Q: In the second half of 2007, events in the markets came thick and fast. Asset-backed securities (ABS) have played a key role here. Can you explain to us briefly what exactly has happened in the ABS segment?
Blomenkamp: The sequence of events started in the US – in the so-called ”subprime” segment – with collateralisation of mortgages to borrowers with a poor credit rating. Because of rising defaults by these borrowers, doubts in the market about the quality of this form of ABS, so-called “mortgage-backed securities” (MBS), increased. Although defaults are primarily limited to subprime mortgages, investors have turned their back on the entire ABS and MBS segment. As a result, yield spreads on ABS have expanded worldwide. This wave has also hit Europe with scant regard for the fundamental quality of the underlying assets.

Q: How do the fundamentals of the European ABS market compare to the US ABS market?
Blomenkamp: The European mortgage market is fundamentally in a better state than the American one. The European real-estate market was less overheated as a whole, and a pronounced subprime segment like that in the USA did not exist to the same extent. The “non-conforming” segment in the UK is similar to the US subprime market in some ways, but lending standards and the expected increase in interest rates for adjustable-rate mortgages are not directly comparable with the US.

In Europe, no uniform real estate market exists. For example, lending practices, loan terms, fixed-interest arrangements and developments in house prices can vary widely across the individual countries.

The European ABS market does not consist only of mortgage collateralisation arrangements for owner-occupied homes. These so-called “residential mortgage-backed securities” (RMBS) currently account for around 50% of the total European ABS market. Other collateralisation is based on leasing receivables, auto loans and other receivables as underlying assets. The UK and Spain account for around 40% of the total European ABS issue volume this year. Germany, Italy and the Netherlands together made up around a quarter of the new collateralisation volume.

Generally, European ABS investors are therefore more strongly diversified. But this is not correctly reflected in current market prices that have been marked down across the whole sector, without consideration for the fundamental values of most securitisations in Europe.

Q: How did this price discount arise across such a wide front?
Blomenkamp: The main trigger was the news of downgrades of American subprime MBS by rating agencies and expected higher losses in the underlying portfolios. Investors in ABS of all kinds reacted with great uncertainty because of undifferentiated press reports across this market segment. The terms “ABS” and “MBS” were globally classified as high-risk. The high level of analysis required when investing in ABS, which is certainly difficult to handle without specialist knowledge, then led to a very cautious attitude among many investors towards all types of collateralisation and an abrupt decline in demand.

A contributing factor to this uncertainty was the fact that the European ABS market is still relatively young. Many ABS investors are still not well enough acquainted with the segment and do not have sufficient capacity to analyse the risks in a securities pool. As a result, many investors relied mainly on the rating agencies, which then reacted relatively late with a new assessment of the risks – in other words, downgrades – of American ABS.

At PIMCO, the purchase of ABS is fundamentally based on our own analysis and not on the rating agencies’ assessment. The underlying receivables-pool of each ABS in which we invest is thoroughly investigated by our credit research team. Only when we are convinced of the inherent value of the underlying do we invest. This applies to new issues as well as to investments in the secondary market.

Q: Do ABS indices offer a good guideline?
Blomenkamp: The ABX indices in the US, which have often been quoted in the press recently, relate only to the segment of US subprime MBS. The indices for the various rating categories of ABS (e.g. AAA) are each formed from twenty transactions with this rating for a specific year. Anyone investing in such an index would therefore enter into an evenly spread investment across these twenty ABS. However, the ABX indices for the various rating segments of the US subprime market may not fully reflect the actual performance of this market segment at the moment. First, the number of transactions underlying the indices is relatively small. Secondly, many market players use the indices for speculative purposes and not only for hedging, so distortions are possible. The index can therefore serve only as an indicator but does not provide comprehensive information about the default probability or the quality of the overall market for US subprime MBS.

Q: How does the primary market for newly issued ABS compare to the secondary ABS market?
Blomenkamp: The European ABS primary market – in which RMBS accounted for about half of all new issuance this year – has come more or less to a standstill since August.

In the secondary market, trading continues but the majority of players are institutional investors. Liquidity is limited, though, with significantly lower volumes than in the first half of the year. Many buyers are extremely cautious and some are holding off under the assumption that prices could possibly fall further. How long the uncertainty will last, is currently still hard to estimate. We assume at the moment that the selling pressure will ease in the first quarter of 2008.

Q: Are there opportunities for investors to profit from the latest events?
Blomenkamp: Many ABS are currently trading at a level which could be described as “distressed”, meaning ABS can, at the moment, be purchased at very low prices relative to their inherent value and quality. “Distressed” in this context does therefore not necessarily relate to the inherent value of the underlying asset but to the prices. Specialised investors with appropriate know-how can through thorough analysis locate market segments or transactions with inherent value and an attractive risk/return profile in the current market environment. To this extent, the market turbulence and the marked price discounts in the European ABS market have created attractive possibilities for a market entry.

When the situation in the market quiets down and the uncertainty gives way to fundamental analysis, we expect a normalisation of prices, which should favour high-quality ABS. Even without a reduction in risk premiums in the near future, inherently valuable ABS, that make the agreed payments until final maturity, offer attractive yield mark-ups over the term of the transaction. For investors who add such ABS to their portfolio and are less sensitive to price fluctuations, the secondary market may offer interesting entry opportunities.

Q: What should investors pay particular attention to in this environment?
Blomenkamp: Investors should be aware that it may take another few months for the market to calm down. Until then, the possibility of further turbulence cannot be ruled out. Careful analysis of ABS papers should at all times precede any investment. Here it is essential not only to examine the quality of the underlying pool and the seller of receivables but also to select the best market segment in terms of asset class and region. The expertise of a specialised asset manager will be very helpful here.

Q: Thank you very much, Felix.