PART II: Is the sky falling... or is it just tiering?

Despite all the ink spilled during the last two months regarding record downgrades, defaults and delinquencies, many ABS veterans contend that the market is not entering new territory, but simply riding out another recessionary cycle.

And more than an overriding concern for underlying collateral, some long-time securitization bankers believe that investors have instead placed an increasingly higher value on the credit outlook of originators. "The issue of how the economy is affecting performance of collateral and the issue of how weaker originators are going to fare through the economy this economic cycle are somewhat related but not equal," says Joe Donovan, co-head of ABS at Credit Suisse First Boston. "The rating agencies have done a great job of structuring worst-case scenarios for collateral performance, so I think ABS structures are very, very safe. But from an investors' standpoint, weaker capitalized entities are completely out of favor. Liquidity is key. A perfectly healthy company one day can be out of business the next day if it loses the confidence of the market." Examples of such "fallen angels" that either went bankrupt or out of business in recent years include asset-based lender Finova Capital; equipment-leasing company UniCapital; Alliance Funding, the home-equity loan platform of Superior Bank; and franchise-loan borrower Convenience USA, whose defaults affected loan pools within certain franchise ABS deals.

According to Donovan, it's not the assets that are being scrutinized, but the issuers. The true effect of damaged consumer credit is not losses by ABS investors. ABS structures are designed to measure the risk inherent in collateral and perform through a recessionary cycle, after all. The problem is that the downgrades produce an exaggerated tiering among originators.

That's certainly been the case recently. While other factors are certainly involved, highly rated finance companies have consistently bested middle- and lower-rated issuers pricing-wise. In late January, for example, ABS stalwarts GMAC and MBNA each brought deals that priced cheap compared with similar offerings from higher-rated entities such as Toyota Corp. and Citibank. In both cases, investors cited the financial strength of the issuers as to why the bids were higher for the higher-rated names.

This trend is expected to continue, especially as corporate earnings continue to lag and rating agencies begin putting greater pressure on issuers to securitize. "The agencies would like to see issuers demonstrate access to the capital markets for any significant asset class in order to receive liquidity credit," CSFB's Donovan adds. For example, Household Finance, a home-equity securitizer, recently said in a conference call that Fitch had changed the company's outlook to negative from stable in part because it was not securitizing enough of its real estate receivables.

Tiering has reached a fevered pitch in just about every consumer-related asset class, sources say. In fact, the secondary market seems to be where recession-related fallout is impacting asset-backeds the most: Within home-equity loans, for instance, names such as Saxon Capital Inc. and Centex Corp. trade 20 to 30 basis points better than lower-tier Conseco Finance Corp. or Aames Financial Corp. In credit cards, top-tier Citibank and MBNA trade 40 bps better than Providian Financial Corp. that has a monoline wrap, and 60 bps better than bonds from NextCard Inc.. In auto-rental ABS, Avis Group Holdings Inc. or Hertz Corp. trade approximately 75 bps better than Budget Corp.

An economic downturn, therefore, exacerbates the tiering that already exists. Take Providian. The troubled credit card securitizer exited the subprime lending business last year when it realized there were too many risks associated with its loans. And just a few weeks ago, the company sold its $8.2 billion prime and near-prime Providian Master Trust credit card receivables to J.P. Morgan for a "mid-single-digit premium" in an attempt to give itself a much-needed liquidity boost.

But by getting rid of its highest quality assets, the company is now left with a $24 billion portfolio of low-end prime and subprime balances after the sale, which have demonstrated poor credit trends. According to CIBC World Markets, these "were largely the driver behind the company's implosion." The company is currently in the market with a $3 billion subprime portfolio, which Bank of America estimates is sporting a 20%-plus loss rate. Even with insurance wraps and other guarantees, analysts warn that the Providian name itself could affect the liquidity of the company's bonds in the secondary markets.

While tiering is more prevalent than ever, investors have always divided up issuers and underwriters based on historical performance, and more important, the quality of servicing. But never before have issuers been so cautious about steering away from subordinate ABS securities. "During the last six months we haven't done anything in the double-B area," says Joseph Lorusso, an investor at Structured Finance Advisors, which specializes in managing asset-backed securities. "We have bought there from time to time, but given the recessionary environment we didn't see the value going there. The bulk of our buying has always been in triple-As."

CDOs feel the pinch

Problem is, even the untouchable triple-A class of asset-backed securities is not as pristine as it once was. According to Deutsche Bank, the frequency of triple-A downgrades has been on the rise. In fact, triple-A securities accounted for 26% of downgrade volume and 9% of the number of issuers downgraded in 2001.

The majority of these triple-A downgrades were for CDOs, which have become a significant ABS player. This asset class, especially bonds backed by high yield loans and those originated in the 1997 and 1998 time frame, accounted for the largest category of downgrades in 2001. Representing between $85 billion and $120 billion in issuance every year, CDOs are a consistent chunk of the ABS market.

Last year, the underlying assets of CDOs, which cover arbitrage, balance-sheet, synthetic, market value and emerging market CDOs and CLOs, were mostly corporate bonds and ABS with BBB' or lower credit ratings. Therefore, they were immediately open to getting hit because of their exposure to subordinate ABS. In 2001, CDOs experienced an unprecedented 53 downgrades that involved 40 credit classes in 28 transactions. Arbitrage and synthetic CDOs accounted for all but one of the downgrades, because they are the sectors most closely linked to corporate event risk.

