This is the first of our two-part 2011 outlook for the global securitization markets. Part 1 includes the macro economy, regulations, CMBS, Europe, and Canada. Part 2 will include RMBS, ABS, CLOs, and an additional section on covered bonds.
The structured finance markets are in slow recovery mode across the globe, but face some headwinds from regulatory changes and potential further declines in collateral performance. In looking ahead into 2011, our outlook examines seven key signposts and an additional section on Canada:
- Macro outlook: Modest GDP growth; Fed on hold until 2012;
- Regulation: More certainty, increased costs, but muted near term impact for most sectors;
- CMBS: Issuance will pick up to approximately $35 billion for the year; collateral concerns remain;
- Europe: RMBS leads the way; the North and South divide;
- RMBS: Minimal issuance in 2011; home prices will remain weak;
- ABS: Issuance is steady; credit problems are limited; and
- CLOs: Issuance is reviving; credit is stabilizing.
The Macro Outlook: Slow Recoveries Expected For Both The Economy And The Structured Finance Market
The U.S. economy is recovering, but slowly. As we head into 2011, several elements are at play that will affect which direction the environment heads next year.
Economic recovery, although weak; low level of interest rates; and a reduction in structured finance securities outstanding.
Uncertain regulatory environment; and a further dip in house prices.
Standard & Poor’s Rating Services’ forecast for the U.S. economy is consistent with our outlook for a slow recovery in structured finance markets. Standard & Poor’s economists are calling for modest real GDP growth and little change in the unemployment rate next year. Interest rates should remain low, with the Fed funds rate on hold until 2012, according to our economists’ forecast. In our view, U.S. housing prices will be weak this winter and decline an additional 7%-10% next year.
For 2011, we are forecasting real GDP growth of 2.4% and an average unemployment rate of 9.5%. We estimate an average Federal funds rate of 0.1% and a yield of 2.6% for 10-year U.S. Treasuries. Our economists project year-over-year Consumer Price Index inflation of 1.7%, and core inflation of 1.5%.
Standard & Poor’s economists David Wyss and Beth Ann Bovino made the following observations in “The More Things Change…,” published November 11:
- The shift in Congressional power makes any major policy initiatives unlikely for the next two years.
- The deficit is likely to narrow over the coming years, even without major policy changes. A stronger economy and the end to stimulus spending could cut the deficit in half by fiscal 2015. But Federal debt will still climb to 72% of GDP from the current 62%.
- Consumers are becoming a little less scared and are starting to borrow and spend again.
- The housing market appears to be stabilizing. We are holding to our forecast of a 7%-10% drop in home prices, hitting bottom in spring 2011 near the April 2010 lows.
- We expect the Federal Reserve to stop its quantitative easing policy at the end of the second quarter.
We expect that the total amount outstanding of rated structured finance securities will continue to decline in 2011. By the end of the year, the amount could fall as low as $3.5 trillion, $2 trillion below the peak in 2007. The flow of funds back to investors should help support demand for new issues. We project that CMBS, CLO, and European RMBS issuance will pick up next year, in our projections, but levels will be far below the peaks they reached a few years ago. U.S. RMBS issuance will remain minimal, in our estimate, and low interest rates will help mitigate refinance risk in 2011.
Regulatory uncertainty poses questions for issuers and investors going into 2011. For most sectors, however, we expect a muted impact, with little effect on new issuance. For a closer look at these issues, please see the regulation discussion later in this report.
The 2011 Regulatory Landscape For Securitization: More Certainty Likely To Set A Positive Tone
by Zachary Wolf
Changes in the regulatory landscape have been one of the most dominant themes in the financial markets during the past year, especially for the securitization market, and we believe it will remain in the spotlight in 2011. The focus, however, in our view, will likely shift from what type of regulations will come and when will they go into effect to how will the new rules will be implemented and what challenges will they bring.
Last year the regulatory uncertainty cast a shadow on securitization markets and likely played a role in keeping issuance subdued in 2010 (in addition to other factors that also contributed to lackluster issuance this year). A high degree of uncertainty does remain in our opinion, but the general boundaries of financial regulation appear to have been set and more certainty (as marginal as it may be) likely sets a moderately positive tone for the securitization market heading into 2011.
While we expect issuance for many securitization markets to increase in 2011, the cost associated with securitization due to many newly enacted financial regulations will likely rise and may present some near-term challenges for the securitization markets to navigate next year. These increased costs can generally be separated into two categories:
- Costs associated with additional capital requirements on an issuer’s balance sheet, such as any mandated credit risk retention, and additional capital requirements due to implementation of the new Basel capital requirements; and
- Costs associated with the implementation and operational elements of the new regulations, such as additional reporting and disclosure requirements.
These costs, as well as any additional ones that may arise as the financial regulations are implemented, are a wildcard for the securitization markets going forward. The added costs will likely affect pricing on structured finance securities as issuers may attempt to pass-on these costs to investors.
Taking Stock Of This Year’s New Regulations
The regulatory changes to the structured finance markets that took place over the last year were quite significant. The litany of changes and proposals came on multiple fronts and from multiple regulatory and legislative bodies.
The Financial Accounting Standards Board’s (FASB’s) newly formed accounting standards for securitizations went into effect Jan. 1, 2010. FAS 166 establishes new guidelines for whether the securitization of assets should be treated as a sale or financing for accounting purposes, and FAS 167 establishes new guidelines for which legal entities, such as special-purpose vehicles (SPVs), should be consolidated on a company’s financial statements. FAS 166/167 essentially require any entity deemed a primary beneficiary of the securitization to consolidate the entire securitization on its balance sheet for accounting purposes. A primary beneficiary is generally defined as an entity that meets two qualifications: it has the power to direct activities that have a significant impact on the SPV’s economic performance and it has an obligation to absorb losses of the SPV or the right to receive significant benefits from the SPV (e.g., retaining a first loss piece of the SPV). This change prompted many institutions to consolidate entities that were once treated as off-balance-sheet assets.
