, BT Financial.

Fund managers are comfortable with Australian mortgage assets, which have performed well as credits, but are warning issuers that they will demand a substantial liquidity premium to participate in RMBS deals going forward.

Structured credit in general faces a crisis of confidence. Investors feel that sectors of the structured market will vanish. ABS CDOs and other re-leveraged products are unlikely to survive. Balance sheet CLOs, where banks package exposure to manage credit risk, will continue to be issued and investors remain open to participating in deals. The less complex and more economical the structure, the more it will be accepted. 

For now markets remain uncertain. It must deal with another wave of bank results that investors hope will reveal the extent of their exposure to the crisis. The credit standing of monoline insurers who insure trillions of dollars of bonds and the fate of non bank lending institutions around the world are also questions marks.

Fund managers all agree that 2008 will be characterised by further volatility.

It could be the period when corporates begin to feel the effects of increased funding levels. 

“Liquidity could start to sort itself out but we could be heading into a fundamental credit downturn,” said a fund manager.

It will also be a year in which credit markets repair themselves and the process to do so has already begun.

By all accounts, the pain is not over but most are glad that it is for 2007.

CDOs plummet from grace

CDOs - those weird and wonderful investments that nobody understood but everyone bought. Some Australian banks had been peddling them with vigour before the crunch, but now they had become a source of outrage around the world.  Almost two years earlier, Insto uncovered some frightening facts about extensive buying of CDOS from NSW councils. That was early days, councils continued to mop up CDOS and when markets froze they were left with red ink and red faces. Even more disturbing is that many charities dabbled in structured credit, some facing up to losses and others settling with the banks eager to avoid severe reputation damage. While securitisation is a genuine financial innovation, finance historians will note CDOs as the embodiment of greed and deceit. 

Insto Bond Diary

***CDOs slammed (25 July 2007)***

As structured credit’s toxic waste rises to the surface, yield hungry investors in global credit are being reminded of the importance of liquidity.

Sales in structured credit products, Collateralised Debt Obligations (CDOs) in the US are reported to be down substantially from US$42 billion in June to US$3.7 billion in July, affecting liquidity and delaying debt raisings.

Last week saw the near-implosion of Basis Capital, the Australian based hedge fund. Much of the fund’s woes were attributed to the market value of their holdings of the lower tranches of sub-prime mortgage CDOs being revised substantially downwards.

Traditionally the historic cost approach was used to value assets. The prevalence of structured products such as derivatives has forced valuations to adopt the ‘marking to market’ technique in which the value of an asset is recorded at its market price.

However the illiquidity of products and the lack of clear price signals has forced funds to mark assets to models, which rely on numerous assumptions. The sub-prime mortgage crisis has exposed some of the shortcomings of marking to models.

The unease which has impacted the ‘mark to market’ of assets has had a knock on effect on corporate spreads, as risk is being ‘repriced’. 

‘These events forced investors to revaluate how comfortable they are investing in these markets. There are few reasons to buy and liquidity dries up,’ said an institutional fund manager.

The model is supposed to show the price that an asset would be trading at in the market. However, when Bear Stearns’ hedge funds were forced to unload their portfolio of sub-prime mortgage backed securities, driving down prices in the otherwise illiquid markets, this created large discrepancies between the model and the market’s valuations.  

“Pricing models don’t tell you where the supply and demand is. If you can’t sell something for a certain price, then it’s not the price,” said a local fund manager. 

“You can’t forget the liquidity premium you have to price in liquidity and make sure you are rewarded for holding illiquid securities,” he added. 

But some feel that the liquidity premium is what attracts investors to ‘illiquid’ CDOs. Institutional funds who are buying to hold are happy to pick up the premium as they do not require the liquidity. For them the investment decision is based on the level of the premium.

Mark to market losses do however present a challenge to investors.

‘If one had to go to an investment bank right now for a price on a CDO, they would tell you that the only price you can get is one you are not going to like,’ said an investor. 

‘We as a fund have to educate investors in a fund that in an extreme market breakdown, we are not going to mark to market. They have to be prepared to trust the fund manager,’ said the fund manager.  

Some observers say the inclusion of retail and high net worth investors is part of the reason for hedge fund Basis Capital’s woes.

‘If a fund has retail investors, no matter how large they are, it has to offer liquidity and market price,’ said a source.

Another contributing factor was the additional leverage the fund attained from separate bank lenders who made margin calls as the mark to market losses revealed themselves. 

