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European Structured Finance Performance Outlook 2009-Troubled Times Ahead


Standard & Poor's Ratings Services believes that collateral performance in most European structured finance asset classes will deteriorate in 2009, continuing a trend that has begun in 2008. Our key expectations include the following:

  • Macroeconomic deterioration will be the main driver of European structured finance ratings performance in 2009…
  • …although falling rates and inflation will mean affordability pressures ease.
  • Collateral performance in most asset classes will come under significant pressure from rising corporate insolvencies and unemployment, and, in some cases, continued deterioration in underlying asset values.
  • Ratings on lower-rated notes will most likely be threatened first.
  • Senior notes could remain less affected because improvements in transaction structures over time can partially compensate for collateral deterioration over the same period.
  • In consumer asset classes, Spain, the U.K., and Ireland are most exposed, due to weaker prospects for economic growth and employment.
  • Borrower performance in other European countries is less at risk, given more conservative household balance sheets and/or a less pronounced prior bubble in property prices.
  • In commercial (and some areas of residential) mortgage lending, we believe there has been a long-term shift in the landscape of credit provision, and that this will have further negative implications for asset values and loan performance.
  • European collateralized debt obligations (CDOs) remain exposed to deterioration among global corporate credits, but as and when any corporate entities experience difficulties the scale of any CDO rating effect will strongly depend on how widely referenced they are.
  • There may also be rating actions due to the application of revised methodology or updated quantitative assumptions.

Focus Shifts From Affordability Stress To Economic Downturn

In 2008 we saw ongoing disruptions in capital markets, leading to constrained credit availability for both individual and corporate borrowers. Pressure on funding costs and capital ratios, as well as greater risk aversion, has led many lending institutions to shrink their balance sheets, either by tightening lending criteria or withdrawing from the market altogether. For borrowers, this has greatly restricted access to credit or made it more costly. In some asset classes, higher interest rates throughout most of 2008 created affordability pressures and a corresponding rise in arrears, especially as borrowers had fewer options to refinance out of trouble. At the same time, less refinancing and principal prepayment has meant that amortization rates in many traditional securitization structures slowed from previous highs, which had been supportive of ratings.

High-profile failures-or at least downgrades-of systemically-important financial institutions has led to increased counterparty risk in many securitizations, as the derivatives market remains illiquid and ineligible counterparties find it difficult to replace themselves. There has also been a direct drop in portfolio credit quality for some CDOs that reference these companies.

Looking ahead to 2009, we believe that affordability pressures will ease but increasingly give way to broader macroeconomic deterioration as the main driver of European structured finance ratings performance. Multiple forms of governmental and central bank intervention across the globe have now begun to mitigate some of the difficulties faced in 2008. Many lending institutions have been recapitalized to a degree, some with government backing and consequent political pressure to restore the availability of credit to more normal levels, especially in consumer-facing markets. Other intervention to boost liquidity for short-term interbank lending, along with recent sharp cuts in central bank policy rates, should ease affordability constraints for borrowers in many asset classes.

However, we do not expect these positive developments to arrest the deterioration in collateral performance in all cases, as it now seems clear that economic activity in many jurisdictions is slowing sharply. We therefore believe that European structured finance collateral performance during 2009 will come under significant pressure from rising corporate insolvencies and unemployment among individual borrowers. In some areas, such as commercial real estate and the nonconforming residential lending niche, we also expect a longer term change in the provision of credit to have a negative effect. In short, 2009 is likely to present the greatest pressure on European structured finance collateral performance since the market's inception.

To what extent deteriorating collateral performance feeds through into rating performance remains to be seen, although there is clearly a strong link. The number of negative rating actions in European structured finance rose sharply in 2008, and upgrades were less common than in previous years. For the first 11 months of the year, the overall downgrade rate was 10.2%, up from 2.0% for the same period in 2007, while the upgrade rate was only 2.0%, compared with 4.0% in 2007. Some downgrades resulted from issues among financial counterparties providing support to the transactions, rather than fundamental concerns over collateral performance. Although idiosyncratic counterparty-related shocks cannot be ruled out in 2009, we expect collateral performance deterioration to contribute more strongly to negative rating actions.

While counterparty problems can weaken ratings in the senior part of a securitization's capital structure if the counterparty is not replaced, collateral deterioration is most likely to damage lower-rated notes. Senior notes could remain less affected because improvements in transaction structures over time can partially compensate for collateral deterioration over the same period. This is especially true in structures that contain trigger mechanisms to redirect principal cash flows to senior noteholders if there is sufficient evidence of collateral weakness.

