Prime RMBS - ininad.co.ukininad.co.uk/RMBS_Oct2012.pdf · The majority of the UK Prime RMBS market...
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Institutional Investment Advisors Limited
Strictly Private & Confidential
Briefing Note
Prime RMBS October 2012
This document is confidential and has been prepared for discussion purposes only. It
should not be transmitted in any form to any person outside the recipient’s organisation. It
is not, is not intended to be and should not be construed as investment advice. It has been
prepared on the basis of information believed to be reliable. IIA makes no warranty,
expressed or implied, as to the accuracy or completeness of any of the information or
opinions it contains. Please refer to the important notice at the end of this report.
© Institutional Investment Advisors Limited Authorised and regulated by the Financial Services Authority (Firm No. 475344)
Strictly Private & Confidential October 2012
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Introduction The largest single asset owned by most households is their house. Not surprisingly, bond issues backed by mortgages
form the second largest main sector in the European bond market after sovereign bonds. These bond issues are of
two types: Residential Mortgage Backed Securities ("RMBS") and Covered Bonds.
This briefing looks at the RMBS market and its main components – the senior secured tranches. With a focus on the
UK as the largest RMBS market in Europe, it compares its size, quality and performance with the corporate bond
market that is currently the preferred non-sovereign bond class for many institutional investors.
Chart 1: UK Market Relative Sizes
Total
Total
Total
Total
Total
AAA
AAA
AAA
AAA
AAA
0
100
200
300
400
500
600
UK RMBS BofA Merrill Fixed Rate UK
Covered
BofA Merrill Lynch Non Gilts
Of which BofA Merrill Lynch Sterling Corps
Sterling AAA Money Market
Funds
Relative Market Sizes - £ billions
Source: AFME, BAML and IMMFA. [BAML data 30Sep12. AFME RMBS data Q1 2012. IMMFA 17Aug12]
Summary The majority of the UK Prime RMBS market was and has consistently remained rated AAA.
Most issues are floating rate, currently yielding in the range 85 to 105 basis points over sterling LIBOR
As such, the UK RMBS market represents
the vast majority by value of AAA rated bonds available to sterling investors other than gilts and supranational
issues such as the EIB
the only substantial source of bonds that are not exposed to losses arising from a rise in the general level of
interest rates
an opportunity to obtain an excess spread of 40-60 basis points over AA rated non-financial fixed rate corporate
bonds [at 27 September 2012] for less credit risk and negligible interest rate risk.
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Residential Mortgage Backed Securities RMBS are securities issued by special purpose vehicles that own a large pool of mortgage loans. These vehicles are
typically put together by the banks that made the original mortgage loans and they are used as a source of funding
for that activity.
The liabilities of the SPV are secured on the underlying mortgages. The liabilities are "tranched", with the most
senior tranches having priority over the lower tranches. The lower, subordinated tranches protect the more senior
tranches from loss under all but the most extreme circumstances (e.g. for senior AAA tranches of Prime UK RMBS,
some losses would result if 1 in 3 houses were being repossessed following an unprecedented fall in house prices).
RMBS SPVs were among the very first types of securitisation vehicle and the vast majority retain their original basic
form and secure structure. Later developments in the securitisation markets involved stretching the model too far
and without sufficient control or care, resulting in failures in the period leading up to the credit crisis. The prime
RMBS structures that dominate the UK market survived the crisis unscathed, except for the collateral "brand"
damage caused largely by the US experience and reflected for a period in prices and spreads, but suffered by any
type of bond to which the term "securitisation" was attached.
Chart 2: Ratings Downgrades of US Non Agency RMBS by Vintage, to August 2009
0%
20%
40%
60%
80%
100%
2000 2001 2002 2003 2004 2005 2006 2007
Prime ARM Alt-A ARM
Subprime UK Master Trust RMBS
Source: Bank of America Merrill Lynch Research
Banks have used these high quality UK RMBS issues not only as a route for financing from the bond market, but also
via the Bank of England's repo facilities. Eligibility of the majority by value of UK RMBS as collateral for use in the
Bank of England's monetary operations1 reflects the importance of the RMBS market in the UK.
The main source of collateral for the Bank of England Special Liquidity Scheme was AAA UK RMBS.
Senior AAA-rated tranches of prime UK and Dutch RMBS are eligible collateral for the Indexed Long-Term Repo
scheme.
The most senior tranches of UK and EEA RMBS rated A3/A- or above provided they were rated AAA at issue are
eligible for Discount Window Facility (DWF) or Extended Collateral Term Repo (ECTR).
