Whether it was the recent Freddie Mac-wrapped Option One home equity deal, or Ford Motor Co.'s corporate bond offering, large, liquid, top-tier names have become the current rage.

Yet in the secondary ABS market, especially the mortgage-related sectors, it is extremely difficult to find top-tier paper. Dealer inventories are light, and investors owning these types of popular paper are unwilling to part company. This has contributed to a tiering which has made second- and third-tier issuers unusually cheap.

Given the wide spreads, we think investors should reconsider how second-tier names might fit into their portfolios. Home equities and other mortgage related asset-backed securities are still cheap to other asset- and mortgage-backeds. So building up allocations to home equities in general continues to make sense. Including second- or third-tier names brings an additional 10 or more basis points, with little incremental risk.

Why Sharp Tiering?

Many of the reasons for tiering in home-equity markets are quite familiar. They are a combination of the factors that caused the reorganization of the home equity industry beginning in late 1988, along with those that caused a broad-based spread widening in fixed income markets during August and September 1999.

Two years ago, most leading home-equity issuers were specialty-finance companies. When the gain-on-sale and negative cash flow model fell into disrepute, some of these were acquired by well-capitalized companies, others received outside equity transfusions, and a few were forced into bankruptcy.

That reorganization caused tiering, based on an issuer's access to capital. The tiering had many components, with the fear of headline risk being paramount. No portfolio manager wants to buy a bond from a company that suddenly pops up on the front page of the Wall Street Journal. Also important is the concern that if an issuer experienced financial difficulty and did not have a strong parent or partner, then its ABS securities might be downgraded, or losses might increase if servicing were transferred.

In an earlier article we addressed in detail many of the risks associated with servicing transfers. At that time, a couple of home equity issuers had recently filed bankruptcy and several were on the brink of doing so. Since then, a few more firms have filed for bankruptcy protection. Southern Pacific Funding Corp. was an early example.

While many issues remain to be worked out with these bankruptcy filings, Southern Pacific's case is well along to completion. One major decision facing any firm going into bankruptcy is whether or not it is in the shareholders' best interests to reorganize the company or to liquidate.

Southern Pacific chose the liquidation route, which appears in retrospect to have been a good decision for ABS investors.

Southern Pacific: An Example

Not that any investor wants to see one of their companies slip into bankruptcy - but the experiences of some home-equity issues (that have had problems) are important indicators of protections ABS investors have in such eventualities. Standard and Poor's recently issued a report which outlines Southern Pacific's steps in its bankruptcy proceedings. (See "The Rise and Fall of Southern Pacific Funding Corp.", Thomas Warrack, Standard & Poor's.)

This report is a "must read" for all home-equity investors. It shows that the protections built into the structures of ABS securities (which include legal responsibilities of the trustee, and in this case, legal rights of a bond insurer) can withstand a bankruptcy. Southern Pacific had issued 12 deals, nine of which were serviced by Advanta, and thus were not part of the bankruptcy proceedings. The other three were serviced directly by Southern Pacific.

As part of the liquidation, the Southern Pacific servicing portfolio, along with a 50% interest in the residual and IO strip income, was sold to Goldman, Sachs & Co. That investment bank, in turn, hired Ocwen Financial to take over the servicing operations.

The S&P report notes that delinquencies picked up just prior to and after the bankruptcy, but shortly after that, delinquencies settled back down. This was attributed to the fact that both the trustee and bond insurer felt it important to maintain the integrity of the servicing operation.

They agreed to set aside company assets for $1.3 million in bonuses, to keep the servicing employees on board and working effectively. That step proved quite beneficial, since delinquencies did slacken. Delinquencies rose with the transfer to Ocwen, but an upward blip is always expected when servicing is transferred. Delinquencies are expected to decline as the loans become integrated within Ocwen's operations.

The point is - from a cash flow point of view, Southern Pacific ABS bondholders did NOT suffer. Of course, their bonds lost market value when that company filed for bankruptcy. Bankrupt home equities trade 40 or so basis points behind on-the-run issues (some earlier trades were done at even wider levels).

This is a classic example of headline risk. Most of these bonds are wrapped. Investors are, in effect, not holding a Southern Pacific credit but that of the bond insurer. Of course, that may take a lot of explaining to an investment committee or a chief investment officer. But it is the "whole truth." If the Southern Pacific bankruptcy had ended in any major increase in fore closures and losses, the bond insurer would have had to absorb the loss, not the investors.

This example drives home the point that owning an ABS bond from a bankrupt company is not the same as holding a corporate bond from a bankrupt corporation. Bond downside following corporate bankruptcy is usually quite a bit more than 40 basis points.

Merger Wild Card

It is also important to remember that some of today's top tier names were yesterday's second- or third-tier names. Given the prospect for continued consolidation in the subprime home equity industry, there is a good chance that by buying a second- or third-tier name, an investor is positioning himself for a tier upgrade.

The subprime mortgage market is becoming ever more dominated by large financial institutions with access to the latest technology and systems. Also, Fannie Mae's and Freddie Mac's expansion in the subprime sector will make it even more difficult for small originators to compete.

There is a very strong possibility that some remaining independents will be purchased by a commercial bank or other financial institution seeking to enter subprime lending. The recent agreement to repeal Glass-Steagall makes that prospect all the more likely.

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