Peripheral RMBS prospects examined

Representatives from Bloomberg, Prytania Group and DBRS discussed peripheral European RMBS in a live webinar hosted by SCI last month (view the webinar here). Topics included the development of the peripheral RMBS market versus core RMBS, a detailed look at the Irish and Spanish markets, pricing challenges and the impact that the ECB's ABSPP will have.

Q: How has European peripheral RMBS evolved since the crisis?
A: Cynthia Sachs, global head, Bloomberg Valuation Service: There has been incredible evolution around the market and it has been a long, hard road. To understand what has happened in Europe, it helps to make a contrast with what happened in the US.

In the States, the Fed had a much easier time intervening by implementing asset purchase programmes, quantitative easing and all the rest of it and that intervention helped to avert a major depression. The US economy, like the UK, is now in a fairly healthy state.

It is a different story in Europe, where the EU has turned into a highly fragmented state, both politically and economically. Strict rules and the common currency make it difficult to be flexible and what works for Germany might not work for Greece, so when you reflect on which levers can be pulled, it is much more difficult in Europe and it has been extremely hard for the ECB to take the kind of actions that have been taken in other countries.

Now the European market is weakening and Europe seems to be lagging the rest of the world, so clearly the pressure is on the ECB. The central bank has now taken extreme measures, both with a massive rate cut in June - where certain rates are now at negative levels - and with the announcement of its ABS and covered bond purchase programmes.

The ABSPP is going to impact the periphery in a positive way, with even countries like Greece and Cyprus - where credit quality is not what you would typically find in the ECB's wheelhouse - benefiting. This action from the ECB is going to be healthy for the periphery.

Mark Hale, cio, Prytania Group: The European ABS markets still do not have the breadth or depth that there has been in the US for many years now. However, there has been a strong recovery since the crisis and you can see a wide variety of bonds traded now across nearly all sectors, in all jurisdictions, and up and down the capital stack.

That pattern is generally observable whether the markets are rising strongly, falling or flat. The relatively consistent activity levels are a clear sign of the market normalising.

Looking at the prices which we take in every day, we are typically receiving between 3,000-4,000 prices daily. There is a degree of seasonality and we certainly saw activity dip around events such as the summer's ABS conference in Barcelona, but the ECB's announcement in September brought with it a strong pick up in activity.

Q: How has collateral changed?
A: Keith Gorman, head of European RMBS, DBRS: The drop-off in European RMBS issuance since the crisis has declined year-over-year and we have already this year surpassed total issuance for 2013. That said, we remain a long way off the 2008 peak.

The drop-off was particularly hard in some of the peripheral countries, with only one or two transactions out of Portugal over the last four years and a similar number from Ireland. There have been a few more transactions from Italy but a common feature you are seeing with the issuance is that these are structured and securitised for balance sheet retention.

ECB president Mario Draghi has mentioned the option for the central bank of purchasing peripheral bonds that are balance sheet retained and currently on repo with the ECB. Current estimates are of around €170bn-€190bn of these type of bonds out there, largely from Ireland, Italy, Portugal and Spain.

The success of the ECB's covered bond programmes has meant that issuers have been able to access liquidity from that market for the last couple of years. The larger banks have often relied on covered bonds and then securitised the ineligible products, which are typically higher LTV loans.

In Italy, a lot of issuance has come from the smaller regional banks, with LTV restrictions typically keeping LTVs somewhere between 55% and 65%. The differentiation in those pools will come from geographical distributions, because a lot of the banks there will be focused on their local region, so you will see some high geographical concentration in the pools.

In terms of structures, something we have seen in Spain, Portugal and Italy is transactions being issued unhedged, with no swap. Previous structures would have relied on the issuer acting as swap provider, but bank downgrades mean they are now ineligible to be swap counterparties.

Q: How does the ECB plan to change things?
A: Sachs: We have known for a while now that the ECB's ABSPP will include RMBS and covered bonds. That will hopefully encourage banks to increase their lending in the consumer finance market, compressing spreads and leading to cheaper financing, with the goal of stimulating the economy.

The bank has also said it wants to bring its balance sheet back to 2012 levels, which is about €3trn. The ECB was a big buyer of sovereign debt then and its balance sheet has come down since, so it has shown that it is capable of ramping up its balance sheet.

The ECB's balance sheet is currently around the €2trn level, which essentially implies €1trn of purchases. Purchases are likely to be in the primary market in order to get sufficient size and are likely to be €150bn-€175bn for covered bonds and around €250bn for ABS.

Draghi has mentioned buying triple-B minus paper in the periphery, but the thinking generally is that he will stick with the highest-rated senior tranches as they are within the standard credit criteria. There has been a lot of talk about whether the ECB will buy mezz tranches, but it now looks like a non-starter for anyone to guarantee those tranches.

