ABS Insight

April 2011
Notwithstanding global macro event driven volatility, the European primary market came back to life in March with 5 billion publicly placed new issuance and a similar amount in the pipeline as at month end. It is thought that the dearth of issuance in February may have in part been due to certain issuers and rating agencies being occupied with deal restructuring prior to the March 1st cut-off date for the ECB amending discount window eligibility requirements to require a minimum of two ratings. A notable transaction in the pipeline includes Gosforth Funding 2011-1, the inaugural post-crisis residential mortgage backed (RMBS) deal brought by Northern Rock plc (NR). We comment on this later. Secondary trading volumes have been relatively thin over the month with greater focus on primary issuance and spreads have generally been stable, although there has been some softness in certain subordinate bonds from the recent price highs achieved in mid February.
European Senior ABS vs Corporate Spreads (bp)
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Banks Senior iTraxx Generic 5yr JPM CB 3-5yr Euro CLO AAA 6-8yr UK RMBS AAA 5yr EUR UK Cards AAA 5yr EUR CMBS AAA 5yr EUR

static loan pool, representing a simplification from the more complex revolving loan pool master trust structure utilised by Northern Rock pre-crisis. Only the most senior AAA rated notes are being offered (AA rated class M and unrated class Z notes are being retained). The senior class benefits from 13% credit enhancement, which is slightly lower than seen in other recent issues, although this is a reflection of the relative quality of the collateral and low average loan to values (LTVs), selected from some of the best mortgages within NRs portfolio. The 1.5 billion of loans in the securitised pool represents approximately 15% of the prime mortgage assets transferred to the good bank following separation. Another notable transaction announced during March was Gable Funding, an attempt by Lloyds to securitise a portion of its UK infrastructure loan portfolio via a collateralised loan obligation structure. The senior tranches offered benefit from 26% credit enhancement and there is a single retained junior tranche. The collateral is a static pool of 66 senior secured, performing infrastructure loans to 57 borrowers. Unfortunately, the launch of the transaction has been delayed following the recent market volatility. We understand there was decent demand for the fixed rate tranches, but filling the order book for the floating rate bonds was a struggle. Successful, broadly distributed placement in due course would represent a noteworthy step towards normalisation of the European ABS market. Focus on the Spanish residential mortgage market

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We commented in the November 2010 edition of ABS Insight that the apparent extent of deterioration in Spanish RMBS in terms of reported delinquency numbers (refer to chart overleaf) was, in our view, being understated by opaque investor reporting, deal structures (which charge off severely delinquent loans against portfolio excess spread or reserve accounts, thereby removing them from reported delinquency balances) and lender loan modification practices. A recent presentation we attended by a Spanish mortgage servicer (Servicer) along with research published by JP Morgan has supported this view. JP Morgan published the results of a recent trip to Spain where they met with a property valuation company, regulators and underwriters. Some of the key issues facing the Spanish residential property market which were raised between the two sources are discussed in the following paragraphs. The Spanish residential mortgage market grew rapidly between 2005 and 2008 to 1.1 trillion, primarily through increased lending of high LTV and debt to income ratio mortgages and increased use of brokers for origination. Approximately 100 billion (25% of that vintage) had an original LTV greater than 80%, leaving equity highly exposed to falling house prices. When cracks first started to show in 2008, banks created entities for balance sheet mortgages to be transferred into until the problem went away. Many mortgages were not actively serviced with borrowers having been put on full interest and principal payment holidays. This continued to occur through 2009 and 2010 and has only recently started to be addressed. Loan extension is

Source: JPMorgan and Bloomberg

Northern Rock return to the securitisation market Gosforth Funding is the first RMBS brought to the market by the good bank following the split of Northern Rock into the ongoing and the run-off businesses. The transaction has been presented as part of the nationalised entitys long term strategy to diversify funding. This is a significant positive for the European securitisation market, in our view, as it provides a clear indication of the UK governments view of the perceived benefit of securitisation and its importance as a source of funding. The structure of the new transaction involves a standalone

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ABS Insight
April 2011

Spanish RMBS 90+ Days Delinquency (% of current balance)

3.0 2.5 2.0 1.5 1.0 0.5 0.0
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Index transactions after 31 Dec 2007 Index transactions before 31 Dec 2007 Index

Source: Moodys Investors Service, Moodys Performance Data Service, periodic investor/servicer reports

The technicals surrounding the repossession and foreclosure procedure further impact the situation. Repossessed balances continue to build with most of the properties remaining at the original 3.0 valuation. Only properties transactions afteroriginal valuation greater than Index with an 31 Dec 2007 Index transactions 2.5 500k are required to be revalued,before 31 Dec 2007 which comprise a small segment Index of the market. For properties in foreclosure there is little incentive 2.0 for third parties to purchase in auction as any potential third party bidder must deposit 30% of the auction amount (generally the original 1.5 appraisal value), with the court. Bids above 70% of this value are 1.0 automatically accepted, while bids between 50% and 70% allow the debtor and lender to improve which further delays the process (or even 0.5 the current owner to cure). If the bids are below 50% of the auction amount the 0.0 deposit will be held by the court until a final decision is made, which can take several months. Aggregate transaction related costs of 15% to 20% of the auction amount can also apply. These factors have contributed to effectively shut out any third party bidders and keep mortgages on the originating banks books. Banks are also offering subsidised lending in an effort to help turnover repossessed properties. For example, 100% LTV mortgages are available at discounts of up to 30% of the original valuation. In reality however, there are very few transactions occurring. JP Morgan estimate that the residential property overhang is between 700,000 and 1.1 million units, which at the current absorption rate of 150,000 units p.a. creates a 5 to 7 year backlog. This overhang is likely to further exacerbate declines in house prices and corresponding increases in loss severities experienced by banks and RMBS transactions. While the details discussed above paint a bleak picture, a positive note can be seen in that transparency for the sector has improved markedly from last year. From the low base of official statistics and RMBS investor reports, the level of disclosure has improved so that now Spanish market participants are more willing to engage investors and discuss the issues facing the market. These developments will allow investors to better make value judgements across the capital structure and in turn potentially help enable Spanish financial institutions regain sustainable access to wholesale funding markets. JP Morgan reported that all lenders they met with commented that their reliance on ECB funding had declined since year end and certain originators were considering trying to sell previously ECB repod RMBS into the secondary market. Certainly, any continued newsflow which sustains the increased level of disclosure will aid their cause.

currently the primary action taken by lenders who are dealing with borrowers which are facing difficulties. JP Morgan commented that none of the originators they met with utilise margin reductions as a course of action although payment holidays continue to be applied in some instances. These factors depress reported arrears levels and contribute to, what appear on the surface to be, relatively benign levels of severe delinquency in RMBS transactions. Furthermore, the tail risk in these transactions has increased greatly as a result; delinquencies which would normally roll to default and get covered by excess spread generated from currently performing mortgages continue to build rather than being incrementally written off. Official house price statistics appear to be massively understating the actual scale of declines. While from 2005 to 2010, government statistics show marginal gains in house prices on average, the Servicer is seeing 25% to 40% average house price declines, depending on the region. From the experiences of the Servicer, lax underwriting standards by independent brokers are clearly evident. They indicate defaults in mortgages which were originated through brokers have outpaced bank originated defaults by 3:1. They believe that the bulk of unemployment related defaults have now occurred although it is very likely that another shock will follow any rise in rates. As 90% of mortgages are variable rate, the impending rate hikes will stretch borrower affordability and lead to the next wave, although it is not is not expected to be as severe.

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