A starker illustration of how things have changed in the ABS market would be hard to find. In late May, UK bank HBOS made public details of a £500 million single-tranche, triple-A rated issue from its Permanent UK RMBS master trust a deal that was seized upon by the market as a sign that the worst was over. Before last summer, HBOS was routinely issuing multi-billion sterling Permanent trades and paying about eight to nine basis points for triple-A paper. The triple-A notes in this deal pay 85bp over Libor. The deal was pre-placed with seven banks and insurance companies.
HBOS certainly did not undertake the deal for funding (it had raised funds in the unsecured market the week before) and the deal was done for strategic reasons. "This was an effort to kickstart the market and get the market moving again," explains Robert Plehn, head of securitization and covered bonds at HBOS. "We are realistic this is just a first step. But the paper has tightened 2bp since we did the deal and we are talking to a lot of investors. This is the result we were hoping for."
Plehn explained that a marked improvement in sentiment during May prompted HBOS to act opportunistically and issue the deal. "We had been receiving a lot of reverse enquiries," he explains. "The Bank of Englands special liquidity scheme helped to take concerns surrounding UK systemic risk [stemming from Northern Rock] off the table for investors."
The Permanent deal is a step in the right direction, but everyone agrees that there is still a very long way to go. Although it is nearly a year now since the ABS market began to unravel, many investors are still wrestling with the implications of what has happened. No constituency in the capital markets was worse affected by the liquidity freeze, and it is unlikely that any constituency will emerge from the crisis as fundamentally altered.
Who bought triple-A ABS?
Investor breakdown by type
This is because such a large proportion of ABS buyers pre-crunch were structured investment vehicles or ABCP conduits (see chart below) the now-infamous ABS funds that suffered so severely from the freeze in the short-term money markets in the third quarter of 2007. These buyers fuelled the securitization markets rapid growth and accelerated its rapid contraction.
Since the ABCP market froze last summer, the SIVs and conduits have shed assets, restructured and been taken onto the balance sheets of their sponsoring banks. What they havent been doing is buying ABS. "It seems there are a lot of funds and vehicles that relied on triple-A liquidity that have now gone," says Brendan Galloway, securitized credit portfolio manager at Barclays Global Investors. Buyers are now limited to institutions with longer-term investment horizons.
The contrast between the ABS markets in Europe and the US has been striking. In the US the source of the sub-prime problem that triggered the credit market unravelling the ABS market has continued to function: a stream of auto, credit card and commercial real estate deals have closed: issuance year to date in the US had topped $132 billion by May. In Europe, the story could hardly be more different (see chart right). "The market has been shut since the summer," says Dirk Schlademann, head of strategic investments, UK, at NordLB. "There was a small window in October but that shut pretty quickly. The market became further dislocated in the New Year and banks stopped activity altogether." There was a sudden uptick in sentiment in late May associated with the announcement of the HBOS deal: indeed, one trader reported volumes surge to "mid- to early-2007 levels". But the market was essentially hobbled from last summer until then. Why?
The truth is out there
European structured finance issuance profile
Source: DB Global Markets Research
"One critical issue in the market is the inability of investors to price risk due largely to a lack of available data," says David Covey, executive director, European ABS research, at Lehman Brothers in London. "Secondary market liquidity has improved much in the triple-A space recently, but in some riskier areas the gap between sellers and buyers is still wide because everyone is having difficulty pricing the cashflows."
European ABS has always been comparatively difficult to price because of a relative lack of underlying transparency. When those attending a recent Reuters seminar in London were polled on their satisfaction with ABS pricing, an unsurprising 77% were dissatisfied, with 40% of this number citing a lack of information on underlyings as their main concern. But this is now compounded by a deep-seated unease about what data there is. "For anybody that uses any type of market risk (VaR) to manage their portfolio there are a whole new set of observations," says Galloway. "The data has totally rewritten itself. All risk models now have to be stressed for what has happened over the last nine months. Standard deviations are fundamentally altered. There is a whole new data set and investors need to go back to the drawing board."
Rather than being an attractive source of yield, the wholesale shift in ABS pricing is actually contributing to investor reluctance in some cases. Before the credit crunch, people bought ABS because it represented stable cashflows, if not excessive returns. But when the market seized up, triple-A assets that had been trading at 7bp to 8bp over Libor were suddenly approaching 200bp over Libor (see chart below). While spreads have retrenched from their highs (in mid-May triple-A Dutch RMBS was trading inside 70bp with UK paper at roughly 80bp), levels still make accurate stress testing of ABS portfolios a challenge. "In the past this was a very stable low beta investment," says Schlademann at NordLB. "If you have a triple-A portfolio with a weighted average spread of 25bp and the worst-case scenario is a spread movement of 10bp, that gets you to 35bp. But if you have a weighted average spread of 300bp and you stress for a 30% spread movement that gets you to 400bp a substantially different risk profile. You either have to increase your risk appetite or shrink your portfolio."
Spreads still wide
Cash spreads in selected ABS sectors vs financials
Source: DB Global Markets Research
Given that an increase in risk appetite is probably not at the top of the agenda, the likelihood of ABS buyers piling back in is pretty remote. "Most portfolios are just too big they have grown too fast for risk projections," says Schlademann. "They need to fall back to some equilibrium level there will be another one to one-and-a-half years of natural amortization. At the moment, there is no form that the market can take; it is essentially doing what it should have done two or three years ago but hindsight is a wonderful thing."
All of the UK master trust issuers know the extent to which the market has needed a deal over the past nine months and have been under enormous pressure. But in mid-May even esoteric assets such as non-conforming triple-A and triple-B paper were in 150bp from their wides: if this sudden rally is sustained, they might tighten even further. It is quite clear that HBOS would be reluctant to undertake a sizeable Permanent fundraising at 85bp over, but if the market continues to tighten a level may be reached where such a move would be reasonable. "We will have to wait and see," says Plehn.
The ABS investor base will inevitably get smaller, and it will fundamentally change. "Investors in securitized credit will need to have longer investment horizons than were previously envisaged. Even at triple-A level it will become more of a buy-and-hold investor base more so than it already was," says BGIs Galloway. Wider spreads will lure new buyers such as hedge funds and the buy-and-hold accounts of credit opportunity funds but the ABS investor base cannot be more than a shadow of its former self in the near term. The substantially higher monitoring and stress testing requirements under IFRS will prolong the absence of many banks from the market, and distressed debt buyers, while becoming increasingly active, will not provide enough momentum to kick-start the market. The emergence of a couple of arbitrage CLOs and a potential prime UK RMBS deal in May suggest that the European ABS market might have turned some sort of corner, but it still has a long way to go. "The market is still dysfunctional just not as dysfunctional as it was when triple-A prime RMBS was trading at 200bp over," muses Galloway.