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Asset Securitization Expands in a Volatile Economic Environment 2001/06/19
RatingsDirect publication
date: 14-Jun-2001 Global
Adjustments Drive Growth and Adaptation "Overall, it's an environment that has been providing both risk and opportunity, but through it all, structured finance markets continue to show remarkable adaptation and resilience," said Patrice Jordan, managing director for global ABS at Standard & Poor's. It is not surprising, therefore, to see investors and issuers embrace this financial tool like never before: volume is way up, setting records in many segments and attracting new users and investors. (For a brief primer on securitization, select the sidebar.)
Rising familiarity and global economic conditions were not the only factors stoking the fires; innovation and technology have also combined to play a big role in the growth of issuance. Together, they produced an ever-widening array of asset classes and led to the discovery of value where it was not apparent before. Both have helped to whittle back risk and make the landscape for investors and borrowers far more hospitable. Where other sectors of finance have come under pressure from unfriendly market trends, structured securities continue to gain converts due to their strong performance and custom-made flexibility and appeal. Macroeconomic factors like the U.S. budget surplus have not hurt either: declining government borrowing has reduced the crowding out effect on credit markets and, as a result, interest rates have been coming down and capital has been seeking a new home. "We see demand coming from all pockets of the market," said Peter A. DiMartino, director and head of Research for ABS and MBS at Salomon Smith Barney. "The shrinking Treasury market has been an important factor," he noted. Based on proven revenue
streams and incorporating legal structures that go far to ensure performance
and quality, structured deals are providing low-cost financing to a growing
assortment of corporate, institutional, and even individual borrowers,
as well as delivering attractive rates of return with low risks to investors.
Moreover, with surpluses forecasted to continue, the long-term positive
effect on capital and credit markets should remain intact. But the road
ahead will be bumpy. The
"R" Word and the U.S. Economy That alone, however, has not been enough to hold back issuance. The first quarter of 2001 saw record issuance of ABS on the back of bank-debt refinancing, corporate expansion, and term-out of commercial paper. The growth in issuance is expected to continue even after putting in a record first quarter, according to Joseph F. Sheridan, Standard & Poor's managing director for North American ABS. "Relative to the cost of securitization, the cost of unsecured funds for finance companies has been on the rise, and the ABS market has become a more attractive source of funding for many," he said. "As a result, ABS issuance will exceed $300 billion in 2001, eclipsing that mark for the first time in this market's 16-year history," added Mr. DiMartino. Volatility in the corporate bond market has also prompted companies to rely more heavily on securitization. "While recovering somewhat, corporate spreads are still quite wide and remain somewhat volatile," noted Neil McPherson, director of ABS for Credit Suisse First Boston. "The ABS market has provided a great place for issuers to hang their hat, so to speak. It offers cheaper funding costs," he added. Another bright spot in the U.S. economy continues to be the housing market, where lower rates have had a decided impact. Home sales, while off their peak, are still historically high, and consumers are still buying. Mortgage originations have risen too, along with home equity lines of credit and refinancings. "The first quarter has been extremely strong, thanks to a supportive rate environment," says Gale Scott, Standard & Poor's managing director for Real Estate Finance. "You can also credit greater discipline on the part of lenders. This has kept problems of oversupply to a minimum," she added. Securitization is fast becoming a principal means of providing financing to the real estate market, giving nontraditional lenders a chance to vie for a piece of this huge pie. And it does not stop
there. Securitization continues to become more and more attractive as
a means of corporate funding, particularly in a weak equity environment.
New
Structures Thrive on Volatility Other permutations of the CDO structure are alive and well, however, thanks to the proliferation in the use of these deals. One area that is currently very in demand is repackagings. "Repacks are a fast-growing market," according to Richard Gugliada, managing director for CBO/CLO Derivatives and Market Value at Standard & Poor's. "Essentially, a repack utilizes CDO technology and incorporates any existing securitized asset in its mix. Right now we are seeing strong growth in the repacks of sub and mezzanine tranches of earlier deals," said Mr. Gugliada. And, he added, "the growth of credit derivatives continues to explode." Volatile equity markets
have also contributed to a surge in new activity in the structured investment
vehicle (SIV), which is an offshoot of a traditional CBO. Growth here
is being driven by the rise in popularity of hedge funds. "SIVs are
vehicles that have securitized the shares in hedge or other funds. "Demand
for the creation of these types of vehicles is off the charts," said
Mr. Gugliada.
