On Sept. 3, 2020, S&P Global Ratings hosted its third annual conference on European structured finance, this time in virtual format. The event featured presentations and interactive panel discussions, led by our analysts and comprising key market participants, including investors, originators, and arrangers. Here are the highlights.
Pandemic Set To Affect The Macro Outlook For At Least Two More Years
In his keynote address, our Chief Economist, Paul Gruenwald, updated delegates on the global macro outlook.
Although economists don't really have a playbook for pandemics, we now know that the effects of social restrictions aimed at dealing with COVID-19 have had a severe impact on GDP, with annualized declines of 30%-40% across the globe. We also know that the composition of GDP declines has been very different from typical downturns, where manufacturing and investment usually take the biggest hit. This time, the largest effect has been on services, with sectors including hospitality, restaurants, airlines, and entertainment the hardest hit by social distancing measures. Not surprisingly, a big drop in economic activity and spending has been accompanied by a decline in global trade. While the U.S., like China, is largely a domestic economy these days, Europe is the world's largest trading bloc, so trade effects tend to have an outsized impact here. That said, both monetary and fiscal policymakers have been very quick to react, in our view, following lessons learned from the 2008 global financial crisis.
Looking at the distribution of quarterly GDP outcomes over the last 25 years shows that the Q2 2020 reading for the U.S. was an "11-sigma event," while the reading for the eurozone was a "17-sigma event". We're likely to see similarly extreme growth figures in Q3, as the rebound begins. We expect global GDP to decline by 3.8% this year, with the eurozone contracting by about 8% as economies slowly begin to mend. By country, Germany is the strongest performing economy in the region, but output will likely still decline by more than 6% this year, ahead of France, Italy, and Spain, each with declines of between 9% and 10%.
However, growth should bounce back in 2021 and 2022, even though the recovery is going to be gradual, rather than "V-shaped," in our view. Firms and the labor market will have to get up and running again, and governments will need to normalize their balance sheets. We don't see global GDP returning to pre-2019 levels until the end of 2021 or maybe into 2022. In this baseline forecast, and taking our cue from the health professionals, we have the vaccine becoming effective and social distancing largely disappearing by the middle of 2021, although this is very hard to predict.
Of course, there are a number of risks to this baseline outlook. One is the risk that some governments' efforts to re-open economies may prove premature and that the virus won't be controlled effectively. There is also a risk that nervousness about the stock of debt may cause policymakers to tighten the fiscal reins before the private sector has recovered sufficiently. This would tend to dampen and elongate the recovery.
The Securitization Market Has Performed Well, But Uncertainty Remains As Support Measures Fade
At our first plenary panel session, more than three-quarters of respondents to an audience poll suggested that the outlook for European securitization remained neutral to positive, despite recent disruption to both issuance and credit performance caused by the COVID-19 pandemic (see chart 1).
Securitization is still playing an important role
Although the volume of securitization issuance has fallen, originators on the panel discussed how several issuers have still been coming to market and successfully executing new transactions. There remains plenty of investor demand for securitization paper amid limited supply, which has dragged spreads low enough to make it an economic source of funding for small- and mid-tier banks, relative to their retail cost of funds. While high street lenders have little appetite to issue securitizations for now, small institutions without a significant current account franchise may see a good opportunity to issue at a relatively attractive price point. That said, there will be some uncertainty in the short term, as various pandemic-related support measures—including furlough schemes, moratoria on property repossessions, and payment holidays—all come to an end.
Investors on the panel were broadly positive too. Transactions today are backed by real assets, the structures are more or less appropriate, and they continue to perform as intended, in contrast to some of the heavily structured, highly leveraged, and synthetic transactions issued before the 2008 financial crisis. Structures are doing what they were intended to do: allocating risk across the capital structure. For tranches rated 'B' or 'BB' there is likely some risk in the current environment, but investors are being paid for that. For investors holding 'AAA'-rated tranches it's hard to think that they will lose their money, even in a severe scenario.
