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.
The European bond markets have had a good first half, but the rest of 2009 may not be so kind.
First, the good news. Markets have done well as asset managers have pushed more money into corporate credit. They have been drawn by record high yields after Lehman’s failure, and also by the need to hunt down an alternative to low risk-free rates while avoiding volatile equity markets.
In spite of the gloomy outlook for defaults and the continuing drumbeat of rating downgrades, investors have taken progressively more risk as bond prices have risen, moving from defensive companies into more cyclical names, and even high-yield credits. This surge has allowed corporate bond spreads to narrow sharply even as companies have thrown a wall of paper at the markets.
These bond investors, whether intentionally or not, have become key players in global corporate finance. As banks rein in lending, companies need the public debt markets more than ever. With credit and funding in short supply, companies are cutting costs, slashing dividends and raising equity to preserve credit quality and keep their bondholders sweet.
The market has taken further encouragement from a series of better-than-expected company second-quarter results that has helped push spreads on the European investment-grade bond index back to pre-Lehman levels.
But a further leg-up from here looks unlikely, and for some companies, the most likely trajectory for bond prices will be down. While it is true that corporate earnings remain surprisingly strong, to the extent that this is due to restructuring and cost-cutting it is likely to prove finite. Meanwhile revenues, and net income, are falling sharply, eroding and in some cases eliminating free cash flow.
Corporate credit quality is therefore likely to deteriorate from here on in. Even though bond prices rose in the first half, the number of “fallen angels” — companies downgraded from investment-grade to high-yield — has been going up too. Two out of the top three months for downgrades to sub-investment grade on record were last month and in March, according to Standard & Poor’s. The ratings agency has identified a further 75 issuers globally with $255 billion of debt in danger of being consigned to junk status.
This has not been priced in by investors, especially at the high-yield end of the market. CDS prices for companies included in the iTraxx Crossover index of high-yield names suggests that the market expects lower default rates over the next year than the ratings agencies expect.
It could of course be that investors have a better idea of the true credit quality of corporate Europe than rating firms do. But the suspicion is that they are just being optimistic. And bondholders aren’t supposed to do optimism.
Ouch! Moody’s has just downgraded some Italian asset-backed debt parcelling leases made by UniCredit to its clients, called F-E Gold. One of the downgraded bonds took a rather nasty dive from A3 to Ba1, but aside from that the rating cuts aren’t too brutal. Moody’s report does give a quick snapshot of how corporate Italy is faring in the economic downturn. (Leasing is a core source of funding for the small and medium-sized companies that make up the economy’s backbone.)
So far about four percent of the companies that borrowed by leasing real estate or equipment have defaulted since the deal was sold three years ago – the same amount Moody’s was expecting over the life of the deal. The agency has now doubled its default assumption to 8.6 percent — let’s hope it’s just being conservative.
Banks holding European commercial mortgage-backed securities at par on the basis that they stand at the top of the pecking order when it comes to repayment should think again.
Even some of the most senior-ranking bonds backed by commercial property loans will have to be written down as the downturn bites. And with about 120 billion euros of European CMBS outstanding, the numbers are big.
Many of the underlying loans are underwater. But companies who manage the debt have refrained from taking aggressive action and enforcing on the loans on the basis that prices may recover, rents are still being paid and borrowers are still up to date on their interest payments.
Their approach is simple enough. Why risk losses from a fire sale if the market may recover by the time the debt comes due five or so years down the line? In fact, of the 1,100 loans packaged in European CMBS, only 39 are classified as being in “special servicing” — shorthand for having a problem — according to Standard & Poor’s.
One deal where the servicer isn’t taking this wait and see approach is a 487 million pound deal called Epic Industrious by Royal Bank of Scotland for now-defunct property firm Dunedin, which was placed in administrative receivership last year.
Ernst & Young is set to sell the properties to vulture fund Max Property, after a smaller auction last week. This is likely to mean losses for senior creditors — a first for CMBS bondholders in this cycle.
As well as a ridiculous name, Epic Industrious has other peculiarities which suggest a wider fire sale of properties from other transactions isn’t likely in the near term.
Firstly the borrower is in administration, necessitating a more speedy resolution than in situations where a loan is simply in default and can be worked out over time.
Another complexity is the fact that the deal is a so-called synthetic CMBS, in which RBS used credit default swaps to shift the risk of the loan to bondholders. In these deals banks may be incentivised to work out the debt speedily, whatever the losses, and claim on the insurance policy provided by bondholders.
Epic Industrious shows how severe losses will be in some CMBS deals. While some loans are still backed by strong properties worth more than their debt, and generating more than enough cash to service the debt, it is clear that property markets won’t have recovered enough by the time many loans come to be refinanced.
Declining rents will tip more loans into default and many will fail to refinance at maturity.
Moody’s noted in a recent report on a deal created by Credit Suisse that originally parcelled 10 loans that it expects “a very large portion” of the portfolio to default, suggesting that the benefits investors thought they would get by diversifying their risk across a pool of loans is worth little in practice.
Tackling problem loans now, and selling some or all of the assets, may yield better recoveries than simply hoping for a market revival.
Much of this pain is already priced into CMBS, with senior bonds trading at about 70 cents in the euro or less. While some banks will hold at market levels, others may have only partially written them down after last year reclassifying fair value assets into loans and receivables.
Anecdotal evidence suggests some banks are still holding senior tranches at par. This looks hopelessly optimistic. A raft of recent and looming rating agency downgrades will force them to increase capital reserves and prompt them to sell, even if it means taking a loss.
Prepare for a rocky ride in bricks and mortar.