Offshore insecurity

Led by the country's bank originators, South Africa's securitisation market has seen explosive growth over the past few years. But trepidation offshore has cast new uncertainty over its future direction and prospects for growth. Mark Pengelly reports

Securitisation in South Africa underwent the best of times and the worst of times during 2007, according to a recent report by Absa Capital. During the first half of the year, the country's main originators of securitised paper had reason to be bullish. Although South Africa's banks came comparatively late to securitisation, its employment as a funding diversification and risk management tool has flourished over recent years.

Growth in the market has been dominated, in particular, by bank balance-sheet issuance of residential mortgage-backed securities (RMBSs) and auto-loan asset-backed securities (ABSs). Issuance volumes of securitised paper have grown year-on-year for five out of the past six years, climbing to R31.8 billion ($4.16 billion) in 2006, according to Absa Capital (see figure 1). This figure represents a rise of 46.5% compared with the year before, and more than 25 times the volumes recorded in 2001.

Such weighty supply has previously been met with robust demand from South Africa's pension funds, asset managers, and conduits - most of which are obliged to invest in local assets. Because of this, they have traditionally offered an easy method of placement for securitised paper. But, by the end of 2006, issuance volumes had begun to reach a level that bankers doubted the local investor base could absorb by itself (Risk South Africa Autumn 2007, pages 10-12)1.

This enticed the country's bank originators to search for opportunities elsewhere - in particular, Europe. South Africa's first international deal, called Nitro International Securitisation Company 1, was launched by FirstRand Bank in November 2006. Repackaged from an earlier domestic auto-loan issue, the bank successfully placed a single EUR200 million Aaa rated tranche of floating-rate ABS notes into the European market. Standard Bank soon followed - in March 2007, Blue Granite International ABS successfully placed EUR233 million of AAA and AA rated South African RMBS notes with European investors. FirstRand then commenced another EUR200 million auto-loan ABS issue, Nitro 2, during April. Further international deals were deemed a certainty from FirstRand and Standard Bank - and indeed, all of South Africa's major bank originators.

Then came the market turbulence of July. The havoc wrought elsewhere across the globe by soaring delinquencies on securitised assets has left South Africa's market largely untouched in the past eight months. Although ballooning losses on US subprime mortgages have seen banks and investors in the US and Europe suffer billions of dollars in losses, South African institutions have escaped the worst of the turmoil, thanks to both restrictive investment mandates and the vanilla character of the local market.

But, while the domestic market has been relatively unscathed by global credit contagion, the crisis offshore has had a knock-on effect on banks' securitisation programmes, hampering efforts to take assets off their balance sheets and distribute them to overseas investors.

"We saw placing internationally with Nitro as an outlet for our funding and liquidity management requirements. Now, somebody has locked up the European market and hidden the key," observes Boshoff Grobler, Johannesburg-based debt capital markets transactor at Rand Merchant Bank (RMB), the investment banking arm of FirstRand Bank.

With European investors shying away from structured finance, the bank has had to rethink its management of funding and liquidity, adds Grobler. "We always needed to diversify our funding sources and our aim was to go into Europe, but the option wasn't available, so we didn't."

Closed market

Megan McDonald, director of securitisation at Standard Bank in Johannesburg, agrees the playing field has altered for South African issuers. "It looked as if the market was poised to see a lot of cross-border issuance. But the credit crisis has meant that overseas issuers from jurisdictions like South Africa haven't been able to access the market since June or July last year. That market remains closed to us."

Credit spreads have widened across the board since August, but South African issuers have faced a double whammy due to wider currency swap spreads, which helped to make offshore transactions uneconomical during the second half of 2007. From 16.5 basis points on June 6, five-year zero-coupon rand-dollar basis swaps peaked at 52bp on August 3, and hovered above 30bp for much of the rest of the year, according to Standard Bank. They stood at 26.5bp on January 28.