Securitization has become one of the hottest sectors of the European credit markets, supported by the single currency environment, greatly improved regulatory frameworks in most jurisdictions, and increased investor appetite as yields in traditional investment sources like government and corporate bonds slump. European securitization activity had its strongest quarter ever in the first three months of 2001, with volumes showing a dramatic 60% year-on-year increase, ending at $29 billion compared with $18.7 billion. The outlook for the second quarter is also bullish, with April volumes ending more than three-fold at $4.4 billion compared with $1.7 billion. May volumes are equally strong, doubling on the same period a year earlier, ending at $14.3 billion compared with $7.5 billion. Kurt Sampson, managing director at Standard & Poor's Structured Finance Ratings group Europe, does not expect global recessionary woes to put the brakes on European ABS growth either. "Demand for European asset-backed bonds has never been so strong," Mr. Sampson said. "The market is continually finding new and innovative ways to apply securitization technology, and the origination and investor bases are still expanding. We're expecting at least a 20% increase in growth in 2001," he added. Europe's New
Frontiers
As the market has evolved, the principles of conventional securitization have been allied with other financing techniques, which have in turn produced many innovative themes on the original concept. In Europe, one of the most successful alliances has been the marriage of securitization with credit derivative technology, a financing tool that really took off in 2000 and is now clearly at the frontier of the European structured finance market's growth (see chart). The process allows financial institutions to use credit derivatives to transfer the risk of a specified pool of assets to third parties, while keeping the assets on their balance sheets. Mr. Sampson explained that this sector of the market has become increasingly important, as it provides European financial institutions that do not necessarily need to raise funding with an efficient balance-sheet management tool. "A lot of European institutions have vast stocks of assets on their balance sheets. However, in some instances, the margins on these loans would not easily support a traditional securitization," he added. "By simply removing the risk associated with these assets and purchasing protection from a swap counterparty, these institutions can achieve many of their balance-sheet objectives, including a better ROE," Mr. Sampson noted. Stephen Stonberg, head of Structured Products, Global Credit Derivatives, at Deutsche Bank, London expects that demand for this type of unfunded risk will continue to grow, supported by the ease of execution, all-in lower structuring costs that it provides over traditional securitization, and the fact that the technology is being applied to an ever-expanding range of assets, including mortgages and ABS. "A synthetic
transaction can be completed in about half the time that it would take
to complete a true-sale deal, and as there is no asset transfer, the costs
can be much lower," he said. "The range of assets being referenced
in synthetic securitizations is also growing so institutions taking this
risk, like insurance companies, for example, can have a more diversified
portfolio with tailored exposure," he added. Cheaper Funding
Costs and Higher Returns
"Most large-cap European companies are now looking at securitization to raise cost-effective funding as they find that lending capacities in the banking sector are becoming increasingly constrained," she said. "These companies will also use securitization to diversify their funding sources." Given the economic woes experienced by the telecom sector, in particular of late, Ms. Adler expects many of these companies to take advantage of securitization technology. "Many telecom securitization mandates are being actively worked on," she said. "Most are undertaking to securitize on a program basis, so this year's debuts will be the first of many trips to the market." Perry Inglis, a director at Standard & Poor's Structured Finance Ratings group, London, adds that the telecoms may look to package their trade receivables from fixed-line and mobile operations into a mixture of term issuance and ABCP conduits. "Billed/unbilled and future flow receivables from residential and commercial users are just some of the receivables that could be securitized, and it would be a relatively economical way of raising finance in either the term or CP markets," he said. "Other potential receivables could include directory advertising and Internet revenues. These companies could also securitize their real estate." Indeed, Telecom Italia S.p.A recently became one of the first European telecoms company to tap into securitization technology when it began to ready for launch a Eur700 million (approx.) series 2001-1 notes as the first issuance by TI Securitisation Vehicle S.r.l. under a Eur2 billion program, explained Anjali Bastianpillai, an associate director at Standard & Poor's Structured Finance Ratings group, London. "Additionally, with almost 21 million customers, this deal also had the greatest number of obligors seen in any one transaction," she said. "Only receivables from fixed-line residential customers were securitzed although this could later be extended in the second series to Telecom Italia's corporate and business client base." Jon Ford, executive director at Lehman Brothers with responsibility for money markets, adds that, on the CP, side there would be enough European investor demand to absorb increased euro issuance, in particular. "Investor appetite for CP has never been so strong," he said. "Recently we've seen many conservative money market investors, who previously bought only highly rated banks and sovereigns, embrace ABCP as a higher yielding alternative." Mr. Ford added that central banks and supranationals are beginning to buy ABCP to increase the return on their cash reserves, while established European investors are also increasing their purchases of U.S. ABCP as quarter-end yield spikes in the U.S. have created great buying opportunities. "Given the amount