Few negative rating actions so far
Looking at securitization ratings and collateral metrics, overall credit performance has so far been good since the pandemic hit. Material weakness has largely been confined to smaller pockets of the securitization landscape, which have narrow exposure to a few of the more troubled corporate sectors. However, in most of the securitization sectors that we cover, S&P Global Ratings has taken very few negative rating actions.
Overall, since the beginning of March, we have taken negative CreditWatch placements and/or downgrades on about 4.5% of our universe of securitization ratings in Europe, affecting only about 150 ratings in total (see chart 2). Corporate securitizations backed by pubs or leisure businesses, along with hotel-backed commercial mortgage-backed securities (CMBS), have experienced proportionally more negative rating actions. However, these are small sectors: taking all of the corporate securitizations and CMBS ratings together, about a quarter had seen a negative rating action, but they only account for 8% of the total universe. By contrast, larger sectors like European collateralized loan obligations (CLOs), have seen relatively few negative rating actions. Although CLO portfolio credit quality has generally deteriorated, that has only led to downgrades on about 2% of our leveraged loan CLO ratings, and typically only lower down in the capital structure.
Investors on the panel reiterated the importance of transaction-specific credit analysis, especially in light of the likely upcoming rise in unemployment as support measures such as furlough schemes end. Some investors will favor higher-quality assets, although even transactions with nonperforming collateral are structured with high excess spread, in order to continue making note payments in times of stress. One investor highlighted there can be differences between what rating agencies analyze (e.g., the transaction waterfall, contractual agreements etc.) and the wider considerations that investors may have, including the strength and commitment of the transaction sponsor. Some sponsors may implicitly support their transactions, even though there is no explicit guarantee that they will do so. This potentially creates a disparity between prices and ratings, which some investors may seek out.
Central bank liquidity support set to constrain securitization supply
Panelists finally discussed how central banks' revamped provision of cheap funding to financial institutions will likely hamper bank-originated securitization supply in the near term. In the U.K., for example, banks have so far taken £30 billion of new funding from the Term Funding Scheme (TFS), since the Bank of England restarted it in response to the pandemic. Some of this funding requirement might otherwise have been met with securitization issuance. In the eurozone, the TLTRO III scheme was already still open to new drawdowns before the COVID-19 disruption. However, since then the scheme has been made cheaper for lenders and TLTRO borrowings have surged, now standing at a record of over €1.5 trillion. This doesn't bode well for bank-originated securitization issuance in the remainder of 2020 and in 2021.
By contrast, nonbanks have not had similar support, which means that the nonbank lending sector is shrinking. Some originators have either shut down completely or reduced their product range. Many have increased interest rates on their loan products, despite the fact that base rates in the U.K. have been cut. Across the nonbank sector, the lack of origination activity will likely lead to less securitization supply.
RMBS Panel: Payment Holidays Are Beginning To Wind Down
Lenders' experience of mortgage payment holidays was a key topic. One U.K. originator segmented market developments into three time periods:
- Up to mid-March. Initially, the U.K. regulator attached no criteria to granting payment holidays, so that any borrower could apply.
- Mid-March to end-May. This led to a high initial take-up rate in the U.K. mortgage market, of roughly two million borrowers or close to 20% of the total, with owner-occupiers and self-employed borrowers tending to have higher take-up rates.
- June to August. Since June, the focus has been on how borrowers will exit payment holidays, and the numbers have fallen by nearly 60%, according to U.K. Finance, as borrowers have started to resume payments.
It now seems that about 30%-40% of borrowers that took payment holidays did so as a precautionary measure, rather than due to a loss of employment or income. For the remainder, lenders are now working to find the best solution, helping borrowers to resume payments once their payment holiday ends. Ironically, certain lenders have seen delinquencies fall during this period, as some borrowers who notionally took a payment holiday actually used the opportunity to pay down existing arrears.
Another originator on the panel offered a view from southern Europe. In Portugal, payment holidays took the form of a straightforward six-month plan, with the whole scheme rolled out by mid-April. By contrast, in Spain there was initially a one-month moratorium, which transformed into a three-month scheme at the end of April. Market participants and regulators therefore took longer to establish various legal and accounting definitions, which made the process more confusing for customers.