‘By lending from the banks you effectively cede control of the fund. The lenders act in their own interests and not in the interests of the fund or its investors,’ said the source. 

‘There may have been nothing wrong with their assets. If it was their cash they could have just frozen the fund, and investors would probably have lost a lot less,’ speculated an observer.

CDOs are once again receiving bad press both at home and abroad. Reserve Bank Governor Glenn Stevens recently referred to CDOs as an example of reckless investing by councils, and other middle market investors.

Australia’s CDO market developed through the retail and middle market funds. The least sophisticated investors have been buying the most sophisticated products.  Research conducted by Insto discovered substantial level of investment in CDOs by NSW councils, with CDOs making up over 50 per cent of some council’s portfolios.

The enticement of juicy yield from products that technically fell within their risk mandates ensured a healthy appetite for CDOs. 

Stevens, however, questioned whether councils understood the real risks of investing in CDOs.  “Are they really cognisant of the degree of risk and the embedded leverage in those products,” he said. 

For institutional funds however, CDOs is an asset class that is here to stay.  The period of volatility is one where the good structures are sorted from the bad.

CDOs can be divided into two broad types – synthetic and managed. Synthetic CDOs are packaged into a closed structure and then set to sail. Managed CDOs have a captain that can steer the ship away from trouble.

The shift in preference for managed CDOs has been going on for some time, as investors are prepared to give up yield to ensure their exposure is monitored.

And while it remains a challenge to value CDO tranches, trading levels are apparently at levels not seen in years, which some say is presenting tantalising opportunities for real money investors to access the better products.

Said a fund manager: ‘We see this as an overdue and a healthy correction. It will widen spreads, force the market to look at credit quality, lead to a tiering of CDO managers, and create buying opportunities.' 

Who was to blame for the credit crisis ?

Insto Bond Diary 

Covering credit markets as the credit crisis unfolded was fascinating. ANZ held a structured credit conference  weeks after the Bear Stearns hedge fund imploded. It turned out to be a charged gathering where lenders (including a stressed out treasurer from RAMS) and investors discussed the bleak outlook and who was to blame. 

 ***ABS market takes stock (20 August 2007)****

Australia’s asset backed issuers and investors gathered against a background of turbulent credit market conditions for ANZ’s annual ABS Outlook conference in the NSW Hunter Valley last week.

While issuance is firmly on hold, the gathering provided a unique opportunity for the market’s sharpest minds to assess an extraordinary few weeks in credit markets.

Last year’s ABS event, held in an environment of tight spreads and private equity, seemed like a lifetime away. The “unprecedented disruption” in markets has put many on the back-foot wondering when activity will return and at what levels.  

A snap survey of the 90 attendees produced some interesting results. Issuers saw ABS AAA spreads between 18 and 22 basis points, while investors see 28 to 32 basis points as a fairer level.

Not surprisingly, the majority of issuers felt that credit markets had overreacted, while investors viewed markets as having acted accordingly.  Issuers are well funded at present, with 83 per cent stating that they do not need to access the capital markets until the new year. Investors are sitting out too and holding a fair split between cash, bank bills and commercial paper.  

Both issuers and investors agreed that while the credit and liquidity crisis was not quite the end of the world, it was very material, significant and disruptive.   

An animated panel discussion tried to make sense of the credit crisis that began with hedge fund implosions and continued with a liquidity crunch and central bank intervention. The fuse was lit by the collapse of the sub-prime home lending market in the United States and the participants tried to interpret the cause and effects.

“The people in the US sub-prime market who have a history of not paying are...not paying,” said Nick Fyffe, director- investor sales, ANZ. 

Over the next 18 months, US$600 to US$800 billion worth of mortgages in the US will have rate resets. The step up in the interest component is expected to have a significant impact.  As loans mature from interest only to include principal repayments, the expectation is that delinquency rates are quite likely to  materially exceed current levels.

“A lot of these US sub-prime loans will see their interest rate reset period at the end of 2007 and 2008. Given current market conditions, the servicer will have to work with borrowers to modify loan terms so that borrowers can still afford to make their payments," said  Moody’s US based analyst Debashish Chatterjee.

Those directly exposed to subprime are home loan originators, loan servicers and to a lesser degree the monoline credit wrappers who have insured sub-prime deals. Hedge funds who took exposure to sub-prime backed structured credit products have also felt the burn with many reporting huge losses.

“In Australia, we have only really had one month of fund asset revaluations  and that was on the  31 July. Market moves in August have to dictate that the next revaluation is  going to be much more severe. It’s going to be causing problems of more magnitude and across more funds,’ said Sarah Percy-Dove, head of credit research, ANZ.

