PIMCO: Eurozone Exit Toxic for Mortgage-Backed Securities

(July 13, 2012) — Investors curious to see how their European residential mortgage-backed securities (RMBS) would fare in case of a Eurozone breakup may want to brace themselves—or look away.

According to an analysis by PIMCO, a Eurozone exit would upend the value of European RMBS, causing uncertainty and confusion that could threaten their worth. The report cautions that many questions inevitably remain about the scope of a potential Eurozone exit. Even so, PIMCO’s study should give pause to investors that do not appreciate the inherent risk of European RMBS.

“An exit would be devastating to Euro-denominated RMBS mortgage collateral of that country, with the likely redenomination/devaluation wiping out the entire available credit enhancement for most deals,” says the report. “The massive losses of redenominated loans can overwhelm credit support, even for well-performing deals. Important secondary effects include broader macroeconomic dislocation and the effect of the exit on counterparties and structural features of the RMBS.”

PIMCO looks at five ways in which fallout from a Eurozone exit could impact RMBS. For one, bond redenomination could result in significantly devalued mortgages, which could also greatly erode the value of collateral. Second, interest rate swaps, and the contingent complexity of jurisdictions, structural features, and counterparties could add to conflict in a post-exit scenario. Third, liquidity and credit facilities domiciled in an exiting country could be hamstrung by currency controls, cutting off liquidity from banks in that country. Fourth, servicer/collection accounts could also be subjected to currency controls from an exiting country, possibly causing capital to languish because of exchange moratoriums. Finally, the structure of the RMBS that governs which bondholders get paid first could be affected by an exit.

On the whole, PIMCO paints a rather gloomy picture for holders of European RMBS in case of a Eurozone exit. “A country exiting the Eurozone is no longer a farfetched fantasy and the risk of a Euro exit remains material, notwithstanding the latest positive steps; such a scenario should be incorporated into the analysis of most European RMBS and the outcome is material to bond returns in most cases,” the report concludes.

To read the PIMCO analysis in full, click here.