Considering that investors in CDOs are actually looking to take measured exposure to credit risk in order to garner juicy spreads, the record level of corporate defaults in 2001 caused CDO investors to become increasingly discriminating when it came to choosing managers for their deals late last year. "Sept. 11 only exacerbated a trend we were already seeing a year and a half ago," says Romita Shetty, who is responsible for J.P. Morgan's global structured credit product unit. "Investors are skewing their buying to the best asset managers."

The pangs of consumer credit hit the CDO sector hardest. CDOs backed by ABS are most at risk for 2002, analysts say. Given that deterioration is likely in some home equity loan and manufactured housing subordinates, which typically make up about 10% of the collateral in ABS CDOs, there is incremental risk to CDOs which have exposure to subprime consumer credit. Even CDOs collateralized by CDOs are going to have increased risk in 2002. According to Lehman Brothers, there has been marked credit deterioration in triple-B tranches of CDOs, which are often used in CDO collateral pools.

But that's not the last of the burdens continuing to weigh on ABS this year. Even corporate event risk touched asset-backed securities too close to home in 2001, and that trend may continue.

Over the last few months, structured finance analysts have been gauging Enron Corp.'s bankruptcy and its impact on the various market segments, such as the CMBS deals with Enron office space exposure. CDOs referencing Enron, as well as the asset-backed commercial paper market, at one point had nearly $10 billion of Enron exposure. In fact, synthetic CDOs comprised the bulk of ABS downgrades during the fourth quarter because of their exposure to Enron.

Then there's the whole issue of off-balance-sheet financings. Some fear that regulators will confuse Enron's corporate-style financings with what asset-backed securitizers do. The main difference is that in ABS, it is the assets that support the debt, while in the case of Enron and other corporations, it is the company supporting the debt, with either putbacks or guarantees to the company.

Enron's off-balance-sheet financings are structured very differently from 99.9% of securitization transactions, market sources say. And because ABS is very important to the funding of corporate America, market participants fear that if regulators or government entities don't understand the differences between what Enron was doing and what structured finance professionals do, there may be an overreaction by both regulators and accounting firms.

Whither creativity?

Such an Enron-related misunderstanding, coupled with the precipitous plunge in consumer credit and confidence, leads some asset-backed players to think that it might be tough to get inventive or marginal deals done in 2002. "Creativity has been the hallmark of the ABS sector," says Andy Dym, co-head of North American ABS at J.P. Morgan. "You'd like to think it can grow or change. But it might be less creative over the next year."

Adds CSFB's Donovan, "It will require structural creativity and an appeal to the traditional smart money' private investors to get certain deals done."

Yet there seems to be a divide in the market over whether the current deterioration in consumer credit and confidence is as serious as it seems, or whether the market has seen the worst. Surely, Sept. 11 caused the aircraft-backed and EETC sectors to suffer, as well the auto rental-fleet and timeshare receivables asset classes. Things might look bad, but is the sky falling? "I don't think we've seen the worst, because the consumer is not terribly plagued yet," says Deborah Cunningham, an ABS portfolio manager at Federated Investors Inc. "If unemployment continues to rise and layoffs continue to occur - and unemployment is a six-month lagging event - then we'll see the worst as far as ABS deterioration after unemployment peaks."

The vulnerable areas are isolated in small pockets around the sector, for sure. While those pockets will be extremely prone to further downgrades, the negative credit environment has not yet affected the market as a whole. Out of the entire structured finance universe, with over $1.5 trillion in ABS, CMBS and CDOs currently outstanding, the percentage of deals unable to maintain ratings has been less than 1%, according to Deutsche Bank.

"We actually think the current environment creates incentive to innovate," says Deutsche Bank's Anthony Thompson, since for most issuers securitization is the cheapest financing option.

Indeed, this downturn might cause the need to tweak the structure of certain deals. In the past, for example, when the home equity sector was volatile due to the economy, more bond-insurance transactions were added to the mix to make the structures more stable. In fact, the monoline guarantee business, a staple of the ABS market, is actually benefiting from the current recession. "A downturn is going to tend to increase the perceived value of our product," says Iain Bruce, who is in charge of the consumer asset-backed group at AMBAC. "There is a greater willingness to use bond insurance than previously. The type of environment makes a sure' deal look like a better play."

Of course, the one curveball that no one could have predicted was the Sept. 11 tragedy, and for the ABS market, the main lesson learned is that a total reliance on models does not always work in the long run. While the asset-backed market was one of the first to get back into business immediately following the attacks, SFA's Lorusso feels that it is just now starting to find its legs with some confidence. "Models absolutely did not work," Lorusso says. "You couldn't model [9/11], and even if you could, they would have thought you were crazy. This market is so cash flow oriented. But after you run the models, you have to put the human element in. Because after Sept. 11, you looked to your models and there was silence; there's no answer." As a result, for September, October and a good portion of November, Lorusso did not invest any money.

That might have been a wise choice, considering that the attacks put a dent into many portfolios due to marked-to-market losses that occurred when spreads widened. Moreover, several travel-related issuers, such as ANC Rental Corp., parent of the Alamo and National car rental companies, were forced to file for bankruptcy.

Despite the failure of mathematical models on Sept. 11, the ABS market has held up rather well, compared with what investment-grade tranches of most structured financings are able to withstand, says Mark Adelson, head of structured finance research at Nomura Securities.

Still, the lesson for asset-backed players has been learned quite well as the market embarks on a tough year. "Responsibility for making business decisions rests on professionals, not models," Adelson says. "Professionals will do their jobs better if they augment their models with the equally powerful tools of judgment, imagination, experience and common sense."

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