Heilig-Meyers: Who dropped the ball?
Though default studies continue to champion structured finance securities, ratings volatility and credit quality are on the minds of investors, especially as the economy heads into a slowdown.
Moreover, recent headline events in the industry - namely the severe downgrades associated with Hollywood Funding and Heilig-Meyers, and the true sale legal battle associated with LTV Steel - have challenged the safety-in-structure notion that has visibly benefited asset-backed securities over the last few months, drawing investors away from the unsecured debt markets.
Skeptics, however, would not be surprised if ABS were to get hit harder than anticipated as the market seasons.
"We've thought for a couple of years that ABS is going to start looking more and more like corporates in terms of losses and ratings volatility, and I think that's starting to happen," said one ABS investor.
This investor argued that studies comparing ABS to corporates do not always factor in the relatively short average lives of asset-backed, or the disproportionate amount of triple-A's in the market.
However, other observers note that the extreme rating events in ABS, such as Hollywood Funding and Heilig-Meyers, tend not to be as much credit stories as they are fundamental flaws in the deals themselves: be it structural problems, mismanagement, or fraud.
In Hollywood Funding, because of a refusal by Lexington Insurance Company to honor a triple-A wrap on two deals, both were downgraded by Standard & Poor's to CCC-minus' from AAA.' Lexington is a wholly owned subsidiary of American International Group (see ASR 3/19 p. 1).
In the Heilig-Meyers' event, where two series of triple-A rated notes were downgraded to below investment grade by all three ratings agencies, the ratings actions were the result of significant portfolio deterioration following a controversial servicing transfer.
"I think Heilig-Meyers is a real event, and a wake-up call," said one bank researcher, formerly a senior at one of the rating agencies. "I think the Hollywood Funding event, timing wise, was just a coincidence, and not a symptom of the same problem, except to the extent that they are both risky deals to begin with."
According to the researcher, Heilig-Meyers is most significant because the structure failed, and the pool performance was more directly tied to Heilig-Meyers corporate credit than ABS professionals (especially investors in the deals) are comfortable with.
Cited from a Nomura Securities research report: "[A]lthough the legal connection between the company and the credit card receivables may have been severed, an economic and functional one persisted."
Two universes of deals
Still, when considering ratings volatility, ABS analysts contend that a distinction should be made between commodity ABS and off-the-run sectors prone to third-party risk.
"The case where we kid ourselves is by measuring volatility as a percentage of the whole universe of [ABS deals]," said the bank researcher. "It's really two separate universes: the universe of big companies that look out for their deals, which are backed by good assets to begin with, versus the deals that had iffy collateral, which means that the servicer is more likely to be called upon, and may have less motivation, thinking it's going to be good money going after bad."
The researcher suggested that it's fair to generalize that ratings on home-equity ABS are more volatile than ratings on bank credit card ABS. Similarly, ratings on private label credit card deals are more volatile than ratings on bank credit deals.
"The problem is, overtly agreeing to those generalizations is admitting that we're not achieving what we aspired to," the researcher said. "Are we admitting failure? I don't think it's failure that different sectors end up performing differently, I think it's just natural."
Said one source citing the most recent pool performance data, the non-payment rate in the Heilig-Meyers trust trended-up to 74% from 70%, while the obligors who are still current tend to be paying the full amount each month. Roll rates, or the rate at which borrowers move into the next bucket of delinquency (i.e. 30-days, 60-days...), was relatively unchanged.
"I wouldn't say it's deteriorated significantly from the month before, but I can tell you that it hasn't gotten any better," the analyst said.
Between Heilig-Meyers' July servicer report and the data released in late February, there was a relative freeze of information. During that period, delinquencies spiked to as high as 70% from below 10%.
All three rating agencies placed the Heilig-Meyers trusts on review for downgrade in August, after the company filed for bankruptcy, and indicated to the trustee, First Union, that it would no longer be servicing the portfolio. At that point, the securitizations began amortization, as bankruptcy was considered a trigger event.
The Heilig-Meyers portfolios are backed by finance contracts on installment, taken out at the time of purchase, for products such as home furnishings and furniture. In this situation, more than two-thirds of the borrower base made payments on location at the various Heilig-Meyers' department stores.
For the transfer, the borrowers had to be "reconditioned," as one source phrased it, to pay by mail, when the actual department stores were shut down. Within a day or two of Heilig-Meyers' filing for bankruptcy, First Union was able to get a state-ordered injunction preventing Heilig-Meyers from firing the personnel necessary to do the servicing, which it had intended to do. In October, First Union brought on OSI Portfolio Services to take over the servicing operation.
Considering the substantial portfolio deterioration, the question arises, "Did the rating agencies adequately factor in the difficulty of a servicing transfer when they rated these bonds?"
"Clearly they did factor in the risk," said one banker. "Did they consider it? Yes. Did they adequately account for it in the deal structure? That is at issue."
At least one rating agency source, who chose not to be named, was willing to accept some of the responsibility.
"First Union, in their role as back-up servicer, should have had a plan in place to deal with a far-flung, decentralized servicing platform like that," the source said. "[But] it is the rating agency's job to make sure that the plan is appropriate. I don't know that the ball was dropped on our side... but this is something you learn from. It's unfortunate if anyone loses any money because of it."
However, also at issue is when and if First Union was ever required to be the back-up servicer. In a previous interview with ASR, Maria Dantas, attorney at Leboeuf, Lamb, Greene & Macrae, and outside counsel to First Union, said that the bank was not required to be back-up servicer, but was only required to facilitate the transfer to a replacement servicer. Dantas argued that First Union more than adequately fulfilled its role, considering the circumstances.
"[It was] a very short period of time to do a lot of transitioning, and the trustee was successful in doing it," Dantas said. "I think that First Union did an excellent job in assisting the transition of one servicer to another."
According to the Master Pooling and Servicing Agreement, First Union was entitled to 120 days to find a replacement servicer before the bank was required to run the platform itself.
However, because of the unique serving platform, First Union as trustee had other monitoring responsibilities. In the Moody's Investors Service new issue reports, for both series 1998-1 and 1998-2, the rating agency wrote:
Heilig-Meyers is required to provide First Union with monthly tapes containing billing and collection information on obligors. First Union must review the content of each monthly computer tape for general completeness and readability and, if necessary, follow up with Heilig-Meyers to rectify any problems with the data provided on the computer tape.
At this point, it's been established that Heilig-Meyers wasn't keeping accurate, up-to-date records with regards to the borrowers, which was one of the reasons the servicing transfer was so disastrous.
Because so many of the borrowers made payment on location, it wasn't necessary for the company to keep accurate records for the portfolio to perform.
Some sources argue that First Union should have been more closely monitoring Heilig-Meyers, although in ASR's last interview with First Union, Dantas said that this is not the responsibility of the trustee.
With respect to fundamentally flawed transactions, in this case, relatively key players in the transaction seem to be at odds in terms of who was supposed to do what and when.
Again, the questions are: Should First Union have been more closely monitoring Heilig-Meyers? Was it the rating agencies responsibility to make sure that First Union had a plan in place to handle a servicing transfer? Or was it an issue of credit enhancement?
"We'll definitely be focusing on these issues with closer scrutiny in the future," said one ratings agency source. "Certainly, if everything was going according to plan you could say we didn't size [the credit enhancement] appropriately... clearly the collateral deteriorated far beyond our worse case triple-A scenario."