Thursday, January 31, 2008

S&P: 2007 Proved To Be A Mixed Bag For The Canadian Structured Finance Market

The Canadian term structured finance market ended 2007 feeling a clear knock-on effect from the turmoil in the global credit markets as well as from the dislocation in the Canadian nonbank asset-backed commercial paper (ABCP) market that started in the summer. Total issuance for 2007 was C$7.11 billion, down 60.94% from C$18.21 billion a year earlier.


Asset-Backed Securities Issuance Down From 2006

The issuance of Canadian term asset-backed securities (ABS) consisted of six issues (see chart 1) compared with 22 issues in 2006. In terms of collateral type securitized (chart 2), there were two credit card-backed transactions that constituted 30.94% of the issuance, two auto-related asset transactions (46.48%), a reverse mortgage transaction (9.48%), and a single residential mortgage transaction completed in the first quarter (13.11%). Poor credit conditions also resulted in the cancellation or postponement of a number of term issues that we now expect to come to the market sometime in 2008.

Chart 1

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Chart 2

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Generally, the reduction in issuance was across all asset classes but was particularly acute in credit card and auto finance-related transactions. Credit card issuance fell to C$1.1 billion in 2007 from C$5.5 billion in 2006. In addition, auto finance-related issuance dropped to C$1.65 billion in 2007 from C$3.22 billion in 2006.

For 2008, there are a number of factors that Standard & Poor's Ratings Services expects will influence issuances in the ABS term market. Clearly, investor confidence in this market generally will need to be restored before term transactions will return to the market with any degree of regularity. This confidence is predicated on the ability of the Canadian economy to absorb any knock-on effects from the slowdown in the U.S. economy and the resultant impact on asset performance in Canada. Generally, asset performance in Canada hasn't deteriorated as it has in the U.S. However, the passage of time will demonstrate whether this is due to the inherent robustness of the Canadian economy or simply a lag effect from the events in the U.S.


Removal Of Withholding Tax Introduces New Dynamic

A second factor whose impact is still to be determined is the removal of withholding tax by the Canadian government, effective Jan. 1, 2008. See "Elimination Of Canadian Withholding Tax May Prompt Change In Canadian Securitization Landscape", published Jan. 9, 2008, on RatingsDirect for a discussion of this change. It is still too early to determine what, if any, impact such a change will have on the Canadian market. However, the removal of the tax creates an opportunity for U.S. credit card issuers and auto finance companies to fund Canadian assets in their U.S. platforms, thus potentially reducing the amount of issuance of these two dominant asset classes. Moreover, the tax's removal opens up the possibility of Canadian transactions being sold to U.S. investors.


Canadian ABCP Moves To Global Standard

Perhaps the most significant story for 2007 was the dislocation in the Canadian nonbank ABCP market and the resulting movement away from general market disruption (GMD) triggers that were the norm in Canadian ABCP liquidity agreements and the reason why Standard & Poor's did not rate Canadian ABCP conduits. Standard & Poor's global ABCP criteria approach viewed GMD liquidity as an insufficient mitigant to the liquidity risk that exists within GMD supported ABCP programs.

The shift from GMD liquidity has allowed Standard & Poor's to provide its first credit rating to a Canadian ABCP conduit, Okanagan Funding Trust.

We expect that the Canadian market will continue to ask for alternative rating agency opinions where globally consistent criteria and methodologies will be applied. Moreover, we anticipate that Canadian conduits will feature structural components seen globally, such as liquidity and programwide credit enhancement.


Canada Enters Covered Bond Market

Notwithstanding the turmoil in the global markets, two Canadian issuers entered the global covered bond market in 2007 and early 2008. Royal Bank of Canada (AA-/Positive/A-1+) sold a €2 billion five-year series followed quickly by a €1.25 billion 10-year series. In addition, Bank of Montreal (A+/Stable/A-1) issued a €1 billion five-year series. Overall, these issues have been well received in the global market and create an additional source of liquidity for the Canadian banks. For 2008, Standard & Poor's expects continued issuance as well as the entrance of additional financial institutions into the covered bond market.


Strong Issuance In First Half Of 2007 Offset By Weak Issuance In Second Half

The Canadian commercial mortgage-backed securities (CMBS) market began the year much like 2006 ended--with strong issuance throughout the first six months of the year. However, as spreads widened dramatically in the summer the issuance calendar dropped off quickly. In the third quarter there were only two transactions that closed and there were no transactions completed in the fourth quarter. The volatility in the capital markets made it difficult for issuers to price new loans and to issue previously closed loans would result in a loss to the issuer. By year-end there were eight deals completed, which generated an overall issuance of C$3.6 billion (see chart 3). The cumulative issuance through 2007 in the Canadian market was C$23.4 billion in 63 transactions (see chart 4).