As we continue to refine our rating approaches over time, we cannot rule out the potential for rating actions in 2009 due to the application of revised methodology or updated quantitative assumptions. For example, we recently announced that we will soon begin to explicitly reflect credit stability as part of our ratings. Because this new approach will be applied to both new and existing ratings it may have negative implications for outstanding ratings in some asset classes that were originally assigned using our previous approach. In October, we also announced that we will no longer assign 'AAA' ratings to securitization debt instruments whose performance depends on derivatives counterparties that are rated 'A-2'. This could have an effect on some existing ratings.

RMBS: Ratings Under Pressure In Some Countries From Rising Arrears And Falling House Prices

Ratings on European residential mortgage-backed securities (RMBS) experienced significant upgrade rates in recent years, but this did not continue in 2008. While most transactions continue to benefit from the positive effect of sequential paydown-where senior notes are repaid first-the typical rate of amortization has slowed in most countries over the past year, given less attractive refinancing conditions for mortgage borrowers. At the same time, the benefits of structural amortization have, in our view, been countered to a greater extent by more rapid deterioration in the credit quality of the mortgage pools as transactions season. Until recently, downgrades in European RMBS were unusual, and most were due to concerns over supporting parties in the transactions, rather than problems with collateral performance. However, performance-related downgrades have now become more commonplace, and the number looks set to increase in some countries during 2009.

Arrears trending up in most countries, initially due to higher rates

According to data from securitizations that we rate, mortgage arrears have been rising in most countries. In many cases this has reflected greater affordability pressures on borrowers, given higher effective mortgage rates throughout most of the year and a less competitive lending environment. The German and Dutch markets have been least affected, given the popularity of longer-term fixed-rate mortgage products. However, Spanish borrowers, for example, whose loans typically have floating rates, have suffered directly from the elevated level of relevant interest rate benchmarks, such as EURIBOR (European interbank offered rate). Many Italian mortgage products have similar dynamics, though there appears to be less sensitivity to interest rates, partly due to more conservative household balance sheets. In the U.K., where many mortgage loans have a short-term fixed rate, arrears have risen most among loans coming to the end of their discount periods, as some borrowers have refinanced into a higher rate environment and others, unable to refinance due to tighter lending standards, have seen their rates revert to lenders' higher standard variable rates.

It is worth making special note of the revolving master trust transactions that account for most U.K. residential mortgage securitizations. Here, underlying credit characteristics have in most cases remained more stable, given lenders' flexibility to manage the quality of their mortgage pools to some extent. However, lower origination volumes, falling house prices, and rising arrears mean it is increasingly problematic for originators to maintain the credit quality of these pools. In 2008, we saw the first breach of a master trust non-asset trigger when the originator allowed the seller share to fall below its required minimum by not replenishing the pool with new mortgage loans. Depending on originator motivations it is possible that 2009 will see further trusts wind down as lenders re-evaluate their funding strategies.

Government and central bank interventions, if successful, should reduce the impact of affordability pressures across the European residential mortgage landscape. Although interbank lending rates remain dislocated from central bank policy rates by historical standards, the spreads between them at least seem to have stabilized. Recent sharp reductions in central bank policy rates are slowly being reflected in interbank benchmarks, with direct benefits for floating-rate borrowers, albeit sometimes delayed in cases where the rate only resets every few months. In the U.K., some borrowers who may have moved to higher variable rates after their initial discount period should also benefit.

As rates now fall, affordability gives way to unemployment concerns

However, the differing degree of mortgage loan arrears growth across different jurisdictions indicates that affordability has not been the only mechanism at play, and provides some indication of how performance could develop in 2009. In fact, arrears growth has been markedly more severe in countries where unemployment has begun to rise strongly. This in turn corresponds to countries where there has been a more pronounced housing bubble, and where economic activity and employment depend more on the real estate sector. Notably, arrears growth in Spain has to date far outpaced that in other European mortgage markets (albeit from a low base), partly due to a far greater rise in the unemployment rate (see chart 1).

We believe economic prospects for 2009 differ somewhat between European countries, with a correspondingly mixed outlook for mortgage loan defaults and RMBS rating performance. We forecast that Spain, the U.K., and Ireland will suffer the greatest GDP contraction and growth in unemployment over the coming year, and that this will continue to drive up arrears among consumers. Italy, Germany, and The Netherlands seem better positioned. They are likely less susceptible to the deflation of global housing bubbles and the broader contraction in credit availability, given lower consumer indebtedness generally and/or a less dramatic previous run-up in residential property prices.

