ABS performance review - fundamental focus

Recent headlines have painted a nervous picture of the health of consumers across Europe. Simultaneously, rating agencies have upgraded their outlook on the same consumer assets to neutral. The short story is that, although there has been a mild weakening in performance metrics, the consumer has held up well and is ahead of our base case expectations in almost all areas. We acknowledge that the mild uptick in arrears in some of the pools backing these securitizations. However, this has been contained, and in areas of weakness there has been a general push from lenders to prioritise forbearance, resulting in very few cases of default and even fewer losses. Another thing to note is consistent tightening of lending standards post-COVID across Europe, transposing to a higher quality borrower in recent securitised pools.

While the performance stresses we throw at securitisations require a far more extreme downturn in consumer health before credit risk becomes a concern, we wanted to share some hard data from our recent sector reviews.  

In Europe, where the entirety of our consumer asset-backed securities (ABS) exposure lies, asset performance is ahead of where the markets base case expectations sat coming into the year. There are a few drivers for that, but we can begin by analysing the health of the labour market. Unemployment in the UK is sitting at 4.4% and between 3.5-6.5% for most of core Europe, which has weakened from recent post-Covid lows that resulted from labour shortages. However, current unemployment is at or maybe slightly below levels consistent with what most economists would see equilibrium rates and are likely on a trajectory to increase modestly over the next 12 months. Historically, labour markets have tended to change rapidly once the pendulum turns. We note that the Bank of England (BoE) and the Federal Reserve (Fed) has cited a period where businesses have horded labour now being a potential driver of underperformance, however, there is not a clear macroeconomic catalyst for this to unfold in the UK and core Europe that we foresee. In conjunction with this, we have seen healthy real wage increases across the region (year-on-year (YoY) real wage growth sits at 2.1% in the UK, and Europe negotiated wage growth rose to 4.7% for Q1 2024), facilitating saving rates that are still above pre-Covid averages in the UK and Europe.

Consumer loans

The segment of the European ABS market secured by consumer loans has seen a buoyant year so far, with a post Global Financial Crisis (GFC) record of €7.7bn primary market activity. This has been accompanied by consecutive reports of insulated fundamental performance of the underlying assets. Reflecting a supportive macroeconomy onto the performance of securitisations, we have evidence of stronger than expected consumers. First taking a look at defaults, we have evidence of stable annualised levels over the past 12 months with a range of 2.5-3%. Delinquencies, particularly in unsecured consumer loans, have seen a modest increase since the start of the hiking cycle, however, the pace is beginning to stabilise, and the observed weakening has been limited mostly to two areas of the securitized market – German unsecured consumer loans and Spanish pre-approved loans. The weakening of the German consumer predated more recent headlines of consumer weakness, meaning loan originators have long since tightened underwriting standards and thus we have seen a containment, and in some cases, reversal of early indicators of stress in these transactions. The same can be said for loans in Spanish transactions, where older so called “pre-approved” loans underperformed, lending criteria has tightened over the past two years in response and is now being seen in data. Further supporting evidence comes from monthly payment rates from UK credit cards, where consumers have maintained a monthly payment rate close to 30% over the past 12 months against a 10-year average rate of 26%. 

Looking forward, we do not expect widespread deterioration in default metrics, this is supported by stringent credit standards in Europe and a healthy consumer balance sheet.

Auto loans 

To obtain an additional illustration of consumer resilience, we can analyse the performance of ABS backed by auto loans. New car sales in Europe increased 4.4% YoY to March 2024, but remain close to 20% below pre-Covid levels. Reduced supply-side disruption has pushed used car prices closer to a longer-term average and sits close to 55% of list price after 36 months. While the Battery Electric Vehicle (BEV) secondary market is still in its infancy, the next few years will see a higher degree of price uncertainty as new the technology drives more efficient vehicles and brand competition (also from China), and consumer reservations about the performance of older models are answered. Reflecting on the impact here for securitised pools, we note that the presence of Alternative Fuel Vehicles (AFVs) in ABS transactions remain limited, contributing close to 20% on average, well below the 40-50% of new sales seen across Europe. 