On the domestic front, issuance continued during the second half of 2007, but spreads on securitised paper rose, deal sizes were reduced - and, in one case, a putative transaction was abandoned before being brought to market. The R3 billion auto-loan ABS, called Accelerator 3, was awarded preliminary local-scale ratings from Moody's Investors Service and Fitch Ratings in November, and the originator, Standard Bank, had commenced a roadshow for investors. The deal was never completed.

McDonald claims spreads were just too wide for it to complete the issue. "We always indicated to investors on the roadshow that there is a certain level where it makes economic sense for the bank to do the transaction. And the bank will not do a transaction outside those levels, because it has alternatives."

From January to December 2007, spreads on five-year AAA rated auto-loan ABSs increased by 30.5% to 47bp, according to Absa Capital. Spreads on five-year AAA rated RMBSs had blown out by 53.8% to 60bp, while five-year AAA rated commercial mortgage-backed securities (CMBSs) had widened by 37.5% to 55bp.

In total, 12 domestic deals took place during the second half of the year, bringing annual issuance volumes up to R41 billion. This still represents growth of 28.9% over the year before, but is down on the whopping 46.5% year-on-year rise recorded in 2006.

Absa Capital, Investec, Nedbank, RMB and Standard Bank all say they remain committed to issuing offshore. But when they do so is contingent on when European markets are ready to re-engage with issuers from South Africa. While some venture to predict this may be around the second or third quarter of the year, they add that it is anybody's guess.

Major bank originators continue to have plenty of assets to securitise. South Africa's real gross domestic product growth has run near 5% over the past three years, bringing unprecedented access to retail lending among the country's consumers and ascendant black middle class. Encouraged by the demands of the Basel II capital framework, which was officially implemented in January 2008, banks remain eager to repackage their assets to reduce regulatory capital requirements. But, in the face of offshore insecurity, the capacity constraints of local investors have come to play an important role in the market again.

"There's certainly a huge amount of supply. Whether all those transactions will come to market is another thing," sighs Standard Bank's McDonald.

Altered market conditions

Average deal sizes fell to around R1.5 billion in the second half of 2007, compared with around R2.8 billion during the first six months of the year. Individual transactions in South Africa had previously reached R4-5 billion in size, but changed market conditions mean it is now impossible to orchestrate such bumper issuances. Currently, the accepted market wisdom is that roughly R1.5-2 billion is the maximum investors can digest in one go.

"This is a far cry from 18 months to two years ago, when securitisation transactions were oversubscribed up to four times," remarks Tertius Smith, Johannesburg-based managing director of Fitch Southern Africa. "Now, people are struggling to make up their securitisation volumes."

Previously, local demand for securitised assets was also bolstered by the country's asset-backed commercial paper (ABCP) conduits. Conduits raise short-term funding through the ABCP market and invest in longer-term assets such as ABSs - enabling them to generate returns by taking advantage of the spread between their investments and cheaper, short-term financing. But, like other domestic investors, capacity constraints seem to have stymied their continued participation in the market. "In the past, it was the conduits that got spreads on securitised paper down from Jibar-plus-70bp to Jibar-plus-30bp. That is no longer the case," says Clinton Clarke, head of fixed-income sales at Absa Capital in Johannesburg.

Clarke believes liquidity problems - in particular, the difficulty conduits have faced in rolling over short-term financing - may have had an effect on demand. South African ABCP spreads have evinced a delayed reaction to international events. In November 2007, three-month ABCP priced at around 15-20bp, according to Clarke. By January 2008, these funding costs had shot up by about 10bp, to 25-30bp.

Bank originators are now thinking creatively about what kind of assets they can most economically take to the local market. Richard Hayne, head of securitisation at Nedbank Capital in Johannesburg, says: "There's been a lot of issuance of RMBSs and auto-loan ABSs. Maybe some investors are getting a bit full of that. They could decide not to participate or demand higher rates."

