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Credit Quality to Erode as Underwriting Continues to Weaken in Structured Finance

December 27, 2018, 09:00 AM
Filed Under: Economic Commentary

The performance of structured finance transactions around the globe will largely remain strong on the back of continued, but slowing, growth across the regional economies; however, late-cycle trends such as weakening in the underwriting of both corporate and consumer loans and the loosening of structured finance transaction documentation will intensify in 2019.

That's according to a new Credit Outlook Report from Moody's Investors Service that found other potential risks to securitization performance, including the still-unresolved mechanics of Brexit, trade tension between the US and China, environmental disasters and new technological developments that facilitate the easing of underwriting  standards.

In the U.S., "[T]he credit quality of both consumer-and corporate debt-backed securitizations will continue to decline in 2019 amid the later stages of the current credit cycle," Moody's said. "Consumer ABS and RMBS Weaker underwriting across most consumer sectors will lead to marginal deterioration in credit quality.  We expect CLO collateral quality to weaken in 2019 and for CLO structures to compensate for this deterioration. However, structures will likely continue to loosen as key deal metrics tighten and the market prepares for a turn in the credit cycle."

The analysts continued: "Although the credit quality of new transactions will remain strong in most sectors, underwriting will continue to deteriorate in some. For example, the credit quality of small-ticket equipment ABS will weaken slightly as sponsors move down the credit spectrum to lend to new and/or riskier obligors. And although high corporate leverage will result in flat-to-weakening credit quality of fleet lease ABS sponsors overall, the credit quality of fleet lessees in the pools will remain strong owing to the continued prudent underwriting standards of most major securitization sponsors that originate the leases.

According to the report:

Credit quality will erode as underwriting continues to weaken.
As the U.S. economy continues to grow and the credit cycle enters its late stages, the credit quality of new loans in some sectors will continue to weaken and their structured finance
documentation will continue to loosen.

Growth will continue to drive performance.

Although slowing in many regions, world economies will continue to grow in 2019, aiding both consumers' and corporates' abilities to make payments on the debt backing structured finance transactions.

Political risk and trade tension will weigh on some sectors.
In the event of a no-deal Brexit, the performance of UK buy-to-let (BTL), non-conforming residential mortgage-backed securities (RMBS), and credit card asset-backed securities (ABS) would weaken. Although ongoing trade disputes between the US and China have the potential for trickle-down effects across asset classes and regions, US container ABS and Chinese collateralized loan obligations (CLOs) and consumer loan ABS are at more acute risk in the event of further escalation.

Technological advancements will have mixed effects on the credit quality of securitizations.
Technology investments will bolster the credit quality of wireless tower ABS in the US, while automation of underwriting processes will have both positive and negative credit effects on RMBS.

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