1 http://www.bankofengland.co.uk/markets/money/publications/summary_collateral.pdf
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The Bank of England also provides a useful three part framework under the headings "Complexity,
Interconnectedness and Opacity". Or in simpler language: can the structures be understood; do they expose
investors to intricate chains of counterparty exposure; can investors see what assets underlie the liabilities initially
and over time. This framework distinguishes the main RMBS SPVs as very strong in comparison to the weaker later
developments in the securitisation market.
Complexity: Simpler than a corporate credit, well understood by leading asset managers
RMBS structures used in the majority of the market have been around for many years and are widely
understood. They are also not especially complex. Indeed, the Special Purpose Vehicles that issue RMBS are
considerably less complex and easier to analyse in terms of risks than most large corporations (and certainly
large banks and insurers) that issue bonds or in which investors hold equities. They are in a structural sense like
very simple banks that do nothing except hold mortgages, with buffers in place to protect holders of senior
liabilities. By absorbing losses, these buffers ensure that the economic character and risk faced by investors in
the senior liabilities are completely different from those involved in holding a pool of mortgage loans.
Interconnectedness: Very limited counterparty dependence, a diversification away from bank risk
RMBS are a method of diversifying away from general bank risk and thereby breaking chains of
interconnectedness of counterparty exposure. Granted, there are some residual exposures to banks involved in
RMBS, but these are not the main risks, are well understood and capable of being controlled. (E.g. swap
counterparties, where the risk is typically collateralised, and servicing obligations that could be taken over by
another party). This diversification feature is an investor benefit and has ensured that RMBS transactions
continued to be issued during the latter part of 2011 when the market for senior bank bond issues had all but
shut.
Opacity: More frequent, prompt and comprehensive reporting than any other major type of bond issue
High quality RMBS issuers such as UK Master Trusts have for many years reported comprehensive data, including
information on the status and performance of the underlying loans, with (1) greater granularity by type and
measurement band, (2) greater frequency (typically monthly) and (3) more promptly (e.g. December 2011
reports available mid January 2012) than any other type of bond issuer. In this respect, RMBS SPVs are among
the least opaque of issuers. As a result, it is no surprise that the ratings of these UK RMBS issues have proved
generally to be among the most stable of any AAA rated bonds.
Liquidity is provided by over 20 major investment bank market makers as well as several brokers. The highest credit
ratings, repo eligibility, a broad investor base and lack of interest rate risk (being floating rate bonds) all facilitate
secondary market liquidity in RMBS that is comparable to other non-government bonds. Even at the depths of
market disruption during 2008-9 there was always a bid, though prices were lower. Current typical bid/offer spread
is 2bps -10bps in £5m - £25m and larger trades are common. New PCS ("Prime Collateralised Securities") standards
will help to expand the investor base and deepen liquidity further.
Strictly Private & Confidential October 2012
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RMBS in a Global Context Chart 3: Bond Market Relative Sizes – US and Europe 31 March 2012 Euro Billions
4,350
1,184
5,486
1,064
126
1,504
1,580
374
3,056
795
355
4,760
569
169
1,850
965
18
67
- 1,000 2,000 3,000 4,000 5,000 6,000
Euro/Europe
£Stg/UK
USD/US
Covered Other Securitised RMBS Corporate Quasi & Foreign Govt Sovereign
Source2: BAML, AFME
Chart 4: European RMBS Market Relative Sizes - 31 March 2012 Euro Billions
0 50 100 150 200 250 300 350 400
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Portugal
Russia
Spain
Turkey
UK
Source: AFME
2 Source: All data sourced from Banc of America Merrill Lynch fixed rate bond indices, except for Securitised. Securitised sourced from AFME Q1 2012 report.
Note: All data in Euro billions or equivalent. “Securitised” categorisation is by region of collateral not currency. All data other than Securitised are for fixed rate
index qualifying bond denominated in EUR, GBP or USD only. Index qualification criteria include minimum issue size of Euro250 million, GBP100 million and
USD250 million. Covered Bonds: Index data used as full data not available as at 31March2012. The currency selection excludes DKK, NOK, SEK and CHF bonds
among others from the index data used above. Total covered bonds outstanding globally in all currencies amounted to €2,501 billion equivalent at 31 Dec 2010
(Source: ECBC) of which €562 billion equivalent was floating rate and only €920 billion equivalent (47% of the fixed rate remainder) qualified for fixed rate index
inclusion. Of the full 2010 total, €1,700 billion was denominated in Euro of which only €870 billion (51%) qualified for fixed rate bond indices at that date.
