Look for the U.S. structured finance team at Deutsche Asset Man-agement - a large investor in the ABS market - to grow its portfolio even more over the coming year.
The New York-based team, which completed its first CDO as collateral manager in November last year, is on the lookout for assets that would be appropriate for possible future deals, said Sean McCaffrey, the managing director who heads structured finance investing.
McCaffrey conceded that Deutsche is very choosy about the investments it makes - even more so lately because of tight spreads and increasing concerns about credit quality. But he said its interest in the market is as strong as ever.
"We're differentiated from a lot of firms which use structured finance simply as a place to get spread sector exposure in the swaps-based or Libor-based markets," McCaffrey said. "Sometimes you need one or two people to do that. Here, we have a huge commitment to structured finance, which we use as a primary alpha generation tool across our client mandates."
His 12-member team, which includes portfolio managers, traders and researchers, oversees more than $18 billion in term structured finance assets, with roughly 40% allocated to CMBS and the rest divvied up among ABS, prime RMBS and CDOs.
The team is part of a larger U.S. effort for Deutsche Asset Management that handles approximately $150 billion in investment-grade, fixed-income investments. Almost $100 billion is in term assets, with another $50 billion in money market securities, which includes asset-backed commercial paper.
Deutsche's allocation to CMBS has been increasing for the past year - a trend that is expected to continue.
James Grady, the senior structured finance portfolio manager, said the risk/reward profile for CMBS is more compelling than alternatives in other markets.
"To put some numbers around it, if you look at the 30% Super-Duper seniors in CMBS land, they currently come in at 24 to 25 over swaps for the 10-year part of the curve," Grady said, noting that swaps are at 54 to 55.
So CMBS offers 78 to 80 basis points over Treasurys for 10-year triple-As with 30% credit enhancement, he said.
"It's structured to withstand an unprecedented downturn in the commercial real estate market," he said.
"If you compare that to the corporate market, you're probably talking about something like a single-A level of risk to get the same spread."
An interest in everything
Deutsche is interested in every type of asset class because it has the expertise to evaluate even the most unusual deals.
"We look at the whole spectrum, both on the run and off the run - on the run being autos, credit cards, rate reduction bonds and home equities, and off the run including CDOs, auto and equipment leases, private student loans, time-share deals, franchise loans and recreational vehicles," Grady said.
Deutsche has a dedicated structured finance research team to evaluate credit quality - which Grady described as a "tremendous" help that enables the company to consider such a wide range of potential investments. The research team is headed by Meena Pursnani, who joined the company in 2002 from Moody's Investors Service. Steve Lynch heads the trading effort, having joined Deutsche in 2004 from JPMorgan Fleming Asset Management.
Although Deutsche sees fewer deals it likes lately, there are no particular asset classes it avoids. "We're willing to take a look at anything because if the price is right, it could make sense for us," Grady said.
All of the investments are U.S. dollar denominated, and almost all are domestic assets.
Deutsche has purchased U.K. RMBS, but only "on a very limited basis" because those deals generally don't offer enough spread to make them compelling, Grady said. "You get some diversity benefits, but from a relative value standpoint, they are not very attractive."
Moving up in credit quality
Deutsche also buys a range of credit quality and durations.
"In addition to being in all different asset classes, we play up and down the capital structure - primarily investment grade, but also some non-investment grade," Grady said.
Tightening spreads over the past year generally made the lower tiers less appealing to Deutsche, however.
Grady said the shift away from lower credit quality is a relatively recent change in Deutsche's strategy.
McCaffrey said Deutsche could find a place in its portfolio for almost any duration because, aside from being a large institutional and mutual fund manager, the company is also the largest third-party insurance general account manager. The New York team manages investments for several business areas within the company, including Deutsche Asset Management's global insurance business, its DWS Scudder mutual funds, and institutional accounts.
"There's a place to put everything that we like," McCaffrey said. "With our client base and the diversity of mandates we have, it does allow us to play in the markets across the curve and capital structure, both fixed and floating rate."
A growing team
The structured finance team has been slowly adding people over the past few years, as the overall amount invested in the sector increased. McCaffrey said he expects the trend in portfolio growth to continue, especially with the initiative to increase its role as a CDO collateral manager.
"Historically, we've had a very large commitment to structured finance investing," he said. "Based on a very favorable experience with the sector and our outlook for the market, that commitment continues to grow."