SEC’s Proposed Amendments To Reg AB
On April 7, 2010, the SEC issued its proposed amendments to Regulation AB. Generally, the proposals focus on greater disclosure and initiatives to safeguard investors. Specifically, the proposal includes a mandated 5% credit risk retention for each tranche being sold or transferred to investors–a so-called “vertical slice.” The risk retention proposal would only apply to universal shelf registrations and delayed shelf offerings and would not apply to privately placed transactions (e.g., 144A) or publicly issued transactions that aren’t eligible for universal shelf registrations and delayed shelf offerings. For more information, please see “Structured Finance Week: What Credit Risk Retention Rules Might Mean For The U.S. Securitization Market,” published Sept., 23, 2010.
SEC Rule 17(g)5
Nationally Recognized Statistical Rating Organizations (NRSROs) were required to be in compliance with SEC rule 17(g)-5(a)-(b) on June 2, 2010. Essentially, Rule 17g-5 requires issuers, sponsors, or underwriters (arrangers) to post on a password-protected Web site all information they provide, or contract with a third party to provide, to an NRSRO for determining an initial credit rating or for conducting surveillance. Rule 17(g)-5 is intended to provide NRSROs that are not hired by an arranger to rate a structured finance product covered by the rule to have access to the same information that hired NRSROs have access to so that they can issue unsolicited ratings and monitor them. To be compliant with the rule, any NRSRO that accesses such information on an arranger’s 17g-5 Web site must commit to providing ratings for at least 10% of the deals for which they obtain information if they access such information for 10 or more structured finance products in the calendar year. European regulators have floated the idea of adopting similar rules.
The Dodd-Frank Wall Street Reform And Consumer Protection Act
The Dodd-Frank Wall Street Reform And Consumer Protection Act, which has been deemed by many as the most significant piece of financial reform legislation since the New Deal was signed into law in the 1930s, was signed into law on July 21, 2010. For the securitization markets, the Dodd-Frank Act’s mandates for credit risk retention are key focal points. This area of the legislation, which stipulates that “securitizers” retain a 5% first-loss position of the securitization, is aimed at aligning the interests and incentives of securitizers with those of potential investors. The legislative belief is that risk retention will motivate issuers to increase the quality of the assets they securitize and reduce the risk of poor asset performance because lax underwriting standards. The Dodd-Frank Act explicitly recognizes circumstances under which credit risk retention would not be required and where alternative forms of risk retention would be acceptable, such as allowing B-piece buyers in commercial mortgage-backed securities (CMBS) transactions to fulfill the requirement. The Dodd-Frank Act leaves the specific risk retention regulations to be issued by various regulators, including the SEC, FDIC, the Fed, and others, no later than April 18, 2011. For more information, see “Structured Finance Research Week: What Credit Risk Retention Rules Might Mean For The U.S. Securitization Market,” published Sept., 23, 2010.
- Other notable provisions in the Dodd-Frank Act include: parties involved with a securitization are prohibited from engaging in activities that constitute a material conflict of interest with asset-backed securities (ABS) investors (with certain exceptions) for one year from the transaction’s closing date;
- The removal of statutory references to rating agencies from such statutes as the Exchange Act, the 1940 Act, and the Federal Deposit Insurance Act ;and
- The repeal of the NRSRO exemption to Rule 436(g) of the Securities Act with respect to expert liability.
The Dodd-Frank Act also contains provisions that require mandatory clearing and specific margin requirements, which may affect the use of derivatives in structured finance transactions because structured finance entities generally do not post collateral. For more information, see “The Financial Reform Act’s Potential Implications For Derivatives In Structured Finance Transactions,” published Sept. 30, 2010.
The New Article 122a Of The European Union’s Capital Requirements Directive
Among the earliest and most securitization-focused proposals raised for regulatory reform in Europe, the new Article 122a of the Capital Requirements Directive (CRD2) take effect for new stand-alone transactions in January 2011. Among other things, the new rules place an onus on regulated credit institutions that invest in securitizations to ensure that the originator has retained a minimum level of risk exposure and to demonstrate that the investing institution has suitable due diligence and surveillance processes in place. There are also heightened disclosure requirements for originator credit institutions.
On Sept. 12, 2010, the Basel Committee on Banking Supervision announced revisions to the international regulatory framework for banks. The updated framework includes stricter requirements for how banks treat structured finance assets in the calculation of each bank’s capital requirements. Some of the changes include the application of a 1250% risk weight to some lower-rated and unrated securitization exposures, more conservative collateral haircuts for securitization collateral with respect to counterparty exposure, and the introduction of specific risk haircuts for securitization exposures when calculating the capital requirement related to market risk. For more information, see “Tougher Capital Requirements Under Basel III Could Raise The Costs Of Securitization,” published Nov. 17, 2010.
The FDIC’s Updated Safe Harbor Rule
On Sept. 27, 2010, the FDIC finalized its new rule on the treatment of financial assets that have been securitized by an insured depository institution (IDI) in the event of its conservatorship or receivership. The final rule makes qualification for FDIC safe harbor contingent on compliance with specific provisions and conditions related to securitizations, such as risk retention. The rule also sets additional provisions (e.g., tranche limitations, servicing powers and standards, prohibition of external credit support) specifically for residential mortgage-backed securities (RMBS) transactions. The rule provides grandfather provisions for master and revolving trusts and will ultimately adopt the same risk retention requirements as the Dodd-Frank Act. The final rule establishes two types of safe harbors for securitizations: one for those that qualify for sale accounting and are off-balance-sheet and another for those that must be consolidated on an issuer’s balance sheet. For more information, see ” Understanding The Regulations: A Look At The FDIC’s Updated Safe Harbor Rule,” published Oct. 13, 2010.
We would view a harmonization of these various regulatory rules and policies as a positive development for the securitization market. One coherent and consistent set of regulations may likely allay many concerns that market participants have about the impending regulations.
2011 Will Likely Be A Year Of Transition And Diminished Uncertainty
Given the changes that were introduced in 2010, it seems that discussions within the securitization markets will continue to focus on financial regulations and their impending applications. As market participants continue to implement changes to comply with the new regulations, many of which go into effect next year, it’s likely that some unforeseen challenges, and perhaps some unintended consequences, will arise.