House prices set to continue declining in some markets

The evolution in house prices also has an effect on loss severities ultimately suffered by lenders or RMBS transactions in cases where borrowers default. In countries with a long foreclosure period, such as Italy, this is less important in the short-term, and transaction cash flows will be more affected by the details of the write-down mechanisms they employ. In other cases, such as the U.K., however, the current house price environment will dictate loss severities on foreclosure.

A sharp correction in U.K. house prices has now been ongoing for more than 15 months. Given the current momentum of price declines it seems likely this trend will continue for some time. We anticipate a further nominal decline of at least 10%-15%, which would see prices return to a level where fundamental indicators of affordability-such as the ratio of prices to average earnings-had returned to their long-term averages. In Spain, while official house price data suggests only a 1%-2% decline in average prices since their peak, survey data from other sources varies widely, and is generally more negative.

House price drops will also place numerous borrowers in negative equity. Although this will not affect their ability to stay current on their mortgage under normal circumstances, it can act as a catalyst for higher default rates overall, given that it reduces borrowers' options should payment difficulties arise for other reasons, e.g., divorce or unemployment.

Junior note ratings exposed to collateral, senior to counterparty risks

These considerations of mortgage collateral performance could have an effect on the RMBS ratings we have under surveillance. However, we expect the effect to be differentiated significantly by country and by seniority in the capital structure. In U.K. and Spanish transactions negative rating actions are likely to continue in 2009. Lower-rated tranches are most likely to suffer downgrades as rising losses place pressure on excess spread, which forms a disproportionately significant part of their credit enhancement compared with more senior tranches. Spanish transactions in particular also include interest deferral mechanisms, which divert cash flows to benefit senior noteholders at the expense of the junior notes if performance deteriorates too far.

Any downgrades in German RMBS next year are likely to be based on individual circumstances, rather than due to systemic deterioration. Most of the arrears growth observed to date has been confined to a handful of transactions backed by non-standard mortgage products aimed at higher risk borrowers. For more traditional transactions, performance is flat. Dutch and Italian transactions are also likely to see only minor collateral deterioration for the reasons mentioned above, and therefore ratings should not come under significant pressure. The recently elevated level of prepayments in Italy, following the lifting of costly early repayment charges, is also likely to be supportive, although prepayment rates are now beginning to fall again.

A final issue for some RMBS (and asset backed securities; ABS) transactions is the role played by banks with 'A-2' short-term ratings, given recent changes to our counterparty criteria. Again, Spanish transactions are most likely to be affected, given the relative prevalence of 'A-2' rated institutions in that country. Going forward, we will no longer assign 'AAA' ratings to securities that depend on the performance of 'A-2' rated counterparties. In our view, support provided by 'A-2' rated derivatives counterparties would be more commensurate with issue ratings no higher than 'AA'. This will potentially cause some short-term rating volatility in Spanish securitizations, as many of the 'A-2' rated banks acting as counterparties in outstanding securitizations may find it hard to find suitably rated replacements. This could result in some downgrades to 'AAA' tranches, and indeed several potentially affected tranches are on CreditWatch negative at the time of writing.

Consumer ABS: Risks For Senior Notes Mitigated By High Payment Rates

Over the past three months, pressure on European consumers has also resulted in slight collateral deterioration for some ABS transactions. As with RMBS, however, Spanish transactions have experienced the greatest rise in arrears, in line with a more pronounced increase in unemployment. As a result, there have been some negative CreditWatch placements and downgrades, mostly to lower-rated tranches.

The short maturity of most loans and relatively high prepayment rates, combined with structural triggers in the ABS transactions, mean that ratings on senior notes are often protected from all but the most rapid collateral deterioration. For example, in certain transactions with a revolving asset pool, if delinquencies or losses rise too far, future principal proceeds are used directly to repay bondholders, quickly delevering the structure and effectively building relative credit enhancement for the rated notes. In some auto ABS transactions that are now breaching such early amortization triggers, for example, it has not been uncommon to amortize 25% of the principal balance in as little as six to nine months. This is supportive of the ratings on senior notes. However, the ratings on junior notes may be more vulnerable, as they become more exposed to an adverse selection effect once higher quality loans have been repaid and have left the pool.