of U.S. CP I have sold to European investors, it's clear that there is
more demand than supply in European ABCP," he added. Whole Business
Securitization in the U.K. "There is an increased focus on whole business securitization throughout Europe, triggered, among other factors, by the recent flurry of merger and acquisition activity," he said. "In a whole business, or corporate securitization, a special-purpose entity (SPE) issues bonds backed by the entire cash flow of a company, a process that can allow the entity to achieve a higher rating than the corporation itself under the correct circumstances," added Mr. Koranteng. Operating company transactions emerged in the mid-1990s in the U.K. with the securitization of cash flows generated by a nursing home company, followed by several transactions involving assets as diverse as entertainment, theme parks, pubs, and intellectual property, Mr. Koranteng continued. "This type of
securitization allowed companies such as Punch Taverns Ltd., a U.K. pub
chain, and Welcome Break, a chain of U.K. service stations, to bring their
whole businesses to market," he said. He also noted, "Most of
these are in the U.K. because of the creditor-friendly environment. Assuming
certain legal issues can be resolved and the economics still look attractive,
we should see whole company securitizations spreading across the continent."
Securitization
on the Continent "Most European jurisdictions have accessed the securitization market at this stage, although Germany and Italy have been front-runners," he said. "Given the positive market conditions, we expect strong growth in Spain, and the Portuguese market could also gather momentum if the legislative framework relative to mortgage securitization is clarified." One trend that Mr. Carron expects to see expand on the Continent is the use of securitization by the public sector to raise off-balance-sheet debt. "The Italian government has already successfully tapped the market twice with portfolios of performing and nonperforming receivables, and there is market talk of it mulling a third issue," he said. "This has clearly set a precedent for other local and central governments that could even use securitization to sustain Maastrict debt/GDP ratios." Andrea Perona, head of Southern European Securitization at BNP Paribas, London is also expecting more securitization activity from local and central governments. "We believe this is a growth area, after the precedents set in Italy by the social security agencies and the Lazio region, and in Greece by the Ministry of Finance," he said. Another interesting government securitization was seen in the German market in 2000 when Kreditanstalt fuer Wiederaufbau (KfW) became the first government body to enter the world of synthetic risk transfer after it launched its PROMISE program. PROMISE is organized as a standard platform open for cost-efficient securitizations of predominantly promotional loans to small and midsize enterprises (Mittelstand) throughout Germany. Any bank cooperating with KfW can make use of this template. Dr. Dieter Gueder, head of Business Policy for Banks and Financial Institutions at KfW, explained that the rationale for the PROMISE program was to take the credit risk off the books of the bank, thereby freeing up capital that can be re-employed in new promotional loans businesses. "Studies showed that it was becoming increasingly difficult for commercial banks to originate loans for the Mittelstand, so we felt it was necessary to step in and help free up regulatory capital," he said. "In 2000, a total of €3.5 billion in loans was securitized. We have already completed one transaction this year, the Promise-K 2001-1 PLC Eur57.75 million credit-linked floating-rate notes and at least two others are in the pipeline." Facilitating all this future growth is a strong mortgage securitization market, said Karen Naylor, a director at Standard & Poor's Structured Finance Ratings group in London. "If the residential
mortgage market is strong, it lays a good foundation for other classes
to be securitized," she said. "In the U.K., high-street and
subprime lenders have now become repeat issuers, and many are using securitization
as their primary financing tool." Surging CMBS
"The CMBS sector is growing at a phenomenal rate," he said. "Unlike the U.S., where the maturity of the mortgage securitization market means that it relies heavily on new origination, the European CMBS sector has only just scratched the surface of existing loan portfolios, giving it a considerable, as yet untapped, resource, which should protect it from a short-term economic downturn. A lot of property-lending banks are now playing catch-up," Mr. Hansell continued. Major trends include repeat issuance, the securitization of mortgage-only portfolios as opposed to trophy securitizations, and the emergence of Pan-European CMBS transactions, he added. Clayton Hunt, a managing director for international CMBS at Standard & Poor's Structured Finance Ratings group, New York agreed, and added that he expected more European corporations in particular to take advantage of securitization technology. "Many European businesses and corporations own the real estate on their balance sheets and that ties up a lot of valuable capital," he said. "We expect a number of companies to sell all or some of their portfolios to unlock valuable capital and lease back the property they need for day-to-day business. This would, in turn, release these buildings for securitizations." The European securitization
market has advanced at a staggering pace in the past five years, supported
by its ability to constantly adapt and reinvent itself. With the building
blocks now firmly entrenched, that steady growth pattern is set to continue.