In the U.S., 2011 begins as the FDIC’s updated safe harbor rule takes effect (for transactions issued Jan. 1, 2011 and thereafter). Banks may attempt to circumvent the new rules by issuing securitizations through non-IDI entities to avoid being subject to FDIC’s new securitization conditions. They may also seek to rely on legal true sale opinions, which put the assets beyond the reach of the FDIC acting as receiver in an insolvency of the IDI, to avoid having to comply with the new conditions (even though the FDIC seems to believe that the assets would still be within their reach in this situation). For issuers that aim to comply with the new conditions, logistics surrounding additional and more granular asset reporting and disclosure will need to be put into place. Additionally, even though the FDIC will adopt the credit risk retention guidelines outlined in the Dodd-Frank Act, the safe harbor rules will only adopt those guidelines when those rules go into effect. Until then, issuers will be required to retain a 5% exposure of each tranche from the securitization or retain a representative sample of not less than 5% of the principal balance of the assets being securitized.
Meanwhile in Europe, the start of 2011 will mark the first raft of new securitization-focused regulation going effective in the form of CRD2. As in the U.S., much attention has been focused on the new rules regarding originator risk retention. However, given less widespread adoption of so-called “originate-to-distribute” business models in Europe, we anticipate that this element of the new regulations will not substantially alter most originators’ motives to securitize. Given a wide range of forms of risk retention that are considered eligible–including a vertical slice of the notes, a first-loss position, keeping equivalent underlying assets on the balance sheet, and maintaining a certain minimum seller share in a master trust structure–we anticipate that most European originators probably already meet the 5% retention threshold. Much of recent European issuance has been from U.K. prime RMBS master trusts, and the new retention rules will not apply to these revolving structures until some years later.
Other new measures in CRD2–including investor due diligence and monitoring requirements, as well as heightened originator disclosure–in principle, do not look set to materially alter regulated investor or originator motivations to participate in the securitization market. However, details on how the new rules will be applied in practice remain a key uncertainty.
The next significant date on next year’s calendar is April 18, 2011, which is when the SEC, FDIC, Fed, OCC, HUD, and FHFA will issue risk retention regulations. In October 2010, the Board of Governors of the Federal Reserve System submitted a report to U.S. Congress on risk retention as required by the Dodd-Frank Act. The report recognizes that a one-size fits all approach for risk retention is not prudent given the heterogeneity of asset classes and securitization structures. The report provides recommendations and guidelines that regulators may want to consider when tailoring the credit risk retention provisions for the different asset classes. In our view, this report was a positive development and provides market participants with some insight and clarity into how the risk retention rule may ultimately play out.
We expect that the SEC will issue its final amendments to Reg AB sometime in 2011, but only after much of the rule-making prescribed by the Dodd-Frank Act is completed. We also believe that the SEC may adopt the same or similar risk retention policy as the Dodd-Frank Act, especially now that the FDIC has done so. This would further reduce market participant concern regarding multiple and inconsistent risk retention standards.
Regulators will likely attempt, in our view, to further mitigate market uncertainty with additional clarifications and addendums going into next year. For example, the SEC recently removed some uncertainty in the public issuance markets by stating that it will extend its “no action letter” and indefinitely allow structured finance issuance without rating disclosures, which Reg AB now requires. This announcement followed a previous six-month exemption that was prompted by the Dodd-Frank Act’s repeal of the exemption afforded under Rule 436(g) to credit rating agencies with respect to expert liability for purposes of Section 11 of the Securities Act.
There are many questions and unknowns regarding financial regulations and their impact on the securitization markets that may remain well beyond 2011. However, we believe that as the securitization market transitions from the rulemaking stage of financial regulation to the actual implementation stage next year, more uncertainties will be resolved and the increase in costs will become more understandable. In our view, this evolution may provide a moderately positive backdrop for new securitization issuance in 2011.
Recovery Is In Sight For Commercial Real Estate And CMBS As 2011 Approaches
by James M. Manzi, CFA
After an extensive period of notable hardship, 2010 finally brought with it some tailwinds for the U.S. commercial mortgage-backed securities (CMBS) and commercial real estate (CRE) sectors, though some headwinds certainly remain. Absent a double-dip recession, we expect the ongoing recovery for CMBS/CRE to continue to strengthen into 2011, albeit at a moderate pace.
Before we delve into our forecast for 2011, it’s worth noting how CMBS/CRE trends shifted throughout 2010 (see table 1). The following trends have helped shape our outlook for the coming year:
- Trading spreads tightened strongly;
- New issuance of CMBS increased somewhat,
- Year-over-year sales volume are projected to nearly double;
- The volume of distressed loans is up markedly (as are resolutions);
- CRE prices have increased in the larger, primary markets (mostly coastal), though on a national basis they’ve barely budged; and
- The tone within news articles on CMBS and CRE has softened.
Table 1 | Download Table
|2010 CMBS Review|
|Metric||Late 2009/early 2010||November/December 2010|
|1. Recent vintage super senior spreads||Swaps + 480 bps||Swaps + 250 bps|
|2. Recent vintage AM class dollar prices||High $70s/Low $80s||Many trade near, or even north of par|
|3. Issuance (annual)||$3.0 billion (2009)||approximately $10 billion|
|4. Active originators of loans for Securitization||approximately 5||approximately 20-25|
|5. Sales volume (RCA)||$54.4 billion||approximately $100 billion projected|
|6. Overall CMBS delinquency||5.15% ($30.6 billion)||8.26% ($46.2 billion)|
|7. Outstanding distress (RCA)||approximately $175 billion||approximately $186.5 billion (October 2010)|
|8. Overall CRE price change since 10/2009 (RCA)||N/A||+1% (3Q 2010)|
|9. CRE price change since October 2009 (RCA) for New York, Los Angeles, San Francisco, Washington D.C., Chicago, and Boston only||N/A||+19% (3Q 2010)|
|10. CMBS/CRE-related newspaper/media headlines||Articles are almost exclusively negative in tone, with the exception of some positive news regarding TALF and the first new issue deals (DDR, Flagler, Inland-Western) since 2008||Some negative stories regarding legacy collateral, many positive stories regarding “signs of life” in CMBS new issuance market|
|AM class–[20% credit enhanced at issue]. N/A–[not applicable]. Bps–basis points. RCA–Real Capital Analytics. Sources: Trepp, Commercial Mortgage Alert, RCA, Bloomberg, Standard & Poor’s.|
New Issuance Will Reach $35 Billion, But Spreads And Financial Regulations Are Potential Wild Cards
Our current forecast is that new CMBS issuance in 2011 will total $35 billion. We based this projection on a regression analysis relating the amount of new issuance to CMBS spreads and treasury yields, with adjustments for qualitative factors, such as the number and size of issuers/originators and the impact of new financial regulations.