New car sales fall sharply, but auto ABS performance remains stable outside Spain

In 2008, we saw the first ever downgrades in European auto ABS that were due to collateral performance rather than supporting party rating actions. Until 2008, our auto ABS index of 90+ day delinquencies, for example, had been relatively stable for several years, but the index rose by around 25% between Q2 and Q3 2008. Spanish transactions contributed most of this increase, while collateral performance in the sector's other major countries, such as Germany, France, Italy, and the U.K., still appears stable for now.

In addition to the clear concern over recession and unemployment levels, supply and demand dynamics in the used-car market, and the combined effect on used-car prices, can also play an important role in auto loan credit risk. Most loan products found in auto ABS collateral pools are secured by the financed vehicles. If the borrower doesn't repay his loan, proceeds from repossession and disposal of the vehicle typically account for the largest portion of recoveries. Used-car values also affect residual value risk for products where the borrower has the option to hand the vehicle back, and a depressed market can contribute to increased default rates if borrowers find themselves in negative equity. We expect European used-car prices to continue declining throughout most of 2009, although the experience in different countries will vary.

The trend in the number of new car registrations gives some insight into demand patterns. Data from the European Automobile Manufacturers' Association shows that new car registrations in the EU15 countries dropped by more than 15% in October 2008 compared with the same month a year earlier. Of the main countries where auto ABS is issued, the worst affected were Spain, where October registrations fell by around 40%, and the U.K., where the decline was 23% (see chart 2).

We expect total Eurozone sales in 2009 to be 6%-9% lower than in 2008, with the biggest falls in Spain, the U.K., and Italy. While this implies a weakening of demand for new cars, clearly there may not be a direct correlation with used-car values, with some planned purchases switching from new to used vehicles.

Despite a likely weakening in arrears performance and recovery rates, we still expect prepayment rates in auto ABS transactions to continue in the range of 12%-15% per year. When combined with scheduled principal payments, this acts as a powerful flow of cash that can be diverted to noteholders if needed. Excess spread also remains high in these transactions.

Given the current economic climate, one final question is how auto ABS transactions would fare in the event of a manufacturer insolvency. Within the past few months we lowered our corporate ratings on the major Michigan-based manufacturers to 'CCC+' or lower, and see a potential default of one of these players within the next 12 months as a distinct possibility.

The captive finance arms of these manufacturers are major securitizers who retain loan servicing responsibilities in the corresponding ABS transactions. However, all transactions contain a trigger that sees these duties transferred to a back-up servicer upon the originator's insolvency, if the trustee deems this to be in the interests of the noteholders. A manufacturer insolvency would also add further pressure to used-vehicle values, and our rating assumptions for stressed recovery rates consider this scenario.

Credit card charge-offs should rise next year, but senior tranches protected by high payment rate

The performance of credit card receivables backing ABS transactions that we rate has recently followed a different trend from most other European structured finance asset classes. Other forms of corporate and consumer lending have all contracted over the past 12 months or so. However, European credit card originators-mostly in the U.K.-had already substantially tightened underwriting criteria following an earlier period of collateral deterioration in 2005-2006. This has arguably placed credit card collateral in a stronger position to weather the current downturn, and performance has remained stable for the past year. During the period of worse performance in 2005-2006, our index of credit card charge-offs rose in line with rising personal bankruptcies and individual voluntary arrangements (IVAs). While personal bankruptcies have now started rising again, and are up 20% from their trough in late 2007, charge-offs have so far remained relatively stable, suggesting that the improvement in underwriting standards is having the desired effect.

Headline interest rates on credit cards remained little changed throughout most of 2008, unlike in other asset classes. From a borrower perspective, capacity to service credit card debt has therefore not reduced as materially, although sharply rising consumer prices earlier in the year would have hurt disposable incomes somewhat, and borrowers' ability to restructure credit card debt by drawing down housing equity would also have been constrained.

One concern that has been widely debated is the trend in the rate of card use. Earlier in 2008 some commentators hypothesized that high consumer price inflation, coupled with rising mortgage rates for many, could lead consumers to turn more to their credit cards in funding everyday expenses. The economic landscape has, in our view, changed significantly since then, with inflation concerns all but forgotten, and sharp cuts in central bank policy rates likely to lead to falling mortgage rates in the near term. Indeed, the overall aggregate trust balance for the credit card ABS that we rate has generally been flat or trending downwards since the beginning of 2006. In the previous downturn, utilization rates remained flat, even though originators were generally reducing the size of cardholders' credit lines.

