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The future of ABS in Europe

Securitisation Research 13 March 2009

Hans Vrensen, CFA In this note, we update our outlook on the future of the EUR1.1trn European ABS
+44 (0)20 7773 3502 markets. We look at challenges in the short term but also consider the longer-term
hans.vrensen@barcap.com viability of the market. The European ABS markets have been largely dysfunctional
www.barcap.com from early autumn 2007. Since then primary issuance placed with investors has largely
ceased and the focus has shifted solidly onto central-bank liquidity facilities and trading
in the secondary market. The market continues to face a number of different and inter-
connected challenges, which will determine its prospects in the short term.
Widening confirms that ƒ Technicals: Over the last year and a half, technical factors such as the SIV and ABCP
positive technicals in unwinds have had a significant negative impact on secondary spreads up to year-
first two months of end. However, in the first 6-7 weeks of 2009, other technical factors have actually
2009 did not have a resulted in spread tightening. Despite more recent widening since then, as illustrated
lasting impact in Figure 1, the tightening was mostly due to the re-classification of ABS assets on
banks’ balance sheets. This re-classification has also partly reduced the need for
forced selling after year-end 2008. Furthermore, issuer buybacks have also been a
positive in the secondary market, albeit one that is difficult to quantify. The recent
widening confirms that the positive technicals that caused the spread tightening in
the first 6-7 weeks of the years in question did not have a lasting impact.

Figure 1: AAA UK Prime RMBS secondary spreads

1,600
1st Jan 2009
1,400 Avg (LHS)
1,200

1,000

800
600

400

200
0
Sep 06 Dec 06 Apr 07 Jul 07 Oct 07 Feb 08 May 08 Aug 08 Nov 08 Mar 09

Source: Barclays Capital

Deteriorating ƒ Fundamentals: As the economic slowdown has spread from the US to the rest of
fundamentals will lead the world, declines in GDP growth, increases in unemployment and declines in
to increased defaults house prices have taken place at impressive speeds. The continuing problems faced
and losses by banks and the capital markets have led to a lack of new lending for both
consumers and businesses alike. This is still having a second-round impact on the
real economy, further extending the slowdown. Over the last six months this has
led to a marked increase in delinquencies in our mortgage pools, with defaults and
losses expected to follow suit. We expect increased defaults and losses on the

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underlying collateral pools to come in late 2009 and 2010, as a result of further
deteriorating fundamentals.
Legal deal structures ƒ Structurals: There is an increasing trend of structural deal features failing in European
not always working ABS. This is partly due to counterparty failings, triggered by some of the technical and
as expected fundamental factors mentioned above. However, one could argue that the breakneck
speed of the markets’ issuance in the period from 2005 to 2007 might have resulted in
some deal structures not being fully reviewed by all parties. Inconsistencies between
the offering circular and the transaction documents are also emerging in some cases.
Also, the modest fees which servicers and trustees were able to negotiate in that
environment might make it difficult to allocate adequate resources to address current
and upcoming problem situations on behalf of investors. Some of these issues are more
fully described in our publication, Structural surprises in European ABS. It does seem
that the structured part of structured finance is not always working as expected.
Despite significant ƒ Policy uncertainty: The myriad of government policies announced over the last six
policy announcements, months has been partly successful, but some uncertainty remains around the
much uncertainty implementation and details of some of the programs. Especially, some forms of
remains on government assistance for business and consumer borrowers could ultimately have
policy impact a negative impact on bond holders. For example, due diligence requirements for
ABS investors might be more stringent compared to equally complex bank bonds.
But even more so, the uncertainty around the UK banking bill that came into effect
on 21 February 2009 has brought into question the legality under this new act of
the true sale of securitisations in the UK and how the bill in effect might overwrite
contract law in securitisations.
Large amount of Of course, central bank liquidity provision to banks through repo of ABS (and other
issuance placed with assets) has been hugely successful over the last 18 months, providing banks with a
central banks provides useful source of funding. Based on ECB and BoE disclosures, we estimate that there is
useful funding, but about EUR700bn in ABS with central banks. If we add a further EUR300bn for Q4 08
raises questions on that we estimate was posted with the ECB, this adds up to EUR1trn. This is about the
long-term prospects same amount of ABS notional as has been placed with investors since the markets’
inception. Of course, there is likely some overlap, as the ECB accepts existing ABS as
collateral, as long as it meets its criteria. In general, the negative public and political
sentiment relating to ABS is likely to limit any positive policy bias towards ABS. In our
view, the long-term viability of a market that is half placed with investors and half
placed with central banks can be legitimately questioned as it seems unrealistic to
expect central banks to provide funding to ABS in this way in the long term.
Need clear government To address the current uncertainty, we need a strong and clear signal from regulators
commitment to assist in and lawmakers that they are committed to continue to work with the ESF, banks and
restoring the the rest of the industry to restore securitisation as a funding channel. Of course, the
securitisation market various degrees in which different European countries have tapped into securitisation
makes a coordinated policy response on an EC level difficult, as some countries have
much more at stake than others.
We expect the breadth ƒ Ratings pressure: The number of downgrades in the first two months of 2009 has been
and speed of strong and we expect further downgrades to come through during the rest of the year.
downgrades to increase Even if rating agencies leave their existing models in place, they will be re-visiting some
of their assumptions, typically based on historical data, with the recent, unprecedented
decline in economic activity and asset values. Rating agencies have also seen a wide
range of new regulatory proposals from many different agencies, both European and
US. The revision of model assumptions and methodologies, together with significant
regulatory pressures, is likely to increase the breadth and speed of rating downgrades.