Although most reporting of payment holidays tends to focus on averages, S&P Global Ratings analysts have seen significant outliers from transaction to transaction in both the take-up rate and roll rates to arrears. In the U.K. market, there is also a clear differentiation between buy-to-let, prime owner-occupied, and nonconforming collateral. In a recent report, we highlighted the different reductions in payment holiday rates across these subsectors since the peak.
An investor noted that payment holidays may only have "delayed the inevitable" for some mortgage borrowers. Consumers have benefited from both income support and reduced outgoings, as payment holidays mean that they haven't had to pay their debts. We are only now beginning to see how this will materialize and how many borrowers on payment holidays will ultimately fall into arrears and default.
Taking the U.K. as an example, most respondents in an audience poll thought that between 5% and 15% of payment holiday cases would lead to arrears, although nearly one-fifth of respondents thought the figure could be higher (see chart 3).
Our analysts explained how we have been testing the resilience of residential mortgage-backed securities (RMBS) transactions from a ratings perspective. We initially considered liquidity risks and whether structures could deal with significant numbers of borrowers not making their scheduled payments for a period of time. We found that structural features like reserve funds and liquidity facilities were largely performing their intended role.
We also had to consider that unemployment looks set to rise, which will likely lead to higher delinquency and default rates. Across European jurisdictions, we have therefore increased our default assumptions for rating stresses from the 'B' to the 'AA+' levels by around 25-50 basis points for an archetypical mortgage loan pool.
Finally, one panelist said there may be ongoing political risk across European mortgage markets. In particular, there is uncertainty over whether payment holiday schemes and repossession moratoria in different countries could be extended. The overall impact of the COVID-19 crisis is therefore likely to last into 2021, and higher delinquencies and defaults have already started to materialize in some RMBS transactions.
CLOs Panel: Challenging Arbitrage Is Likely To Hamper New Issuance
Our analysts explained that, since March 1, we have placed 34 European leveraged loan CLO ratings on CreditWatch negative—equivalent to about 3% of our European CLO ratings universe. For those CreditWatch placements that have since been resolved, 30% of the ratings were affirmed while 70% were lowered. Downgrades were largely to ratings in the 'BB' category, and the average rating change has been one notch. Ratings were lowered due to a combination of factors, including declines in portfolio credit quality, as well as par erosion driven by trading losses and defaults. Underlying corporate rating downgrades have slowed for now but a second wave of COVID-19 cases could put further stress on European economies and corporate borrowers.
There has been some new CLO issuance since the onset of the pandemic, although more recently this has largely been driven by the terming out of existing warehouses. New issue CLO structures now differ from those in the pre-COVID period: they are generally smaller in size with more par subordination, shorter duration, and no 'B' or 'BB' rated tranches. European CLO documentation also continues to evolve. In particular, structures are including more flexibility to deal with distressed assets, such as the ability to purchase loss mitigation loans (or workout loans) and conduct bankruptcy exchanges. This allows managers to maximize recoveries on the CLOs' distressed credits. While generally viewed as credit positive, the purchase of loss mitigation loans is not subject to eligibility or reinvestment criteria, and they may be purchased using principal, which could lead to par erosion. There are, however, mitigants such as a bucket limitation and the language looks set to continue evolving.
A CLO investor noted that the CLO arbitrage is currently challenging, as tranche spreads have widened due to the risks associated with the downturn. While tranche spreads may tighten in the near term, this may not be as quick as the tightening of the underlying asset spreads. New CLO formation will only occur when the arbitrage is economically meaningful, and issuance volumes could therefore be suppressed until at least the end of next year.
However, post-COVID transactions that do come to market will likely have some positive characteristics, from an investor perspective. For example, they may have much stronger collateral pools, given that managers can now reflect the consequences of the pandemic in their asset selection. By contrast, when CLO managers were buying credits for transactions one to two years ago, they did not know that a global pandemic was around the corner. For existing transactions, however, this investor expected higher 'CCC' buckets and more defaults over time, as well as an increase in par value test failures. While few transactions have experienced these issues, more could start to fail their overcollateralization tests next year.
