S&P predicts tougher year for structured finance in 2007

Standard & Poor's (S&P) has warned that the pace of ratings upgrades in the European structured finance market will slow in 2007. Last year, the ratio of upgrades to downgrades reached a new high, as the benign credit environment helped the performance of structured finance transactions.

"More than 96% of ratings remained the same or improved, and upgrades exceeded downgrades by more than ever last year," says London-based S&P credit analyst Andrew South.

However, South predicts that changing market fundamentals may begin to negatively influence ratings in 2007. "Asset performance is deteriorating in some sectors, but structural mechanisms in many asset classes mean ratings are largely protected on the downside," he says.

This is borne out by S&P's predictions for ratings performance throughout various asset classes. Residential mortgage-backed securities (RMBSs) saw the highest number of upgrades in 2006, and S&P says many transactions benefited from house price inflation, low levels of delinquencies and high prepayment rates. But the agency believes this trend may slow and some RMBS deals could face performance difficulties, particularly if delinquency levels rise. Any correction in house prices may also prove problematic, as foreclosure frequencies and loss severities on default would increase.

However, the agency adds that even with deteriorating economic conditions, RMBSs would probably be shielded from widespread downgrades due to the fact that borrowers tend to keep up repayments, even under pressure.

In the commercial sector, the amount of commercial mortgage-backed securities (CMBSs) outstanding has increased by 40% in the past year. The agency believes default rates will rise, but says the increase in risk will be offset by the fact that commercial property values are unlikely to fall. As CMBSs are typically financed by small loan pools, S&P warns that their ratings performance will remain heavily contingent on loan-specific and event risk into 2007.

Meanwhile, asset-backed securities (ABSs) have seen a deterioration in the quality of underlying asset pools. Debt-ridden UK consumers are partly to blame for high levels of credit card delinquencies and charge-offs, while an upward trend in loss rates and delinquencies on automobile ABSs are also occurring across Europe. However, S&P says these are unlikely to have an immediate effect on ABS transactions, as either excess spread or structural protections will safeguard rated deals.

In the collateralised debt obligation (CDO) market, S&P predicts that corporate default rates will increase but will stay beneath the long-term average. However, CDO-squared transactions will continue to experience greater ratings volatility as a result of their leverage. Conversely, managed deals have historically shown less rating volatility than others, and for these CDOs management skill will remain an important factor in 2007, the agency says.

Mark Pengelly.

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