For years esoteric ABS kept its little brother status in a securitization market that was largely dominated by more conventional asset classes.
However, with the U.S. mortgage securitization market still at a standstill, industry players are now more free to appreciate the art of structuring esoteric ABS.
Historically, esoterics have been a small part of a much larger ABS business, but a confluence of events has supported an uptick in issuance in this securitization segment.
Investor acceptance, their hunger for yield and their ability and time to get to know these assets because of the slowdown in commodity-based transactions - with spreads on some of these conventional assets reverting back to pre-crisis levels - have allowed industry professionals to get these deals done.
The issuers themselves are accessing the capital markets in a way that they couldn't in 2008 and 2009. Since banks haven't been receptive to these asset classes, industry sources said it has presented a nice opportunity for the ABS market to step in.
These factors have led to the greater credibility and acceptance across the different subsets of esoterics.
"I would say it is an exciting time to be part of the esoteric world," said Fouad Onbargi, managing director of securitized products at Aladdin Capital. "Our world used to be a very small part of the overall ABS market...fast forward to today where the mortgage market is very quiet, student loan and credit card issuance is down significantly and other U.S. consumer credit volumes are down. All of that has happened while esoterics have gained market acceptance and credibility and as investors search for yield and you are seeing a lot more issuance in that space."
A Brief Timeline
The myriad of asset classes that fall under the esoteric umbrella can be categorized as more on-the-run assets - like timeshares and rental cars - and the more unusual asset classes that are considered by buyers to be more off the run. At the height of the crisis, even securitizations backed by on-the-run assets like rental cars from Avis, Dollar Thrifty Automotive Group or Hertz were hard to get done. The first to come back were credit cards and autos, although the Term ABS Loan Facility was very helpful to get the rental car program back on track.
Fast-forward to this year where Avis executed a triple-B-minus deal in the market, which is something the issuer could not have done even pre-crisis, explained Onbargi. "There are bids for double-B paper in the rental market today," he said. "In timeshare, it's not just marquee names like Marriott and Wyndham that have tapped into the market down to double-B levels, which was probably also not achievable at the height of the market, but we have also seen smaller developers in this space with people like Silverleaf and Bluegreen tapping the market. These guys are accessing capital via the ABS market very efficiently."
Onbargi said that today the market is also seeing more unusual assets like structured settlements - which at the height of crisis the market shut down for these issuers - finding a good deal of investor interest. "Today most issuers can access triple-A paper at the +150 area. It's still not pre-crisis levels, which were as low as +30 or +40, but there is still a huge bid for this kind of paper," Onbargi said. "We have seen that liquidity has returned for those asset classes."
Pre-settlements, which are loans to litigants in anticipation of settlements, have never been done through the ABS space. Onbargi explained that there has been some capacity delivered via hedge funds and institutional money, but never through a large capital markets-rated deal.
He added that conversations with hedge funds and insurance companies on whether there is a bid for this type of product have shown that there is one. "For an insurance company to be interested in this asset class is a testament to how much liquidity has returned to the esoteric," he said. "So whether you are talking more on-the-run asset classes or off-the-run asset classes - there is liquidity there."
To be sure, if a deal can be structured and rating agencies can understand a transaction and put a rating on it then placing it with investors will not be challenging. This is because many buyers are attracted to the opportunity to diversify their portfolio holdings and also some yield on the investment.
"If there is enough information for an investor to get comfortable with a deal then there is probably enough information for a rating agency to rate it at that point. Does a rating really hold much weight in an investor due diligence and credit approval process?" said Omer Uzun, a director at Proteus Financial Group. "We saw what happened in the crisis and we saw what happened to the reputation of the rating agencies. Would an investor who is presumably taking a large piece of a deal that is esoteric really feel comfortable relying on just the rating? "
Before the crisis, many esoteric deals were wrapped by monolines and once the deal got a triple-A rating, investors did not do much more due diligence. Today buyers really do their credit work and understand the underlying risk. Issuers are also forced to go back to the rating agency and given that they no longer have the monoline wrap option, these companies must figure out how to raise money in the capital markets without this insurance.
In many cases, it is still possible to get a high rating. In this post-crisis market, issuing deals without wraps makes sense because buyers across the board are doing the work and getting comfortable with the assets.