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Rating Performance The two largest RMBS markets in Europe are in the UK and Netherlands. AAA tranches of both exhibit rating stability
through the post Lehman crisis and the more recent Eurozone crisis, exceptionally so in the case of the UK.
Chart 5 Proportion of issues retaining AAA rating from May 2007 to May 2011 – Moody's
0% 20% 40% 60% 80% 100%
UK Prime RMBS
UK Credit Card ABS
Dutch RMBS
Italian RMBS
Italian Consumer Loan ABS
German Auto ABS
Spanish RMBS
Spanish Consumer Loan ABS
UK Non-Conforming RMBS
Irish RMBS
Portugese RMBS
Greek RMBS
Source: Moody's Investors Service July 12, 2011 Special Report: “European ABS And RMBS Rating Performance During The Crisis: Major Markets Prove Resilient, While Periphery Weakens”
European AAA RMBS had more stable ratings than other European or US structured products or corporate bonds
(mid 2007 to Q1 2011)
Chart 6: Proportion of rating downgrades in the period mid 2007 to Q1 2011
0%10%20%30%40%50%60%70%80%90%
100%
AAA
AA
A
BBB
BB
B
Source: S&P
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Spreads and Relative Value The following chart compares AAA UK RMBS spreads with non-financial corporate bonds from the resumption of
issuance after the post Lehman crisis to date. Since the onset of the Eurozone crisis in the Autumn of 2011, UK RMBS
spreads have been less volatile than non financial corporate spreads. While they have performed better, narrowing
significantly during 2012, they continue to provide better value than AA or A non-financial corporates.
Chart 7: UK RMBS spreads over LIBOR/EURIBOR Vs Non-Financial Corps
0
50
100
150
200
250
300
UK RMBS AAA 5y EUR EMU Corp Non-Financial AA UK RMBS AAA 5y GBP
Euro Corp Non-Financial A Euro Corp Non-Financial BBB
Source: BAML, JP Morgan weekly data
Similarly, AAA UK RMBS spreads have been less volatile than senior bank bonds and the generality of covered bonds.
These latter two sectors have experienced a general widening. Bank senior only began to retreat in late 2011 after
the ECB's LTRO operation. Meanwhile, the very strongest German pfandbriefe, – the original covered bonds, now
yield less than EURIBOR.
Chart 8: UK RMBS spreads over LIBOR/EURIBOR Vs Banks, Covered Bonds and AAA Pfandbriefe
-50
0
50
100
150
200
250
300
UK RMBS AAA 5y EUR EUR Corporates Banking Type-Senior
EMU Pfandbriefe 1-3 Yr AAA Rated UK RMBS AAA 5y GBP
EMU Covered Bonds Index 3-5 Yrs GBP AAA Covered 3-5 (monthly)
Source: BAML, JP Morgan. Weekly data except for GBP AAA Covered 3-5
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Prime UK RMBS in 2007/08 and in the current Eurozone crisis
2007/08 and the period until Autumn 2011
The long period prior to the crisis of
very low spreads on the highest
quality ABS was largely due to the
impact of the leveraged section of
the buyer base and especially highly
leveraged SIVs and ABCP conduits.
(See Chart 9 for RMBS).
This was particularly the case for
floating rate issues since they could
be financed readily via borrowing or
repo on a floating rate basis without
requiring a swap to extinguish
interest rate risk.
During the first seven years of this
century, the market was in effect
overbought as regards an
unleveraged investor who therefore
did not buy this paper.
Meanwhile, 10bps to a 15X leveraged investor was worth 150bps gross.
When the crisis occurred, the SIVs and ABCP conduits were forced to liquidate when their funding ran dry or they
were absorbed by their parent banks. The demise of the ABCP conduits alone is reflected in the fall in total USD and
Euro outstandings for all ABCP borrowers from $ 1,400 billion equivalent in 2006 to around $400 billion in 2010 and
at mid 2011.
During the 2007/08 crisis and at the extremes, the raw spread data in Chart 9 for RMBS reflected non-binding broker
marks in the context of disrupted secondary market activity, the vast majority of which involved forced transactions
many of which were not at arm's length. The overwhelming overhang of RMBS as the leveraged investors withdrew
ensured that spreads reflected demand falling off a cliff rather than fundamental credit concerns.