"Structured finance activity continues to grow in tandem with the need for financing in the region," observed Rosario Buendia, managing director for Latin America ABS at Standard & Poor's. Much of what is being done revolves around future flow deals, and there is a good reason for this: future flows are stable, predictable deals in what can otherwise be volatile markets. Future flows are attractive because they are based on businesses that have steady and proven cash flows, like oil producers or major commodity exporters. They can be private companies or state owned. The important factor is that the issuers have demonstrated to a high degree that their operations will continue even under variable economic and political conditions and that there is available cash flow to pay creditors. But while these deals are attractive, there are a limited number of investors moving into them. "Your typical investor in a future flow deal must have both the structured finance expertise and emerging markets savvy," noted Martin S. Avidan, director of portfolio management for CGA Investment Management. "It's a crossover niche, and not many investors have the skill set. In addition, it's very much a buy-and-hold kind of investment because of the frequently illiquid nature of these markets. That makes it appealing to credit-oriented institutional investors who have the long-term investing horizon and who can sustain substantial price volatility," he added. A legal framework whereby creditors are well protected supports the future flow structure. "An SPE is a bankruptcy-remote vehicle that is created, and whose function it is to distribute the income stream from the issuers' operations," said Diane Audino, director of Structured Finance for Latin America at Standard & Poor's. "Revenues from business operations flow first to the SPE, and from there, creditors are paid and any remaining cash flows back to the company." "Future flows work particularly well for Latin American companies because of their unique position," said Alexander Batchvarov, Merrill Lynch's managing director for Asian and Latin American ABS and MBS in London. "In other emerging markets, it is often hard to find strong, investment-grade companies with a steady flow of dollar receivables. But because Latin America is home to many companies that export to the U.S., this type of structure is a natural." Ratings on Latin American
and other emerging market structured finance deals have always been influenced
by the sovereign ratings of the country in question. However, strong historical
performance of many of these deals and better legal safeguards have shown
that many transactions can withstand sovereign downgrades without an adverse
impact on their credit quality. "That simply means that a deal might
be able to retain its rating in the case of a sovereign downgrade,"
says Jose Ramon Tora, a director in Standard & Poor's Latin American
Structured Finance group. Over time, this is likely to lead to less ratings
volatility or, at the very least, a reduction in one element of uncertainty.
