European structured finance reached a golden pinnacle in the first half of 2007, with Eu211.7bn of bonds sold between January and June, at tight spreads.
Ironically, these sunny conditions which may never be repeated did not feel at the time like the peak of a bull run. Yet the destruction of the market in the second half of the year could not have made a starker contrast.
After a two month hiatus during the summer with next to no issuance at all, only a trickle of deals emerged in the autumn. The vast majority of planned transactions were pulled and issuers turned to other sources of funding.
The deals that were sold had to offer wide spreads and needed extensive premarketing and private placement.
This can no longer be dismissed as a temporary dip. After being struck by the subprime bug, agency securitisation is struggling to survive in Europe.
"No question about it, its going to be a difficult market," says Allen Appen, global head of securitisation at Barclays Capital in London. "Its going to take some time before form reverts, and reversion to form doesnt mean going back to a $500bn equivalent market. Its going to be a smaller market."
Securitisation specialists had long realised that Europes biggest, most highly rated banks were likely to switch some of their issuance away from residential mortgage backed securities (RMBS) and into covered bonds because of Basle II.
The new capital adequacy regime reduces the capital relief from securitising mortgages, by lowering the capital that unsecuritised mortgages consume in the first place.
The credit crunch has accelerated and hardened this shift. "In the residential mortgage asset class, bank issuers will move very quickly into the covered bond market," says Appen. "Banks will adjust to a world where they have imperfect access, if any, to the RMBS market. And once theyve adjusted, theyre unlikely to come back."
For many banks, Basle II is effective from January 1, 2008, while for others it begins to bite on January 1, 2010.
However, many believe some prime mortgage lenders will want to keep a foot in the RMBS camp, simply to retain as many funding options as possible. The covered bond market could have its own rainy day.
And for assets other than residential mortgages, regulatory capital relief is still worth considering.
"In the Basle II world, the risk weighting of different assets is important in ascertaining whether securitisation is cost-effective," says Richard Harding, head of capital raising at Royal Bank of Scotland in London. "Under Basle II home loans are less attractive assets to securitise than things like credit cards and some commercial loans."
If pricing stability and investor demand return, it will still make sense for even the biggest financial institutions to securitise credit cards, car loans and small and medium-sized enterprise (SME) loans.
Some issuers, of course, do not have the same luxury of choice in their funding options as the worlds top banks.
These include the specialist lenders in the UK non-conforming mortgage market, and the investment banks that have aped their business models in the past few years as well as going deep into commercial mortgage lending. There are billions of pounds of this collateral waiting to come to market as soon as spreads make it possible.
Investors go into hiding
However, the shortage of ABS issuers is matched by a shortage of investors. Structured investment vehicles and asset backed commercial paper conduits have been devastated by the subprime crisis, while some other investors may have been shocked by the crisis into deciding that ABS is just too exotic, complex and dangerous.
"I dont expect SIVs to be back," says Etta Ferrier, an ABS investor at European Credit Management in London. "The conduits, money markets I think will be back, but again in smaller size. Theyll be looking to diversify their funding sources away from just the short-term market."
Thus, even issuers that have to come back to the securitisation market may find a lack of takers for their deals, as some did in the dire days of late 2007.
"Demand may be very selective, led by a few key accounts during early 2008," says Matthew Cooke, head of European financial institutions securitisation at Merrill Lynch in London. "Since many issuers want to access the market, there is a risk that the market reopening could herald a flood of supply later in the first quarter, and timing will be key. Investors will be more critical than ever about reporting standards, including content and timeliness of investor reports, and deal transparency. When it comes to structuring and financial engineering, expect a movement back to keeping it simple."
Spanish property out of favour
In recent years Spanish RMBS have accounted for a big chunk of European agency ABS. Unfortunately, the Spanish mortgage market, like its Irish counterpart, is showing cracks.
House price growth in both countries has slowed with rising euro zone interest rates, after headlong booms in recent years.
Spanish RMBS was already priced up to 10bp wider than the best quality deals when the liquidity crisis hit. The penalty for Irish paper was smaller, but growing.
The bid for this paper has now vanished. Ironically, Spanish issuers have been the most active in Europe since August, issuing securitisations but retaining them for use as repo collateral.
Some Eu26.5bn of Spanish mortgages, small and medium sized enterprise (SME) loans and consumer loans were securitised between September and November, outstripping the rest of the European market combined. Yet little if any of that paper went to investors.
Some believe it will take a rate cut from the European Central Bank to improve the situation, but others believe the market is overreacting.
"The thing Im most frustrated by is the now widely held belief that property markets cannot soften without axiomatically giving rise to real problems for holders of residential mortgage backed securities," says Appen. "Thats obviously a belief grounded in whats happened in US subprime, but theres no reason to believe that the Irish and Spanish markets cant soften, that the UK market cant soften, without causing investors in any class of RMBS backed by those mortgages to experience real damage."
Corporate ABS bloodied but unbowed
Corporate securitisation has been relatively unscathed by the crisis. Spreads have widened and marketing is tough, but because these deals go to different investors from financial asset ABS, corporate deals were done throughout the crisis.
Thames Water raised £900m in August, less than planned but far more than most banks could raise. Several hospital bonds and a tap of the Marstons pub securitisation have since been placed.
But many deals of this kind, such as BAAs airport securitisation, have been put back by fears over the creditworthiness of monoline insurers, which have wrapped many corporate ABS issues in recent years.
Investors had a fright in September when rating agencies warned that subprime exposure would lead to downgrades of some monolines unless they could increase their capital cushions.
The most endangered of the triple-A insurers, CIFG, was rescued by the shareholders of its parent company Natixis (though there may still be downgrades in the future), but not all of them have such deep pockets.
"Our sector has been very reliant on the ability to use monolines," says James Miller, head of corporate securitisation at RBS in London. "If they were not there in the same way it would have a significant impact, but I think this is highly unlikely, even if spreads do not go back to the same tight levels as before." Miller believes that if the rating agencies tell monolines they need more capital, they will raise it, so as to protect their triple-A ratings.
The main competitor market for corporate ABS, leveraged finance, is if anything in worse trouble.
"Corporate securitisation and whole business securitisation could see more of a resurgence in 2008," says Miller, "given the greater fallout in the banking market and the fact that refinancing risk will be a key concern for [company] owners with leveraged debt."
An uncertain future
The European securitisation market will certainly be smaller in 2008. But even now, half a year after the liquidity crisis took hold, there is little else that market specialists can predict with confidence.
The fundamental economic rationale for securitisation is still sound in most asset classes, but the state of demand prevents a return to normality. The longer that state of affairs continues, the greater the risk that balance sheets come under pressure and true credit contagion hits Europe.
"Its a question of when funding restraints will lift," says Ferrier. "The banks need to absorb losses, the off-balance sheet conduit structure of MLEC will offer some respite as a funding route, and central banks will be key in their response. If those factors fall into place, banks become more comfortable with ABS, interbank rates stick and there is more liquidity, then the ABS buyer base will be able to participate again. Thats all with the caveat that fundamentals remain okay, because so far this isnt a fundamental issue, its a technical liquidity funding issue. But if it goes on long enough it will become a fundamentals issue."