Control is being re-established by central banks and regulators to ensure that the SIVs and ABCP conduits do not
return. As a result, spreads for highest quality ABS – RMBS, Auto loans and Credit cards –had settled at levels around
150bps by late 2011, delivering a good running yield for a non-leveraged buyer. Since then, holders have benefited
from substantial spread narrowing. However, spreads are highly unlikely to revisit the previous very narrow levels.
The Current Eurozone Crisis
In the current crisis, the investor base for high quality ABS is much more stable. The SIVs and ABCP conduits have
gone. Holders include many more unleveraged "real" money investors such as insurance companies and pension
funds. Concerns abound for both the asset (sovereign, corporate and retail lending) and liability (funding and capital)
sides of bank balance sheets, and bank senior debt spreads have risen significantly. This has been exacerbated by the
EU Commission "bail-in" proposals of June 2012 for senior unsecured bank bondholders. European banks have
resorted to covered bonds as an alternative funding tool, placing more pressure on senior bondholders as assets are
tied up for collateral. In this context, senior Prime AAA RMBS and other high quality senior ABS spreads have shown
much lower volatility. We believe this is an appropriate response to their strong credit fundamentals, being secured,
underpinned by junior tranches and bankruptcy remote from their bank originators.
Chart 9: UK Prime AAA RMBS versus Euro Corps – Spreads to EURIBOR – basis points
0
50
100
150
200
250
300
350
400
450
Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11
UK Prime AAA RMBS Secondary Markets RMBS New Issues
Euro 3-5 Yr AA Corps
Source: JP Morgan, Bank of America Merrill Lynch, 24AM
Strictly Private & Confidential October 2012
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UK Prime RMBS Credit Fundamentals The Table below shows fundamental data for UK Prime RMBS Master Trusts from September 2012. This data is
derived from the regular detailed reports provided monthly by the Trusts.
With one exception (Granite), net loss rates are amply covered by “Excess spread” (net residual margin). In Granite's
case, the level of Excess spread cover is lower, but the level of AAA credit enhancement is significantly higher than
for any other Trust listed below.
UK Prime RMBS
Master Trusts Originator £bn
Weighted
Average
LTV
(indexed)
Net loss
rate Seller share Excess spread Credit enhancement:
AAA AA A
Arkle Lloyds 21.2 64.86% 0.04% 38% 0.73% 17.8% 15.9% 15.5%
Fosse Santander 19.0 64.98% 0.00% 13% 1.03% 21.3% 19.7% 19.5%
Gracechurch Barclays 10.6 58.57% 0.01% 34% 0.86% 15.9%
Granite N Rock 18.6 85.56% 0.58% 22% 0.82% 33.5% 24.9% 16.4%
Holmes Santander 14.2 67.59% 0.03% 18% 1.32% 20.1% 19.1%
Lanark Yorks and Clyds 3.7 62.21% 0.00% 39% 2.03% 17.9%
Permanent HBOS 29.4 64.84% 0.08% 31% 0.96% 19.0%
Silverstone Nationwide 25.5 60.20% 0.02% 17% 0.81% 16.7%
Source: JP Morgan, 24 Sep 2012
Size: These Master Trusts are large. The smallest is well over £3 billion, the largest is £30 billion
LTV = Loan to Value: With the exception of Granite, these seasoned Trusts contain loans with LTVS under 70%.
Net Loss Rate: Except for Granite, the net loss rates are all in single digit basis points and amply covered by
Excess Spread.
Seller Share: This is the "Skin in the Game", the economic risk in the structure retained by the originating
bank. In all cases, it is significant and well above the 5% requirement for issues after 1 Jan
2011 under the new Capital Requirements Directive for Banks and Solvency II for Insurers.
Excess Spread This is the first element of the structure available to absorb losses, being the excess of the
interest receivable from borrowers over the interest costs of the SPV's liabilities and
representing the originating lenders profit margin.
Credit Enhancement The proportion of the capital structure that ranks respectively behind the AAA, AA and A
senior tranches and acts as a loss absorbing cushion. This is broadly comparable with, and in
all cases substantially in excess of, the minimum 10%Tier 1 Capital or loss absorbing cushion
of a bank that investors would expect to be maintained.
Important Notice
Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other financial
instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended
to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any
specific person or institutional investor. Investors should seek financial advice regarding the appropriateness of investing in financial instruments and
implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be
realised. Any decision to purchase or subscribe for securities or loans in any offering must be based solely on existing public information on such security or loan
or the information in the prospectus or other offering document or information memorandum issued in connection with such offering, and not on this report.
October 2012