ABS Panel: Underlying Originations Recovering In Some Sectors
Payment holidays were again a key topic, along with trends in loan origination.
Payment holiday take-up has varied widely across ABS collateral types
An investor noted that, since the start of the pandemic, there has been a small but noticeable increase in delinquencies across countries and subsectors within European the asset-backed securities (ABS) space, particularly for self-employed borrowers. Nevertheless, smaller balance loans—such as those backing auto and consumer ABS—have seen lower delinquency rates. Small and midsize enterprise (SME) ABS pools have had the highest payment holiday take-up, ranging from 40% to 50%, compared with auto or consumer ABS where the take-up rate has generally been more like 5%. The take-up rate has been particularly low for salary- and pension-backed loans.
Overall, roll rates from payment holiday to arrears will depend on how soon fiscal support is withdrawn, particularly in the form of furlough schemes and support for self-employed borrowers across the U.K. and the rest of Europe. Recent data from the larger U.K. banks indicated that about 70% of mortgage and credit card borrowers previously on payment holidays had resumed payments as of July, with the rest requesting extensions and only a small proportion rolling into arrears. Ultimately, unemployment rates will be the key driver of credit performance.
Underlying origination volumes have recovered in some sectors
An originator of Spanish point-of-sale financing noted some interesting lending trends. Volumes on in-store point-of-sale lending during April were down by 95% year-over-year, but by July they had returned to 95% of pre-COVID levels. Along with the volume recovery there has also been a shift in the new borrower credit profile. More higher quality borrowers have been opting to use point-of-sale financing to preserve their personal liquidity, as this financing is often interest-free for the client in Spain, with the merchant effectively paying the interest through a discount mechanism. Growth in e-commerce versus traditional stores has also accelerated. A U.K.-based originator agreed that credit card lending volumes dropped by an unprecedented amount at the height of lockdown, with very limited spend on travel, for example.
Looking at the performance across different originators in the market, payment rates have clearly softened over the summer period, but not by as much as some might have expected. In fact, many lenders saw borrowers on payment holidays continuing to pay, maybe due to spend levels being lower and furlough schemes coming into effect. Some lenders have seen a slight uptick in delinquencies and charge-offs, particularly in the subprime sector, but yields generally remain robust. As a result, excess spread in the various securitization programs has stood up well for all issuers in the market.
Used vehicle residual values have help up, but longer-term trends may be detrimental
We were also joined by the Sector Lead for EMEA automotive from S&P Global Ratings' corporate practice, to discuss trends in the industry and how these may affect residual value risk in auto ABS. Residual values have so far held up relatively well, especially in France and Germany, irrespective of the large shock caused by COVID-19. In fact, price declines have been limited to a range of between 1% and 5%, which is relatively low compared with what was observed during the 2009 financial crisis.
That said, a number of new concerns are arising. First, moves toward large incentive schemes could distort the market, especially at a time where technology in the automotive space is changing quickly, given the current trend toward electrification. Electric vehicle models now coming to market are already very different in terms of range and performance to those that were considered new only three years ago. Second, there will probably be markets where these incentives are particularly generous (e.g., Germany and France), and this might weigh on used car valuations. For example, there will be little incentive for a purchaser to consider the second-hand market if incentive schemes might cover up to €9,000 of the cost of a new car, incorporating the latest technology.
CMBS Panel: Loan Amendments And Waivers Come To The Fore
One investor suggested that the European CMBS sector had arguably performed a lot better than many would have expected since the pandemic started, with credit stress generally confined to the hotel and retail sectors. Admittedly, within those areas, revenue declines have been severe. Outside these sectors, however, European CMBS has benefited from tenant and property diversity, with logistics and industrial sectors so far the clear winners.
The pandemic did highlight some potential deficiencies in the secondary market for European CMBS. It was not really a widely-traded asset class pre-COVID, so liquidity and transparency were very challenging in March and April, especially away from senior classes. In the end, however, recent experience could positively affect the liquidity of European CMBS, as many market participants have now done their homework on the outstanding universe, making them more willing to bid these assets in the future.
