Securitization has been a boon to banks looking to manage their loan exposures and free up capital, and Jeffrey Stern has played a significant role in the development of that market over the last 10 years.
One of Stern's specialties, the fastgrowing collateralized debt obligation (CDO) market, in which corporate loans and bonds are pooled and then sold to investors as securities, faces hurdles but is nevertheless continuing to grow and spread beyond its traditional bank base.
Since the early 1990s, Stern worked at law firms specializing in this arcane area of financing - in 1995, for example, he helped former employer Mayer Brown & Platt structure its first CDO ever for the New York office of France's Indosuez Capital.
And just a month ago, Stern moved over to Stroock & Stroock & Lavan as a partner in structured finance, joining several other partners and associates focusing on securitization (see ASR 7/7). Since securitization has begun to merge in recent years with other arenas of finance, his division works closely with Stroock departments focusing on other types of complicated financial transactions.
"The securitization market has become very multidisciplinary. Stroock has depth in derivatives, insurance, bankruptcy and hedge funds, and that combination allows us to offer a richer suite of expertise to clients," Stern said.
His expertise includes areas like synthetic CDOs, Latin American securitizations, "exotic" securitizations - such as securitizing future revenue from the Isley Brothers' portfolio of music and related products - and commercial paper conduits, as well as various types of securitizations and derivative transactions designed to provide banks with regulatory capital relief.
In his first few weeks at Stroock, Stern said, he worked closely with the insurance department on a transaction combining insurance and securitization, and he has been working lately on several projects combining insurance with derivatives. His firm has also been talking to clients about next-generation CDO products, including synthetic insurance-based CDOs, CDO products containing hedge fund elements and CDOs backed by trust preferred securities issued by both banks and insurance companies.
"As the structuring becomes more interdisciplinary and complex, often involving derivatives contracts, the technical expertise of the derivatives attorneys becomes especially important," Stern said. Stroock's derivatives specialists have pored over the ISDA's rules governing those transactions with a fine-toothed comb, and can promote the structural protections that may not be in standard contracts and have to be negotiated, or may not be offered at all by a counterparty.
In addition to sharing expertise, the multidisciplinary approach also gives the attorneys more perspective on trends in the financial markets. Banks have so far been the biggest beneficiaries of securitization and derivatives in terms of using those instruments to manage risk exposures and capital, but insurance companies are also increasingly significant participants in the market.
Traditionally, insurance companies have been the main investors in these transactions, buying pieces of CDOs or acting as derivative counterparties. Over the last year or so, however, insurers have been more actively using the securitization and derivatives markets to raise capital and manage risk, Stern said. Securitizing insurance premiums is one way insurers have raised capital, and they've also sought to distribute risk by issuing securities like catastrophe bonds, in which bond investors agree to cover losses resulting from events set out in the securities' terms.
"So now insurance companies are transferring risk to the capital markets, much in the way banks have done," Stern said. "My expectation is that we'll see the same kind of disintermediation in almost any category of risk in which an insurance company feels overly weighted and wants to lessen exposure, or feels there may be credit deterioration, or concludes that the ongoing premiums don't justify the capital held against that exposure."
More directly affecting banks, Stern said, is the second Basle Capital Accord, which as currently proposed requires banks to hold more capital against lower-rated assets. Since banks often hold the subordinated portions of securitizations they manage, that provision - which the American Securitization Forum is seeking to revise - is likely to result in banks rejiggering their finances.
"That's a concern in the bank securitization market, and I'm sure banks are already starting to rebalance their portfolios," Stern said.
It will be several years, however, before the second round of the Basle Accord becomes mandatory. A more immediate concern, Stern said, is FASB Interpretation No. 46- the consolidation of variable interest entities, which may require a collateral manager with the ability to buy and sell assets for a CDO to consolidate the assets on its balance sheet, even though it doesn't hold a stake in the transaction.
"This would create a lot of volatility and would tend to distort the balance sheet of the collateral manager. It doesn't seem to be FASB's intent, but it may be a result of the way the rule was drafted," Stern said.