Global Securitisation – Are we heading into a coronavirus credit crisis?

Timothy Lopes, Executive, Vinod Kothari Consultants

The global financial credit crisis of 2007-08 was a result of severe financial distress arising out of high level of sub-prime mortgage lending. Top Credit Rating Agencies (CRA) downgraded majority securitization transactions, slashing ‘AAA’ ratings to ‘Junk’.

Sub-prime borrowers could not repay, lenders were weary of lending further, investors investments in Mortgage Backed Securities (MBS) were stagnant and not reaping any return.

All these factors led to one of the worst financial crisis that affected global economies and not just the US alone. Recovering from such a crisis takes ample amount of time and efforts in the form of policy measures and financial stimulus / bail out packages of the government.

The rapid spread and depth of Coronavirus (COVID-19) outbreak has had severe impact across the globe in a matter of months. Stock markets are witnessing a global sell off. Countries have imposed complete lockdowns countrywide in order to mitigate the impact of this pandemic. Securitisation volumes are likely to witness a drop in light of the pandemic.

Daily, the situation only seems to be getting worse due to the unprecedented outbreak of COVID-19 and its rapid spread. There is absolutely no doubt that the impact on the financial sector and on economies worldwide is / will be a negative one.

As stated by the RBI Governor, in his nationwide address on 27^th March, 2020 –

“The outlook is now heavily contingent upon the intensity, spread and duration of the pandemic. There is a rising probability that large parts of the global economy will slip into recession”

The question here is, “Are we headed for another global financial crisis?” We try to analyse this question in this write up, in light of the present scenario.

Global securitisation impact of COVID-19

Worldwide businesses are affected, due to global travel bans in major economies affecting airlines, local transport, auto industry, hotels, etc. These industries are highly impacted by the spread of COVID-19. This impacts cash flows, liquidity, and capacity to repay liabilities in the short term as well as severely impacting profitability.

In the lending space, lenders have put a halt on lending, since collections from borrowers have stopped. Further, borrowers’ capacity to repay has been affected by the outbreak, leading to a halt in repayments as well. Since companies and individual borrowers will have financial difficulties in a slowed down economy, there is an anticipated increase in defaults, delinquencies and NPA recovery rates as a result of the pandemic.

Amidst the unavoidable circumstances, globally, several relief measures have been initiate by Governments, by providing stimulus/ relief packages to SMEs, student loans, etc., while also urging banks to allow relief to borrowers on repayment of their loans and EMIs. This is the case in several economies including Italy, Hungary, USA, Australia and India as well.

Although these measures will aim to mitigate the adverse effects in the short run, the duration of the pandemic caused crisis is still uncertain. This high level of unusual uncertainty has led to negative outlook for securitisations across the globe.

Rating agencies are downgrading securitisation portfolios as the outlook gets worse each day. The magnitude of impact would depend on the asset class and industry. Thus, ratings would change accordingly.

Issuers and servicers are taking several measures to respond to outbreak in day-today-operations. Lenders have begun implementing their business continuity plans, while banks and financial institutions have started granting payment holidays to help affected consumers.

We cannot foresee the duration of the pandemic, however, at present the situation only seems to worsen by the day, resulting in highly unusual uncertain in global securitisations.

Impact on various asset classes globally

Italy –

Italy is one of the worst affected countries, leading the government to take measures to completely shut down economic activity in the country, banning travel and public gatherings, etc[1].

According to a Moody’s research report[2] the above measures by the Italian government are credit negative for Italian structured finance transactions and covered bonds, with adverse effects on the credit quality of underlying assets because borrowers will face financial difficulties, ultimately increasing delinquencies and defaults. In case of NPLs, recoveries will be delayed.

Further, the Italian Banking Association (IBA) has announced an agreement for a voluntary 12-month moratorium on principal payments of SME loans and leases. According to Moody’s, The agreement between lenders and borrowers would suspend or extend repayments on medium and long-term loans, including mortgages, which could create liquidity pressure for Italian transactions.

Impact on various asset classes in Italy–

Given the above factors, Moody’s expect these issues to increase delinquencies and defaults in portfolios backing RMBS, consumer ABS and covered bonds. Further, NPL transactions primarily backed by mortgages will have delayed recoveries.

Further, Consumer ABS, SME ABS and RMBS portfolios have relatively high concentrations of loans originated in three major regions in Italy (Lombardy, Emilia-Romagna and Veneto), which also happen to be the most virus-affected and locked-down regions. These three regions happen to account for more than 40% of the Italian GDP.

USA –

Kroll Bond Rating Agency (KBRA) has reported[3] that since the beginning of March, 2020, the US stock market is down approximately 18% and unemployment claims are rising quickly as state governments, including California, New York, and other jurisdictions have directed citizens to shelter in place except for food, health care and essential jobs.

Isolation measures have suddenly and dramatically impacted GDP, with payrolls shrinking rapidly across service sectors. The current consensus GDP decline among investment bank forecasts is -2.4% for 2020.

