The recent (10/22/99) submission of the Bond Market Association's (BMA) proposal to the Department of Labor to make certain subordinated MBS/ABS/CMBS classes ERISA-eligible could give a much-needed boost to these subordinated sectors. If the BMA's proposals are implemented, a major new source of demand would be created for these securities, while simultaneously providing pension funds with a new array of high yielding investment products. New progress, yes. But this is not a new topic.
The BMA has discussed the issue with the Department of Labor (DOL) for several years. A draft proposal was submitted by the BMA in April of this year. Their final proposal contained changes suggested by DOL. Because BMA's proposal incorporates issues already raised by the DOL, it may increase the likelihood that some portions will be adopted. This is especially true for AAA through A subordinated securities. (Yes, it IS possible to have subordinated AAA se-curities! It is also possible to have AA or A seniors.) It is less clear as to whether the DOL will allow BBB securities.
NET - there's no guarantee as to what, if anything, the DOL will ultimately adopt. But as presently formatted, there will probably be some expansion in the range of structured securities deemed "ERISA-eligible."
Complex Law Created Anomalies
The original legislation, subsequent amendments and various exemptions - made ERISA one of the most complex and frustrating areas of government regulation that fixed income markets contended with. Anyone who has tried to get a definitive answer as to whether a particular ABS security is ERISA-eligible will heartily agree.
You cannot find one ERISA lawyer who will declare that a particular ABS security IS indeed ERISA-eligible. The best they will do is state that it MIGHT be eligible. It is common for a prospectus to list four or five possible exemptions, but to conclude that the security may or may not be eligible under one, all, or any, of the listed exemptions.
This complex law has led to glaring contradictions and anomalies. Subordinated AA, A, and BBB ABS securities are not ERISA-eligible, yet corporate bonds with comparable ratings are.
Retirement plans can invest in (riskier!) equities, but they cannot invest in investment-grade, subordinated ABS securities. Plans can invest in commercial mortgages, but not in subordinated CMBS. This is true even though many believe that an ABS security is a stronger credit than a comparably-rated corporate bond. In at-tempting to protect employee retirement funds, ERISA created rules that limit pension fund managers to make sub-optimal investment decisions.
Background
When ERISA (the Employee Retirement Income Security Act) was first passed in 1974, it included a section that defined "Prohibited Transactions," i.e., investments prohibited for plan purchase. The intent was to prohibit a manager from investing a plan's money in assets that might in some way benefit any individual plan member.
As an extreme example, a plan could not invest in any company wholly-owned by a plan participant. Over time, the DOL approved a number of exemptions to the Prohibited Transaction rule for investments which, in strict reading fell under it, but in reality, had virtually no possibility of violating the spirit of the law. These came to known as Prohibited Transaction Exemptions (PTEs).
Underwriter's Exemptions
One of the first PTEs was for U.S. government and Agency securities. This made Agency MBS ERISA-eligible. Subsequently, PTE 83-1 made single-family residential mortgage pools ERISA-eligible, but it did not cover multi-family or commercial mortgage pools, nor subordinated MBS.
ABS pools were not eligible during ERISA's early days. In part, this reflected a special problem that MBS and ABS securities (backed by pools of consumer loans) have under Prohibited Transactions that other securities do not.
Besides eliminating all subordinated ABS from the eligible list, these restrictions also eliminated some other ABS securities, even though they were senior securities. For example, credit cards were eliminated for the following reasons: (a) credit cards are issued from a revolving trust, so they do not meet the pre-funding date requirement; (b) the receivables in a credit card trust are not secured, so they do not meet the "secured asset" requirement; and (c) many card trusts incorporate interest rate swaps.
Two major card issuers (MBNA and Citibank) petitioned the DOL, and have received exemptions (PTE 98-13 and PTE 98-14, respectively) for the senior securities issued from their credit card trusts. The BMA's proposal requests that the MBNA and Citibank exemptions be extended to other credit card issuers, and that a new exemption be created for subordinated credit card securities.
Proposal Strategy
When the BMA began to consider a formal proposal to update ERISA rules (to relevant developments in the capital markets over the past twenty years) they could have taken either of two major approaches: (1) a wholesale rewriting of ERISA legislation to remove anomalies and incorporate language enabling eligibility for subordinated MBS/ABS/CMBS securities; or, (2) specific proposals under existing law for new PTEs for a well-defined set of securities. The first approach was favored, but the odds of it happening in an acceptable timeframe were deemed relatively small (rewriting legislation is a time-consuming and uncertain process). Thus the BMA selected the latter approach.