When choosing investments, Deutsche uses a team approach that relies on consensus-based decision-making. "The teams work together - research, traders, portfolio management - to try to come up with a decision that everyone agrees with," McCaffrey said. "Obviously, you can't always get 100% consensus. So the buck has to stop with somebody and that's generally the lead portfolio manager on the effort."
The portfolio managers and traders at Deutsche work across all sectors of structured finance, while analysts specialize in assigned subsectors, with some cross-training to handle each other's work when needed.
Sizing up the sectors
Roughly 600 issuers are part of the investment bank's overall structured finance portfolio.
The one asset class where issuer concentration is starting to become a factor for Deutsche is credit cards.
With the consolidation in that sector, the top 10 credit card issuers comprise an increasingly larger percentage of issuance, Grady said, citing Bank of America's purchase of MBNA and Fleet. "It has become more of an issue that we need to deal with," he added.
Real estate is a large part of the Deutsche portfolio - including "a sizable exposure" to subprime home equities within its ABS investments, along with CMBS and RMBS, Grady said.
So Deutsche is closely monitoring the shift toward affordability products.
Grady cited the increase in interest-only and longer-term loans over the past year and a half as a concern, along with the growing number of investor and other non-owner occupied properties.
"A lot of these products are untested, so it's something we're cautious about," Grady said. "We want to be compensated for any additional risk at the pool level by an increase in credit enhancement and/or spread."
He said concern about both underwriting standards and affordability products is among the reasons that Deutsche is very selective.
"The number of deals we pass on has actually increased over the past year or so," Grady said.
"I wouldn't say there's one deal or one sector where we say no way,' but the hit ratio has decreased as we've seen some of these underwriting risks increase and spreads tighten."
On the new regulations
Reg AB, which took effect January 1, drew mixed reviews from Deutsche.
Grady said that one of the biggest benefits of the regulation is easier access to data, a situation that has only minimal impact for longtime asset-backed investors who have dedicated resources in the sector, know how to get whatever information they need, and often meet directly with issuers. But the casual investor might find it more helpful.
"Now there is static pool data that they will be able to locate and, for the most part, it will be laid out for them the way they want it to be," Grady said. "For a long time, we had to get that data ourselves and construct it."
A potential drawback of Reg AB is that issuers might choose to disclose only the information being required.
"Certain issuers provide more data than is necessary under Reg AB," Grady said.
The concern among investors is that the data could be pared down to the basic requirements. If that happens, the unintended result of Reg AB could be a decrease in information available.
Grady said it's too early to tell whether any issuers might revert to providing less data. But he anticipates the possibility partly because such scenarios happened with Reg FD.
"More and more, when you'd have one-on-ones with issuers, you'd ask them a question and they'd say, Well, I can't tell you that because of Reg FD concerns. I haven't disclosed it broadly,'" Grady said. "The intent was to get more information out there. But it actually had the effect of putting less information out there. So to some extent, I'm a little bit concerned about that."
Securities offering reform is more of a sell-side issue, but one impact on investors is that administrative snafus sometimes delay deal pricing, Grady said.
The culprit is the administrative burden of ensuring that the new rules are followed, such as making sure each investor has all the deal information at least 24 hours before pricing.
"We've heard a lot of people say, We have to push back the pricing of this,' and it usually has to do with the offering reform," Grady said.
Expect more CDOs
Some of the deals Deutsche participates in will be bundled into CDOs going forward.
While the company is already a large CDO collateral manager in Europe - with about 15 deals outstanding there - the U.S. team acted as a collateral manager on its own deal for the first time last year, with more to come.
"We don't want to hold ourselves to doing a transaction every quarter or semi-annually. But we will be out with additional deals as the opportunities present themselves," McCaffrey said.
"Because we have a very diversified fixed-income client base, we don't have a need to pump out a new CDO transaction within any specific period."
Grady said there is a strong demand for CDOs from highly experienced managers such as Deutsche.
McCaffrey, who came from Fidelity Investments in 1996, started as a portfolio manager specializing in structured finance. He took over his current role heading structured finance investing several years ago.
Grady, formerly of Fitch Ratings, joined Deutsche in spring 2001 as a senior credit analyst for ABS. He moved over to the portfolio management side in early 2004.
Grady described the team's first CDO, which priced in November, as a high-grade transaction, but said future deals might be different.
"We chose to do that kind of transaction because that's where we felt the best relative value was in the market," he said. "We will look where the relative value is in the market and focus on those types of deals going forward."
(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.