With home price appreciation on the downturn, widespread record-tight ABS spread levels and stricter credit enhancement levels now in place on certain home equity loan deals, GSC Partners picked a fine time to launch a pair of CDOs referenced to home equity loans and make its debut as an RMBS issuer. Despite such apprehensions, the company recently priced and completed deals totaling nearly $2 billion.
To concerns of a weakening housing market, and its eventual effect on real estate ABS, GSC Partners has a simple answer: Do plenty of good old-fashioned homework. Simplistic as it may sound, digging deep into the plethora of information on the residential mortgage market has earned the Florham Park, N.J.-based investment advisor a reputation as a CDO issuer accustomed to turning out spotless deals. The company recently expanded its role to RMBS issuer, with a pair of deals totaling $857 million in April.
In charge of $10.7 billion of assets, GSC Partners operates several investment groups. The structured finance group oversees $3.1 billion in assets through GSC Capital Corp., its real estate investment trust (REIT) and several hedge funds. The company also operates several CDO funds, out of its corporate credit group.
Sniffing out sound credit bets is the young company's heritage. Founder Alfred C. Eckert, III was co-chairman of Goldman Sachs Merchant Bank's investment committee from its inception in 1986 to 1991, according to GSC Partners' Web site. After founding the leveraged buyout practice at Goldman Sachs and serving as a partner there, Eckert formed a couple of other investment ventures before founding GSC Partners in 1999. The structured finance group is stocked with big names in the asset-backed securities industry. Previously, Ed Steffelin, managing director of its structured finance group, created and managed CDO equity funds for the Trust Company of the West. Dan Castro, who with more than 23 years of experience at firms, including Moody's Investors Service and Merrill Lynch, is considered a founding father of ABS research. Castro oversees GSC Partners' credit. Wenbo Zhu, the managing director and senior quantitative analyst, hails from Paine Webber and Merrill Lynch.
Attention to detail extends to GSC Partners' back office operations, too. While banks and other institutions are making strides toward a standardized framework for documenting contracts on credit default swaps (CDS) on ABS, and their subsequent trades, GSC Partners already has a model in place that replicates CDS cash flows. That allowed the company to avoid the legacy problems that are now a concern for other firms. The company is also working with an outside firm to design a custom system for tracking CDS cash flows. Even so, navigating the road to efficient CDS documentation has not been easy, Steffelin acknowledged, adding that vendors are just now tackling the issue.
If a credit event crops up in a CDS contract, the company would likely ferret it out by regularly tracking trustee reports. It is an intensely manual undertaking, Steffelin said. This has prompted some market professionals to consider forming companies called enhanced trustee services, freeing up firms such as GSC Partners to concentrate on their core businesses.
"It would be a very welcome service," Steffelin said.
When assembling its pool of underlying loans for CDOs and RMBS transactions, GSC Partners steers away from the typical formula. Generally speaking, dealers and issuers think of loan pools as a collection of mortgages that are subject to statistical manipulations. They diversify their loan pools as a way of maximizing their funding and thus, returns on their assets. They generally stay away from a homogenized set of underlying assets, observed Steffelin. Although that approach works well for many, it tends to lead issuers to become uneasy about single risk factors, such as a low FICO score.
"We're undoing that puzzle," said Steffelin. "What you're really concerned about is whether the individual mortgage is a low FICO, and on a second home, and a condo in Miami and he used a second mortgage for the payment."
GSC Partners spent a lot of time getting acquainted with the characteristics of every single loan referenced in its CDO deals, the loans in its RMBS transaction. While screening those assets, executives take each loan and score it for default probability, recovery if there is a default and the propensity to prepay, said Steffelin.
"We don't buy anything on which we don't have individual loan data," said Steffelin. GSC Partners does rely on industry modeling tools, particularly those from Intex Solutions, Needham, Mass. GSC Partners creates automated scenarios for its hand-picked loans and runs them through the Intex software. Such thoroughness, according to Steffelin, is also why the firm receives what he calls reverse inquiries from ABS investors to put together structured finance products, said Steffelin.
"A lot of people don't necessarily put in the time, because they don't have to," said Steffelin. "That's the pitch we make to other people. We are doing more [extensive] credit work than others."
That GSC Partners waits patiently to put together the right deals does not diminish risks. True enough, the residential real estate has given ABS market professionals plenty to talk about and possibly be anxious over recently. The Office of Federal Housing Enterprise Oversight (OFHEO) reported that its home price appreciation index came in at 8.1% annualized in first quarter, down from 21.3% the previous quarter. Also, 22% of MSAs saw small declines in their quarter-over-quarter home price appreciation figures in 1Q06, compared to much smaller proportions of lagging MSAs from previous quarters.
"One quarter certainly does not make a trend," according to Lehman Brothers, which commented on the OFHEO's findings in a report. It continued: "but these figures point to some broad-based weaknesses."
Further, said Lehman, tighter asset spreads have eroded equity returns on certain high-grade CDOs, and resulted in slower ramp-up schedules. Double-A and single-A HEL deals, in particular, might come under pressure as a result, the bank said.
It is common knowledge that house price appreciation across the country has paralleled economic growth for the past several years, said Steffelin. Not withstanding how complex and far flung the bond markets have become, GSC Partners remembers that real estate is a provincial business, at its core.
"The markets that have had the best growth have had the lowest delinquencies and the lowest defaults," said Steffelin. Residential real estate is a comparatively safe asset class because its borrowers dutifully keep up with their mortgages, he said. Further, the depth and quality of the home equity market has grown to the point where current subprime FICO scores average 620 or 630, up from a score of 500 several years ago.
"We don't feel it is an absolute doomsday scenario," said Steffelin.
As for a potential spreads quandary in CDOs, GSC Partners is used to slow ramp-up periods, even on cash deals. Such was the case with a recent CDO that the firm completed through Merrill Lynch, which used a hybrid cash and synthetic structure. As is the case with many cash deals, issuers generally prefer to stock the underlying assets with new ABS issues. GSC Partners, however, took nearly nine months to ramp up half of the deal with cash assets.
"We could probably do less and be more 'profitable'," said Steffelin, "but it's not a very good long-term strategy in the credit cycle. Our view is that GSC is a company that will grow, and it is here for the long term. What is prudent today is to build that credit and reputation, because that is what differentiates you in the long term."
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