While credit card performance has therefore neither suffered from the affordability issues nor the contraction in credit availability observed in other forms of lending, upcoming economic weakness in the U.K. will no doubt have some effect on performance.

We anticipate that credit card charge-offs will rise with growing unemployment, but will lag the onset of the economic downturn that began in 2008. As such, we expect average charge-off rates to rise over the course of 2009, perhaps by as much as a third, from their current level of around 6.4% to somewhere in the 7.0%-8.5% range. Average yield and payment rates may correspondingly fall by around 10%. Such a development in performance would essentially repeat the performance dip experienced in 2005-2006, although in this instance the cause would be economic pressure on borrowers, rather than a change in the borrower mix brought about by a decline in lending standards.

It is important to remember that lenders have numerous tools at their disposal to support yield if it comes under threat from poorer borrower performance. First, they are able to change rates on an ongoing basis. At present, there has been limited repricing activity, meaning that lenders potentially retain this option for a time when losses start to increase.

Although there has been a small drop in average payment rate, it is important to realize that payment rates in absolute terms remain extremely high, at around 15% per month-the receivables, in other words, have a very short expected life. This acts as a significant risk mitigant for senior notes in credit card ABS structures, because they can divert this heavy stream of principal cash flow to amortize the rated notes should performance begin to deteriorate significantly. Most of the seller's share of principal inflows is also used for this purpose when the trust goes into amortization mode. In such a scenario, junior notes do become exposed to the adverse selection effect inherent in accelerating senior note amortization, although these are in turn protected by triggers used to trap excess spread. For example, the 'BB' rated notes in many structures could quickly become fully backed by cash in the face of moderate collateral deterioration.

We believe that over the next 12 months the junior rated notes in some trusts will see their ratings come under pressure, given a likely increase in our assessment of their default risk, while senior notes are likely to see their ratings remain stable. Those trusts with above-average charge-off rates are, in our view, most likely to be affected. However, in the medium term we do not believe that any of the notes will default, as all the trusts we rate have a high seller share and cash trapping mechanisms that provide protection.

SME ABS: More At Risk From International Economic Pressures

We segment securitizations backed by loans to small to midsize enterprises (SMEs) into transactions motivated by balance sheet considerations, which are common in Spain and Germany, and the German arbitrage transactions backed by mezzanine loans. In our experience, nearly all Spanish SME transactions are static and amortizing. This means that scheduled and unscheduled principal prepayments can help to considerably reduce the default risk of the rated tranches over time, provided there is not too much adverse selection. However, it also means that deteriorating loans are not generally substituted from the asset pool.

Indeed, delinquencies in Spanish SME ABS have been rising significantly since early 2008 and continue to trend up very steeply. Prepayment rates in any case are starting to slow, and we expect these to keep falling with transaction seasoning as the higher quality loans leave the transactions' asset pools over the next year or so. As a result, at the time of writing we have a number of lower rated tranches in Spanish transactions on CreditWatch negative, based on credit concerns.

As mentioned above, a marked economic downturn has already materialized in Spain over the course of 2008, with particular concerns over real estate sectors. Most Spanish SME ABS portfolios contain around 30%-35% exposure to companies with activities related to real estate, such as construction, in some cases with bullet repayment profiles. Although we do not yet see clear evidence of these sectors contributing disproportionately to arrears growth, we are watching their performance closely, and higher portfolio concentrations in these sectors would pose greater concerns. We believe 2006 and 2007 vintage transactions are most exposed because they are backed by loans originated at the peak of the credit and housing boom, which may also have had negative repercussions for underwriting standards.

In Germany, while the picture for consumers is more positive than in most other European economies there are more causes for concern among SMEs, many of which will have economic links with customers or suppliers outside Germany, including the U.S. In the traditional balance-sheet transactions we expect delinquencies and defaults to rise, although the extent of any rating pressure will depend on the pace of this growth. The transactions benefit from the originating bank's ability to manage the asset pool to a certain extent via replenishments and substitutions, which may help maintain its credit quality.

In the mezzanine transactions, on the other hand, pools are static and far less granular, making ratings more susceptible to idiosyncratic risks. In these transactions we believe that the economic downturn could have a further negative effect sufficient to result in more downgrades.