The increase in lenders within the CMBS space between early 2010 and now is one reason to expect higher issuance in 2011. Between traditional legacy firms (e.g., Bank of America, J.P. Morgan, Wells Fargo) and nontraditional new entrants to the market (e.g., Basis Real Estate Capital, Ladder Capital, Starwood Property), there are now 20-25 active lenders operating in this space (compared with about five at year-end 2009). In addition, we expect that a couple more conduit issuance shelves will be formed, or reopened in early-mid 2011.
We have already stated to see an increase in originations. Specifically, the Mortgage Bankers Association reported that third-quarter 2010 commercial mortgage loan originations were 32% higher than during the same period last year and 15% higher than in second-quarter 2010. It’s also worth noting that in some situations, some of the nontraditional lenders with real estate expertise have expressed the willingness to finance (or find financing for) the share of remaining debt between what can currently be securitized and the value of the mortgaged property (i.e., the debt that is held outside of the CMBS trust). This would certainly help underwater borrowers with maturing loans who are seeking refinancing for their properties that are now worth less than the mortgage note due to recent price declines.
Due to the large number of originators and the fact that most seem to be increasing their lending volume, we believe that additional spread tightening could push issuance above our $35 billion projection because tighter spreads would likely lead to higher profit margins, at least temporarily.
The effect of new financial regulations (Dodd-Frank Act, the SEC’s proposed amendments to Regulation AB, the FDIC’s Safe Harbor Rule, etc.) are potential wild cards in the new issuance arena. While we don’t believe that these regulatory efforts will have a considerably harmful impact on CMBS issuance volume, some uncertainty remains as to what the final versions of each rule will look like. This lack of clarity could delay or slow activity in the short term, as issuers may opt to focus their resources on developing solutions to address regulatory uncertainties rather than originating loans and issuing securities.
There is additional uncertainty about the treatment of B-piece buyers. As the regulations stand now, it appears that a B-piece buyer satisfies the risk retention requirement present in most of the regulations. If this changes, such that issuers have to hold a first-loss tranche or portion of the securitized assets, issuance volume would likely fall well below our forecasted amount. Furthermore, under this scenario, due to the proposed terms of the amendment to Reg AB, we would likely see a shift in issuance toward 144A private placements, which would significantly restrict the investor base.
Deals Will Likely Become More Standardized, Albeit Slowly, In 2011
2010 vintage transactions introduced some new structural terms that we’ll likely continue to see in 2011 deals. For example, the documents for Goldman/Citigroup’s August 2010 conduit transaction gave special servicing “control” rights, traditionally the domain of the B-piece buyer, to the senior buyers in the capital structure. J.P. Morgan’s October 2010 deal also included senior investor “protections,” some of which were new. Among them were:
- The use of appraisal reduction amounts (ARAs) for determining control rights (versus actual realized losses);
- Pentalpha Surveillance was hired as a “senior trust advisor” to monitor the performance of the deal’s special servicer (Midland Loan Services);
- Prospective investors were given a copy of the securitization’s pooling and servicing agreement (PSA). PSAs haven’t traditionally been released for offerings issued privately under SEC Rule 144A; and
- The offering documents included a full description of the representations and warranties provided to investors rather than just a summary.
A Deutsche Bank conduit offering (part of the COMM shelf) in October 2010 that followed the J.P. Morgan led-deal contained similar provisions with regard to considering projected losses and ARAs (not just realized losses) when calculating special servicing control rights. Then, an issue from Wells Fargo/Bank of America (October 2010) added one twist relating to valuing troubled properties within the trusts: an independent firm, aside from the B-piece buyer, would also be hired to produce appraisals that the special servicer has to reconcile. Hence, the shifting of control rights could be somewhat influenced by an independent third party.
We believe issuers will continue to adopt many of these new terms and that many of the items will slowly become standardized at some point within the next year or two. However, given that no deal since the first Goldman/Citigroup conduit offering gave the senior buyers special servicing control rights, we don’t believe that this structural twist will appear again.
With respect to other predictions for 2011 deals, we think that:
- Deals will gradually rise in size and probably include more contributors. Sizes, however, should remain well below those of the typical 2006-2007 vintage transaction;
- Loan-to-value (LTV) ratios will rise gradually inside and outside the trust as lending conditions improve. Competition among many active lenders will probably drive LTVs a bit higher than the very conservative levels we have been seeing (high 50s – low 60s), but investors will likely not tolerate any large increases in this metric without demanding significant spread compensation;
- Debt service coverage ratios will likely not come down, as interest rates are likely to stay at relatively low levels;
- Issuers will continue to seek alternatives to traditional interest-only (IO) structures, given changes in the way some rating agencies evaluate the credit risk inherent in those securities; and
- There will likely be more diversity by property type as fundamentals improve (the collateral for most 2010 pooled deals was concentrated in either retail or multifamily).
