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.
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.
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.