Thursday, December 24, 2009

Retained ABS Start To Hit The Market, Outlook Unclear

Original posted in the Wall Street Journal by Mark Brown:

The market for European asset-backed securities--bonds backed by repayments on consumer loans, mortgages, credit cards and the like--has taken another step towards normalization in December, but the outlook for 2010 remains uncertain thanks to an unclear economic outlook and a shrunken investor base.

Earlier this month, Friesland Bank NV of the Netherlands sold EUR560 million of triple A-rated securities backed by residential mortgages to investors in a deal from its Eleven Cities program. These bonds had originally been put together by the bank, but weren't sold, in May 2008.

One recent estimate suggests that European banks have held back, or retained, almost EUR300 billion of ABS in 2009 alone, to be used as collateral in the event the banks needed to borrow cash from the European Central Bank.

One key to reviving the market, and unlocking bank lending to shoppers, home buyers and businesses thereby supporting the nascent economic recovery, analysts said, would be to wean banks off that ECB liquidity by putting those retained ABS into circulation among investors.

The disappearance of demand for asset-backed bonds was one of the first warning signs of the coming global economic crisis. As the U.S. market for subprime mortgage began collapsing in 2007, investors lost confidence in such deals, whatever their rating.

But demand has started to return in 2009. The Friesland deal could represent another milestone on the path to recovery.

"The interesting thing about the [Eleven Cities] deal was that it had already been structured and retained," said Tim Michael, syndicate banker at Royal Bank of Scotland Group PLC, sole bookrunner on the transaction. "To our knowledge, it's the first retained deal to be syndicated, and it showed that investors are comfortable buying bonds on that basis."

In November, the ECB said it would tighten standards for accepting certain ABS as collateral for its refinancing tenders, requiring them to have two separate credit ratings to be eligible from March 2011.

ABS analysts at Deutsche Bank said that Friesland Bank's move to sell the bonds was "possibly aided by recent pronouncements from the ECB," suggesting that the central bank is starting to achieve its stated aim of helping the recovery of the European ABS market.

Selling more retained deals to investors could be the next step in that recovery, but it isn't always a straightforward process. Because so many bonds were created with no real prospect of being sold to investors, the coupons--the interest payments made to investors--on many retained deals are unrealistically low.

This may necessitate "a wave of deal restructuring" before retained deals "start flowing into the market," Bank of America Merrill Lynch analysts said recently.

RBS's Michael said it was hard to estimate how many retained deals could be sold straight into the market, because some would have to price significantly below par to give investors realistic returns given the low coupons in place.

He said the Eleven Cities deal had "quite a high running coupon" and also offered investors a "significant" increase in interest payments if the bonds are not bought back, or called, when the issuer has the option to do so.

"A deal that pays a materially lower coupon could still be sold, albeit at a significant discount," he said. "However, investors will be very focused on how much the coupon steps up if the bonds are not redeemed on the call date."

Still, the deal is an encouraging sign, and may have started a trend. Spain's Banco Bilbao Vizcaya Argentaria SA (BBV) has also been seeking to sell debt backed by loans to small and mid-sized businesses that was originally retained by the bank nearly a year and a half ago.

If more of these deals are executed successfully, European ABS issuance volumes can increase in 2010. Since the market reopened in September, just over EUR7.3 billion worth of bonds backed by U.K. and Dutch mortgages, German auto loans and loans to small and mid-sized Spanish companies have been sold publicly.

That's a start, although it is tiny compared to the boom years of 2006-2007, and the outlook for 2010 issuance volumes is unclear. One problem is that the hedge funds and specialist investment vehicles that fueled Europe's 2006-2007 ABS boom have exited the market, which has "dented significantly the available investor base," said BofA Merrill Lynch.

But some of the other traditional buyers of European ABS, such as banks and insurers, could return to the market as they seek to diversify their investments either to receive higher yields or for regulatory reasons.

BofA Merrill Lynch bank also pointed out that so far in 2009, investors have only bought the least risky, top rated tranches of European ABS, not the lower-rated tranches exposed to the earlier losses in the underlying loan pools.

So overall, the outlook for European ABS in 2010 remains uncertain, so much so that BofA Merrill Lynch said new issuance next year could be anywhere between EUR50-EUR150 billion.

Still, if ABS volumes hit the upper end of that estimate, they will be back at 2001-2002 levels. These should be more sustainable than the huge issuance of 2006-2007, which arguably encouraged imprudent lending and left some banks over-reliant on asset-backed securities.

"We are seeing some signs of life, but I am not too excited. Yet," said a second syndicate banker.

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