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Prime please!

24 August 2017 by Aza Teeuwen

I know it’s only August…. but I’m already thinking about Christmas and compiling my wish list…. aside from some new golf clubs and the usual things, it made me think that I would really like to see more proper, high street originated, Prime RMBS.

All joking aside, the market is desperate for more Prime RMBS issuance. Maybe we have been spoilt in the past but we haven’t seen as much issuance of Prime RMBS as we’d like, in any jurisdiction. AAA Prime RMBS spreads are tight as a result of a supply-demand imbalance. It’s no surprise though that banks haven’t been using the securitisation market (or in fact covered bonds) as much as they used to. Imagine you’re a treasurer responsible for the financing of your bank, and the central banks provide you with all the financing you need (and more) at dirt cheap rates – you would be mad to use more expensive capital markets funding, other than to ensure you keep your future funding sources alive. Rob wrote last week about the end of TFS, what it has done and why we’re happy to see it go (https://twentyfouram.com/en/2017/08/18/end-term-funding-scheme-party/).

Let’s take a closer look at the 2 main Prime RMBS markets in Europe, the UK and the Netherlands, which in 2010 to 2012, as the best quality assets were unsurprisingly the foundation of the revival of securitisation issuance. The graphs below show how quickly the outstanding balances in UK and Dutch Prime RMBS have fallen since the global financial crisis. Outstanding UK Prime (so high street originated) RMBS is at historically low levels of below €30bn equiv., and even Dutch Prime RMBS, which has stayed higher for longer, has dropped to €43bn from a peak of €87bn. In both markets another €7bn is expected to amortise in the next 12 months according to Morgan Stanley.

 

Source: Morgan Stanley Research

For investors that can only buy prime there have been a handful of transactions, arguably some of questionable quality, and I would argue that due diligence is now more important than ever. Most readers will know about our aversion to PE sponsored deals with questionable economic skin in the game; just last week we saw a non high street Prime Dutch RMBS deal of this nature. This Goldman Sachs sponsored deal brought good quality, newly originated mortgages to the market and we appreciate that the cost of setting up an origination platform is significant, but the ability to price a deal of this kind at tight levels is clearly driven by a lack of bank originated paper and tight markets.

Although, Goldman Sachs as the sponsor retains 5% of every bond to satisfy the risk retention regulation, they don’t own the actual origination business or the servicer, and have sold all future residual cash flows (so essentially the P&L in the transaction) to achieve off-balance-sheet treatment. By selling the P&L they offset the actual cash that is required to buy the 5% risk retention slice, and because of that we have concerns over alignment of interest in the long run. We should not forget that a number of similar RMBS deals were done in 2004-2007, as 5 year bonds, from the same origination platform and that now, over 10 years later, they are still outstanding and trading well below par.

Part of the appeal of high street originated Prime RMBS is the long history of issuance, ongoing support of redemption schedules and amazing liquidity in the market; deals like the Goldman Sachs one might be prime but won’t necessarily have this, due to the reasons we discussed above.

In markets like this investors should be cautious and rather than chasing non high street “Quasi-Prime RMBS” we prefer short-dated Non-Prime UK RMBS with the right structural protection. The question is how many banks will start issuing RMBS after the ECB starts tapering and TFS has rolled off? From discussions we have had with a lot of treasurers, many essentially already have their funding in place for the foreseeable future, but we believe that once the extraordinary funding programmes are out of the way, then surely Prime RMBS markets will slowly restart and we will certainly welcome increased issuance from the high street lenders.

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