The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of US insurance companies. A list of archived Capital Markets Bureau Special Reports is available via the index
Global Structured Finance Rating Trends and Default Rates
As a follow-up to a previous special report titled, “U.S. Corporate Bond Default and Recovery Rates: Impact on Related Insurance Company Investments,” this special report will focus on rating trends and default rates in global structured finance. Structured finance includes securitized asset classes — such as asset-backed securities (ABS), mortgage-backed securities (MBS), collateralized debt obligations (CDOs), collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs) — all of whose cash flows depend on the cash flows of an underlying pool of assets. The three most common types of ABS are those backed by automobile loans, credit card receivables and home equity loans. MBS are instruments whose cash flow depends on the cash flows of an underlying pool of mortgages, either residential or commercial. Structured credit is a subset of structured finance and, in this special report, will include CDOs, CBOs and CLOs. The focus of this special report will be on ABS and structured credit. Residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) are not the focus of this report, but are included in some of the statistics provided by the nationally recognized statistical rating organizations (NRSROs).
Credit Quality Improving
The credit quality of global structured securities began to stabilize in late 2010 into 2011. Rating downgrades subsided after a tumultuous period in 2008 and 2009, when credit quality was severely and negatively impacted by the economic and financial crisis in the United States. For example, on average, when Standard & Poor’s (S&P) lowered ratings of global structured securities in 2010, they were downgraded 1.4 rating notches. This compares with 3.5 rating notches in 2009 and 3.2 rating notches in 2008, and reflects a lower severity of credit quality deterioration in 2010. A notch is one rating level; for example, one notch would be a downgrade from AA to AA- or an upgrade from BBB+ to AA-. In addition, as illustrated in the chart below, the frequency of rating downgrades remains at elevated levels, compared to downgrade activity from 1999 through 2006, but is beginning to decline. Fitch downgraded 57% fewer structured finance securities in 2010 than in 2009. However, with continued high unemployment rates in the United States and weakness in the U.S. housing market, it remains to be seen whether this trend will continue.
Almost 75% of Fitch’s rating downgrades of structured securities in 2010 were related to RMBS and CMBS. ABS represented only 5.6% of the downgrades and structured credit represented 20.4%.
Although ABS was affected the least by the latest credit cycle, rating downgrades for ABS increased year-over-year (as illustrated in the following chart) primarily due to revisions in how certain risks influence the performance of student loan ABS. However, ABS upgrades also increased year-over-year, with the majority of the upgrades in the auto loan sector as a result of stable collateral performance and increased credit enhancement.
According to Fitch’s rating transition matrix for ABS below, the BB rating category experienced the largest amount of credit quality deterioration, with 30.16% of ratings downgraded. The B, CCC and AA rating categories followed closely behind, with 27.45%, 26.92% and 26.76%, respectively, of ratings lowered. AA-rated ABS transactions suffered an unusually high percentage of downgrades to BBB and BB primarily as a result of a combination of 1) deteriorating performance in some private student loan deals and 2) revisions in how certain risks influence the performance of Federal Family Education Loan Program (FFELP) student loan deals. FFELP is one of the largest U.S. higher education loan programs under which private lenders make federally guaranteed student loans to parents and students. The BBB and AAA rating categories experienced the least amount of deterioration, with only 10.32% and 10.76%, respectively, of ratings downgraded. With the exception of the AA rating category, the investment grade rating categories enjoyed lower negative rating volatility than the non-investment grade rating categories.
Downgrades in structured credit at Fitch declined in 2010 after three straight years of year-over-year increases. The downgrades were attributable to 1) commercial real estate CDOs; 2) trust preferred CDOs; and 3) new ratings criteria for structured finance CDOs.
Similar to ABS, securities with higher ratings tend to be more stable than their lower-rated counterparts. The AAA rating category saw 25.26% of ratings downgraded, while the CCC rating category suffered more severe deterioration, with 67.38% of ratings lowered.
Given the continued high unemployment rate and weak housing market in the United States, collateral performance and, therefore, ratings will likely remain under some pressure. CreditWatch information provided by S&P provides insight into potential rating behavior for the near term. The following table shows that structured securities, in general, are at risk of continued downward ratings migration, as the number of transactions on CreditWatch with negative implications clearly outweighs those with CreditWatch developing or CreditWatch with positive implications. This data would look different, however, if the outlook for global corporate credit, unemployment rates, interest rates and/or the housing market changed dramatically.