Accordingly, the BMA developed a request for a specific set of new exemptions covering a well-defined set of asset classes. That required approval only from the DOL, not the creation of new legislation and Congressional benedictions.
In addition, since the DOL could grant exemptions only to specific companies under an underwriter's exemption, this route meant that the BMA's proposal took the form of a proposal for exemption for an individual company. (Once achieved, the exemption could then be extended easily to other underwriters.) Thus the proposal was submitted as an "Amendment to the Prohibited Transaction Exemptions (PTE) 1990-24 and 1997-34 for Morgan Stanley & Co."
Demand For Subordinated Securities
What impact would this have (if enacted) on the market for subordinated MBS/ABS/CMBS? Private pension funds would be eligible to purchase these securities. (Governmental pension plans and certain Church plans are outside the ERISA regulations.)
As of Q2 1999, these private funds had assets of $4.6 trillion. Corporate equities represent by far the largest category, and total $2,344 billion, which equals about 50% of total assets. Corporate bonds represent $322 billion. U.S. governments command about $587 billion. There are very few MBS only $29 billion. The plans use equities and corporate bonds for yield and price appreciation, and governments for liquidity. Apparently, yield on Agency MBS is too low to be attractive. We think it possible that some of the money invested in corporates would shift over to MBS/CMBS/ABS subs if the BMA's proposal is accepted.
Volume Of Subordinated Bonds
Making subordinated securities ERISA-eligible could have a significant impact on the sector. One of the reasons is that currently, relatively few of these securities are issued yearly. We adjust those earlier estimates to reflect only investment-grade subordinated bonds impacted by the BMA's proposal.
Virtually 100% of home equity and MH subs, about 80% of Jumbo whole loan subs, and about 60% of CMBS subs, are investment grade. Even then, our estimates show that CMBS is by far the largest sector, with around $10 billion of investment grade subs. This sector is so large because the base (total volume) of CMBS is large and then the percentage of that base which is subordinated (at around 30% in the aggregate, and about 18% within the investment grade portion) is much larger than in other sectors.
Whole loans and home equities follow in size, with $3.4 billion investment grade subs. The smallest mortgage-related areas are MHs and hi-LTVs, with $1.8 and $0.3 billion, respectively.
Almost all card deals have senior/sub enhancements. The amount of subordination varies by issuer, but the average is about 8.5%. Virtually all of the card subs are rated A, although some recent deals, in addition to an A class, contained BBBs in place of privately placed CIAs. Subordinated credit card volume runs around $3.2 billion/year, about the same as in whole loans and home equities.
The average amount of subs in the auto sector runs about one-third as much as in cards, even though total auto issuance is roughly comparable. The lower subordination volume within auto loans is caused by two factors. First, subordination for prime auto issuers runs 4-6%, much less than in cards. Second, about 50% of auto deals use bond insurance rather than subordination for enhancement. This lowers average subordination for all auto deals (wrapped plus senior/sub) to around 2.5%, which annualizes at about $1 billion.
Adding [mortgage-related sectors + cards + autos] delivers total investment grade subordination of around $23.4 billion/year. As we saw earlier, private pension fund assets currently amount to around $4.6 trillion. Even a small shift toward MBS/ABS/CMBS subs could significantly impact these markets.
Timing
(It's Always Everything, Right?)
It is never easy to predict if, or when, a particular government regulation will change. We certainly have seen many "sure-fire" proposals disappear into a regulatory black hole, never to be heard from again. On the other hand, some of the most unlikely changes sail right through.
In the case of BMA's proposal, it appears that the basic concept of expanding the underwriter's exemption is supported by the industry, and has at least some modest acceptance by the DOL. So it seems more likely that some version of the proposal will be enacted.
If all proceeds smoothly, the DOL could publish its own version in the Federal Register, and start the 45-day comment period during Q1 2000. Since we are not aware of any major opposition, it should not take long after the comment period for the DOL to draft a final rule. It is conceivable that the new regulation could be implemented by mid-2000.
Subs Look Even Cheaper
Prior to the submission of the BMA's proposal, it seems to us that most A and BBB subordinated bonds looked unusually cheap. They had not kept pace with the tightening in AAAs and AAs from the late August/early September wides. While it is difficult to judge how much pension fund money might flow to these sectors if the ERISA exemptions are granted, the potential is sizeable. We suspect that these sectors will see increased demand and tighter spreads in the weeks ahead.
