The European ABS Market – A Week in Review

Before this past weekend, the risk of bankruptcy at another Wall Street investment bank seemed real, but market participants expected a repeat of the Bear Stearns buyout scenario. When Lehman Brothers filed for bankruptcy protection on September 15, credit investors were taken by surprise, and they reacted by driving the cost of credit protection on financial institutions to record highs:

In the European ABS space, the upheaval sweeping through the financial services industry was most evident in the synthetic market. Few expected Lehman’s collapse, a turn of events that created a dilemma for Lehman’s clients since it acted as one of the biggest ABCDS counterparties. Post-collapse, the most liquid European ABCDS names have soared to record highs in a move that may be more reflective of a supply and demand imbalance than actual increase in risk:

Predictably, the negative basis that we have seen since the end of March turned rapidly to a positive basis, which is generally the sign of massive risk aversion, reflective of illiquidity in the credit and money markets that we last saw in January.

The Lehman effect did not stop at EABCDS.  Interestingly, one specific criterion that the European Central Bank has added to its new repo plan is now the centre of attention: interest rate and currency swaps within an ABS deal where Lehman is the counterparty.

This risk can largely impact the SPV as unhedged currency and interest rate market changes move to adversely affect holdings. Finding a way to hedge this exposure has grown increasingly difficult as firms are unable to find able counterparties.

The European deals where Lehman was involved are presented in Appendix 1 and are classified by role. Also presented are all deals where AIG, HBOS and Morgan Stanley are listed as the swap counterparty.

This event pushed interbank lending rates higher on Monday, supporting last week’s analysis that European central banks will cut rates soon:

 

 There was more bad news from Spain and Australia as Colonia, Spain’s largest property group, struggled to restructure its debt and Centro Property, an Australian shopping mall owner, failed to sell US assets.

In the UK, Moody’s Investors Service cut Bradford & Bingley’s long term bank deposit and its unsecured debt ratings to Baa2 from Baa1, its short term rating to P-3 from P-2 and its financial strength rating to D from C-.

These ratings actions put pressure on Aire Valley Master Trust’s ability to substitute mortgages in the pool. The current Aire Valley Master Trust collateral is shown in Appendix 2.

The European ABS market’s top five biggest movers were, once again, all deteriorators:

 
Contrary to last week, one new deal was priced just before the Lehman news broke and, despite pricing slightly tighter than secondary market levels, this one was probably public:

It was the second Driver deal to be priced this year after Driver 5 in February:

Despite all the negative news, cash ABS sector spreads did not widen as much as synthetic spreads. There are two potential reasons for this:

-Synthetic contracts are traded by dealers that have been instructed to hedge their books no matter what the cost

-The cash ABS market ceased to exist on Monday since nobody expects the market to stabilise at these levels. Despite the current positive basis, many traders expect spreads to tighten once books are hedged and to repeat the cycle of the January-March period:

The US government’s rescue of Fannie Mae and Freddie Mac provided a massive boost to the global credit markets but Lehman’s bankruptcy abruptly curtailed it.

By leaving interest rates unchanged this week, the US Federal Reserve may have been waiting to let markets digest the news of the AIG bailout before implementing a rate cut that would normally provide a boost.

In the UK, focus centred on HBOS as investors feared parallels between the US and the UK will continue: Northern Rock/Bear Stearns, US government actions/UK government actions, Fed cut/BoE cut, and Lehman Brothers/HBOS.

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