Securitization: A new kind of crunch
Borrowers and mortgage lenders are feeling the pinch of an unprecedented credit crunch. Is there any way back to the buoyant days when securitization drove the market? Duncan Wood reports.
When securitization markets for residential and commercial mortgage loans froze last summer, a key funding source was removed at a stroke. Before the crisis, up to 40% of home loans and 20% of commercial loans were funded through securitization. In Europe lenders had to adjust quickly, tapping other funding sources and reining in the number of new loans. However, questions remain about how long the straitened environment will persist, and whether there is enough funding supply to meet borrowers’ demands.
"This is a market we’ve never seen before," says Peter Charles, chief economist for UK mortgage lender Bradford & Bingley. "All previous credit crunches in the post-war period came about because the authorities were raising base rates to choke off demand. That kind of decline is comparatively easy to cope with because it can be anticipated and it’s quite structured. This is the first time a crunch has been caused by a shortage in funding capacity, and what we’ve been trying to do is adjust the level of demand to fit supply. This has not been an easy task."
In order to avoid over-extending themselves, lenders have taken products off the market and have raised the rates on others. Loans such as Northern Rock’s now-infamous Together range, which allowed customers to borrow up to 125% of the value of a home, have vanished, and it’s now standard practice to tack on special charges for any loans with a high loan-to-value ratio. Gregg Kohansky, senior director in the European structured finance team with Fitch Ratings in London, says: "Things have really tightened up at the riskier end of the prime mortgage spectrum. Many lenders are basically trying to price themselves out of the market because it’s difficult to exit these loans via securitization."
If nothing else, says one market participant, the past nine months will have settled a perennial topic of debate that used to arise at the annual funding conferences organized by the UK’s Council of Mortgage Lenders: "The question was always ‘to what degree does funding drive lending?’ There’s no need to ask that any more." As silver linings to clouds go, that’s not very shiny.
Bradford & Bingley’s Charles says that mortgage demand was waning before the credit crunch began. At its peak in the fourth quarter of 2006, the UK mortgage market was seeing about 125,000 new loans for house purchases each month – a figure that dropped to about 105,000 by the middle of 2007 as affordability issues and interest rate increases took their toll on demand. Since the crunch, though, the decline in approvals has been precipitous, with the latest figures showing a record low of 64,000 in March and further declines expected. "Affordability had an impact on loan volumes – but nowhere near as great an impact as the drying-up of the securitization market. It’s pretty hard to adjust when approvals halve in the space of one year," says Charles.
Residential lenders have had to cut their cloth according to the remaining funding supply, and commercial lenders have done much the same, says Richard Curtis, head of bond syndicate with WestLB in London: "The investment bank conduits who moved into this space a few years ago have been squeezed out because their model was to lend and then recycle the risk into the capital markets via securitization, and that’s just not possible at the moment. But even other lenders are lending less, and when they do lend they’re charging a higher price and insisting on stricter terms – which some people simply can’t afford. Deals that would have been done a year ago are not getting done now."
Before the crisis, it was fairly common to make loans at 85% to 90% LTV, while today the upper reach for LTVs is more likely to be 70% to 80%, Curtis says. The cost of borrowing, meanwhile, has gone in the opposite direction – last summer, a typical commercial mortgage rate would have been around 80 to 90 basis points over Libor. Earlier this year, Eurohypo claimed to be originating senior loans at 125 basis points, he says.
One of the CMBS market’s blessings is the small volume of loans that are coming up for refinancing this year, says Hans Vrensen, head of European securitization research with Barclays Capital in London. There are about €150 billion in outstanding bonds, with loans that have outstanding balances worth less than €10 billion in total due to refinance in 2008 and 2009, he says. Many borrowers with loans of a similar vintage took the opportunity presented by low interest rates and rising property values to refinance or pre-pay their loans in recent years, removing much of the demand that would otherwise have materialized over the next three years. However, Vrensen warns that the focus on refinancings could extend into 2010 and possibly even 2011 if current property value declines continue beyond next year.
The picture is similar in the US. Julia Tcherkassova, CMBS strategist with Merrill Lynch in New York, says that only $17 billion of the total $730 billion fixed rate market needs to refinance this year – down from $25 billion last October. So far, insurance companies and regional lenders have been happy to step up and provide the funds. "If you go back 15 years, prior to the advent of the CMBS market, most commercial mortgage lending was done by insurance companies. With CMBS out of the picture, this is a sweet spot for insurers and commercial banks right now – they can pretty much pick the best loans, the best properties and the best borrowers and provide refinancing. It’s become the first and most important source of financing for the market," she says.