Since 2004, commercial property companies have found success tapping the local market with CMBSs. But the first half of 2007 saw the first bank-originated multi-borrower CMBS transaction. Private Commercial Mortgages Series 1, a R1.47 billion deal brought by Investec in March, was also the first to include a BB rated tranche. The transaction, which repackages mortgage loans on premises mainly in Gauteng Province and the Western Cape, is expected to be the first of a R10 billion repeat issuance programme. South Africa's bankers muse more transactions of this kind might give local investors some much-needed diversification in 2008.

Yet more innovative structures are also taking shape. Despite market worries, the second half of 2007 saw the launch of the local market's second synthetic collateralised loan obligation (CLO). Having completed the first such transaction in 2003, RMB raised R2.06 billion with its Fresco 2 deal in July. The structure references a pool of senior unsecured investment-grade loans, which can be substituted to suit the needs of the arranging bank. Nine classes of notes were issued, rated from AAA to BB by Fitch on the agency's national ratings scale.

Other banks are looking to follow in the footsteps of RMB with similarly advanced-structures. Investec, for instance, says it is currently rolling out a synthetic CLO for the South African market, although the bank will not comment further on the deal. Grobler of RMB also hints the bank will consider issuing another synthetic CLO in the year ahead.

Notwithstanding these new ideas, the mood among those in the market is considerably less upbeat than it has been in the past few years. Some observers doubt the market's ability to achieve year-on-year growth in issuance volumes during 2008, believing annual volumes will instead remain around the R40 billion mark. Others express fears further systemic shocks across global markets might push spreads past the point at which it becomes too costly for banks to issue paper.

"It hinges largely on the international situation," notes Kate Rushton, credit analyst at Absa Capital in Johannesburg. She forecasts moderate growth for the market in the year ahead, with most activity in commercial property deals. "I think it will be single-digit growth for securitisation as a whole, probably with the largest single-digit growth in CMBSs," she notes.

Christophe de Noaillat, senior vice-president at Moody's in London, stresses the South African securitisation market has fared much better than others during 2007. He and his colleagues anticipate a slowing of growth in the first half of 2008, followed by a potential pick-up in activity towards the second half of the year.

But he suggests not all of the market's likely fears may come from abroad. The South African Reserve Bank's key inflation rate - the consumer price index excluding mortgage rates (CPIX) - broke its upper 6% target during April 2007. Last December, the CPIX spiked at 8.6%, according to government statistics. These levels have brought forth a tightening cycle of interest rate hikes. From June to December 2007, both the Reserve Bank's repo rate and the prime rate, at which banks lend to consumers, increased by 200bp to 11% and 14.5%, respectively. "We are currently witnessing a slight increase in delinquencies for some of the ABS transactions, given the rising interest rate environment," warns de Noaillat. "As of today, the expectation is that it will level off, but it's something we're monitoring."

Heightened delinquencies

Together with local investors' nerves about global markets, heightened delinquencies on consumer loans may make them even more vigilant about the assets on offer from originators. Indeed, some bankers say such greater vigilance is already occurring. In November, Moody's assigned definitive national-scale ratings to a R1.59 billion RMBS issue by Investec, called Private Residential Mortgages Series 2. Marianna Papadopoulos, a Johannesburg-based arranger who led the transaction, says investors were more scrupulous in their examination of the recent deal. "We found investors applied a far more rigorous credit analysis process to the underlying obligors and triggers," she attests.

On the other hand, some note an environment of rising rates and lower consumer credit may eventually take pressure off the supply side of the market. Lenders have also become charier of extending credit due to the National Credit Act, which was brought into effect last June. This aims to give greater protection to South Africa's burgeoning army of borrowers, but what effect it will ultimately have on the securitisation market remains to be seen.

For now, the focus for South Africa's banks is overseas, and principally Europe. Given an uncertain outlook for global markets in 2008, Grobler of RMB predicts those originators with the ability to juggle between domestic and international involvement will be the ones with the most success.

"The year is going to be a play between what Europe would want when it opens, and what local investors want. The bank originators that have access to asset classes that fit both those bills will probably do well this year."