05/07/2010

Europeans on Edge Over Fiscal Struggles

Mortgage bonds in the U.K. and The Netherlands could be headed down the same path as similar products issued in Europe's shakier nations.

So far, secondary-market prices for paper backed by U.K. and Dutch home-loan pools have more or less been holding steady as fiscal woes drag down the values of comparable instruments issued in Greece, Spain and Portugal. But market players see a contagion taking hold in the coming weeks.

Some suggest secondary-market spreads for U.K. and Dutch mortgage bonds will widen by 50-100 bp. Others see those projections as overstated, but still think values will drop to some degree. "That's a disaster scenario," one London-based trader said.

Spreads on the five-year senior portions of U.K. and Dutch issues had already widened by 20 bp at the end of April, as it became clear that Greece wouldn't be able to make good on debt payments. They regained the lost ground by May 3, however, and now are trading at 120-140 bp over Euribor.

Market players keep an especially close eye on the values of mortgage bonds issued in the U.K. and The Netherlands, as they are considered benchmarks for other structured-finance instruments in Europe. The thought is that it's only a matter of time before their prices drop again, as has already happened for other debt and equity products in the region. "I think it has to, I don't see any reason why it shouldn't," one broker-dealer executive said.

Equity and debt markets worldwide were hammered this week by concerns about the effectiveness of a $144 billion aid package that Greece is set to receive from other eurozone nations and the International Monetary Fund. Investors were also spooked by S&P's April 28 downgrade of Spain to "AA" (from "AA+"), and by Moody's May 5 move to place Portugal's "Aa2" rating on watch for a cut. Ireland and Italy have been of concern as well.

The values of Greek mortgage bonds already slid by as much as 10 cents on the dollar late last month, according to an April 30 report from RBS researcher Ganesh Rajendra. Prices also fell, to a lesser degree, for securities in Spain and Portugal.

Meanwhile, industry participants are puzzled by the resiliency of mortgage bonds from elsewhere in Europe. While structured products are in many ways insulated from broad economic concerns, they would be expected to react to such major developments.

One explanation may be that a runup in prices earlier this year was due to trading among investment banks, as opposed to rising bids from other types of investors. With nervousness mounting about sovereign-debt strains, many of those institutions are only now seeking to reduce their mortgage positions. Several have circulated large bid lists in recent days. However, other investors appear focused on a growing new-issue supply - resulting in a drop in secondary trading.

New mortgage bonds in Europe have seen strong pricing. For instance, the 2.8-year portion of a $4.2 billion securitization Lloyd's Banking completed April 30 fetched a spread of 115 bp over Libor. Alliance & Leicester is now marketing its second deal of the year, estimated at $1 billion.

Ultimately, a $936 million securitization of Spanish auto loans from Volkswagen may be more influential in determining the market's direction. That deal has been making the rounds since April 14, sparking speculation that it could be shelved by worries over the country's fiscal struggles. If it doesn't price, or prices poorly, other structured products could find themselves under even more pressure.

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