Chart 3

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Chart 4

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Ten Years Of CMBS Issuance In Canada: Back To Basics

The conduit market continues to be the dominant form of issuance; Canadian Imperial Bank of Commerce (A+/Negative/A-1) returned to the market with its ClareGold 2007-1 issue, which combined a seasoned portfolio with new loans. The average transaction size remained consistent with 2006 at about C$400 million. However, the outlook for 2008 is for smaller transactions with concentrations in more "vanilla" property types. These smaller transactions will likely be less diverse.

We'll be monitoring maturity date refinancing risk; in 2008 there is about C$998 million in loans that are scheduled to mature and will need to be refinanced to pay the balloon amounts associated with these loans. The current lack of liquidity in the mortgage market has increased the refinancing risk in these loans. A number of factors, however, mitigate this risk. The largest portion of these loans scheduled to mature were originated in 1998 and 2003. Since origination, these loans have benefited from improved cash flow that has improved the in-place debt service coverage rations. In addition, as cap rates have compressed since 2003, the underlying properties have increased in valuation since origination, reducing the loan to value on maturity. As a result, the maturing loan balances using debt per dollar of cash flow as a measure of leverage; this indicates that the maturing balances are more conservative than current underwriting standards and, therefore, should be able to find refinancing. While this is generally true, individual property dynamics will affect lenders' appetite to refinance the maturing loan balance.

Asset performance in the Canadian CMBS market continues to be strong. Delinquencies have remained consistently low as occupancy levels for most property types in most markets are at or near historical highs, which has maintained coverage levels. Overall, as of Dec. 31, 2007, there were no delinquent loans (0.0% by principal balance) for Standard & Poor's rated transactions. Transaction level performance also was strong, with upgrades again outnumbering downgrades (there were 39 upgrades and two downgrades in 2007). The two downgrades were in credit tenant lease transactions where the ratings depend on the underlying rating on the tenant; there were no downgrades in conduit transactions.


Servicing

Supporting our CMBS and RMBS initiatives, Standard & Poor's continues to provide servicer rankings on Canadian commercial and residential servicers. The servicer evaluations are intended to assess a servicer's strengths, weaknesses, opportunities, and limitations through an examination of three key areas: management and organization, loan/asset administration, and financial position. To attain a minimum ranking of AVERAGE and become a select servicer, a company must display competency in a number of crucial operational areas and management must have acceptable industry-level experience, with adequate policy and procedure manuals to ensure a well-informed and knowledgeable staff. Companies should display internal controls over the cash management process to minimize the risk of loss from fraud or human error. Select servicers must have a viable internal audit process and appropriate disaster recovery measures. Overall, competent servicers should possess a coherent organizational structure that adequately delegates responsibilities among the dedicated staff.

There was one servicer ranking action in 2007 as First National Financial LP's Master Servicer rankings were raised to ABOVE AVERAGE from AVERAGE. There are 16 commercial rankings on Canadian servicers, as well as two residential rankings and one equipment lease servicer. We expect additional servicer ranking announcements in 2008 as we review and rank the servicing capabilities of financial institutions participating in the covered bond market.


This Year: Lower Issuance Likely, But CMBS Well Positioned

The outlook for 2008 in terms of issuance appears uncertain. While maturing mortgages from transactions that were originated in 1998 and 2003 provide potential to be refinanced into new transactions, many of these loans have been previously defeased. The removal of the withholding tax between Canada and the U.S. may relieve some of the liquidity constraints in Canada. Also, these loans may end up in U.S. transactions, which would also reduce issuance volumes for Canada. Issuance volumes will likely drop considerably from the pace of the past few years, with potential issuance in 2008 likely to be below the issuance levels of 2003 at about C$1.5 billion.

Contrary to the issuance outlook, Canadian commercial real estate fundamentals appear to be well positioned for 2008. Property types such as retail and office properties benefit from long-term leases and new supply coming online in 2008 would appear to be limited. Multifamily properties have benefited from continued rent growth and very low vacancy levels. Industrial properties in eastern markets could see some softening if the manufacturing sector and related industries experience a more prolonged period of weakness. Lastly, the lodging sector could see some weakness in 2008 if business travelers reduce travel budgets and demand softens from leisure travelers as a result of the strong Canadian dollar.

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