A servicer reported that, between April and July, about 30% of loans were subject to a request for an amendment or a waiver, mostly in the retail and hotel sectors. The waivers and amendments being requested were typically for a deferral or reduction in interest payments and a lot of covenant waivers as well, especially for the July interest payment dates.
During the 2008 financial crisis, there were actually very few payment defaults. Then, the risks were with leverage and liquidity, which meant that servicers could "kick the can down the road," and as long as coupons were being paid, servicers could delay taking any action. This is not the case in the current crisis, but servicers will have to consider how long to apply these waivers for. Should covenant breaches be waived for a couple of quarters or 12 months or even longer? This will depend on how long the borrowers will need to rectify the issues caused by COVID-19.
Our focus for the first half of 2020 has been on understanding the cash flow prospects for the individual CMBS transactions and the liquidity risks. Generally speaking, the transactions that we rate have performed comparatively well during the pandemic. To date, there have been no interest shortfalls on any of the transactions that we've been monitoring, for example. However, we have seen the first borrowers drawing on liquidity support as well as equity being injected by sponsors.
In 2020, the bulk of our rating actions have centered on the retail and the hotel sectors. Downgrades in the retail sector represent a pre-COVID trend, which has been ongoing for the past 12 to 18 months. COVID-19, social distancing, and isolation measures have really accelerated that trend. We will continue to focus on the cash flow and liquidity risks, but we will also look more broadly at market fundamentals, monitoring how valuations are going to start behaving over the medium to long term as a result of COVID-19.
The office sector is also receiving more attention as some observers question whether there will be long-term changes to office working patterns. Generally speaking, the CMBS transactions with office exposure are backed by high-end, prime estates, which are subject to long leases and strong tenants. We recently published some research, which showed that the office-backed CMBS transactions that we rate would have to experience close to a 7.5% or 10% increase in vacancy levels to start seeing one- or two-notch ratings movements, all else being equal.
That said, there are always pockets of risk across the transactions and there may be areas which show greater vulnerability. We're likely to see net cash flow numbers decrease in some cases, be it through higher vacancies or lower contracted rents, which we will continue to monitor.
Green And ESG Securitization Panel: Policy Push Continues To Develop
Market participants discussed ongoing developments in the nascent market for green and environmental, social, and governance (ESG)-focused securitizations.
Panelists agreed that Europe is leading the way in adapting the structured finance market to ESG considerations and there have been numerous supportive signals from various EU regulators, although the market is still in its infancy. There are two key challenges: the lack of assets available for securitization and the lack of common standards defining what ESG principles really mean. Interestingly, the COVID-19 pandemic has given some further impetus and shifted the discussion among institutional investors to the social effects of their investments. According to one investor in the securitization market, positive signs include the policy framework established by the EU and the focus of institutions such as the European Investment Bank and the European Investment Fund on using securitization to really jump-start a green investment agenda.
We have seen further policy developments since the European Commission's first sustainable action plan in 2018, which really focused on environmental impacts. Since then, last year's EU Green Deal plan has introduced the ambitious goal of making the European economy climate-neutral by 2050. Following the 2018 action plan, there was a legislative package, which included a taxonomy regulation and a disclosure regulation. Neither covers securitization directly, but indirectly the taxonomy has an impact on asset managers dealing with securitizations. Now, the most recent initiative that could affect the securitization market was a consultation from the European Commission that closed in July 2020. This was on the renewed sustainable finance strategy, including an entire section on green securitization. In particular, the Commission asked if market participants think there is a need for a dedicated framework to cover green securitization.
- U.K. Mortgage Payment Holiday Risks Emerge As COVID-19 Requests Have Peaked, Sept. 2, 2020
- The Global Economy Begins A Slow Mend As COVID-19 Eases Unevenly, July 1, 2020
- Vacancy Up, Ratings Down? European Office CMBS Transactions After COVID-19, June 29, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Arnaud Checconi, London (44) 20-7176-3410;|
|Secondary Contact:||Andrew H South, London (44) 20-7176-3712;|
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