Published: January 02, 2008
Despite recent market turmoil, ‘plain vanilla’ term-securitization is well-established in the US and western European markets. Substantial growth is now imminent in both Central and Eastern Europe (CEE) and CIS. RZB is a substantial player in these markets, with two asset-backed securitization programs in CIS totalling $600m, one backed with auto loans and the other residential mortgage-backed (RMBS). Many corporations rely on asset-backed securities for their medium- and long-term investments due to their strong credit, liquidity and reliability of returns but confidence in these investments has been shaken following the US sub-prime crisis. We believe the nascent CIS and CEE securitization markets are well-positioned to weather the credit storm and prove reliable for investors with strong investment opportunities and the absence of a sub-prime market. Issues up to now have benefited clearly from the need to convince investors that the CEE/CIS risk was not compounded by further structured risk. As past deals repay, in full and on time, confidence will be bolstered. In this article, we look at some of the activities and trends in the regional securitization markets and the outlook for the coming year.
Although there was little securitization activity in the CEE countries during 2007, we see increasing opportunity during 2008, including multi-jurisdiction issuances.
CIS, Kazakhstan and Ukraine had their first securitizations of existing assets in the form of residential mortgage-backed transactions while Russia launched seven transactions: four mortgage-backed, two diversified payment rights (DPR) and one auto loans. Russian securitization transactions are also increasing in complexity and quality. The Agency for Housing and Mortgage Lending’s (AHML) first residential mortgage-backed security was also the first domestic transaction to use tranching, DeltaCredit’s residential mortgage-backed transaction was the first in Russia to use a principal deficiency ledger (PDL)6 mechanism. RZB’s USD 400 million auto-loan deal was the first in its asset class to achieve a single A rating in Russia.
2007 continued an extended period of strong economic growth in the region. 2006 has shown record high foreign direct investment (FDI) levels, with USD 14 billion in Poland and USD 5.95 billion in the Czech Republic, with CEE countries benefiting from relatively low labour costs and improving levels of productivity. Although many banks have been busy with the implementation of Basel II, commercial and retail lending activities continue to boom following good results and strong economic prospects. The economies of Central and Eastern Europe are also often viewed as an attractive gateway to the prospective markets of the CIS. With both inflation and foreign exchange rates remaining stable, the flourishing business environment has resulted in strong GDP growth rates (see fig 1).
Strong GDP growth, coupled with low interest rates and high consumption levels, has led to an economic boom in real estate resulting in a growth in mortgages as well as other forms of lending. The potential asset pools are therefore sufficiently sizeable to consider securitization as a viable option, despite the existence of a traditionally strong covered bonds market. [[[PAGE]]]
Like Russia (as we will discuss later in this article) Kazakhstan and Ukraine have experienced tremendous growth in mortgage and consumer lending. Both countries’ economies have experienced strong growth over the past few years with real GDP growth exceeding 8% every year this century in Kazakhstan (forecast at 9% in 2007 by Moody’s) and impressive growth in Ukraine, with 6.2% real GDP growth in 2007 in Ukraine (Moody’s). Consistent growth has increased the wealth of residents in these countries and created a demand for consumer and mortgage loans. As many of the banks providing these loans are independent, they have started to look to securitization as an effective method of obtaining cheaper funding and refinancing for their loan portfolios. Kazakhstan has seen securitization transactions nearly every year since 2003. In 2007, the country saw its first mortgage-backed securitization of existing assets. Several banks have also conducted DPR securitizations, and the volume of issuance in the first half of 2007 of just over USD 600 million surpassed the total issuance of USD 400 million in 2006.
Ukraine had its first public securitization transaction in the first half of 2007 with Privatbank’s USD 180 million residential mortgage-backed security which achieved an investment grade rating of Baa3 piercing the foreign currency ceiling of Ba3 through the use of political insurance. As in Kazakhstan, there are still legal issues surrounding securitization; although a number of organizations are lobbying to enact a securitization law, the government has so far been slow to respond. According to Moody’s projections, securitization will continue to grow in both Kazakhstan and Ukraine.
One of the key drivers for the Russian securitization has been the development of the mortgage market and lending in Russia has continued to grow quickly. For example, at the end of the first quarter of 2007, the volume of outstanding mortgage loans in Russia increased by more than four-and-a-half times and amounted to USD 13bn from USD 2.86 bn a year earlier. This expansion is not only in the volume of transactions but also in the variety of loans offered. There are numerous lending programs at different banks ranging from loans to young professionals to loans for construction of homes/improvements and even home equity lines.