Five- And Seven-Year Loans Face The Biggest Refinancing Hurdles In 2011
Our estimates show that roughly $49 billion ($33 billion fixed-rate, $16 billion floating-rate) of CMBS matures in 2011. Considering our $35 billion CMBS issuance for the year, that leaves at least a $14 billion shortfall (i.e., if all of the new bonds represent refinancings), which represents less than one-half of 1% of the more than $3 trillion of commercial and multifamily loans outstanding. However, while the amount of maturing loans in CMBS is small compared with the overall commercial mortgage market, these loans will have to compete with the roughly $300 billion of commercial real estate loans maturing next year, according to data from Real Capital Analytics.
Table 2 | Download Table
|CMBS Fixed-Rate And Floating-Rate Maturing Loan Balances, 2011-2017|
|Sources: Trepp LLC, Standard & Poor’s.|
About 40% of the fixed-rate U.S. CMBS loans coming due in 2011 were originated in 2001 or earlier. These loans should benefit from price appreciation over their 10-year lifetimes and the fact that long-term commercial mortgage rates remain historically low. Five- and seven-year loans, which make up 45% and 12% (both figures include floating-rate product), respectively, of the total amount of CMBS loans maturing next year, may be a different story. Even though mortgage rates remain depressed, many of these shorter-term loans (especially five-year product in nonprimary locations) are not likely to benefit from price appreciation given that overall national CRE prices are down some 43% peak-to-date. In addition, the loans in the floating-rate deals are typically collateralized by unstable properties that are in transition due to a recent renovation, the loss of a significant tenant, a market repositioning, or even a change of use. These loans are generally originated with the assumption that cash flows will increase to a stabilized level after the property is complete and operational. Achieving stabilization has been difficult for many of the properties, however, given economic conditions, which may make it more challenging for borrowers when these loans come due for refinancing. As such, these short-term loans (both fixed- and floating-rate) could experience considerable losses. Borrowers of shorter-term loans may have trouble meeting refinancing hurdles into 2012, as $30.5 billion of the approximately $59 billion set to mature has a five-year term ($9.3 billion is seven-year product). These loans were originated near the time when market valuations peaked in early 2008.
Spreads May Tighten As Supply/Demand Dynamics For CMBS Shift
We expect to see more maturing loans than new issuance in 2011 and probably into 2012. Also, as the market continues to thaw, more loan liquidations (as opposed to extensions) will put money back to investors, which they, in turn, must put to work (i.e., re-invest). With Treasury yields low and spreads on many competing assets (with similar perceived risk profiles) tight, many investors may be looking to put this “roll-off” back into CMBS. This should keep the demand for CMBS investments robust, especially new issue paper, which generally doesn’t carry any legacy issues and still offers a decent spread. However, that’s not to say that investors who are willing to do the credit work won’t continue to find opportunities for higher yields in the secondary market. Indeed, we saw this already in 2010, as selected AM and AJ classes appreciated, on average, about 50 percentage points on a dollar price basis (percentage of par) due to robust demand. We’ve also heard of investors moving into select (originally rated) ‘AA’ and ‘A’ paper from earlier vintages in search of better returns.
High Unemployment Will Keep Significant Rental Growth In Check, And Two Sectors Are Already Rebounding
Standard & Poor’s economists are forecasting real GDP growth of 2.4% for 2011 and an average national unemployment rate of 9.5%. The elevated unemployment rate will likely keep the recovery in CRE fundamentals to a moderate pace, as employment directly or indirectly affects all five major property types (see table 3).
Table 3 | Download Table
|Rental Growth Rates, 2009-2012P|
|Sources: CBRE/Torto Wheaton Research, Smith Travel Research, PriceWaterhouseCoopers, PKV Hospitality Research, and HVS Global Hospitality Services, Standard & Poor’s.|
With new nonresidential construction likely to remain low, this nascent CRE recovery depends mainly on the demand side of the equation. Trends are already improving for lodging and multifamily, as both sectors appear to be benefitting from tailwinds: lodging is getting a revenue per available room (RevPAR) boost from higher occupancy stemming from moderately increased business spending (room discounts no doubt helped), and multifamily housing is experiencing increased demand due to much stricter underwriting standards (especially the requirement of 20% down payments) and concerns that home appreciation may be on hold for a while.
Delinquencies Are Slowing But Loss Severities Remain Elevated
After growing rapidly during between second-half 2008 and first-half 2010, delinquencies slowed during the latter half of 2010. We expect modest growth (up to the 9%-10% range) in the delinquency rate during 2011, though borrowers seeking to refinance shorter-term loans could add some upward pressure to the overall number (including in 2012). Loss severities remain elevated (and may remain historically high during 2011), but differ widely by property type and geographic location.
At the end of October, the delinquency rate stood at 8.26% and the amount delinquent totaled $46.2 billion. Even though fundamentals are only improving modestly and property values only seem to be growing in the largest coastal markets, there are two factors that suggest that delinquency growth will continue to moderate in 2011: the ratio of new delinquencies to loan resolutions is narrowing and loan modifications remain high.
According to Standard & Poor’s CMBS group, the ratio of new delinquencies to resolved loans in the first quarter was 3.36 to 1. The margin then declined in the second quarter to 2.46 to 1, and then narrowed further to 1.25 to 1 in the third quarter. Data from RCA also suggests a similar trend, but its measure of “distressed” loans includes loans from all sources, not just CMBS. RCA’s distressed loan measure notes a significant climb in the number/balance of workouts climbing toward the end of 2010. In the third quarter, RCA reported a ratio of 1.15 to 1 for new distressed loans versus worked out loans. And in October, preliminary data showed that workouts actually outpaced the volume of new distressed loans by a margin of $6.2 billion. Perhaps funds similar to PIMCO’s announced “Bravo” platform, which it said will raise $1 billion to buy troubled commercial and residential assets from banks, will help this trend to continue.
In an October podcast, RCA projected a further 50%-75% increase in year-over-year transaction volume in 2011. With all major property sectors now experiencing positive sales momentum, we expect to see more liquidations in 2011, as special servicers move aggressively to dispose of distressed assets. We believe that smaller balance loans are more likely to be liquidated than modified due to their disproportionately higher specially serviced fixed costs. Properties located in tertiary markets (and weaker properties in secondary markets) may also experience more liquidations than modifications, as we don’t expect pricing improvement for these markets in the near term.
