Standard & Poor's Andrew South on European structured finance downgrades
Standard & Poor’s Ratings Services expects weak consumer demand and high government debt to hamper economic recovery, leading to sub-trend growth in Europe in 2010, and for the first half of 2011. We believe this will not lead to a tangible improvement in securitised collateral performance.
Downgrades increased in European structured finance during Q4, as there were 1,574 rating actions, comprising 1,556 downgrades and only 18 upgrades. Collateral deterioration was the primary driver behind these rating actions.
Collateralised debt obligations (CDOs) accounted for 70% of all downgrades. These downgrades were mainly due to the update of ratings criteria and credit deterioration of the corporate bonds in the underlying collateral.
Poor collateral performance also caused the bulk of downgrades in European residential mortgage-backed securities (RMBS), which saw 121 downgrades in 26 transactions, as evidenced by increasing delinquencies, losses, and realised severities. The relative stabilisation of collateral performance, helped by low interest rates and rising property prices, limited further widespread downgrades in the UK nonconforming sector, although Q4 saw the first downgrades in UK prime RMBS during the ongoing difficulties.
Poor collateral performance also triggered the vast majority of downgrades in asset-backed securities (ABS) (64 downgrades in 23 transactions). Downgrades affected securitisations backed by loans to small and midsize enterprises (SMEs) in Spain and the UK, UK corporate securitisations, and auto ABS in Spain.
In commercial mortgage-backed securities (CMBS), the unprecedented events in European real estate – that have resulted in drops of property values in some markets up to 50% from peak-to-trough – and the looming refinance risk translated into weak collateral performance, causing 281 downgrades in 61 transactions during Q4.
Repacks saw five downgrades in five transactions, following corresponding downgrades to the issued debt of some banks and other corporates. CreditWatch placements fell sharply to 37 in Q4 from 2,590 in Q3, and most Q3 placements were resolved.
Downgrade spike
In European RMBS, Q4 was a quarter of contrasts. On the one hand, there was a relative stabilisation of collateral performance, helped by historical low interest rates and rising property prices, which limited further widespread downgrades in the UK nonconforming sector. On the other hand, the UK prime RMBS sector saw its first downgrades in the current downturn, as 78 tranches of the Granite Master Issuer PLC trust had their ratings lowered. These related actions alone accounted for 64% of RMBS downgrades in Q4.
Downgrades were primarily concentrated in three countries: the UK (both prime and nonconforming sectors), Ireland, and Spain. Almost all downgraded tranches (97%) were from 2005, 2006, and 2007 vintage transactions.
Deterioration
For ABS, the negative trend recorded since Q4 2008 continued into Q4 2009. We lowered 64 ratings across 23 transactions, including, among others, SME ABS in Spain and the UK, UK corporate securitisations, as well as auto ABS in Spain. There was only one upgrade within ABS. Poor collateral performance explains the bulk of downgrades, while the economic climate in Europe has subdued consumer and business confidence.
Economic woes have hit both the corporate and consumer sectors. Lower profitability and cashflow generation among companies has led to weaker repayment capacity and, in extreme cases, to bankruptcy. Households have grappled with the problems associated with rising unemployment. As a consequence, collateral quality in most ABS sub-classes has weakened, despite the temporary positive impact of widely applied government stimulus packages.
Looking ahead, it appears governments are increasingly focusing on the necessity to bring their budget deficits under control in the coming years. This could mean the positive effect of safety nets and other measures aimed at reducing hardship in the recession – and helping to support securitisation collateral performance – will become more limited, in our view.
CDO ratings still underperforming
CDOs accounted for 70% of downgrades among European structured finance in Q4:
- The number of CDO downgrades in Q4 2009 corresponded to around 26% of the number of CDOs tranches outstanding.
- Synthetic CDOs saw proportionally more downgrades than cash CDOs, taking into account the number of tranches outstanding.
- Synthetic CDO downgrades represented the bulk of CDO downgrades (72%), with synthetic CDOs referencing investment-grade corporates accounting for 45%. This partly reflects their prevalence among CDOs outstanding.
Sub-trend economic growth expected
We consider unemployment to be a key determinant of future performance for European RMBS, driving borrowers’ future payment behaviour. Following recessions, drops in unemployment tend to lag recovery in GDP, so collateral performance could continue to deteriorate initially in 2010, even if economic recoveries become more established. The other critical variables to monitor will be the available volume and price of mortgage credit, which could affect borrowers’ flexibility to deal with payment problems.
While borrowers’ payment behaviour in credit card ABS is also strongly correlated to unemployment trends, additional pressure on credit card ABS transactions could mount due to rising funding costs, should these not be fully passed on to customers. The extent of downgrades may depend on the pace of deterioration and the ability of excess spread trapping mechanisms to build credit enhancement.
SME ABS may continue to be significantly affected, in particular the Spanish and German mezzanine transactions. On the economic front, despite encouraging quarterly GDP readings in the middle of 2009, recent estimates for Q4 suggest the German GDP recovery may have stalled, possibly due to a strong dependence on net exports, which could be volatile, especially with a strong euro. In Spain, transactions may continue to suffer from the ongoing effects of a severe recession, and the necessarily long-term nature of structural reforms, such as a dilution of the economy’s dependence on the real estate and construction sectors.
Overall, corporate credit rating transitions should reach an inflexion point, with the pace of downgrades slowing and upgrades rising in the coming months. That should benefit the performance of the collateral backing synthetics CDOs. However, the outcome will be highly dependent on exactly which underlying entities see any negative or positive developments, given the high degree of overlap between reference portfolios.
The pace of economic recovery will be key to the CMBS sector, with less pressure being exerted on market rents while interest rates start rising again. That will be particularly true for the Irish, Spanish, and UK markets. Our current criteria review for single-borrower transactions may also affect rating actions in the coming months.
Andrew South is senior director of Standard & Poor’s Ratings Services