Banks retain a fair amount of mezz debt, so as senior spreads tighten the mezz debt should trade up naturally on a relative value basis. If that prompts banks to start selling then it will free up capital and should increase lending, so there are many knock-on effects.

Q: How will the ECB's involvement affect pricing?
A: Hale: There has been a sharp, sustained rise across relevant ABS and covered bond sectors and the announcements which the ECB has made appear to justify such rises. There has already been a spill-over impact into segments of the market that are not going to be directly targeted by the ECB.

The market is anticipating some of the capital will be recycled from bonds sold to the ECB back into other structured credit products. The main challenge is that the quantum of eligible bonds relative to the desired balance sheet expansion of the ECB is very small in Europe, therefore it contrasts quite significantly with what the Fed was able to do with for example US agency mortgages.

There is perhaps €160bn-€190bn of eligible publicly issued collateral out of a European structured credit market of €1.5trn, so only a small portion of the secondary market is eligible. We expect a steady and gradual pace of buying with a focus on primary market purchases.

RMBS prices have already closed on - or, in some cases, gone through - the equivalent government bonds asset swaps to give a Libor spread equivalent. There might be room for another 10bp-20bp of tightening at the senior end of the market, but to get very much tighter than that, such as to the levels that we see some US ABS trading, would seem somewhat constrained by the relative value against sovereign bonds.

In terms of the relative value against other asset classes within the ABS universe, there may be an opportunity to book profits where European bonds run strongly up towards par and find better relative value outside the eurozone and within the very strong economies of the UK and US. Asset classes which will be excluded from the ABSPP already have quite a wide spread differential.

Q: How do similarities and differences between the Irish and Spanish markets illustrate these themes?
A: Gorman: Ireland and Spain both experienced the real estate bubble with the sharp decline. Prices in Ireland dropped off by 51% peak-to-trough and Spanish prices dipped 37%, although in Ireland we have seen gains of about 15% over the last year.

Ireland is really split between Dublin-centric and non-Dublin. The economy has been recovering and there is job growth in Ireland, while there is also the potential for a housing shortage in Dublin, so that is pushing up prices. By contrast, in Spain unemployment is picking up and home prices are flattening out, so there is not the same boost that you are getting in the Dublin area.

Saying that, there are probably bigger opportunities to look at Spain compared to Ireland as there is a bigger geographic region and you can look at different pools for different concentrations in different areas of Spain. Madrid and Barcelona can account for as much as 30%-40% in some transactions and depending on the originator you could have some other areas of Spain with higher concentrations.

There have also been increased defaults and arrears, but the structures in Spain and Ireland differ. In the Spanish transactions you typically have a default protection mechanism where after the loans reach 12 or 18 months in arrears, excess spread is automatically diverted to cover the defaulted balance of the loan on the principal side to keep your assets and liabilities matched up. By contrast in Ireland the losses are not crystallised until there is actually a foreclosure process or some kind of judicial conclusion on the borrower.

In effect the Irish government has prevented banks from foreclosing on borrowers, so there have been many modifications to underlying loans in Ireland, with a combination of extended loan maturities and lowered interest rates. Loans have not been written down but senior note durations are being extended because there is no cash being diverted to pay down on defaulted balances in the way that that is happening in Spanish transactions.

We have definitely seen some of the performance flow through in the Spanish transactions. 90-plus delinquencies have levelled off there because the loans which had been 90-plus delinquent are flowing through into default. By contrast in Ireland there is a build-up of 90-plus because borrowers are not being pushed through to default and loss just yet.

Sachs: We are seeing a lot of activity, particularly in the Spanish ABS market. There has been massive spread tightening since the ECB's September announcement, with 40% double-A spread compression in the first two weeks to 40bp-50bp. We also saw tightening down the stack, although that was to a lesser degree.

The biggest moves down the stack that we did see was down below double-B in the Spanish consumer space and also in Spanish SMEs, where spreads tightened significantly. We saw huge moves of 60%-70%. Although spreads can still be as wide as 600bp-700bp down the stack, they used to be considerably wider than that.

In certain pockets we have also seen some widening as different market participants are selling into the rally. There is some selling pressure, so we see some spreads widening back out a bit. That is healthy and the market seems to be functioning pretty well.

Hale: Ireland and Spain rather exemplify the story of the tortoise and the hare; Ireland famously took the harsh necessary action, both in terms of fiscal policy and in addressing the issues in the real estate and bank markets relatively quickly, whereas other parts of Europe, including Spain, infamously did not really grasp the problems until more recently. We have now seen a dramatic shift in the data from Spain in the last year, with material progress in addressing the problems both in the real estate and in the financial sector.