"This should be positive for securitization generally, and should
lead to an expansion of cross border deals in the future," Mr. Tora
added. Australia
Stays Hot And while term ABS issuances have been limited, it is encouraging to note that the diversified asset types finding their way into ABCP conduits are expanding to include small business loans, margin loans, and auto and equipment contracts, along with the traditional trade receivables pools, residential mortgages and repackaged RMBS, and corporate loans and bonds. But Australia is a relatively small country so its limited population, combined with its isolation from other capital markets, has encouraged it to move in new directions in recent years. It seems that some Aussie issuers will be stepping into the U.S. market, a trend that is already emerging, with four of the seven offshore issues tapping into the U.S. markets, in 2000, through global offerings. What is more, there are many more issues expected in 2001. "The main reason we haven't seen more offshore issues this year is the spreads on the cross-currency swaps," Ms. Michaux said. "And, for the smaller issuers and those with limited balance sheet or warehouse capacity, the weakening performance of the Australian dollar against the U.S. dollar means that significantly more Australian dollar-denominated assets are needed to support U.S. dollar offerings." Concurrently, domestic
investors are becoming willing to move down the credit spectrum to securitizations
rated as low as 'BBB', and they are branching out into securities backed
by consumer assets, including retail credit cards and auto loans, as well
as commercial mortgages. Also, at the short end, Standard & Poor's
is seeing more 'A-2' rated conduits coming to market. Furthermore, in
the past year, the first 'A-3' rated conduit was launched by ANZ Investment
Bank. As investors begin to take on additional risk, their internal organizations
are changing as they hire credit analysts to focus specifically on structured
finance paper. Steady
Growth for Asia; Korea Shines "Banks are flush with cash and they can lend at competitive rates," noted Batchvarov. "Moreover, since 1997-1998, many banks have been left with fewer assets and finding more has become difficult." One country that has seen particularly strong growth is Korea, which has now taken the lead in overall activity. "Many people probably don't know this, but Korea may be the second largest securitization market, tied with Japan," said Calvin Wong, Standard & Poor's Asia-Pacific managing director for Structured Finance based in Hong Kong. However, only a small portion of Korean securitizations are sold offshore and rated by international rating agencies. "Volume in the domestic market hit US$30 billion last year, primarily ABS, with a mix of consumer loans, corporate loans, and term paper. There is also rising activity in the CBO/CLO sector." Korean banks and financial institutions have also been prolific users of balance sheet transactions in the form of restructured and nonperforming loan securitizations. There is a continued need to move unproductive assets off their books. Hong Kong and Singapore are also potential areas of rising securitization, but for now, activity remains tempered by the fragility of the Hong Kong property market, which has yet to recover fully from the 1998 downturn. As a consequence, activity in the CMBS and RMBS sectors are likely to see only marginal gains this year. "Growth is not going to pick up substantially this year, as there are no compelling reasons to come to market," said Wong. Furthermore, fierce competition among banks to originate residential mortgages has brought yields down to the point where securitization is not economical for most potential issuers. Some feel that could
spur activity toward more innovative deals in other assets. There is evidence
of this already: last year saw some increase in CDOs and trade receivables.
In Singapore, the government finalized its official securitization rules
last year, paving the way for a friendlier environment this year and going
forward. Japan
Looks to Reverse Last Year's Contraction "Some companies are having difficulty securing capital from traditional lenders, like banks, so asset securitization is one of the only means of obtaining funding," Mr. Chang noted. "And investors like it because of the yield pickup." "The Japanese government is trying to get banks to speed the removal of bad loans from their books, and this has been leading to the increased use of nonperforming loan securitizations. This is likely to continue," said Mr. Chang. However, it is a politically and economically sensitive issue. Besides, Japanese banks still prefer debt forgiveness, which is considered the least radical approach, although it is a method that has done little in the past to remove endemic financial weakness in the economy. Moreover, while the government is moving forward with a plan to get banks to write off bad loans, it is not pushing the banks aggressively to do so, probably in consideration of the fact that large numbers of wholesale write-offs would trigger a rash of corporate bankruptcies and higher unemployment—two things that are neither politically nor economically desirable. As a result, corporate credit quality is not likely to improve substantially. While the banking sector moves slowly through its morass, other sectors are showing a strong rise in securitization activity. "Overall, volume is likely to grow at least 25% in 2001, with most of that growth coming from an increase in ABS deals backed by unsecured consumer loans and strong growth of CMBS," observed Mr. Batchvarov. "Both sectors have turned hot," explained Mr. Chang. "Consumer finance companies are using securitization to raise funds, while the weak real estate market has actually boosted the use of CMBS as more companies prefer to move out of direct property ownership." The Japanese stock market remains a question mark going forward. "For most of 2000 and so far in 2001, it has been a strong reason for securitization activity," said Mr. Chang. "Many companies' fortunes are still tied to trends in equities, so if the market was weak, so were their balance sheets. They would use securitization as a means to access capital. If, however, there is a rise in share prices this year, that could temper some of the need for issuance," he added. However, Mr. Batchvarov
added that a sustained rise in the Japanese equity markets would require
structural changes in the economy, and that is only likely to be accomplished
with the help of securitization. Looking
Ahead
Ms. Jordan of Standard & Poor's sums it up this way: "The world of structured finance continues to expand across asset classes, geographically and through creative new structures. Even in the more mature market sectors, growth and innovation are the norm. There are challenges on the horizon, but none appear insurmountable, and each test passed further strengthens the market." Ahead, then, to new opportunities. By: Michael Norman
and Jackie Rodgers
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