“The credit issue and the market issue are different. If the credit quality hasn’t changed and the liquidity has, then over time you should get your money back. The tail is now wagging the dog in this market,” said Fyffe.

Economists assume that losses resulting from sub-prime will total between US$100 billion to US$125 billion. 

The ABX BBB- index, which is used as a measure of sub-prime securities performance, has plummeted. 

“Even though it has declined a long way, very quickly there will be funds at some point  wanting to enter the market. This will put a floor at some level. Hedge funds take a lot of  blame in these environments but importantly they also provide liquidity.  The shorts in the market will unwind at some point,” said Percy Dove.

With equity volatility indexes still nowhere near historic highs, the fall in stock markets may be far from over.

The outlook is unclear and the ripple effect in the equity market has only just begun. They (the equity market) haven’t figured out what is going on and they still have to adjust quite considerably,” added Percy-Dove.

The proliferation of leverage in the system has exacerbated the credit issues that began with the US sub-prime crisis. 

“Corporate balance sheets are in good shape but I would be a little concerned if I just started working in a leveraged finance department at an investment bank. That’s where you will see the slowdown in private equity and M&A,” said Fyffe.

The leverage of households may be the bigger issue.

“The big uncertainty is the leverage of household balance sheets. What will be important is the extent of pressure a tightening of financial conditions puts on households. That is where we could get a general deterioration in credit quality across the economy,” said Warren Hogan, head of economics and strategy, ANZ.

Hogan, however, feels that the next 12 months will be rosy for earnings and GDP growth and that stresses to the system will be managed by central banks. 

The panel also speculated as to who is to blame for the credit crisis.

Was it banks and other lenders that aggressively wrote business in the knowledge they could sell exposure?  Have the rating agency models failed to serve their purpose or have yield hungry investors abandoned their valuations and oversubscribed to risky deals?  

The debate was lively but there was a general consensus that this had as much to do with the system as it did the interests of various participants.

“This is a natural cyclical process in a market system after a period of excessive liquidity growth. There has to be a transition into normal financial conditions and unfortunately that process is happening in the presence of a unprecedented amount of leverage, causing distress,” said Hogan.

Many uncertainties remain in a financial system that has grown ever more complex.

 With volatility comes opportunity and real money remains cashed up. 

“People looking to enter the market have money to be put to work and they recognise that the volatility provides buying opportunities. But they are not buying until they get a sense of stability. Once they are prepared to re-enter, there will be a stabilising effect,” said Percy-Dove.

The conference also featured discussion on growing and emerging asset classes. Commercial Asset Backed issuance has experienced significant growth as property trusts engage in capital recycling. Also as Australia continues to grow older, securitisation techniques are being applied to cash flows from retirement properties in the form of deferred management fees. 

Another new product set to hit the wholesale shelves is shared appreciation mortgages (SAMs), which could assist home owners by allowing them to trade the capital appreciation of their homes for more affordable rates.

In Australia, the media has attempted to draw parallels to the sub-prime chaos in the US, but the market here remains fundamentally sound.

“We are not seeing the problems today being talked about in the media. Some of the interesting statistics are very headline driven. An article last week stated that claims on mortgage insurance were up 329 per cent in a year but that total claim was A$210 million on a market of A$800 billion, which is less than 5 basis points of losses. If anything it shows there is a long way to go before we have problems,” said Ben McCarthy, managing director, Fitch Ratings.

As the market waits for calm to be restored, there are some concerns of the long term fallout of the sub-prime crisis. Some speculated that there could be a political reaction, resulting in industry scrutiny and regulations similar to Sarbanes Oxley type legislation.

Participants took comfort in the fact that securitisation presents far more solutions. The technique of risk transfer has arguably done far more than any policy to promote asset ownership and is regarded as one of the greatest financial innovations of the last 100 years. 

The last few weeks have been some of the most challenging for capital markets, asset backed issuers and investors are patiently observing credit markets, positioning themselves to resume activity.

Former Wallaby skipper Phil Kearns offered some advice to weary market participants, which includes credit traders who have spent many a weeknight awake on their sofas clutching their blackberries, on how to handle adversity - Keep composure, stick to doing the fundamentals and everything else will fall into place.   

