Securitized assets: Caught in the storm but with scattered bright spots

Now seems an opportune moment to provide an update on the securitized market— a fixed income sector that, in many ways, has been on the front lines of the ongoing turmoil in the US banking sector. However, as discussed below, our view is that not all securitized subsectors are equally vulnerable in this environment.

March 2023: A tough month so far

US Treasury yields have fallen, while credit spreads and global market volatility have risen, amid the recent challenges faced by a growing number of banks in both the US and Europe. As a result, March has been a tough month for many market sectors as of this writing, and the securitized asset space has been no exception.

Agency MBS have been the laggards 

Agency mortgage-backed securities (MBS) have been directly impacted by the crisis, making them one of this month’s worst risk-adjusted performers within the securitized space. Many smaller, regional banks have significant exposure to agency MBS and began to sell such securities as they experienced swift deposit outflows, which they feared would only accelerate. 

The Bank Term Funding Program (BTFP) announced by the US Federal Reserve (Fed), which offers loans pledged to agency MBS or Treasuries at face value, has helped ease some of the concerns around MBS sales, allowing their spreads to partially retrace some of the recent widening. However, the uncertainty around this subsector remains elevated, even after preliminary government steps to stabilize affected institutions in both the US and Europe. 

Securitized credit risks vary by subsector

In contrast to agency MBS, securitized credit (non-agency RMBS, CMBS, CLOs, and ABS) constitutes a smaller share of most small regional banks’ portfolios, but these assets have not been immune from spread widening on the back of deteriorating liquidity conditions and a worsening macroeconomic backdrop this month. Moreover, the likelihood of increased regulatory capital requirements being imposed on regional banks is apt to adversely impact securitized credit broadly. 

Yet it’s important to note that each securitized subsector carries different (and varying degrees of) risks from the current banking situation: 

• Residential mortgage-backed securities (RMBS): Given the strong starting position of the US consumer, combined with conservative underwriting standards and adequate credit enhancement, we believe most RMBS deals can withstand today’s pressures. The housing market potentially benefits from a structural supply/demand imbalance, substantial accumulated homeowners’ equity, and now somewhat lower interest rates as well. As such, our outlook for this subsector remains favorable. 
• Commercial mortgage-backed securities (CMBS): These securities are likely to face a rockier road ahead. They were already suffering from higher cap rates and major secular changes in both the office and retail spaces, which had cut into many properties’ operating income. The challenges at small and regional banks, which are among the largest providers of commercial real estate (CRE) financing (Figure 1), might make matters worse for this subsector. Borrowers with in-place financing may not feel the pinch yet, but refinancing a CRE loan could become more difficult and add to downward pressure on property prices. 

Figure 1

• Collateralized loan obligations (CLOs): There was initially some concern that CLOs, like agency MBS, could face selling pressure given banks’ high participation in this sector. But the weakest regional banks own less than 3% of all bank CLO holdings, whereas large money center banks own roughly 80%. From that perspective, we anticipate limited direct impact on most CLOs, although regional banks are active with smaller loan facilities, which could impact credit availability in the market.
  
  Other factors, including broad market volatility and credit performance of underlying loans, may also drive spreads wider. Additionally, selling could arise given that higher-quality CLOs have often served as an attractive funding source during periods of stress. On the other hand, deposits fleeing smaller banks toward larger ones may lead to increased demand from the latter group for AAA rated CLOs’ credit quality, higher spreads, and floating-rate coupons. 
  

• Asset-backed securities (ABS): The worsening macroeconomic environment is likely to negatively impact the consumer loans backing many ABS as well. A material credit contraction due to tighter lending standards could send unemployment and loan delinquencies higher. However, as noted above, US consumer fundamentals and balance sheets generally remain strong, especially for higher-income consumers. The lower-income consumer cohort is likely to struggle more but comprises only a relatively small share of the underlying collateral in ABS deals.