The collateral backing European auto transactions, has been resilient over the past 18 months, with very few pockets of weakness. The average monthly default rate, over a three-month window, has been in the range of between 0.5% and 1%, while late-stage delinquencies have been benign for most of Europe, and in line with average levels over the past decade. One area that has seen more prominent decline is the sub-prime collateral that backs a pocket of securitisations in the UK (a tiny fraction of the overall lending market), where Chart 2 depicts the divergence in default rates, this is useful in that is shows how a more marginal consumer is bearing the brunt of weakening. We note that weaker asset pools and ensuing deterioration is compensated for in ABS through deeper structural protections and higher levels of excess cashflow, therefore performance remains within the boundaries needed to create risk of impairment in most cases.

Residential mortgage loans 

As elevated interest rates put a spotlight on the health of the consumer, a large part of the equation has been dominated by mortgage affordability. The collateral that backs European residential mortgage-backed securities (RMBS) is now overwhelmingly comprised of loans originated after the GFC, with borrowers subjected to conservative lending standards. 

We can analyse the early arrears and default metrics of prime mortgage securitisations across Europe over the past decade, with data that supports our claims of a stronger than expected consumer. The latest 30+ days delinquency levels for prime transactions sits between 0.2-1.5%, levels are below half the past decade’s average in all jurisdictions. The same can be said for defaults, where current annualised default rates of 5-25 basis points (bps) are towered by pre-GFC averages. In the UK, despite five-year prime mortgage rates increasing by 2.5% since December 2021, arrears have increased by just 0.3%.

“So, what is driving the headlines? – there is a subsection of the outstanding European mortgage market that was originated before the GFC. The performance for this cohort is diverging from the wider index, and performance is deteriorating rapidly in some cases. To explain this, we can assess the negative selection of assets here, as they are generally on variable rates and represent borrowers who have either not been able to refinance or have chosen to enjoy low floating rates for the past decade, meaning elevated base rates have an immediate effect on monthly mortgage payments.”

The post-GFC collateral has also mild increases in delinquency metrics (from a very low base), however, the key differential is that this deterioration is well within the stressed scenarios that we model for when underwriting a mortgage-backed security, and with momentum in favour of the consumer in Europe (such that transactions are well insulated), we expect the securitisations to remain well insulated. The outlook, as mortgage rates trend lower, is positive for performance across Europe and is evident in the lack of downgrades across the RMBS sector.

Collateralised Loan Obligations (CLOs) 

We have seen strong performance in sectors backed by consumer assets, but what about the leveraged loans held within CLOs? Generally, CLO performance in Europe has been strong this year, supported by low corporate defaults. The Moody’s CCC bucket in European CLOs currently sits at 5.2%, this is up 1.5% year-to-date (YTD), and driven mostly due to the Altice downgrades in March and June of this year. The graph below depicts this rise in CCC %, but importantly also plots the reality of this number of the past 15 years, including a peak in 3rd Quartile CCC levels at 16% during the GFC, which is far greater than near-term forecasts for the current cycle. 
 

CCC exposure is expected to rise into the end of the year, however, overcollateralisation (OC) cushions in European transactions have remained healthy, we note that there are no breaches of OC tests for deals inside the reinvestment period in Europe. The underlying default rate in Europe has stabilised and is expected to decline gradually over the next 12 months, and critically those cases of default have remained idiosyncratic. It is also worth noting that European loan issuance has been healthy, with over €125 bn of issuance YTD. A large share of this issuance was driven by loan repricing’s, facilitated by strong markets, and has pushed out the maturity wall for the European loan market.

Looking ahead 

Both the European Central Bank (ECB) and BoE have delivered their first cut off the cycle, and we do expect interest rates to drop again before the end of the year. Meanwhile, consumers in the UK and Europe have enjoyed sustained real wage increases and savings rates are elevated above pre-Covid ranges. Without disregarding the mild deterioration in consumer assets over the past 18 months, we have not seen signs of material weakness in loan level data we receive for European ABS deals to this point.