First encounter with sub-prime

This article was my first encounter with the sub-prime crisis. In a phone call, a fund manager from Deutsche Asset Management told me it was something I should mention in a routine article about US banks. Back then we had no idea it would bring global capitalism to its knees..Australian fund managers hoovered up US bank bonds and sang the praises of the US Investment Banking sector (could they have got things more wrong!) and even the analyst I interviewed thought that bank M&A activity was the bigger theme in the sector. Markets at the time agreed. Deals continued to print at record volumes, credit spreads tightened further and the equity maket continued to storm ahead. But the warning signs were there and it would still be several months until the rest of the world would awaken to the sub-prime nightmare.  

Insto Bond Diary

**US banks flood market, as sub-prime lenders feel the pressure (9 February 2007)***

US financial institutions have rushed to the Kangaroo market with over A$4 billion issued by the sector in February. 

Citigroup, Bank of America and Morgan Stanley have all completed billion plus trades with other names such as Merrill Lynch, touted to follow in the near future.

“Banks got off to a strong start in 07 and pricing levels are tight reflecting a benign outlook for global credit,” said a fund manager.

Demand for exposure to US financial institutions remains strong.
 
“The sector has been very solid. We’re quite happy with the way they have performed and we’re prepared to pick up decent exposure,” said an investor.  

Citigroup and Bank of America saw deals upsized, with Citigroup completing a US$1.55 million five and 10 year issue on Friday and Bank of America pricing a A$1.2 billion five year senior and 10 year subordinated tranche on Wednesday. 

Both five year tranches priced at 18 basis points over swap. “Bank of America was fairly tight compared to the level where a better rated Citigroup priced. We thought it should have paid at least a basis point more, so we were picky there,“ said a fund manager.

Bank of America’s 10 year subordinated piece provided a pick-up and variety for investors. “Under Basel II subordinated debt should outperform senior debt,” said an investor that participated in the sub debt tranche. 

“The sub debt priced in line with offshore levels.  We’re comfortable with all names in the sector but are full up on exposure,” said another investor.

Investment Bank Morgan Stanley priced a large four and 10 year issue today. Like Citigroup and Bank of America, the trade offered a large liquid line of floating rate notes, with investors favouring the format amidst concerns about inflation and future rate rises.

“Morgan Stanley priced pretty much in line with where it trades in the US. Results have been very good, easily above expectations and we don’t see any huge catalyst to cause deterioration in underlying fundamentals,” said an investor.  

The IB sector remains a strong favourite with investors, and Merrill Lynch and one other set to follow Morgan Stanley’s lead and return to the domestic market.  

“The US economy is showing signs of slowing but investment banks are in good shape and M&A remains strong. Fixed income and equity businesses are also performing better,” said a fund manager. 
  
While the major banks are in good shape there are some jitters at the lower end of the lending spectrum. 

This week saw HSBC increase their loss provisions as default rates in the US sub prime lending market start to rise. 

The effects of a weaker US housing market and continuous rate hikes have begun to appear, putting pressure on sub-prime borrowers. 

The increased provision will impact the earnings of HSBC as a whole but the bonds of HSBC Finance - the group's predominantly US household lending arm - are expected to be hit hardest given this is where credit quality is under the most pressure. 

“The increase in delinquencies and corresponding increase in provisions is impacting on equity prices. We expect this trend to impact credit spreads, particularly on those issuers exposed to the subprime market,” said Andrew Morgan, fund manager at QIC. 

"Current spread differentials between HSBC Finance and HSBC Bank should be greater because of HSBC Finance's exposure to sub-prime loans," said Bradley Bugg, senior credit analyst, ANZ Investment Bank. 

Apprehension in the sub-prime space may also impact other Kangaroo issuers.

Wells Fargo has said its provision levels were better than expected, but they have seen an impact on their sub prime auto loan book. 

Conditions are also difficult for another regular issuer, Countrywide, which says it is able to manage the effects of challenging times in the sub-prime sector but is expecting a softer 2007.

While there is pressure on cash and credit default swaps spreads, there are other factors at play to keep spreads in check.  

Spreads of sub-prime lenders had held tight as lenders are targeted by the stronger rated financial institutions looking to ‘buy’ growth.

“The two best performers of the US financial sector - Bank of America and Wachovia - have achieved their growth through acquisitions. While there will be greater scrutiny of asset quality, we still see M&A as the bigger theme of 2007,” said Bugg.  

Another US lender and Kangaroo issuer - SLM Corporation (Sallie Mae) has also been in the news. Sallie Mae, the provider student loans, has seen fiscal reshuffling reduce the level of government support given to loans over time. The reduction had been greater than anticipated but with a large majority of loans still benefiting from a government guarantee, the news did not have a significant impact on the performance of SLM credit.