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Selling pressure on ƒ Selling pressure: Ultimately, potential further rating downgrades, are expected to
banks is likely result of trigger increased capital reserve requirements for banks’ ABS holdings. Given that
ratings downgrades, banks have become the largest ABS investor category again, we see significant
unless capital reserve pressure for further ‘forced’ selling by banks, some of which might be unable to meet
requirements capital reserve requirements. Of course, any changes in the interpretation or
are relaxed (temporary) relaxation of these capital reserve requirements by local regulatory
agencies should help alleviate this pressure. However, the lack of a significant inflow
of buyers is expected to hamper further spread tightening for some time to come.
Emerging trends from our roadshow
Some common trends With this rather bleak outlook for our markets’ future, we want to share some of the
from European feedback from our recent Europe roadshow. As in previous years, we presented our
roadshow meetings: 2009 securitisation annual to our existing European ABS investor client base. In this
return to home country context, we met with almost 70 clients in 19 cities and 10 countries over the last seven
and re-focus weeks. In general, we observe the following trends with existing investors. First, most
on surveillance are returning to their core competence and focus on their home jurisdiction, which is
easier to get approved by senior management and risk departments. In general, Spanish
investors are bigger buyers of Spanish RMBS and Dutch investors are focused on Dutch
RMBS, etc. Buybacks are likely driven partly by this and it may result in less portfolio
diversification. Secondly, most investors have re-focused their attention on closely
monitoring their existing portfolio (with the helpful assistance of their risk colleagues)
and are not re-investing (most of) the cash prepayments on their existing ABS holdings.
Some new investors So far, this is certainly consistent with the overall outlook. But there were also a number
coming in, especially UK of other more positive things going on below the surface. In particular, we are seeing
and Dutch some green shoots of new investor activity, especially with UK and Dutch pension funds
pension funds and and insurance companies. A number of UK and European fund managers are
insurance companies attempting to raise capital for distressed debt and ABS funds. Some are also increasing
existing ABS mandates or increasing the percentage permitted to be allocated to ABS.
Although limited in size, these initiatives are likely to be the start of a slow revival that
can be expected to unfold over time. Given previous false starts last year by some
investors, when further spread widening killed some of the new initiatives, we expect
any increase in buying activity to be cautious and slow, especially on the higher-rated
tranches. However, in the subordinated tranches, we could see a quicker recovery if
hedge funds are able to pick up any heavily discounted portfolios in size from highly
motivated (bank) sellers.
Investors committing The second positive trend emerging from our roadshow is that a significant number of
more to in-depth and investors seem to have committed to investing time and money in stress testing after
stress-testing analytics the publication of our own series of stress-testing analyses across most actively-traded
European ABS sub-sectors. Many mentioned that they had signed up to third-party
cash-flow model providers and were keen to share experiences on the use of these
systems. Some who had previously invested in the development of in-house modelling
and data infrastructure also admitted to now switching to these same third-party cash-
flow model providers. Most are well aware of the shortcomings of these models, but our
view is very positive on this development. We believe that the more widespread use of
third-party cash-flow models will allow investors in future to further expand their
discussions on their model assumptions, which many of them already shared with us.
These types of discussions should allow buyers and sellers to bridge more easily the bid-
ask spread, resulting in more effective secondary trading.