RZB's USD 400 million autoloan deal was the first in its asset class to achieve a single A rating in Russia.
Major banks, small second-tier banks, and those in between have started developing plans to refinance their mortgage portfolios through term securitization transactions or warehouses, which also enables them to lengthen their funding sources. However, while demand for securitized products continues to grow, there are still legal uncertainties. The government has organized an expert consultation group to review the existing law and to propose changes and amendments to make domestic mortgage securitization transactions easier and more efficient to conduct.
Following an increase in house prices in Russia of over 100% per year in recent years, the first half of 2007 saw continued growth in the provinces, but residential real estate prices in Moscow and St. Petersburg have levelled off and in some segments in the market even declined slightly. The slow-down in price appreciation in Moscow and St. Petersburg may have implications for assumed recovery rates in loans to be securitized and may also contribute to a further push in lending volumes. In recent years, buying a home was out of reach for many Russians due to the escalation in prices, but as prices stabilize and incomes continue to increase, obtaining a mortgage could now become more achievable. It was announced recently that a number of mortgage lenders, including the largest, AHML, are reducing interest rates on mortgages by as much as 2% annually. This will help make mortgages more affordable and may spur further growth in mortgage lending.
A sub-prime (defined as adverse credit quality) mortgage market like that in the US does not exist in Russia. The main drivers for the collapse of the US subprime mortgage market were the decline in house price growth, rising interest rates and low underwriting standards within the sub-prime segment. Russia and CEE have different drivers governing the residential mortgage and domestic lending markets and consequently, we would not expect to see a similar occurrence.
However, the ramifications of the US sub-prime collapse are likely to be long-lasting with both direct and indirect effects. Up to six million US subprime borrowers expected to default on their mortgage payment obligations and 20% of sub-prime mortgages originating during the last two years are expected to end in foreclosure, many of which are of extremely poor credit quality due to low underwriting standards. Large scale refinancing of residential mortgage-backed securities via CDOs (collateralized debt obligations) is taking place and there is significant consolidation of sub-prime lenders and massive rating actions. [[[PAGE]]]
This situation is still creating major waves across both the US and global markets, with two German banks and one British bank forced to seek government help and significant write-offs announced by a number of banks. There are inevitable short- to medium-term effects on non asset-backed credit markets and the asset-backed market; for example, since the US sub-prime crisis first struck, European asset-backed securities have shown a significant widening of spreads amongst all asset classes including segments which are usually robust and stable, such as the UK prime residential mortgage-backed sector. This is despite the fact that the credit quality fundamentals, such as the level of delinquencies and defaults etc have remained unchanged. Mark-to-market losses have hit many asset-backed portfolios unexpectedly and many investments remain illiquid. There are a number of deals which have been halted due to unfavourable market conditions, such as Windermere XII and Hawthorne Finance which is likely to continue to be the case until market conditions stabilize. There is limited activity in the secondary markets and low levels of liquidity. While there are numerous bid lists on the market, there are few buyers.
Although the Russian securitization market lacks the issues associated with a sub-prime market, the Russian asset-backed security market cannot avoid being affected by the US sub-prime crisis like every other credit market. For example, we envisage higher risk premia, reduced investor appetite in an already illiquid market, and a greater focus by investors on the originator, beyond the transaction’s structural features. Important factors include a transparent and strong ownership structure, efficient credit and collection policies, robust underwriting procedures, a respectable history and reputation and prominent market position.
Rating agency Fitch expects a further deterioration in the performance of the sub-prime mortgage sector and a negative subprime environment to remain in 2008. According to S&P, US property values are likely to see a decline of 8% between 2006-2008. Furthermore, payment adjustments and increasing sub-prime mortgage delinquencies due to rate changes on adjustable rate mortgages (ARM) are expected over the next 18 months, according to S&P. The first quarter of 2008 is expected to exhibit the most severe mortgage resets and the foreclosure procedures are likely to extend throughout 2008 and beyond. After the first quarter of 2008, adjustable rate mortgages are expected to moderate.
One of the key drivers for the Russinan securitization has been the development of the mortgage market.
