By Maximilian Clarke

Deterioration in the credit quality of European banks will negatively affect new and existing SME ABS (small to mid-sized enterprises’ asset backed security) transactions and lead to a rise in loan defaults in 2012, according to a new report published today by Moody's Investors Service.

The impact will be most acute in transactions without additional structural features or more credit enhancement to compensate for the reduced credit quality of counterparties.

"Sovereign turmoil and banking sector stresses will continue to take their toll on the credit quality of counterparties that play critical roles in SME ABS deal structures, particularly account banks," says Stefan Augustin, a Vice President -- Senior Credit Officer/Manager in Moody's Structured Finance Group and author of the report. "The shrinking universe of sufficiently highly rated counterparties will magnify counterparty risk for new transactions as fewer banks become counterparties in increasing numbers of deals."

Operational risk will also increase in existing transactions where counterparties face deteriorating credit quality. Moody's expects new deals in 2012 to have more straightforward structures with static pools and with no basis swaps, which will make them more transparent. The rating agency also expects such deals to include better quality underlying collateral. They will include either more recent loans originated according to tighter underwriting criteria or more seasoned loans that have had time to weather a period of economic stress and de-lever.

"The credit quality of existing portfolios will deteriorate in 2012, as defaults rise and recoveries fall or are delayed," adds Mr Augustin. Transactions heavy with peripheral euro area SME loans and/or exposure to the real estate sector in particular are expected to suffer. SMEs focussed on exports to growing economies such as Asia and Latin America may be afforded some protection but they will likely face challenging domestic macroeconomic conditions coupled with a slowing rate of growth in their export markets.

Key among challenges for European SMEs will be access to and the cost of bank funding in order to refinance as the banking system outlook remains negative in all major European SME ABS markets. Various government initiatives have been launched to boost liquidity to the sector but Moody's expect their palliative effects to be limited in 2012.

Despite such challenges, Moody's expects to see many originators returning to market, particularly from Spain and Italy, driven by secured funding needs amid the continued effective seizure of the senior unsecured markets. The vast majority of new deals will be for ECB placement and they will therefore largely be structured to meet the reduced minimum eligible rating for repo to minimise the cost of funding to the originator.

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