Whether a “careful plan” or strategic blunder, Dubai’s request for a debt standstill for its Dubai World holding company has rattled lenders who were counting on government support.
LONDON, Oct 27 (Reuters) – Is mortgage securitisation
making a comeback? Nationwide Building Society <POB_p.L> has
just sold 3.5 billion pounds of mortgage-backed bonds, just the
second deal this year after a similar transaction by Lloyds
<LLOY.L> last month.
The fact that two large transactions have happened is a
good sign, but the market is still some way from recovery.
That’s the message given by Moody’s today on the resilience of UK mortgage-backed securities to the current downturn. The survey is based on so-called master trusts, a kind of securitization vehicle first applied to U.K. mortgages about a decade ago which quickly became the most efficient way for a large bank to securitize home loans. The master trusts grew so big that they now finance about a fifth of all UK home loans (although a large chunk of this must have been from deals issued by banks after the credit crisis to use as collateral for borrowing with the central banks).
Master trust bonds haven’t been immune to the credit crisis. Forced selling by SIVs and funds caused yields on AAA master trust securities to gap out sharply from their low of around a tenth of a percentage point over Libor. Spreads have rallied in recent months, but they are still around 2 percentage points over Libor, largely because many asset managers simply won’t touch illiquid asset-backed debt, even if the returns are much higher than equivalent corporate bonds.
Private equity and European high-yield bond investors have an awkward relationship. Investors recoiled from the market after telecom companies went bust in the dot-com crash. Issuance picked up during the recent credit boom, but PE firms raised most of their funding through private bank loans, many of which were repackaged into collateralised loan obligations (CLOs).
Now that banks won’t lend and the CLO machine is broken, financial sponsors need to find a way of refinancing the hundreds of billions of euros of loans that will come due over the next five years (S&P estimates over 500 by the end of 2015).
A new record has been broken in Moody’s index for UK credit card charge-offs. The index, based on data from credit card debt included in asset-backed securities it rates, saw write-offs rise to 10.12 percent in June, up by nearly half from a year ago and the highest on record.
Moody’s outlook is bleaker still: charge-offs could reach 12.5 percent by June 2010 as unemployment rises. The inevitable result will be more losses for banks and pain on the high street.
Losses seem to be slowing on the 26 billion swiss francs of leveraged loans, asset-backed debt and other exotica UBS shifted last year from its trading to its loan book to avoid having to mark them to market.
UBS, Deutsche and other European banks made good use of this accounting trick introduced in October to avoid taking losses on volatile assets. The justification was that market dislocation exaggerated the assets’ true risk. Of course, it was only a temporary dodge as assets still have to be written down over time as borrowers default or forecast cashflows decline.
European asset-backed bond prices have gained strongly in recent weeks, but the rally could end in tears.
Prices have rallied as bond investors have increased their allocations to asset-backed debt and some have set up specialist funds to take advantage of distressed prices. They have also been helped by the general increase in demand for all kinds of credit. Accordingly, the spread on top-rated mortgage-backed bonds sold by benchmark UK issuer Lloyds TSB has narrowed to 1.9 percentage points over the 0.886 percent Euribor rate, down from about 3.2 percentage points over the last six weeks, according to broker Brains Inc.
And in many cases, good returns are still on offer.
But there are signs that investors are becoming indiscriminate in their search for yield. One warning sign are optional call dates. In the good years many bonds were structured with optional calls that enable an issuer to repay debt before all the mortgage loans have paid down. In pre-crisis times it would have been easy for a bank to call the debt and refinance the remaining mortgage loans. That’s not the case anymore — any bank that choosing to redeem bonds would be giving investors a windfall, arguably to the detriment of its own shareholders.
Many Dutch mortgage-backed securities are now trading at levels that imply investors believe issuers will redeem them at their planned call dates, although some Dutch issuers have already chosen not to do that and more will likely follow. After all, it is logical from their perspective. It’s far cheaper for them to leave the bonds outstanding rather than have to finance them at today’s rates.
Perhaps buyers know something about the originator’s financial prospects or intention that the rest of the market doesn’t, but this looks like exuberance. And it could be painful if punctured. A bank choosing not to redeem bonds at their call date will cause debt maturities to extend and prices to fall.
There are further signs of bubbliness. Some of the riskier mortgage-bonds from bombed out housing markets, such as Ireland and Spain, have rallied sharply too, according to traders. Yet there is little reason to expect good news in those markets for the foreseeable future. The yield on some Santander mortgage-backed debt has compressed inexplicably by some 2.6 percent over the last six weeks.