CDOs: Corporate Defaults Expected To Rise In Economic Downturn

We broadly segment European CDOs into synthetic transactions, which mostly reference investment-grade corporate credits, cash transactions backed by speculative-grade leveraged loans, and CDOs of ABS, where the underlying assets may include U.S. and/or European mezzanine or high-grade structured finance securities.

Synthetic CDO ratings at risk from downgrade potential among investment-grade corporate credits

The past year has seen significant ratings deterioration among investment-grade corporate synthetic CDOs, given the crisis in various capital markets that has especially affected the ratings on entities in the financial services sectors. This initially included the "monoline" bond insurers, but later enveloped broker-dealers, retail banks, and insurance companies, and culminated in September and October with a number of high profile bankruptcy filings and government-backed restructurings. These triggered credit events in numerous CDOs we rate in Europe.

We expect the global economic downturn that began in 2008 to be negative for corporate rating behavior in general. For example, currently around 15% of issuers we rate above the 'CCC' rating category have either a negative outlook or ratings on CreditWatch with negative implications. This compares with only around 4% that have a positive outlook or ratings on CreditWatch positive. At the beginning of September, 3.0% of corporate issuers we rate were rated in the 'CCC' category or lower, compared with only 1.7% a year earlier.

Economic pressures in the coming year are, in our view, likely to be more widespread by industry sector than the financial market-related credit issues in 2008. While banks, in particular, continue to constitute a large proportion of those corporate entities exhibiting downgrade potential, the media, entertainment, and consumer products sectors are also showing signs of potential ratings stress (see "Credit Trends: Downgrade Potential Across Credit Grades And Sectors (Premium)," in "Related Articles").

The events of 2008 once again highlighted one of the key features of the synthetic CDO sector: The high degree of overlap between reference portfolios backing nominally different tranches, and hence the high degree of similarity in the behavior of the tranches' ratings. In early December, for example, we downgraded tranches in around 50% of all outstanding synthetic European CDOs, largely as a result of credit events triggered by seven financial institutions.

Looking ahead, this characteristic of the sector makes it difficult to forecast aggregate synthetic CDO rating behavior, since the outcome will as ever be highly dependent on exactly which underlying entities see any negative or positive rating developments. We recently published a list of the 50 most widely referenced corporate obligors (see "Related Articles"). Clearly, the extent to which any of these entities experience rating migration will have a greater systemic effect among CDOs than similar actions among less widely referenced entities.

Leveraged loan CLOs set to see pressure, as underlying default rates rise

The performance of leveraged loan collateralized loan obligation (CLO) tranches to date has been stable. There have been few rating actions, and none yet directly as a result of declining creditworthiness in underlying leveraged loan portfolios. However, there are already emerging signs of a downward shift in leveraged loan creditworthiness and this pattern should remain over the next 12 months. Beginning in 2008 there has been an uptick in default rates, which now stand at around 2%, and we would expect this trend to continue in 2009. Some CLOs have seen 4%-5% default rates in the portfolio.

It is worth noting that the credit quality profile in most CLO portfolios is generally now more dispersed than, for example, three years ago, when credit estimates on the underlying loans were commonly all in the 'B' rating category. Now, some deterioration in credit quality among underlying names has increased the proportion of transactions' portfolios that are rated 'CCC'. However, at the same time, the contraction in leveraged finance activity has meant that strongly performing corporate borrowers who in previous times might have prepaid their debt and re-leveraged have had this option effectively removed. Although there is still limited takeout for these names via business-to-business transactions or initial public offerings, this strategy is, in our view, generally harder to pursue in the current market climate. As a result of this "de-risking," our credit estimates have migrated upwards in a few cases. In addition, certain crossover credits rated in the 'BBB' and 'BB' range are currently available at spreads that are attractive to leveraged loan investors, which would not previously have been the case. Depending on its degree, this ratings dispersal may have some negative effect on our assessment of portfolio risk in CLO transactions.

Overall, we have seen downgrades of European leveraged loans outnumber upgrades by 3 to 1 in H2 2008, and with the increasingly severe economic outlook in most European countries, this looks set to continue through 2009.

The rating threat in this sector has arguably moved away from downward pressure on achievable collateral spreads, which remains an issue but a less pressing one. Most leveraged loan collateral is from 2007 or earlier vintages, so CLOs are locked in to the historically low spreads that prevailed at that time. As limited numbers of leveraged finance transactions continue to be done, there is at least some scope for reinvestment at current wider spreads in the long term. However, we believe that many CLO managers have reinvestment rules that may limit their freedom to take full advantage of market opportunities.