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The future – meeting the challenges through bold reforms

Some progress has been In our view, the future of the European ABS markets will depend on how the sector
made in meeting meets the above challenges. The ultimate impact of policy initiatives, once finalised and
challenges, but bolder implemented, will also depend on how pro-actively the sector embraces reforms. In this
action is needed respect, the industry group European Securitisation Forum (ESF) and others have made
some good progress in working with the wide range of government and regulatory
agencies. In particular, the recently announced standard reporting formats with their
mandatory fields and published list of committed banks is a great step forward.
Loan-by-loan data However, despite this progress, we believe that bolder action is needed. In private
should be made public conversations, many investors seemed to agree with us that public disclosure of loan-
and will allow for by-loan data on the collateral pools, material transaction documents and standard data
improved analytics templates are not just nice to have, but essential to meet the new legal requirements
that investors might face. We support S&P’s president’s suggestion that the market
should have public access to the same data as the rating agencies. Of course, easier-to-
use third-party cash-flow models and other databases, which would allow a wider range
of investors to benefit from the improved analytics fuelled by loan-by-loan data and
standard data formats, are also essential. The wider adaptation and expansion of
standard data formats for post-issuance reporting will also help boost efficiency in
third-party cash-flow and other analytical systems.
Public disclosure Public disclosure of transaction documents, if and when material, is probably required
of material by law in most European countries. As circumstances change, what was perhaps not
transaction documents material at the issuance date of the bonds can easily become material once a swap
counterparty fails or a liquidity facility is not renewed. Clearer guidelines and standards
for servicers and trustees with regard to providing public access to the relevant
transaction documents might avoid legal issues later.
For existing issuance, Legal counsel might be able to help in thinking about ways to implement changes in
guidance and standards disclosure standards, even for existing transactions. In fact, the American Securitisation
might avoid legal issues Forum (ASF) has provided the industry with some useful guidance, partly through its
RESTART project, as to how to interpret legal transaction documents for existing
transactions to avoid further unnecessary and harmful legal actions. A similar initiative
from the ESF in Europe would also provide huge benefits, in our view.
More standardised and We believe that more standardised legal structures that are easier to understand are
easier-to-understand essential for any new primary issuance, while at the same time providing essential legal
legal structures protections for investors as well as issuer efficiency. This might not include master-trust
essential for structures, with their large number of triggers and bond tranches, as well as uncertainty
new issuance around the sponsor’s willingness and ability to maintain the trust with loan substitutions.
Reforms need to be Given the negative political sentiment regarding securitisation and banks in general, we
aimed at current believe it is essential for industry groups, like the ESF, to help the industry overcome as
challenges not only many of the current challenges for existing bonds as possible and implement bold
new issuance reforms. Focus on the revival of new primary ABS issuance in the short term,
government-guaranteed or otherwise, might delay any of these solutions and reforms.
Leadership from In the end, investors do need to take responsibility for pressing for these reforms
investors and central through their industry representation. Given the current role of the ECB and BoE, we see
banks is needed a leadership role in this respect for central banks as well. Of course, all of this will take
hard work and might in some cases even require cumbersome legal actions. New
investors will only continue to come into the sector if and when ABS can prove that it
has performed in line with expectations, despite all the challenges it faces.

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To summarise, we believe industry reforms should include:

ƒ more detailed, loan-by-loan collateral data
ƒ adaptation and expansion of existing standard reporting formats
ƒ improved data and modelling infrastructure
ƒ public disclosure of all material transaction documents
ƒ legal guidance on existing deal structures and disclosure standards
ƒ standardised and simpler deal structures for new issuance in the future.

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Securitisation Research Analysts

5 The North Colonnade
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Hans Vrensen, CFA Anca Gagea Mark Nichol
Head of European Securitisation Research Consumer ABS Commercial Mortgage-backed Securities
+44 (0)20 7773 3502 +44 (0)20 7773 9874 +44 (0)20 7773 4503
hans.vrensen@barcap.com anca.gagea@barcap.com mark.nichol@barcap.com
Dipesh Mehta
Residential Mortgage-backed Securities
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dipesh.mehta@barcap.com

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Glenn Boyd Joseph Astorina Ying Wang
Head of US Securitisation Research Subprime MBS, Consumer ABS Subprime MBS
+1 212 412 5449 +1 212 412 5435 +1 212 412 2512
glenn.boyd@barcap.com joseph.astorina@barcap.com ying.wang2@barcap.com
Elena Warshawsky Wei-Ang Lee, CFA Priya Misra
Subprime MBS, CDOs Subprime MBS Agency MBS
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elena.warshawsky@barcap.com weiang.lee@barcap.com priya.misra@barcap.com

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