Loan modifications and extensions may remain high for larger sized maturing loans whose borrowers are having trouble finding more permanent financing. We expect larger size loans to continue to be modified to the extent that it makes economic sense (i.e., existing cash flow results in an acceptable debt service coverage ratio for the amended loan that is expected to remain at that level or improve), which should constrain any notable upward momentum in the delinquency rate.
During the second and third quarters of 2010, loss severities on about $4.3 billion worth (par value) of liquidated assets averaged around 45%-48%, down from a little over 50% in 2009. Loss severities varied relatively widely by property type, as retail and health care experienced severities of 60% during the third quarter while office, industrial, lodging, and apartments saw severities of 36%-48%. We expect the overall loss severity to drop slightly in 2011 as property fundamentals improve and pricing picks up modestly, but not by very much (the mid 40s seems reasonable). This expectation is supported by the fact that a rising sample of distressed loans have been resolved at par–that is, with only minimal (due to fees) or zero loss In third-quarter 2010, RCA reported that nearly 25% of all recoveries were full recoveries, up from about 5% during the first and second quarters of 2010.
Rating Actions Will Remain High (And Negative), With Fewer Downward Movements To Speculative-Grade Level
While we initiated a similar number of rating actions on CMBS, re-REMICs, and CRE CDOs during the first three quarters of 2010 (2,664) than we did in 2009 (2,522), we lowered fewer investment-grade ratings, including ‘AAA’s. In 2010, we observed a higher proportion of rating actions on speculative-grade ratings, a record number of which were lowered to ‘D’. Most were the result of interest shortfalls (which, in turn, were due to the high volume of appraisal subordinate entitlement reductions [ASERs], special servicing fees, and advances deemed nonrecoverable by the servicer). We expect the number and percentage of ratings lowered to ‘D’ to remain high through 2011.
Our CMBS surveillance group believes delinquencies may be moderating, as the property and credit markets are exhibiting signs of recovery. Negative rating activity will likely remain relatively high in 2011. Higher relative unemployment rates will probably continue to pressure property fundamentals, with varying impact by sector. Vacancy rates started to decline or stabilize for the major property types in the third quarter, but most continued to experience rental declines. The four main property types (industrial, multifamily, office, and retail) have experienced significant rent declines over the last few years, and we don’t expect them to see rental growth until 2011 or 2012. Without rent recovery, debt service coverage impairment and lower property valuations (via updated appraisals or other value estimates) will likely keep downgrades at relatively high levels.
Europe Sees A Widening Geographic Divide As U.K. And Dutch RMBS Lead Issuance Revival
by Andrew South, Mark Boyce, Arnaud Checconi, and Sabine Daehn
Over the past year there has been a revival in new issuance for some European structured finance asset classes—notably U.K. and Dutch residential mortgage-backed securities (RMBS), and German auto asset-backed securities (ABS)—due in part to stabilizing credit fundamentals in these sectors. While we expect further recovery in 2011, the European structured finance market could be set to divide further along North-South lines, both in terms of issuance and credit performance.
We understand that weaker lending institutions in peripheral European economies are currently effectively locked out of private funding markets, with securitization no exception. To the extent that these woes reflect continued macroeconomic pressures, we would expect ongoing deterioration of securitized collateral performance. Where banking systems or sovereigns are under stress, the possibility of falling creditworthiness among transaction counterparties and rising country risk could also add to downward rating pressure on some securitizations.
By contrast, collateral performance is stabilizing for many asset classes in core European countries. At the same time, secondary spreads on legacy securitization issuance in these asset classes have now settled sufficiently to suggest that the sector could return as an economically viable funding source. Regulatory uncertainty remains a risk, but is slowly diminishing, in our view, and the most immediate new rules—in the form of amendments to the Capital Requirements Directive (CRD 2), which become effective from January 2011—are unlikely to have a significant effect on the market’s return.
European RMBS: Crawling Before Walking
Following two years of very little investor-placed issuance and deteriorating credit fundamentals, the RMBS sector began a modest issuance revival in 2010. Arrears began to stabilize, the volume of underlying mortgage lending bottomed out, and pockets of new investor-placed issuance raised hopes that the market is returning to health. We believe this recovery will continue in 2011, although we expect it to be slow and vulnerable to downside risks.
Mortgage lending volumes should continue to rise slowly, as financial systems and housing markets in many European countries emerge further from the downturn. Gross residential mortgage lending in the Eurozone fell almost 60% from its peak in the second half of 2007, before bottoming out in the first half of 2009. In the year to Q2 2010, however, lending rose by about 5%. Although many banks have recapitalized, we believe that caution continues to reign in lending decisions, and volume growth looks set to be steady at best. On the one hand, lenders have generally tightened their underwriting criteria, meaning that fewer borrowers qualify for mortgage products. On the other, fiscal retrenchment across Europe will make for slower economic growth, elevated unemployment, and lower consumer confidence, all of which are likely to weigh on mortgage demand, in our opinion.
All the same, we expect some new lending to be funded through RMBS issuance. In the U.K., we estimate that in 2010 some 20% of gross lending was RMBS-funded—a return toward the long-term norm—although this statistic could prove volatile. All told, originators placed more than a third of new issuance in 2010 with investors rather than retaining it for possible use as collateral in central bank liquidity schemes. We believe that this up-tick in investor-placed issuance will continue in 2011, though it is unlikely to grow sharply in absolute terms over the next year with lending remaining constrained.
Our data indicates that Dutch and U.K. prime RMBS have accounted for practically all issuance since the market began to recover, and they are likely to remain dominant in 2011, although the recent completion of the first post-recession Italian RMBS transaction to be placed with investors suggests the recovery could slowly broaden beyond these core markets.