ABS industry gathers under a cloud - and away from the press

As the Australian securitisation industry came to terms with the fact that it was being wiped from the face of the earth, their usually opulant conference, had a more macabre feel. The red carpet was always rolled out for the press but this year they took the bizarre decision to ban the media because they felt 'speakers would be reluctant to be open and frank'. What a joke!  Myself and my colleagues were furious at their double standards. They courted the press in good times and had now when the conference actually meant something they shut us out! Their banning of the media however made me adamant that the industry was in deep trouble and I spent the week making sure I uncovered exactly what lay ahead for securitisation in the industry. 

Insto Bond Diary

***ABS industry gathers under a cloud (29 November 2007)***

As the Australian securitisation industry gathers for its annual conference, it faces the most critical period in its short history. 

The Australian Securitisation Forum conference takes place behind closed doors this year as participants come to terms with a market that has been altered dramatically in 12 months. 

Australia’s ABS market has not been immune from the effects of a global credit crisis as investors retreated, liquidity dried up and lenders came to terms with a drastic shift in cost of funds. 

The year began well enough.  Aussie issuers flocked to global markets with multi-billion dollar deals and tight pricing levels. Westpac and Commonwealth Bank of Australia completed the largest Aussie ABS deals in history with A$7 billion RMBS offers and domestic ABS issuance was on track to exceed corporate bond issuance for the first time ever.

But everything changed suddenly. As the sub-prime lending crisis in the US deteriorated and credit spreads blew out, the shutters came down on global structured credit issuance. Domestic ABS  volume was reduced to A$6 billion in the second half of the year from A$25 billion in the first half.

In September the ABS market staged a recovery with Macquarie Securitisation’s PUMA vehicle, Bank of Queensland and Adelaide Bank bringing deals to market, albeit at reduced issue sizes. Other issuers such as RAMS, Calibre and Columbus had little choice but to brave hostile markets for term funding. A further deterioration in credit put the brakes on the recovery with most issuers and investors electing to sit out a difficult year.  

The prolonged market disruption has taken its toll and placed significant strain on lenders reliant on securitisation for funding. Exactly who is reliant on securitisation and to what extend remains uncertain.

“The banks have a variety of different options to raise money. Even the non banks have warehouse facilities with a plethora of organisations which means they use they use them as different funding lines. They get their diversity slightly differently. You just don’t know who has what and why but they are all managing. If they have managed themselves well up until August largely they’ll be okay,” said Ben McCarthy, managing director, Fitch Ratings.  

The predicament of the non bank lenders presents the most immediate concern for the ABS marketplace. Securitisation has allowed a number of smaller lenders to exist by using the capital markets to fund loans at competitive levels and in large volumes. Traditionally operating in non-core lending markets, the growth of securitisation allowed them to expand their operations and in many cases compete with the major banks. 

The shift in tide has left many issuers without access to the capital markets. As they continue to write loans, their warehouse facilities are filling up and credit lines are running dry. 

The only immediate solution for these lenders is to reduce or halt lending.   

A number of issuers have lifted lending rates, cut budgets and reduced lending as warehouses reach capacity and previous issuance volumes appear unsustainable.   

“Many issuers have said our warehouses are fine, they’re just not writing any new business,” said an analyst.

Others are in the precarious predicament of having to renegotiate warehouse facility agreements and terms are likely to be very different to those offered pre-crunch. 

For the banks that provide these facilities the situation is far from ideal. A full warehouse means that the origination business is slowed or stopped. If the issuer is unable to sell ABS, the bank is also stuck holding assets and runs the risk of having to service the portfolio if the originator goes out of business. 

Also if warehousing costs are locked in at spreads that are lower than primary issuance spreads, lenders may not have the economic incentive to term out their assets. In this case the banks are effectively being underpaid for their risk. And the past few months have shown that there is plenty of risk - be it credit risk or liquidity risk. 

Lenders now face a huge challenge.  As markets demand a greater risk and liquidity premium for holding ABS securities they must charge their customers more if they are to retain their profit margins. But they will face competitive pressures from better capitalised lenders who can afford to hold their prices down.  

Another massive impact for theΩdomestic market has been the retreat of conduit and offshore investors. Before July, more than half of Australian ABS issues were sold to offshore investors. Conduits or arbitrage vehicles borrow short through commercial paper issuance and lend long through purchasing assets including ABS, earning the spread differential. These buyers would often absorb entire tranches outbidding fund investors. 

