The shape of the home equity industry continues to evolve as its overall reorganization proceeds. One principal change is a greater reliance on Wall Street firms as securitizers of whole loan collateral. This builds on a pattern of many years, in which Street firms have purchased whole loans from originators and securitized those loans using their own shelves. It is frequently cost-effective for originators to sell product to others, rather than to issue securities directly under their own name. However, several recent developments increased the attractiveness of the Wall Street distribution channel, and we expect that avenue to continue to grow in importance.
Home equities created by Street firms can be more attractive in some respects than those from traditional issuers. For example, the extra level of due diligence often produces collateral which should perform better than collateral in a typical sub-prime deal. Additionally, Wall Street deals often offer wider spreads. Investors not familiar with this segment of the market should consider the investment opportunities it provides.
Table 1 shows issuance from the major Wall Street shelves over the past three years. Issuance from this source increased from $5.8 billion in 1998 to $6.5 billion in 1999. It has risen to $7.8 billion through Q3 2000, and could easily reach $10 billion by the end of the year. Meanwhile, total volume of home equities is falling, from $74 billion in 1998 to a projected $50 billion in 2000. The increase in Wall Street shelf volume within a time of a declining total volume is pushing up Wall Street's relative participation - from 7.8% in 1998 to a projected 20.0% in 2000. Clearly, the Street distribution channel has become more than just a footnote to the home equity supply story.
In addition to increased overall market share and volume, another trend shown in Table 1 is the shift between individual issuers. In 1998 and 1999 Salomon Smith Barney's SBM7 shelf was by far the largest of the Wall Street home equity issuers, while so far this year Lehman's ARC shelf has been the largest. The ARC shelf issued three deals this year, ranging in size from $1.3-2.9 billion and totaling $5.3 billion. In addition to their unusually large size, the ARC deals are also noteworthy because the loans are covered by lender-paid mortgage insurance (MI). ("Lender-paid" is a bit of a misnomer because the MI is paid from the deal proceeds, not by original lenders of the loans.) The ARC deals also use subordinated bonds for enhancement, but the subordination is less than usual for a home equity deal because a large percentage of the loans are covered by MI. Apparently, MI with subordination proved to be a cheaper execution than bond insurance.
This is one of the first deals (and by far the largest) with a large concentration of lender-paid mortgage insurance, and we understand others are in the works. The advent of deals in which MI plays an important role opens up an entirely new enhancement alternative for sub-prime issuers - in this case, for a major Wall Street shelf.
Options For Originators
Sub-prime originators have a choice of holding loans in portfolio, selling them as whole loans, or securitizing them. Many specialty finance companies and smaller mortgage bankers do not have the capital, nor access to funding, to hold their production in portfolio for any length of time. Hence, they must either sell whole loans or securitize their originations. Furthermore, many small mortgage bankers do not originate sufficient volume to support a securitization. Small deals find less investor interest and can experience poor execution. So it is natural for a small originator to sell its production as whole loans.
The buyers of these whole loans could be other originators who regularly issue home equity securities. It could also be a depository institution that will portfolio them. Increasingly, a third outlet for whole loan sales is Street firms, which will accumulate collateral from one or more originators and then issue a deal from their own shelf.
All of these channels have become more active during the reorganization of the home equity industry over the past two years. However, as illustrated in Table 1, there has been an unusually large increase in whole loan sales to Wall Street.
Why More Whole Loan Sales?
What influences are causing originators to sell a greater percentage of their production as whole loans and, in particular, why more to the Street? There are many reasons behind this trend. Most are related to the credit/liquidity crisis that swept through the industry in recent years.
*Need for positive cash flow execution - After the credit/liquidity crisis of late 1998, many issuers found it impossible to securitize, since that typically means running businesses on a negative cash flow basis. With limited access to both short and long term borrowing, it became virtually impossible to use negative cash flow strategies such as securitization. By contrast, whole loan sales provide positive cash flow execution. Accordingly, many issuers increased their amounts of whole loan sales.