That progress has been given a strong endorsement by the market, as shown by Spanish CDS, government bond prices or RMBS prices. To a large degree the gap between peripheral countries like Spain, Portugal or Greece has converged on the core markets.

Clearly some of that is to do with nationally-specific progress made but most of it is to do with the broad global rally and search for yield, and specifically the enthusiasm generated by the prospect of almost unlimited ECB support. Since the last eurozone shakeout in the summer of 2013, the spread convergence that we have seen in the major markets of Italy, Spain and Portugal has been striking.

As for Ireland, Irish and UK RMBS used to trade relatively closely until surprisingly late in the crisis. There was then a massive underperformance from Ireland that lasted a very long time and it took a while before RMBS prices started to respond to the better data coming out of the country.

That response has been particularly strong in recent times, to the point where spread differential between Ireland and the UK is almost back to where it was pre-crisis. However, while the UK has a strong, pervasive, long-standing house price boom with almost no delinquencies observable in prime RMBS, the improved picture in Ireland still includes a lot of pain which is yet to be felt through the structures.

Q: Where is the market headed next?
A: Gorman: The growth of the RMBS market in peripheral jurisdictions has been marginal over the last few years and over the short- to medium-term that trend will continue. We are, however, expecting to see a few transactions.

A lot of the smaller Italian banks which have been issuing recently have been starting to run dry and look for new product, so they may not quite be ready to securitise again. As for Spain and Ireland, new eligibility criteria might lead to loans being repurchased out of old transactions and used in new ones.

The trend for covered bonds to cannibalise the RMBS market has been well observed. We expect the attractive funding for covered bonds versus RMBS for a lot of banks to continue to drive that trend.

In the longer term, the return of RMBS relies on these peripheral economies starting to turn the corner a little more. Ireland has made progress but it will still be some time before banks lend again there, while in Spain they still have to work out some of their issues and get the economy rolling again before you really start to see the mortgage market grow year over year.

Q: What can be expected for pricing?
A: Hale: We can expect to see further spread tightening. Fundamentals perhaps justify that and the relative spreads on structured credit assets against other comparables in the investment universe also justifies it.

Without a paradigm shift in terms of where European peripheral government paper trades or CDS trades, there may be a limit to how much more the senior paper can rally in. In our view that could be 15bp-20bp.

Beyond that it depends on the extent to which the ECB's ABSPP, perhaps supplemented by other regulatory measures, can drive a much greater renaissance in the European market. If you could push up issuance from below the €100bn level up to more like €400bn-€500bn per annum as we saw pre-crisis, that would materially transform the outlook for investors.

Potentially also the ECB could open up new asset classes by being the buyer for senior bonds in the very first instance, which could increasing the size and frequency of issuance and so generate greater liquidity and encourage a wider diversity of originators to come to the market. That is something the ABSPP can help to stimulate, but cannot do alone; for a broader based renaissance we are looking at national governments or parastatals to respond to Draghi's invitation for government guarantees so the ECB can buy mezzanine bonds.

Q: What other developments are expected?
A: Sachs: In the US we have seen agency RMBS come back but non-agency has been more limited. With that in mind, the ECB's efforts are welcome, but it remains to be seen whether they can jumpstart the market.

It might be the covered bond market that leads the way and then we will see where the securitised part of the market goes. I think it will be interesting to see how it plays out and what other steps Europe may take to jumpstart the economy, whether it is continued sovereign bond purchases or other asset classes to just keep on moving forward. We are at an inflection point.

Hale: Clearly the ECB has failed with words alone and with its repo operations to address the issues that have continued to bedevil the European economy, where deflationary forces remain extremely strong. To some degree the ECB's credibility is at stake, so over time we need to see definitive action.

Whether or not the ECB is right is almost less important than whether it maintains credibility. If it does then I think Draghi has done a great job once again in managing expectations such that he can pull off the trick of having this extraordinary monetary policy shift without getting to the very difficult political question of outright quantitative easing - buying government bonds - which obviously we have seen in other countries. That balance is a very difficult one and if the monetary data and economic data can continue to show an improvement into 2015 then he will not be challenged, but otherwise we may need to see the ECB taking even more strenuous efforts in order to meet their policy objectives.

Gorman: Besides the ECB programme there are some other things going on in the market that can help to generate some positive momentum and clean up some of these problems we are still seeing on bank balance sheets. For example we are seeing a lot more special servicers being built up in Ireland, Spain and Italy.

Prior to the crisis there simply were not large numbers of borrowers going into default so these jurisdictions did not have much of a strategy in place for dealing with large scale defaults. Having these special servicers now helps to get the loans off bank balance sheets.

Also, with NAMA in Ireland winding up its programme two years earlier than intended, there could be good news from other bad banks. In Spain they are also being aggressive in selling off collateral.