Some other sectors, however, will likely struggle to make a comeback in the near future, notably the formerly significant Spanish RMBS market, for which risk appetite appears to remain limited. Any suggestion that the U.K. nonconforming sector may be gearing up for resurgence also appears premature, in our view, despite one recent issuance in the sector—another post-recession first. Nonconforming lending has not yet returned to the U.K. in any substantial way, with almost no mortgage products available to credit-impaired borrowers. Until that happens, it is unlikely that significant nonconforming RMBS issuance will return. The CRD 2 amendments to European credit institution regulations, set to be introduced in January 2011, will likely further hamper nonconforming issuance by effectively requiring lenders to retain a 5% stake in their transactions if they wish to attract regulated credit institutions as investors. This may be more onerous for the non-deposit-taking lenders that typically originated nonconforming mortgage loans in the U.K.
We consider it noteworthy, however, that the arrears performance of European RMBS in general significantly improved over the course of 2010, and will likely continue on the same path next year. As unemployment has flattened and historically low interest rates have helped to make borrowers’ mortgage payments more affordable, collateral performance data indicate that arrears in European RMBS have leveled off and repossession rates have decreased. A recent analysis of loans in the U.K. revealed that since the second half of 2009 the rates of new arrears in both the prime and nonconforming sectors have been steadily falling and the cure rates of loans in arrears have been rising. We expect policy interest rates to remain low for most of 2011 and unemployment to remain steady, so arrears should ease further.
House price dynamics in some countries may also partially explain improvements in arrears since last year. Since the property collapse of 2008-2009, market values in most European countries have steadily recovered. Borrowers’ increasing equity stakes in their homes increase their incentive to keep up with mortgage payments when under financial stress, in our opinion. Conversely, severe falls in house prices can lead to spikes in negative equity and arrears, which continues to be an issue in some countries, most notably Spain and Ireland.
In general, European RMBS performance and issuance trends are likely to continue to improve modestly. In most countries, in spite of planned fiscal austerity measures, borrowers will continue to feel the benefit of expansionary monetary policy, and we don’t expect unemployment to spike. To the extent that mortgage lending increases, we believe that a growing portion could be funded by investor-placed RMBS issuance.
European CMBS: Wall Of Loan Maturities Means More Restructuring Is Likely
We believe the greatest credit risk for European CMBS in 2011 stems from an increasing number of pending maturities on bullet and balloon loans, and borrowers’ likely lack of refinancing options at that time. Deeply-reduced equity positions after swinging falls in real estate values, as well as tighter lending criteria, will likely give rise to a so-called “funding gap” for many borrowers—the difference between the balance of debt maturing and the level of new debt that the property can secure. Whether refinancing failures end in enforcement, or some form of restructuring and maturity extension, the credit risk of notes across the CMBS capital structure is likely to be affected.
The pipeline of loan maturities has picked up since H2 2010, and more than 150 loans backing our rated CMBS universe are due to mature in 2011. While these loans account for about 14% of balances outstanding—or €15 billion equivalent—their fate at maturity could have implications for nearly 40% of outstanding CMBS issuance. Of the loans that matured between January and August 2010 in CMBS that we rate, and for which we had received updated information, borrowers had fully repaid only about one in four by the end of Q3 2010, equivalent to about 15% of the maturing loan balances.
One mitigant is that more than half of loans maturing in 2011 are secured by German real estate, compared with about 30% U.K. and 8% French (see chart). A relatively more benign real estate market in Germany could make refinancing less problematic.
Chart 1 | Download Chart Data
We note that any 2011 loan restructurings that end in a maturity extension of the CMBS notes could result in us temporarily lowering note ratings to ‘D’, potentially across the whole capital structure. This reflects the fact that extending a note’s legal final maturity date is technically a form of default on the original terms. However, in general we would then immediately raise the ratings to a level based on the revised note terms shortly afterwards.
Our data indicate that investor-placed primary issuance of European CMBS was close to negligible in 2010, and indeed has been since the end of 2007. However, with occupier markets arguably over the worst in core European countries, commercial real estate investment demand appears to be returning, at least for prime properties in major cities. The question is to what extent CMBS—with structures redesigned as appropriate—could find a share in funding the associated debt financing.
European commercial real estate investment volumes have continued to rise steadily from their Q1 2009 trough, reaching about €100 billion on a 12-month rolling basis at the end of Q3 2010 according to CBRE Research, though still heavily depressed from the mid-2007 peak of more than €250 billion. However, any renaissance in commercial real estate lending is in the short term unlikely to be funded via securitization, in our view. With indicative secondary spreads on ‘AAA’ rated CMBS still above 500 basis points (bps), we feel that securitization funding remains effectively closed, given funding costs way above current loan margins of 100 bps-200 bps in core European economies.
Any tangible recovery in primary European CMBS issuance is unlikely to materialize until there is meaningful progress in tackling the overhang of under-capitalized real estate. We anticipate that any post-recession CMBS market could adopt a clean break from structures of the past, with a focus on transparency. For example, single-loan transactions may be preferred to conduits, and amortization schemes could be simplified. We note that one potential upside of continuing regulatory debate is that senior CMBS could yet become a preferable form of real estate exposure to direct investment for certain types of regulated investors.
European ABS: Traditional Sectors With Strong Fundamentals Favored
The disparate European ABS sector has become polarized during recent years. German auto ABS, for example, was among the first European structured finance sectors to return to meaningful investor-placed issuance, given an established investor base and little downturn in underlying credit performance. Others, however—notably consumer and small and midsize (SME) loan-backed securitizations in some of the southern European jurisdictions—could prove slow to return, leading to a potential North-South divide in issuance terms in 2011.
Even auto ABS has fallen in relative significance as a funding tool, judging, for example, by the drop in issuance volumes relative to the trend in number of new passenger car registrations. However, this trend could reverse in 2011. Europe’s major auto manufacturers have large existing loan portfolios, meaning the raw ingredient for securitization is available. Senior auto ABS spreads also remain comfortably inside manufacturers’ unsecured funding costs, although we expect originators to only use ABS for funding opportunistically as investor demand allows.
