Over the past six months the long anticipated new protections have been added to 12b-1 mutual fund fee securitizations, sources said. Hedged-collateral offerings should dominate the landscape in the coming year. Through the use of equity put options, issuers hope to mitigate the risk associated with the volatile equity markets. With these new protections, the sector should grow, via larger transactions offered overseas as well as in the U.S.

Developed in the booming stock market of the late 1990s, mutual fund fee ABS has fallen on hard times in the economic downturn. The sector as a whole accounted for 16.6% of the traditional ABS market's 102 downgrades in the first half of the year, according to Moody's Investors Service (See ASR 9/23/02), prompting issuers to seek protections against equity market volatility. Put options won out, due to the lack of active management needed to decrease market risk.

Both of the two remaining issuers in the sector - Citibank N.A. and Constellation Financial Management - have incorporated two slightly different put options into the trusts that issue 12b-1 fee ABS and will continue to do so in the future.

According to Paul Donlin, a managing director in the global securitization group at underwriter Salomon Smith Barney, Citibank has begun using equity-indexed put options as a hedge against declines in equity valuations. These protect against declines in specific broad-based stock indexes, such as the S&P 500.

Constellation, on the other hand, is using Asian style index basket put options for the stock indexes. Asian style puts, unlike the standard puts used by Citibank, have payouts based on the average of the prices of the underlying asset prior to the strike date. The baskets consist of equity, fixed-income and even currency indexes.

"Asian style options more closely resemble our business to perform like our own risk management strategy," notes Constellation managing director of asset-backed structuring Joe D'Anna. "While more exotic and complex, Asian style options more closely track 12b-1 fee performance. Also the diversity of Constellation, with exposure to 600 to 800 different funds, reduces our basis risk and makes the Asian style more efficient for our securitizations."

The put options allow issuers to realize positive cash flow from the hedge in the event of a prolonged downturn in equity markets, which crunch the 75 basis point fee the fund distributor collects, based on the net-asset value of its fund. If, as has been the case over the past two years, fund values decline, the puts are exercised for a profit, and applied to payment of the bonds.

"In the current economic environment, with the Nasdaq off 70% and the S&P 500 down over 30% from their highs, the trust can exercise the options for the difference in price and redirect those cash flows to support the bonds," notes Moody's senior vice president Michael O'Connor. "At different points during the life of the transaction the trust looks at valuations of the options, if the puts aren't in the money, the 12b-1 fee collateral is likely performing and supporting the deal." There is a slight chance that while the indexes are increasing in value, the specific stocks in which the fund is invested have not increased in value, O'Connor added.

As for how much hedge protection a 12b-1 fee securitization needs, the rating agencies tackle this as deals are presented to them, according to Standard & Poor's director Lily Cheung. "Different pools have different guidelines, so the amount of the hedge is decided on a deal-by-deal basis," she said.

So far this year, Citibank has issued three hedged 12b-1 fee deals, for a total of $425 million. Constellation has issued just two ABS this year, a $146.4 million FEP Receivables Funding 2002-2 deal that priced June 27 via Bear Stearns and a $150 million negotiated private deal. Although specific volume numbers could not be accurately assessed, it is believed that 2003 supply will exceed this year by at least 50%, added S&P's Cheung.

Salomon's Donlin added that Citibank transactions in the pipeline for the coming year are larger than previous offerings and will be marketed in the Rule 144A market, as opposed to the traditional private markets. Donlin envisions a global investor base for 12b-1 fee deals, hoping to add European accounts to the fray.

Constellation is evaluating whether it will choose to increase securitization activity in 2003. D'Anna cited unfavorable market conditions for mutual fund fee ABS, comparable to the bank financing it is currently using. Constellation is in the process of increasing the $680 million credit facility it has with 17 banks by an additional $500 million through CP conduit financing.

The success of the sector now invariably depends on investor willingness to learn about the new protections added to these offerings, and, subsequently feel comfortable enough to buy them.

But, noted Moody's O'Connor, given the performance of the equity markets over the past two-and-a-half years, the downgrades seen this year should be expected. "If some of those deals hadn't been downgraded, I would say they were over-enhanced. The Aa2' rated deals are actually performing pretty well."

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