The conduits are gone and not likely to return. Not only are they not buying, but selling what they hold. The sheer volume of existing paper held by these offshore arbitrage vehicles could have a significant impact on pricing. Some are being forced to offload their holdings in the secondary market, putting pressure on market prices and driving new issuance spreads wider. 

“With better seasoned secondary paper offered at more attractive levels, there may be no incentive to participate in new issues,” said an investor.

“The domestic ABS market has always been a buy and hold market. But offshore investors including conduits and SIVs have participated and bought very large tickets. Now many of these investors are having to offload assets at very wide spreads. We’ve seen seasoned AAA rated Aussie ABS assets with two year WALs trading in Europe and the US north of 100 basis points,” said Doug Banks, head of Australia and NZ securitisation, Citi.

The higher cost to borrowers will reduce the volume of business lenders can generate, as will the reduced capacity of capital markets to absorb billion dollar plus deals.

There may well be casualties. 

“They will lose market share and funding and warehouse costs will increase. The ones with robust business models and those that operate in niche markets and not competing directly with the banks are more likely to see things through,” said Chad Karpes, head of AUD syndicate, ABN AMRO.  

For now, certain lenders are desperate to clear their lines and are turning to local funds to see them through this period. 

Domestic investors, previously marginalised by massive global demand for Aussie paper, are now calling the shots. They are in position of strength and are demanding greater spread, better quality assets and more robust structures. 

“There are different spectrums of investors. Some accounts are willing to participate in deals at certain levels. Others have been told to put everything on hold and are sitting on the sidelines until credit markets, and more specficially spreads, stabilise. Investors that bought the deals issued after the crunch at wide levels are suffering slightly as spreads have widened even further,” said Karpes. 

But juicer spreads are also seeing some new accounts enter the market. 

“We’re also seeing accounts that have been absent from the market for quite some time return, taking further advantage of these wider levels” said Karpes.

While some funds see current conditions as an opportunity to pick up good assets and cheap levels, others remain weary of further spread widening and ratings downgrades. 

The fate of the mortgage insurers remains a concern as defaults in the US eat into their capital. As most Aussie RMBS deals are structured to include LMI cover, a downgrade of the insurer would trigger a downgrade of a wave of securities.  

“RMBS investors are not so concerned about losses when it comes to the LMI's but rather about ratings migration,”says Anthony Bell, Societe Generale’s head of syndicate.

While the market grapples with a number challenges thrown at it, there are some positives to have emerged. Many view the last few months as a necessary albeit harsh repricing of risk that should result in more normal spread levels. 

The biggest positive however has been the relative resilience of the domestic ABS market. While Europe and the US have ground to a halt, public domestic ABS issues have occurred and genuine deals have been brokered. The market has shown that in the absence of the offshore bid, a degree of self sustainability exists.

The strength of Australian collateral, the standards of high lending practises, and the sophistication of domestic investors have all contributed to the robustness of the local market.     

“Deals are being done and being done regularly but at a smaller size and in a more structured way with a lot more interaction and engagement with investors to give them the transactions they are looking for in this marketplace,” said Phil Vernon, chairman of the Australian Securitisation Forum. 

Another local positive has been the continued diversification of the domestic market. This year has seen non RMBS make a far more significant contribution to issuance with sizeable auto deals and a number of commercial loan securitisations. 

“There is a change in the asset mix in the market. Its not all mortgages anymore and we’re seeing that in our pipeline of what we are rating. We were spending 60 per cent of our time on mortgages but 80 to 90 per cent of our ratings were mortgages. Its flipped around now and  we have more ABS deals than RMBS deals in the pipeline,” said Ben McCarthy of Fitch. 

Global uncertainty remains and participants are hoping for confidence to be restored to securitisation markets. 

“We are a part of a global market and we need stability in the global markets before things come back to long term normality. That will take time,” says Kevin Lee, division director, Macquarie Bank.

Transparency is emerging as another trend that will define post crunch securitisation markets. The ASF, along with other global industry bodies has identified greater disclosure pre and post deal as a step needed to restore confidence in structured credit.  

It’s been a torrid year for ABS globally but the economic rationale to securitise remains compelling. The process of risk transfer remains an efficient mechanism of sharing risk and lowering costs of capital.  

The global industry faces the challenge of convincing the world of its merits.  To do this it may have to go back to basics.

“There is demand for ABS, but the underlying structure of the end investors has changed and it will take time for new investor models to emerge,” says Banks of Citi.

“In the meantime we will return to a more simpler and digestible structures, effectively starting from scratch again.”