The medium-term outcomes are more difficult to predict. According to Moody’s, the turmoil caused by the sub-prime crisis in the US gives ‘serious reasons to worry’ across credit markets, with some degree of asset destruction inescapable and no quick recovery expected. ‘Headline risk’ i.e. the effect of sensational media coverage is also likely to have a strong influence in an already nervous market environment, creating possible further contagion in the economy. It is increasingly difficult for companies for source cheap funding while rates further out on the yield curve remain at elevated levels, reducing market activity and liquidity.
However, in the longer term, particularly beyond the end of 2008, some positive outcomes are also envisaged. Under the weight of regulatory and risk management pressure, underwriting standards are certain to improve for sub-prime origination leading to improved security of securitized instruments in the future. All rating agencies have revised their sub-prime RMBS rating methodologies, and going forward, these ratings will incorporate the credit risk aspects of sub-prime mortgages more precisely. Furthermore, with the lack of a sub-prime market in CEE and CIS, the opportunities for investors are potentially more positive than in markets more closely affected by US economic pressures.
While the risk profile differs in CEE and CIS, there are various potential snags associated with collateral in the emerging securitization markets which are not commonly found in the developed markets. For example, there is a lack of historical data with regards to collateral performance. This issue relates to virtually all types of performance data, such as delinquency and default rates, recovery rates, and amount of prepayments. In most emerging securitization markets, the residential mortgage market has only developed over the past few years and mortgages were initially offered only to a highly selective group of borrowers, resulting in very low delinquency and default rates. This significantly complicates the analysis of historical data and in most cases the results of this analysis cannot be interpreted with any statistical significance.
In addition, rapid growth of these markets combined with quickly developing economies means that this historical data may not be representative of the future situation when market growth stabilizes or an economy enters a recession. Furthermore, as a market grows, the nature of the collateral itself may change, as competition leads to decrease in interest rates and the potential development of a refinancing market, which may result in increased prepayment rates. Another issue related to collateral is a lack of data with regards to the foreclosure process, such as foreclosure costs and timing. [[[PAGE]]]
In many CIS countries, the quality of housing stock constructed before the break up of the Soviet Union is starting to deteriorate rapidly, which may impact the resale value of the properties and the resulting recovery rates in case of default. Finally, the rise in house prices, which has taken place in many new markets, particularly in the major cities has to be monitored carefully.
While this increase may be very beneficial to the value of the collateral pool, it is not yet clear whether this rise in prices represents a bubble which may deteriorate in a recession. Moody’s has observed that in many new markets, specifically in CIS countries, house prices have just reached the levels that were recorded before the recession of the late 90s in real terms. This may signal that the rise in house prices is not a bubble, but rather a recovery of house prices. If so, it would be reasonable to expect house price growth to stabilize rather than to fall, depending on the quality of housing stock and economic recession.
The typical Russian mortgage loan can be regarded as prime and there is no mortgage market for borrowers who do not have a viable financial track record. Mortgage loans in Russia are generally underwritten on the basis of debt to income ratios, defined in a variety of ways including payment-to-income and obligations-to-income. The maximum loan to value levels range from 70% in the case of AHML to 90% for Sovfintrade. Standard mortgages are fixed rate with a 15-year maturity. Income verification is based on a variety of documentation, including employer’s letter, tax returns (for self employed), but also some kinds of income, such as rent and dividends, may be included.
Mortgage loans in Russia are generally underwritten on the basis of debt to income ratios, defined in a variety of ways including payment-to-income and obligations-to-income.
In terms of underwriting standards, a variety of proprietary systems and standards are currently in use in Russia but there is a gradual move towards standardization based on the standards used by the large purchasers of mortgage loans in the secondary market (including AHML and Sovfintrade). A central agency to register arrears and bankruptcies is in development but so far is not widely used to support the underwriting process.
The asset-backed market will take time to recover from the shocks of the recent pat and immediate future but in the long term, the market has much to offer to investors with more stringent underwriting procedures and closer scrutiny by the rating agencies. Although emerging securitization markets will be affected by the same uncertainties as the more developed markets, they represent a viable and potentially attractive investment opportunity, with the lack of a sub-prime sector and low risk of default. The securitization market is still nascent in CEE and CIS and its growth will inevitably be slowed by the sub-prime crisis; however, the opportunity is all the more attractive after recent spread-widening and we see a bright future in these dynamic and innovative markets.
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