There will be a heavier refinancing burden next year in the US – and from 2011 onwards in Europe – so eventually, the absence of the CMBS market might start to pinch more severely. Tcherkassova has no doubt that there’s enough funding available to cover the needs of borrowers with performing loans who will be refinancing this year, with some capacity left to cover part of 2009. "Hopefully, by the middle of 2009 we’ll see CMBS back in action. If not, then we’re definitely going to have an increase in non-refinanced CMBS loans entering default – the other funding sources have their limits and by the middle of next year I think they’ll be exhausted," she says.
Residential borrowers in the UK are already finding refinancing tough. The Bank of England’s first-quarter credit conditions survey, published at the start of April, noted that demand for replacement loans had exceeded the industry’s expectations, as the low rates available during the first years on many loans expired and borrowers suddenly found their loans resetting to much higher variable rates. Anecdotal evidence suggests that many of these borrowers have not been finding it easy to get new loans – and have certainly not been able to match the favourable terms of their existing ones. "There’s a lot of talk in the UK about people who have been on two-year low-rate mortgages that have recently reverted to the standard variable rate," says WestLB’s Curtis. "Until recently, people haven’t seen that as a problem – they’ve just refinanced. But now, of course, they’re finding that they can’t do that."
So the hope for both residential and commercial borrowers is that revived securitization markets will ride to the rescue. In the meantime, central banks are filling in for RMBS investors. But how realistic is the hope that things will revert to the way they were?
Optimists will point to the dramatic tightening in RMBS and CMBS spreads that has followed the wides reached in March. Barclays Capital’s Vrensen says that AAA rated residential deals have seen spreads more than halve, coming in from about 185bp to about 80bp as of mid-May. In contrast, CMBS spreads at the AAA level have remained stable at around 250bp, he says, albeit with a wide margin around this – but other analysts argue that the lack of primary supply and secondary market liquidity in CMBS means that default swap spreads provide a better read on the market’s assessment of credit risk. Here, spreads have more than halved from a peak of 330bp to about 150bp, says Ronald Thompson, head of securitization research at RBS global banking and markets in London.
"[Spreads have] gone from totally catastrophic loss assumptions to just dire"
Ronald Thompson, RBS
Even at these much-reduced levels, spreads still indicate high loss expectations on the part of investors. "They’ve gone from totally catastrophic loss assumptions to just dire – and they remain above the levels at which issuers would want to sell large transactions," says Thompson. In CMBS, says WestLB’s Curtis, the pre-crisis market worked on the basis of loans that were originated at about 80bp -90bp and AAA bonds that were issued at 25bp. If lenders such as Eurohypo are now originating at 125bp, he suggests they would need to be issuing AA at 70bp -80bp. Those estimates differ from one observer to the next: Ronan Fox, a director in the European structured finance group with Standard & Poor’s in London, says that 125bp lending could be securitized if AAA paper was paying somewhere just under 100bp. Still, the bottom line remains the same: "There’s a fair way to go before it would be economically viable to start issuing again," says Fox.
Prospective RMBS issuers are also not dusting off their master trusts. "Most issuers tell us they would be really interested in the low 30s and high 20s," says RBS’s Thompson. That would require current AAA spreads to repeat the kind of tightening seen recently, which will only happen if investors have a dramatic change of heart. WestLB’s Curtis doesn’t see that happening. "There are two forces acting against it," he says. "First, it’s been shown that the AAA bonds produced in the past were not rated conservatively enough, so structured finance ratings have lost a lot of credibility. Second, the big buyers in the AAA world were leveraged buyers. A lot of them – the SIVs, the conduits, the credit funds – are out of business."
A modest turning point in investor sentiment may have been reached on May 20, when HBOS privately placed a senior tranche RMBS deal using its master trust programme.
CMBS analysts are preparing for an extended spell on the sidelines. "It’s the kind of thing no analyst wants to talk about because you’re almost talking yourself out of a job – but 2008 looks like a write-off for new issuance and 2009 looks like it will be very, very quiet," says one analyst.
Despite all this gloom – and growing problems in the underlying property markets – outstanding CMBS and RMBS transactions are still performing well. Downgrades remain few and far between – this year, S&P has downgraded three European CMBS deals, while Fitch has downgraded five RMBS deals issued by GMAC.
Some market participants still hope that banks can be persuaded to step back in as investors. Curtis notes that Basle II means that European banks can now hold less capital against AAA rated RMBS notes and can also finance those purchases by borrowing from the European Central Bank. Curtis is cautious – he notes that many investment committees and boards have put a lock on further purchases of structured finance assets and in some cases have ordered business units to wind down existing stocks.