Commentaries

Granite crumbles

Standard & Poor’s dropped a minor bombshell last night when it placed over 100 bonds issued by Northern Rock’s mortgage funding vehicle Granite on creditwatch negative.

Of course the rating actions are lagging the market and a lot of pain is already priced into the bonds. Some of Granite’s mezzanine BBB bonds are trading below 20 pence on the pound.

Nonetheless, there will be some psychological damage to the market if a large UK prime mortgage-backed issuer is severely downgraded. It certainly won’t do anything to help revive the primary market for UK RMBS, which some hope is set for a comeback. The good news is that so far the AAA rated bonds have not been placed on watch.

There’s little cheer to be found in S&P’s statement on the rating actions, which casts doubt over recent signs of recovery in the mortgage market, including house prices rises.

“Although we have observed that the more recent upward trends in severe delinquencies have tempered somewhat, at a time where house price indices have registered their first meaningful rises in almost two years, we do not yet consider that either of these trends is sustainable.’’

Granite now has long-term arrears of 4.67 percent, according to S&P, worse than the Rock’s average of 3.92 percent. Thirty-four percent of the Granite mortgages are in negative equity, compared with 39 percent for Northern Rock’s overall book.

Unending pain in CLO land

Rating firms and analysts have been lowering high yield default forecasts in recent months, but there’s still plenty of pain in store for the banks, insurers (and taxpayers) who own collateralised loan obligations, funds that package leveraged debt.

Here are some cheery stats from Fitch Ratings, which is busy setting about downgrading more European CLOs.

The average cumulative default rate for European CLOs is now 5.8 percent, double the rate in February this year. During that time there have been fifteen defaults, affecting 26 separate CLO funds, Fitch says. Some lucky CLO funds were exposed to as many as five of those fifteen defaults.

Some of the bonds Fitch may downgrade are already firmly in junk territory, though others are still rated as high as single A.

Cat bondage

Catastrophe bond lovers and other insurance-linked securities enthusiasts should take a look at a report on insurance securitisation published today by the International Association of Insurance Supervisors (IAIS).

There is an interesting section in the report looking at the various cat bonds that have gone pear-shaped since the dawn of the market in the 1990s.

The first bond in which investors suffered losses was Georgetown Re, sold by Goldman in 1996.  The report explores four other deals that have come under stress since then due to losses from natural disasters or other insured risks.

All in all, the track record is pretty good for most of the 300-odd deals sold. Unfortunately, the dogs start to mount up after the financial crisis broke in 2007.

Most of the more recent deals that ran into trouble did so not because of the insured risks, but as a result of the way the deals were put together, and bankers’ occasional fondness for using them as dumping grounds for dodgy assets.

First there are the four cat bonds in which Lehman acted as a derivative counterparty and which were collateralised in some cases by asset-backed debt. Investors were left out of pocket when Lehman failed and the bonds’ had to rely on the toxic debt to pay interest and principal.

Then there is Ballantyne Re, sold by Bermudan insurer Scottish Re. This deal was supposed to provide the insurer with regulatory capital, but the collateral it held as cover for that insurance turned out to be subprime and other mortgage assets. That left Scottish Re short of insurance cover and hurt investors. A similar situation developed with Orkney Re II.

Bank of England gets creative

The Bank of England’s changes to the eligible collateral for repo operations announced yesterday contained a curious quirk: the Bank will now accept covered bonds backed by loans to small and medium sized enterprises.

Covered bonds are a kind of secured bank debt, backed by loans or mortgages. If the bank can’t repay the debt, bondholders can liquidate the collateral to get their money back.

Why are the Bank’s new rules interesting? For the simple reason that, to my knowledge, there is no such thing as an SME covered bond — yet.

What is the bank playing at? Clearly UK lenders are under pressure to boost lending to small companies; allowing them to pledge SME loans as collateral may help open up a new funding channel and get some funds flowing to UK businesses. Perhaps it knows that some banks are getting ready to launch the first such deals and wants to give them every chance of succeeding.

SME covered bonds won’t help borrowers that much on their own, since covered bonds are guaranteed by the issuer and don’t allow banks to free up any capital for new lending. That’s why we also need the securitisation market to get back on its feet too. (In a securitisation the bank sells assets or transfers their economic risk, allowing it to recycle capital and make new loans).