ABS Seen Hitting a Bump

Brazil’s fast-growing market for securitization looks set to hit a road bump in coming months. But a slowdown is likely to prove short-lived.
Brazilian securitization markets have been enjoying a boom, prompting frothy predictions of double or even triple digit growth. Some $5.5 billion was securitized in 2006 and the market has been expanding consistently for the last five years, according to Maria Muller, senior VP, Latin America structured financing, at Moody’s in New York.

But in the short-term, the dynamics of supply and demand have been changing. On the supply side, the first issue is that local banks have been coming to the capital markets, with a slew of IPOs in the last few months. On the demand side, the global credit market downturn is reducing appetite for riskier credit.

Banking sector IPOs are liable to slow growth as new capital raised allows banks to lend on balance sheet, which is more profitable than securitization where banks divvy up profits with third party investors, says Muller. International investors and a rapidly growing number of local hedge funds have been so keen to get their hands on loans that they have been going straight to originators and buying entire portfolios in one-off negotiations, she notes.

However, bankers and issuers remain largely upbeat about the medium and long-term outlook for securitization in Brazil. Peter Geraghty, managing director of LatAm trading at Dresdner Kleinwort in New York, argues that the number of banks raising equity and the amount of capital involved may be enough to slow markets in the short term. But he says the impact is small compared to the size of the banking system. This means that although some banks’ balance sheet capacity has been temporarily increased, their ability to lend will soon be outstripped by impressive growth in loan markets.

And some of the IPO activity from smaller banks is defensive, protecting against acquisition by a larger institution. M&A would have been more damaging still to the prospects of ABS. Larger banks have ample balance sheets which obviate the need for securitizing portfolios.

Year-on-year consumer lending has been rising at 20%-25%, with newer segments, such as car loans, expanding by as much as 30%-40% at the bigger banks. That may be just the beginning. The benchmark Selic rate has dropped to 11.5% and the trend is for further reductions, with analysts predicting as low as 10.5% by year-end. Real interest rates of 5%-6% are widely seen as a tipping point for a faster lending growth. That should be enhanced by an investment grade rating within the next year. Inflation is targeted by the Central Bank at 4.5% and forecast at 3.72% by analysts in July.

Domestic Prop
Brazil’s securitization markets are not dependent on foreign investors, unlike its heavily exposed equity markets, says John Tonelli, managing director of the mortgage financing group at Bear Stearns. It is predominantly a domestic-oriented market. A 15% withholding tax on foreign investors has stymied participation by foreign investors, he notes.

And news on the domestic front is positive. Local investor demand has just been boosted with a significant new piece of legislation: the fund regulator, the Conselho Monetário Nacional, recently passed Regulation 3456, allowing domestic funds including pension funds to increase their investments in FIDCs to 20% from 10%, according to Raphael Santoro, at Towers Perrin in São Paulo. The effect on demand will be magnified because funds are growing so quickly: pension funds alone are growing at 15%-20% clip per year, he notes.

The credit fund market, known by the Portuguese acronym FIDC, started attracting new foreign originators and distributors two years ago, including blue chips names such as Lehman Brothers and Merrill Lynch. The funds have been growing more flexible and able to absorb an ever greater array of underlying securities. At the same time, the nascent market in housing-backed loans, or CRIs, while growing much more slowly and still representing a small part of the securitization market, have been being widely tipped for an acceleration because of Brazil’s pent-up housing demand, estimated at some eight million units.

In the FIDC market, growing demand and a tapering off in supply should bring to the fore trends that already existed, making originators more creative about underlying securities and tranching of risk. Until the recent credit market crunch, there had been a great desire by investors for yield, says Geraghty. As investors moved into high-yield Brazil ABS, they drove spreads as low as 107% of the benchmark CDI-interest rate, he says. Portfolios typically have a 3-5-year tenor and pricing that low is for securities rated Triple A locally. That phenomenon was well underway in more plain vanilla structures that were already commanding a local Double A or Triple A rating, he says.

The drive down in yield has encouraged originators to scour the market for more exotic instruments with larger coupons. If FIDCs started with payroll deducted loans and credit card payments, they have been increasingly diversifying into car payments, motorbike loans and even more whacky investments like natural gas vehicle conversion kits. The search for the new has even led to the development of a market for securitizing legal payments. The state of São Paulo has been a frontrunner in this by agreeing to set up a structure (precatório) that pays investors installments that are destined for citizens who have won cash settlements against the state.

Student loans, which are a large segment in the US, are also arriving, says Muller, who has seen some small transactions in the area of five million reais or lower, distributed to local investors. Other initiatives still on the drawing board include commodity-based securitizations.
There has been another trend as investors prove willing to take on more risk. Two years ago, banks kept to simple structures in which the junior tranche was kept on the balance sheet, says Lourenço Miranda, VP of risk management at ABN AMRO in São Paulo. That was partly to show that they believed in their own product and partly because third-party investors were not yet willing to buy into the high risk junior tranche.
Increasingly, originators have successfully inserted a mezzanine tranche in the structure. They are even starting, in some cases, to sell parts of all of the junior tranche to investors, says Geraghty. Finally, less collateral is being used in ABS, adding risk and again allowing for deals to come with a higher coupon.

MBS Blocked
There has been little interest in mortgage-backed securities (MBS). Typically, this is the first securitized market to develop and provide a benchmark for other vehicles. In part, the Brazilian MBS market has been stifled by the obligation that banks have to direct part of their savings accounts to the housing market. This model is increasingly being questioned. Osvaldo Correa Fonseca, managing director of the Brazilian Association of Housing Credit and Savings Institutions (ABECIP) in São Paulo, says that the amount of savings in Brazil is insufficient to meet the demands for housing.

Fonseca says there has been some political progress in considering how to develop a market that is not based on the savings model. “The government is increasingly sensitive to this. Lula talked about change in February, indicating that he’d like to have something ready by the end of the year,” Fonseca notes. Still, he cautions that although the government is discussing the issue, there have been rumblings by politicians against radical change. They argue that Brazil is in a transition period and believe adjustment will happen organically.

The Central Bank is now studying models of mortgage markets from around the world, adds Fonseca, including those from Spain and the US and even smaller markets with interesting features like Denmark. Findings will be presented to government officials in November, he says.

Fonseca adds that there are three vital components for any legal change. The first is changes to the contract cycle, which needs to be accelerated from their current 45 days. Secondly, the requirement that banks direct 10% of their savings deposits must go. “Savings should be seen as seed capital and the start, not the entire solution,” he reasons. “We need to leave it up to banks how to handle lending.” Lastly, the government will need to look at how to encourage liquidity in MBS.

This is a particular problem in Brazil, which is still working to develop a government fixed-income yield curve and where secondary liquidity in corporate names and all but the most liquid government bonds remains negligible. Without such changes, growth in the market for securitizing mortgages will really trail off, Fonseca concludes.

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