While CLO tranches are designed not to default until loan default rates in the portfolio reach far higher than current levels, we do not rule out the possibility of downgrades in 2009. However, we believe that 'AAA' and 'AA' rated tranches are typically well insulated from potential downgrade, even in scenarios where gross defaults in the portfolio over a three-year period reach more than 20%. Ratings on junior notes, however, are likely to be less robust.

As in the synthetic CDO sector, leveraged loan CLOs exhibit substantial overlap in portfolio composition between different transactions. Once again, this makes overall sector performance highly dependent on idiosyncratic rating or default events among the underlying loans: If a widely held loan experiences credit deterioration then there could be an effect on a large number of CLOs.

CDOs of European ABS not yet affected, but mezzanine transactions most at risk

We classify CDOs of ABS as European if they are managed in Europe and were therefore rated by our European team. However, around half of these transactions are predominantly backed by U.S. collateral. Ratings on CDOs backed by U.S. structured finance securities, including subprime RMBS and CDOs of ABS, have been badly affected during late 2007 and 2008. Some European CDOs of U.S. CLOs, on the other hand, have not seen an effect.

For CDOs of U.S. ABS, the principal drivers of rating downgrades have included weakness in the underlying collateral's credit quality, changes in our rating assumptions, and certain structural triggers in some transactions that effectively exposed bondholders to market value risk at a time when the secondary market for the underlying collateral has been very depressed. CDOs of European ABS have been less affected to date, but do contain exposure to various European structured finance asset classes in which we anticipate negative rating trends during 2009. These include U.K. and other RMBS, European CLOs, and commercial mortgage-backed securities (CMBS). While some CDOs of European ABS are backed by high-grade assets, most are backed by mezzanine parts of securitization structures, which is where we believe most credit quality problems will emerge.

CMBS: Pace Of Downgrades Likely To Increase Materially

The European CMBS market continues to face exceptionally tough conditions, given weakness in the underlying commercial real estate sector and ongoing strains in capital markets. While current data suggests a fairly moderate effect to date, we believe that both term and refinance risks are on the increase, and expect loan performance to deteriorate further in 2009. Certain structural features have also exacerbated strains in some transactions. Downgrades in European CMBS exceeded upgrades for the first time during 2008.

The lower number of upgrades in 2008 was primarily attributable to a sharp slowdown in prepayments, given a significant contraction in lender appetite and therefore refinancing activity. At the same time, some deterioration in loan performance following a 10-year period of almost no loan defaults seems inevitable as economies weaken and the dislocation in credit markets continues. We believe these factors will translate into lower occupier and investment demand, which will place additional stress on borrowers and on market values.

Although non-payment has arisen on only 11 senior loans to date, or just over 1% of our European CMBS surveillance universe, we expect the number of delinquencies to rise rapidly in the short term. Commercial real estate values have declined significantly, and will continue to do so, in our view. Falling market rents will further augment rising capitalization rate and several markets could see their largest ever peak-to-trough decline in real estate values.

Creditworthiness concerns

We recently announced that we will soon begin to explicitly reflect credit stability as part of our ratings, and this approach will be applied to both new and existing ratings (see "Standard & Poor's To Explicitly Recognize Credit Stability As An Important Rating Factor," in "Related Articles"). We are actively considering the implications of this with regard to European CMBS, where many transactions are backed by a single loan, which gives rise to certain cliff risks. There is a binary nature associated with any single loan, particularly if it is associated with only one property. Even so-called "pool" transactions in European CMBS rarely have more than 20 loans, and even these transactions are often dominated by one or two loans.

Most European transactions have periods between loan maturity and legal final maturity that are less than four years. We consider this period to be short in the context of legal final maturities in other areas of structured finance. In summary, we are examining whether European CMBS transactions, having regard to their structural characteristics, are consistent with a rating definition that emphasizes creditworthiness rather than narrowly focusing on default risk.

We are also considering counterparty issues. We have already seen refinements to our counterparty criteria this year, and our ongoing review could result in further changes. Counterparties can play a particularly important role in single-loan transactions, as timely payment of interest to 'AAA' rated notes may be wholly or partly dependent on the performance of that counterparty.

Real estate credit concerns are also important. We believe that parts of the European commercial real estate market may experience a severe recession and we are evaluating how we should change ratings through the capital structure given that outlook. Real estate credit-related concerns can rarely be addressed by a broad brush approach, so the idiosyncratic nature of European CMBS means we need to tailor a headline sector view to the specifics of the property, loan, and transaction.

