The core consumer ABS sectors—credit cards and autos in particular—are expected to again demonstrate strong performance and rating stability with private student loans remaining the potential outlier. CLOs are also expected to continue their solid performance barring a significant setback to the US economy.
In the mortgage world, CMBS performance metrics have stabilized but the sector is not completely in the clear. On the other hand, residential mortgage-backed transactions will be a “tale of two cities” with new issue transactions showing stellar performance and seasoned deals remaining under pressure from still-falling home prices.
Clear Skies Ahead for ABS
Though the dramatic 2009-2011 performance improvements are leveling off, ABS will remain at the head of the class among all structured finance sectors next year. Autos will again drive new issuance in the coming year and remain an exemplary performer. Credit card ABS performance will also remain strong though issuance volume is likely to remain low. Conversely, student loan ABS, private student loans in particular, will show greater sensitivity to the fragile job market.
Despite the ongoing poor labor market conditions, most core consumer ABS credit quality measures improved significantly over the past two years, following a period of rapid deterioration through the recession. The exception is in the student loan ABS sector, where the direct linkage to the U.S. sovereign rating has resulted in a Negative Rating Outlook for FFELP student loan ABS and unemployment among recent college graduates has resulted in higher than anticipated defaults and ratings volatility in the private student loan space.
Despite the challenging underlying collateral trends, core ABS sector ratings proved resilient over time, with upgrades significantly outpacing downgrades. In the most recent downturn, the vast majority of investment-grade ABS ratings exhibited very low levels of volatility. Given the higher quality collateral pools and structural enhancements now in place, it is expected that core ABS ratings will continue to perform well.
Fair Weather for US CLOs
Strong corporate credit trends bolster Fitch’s stable outlook for CLOs in 2012. Helping the case for CLOs is the fact that the structures proved to be effective emerging from the credit crisis and crippling recession relatively unscathed. Rating actions across CLOs were generally confined to affirmations in 2011. More of the same is expected in 2012.
Stable trends in the leveraged loan market, specifically stable credit profiles and low default rates, continue to support Fitch’s forecast. Many legacy CLOs delevered significantly from amortization and loan prepayments in 2011, which resulted in increased credit enhancement for outstanding notes. This amortization is expected to slow in 2012 as many leveraged finance issuers took advantage of robust high yield bond and leveraged loan investor appetite over the past two years. CLOs experiencing early redemption calls are also expected to continue in 2012, with existing asset portfolios being sold into new issue CLOs.
Heavy loan refinancing activity in late 2010 and throughout 2011 has significantly flattened the maturity profile of the leveraged loan market for the coming years. This refinancing activity has positively impacted CLOs that are no longer in their reinvestment periods, as senior CLO notes are repaid resulting in increased credit enhancement for remaining notes going into 2012. Conversely, portfolio amortization has resulted in more concentrated loan portfolios with the potential for adverse selection, which has served to temper rating upgrades.
Middle-market CLOs are also expected to have stable performance throughout 2012. In 2011, the credit quality of the private borrowers that comprise these portfolios remained relatively stable. Fitch affirmed most classes from CLOs backed by loans made to middle-market borrowers. Most of these transactions have delevered significantly due to zero-tolerance triggers that divert excess interest proceeds to pay senior notes once a loss is incurred on the underlying portfolios. These excess interest proceeds can often provide significant payments to the CLO liabilities since middle-market borrowers pay a significant premium for financing compared with broadly syndicated borrowers.
Outstanding Fitch-rated middle-market CLOs have amortized an average of nearly 50% of their original portfolio balances to date. Loan amortization is expected to continue through 2012 as loans mature, resulting in increased credit enhancement to rated notes and calls on some transactions. Obligor exposure on a majority of these CLOs runs less than 50 obligors, which will likely limit potential upgrades on their CLO notes in 2012.
A Mix Of Sun And Clouds For CMBS
The weather for CMBS performance is likely to be streaky in 2012. While performance metrics are showing signs of stability, lightning still has the potential to strike the large universe of underperforming loans. Liquidity has been returning to the U.S. CMBS market helping to limit losses through refinancing, but current macroeconomic uncertainty still has the potential to disrupt financing in 2012.
Property market fundamentals are expected to continue to stabilize and possibly improve modestly leading to Fitch’s view that investment-grade ratings will be mostly stable in 2012. However, non-investment-grade ratings will have greater potential for downgrades given the potential performance volatility of the sizable specially serviced loan book.
Hotels and multifamily properties, which through the cycle exhibited the worst delinquency performance, are now stabilizing or, in some markets, showing reasonably strong income growth. Conversely, properties with longer term lease agreements largely insulated against dramatic cash flow fluctuations, such as office properties, will continue to see mixed results, as major metropolitan markets may see rental growth and smaller, weaker, mostly suburban markets will show continued weakness.
Larger metropolitan areas will continue to outperform smaller cities, tertiary markets, manufacturing hubs, and markets with heavy exposure to the housing industry downturn. This continues to make the Washington, D.C./Northern Virginia, New York metro, San Francisco, and Boston markets well positioned to take advantage of the economic recovery. Conversely, Phoenix, Detroit, Atlanta, Las Vegas, most Florida cities, and certain California markets will remain weak.
RMBS Remains Under A Black Cloud
The sector least likely to catch a break anytime soon remains RMBS. With another 10% drop in home prices projected, loss severities are likely to trend higher. A more pronounced risk in the coming year will be interest shortfalls, which may induce rating downgrades even on bonds that are performing well.
Despite modest improvements in delinquency roll rates, defaults are expected to remain elevated with high unemployment driving involuntary defaults and falling home prices driving strategic defaults from a growing population of underwater borrowers. Price declines, the overhang of distressed properties, and extending foreclosure and liquidation timelines will also continue to pressure loss severities on defaulted loans.
While U.S. home prices are nearing a bottom, Fitch does not believe they are there yet, and prices will continue to decline in 2012. Improvements in borrower affordability and historically low interest rates will continue to be offset by weak consumer confidence, tighter credit availability, and, most importantly, a huge overhang of existing and shadow inventory that needs to be cleared. In addition, distressed sales, which according to the National Association of Realtors averaged approximately 30% of existing sales this year, will continue to pressure prices in 2012 and add volatility. Under our base case view, U.S. home prices remain approximately 13% above sustainable values - albeit with significant regional variations. With that said, Fitch believes this further correction will occur over several years with declines coming from inflation-eroding (modestly declining) nominal values.
Regulators and policymakers will continue to play a key role in the development of the RMBS market next year. Greater clarity on key issues hanging over the industry, including GSE reform, outstanding Dodd-Frank provisions, and servicing standards, settlements, and a revised compensation structure, would be a positive for a market still searching for its footing. In particular, the final definition and implementation of qualified residential mortgage rules and related risk retention rules will be a key milestone.
The lone bright spot in U.S. RMBS remains the small but slowly growing prime new-issue market. Transactions are characterized by very high credit quality borrowers and low LTV loans. Fitch expects these transactions to be among the strongest vintages in a decade despite continued weakness in most housing markets.
While U.S. structured finance performance no doubt turned a positive corner in 2011, the fog of economic, political and regulatory uncertainty blurs the forecast for 2012.
Kevin Duignan is a Group Managing Director and Head of U.S. Structured Finance for Fitch Ratings