The market may be getting ahead of itself partly for structural reasons. Many mortgage backed securities — especially those backed by commercial real estate — are too complex and unpredictable for most investors to touch, so instead they will chase up the simpler-looking residential mortgage or consumer loan-backed debt.
There are also broader issues of supply and demand. An accounting wheeze introduced last year allows European banks to shift securities from their trading desks their loan books. This allows them to avoid the earnings volatility involved in marking these assets to market (or to avoid revealing their true losses, depending on your view). But the effect of this has been to take a large chunk of traded securities out of the market, making price movements more volatile and, arguably, prone to overshoot.
Investors and banks may be united in wishing to see prices move higher. Prices rises help trading desks book profits from legacy positions, as well as banks stuck with unsold bonds. But investors should be wary of reading too much into price movements. They should also remember that it’s hard to cash out of illiquid markets when they turn down.
And conditions could swiftly turn. Rising unemployment levels across Europe as companies rein in costs will likely push up defaults and losses, hurting deals’ credit quality.
Investors who delved into riskier credits in the search for yield may rue the day.
We may never see mullet hairstyles or other weird fashions again, but in finance, there is a 1980s revival.
The International Accounting Standards Board has gone back to the future, allowing banks to reclassify assets they previously had to mark to market as loans and receivables, valued at amortized cost. That effectively allowed them to avoid the embarrassment of mark-to-market and return to the historic cost accounting of a quarter-century ago.
The reasons are plausible enough: many asset classes were quoted at nominal, distressed sale prices only. But you ignore market prices at your peril: problems loans are left to fester, exposing investors to the cost of loan managers (understandably) taking a rosy view of advances they may have approved.
Many European banks took advantage of the IASB’s lenience to whip doubtful assets off their trading books — not just plain debt, but collateralized loan obligations, leveraged loans and other doubtful exotica. Now Deutsche Bank <DBKGn.DE> has indicated how this stuff is doing, and the answer is: badly.
Deutsche’s pretty figures would have been quite spoiled had it taken a further 1.4 billion euros of unrealized losses on the 37 billion euros of assets it reclassified since last October.
The discrepancy between the carrying value and fair value shouldn’t be a surprise — that was the whole point of the changes. Unfortunately, the market is proving to have been right in pricing some of these assets as junk, because the losses in the reclassified book are starting to show.
More than half of Deutsche’s 1 billion euro provisions for credit losses in the second quarter derived from these reclassified assets. Some 2 billion euros of the 3.2 billion euro rise in problem loans had previously been reclassified.
Deutsche is not alone. RBS’ <RBS.L> impairment losses on reclassified assets rose to 747 million pounds in the first three months of the year, up from 466 million at the end of last year. UBS is carrying assets reclassified last year at 24.7 billion Swiss francs, versus the fair value of 20.6 billion.
The accounting changes are not designed to bamboozle investors, even though that is frequently the result. Losses may have been deferred, but they will happen. The question for banks is whether they can generate profits quickly enough to offset them. Market prices that seemed ridiculous in the depths of the panic may turn out not to have been the equivalent of the mullet after all.
Moody’s has published some interesting research on how European companies’ pension deficits have emerged from the last few months of financial mayhem, and the impact of accounting practices on calculating their current deficits.
Top of the list for investment nous comes Rolls Royce, whose pension assets gained eight percent in 2008 after the company reduced exposure to equities in 2007. Bottom of Moody’s 20-strong sample was Shell, whose pension assets tumbled 29 percent, according to the rating company’s estimates. The average decline was 14 percent.
This decline means that European companies’ pension obligations are on average 93 percent funded — more or less in line with the agency’s forecasts, and far ahead of their U.S. counterparts.
But let’s not get too jubilant just yet.
Moody’s notes that the results have been boosted by accounting rules that allow European companies to discount their pension obligations at a rate derived from high-quality corporate bond spreads—very handy given the spike in yields last year. This crops up as an actuarial gain in the pension footnote.
One European company booked a reduction in its pension deficit of between 15 and 20 percent as a result of actuarial gains, Moody’s notes, while 14 of the 20-strong sample booked reductions of 5 percent or more. (Actuarial gains, of course, aren’t limited to changes in the discount rate, Moody’s stresses).
Nonetheless, the concern is that falling real bond yields, if not matched by rising asset prices, will cause companies’ pension funding levels to fall further—forcing them to record larger deficits and stump up more cash.