With the onslaught of illiquid assets - particularly displaced MBS and CDO bonds - the development of a market for these securities becomes essential as well as useful not only for the companies that profit from them, but more importantly, the economy as a whole.
SecondMarket, which has its roots creating markets for buying and selling restricted securities, is expanding its reach to cover the trading and analysis of MBS and CDOs, and eventually moving into whole loans, CMBS and ABS.
"It's not only important for us as a business opportunity, but it's really what is needed by way of what's happening in the economy," said Jeremy Smith, chief strategy officer at the firm. "You need a marketplace to get things restarted because its very difficult, if not impossible, to value these securities except through competition and collaboration. We are trying to bring the power of the marketplace to get things moving again. It would take the smart money people paying the right prices."
SecondMarket, which was founded in 2004, started as a marketplace for buying and trading restricted securities - restricted stocks, warrants, convertibles - which were assets that were difficult to trade but not hard to price because there was an available public price that the security's discount could be based on.
However, the firm's business really took off in February 2008 when the auction rate securities market collapsed and investment banks stopped making a market for these bonds. "People thought they had a cash equivalent, but it turned out they were oftentimes holding a 10- or 15-year note," Smith said. Because of the need in this market for liquidity, auction rates became SecondMarket's biggest source of business.
Turning to Securitized Products
Since MBS and CDO illiquid bonds are trying to find a space to trade, SecondMarket is extending its expertise to these areas.
"There's a similar pattern and cadence to starting up markets and once you've figured out how to do it, you can apply that template to other marketplaces," Smith said.
In this vein, SecondMarket has hired securitization professionals to head up this expansion effort.
Richard Gugliada, formerly head of CDOs at Standard & Poor's, recently joined the company as a consultant and is in charge of building the firm's securitized products teams. The firm also hired Michael Anderson, who was previously at DBRS, to be part of its structured finance efforts.
"With the breakdown of secondary mortgage trading on Wall Street, two things have happened," Gugliada explained. First, the dealers who underwrite the deals might not exist anymore, and many of these investment bankers have established their owns shops "crossing bonds."
"But from the investor's perspective, nothing major has changed in terms of the way they sell bonds, they still rely on some broker dealer type to find buyers," he said. However, no one has the capital deep enough to make a firm bid, so the smaller shops are merely crossing bonds and not buying inventory like they used to.
According to Gugliada, SecondMarket is offering investors an alternative by providing them with an "exchange-like environment" where they could list their securities and have established buyers for them. "We are inviting all of the shops that cross bonds to put up their listings and buy and sell through us," Gugliada said.
SecondMarket is planning to hire additional professionals to build up its structured finance business, specifically in MBS and CDOs. Gugliada said that the company is looking for professionals to lead both groups, seasoned secondary traders or sales people for both markets, as well as junior level staff for both sectors. This is aside from the research or clearing employees the firm is looking for to support these businesses. "We are looking to initially hire anywhere from three to six people," Gugliada said.
The firm is gearing up to launch its MBS and CDO businesses in the first quarter, although Gugliada does not expect real activity to happen until midyear. The firm already has a number of CDOs available for sale.
CMBS and whole loans are next in line. "When corporations go under, the CMBS gets in trouble as these firms are vacating their office space," Gugliada said. "It's not about saving homeowners and their mortgages anymore, but it is how the economy is going to do as a whole and we are in unprecedented territory here."
Innovation and Data
SecondMarket not only provides a free marketplace for securitization players to bid and sell on illiquid collateral, the firm also offers information that promotes transparency through its "ecosystem," a platform where participants who are looking for information on these securities could go to for analysis and market research. "Some players just provide research, data and analytics and that's something we are aggregating in this system, which anyone could access for free," Smith said. "We're saying come to all those with any knowledge and analytics, and we'll provide you a platform where you could display the information. This is where the buyers and sellers come in because the ecosystem could give them the transparency and the brainpower that they need to get transactions done or buy what they want to."
Gugliada added that the company also has a market data and research group that provides analytics to those who are interested. For instance, the firm has partnered with ABSNet to feed research and data into analytical models.
Aside from promoting market transparency, SecondMarket has pushed for innovation through the invention of the ManhattanAuction.
"That what's needed when you have everything seized up, you need to start doing things differently, more of the same is not going to work," Smith said. "One of the biggest hurdles to liquidity is attracting bidders, and that's what the ManhattanAuction is designed to do."
In this new auction format, sellers carve out a portion of the sale proceeds, which get paid out to the bidders at the end of the auction. The seller chooses how much of its proceeds it wants to allocate to bidders as well as the number of bidders to whom the proceeds go.
"Essentially you're incenting buyers to do the legwork," Smith said. "There's a decent amount of work to be done to determine the value of these securities, so this auction is specifically geared toward helping incentivize buyers to bid on illiquid assets and enable price discovery on what are otherwise very difficult assets to value."
A Trading Alternative
Gugliada said that what's different about SecondMarket's platform is that it offers an alternative to the traditional way of doing trades, which are usually made over the phone and by privately matching up buyers and sellers. Although the firm also conducts private auctions where only selected parties are allowed to bid, the unique alternative that SecondMarket offers to sellers is the public auction in which everybody can see what bids are being put in for what paper. Although specific names are not disclosed, the prices are.
"That doesn't exist anywhere else in structured finance," Gugliada said. "We've successfully used that model in other markets, now we're going to try to apply it in this space."
Although Gugliada acknowledges that this is not a panacea, SecondMarket is positioning itself so that it's ready to do business when the picture clears up a little.
"The market is what it is right now," Gugliada said. "Everyday there's something new coming out of Washington, and there's still a lot of uncertainty and the markets are still bid 10/offer 90 and just making that information public is not going to close the gap per se but as things become more clear, as government policies get adopted and approved, by midyear, you are going to have a relatively active two-way market in distressed paper. Bank valuations will start to come in line with market valuations, and paper will start moving." The key, Gugliada said, is to launch the company's structured finance platform before secondary market activity takes off again.
"The key is to make sure that you have the buyer and seller network in place and you have the ability to build on it," Smith reiterated. "That's what we're bringing to our market place - an installed base of buyers so that once the sellers come on board, you have a marketplace that's ready to go from early on."
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