Onbargi said that in esoteric land some investors need ratings to get the right regulatory achievement and National Association of Insurance Commissioners grade, although investors today are relying on their own credit work rather than a rating. "Still, the reality is that people are much more comfortable with the rating agency seal of approval and without a rating there is a different price point...deals are less liquid without a rating," he said.
The fact is that in esoterics the ratings agencies did a good job, and there was no massive ratings overhaul since structures performed exactly as they were expected to. Container deals, for instance, were structured to withstand a 25% reduction in cash flow, and when the crisis hit they suffered a 20% erosion in cash flow and the loans performed fine, according to Onbargi.
"ABS investors in esoterics saw their deals perform very well and survive the crisis. There is credibility with the rating agencies and they also know that to get these deals rated you have to put in a lot of blood, sweat and tears," he said. "You have to work months to get the methodology created and then approved."
An Industry Unwrapped
It has taken time to rebuild some of the investor base because many of these buyers used to rely on triple-A wraps and when the monoline market imploded and the liquidity crisis happened, the investors imploded as well. SIVs and CDOs were particularly aggressive in buying monoline-wrapped paper. "It takes time to replace that investor base particularly when you are no longer selling only triple-A securities," said Michael McDermitt, vice president and senior credit officer in the structured finance group at Moody's Investors Service. "Growth in the market is, to some degree, going to rely on growth in the investor base and the return of traditional institutional investors and cash investors to this space."
For the industry, losing the monoline wrap created two big issues. One is the advance rate that typically with a wrap would allow an underlying rating to be provided on the assets of a deal without a wrap. The monoline would want that deal to have an investment-grade type rating of 'Baa2' or 'Baa3', McDermitt said.
"Your advance rate is much higher than it would be for a 'AAA' rating, and what the monoline wrap did is allow a company to get funding on the lower rating, but the issuer's coupon rate would be the 'AAA' rate," he said. "They had to pay the monoline for that saving but got an interest saving and a big improvement on the amount of money the issuer per dollar of assets issued."
In a world without wraps, issuers have to find a way to achieve a similar advance rate. Issuers also found that lower down the credit curve there was a narrower investor base. According to McDermitt, the market for 'Baa2'-rated bonds isn't nearly as deep as it is for 'AAA'. One solution that issuers like rental cars have implemented is moving to senior/subordinated structures. Between the 'AAA' notes and the 'Baa' notes, the total rate achieved is similar to the advance rate these issuers got on a monoline-wrapped 'AAA', McDermitt explained. That structuring bridges the gap and allows issuers to enjoy the majority of the funding mostly on the deep and more liquid 'AAA' bond.
The other main shift is the idea of controlled oversight. The monoline wraps, because they took the first-loss position, provided third-party oversight and, in particular when the deal ran into problems, the monoline was the control party, not the investors. The monolines had a strong invested interest to step up and replace the servicer or change the trustee - whatever was needed to make sure that the deal performed. McDermitt said that the monoline could also step up and implement changes in a timely manner.
Without the monoline insurer, who is looking out for the deal? McDermitt explained that the trustees are generally not active overseers, even though under the document they can be technically charged with representing investors. Investors are interested but not one of them is a control party, and trying to get them together to identify them to each other so that they know to get together is difficult. Then having these groups of investors agreeing on a course of action and then paying the costs is probably impossible to achieve in a timely fashion.
"A deal that otherwise with a little kick in the pants would be just fine could end up quite badly," McDermitt said. "An additional mechanism that we have seen around control has been the addition of a third-party servicer - they still represent the investor and they don't have any risk but they are on the hook to take action and make sure they get investors together to try and take action."
McDermitt said that in some cases, like with the recent Church's Chickenwhole business deal, if investors do not respond in a given amount of time, the servicer can go ahead and take the action that they think is right.
Some deals, however, have never relied on the monoline wrap. Kramer Levin Naftalis & Frankel's securitization team focuses on esoteric asset classes, and most transactions that the group has worked on have never been wrapped. "Our investors are very sophisticated investors that do a lot of due diligence on the issuer and spend a lot of time learning about the asset classes themselves," said Gilbert Liu, a partner at the firm.