Global structured finance impairment rates, which include securities in default or near default, improved in 2010 as ratings volatility stabilized. According to Fitch, the impairment rate declined to 13.43% from 24.86% in 2009, with the impairments concentrated in non-investment grade securities. ABS experienced the lowest impairment rate of 0.94%, compared to 20.05% and 16.26% for structured credit and RMBS, respectively. The 2010 ABS impairment rate increased from 2009’s rate of 0.68%, with investment grade ABS increasing to 0.34% from 0.14% in 2009 but non-investment grade ABS decreasing to 6.87% from 8.17%. Impairment rates for CDOs improved to 20.05% from 23.86% the prior year, primarily due to the significant improvement in investment grade credits from 16.70% in 2009 to just 1.06% in 2010. No impairments were evidenced in AAA ABS or AAA structured credit.
Based on data provided by S&P, the manufactured housing, student loans and auto loans subsectors within ABS were the only major subsectors to experience any default rates in 2010. Manufactured housing had the highest level of defaults at 3.58%, while default rates on student loans and auto loans were less than 1%. These are significantly lower than default rates for RMBS, CMBS and structured credit. The remaining major subsectors — including auto lease, credit card, equipment and commercial other — experienced no defaults or near defaults. CLO performance began improving in 2010 and is reflected in the relatively low default and near default rates in the table below.
Insurance Industry Exposure to ABS and CDOs
As illustrated in the following table, the insurance industry’s total exposure to ABS and structured credit as of Dec. 31, 2010, is $150 billion. The table provides the exposure by type of insurance company and by asset class. Life insurance companies account for the majority of ABS and structured credit exposure, with $119 billion or 79.5% of the industry’s total exposure.
Within the ABS asset class, the top three industry exposures are in the subsectors of credit cards, auto loans and equipment. According to the S&P data cited above, these subsectors experienced more upgrades than downgrades in 2010, as well as minimal to no defaults. The manufactured housing subsector’s ratings, on the other hand, saw almost 34% of its ratings downgraded, and it had the highest default rate within ABS. The industry’s exposure to manufactured housing totaled $2.2 billion, or 1.9% of the industry’s exposure to ABS.
As discussed in a prior special report titled, “Insurance Company CDO Exposure,” the insurance industry’s largest exposure in structured credit is to CLOs. As of Dec. 31, 2010, almost 50% of the industry’s structured credit exposure is in CLOs. According to the S&P default data cited above, CLOs in general experienced lower default rates than CBOs and the majority of CDOs.
In conclusion, the insurance industry’s exposure to ABS and structured credit is comparable to the $190 billion and $128 billion exposures to CMBS and non-agency RMBS, respectively. ABS and structured credit, however, have experienced less ratings volatility and lower impairment rates than CMBS and non-agency RMBS.
Current Credit Spreads and Market Trends
The ABS sector has returned solid performance thus far in 2011. Modest improvements in employment, fewer bankruptcy filings and conservative underwriting standards have contributed to improving credit performance. Solid and improving credit performance is evidenced by credit spreads and trends. For example, the current indicative market spread for an AAA, fixed rate, three-year, prime auto ABS transaction is 29 basis points (bps). This is 8 bps tighter than the year-end 2010 spread of 37 bps and significantly tighter than the recent wide of 600 bps in November 2008. Similarly, credit card ABS have also performed well, as the current indicative market spread for an AAA, fixed rate, 10-year has tightened 10 bps since year-end 2010 to 45 bps from 55 bps. The recent wide for credit card ABS was 600 bps in October 2008.
Student loan ABS also has fared well. A typical AAA, 10-year FFELP student loan ABS transaction trades at 90 bps today — or 10 bps tighter than year-end 2010 and 385 bps tighter than the recent wide in October 2008. ABS backed by private student loans, which have no federal guarantee, also has performed well. A typical AAA, 10-year private student loan transaction trades at 275 bps today — or 95 bps tighter than year-end 2010 and 575 bps tighter than the recent wide of 850 bps in October 2008.
New issuance activity in the ABS market is comparable to last year, with almost $44 billion of new deals issued in 2010 vs. $45 billion in 2009. The majority of new issuance has been concentrated in the auto and student loan sectors. The auto subsector alone accounts for 65% of 2010’s year-to-date new issue volume.
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