*Residuals more difficult to finance - When an originator securitizes loans, deal residuals are typically retained. In the past, many less-well capitalized issuers turned to Wall Street or to other lenders for residual financing. In today's more risk-adverse environment, such financing has become much more expensive - if available at all. And if a company cannot finance or sell the residual, it cannot bring a securitized transaction.
*Increased capital requirements for residuals - This past year bank regulators found that a surprisingly large number of small banks were securitizing mortgage loans and retaining residuals. Many were not accounting for residuals properly, nor did they have a full understanding of residuals' investment characteristics. Two banks that recently failed had booked a large number of residuals, which contributed to Federal Insurance Deposit Corp. costs in those failures. Consequently, bank regulators are requiring larger amounts of risk-based capital for residuals, which makes it more expensive for banks to retain them.
*Tougher gain-on-sale assumptions - Although some home equity issuers no longer employ gain-on-sale accounting, many firms still use the approach. Bank issuers will probably have to start using more conservative gain-on-sale assumptions. The Office of the Comptroller of the Currency recently required Advanta National Bank to sharply revise its gain-on-sale assumptions (a change that significantly impacted Advanta's reported earnings). Presumably, other banks will have to adhere to a similar policy. This will decrease securitization's attractiveness to banks.
*Fewer buyers of residuals - Hedge funds used to be among the largest buyers of residuals. However, since the credit crisis of late 1998, these investors follow much more conservative investment strategies and are less active participants in the residual sector. As a result, there are fewer buyers of residuals and it is harder to find interested parties.
*More expensive credit enhancement - Bond insurers have increased the fees they charge for wrapping sub-prime home equity deals. This makes it more costly for issuers to pursue wrapped securitization strategies. Likewise, for non-tier one issuers, it has become almost impossible to bring a senior-sub deal. The spread required to place the BBB bonds makes it prohibitively expensive to use a senior/sub alternative.
All of these forces have combined to make it more expensive for second- and third-tier issuers to bring securitized deals. Since they are unable to portfolio loans for any length of time, they are forced to sell them into the whole loan market. Even some of the larger independent issuers are doing so. As mentioned earlier, for many years small originators have been selling their production as whole loans. Because of the factors listed above, an even larger group of originators are using whole loan sales to fund an increasing percentage of their production.
Why To The Street?
We have highlighted some of the forces which make it harder for issuers to bring securitized transactions. But why the increased use of Wall Street shelves? Part of the answer lies in the fact that Wall Street firms are good at breaking a package of whole loans up into constituent parts and placing them with various investors. This often allows them to out-bid competing portfolio buyers.
For example, in placing residuals on a deal, Street firms have access to a wider range of investors than would a single originator. Street firms are also better able to temporarily position subordinated bonds and residuals until an appropriate buyer is found, while small issuers may not have that staying power or luxury.
Street deals often use a servicer other than the originator. For example, the recent PMAC 2000-HE1 deal used Litton as servicer. Given that many investors are concerned about the risk associated with a servicing transfer (if an originator faces a severe financial problem) the idea of having a servicer other than the originator is appealing (especially if a servicer has the highest rating from a rating agency).
Street firms take a very tough approach when conducting due diligence for their own deals. They will kick out riskier loans - if they are too big, have too high a loan-to-value (LTV), or some other factor that makes a loan risky. The rejected loans are sold to companies which specialize in servicing such collateral. In general, this means that a deal from a Street shelf has a better credit profile and should outperform the average sub-prime deal.
We don't expect many of the factors driving the increase in Wall Street home equity deals to change quickly. A sudden decline in bond insurance rates or a sharp tightening in subordinated spreads would certainly impact the trend, but neither seems likely soon.
So for the foreseeable future, many traditional issuers will continue seeking alternatives to securitization. That points to more deals emerging from Wall Street shelves. With collateral often better than typical sub-prime deals, and spreads (at times) wider - this source of supply should be carefully considered by all buyers of home equities.