We also expect to see pockets of new investor-placed issuance in other ABS asset classes, such as U.K. credit cards given a large pipeline of scheduled note maturities. This could raise demand for new issuance in order to reinvest in an asset class that has performed well through the downturn. Similarly, we understand that multi-seller asset-backed commercial paper (ABCP) programs continue to play a fundamental role in funding trade receivables, for example, even though arbitrage conduits are no longer widely-used.
European CDOs: Improving Corporate Landscape Drives Stabilizing Performance
The global economic recovery—albeit tentative and rather differentiated by region—is leading to improving corporate creditworthiness, according to our rating trends. We expect credit performance for most types of European corporate collateralized debt obligations (CDOs) to continue to stabilize, or even improve, over 2011.
With the majority of European CDOs referencing diverse global pools of about 150 investment-grade corporates, we believe a systemic rise in corporate creditworthiness and lower default rates are having a direct positive effect on CDO ratings. In addition, reducing time to maturity for many legacy transactions in a market where issuance peaked in the mid-2000s will also drive upward ratings pressure in 2011, in our view.
In cash leveraged loan collateralized loan obligations (CLOs), a similar picture is emerging. The sector generally saw deteriorating underlying credit quality in 2009, which resulted in some corresponding CLO downgrades. However, since late 2010 prospects are improving. In some cases, corporate borrowers that cannot access affordable refinancing terms since banks’ lending conditions tightened are paradoxically seeing their credit quality improve, as profitability increases and balance sheets delever. In better times, with a more active lending market, many such companies may well have re-leveraged and maintained somewhat lower credit quality, in our view. For CLOs backed by loans to these obligors, there is again a resulting upward pressure on ratings. Even loan defaults that occurred during the heart of the downturn are working out with positive consequences, for example, where loans emerging from an earlier-initiated recovery process are in some cases making higher recoveries than might have been assumed, again putting upward pressure on ratings.
However, borrowers’ needs to refinance bullet and balloon loans at maturity look set to become more of a credit pressure over the next few years, as an increasing number of loans mature. We believe the speculative-grade bond market in 2010 relieved some of this pressure, while bank lending remained subdued, but it remains to be seen whether this can continue on a sufficient scale, especially given that many leveraged buyout companies, for example, have failed to exhibit the profitability growth and deleveraging that private equity sponsors initially targeted when the loan was made.
A few remaining European CDOs of structured finance securities look close to triggering events of default in cases where trigger calculations include ratings-based haircuts on deeply-distressed underlying structured finance securities.
In terms of new issuance, activity in cash CLOs has been limited, given still sharply-curtailed underlying loan origination volumes. We understand there are increasing numbers of reverse enquiries for correlation products—such as synthetic corporate investment-grade CDOs—not least because large numbers of legacy transactions are due to mature over the next two years, and investors look to reinvest funds. However, we do not expect large volumes in 2011.
The Canadian Securitization Landscape Should Remain Positive In 2011
by Maria Rabiasz
Following several years of limited term issuance, 2010 brought renewed optimism to the Canadian securitization market. Although issuance will vary among the different sectors and asset classes going forward, Standard & Poor’s believes that the Canadian securitization market will maintain its positive momentum and continue to stabilize in the coming year. We expect this positive movement to continue even as various government support programs, which lowered funding costs and replenished liquidity, have wound down. Despite these positive trends, we expect that securitization in Canada will likely feature increased transparency and disclosure, as well as simple structures using traditional assets (credit cards, mortgages, and personal lines of credit).
Standard & Poor’s expects issuance in Canada’s covered bond sector to continue through 2011. Issuance volumes should continue to grow as additional issuers enter the sector. We expect the 2011 issuance volume to mirror the 2010 volume, which totals approximately C$17.0 billion as at Oct. 31, 2010.
In a similar fashion, we expect asset-backed securities (ABS) issuance in 2011 to at least mirror that of 2010 (approximately C$11 billion as at Oct. 31) and perhaps grow to surpass the C$13 billion peak the sector saw in 2006. In our opinion, ABS issuance in 2011 will likely reflect a combination of financings issuers had postponed due to the credit crisis that began in 2008 and refinancings as outstanding issues mature. ABS issuance over the next year should come from a combination of automobile and equipment issuers, as well as credit card issuers–in the form of both bank and nonbank transactions.
In the credit card sector, we expect bank and nonbank issuers to tap the ABS term market as card issuers extend credit and shift focus to account acquisition strategies from loss mitigation strategies. Standard & Poor’s is of the opinion that credit card originators will continue securitize their receivables given the improving spreads and generally solid performance of these assets despite the difficulties borrowers face in the current economic environment. Though delinquencies and losses on these portfolios have increased during the recession, Standard & Poor’s has maintained its ratings on all rated Canadian credit card transactions.
Recent servicer reports indicate that Canadian credit card portfolios have exhibited improving performance trends year-over-year. These trends include decreasing delinquencies, decreasing charge-offs, higher prepayment rates, higher spreads, and higher average yields. As a result, we expect credit card ABS issuance to continue as the economy continues to recover. Similarly, automobile and equipment issuers will continue to tap the ABS market as their portfolios grow, and the improving ABS market conditions should help these issuers maintain diversity in their funding sources.
We are less optimistic in our issuance projection for commercial mortgage-backed securities (CMBS). Despite the exceptional performance of Canadian CMBS, Standard & Poor’s does not expect significant new issuance until the spread environment makes it more economical to fund this asset class. As a result, the sector will probably begin to see some growth in 2012 rather than in 2011. CMBS performance is currently stable. As of Sept. 30, 2010, Standard & Poor’s was monitoring 32 Canadian CMBS transactions with an aggregate loan balance of approximately C$7.4 billion. The delinquent amount was $17,392,663, and the delinquency rate was 0.24%, which is significantly lower than the U.S. delinquency rate of 8.32% for the same time frame.
In 2011, we project stable credit performance for existing Standard & Poor’s rated transactions in Canada and consistent levels of ABS and covered bond issuance. We expect the current positive momentum in Canadian securitizations to continue through 2011 and 2012 despite the end of government support programs and continued economic pressures.