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.
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.
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.