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| Kevin Duignan |
While the worst of the economic and financial risks that have plagued securitization markets for the past three years may have moved to the rear-view mirror, we haven't completely outrun them, yet. Property prices have rebounded in many markets for U.S. RMBS, but the huge inventory of distressed but unsold properties continues to put pressure on home values. In U.S. ABS, delinquency and loss metrics are better than they have been in years, but unemployment levels remain stubbornly high. Liquidity is returning to the U.S. CMBS market helping to mitigate refinance risk, but the inventory of underperforming loans is growing at an increasing pace. And in U.S. structured credit, loan values have recovered in the CLO sector, but bank TruPS CDOs are suffering from increasing bank defaults and deferrals.
The U.S. securitization market is also dealing with the tangential risks posed by uncertainty in the domestic public finance and international sovereign markets. Credit risks in those areas are not abating as one would hope if a solid recovery were under way. In fact, U.S. state and local governments are, in many cases, just beginning to deal with the ramifications of the credit crisis, as their debt loads and pension obligations have grown while their tax revenues continue to decline. Globally, the risk of Eurozone contagion is forcing investors to reevaluate their perceptions of credit risk and undermining confidence in a global recovery.
Additionally, recent regulatory and legislative changes and their potential impact on new structured finance issuance have added an additional level of uncertainty to the already fragile state of the U.S. securitization markets. It's no wonder that structured finance investors, issuers, and intermediaries are nervous about how the securitization market will evolve over the next 12 to 18 months.
Perspective and Balance
It is particularly important during these periods to demonstrate broad perspective and promote a sense of balance. On the perspective front, Fitch's U.S. structured finance analysts work closely with analysts in other rating groups to ensure that the full range of credit risks is discussed.
For example, Fitch's structured credit analysts work closely with financial intuitions analysts to evaluate bank health and its impact on bank TruPS CDOs. Similarly, our RMBS and CMBS analysts work with our insurance group on producing research regarding life insurer mortgage holdings. This multi-disciplined approach to credit is critical in this environment, when so many previously unrelated credit risks have proven to be highly interdependent.
Considering credit risks and communicating credit issues to investors and other market participants in a balanced manner is also an important part of Fitch's mission. While the poor performance in several structured finance sectors is certainly worthy of attention, it is important to recognize the high degree of rating stability in many others, particularly U.S. ABS.
Despite tremendous performance pressures faced during the depths of the recession, downgrades in credit card, auto loan, and FFELP student loan ABS were remarkably low. It is important to recognize factors that contributed to that relatively strong performance -- rational competition, consistent underwriting, limited presence of the originate to distribute model, and straightforward structures -- and use that knowledge to consider and mitigate the risks in other sectors, ensuring a high and consistent level of rating stability going forward.
New Challenges Ahead
All securitization market participants are digesting the wide variety of regulatory and legislative changes that have been proposed or passed during the past 18 months. Some, like the FDIC safe harbor notice of proposed rulemaking, could have direct implications on how Fitch and other market participants perceive and analyze credit risk in certain securitizations.
Others like the SEC's update to Regulation AB will have limited credit implications but a more pronounced impact on the economics of securitizations for issuers in the form of risk-retention requirements. At the same time, Reg AB will provide for additional transparency and data sharing, which should benefit some investors. Furthermore, the SEC Rule 240 17-g5 has the potential positive impact of giving investors access to a greater variety of opinions while introducing the mixed blessing of divergent ratings.
Finally, the Dodd-Frank Act has something for everyone -- increased issuer risk retention, increased rating agency liability, and greater consumer protection. All these developments will have to be considered carefully by investors during their investment-decision process.
Performance to Remain Mixed
The fragile state of the U.S. and global recovery along with the growing burden of legislative and regulatory changes will continue to impact the performance of U.S. ABS, RMBS, CMBS, and Structured Credit transactions to varying degrees, but for an extended period in all cases.
Fitch believes that ABS ratings will continue to exhibit the greatest degree of rating stability among the major structured finance sectors. For the RMBS sector, Fitch expects home prices to continue their negative decline, albeit at a dissipating rate through year-end. Negative rating migration will therefore continue but at a much slower pace than over the previous two years. CMBS ratings have stabilized to a degree but the overhang of distressed assets will keep pressure on property values and performance. Finally for Structured Credit, the story is very segment-oriented. The worst of the downgrades have passed for structured finance CDOs but other sectors, particularly bank TruPS CDOs still face an extended decline.
Despite the mixed signals, what remains clear is that we have to remain alert at the wheel. While we may have passed some of the riskiest curves in the road, the recovery will need to gain speed and momentum if the recent credit stresses are truly going to fade into the distance.
This week's learning Curve was written by Kevin Duignan, head of U.S. Structured Finance at Fitch Ratings