If Samuel Johnson was right that "when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully", maybe the recent wild market volatility will have the beneficial effect of concentrating our attention on some important concerns in assessing securities backed by 12b-1 fees.
The 12b-1 fees are a 0.75% annual charge on the asset values of B-share mutual fund programs. These asset-based sales charges are always paired with a declining back-end charge, a contingent deferred sales charge (CDSC). Although the fees are small, the assets are substantial. Current estimates for this year at $2 billion in new issues are quite reasonable, while the value untapped in existing B-share programs could be twenty times that or more. The value comes with a cost: the complexity of analyzing the assets and securities backed by them can be daunting.
In any asset class, three risk areas should be addressed: first, legal and structural risk; second, operational risk; and finally, performance or quantitative risk. In any asset class, perception of risks changes over time with more data, experience, and insight. These fees are no different.
At first thought it would seem the third of these risks would be the hardest to analyze - even seeing how to start is far from obvious. However, until recently, much of the risk analysis for securities backed by 12b-1 fees focused on the first of these risks. These concerns, in fact, drove much of the rating process. Some felt structural risks should restrict ratings to no higher than the A or even the Baa level.
Termination Risk Abandoned
The main culprit was "termination risk". The Securities and Exchange Commission requires a mutual fund's board to affirm use of the fees on an annual basis. This requirement cannot be contractually waived or constrained. Since these assets often support eight-year term deals, each fund has eight chances to disrupt payments to the securities. In the nightmare scenario, all funds simultaneously end their 12b-1 programs the night after closing, and the hapless investor awakes in the morning to find that his 12b-1 fees have vanished without hope of recovery. As with most nightmares, colder light reveals that excessive concern to be unwarranted. No fees have ever been disrupted by board termination. Little incentive or motivation exists. Investors and rating agencies have been become increasingly sanguine about this risk. Moody's ratings of Aa2 for several tranches in recent deals are consistent with this trend.
Concern about operational risk tended to be minimized, originally. A finance company purchases the rights to monthly packets of a fund family's originations. These rights are then combined with those from other fund families to form a diversified pool of assets.
Although the calculations needed to assess the values of the funds and the fees generated are complicated and laborious, transaction agents and others in the mutual fund industry perform them routinely millions of times daily. The industry is highly regulated, and data integrity concerns are recognized as of paramount importance. Thus the core calculations and data and the ability to manage the related cash flows required to service these assets are well integrated and provided for by the infrastructure of the industry, itself. Little more seemed necessary. However, each finance company has customized nuances that add complexity. Moreover, the monthly pools, separate securitizations of adjoining monthly pools, and multiple financiers require new data and calculations unforeseen in the general situation. This added complexity makes it important to assure that operational knowledge is secure and can easily be transferred, if necessary.
Finally, we can turn to the upside of hanging. In the last year, the S&P500 has bounced up and down 10% to 15% to end where it started. In the last few months, 10% to 20% monthly of Nasdaq market moves have been common. The "dot-coms" and other high tech fly to nosebleed P/Es. But will some crash and burn? Such gyrations concentrate the mind wonderfully on the dominant role of market performance on 12b-1fees performance, and hence, on the performance of securities backed by them. Not termination risk, not operational risk, but performance risk is and should be the primary focus.
But how is performance analyzed? The first step is to construct a model of a fund (or fund family or pool of fund families) that given the net asset value (NAV) yields the fees generated. How? By statistically studying myriad historical data like redemption rates and reinvestment rates. Next a model is built to simulate the path the NAV of a fund. How? Generally, by regressing a fund's historical NAV against some set of market indices. The last step is to simulate the path of market indices. How? Many ways - from simple historical sampling of indices' performance to elegant engines derived from fundamental principals. Finally, expected bond performance follows directly from the simulated cash flows.
The models are good and informative. Maybe, before the wild ride of the last few months, when in the thrall of a long bull market, we would be done. It sometimes seemed that the major concern should be how strong had the bonds become, rather than how risky could they be. Now it's clear we must assess how good is the analysis. What are the implications of modeling decisions? For example, is the design of the model sufficient? Is it stable? Is it suitable for the funds being analyzed? Have model error, parameter error, and random effects been accounted for?
Looking back, the good news predominates. The assets are deep, and the class is growing. Termination risk is not so scary. Operational risk can still be minimized, but maybe not passively, as we thought before. We have a much more detailed understanding on how to analyze performance and much more knowledge on parameters influencing performance. We even begin to have historical data to compare actual performance with predictions, to find what we do well, and what we can do better.
Looking forward is always harder. While concern for market performance is always justified, diversification and subordination should cushion the highest-rated tranches from all but the deepest, longest and most widespread market declines. Even in this time of volatility, Aaa ratings will be achievable. Difficult, but achievable. On the other hand, lower-rated tranches with less diversified pools almost certainly would suffer credit losses from deep or long declines in markets, where they have significant exposure. The adverse effect of prolonged slow or no growth would not be great on older securitizations that have benefited from years of rapid growth. Low-rated tranches of newer securitizations would feel pain. In general, short-term market swings have little performance impact.
