What's Next, Securitized Bridge Tolls?
What do credit cards, security-alarm contracts, student loans, mutual-fund fees, and delinquent child-support payments have in common? The answer: securitization, one of those ugly words that investment bankers come up with. Through the wonders of this red-hot financing technique, companies--and even local governments--are creating marketable securities out of just about anything but the kitchen sink, as long as it's sitting on a balance sheet.
Corporations issued $75 billion worth of asset-backed securities (ABS) in 1994, $108 billion in 1995, and are on track to churn out a record $140 billion in 1996 (chart). According to Securities Data Co., ABS offerings are growing at nearly twice the rate of corporate bonds. "There is a huge investment-banking community going after this business and an insatiable demand from investors," says Calvin R. Wong, head of Standard & Poor's New Assets group.
HIGHER YIELDS. And it's not just the same old assets showing up on the scene. Not long ago, deals involving credit-card, auto, and home-equity loans dominated the ABS landscape. But as those deals become a high-volume, low-margin business, investment bankers are targeting new asset types where they can charge higher fees and where investors can find higher yields. This new generation of securities is backed by aircraft leases, royalty streams from films, home-improvement loans, property tax liens, student loans, and auto loans to people with poor credit histories. New York City may even securitize delinquent child-support payments. Municipalities in New Jersey and New York have already securitized tax liens, and others may follow. Parking tickets and bridge tolls may be next.
Wall Street's latest burst of creativity may bring new risks to a market that has experienced few setbacks since its inception in 1985. "When everybody wants to securitize, and everyone is willing to buy, and everyone thinks nothing will go wrong, there gets to be a feeding-frenzy atmosphere, and you have to remain cautious," says Paul Stevenson, managing director of Moody's Investors Service Inc.'s Asset-Backed Finance group. The new generation of assets are piggybacking on the reputation of traditional asset-backed securities as safe investments, but many of them have little or no track record. Even tried-and-true assets such as credit cards have some investors jittery, since the combination of weakening consumer credit quality and a slowing economy could result in a lot more delinquencies.
So how does this financial alchemy work? Say, for example, XYZ Finance Co. wants capital to make more loans to low-income families but finds bank financing too expensive or doesn't have a high enough credit rating to make a corporate bond offering economical. The company, which is rated BB, finds that an ABS deal will, in effect, allow it to borrow funds at about the same cost as an AAA borrower. It decides to turn to the ABS market.
After picking which loans on its books to package together, XYZ's underwriters and lawyers work with rating agencies to figure out how to structure the deal so that it gets a good rating. XYZ may have to buy insurance in order to make the rating agencies happy. The securities are then sold and XYZ gets the money. The assets are even transferred to a separate corporation so that in the unlikely event that XYZ goes bankrupt, creditors can't touch them.
The assets then go to their final resting place, a trust. Now, when loan payments come in, they flow into the trust to pay the interest on the securities. The securities are set up to mature in, say, three years, when investors get their principal back.
GOBBLED UP. Securitization has been a lifesaver for banks. "In 1990 and 1991, the biggest impetus for banks to do ABS was to get assets off the balance sheet to improve their capital ratio," says Tracy van Eck, who is a senior managing director at Bear, Stearns & Co. "Now, as banks continue to see core deposits flow out, they need to replace that financing, and they've chosen to do it in the ABS market."
On the other hand, the growth of the ABS market is taking business away from banks. Finance companies such as Green Tree Financial Corp., a manufactured-housing lender, use asset-backed securities to fuel their rapid growth. Says Martin P. Harding, co-head of Lehman Brothers Inc.'s Asset Backed Securities group: "These companies are building their business through accessing the capital markets rather than through bank lines of credit and other forms of financing."
Institutional investors are gobbling up ABS deals. Insurance firms and pension funds like the mix of a top rating and a yield that is a lot higher than they can get on Treasuries of comparable maturities. Insurance companies, which have to hold cash in reserve against investments, are big fans because the top ratings on deals minimizes the cash that needs to be held against them--and yet they get those higher yields. Also, since asset-backed securities have shorter maturities than many other fixed-income securities, they're not as sensitive to interest-rate swings.
One risk to ABS investors is that the payments flowing into the trust don't follow their historical pattern. That could extend the life of the security. Another concern is whether a deal is properly structured so that the assets are actually isolated from a bankruptcy of the issuer.
A more pressing worry for investors in deals backed by consumer loans is the decline in consumer credit quality. In June, aggregate charge-offs in the pool of $150 billion in credit-card deals tracked by Moody's rose to 5.5%, 40% higher than a year ago. As losses rise, some issuers, such as First Chicago, have added more assets into their trusts to maintain their deal's AAA rating--which raises the cost of the financing significantly.
Strengthening a deteriorating pool of assets avoids a more costly prospect--having to repay investors early. If a credit-card deal had big losses, investors might have to be repaid ahead of schedule. A bank issuer might have to put those previously securitized receivables back on its balance sheet, says Edward Bankole, a vice-president in Moody's Structured Finance Group. That would hurt the bank's ratio of capital to assets, which is closely watched by regulators.
TIP OF THE ICEBERG. There have been few high-profile ABS blowups. The deals that have soured tend to be small private placements backed by nontraditional assets. "People don't know about the deals in trouble because people don't want to talk about them," says David Evans Katz, managing director of Ironwood Capital Partners Ltd. in Hartford.
Problems have arisen with a number of deals involving "subprime auto loans"--auto loans made to people with poor credit histories. Securitization is the main source of funding for these lenders, and their loan volume has exploded in the past 18 months. These issuers typically do private placements, but many are now moving into the public market. Subprime auto loans can make excellent securities, says Katz, but investors have to do a lot of research on the deals. Patricia Young, who manages a number of Alliance Capital Management's mutual funds, has stayed away. "It's clear to me that it's a very good opportunity for the issuer," she says. "It's not as clear to me that it's as good an opportunity for investors."
Investment bankers are working hard to avoid any problems in another fast-growing area--global asset-backed securities. "We're seeing the global emergence of securitization across asset classes, markets, currencies, and countries," says Alvin Hageman, head of securitization for Citicorp. Many deals are based in Latin America and involve "operating assets"--assets such as a prospective soybean crop, or oil in the ground, that exist but haven't yet been turned into a marketable product with a cash flow. Insurance companies may also become big securitizers. Wall Streeters are working feverishly to figure out a way to securitize the reserves that insurers hold against catastrophic risks.
Investment bankers have high hopes for securitization. "The growth in the past decade will be seen as the tip of the iceberg," says Michael Normile, head of Merrill Lynch & Co.'s Structured Products group. And investors will have to work a lot harder to navigate around the unseen perils in the new ABS market.