Liu said that these deals are instead self supported through over-collateralization, but many of the transactions the firm did, like intellectual property deals, died down during the liquidity crisis and have not come back. However, Liu said that there is growing interest in the area and he believes they will come back in the next year or so.
Other areas like structured settlements and lottery deals are easily rated. Liu explained that these assets are typically backed by an annuity company or a safe reserve fund that make these transactions easy to structure and rate. "When you just talk about esoteric as a label it's quite broad and the transactions range from those that are easily rated and highly secured to those that are quite unusual but are not wrapped," he said.
Dick Rudder, a securitization partner at Kramer Levin, said that they are seeing an increasing number of investors trying to get into esoterics because of the higher yields. The firm, he said, is able to work on an unwrapped basis primarily because the focus is on esoteric- only deals and not commodity-type transactions. They are also committed to devoting a lot of time educating first-time issuers or investors on how these deals work.
"Many of our deals are privately placed, and these deals have performed well throughout the crisis," Rudder said. "The whole issue of the credit crisis revolved around commodity-type transactions, but the esoterics did fine and that has helped to fuel the interest in this area."
Among the particular esoteric assets that the firm said performed are timeshare deals, which saw an uptick in volume during the crisis. The firm said that auto lease securitization transactions and government receivables relating to energy savings are among those that performed well. "In summary you hear that there are companies that focus on a specialized industry or specialty finance companies that have been in these markets for some time and are experienced issuers, and have been doing deals throughout the crisis and that is what the issuer landscape tends to look like," Liu said.
Regulatory Landscape
Regulatory changes for esoterics have also proved less disruptive than for other asset classes.
Since historically the investor market has demanded that esoteric issuers retain a significant first-loss piece, risk retention under the Dodd-Frank Act creates no punitive impact for most of these asset classes.
McDermitt also highlighted that the language of the rules could also provide a loophole for many of the asset classes that fall under the esoteric label. "On Dodd-Frank, the one thing that helps is that our issuers are generally not banks," McDermitt said. "Risk retention is going to apply to anything that is an asset-backed security as defined by the Exchange Act of 1933, which describes an ABS as a security that is collateralized by self-liquidating financial assets. A film deal, a royalty deal, and a whole business deal - these aren't self liquidating financial assets, so in theory they aren't ABS and the rules don't apply."
However, McDermitt also noted that some deals that fall under the esoteric umbrella are not structured with the 5% retention, and for these deals there could be some impact. One example is stranded assets, an extremely high-quality asset where all the issuer retains is 50 basis point reserve points.
On commercial finance assets that really are ABS - like small business loans, timeshare loans, construction or lease receivables - typically the deals are issuing either only triple-A or mixed with single-A rated assets. Single-A enhancement levels, McDermitt said, are about 5% and as such are consistent with the 5% risk retention rule.
The exceptions are small business loans and timeshare loans, which could feel some impact. McDermitt added that small business loans are already moving to a different business model where 5% or more is likely to be required by investors. In the timeshare space, the change won't be as disruptive since the deals are typically structured already with 3% risk retention.
Disclosure is another item that could affect the esoteric space. Some of these deals, even on-the-run asset classes, are being done on a pure private basis where managers are intermediating between the issuer and the investor. The Securities and Exchange Commission's (SEC) Reg AB 2 would apply to all deals - private and public.
Traditionally, the SEC took the view that because esoterics were sold to a sophisticated investor base, issuers could determine what kind of disclosure was needed. The SEC did not mitigate the arrangements. However, the commission indicated that it will now implement some regulation on disclosure, and the concern is if regulators will customize disclosure requirements to the particularities of esoteric asset classes. The level of disclosure that the SEC has already indicated would, for some of these asset classes that are less granular, ultimately mean that an issuer is exposing its customers to poaching from competitors. The disclosure standards that are required of large-issuance 144A are not as complex for these trades.
The rule requiring issuers and rating agencies to maintain a Web site on how a rating is derived under rule 17g-5 initially caused some concern, but market players say that it has turned into largely a non event for most people. "That kind of legislation hasn't impeded transactions in any significant way. As the regulations under Dodd-Frank come under focus, it's anybody's guess; we are all waiting to see and hoping for the best," said Laurence Pettit, a partner at Kramer Levin.