The era after Lehman

In our article on the impact of Lehman entities in European CMBS (see "European CMBS-Living With Enduring Uncertainty," in "Related Articles"), we flagged our concerns that the effect of September's and October's events on the bank market could have profound implications for our opinions on commercial real estate debt. This concern arises because commercial real estate is a heavy user of finance, and banks have played an important role as investors in commercial real estate through fund sponsorship. Over mid-2008, we were contemplating losses for some 'A' rated notes, particularly from 2011 onwards in certain stress scenarios. Our scenario analysis article of Sept. 25 postulated losses at 'AA' in a severe stress scenario. Arguably the events of September and October are the precursors of a severe stress occurring and perhaps enduring.

We are continuing to develop our analysis, taking into account all relevant factors, and we may conclude that increased subordination would be required to achieve a given rating for certain existing and new transactions. We hope to conclude our assessments shortly after the first quarter of 2009.

ABCP: Some Downgrades In 2008, But Portfolio Quality Remains Stable

There were two opposing stories in the ABCP sector during 2008. On the one hand, the ratings performance of assets held within ABCP programs remained stable. On the other hand, investor demand for this form of paper has waned considerably over the past year, in our view, and the balance of ABCP outstanding has fallen by around 50% from its peak, returning to the level of three years ago.

Conduits generally are actively managing existing portfolios. Multiseller conduits are tightening terms and conditions for existing sellers, raising enhancement levels, tightening triggers, and revising pricing. Whereas previously competition for new sellers was intense, with a focus on high volumes and low margins, the focus has now shifted towards a high-margin, lower-volume business serving clients of the sponsor. The European ABCP market in 2008 has been severely restricted, but there are tentative signs of firming investor demand, especially from the U.S. Conduit portfolios are also expanding again as sponsors seek to benefit from the Federal Reserve's commercial paper funding facility (CPFF) and the European Central Bank's repo capability (see our latest quarterly ABCP report card "EMEA ABCP Conduit Ratings Affected By Negative Rating Actions On Banks" in "Related Articles" for more details).

In 2008, we downgraded five programs, and three further programs are on CreditWatch negative at the time of writing, in all cases due to corresponding rating actions on a supporting counterparty. We also upgraded three programs during the year because of supporting party actions. We haven't taken any rating actions to date due to underlying collateral performance.

We expect broadly negative ratings development across various European structured finance asset classes in 2009, and this could have implications for the credit quality of assets held in ABCP conduits. However, the assets held by conduits tend to be highly-rated, reducing the scope for a significant effect. In addition, conduits generally have "stop purchase" and/or "stop issuance" triggers linked to collateral performance or ratings, which help limit the extent of asset deterioration. Also, we believe that conduit sponsors are likely to have an incentive to continue managing the quality of their portfolios to support investor demand and maintain the alternative funding that the ABCP market offers. As previously in 2008, we cannot rule out further rating actions related to supporting party downgrades, which in many cases would lead to a corresponding rating action on the ABCP program.

Related Articles

Surveillance Credit Analyst - Research:
Andrew South, London (44) 20-7176-3712;

Surveillance Credit Analyst - ABCP:
Andrea Quirk, London (44) 20-7176-3736;

Surveillance Credit Analyst - ABS/RMBS:
Stuart Nelson, London (44) 20-7176-3621;

Surveillance Credit Analyst - CDO:
Gordon Wright, London (44) 20-7176-8407;

Surveillance Credit Analyst - CMBS:
Michelle Weston, London (44) 20-7176-3646;

Surveillance Credit Analyst - Servicer Evaluations:
Beverley Dunne, London (44) 20-7176-3957;

Country Contact - France:
Nicolas Malaterre, Paris (33) 1-4420-7324;

Country Contact - Germany:
Volker Laeger, Frankfurt (49) 69-33999-302;

Country Contact - Italy:
Roberto Paciotti, Milan (39) 02-72111260;

Country Contact - Spain:
Jose Ramon Tora, Madrid (34) 91-389-6955;

Head Of European Surveillance:
Simon Collingridge, London (44) 20-7176-3841;

All criteria and related articles are available on RatingsDirect, the real-time Web-based source for our credit ratings, research, and risk analysis, at www.ratingsdirect.com. The criteria can also be found on our Web site at www.standardandpoors.com.

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