Impact on various asset classes in the US –

US Residential Mortgage Backed Securities (RMBS) –

According to the KBRA report, for RMBS, broad economic conditions, including unemployment, will likely drive transaction performance and lenders’ continued willingness to extend credit. To the extent targeted actions address unemployment and/or loss of income, as well as mitigate widespread defaults and loan modifications, they can be supportive of mortgage market liquidity and stabilization. However the following impacts are likely –

Increased delinquency rates as a direct impact of increased unemployment, due to industries affected by social distancing measures.
Increased likelihood of modification following a period of delinquency, based on the duration of the contagion.
Lengthening foreclosure and liquidation timelines due to foreclosure and eviction moratoria.
Varied effects on prepayment rates for certain collateral, due to rate movements and liquidity constraints.

US Whole Business Securitisation

According to S&P Global ratings[4], the negative impact on whole business securitizations (WBS) from the coronavirus outbreak in the U.S. will almost certainly be substantial, particularly for the restaurant sector. S&P Global Ratings expects the COVID-19 pandemic to result in a material negative sales impact for many U.S. whole business securitization (WBS) issuers.

The country has recently reported large number of growing coronavirus cases, leading it to be the highest in the world, even crossing China. This only leads to more uncertainty, as markets expect high delinquencies and defaults in payments as well as slow-down in collections.

China –

As per a Moody’s report[5] securitisation transactions in China are moderately vulnerable to disruptions caused by the virus. Mainly because, consumer loans such as residential mortgages, auto loans and credit cards are the main collateral type. Consumer loan asset quality will deteriorate. However, negative implications will vary depending on the extent of asset deterioration and transactions’ structural features.

Chinese auto loan ABS asset quality will deteriorate, with delinquency rates increasing in the first half of 2020 or even longer as the coronavirus outbreak hurts the Chinese economy. In January, the 30+ days delinquency rate for Chinese auto ABS we rate increased to 0.17%, the highest since 2016 but still a low level.

However, strong portfolio characteristics, including prime quality borrowers and geographically diverse pools, will mitigate asset risks.

Australia –

Policymakers in Australia have announced stimulus measures to dampen increasing financial hardship. Australian banks have announced support measures for households and small business customers affected by the coronavirus, including temporary relief from home-loan repayments.

As per the aforementioned Moody’s report, the collateral credit quality of Australian residential mortgage-backed securities (RMBS) and other consumer loan ABS will also deteriorate. Loans to small-and-medium businesses and self-employed borrowers will pose the most risk, given many such borrowers will likely face material disruptions to their business operations, employment prospects and cash flow. Overall, the risks posed to deal credit quality are moderate, although lower-ranked tranches with smaller credit enhancement cushions may come under some pressure in more severe downside scenarios.

These measures could prove effective, however, there will be disruptions in cash flows and repayments to the issuer, especially in case of RMBS where the only regular cash flows arise from collections from the underlying borrowers.

The Indian Scenario

The Indian Government has taken aggressive measures and imposed a complete 21 day countrywide lockdown. There have been substantial rate cuts announced by the Reserve Bank of India. The RBI has also permitted banks and financial institutions to allow a 3 month moratorium for borrowers to make repayments on term loans.

We have covered the details of moratorium permitted by RBI in a separate set of FAQs[6] and write ups[7].

However, as per Moody’s, Indian ABS are highly vulnerable to coronavirus-related disruptions, because their credit quality is heavily dependent on sponsors’. Indian asset-backed securities (ABS) transactions, which are mostly commercial vehicle and small business ABS deals, are highly vulnerable to the bankruptcy of their sponsors, which are also typically the transactions’ servicers. Indian sponsors are now facing a funding issue, which is exacerbated by the rapid and widening spread of the coronavirus, and a deteriorating global economic outlook. The sponsor’s bankruptcy would disrupt cash collections given that, in their capacity as servicers, they largely collect loan payments through their collection agents in person and in cash.

In addition, ABS pass-through certificates would likely default if sponsors go bankrupt, because bankruptcy administrators would take control of the cash in the first-loss credit facility, which serves as both credit enhancement and liquidity in the deals. The assets in the deals also pose a moderate risk to credit quality of the transactions because slowing economic growth weakens demand for commercial vehicle operators, and small business owners. However, declining oil prices reduce operating costs for commercial operators, partially mitigating risks.

Conclusion

The International Monetary Fund (IMF) Managing Director had earlier announced that the global economy has entered a recession as bad as or worse than 2009.

The outbreak has certainly caused unprecedented impact on global economies. Given the high level of uncertainty and negative outlook, there is high probability of a credit crisis in the world of structured finance which could replicate or be even worse than the global financial crisis of 2008.

In case of securitisation structures, the originators/ servicers do not have a right to impose a moratorium. There has to be concurrence of investors and the trustee in the matter. Credit enhancements will have to be dipped into in most transactions.

Ultimately, the impact on securitisation will depend upon the duration of the pandemic, which is very uncertain and unpredictable. One cannot predict but can only wait to see how these events unfold.

[1] http://www.trovanorme.salute.gov.it/norme/dettaglioAtto?id=73629&completo=true;

[2] https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1218335

[3]https://www.krollbondratings.com/documents/report/32289/rmbs-coronavirus-covid-19-u-s-rmbs-and-residential-real-estate-ramifications

[4] https://www.spglobal.com/ratings/en/research/articles/200318-u-s-whole-business-securitizations-under-stress-from-covid-19-11391612

[5] https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1219586

[6] http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

[7] http://vinodkothari.com/2020/03/rbi-moratorium-on-term-loans-impact-on-sec-and-da-transactions/