A $2.5 Trillion Market You Hardly Know
It seems to be the perfect security, the magic bullet of finance. From a package of the riskiest, scuzziest, least liquid loans, you can create a special kind of bond rated AAA. In more than a decade, there has hardly ever been a loss of principal and relatively few rating downgrades. Over the years, the bond has fared much better than traditional corporate debt. And there are $2.5 trillion of these bonds outstanding.
Welcome to the arcane but crucial world of securitization, as the process of creating these bonds is called. The bonds themselves are popularly known as asset-backed securities (ABS) or mortgage-backed securities (MBS). That's because they are collateralized by money flows from the borrowers. Securitization is ubiquitous: If you have a mortgage, credit card, or auto loan, you are likely part of it, whether you know it or not. Securitization's main virtue is that it links the home buyer or the credit-card borrower to the vast resources of the global capital markets.
But despite its gargantuan size, it's a largely invisible market. Asset-based securities don't trade on any exchanges. The ABS and MBS markets, exclusively institutional, release little information and are never covered on the evening news. But there's no doubting the significance of the market. According to Leon T. Kendall, a finance professor at Northwestern University: "Securitization is one of the most important and abiding innovations to emerge in the financial markets since the 1930s."
What the ABS and MBS markets do best is make marketable loans that otherwise would be unsalable: everything from aircraft leases to revenues from old Italian films to tax liens in New York. "We're working on securitizing TV syndication, film libraries, and royalties. The possibilities are endless," says investment banker David Pullman, managing director of The Pullman Group in New York.
Yet after a decade of explosive, unblemished growth, signs of trouble have been cropping up in what has been mostly a AAA world. The market has tended toward excess--too much liquidity in good times, too little in bad.
The current worldwide liquidity crunch is beginning to affect the market, which was reflected in an ABS conference in Bermuda earlier in October. The mood among the normally upbeat attendees was one of "a kind of general malaise," says Brian Clarkson, managing director of Moody's Investors Service. John Wilson, managing director of Prudential Investments, remembers it was only a year ago when "a banker calls us up and says, `We have this deal in the market. Here's a two-page description.... We need the bid in the next half hour."'
The bulk of the securitization business world is shrugging off the bad news. Business at Fannie Mae, Freddie Mac, and Ginnie Mae, the huge government-sponsored enterprises that finance housing, which account for 88% of the MBS market, have been largely unaffected. The three agencies account for more than $1.9 trillion of the securitized paper outstanding.
WIDE SPREAD. But the ABS market has been showing disquieting vulnerability. Spreads in deals are widening rapidly: While AAA deals sold at only 35 basis points above Treasury bonds just last year, now the gap is much larger: 90 basis points. Another gauge is downgrades on deal tranches, securities that have been cut in pieces, by rating agencies. Until this year, less than 1% of the thousands of tranches were downgraded. This year, 3.3% of the deals involved downgrades. That's a small percentage, but another sign that things are not well.
Two major sectors of the ABS market in particular are feeling lots of pain:
-- A slew of subprime lenders who went public at lofty multiples crashed and burned this past year. The reason: The ease with which companies were able to raise cash--and still can--has led to ruinous competition. Citiscape Financial Corp. of Elmsford, N.Y., was the latest subprime lender to go bust when it filed for bankruptcy protection on Oct. 7.
-- The $200 billion market for securitized bonds backed by commercial mortgages--CMBs--is in disarray. Criimi Mae Inc., the biggest buyer of low-rated bonds, filed for Chapter 11 on Oct. 5. Conditions have been devastating for investment banks like Nomura Securities Co. that originate commercial mortgages in hopes of securitizing them. By the time the banks were ready to use the mortgages to back paper, the value of the loans had dropped and the planned bond deals were no longer profitable. As a result, banks delayed doing deals and stopped new lending for commercial real estate. "We are now paying the price for having public markets finance real estate," says E.J. Burke, president of National Realty Funding. "Markets move quickly. They may be generally efficient, but they can be irrational at times."
Efficient markets were exactly what securitization was designed to promote. In the 1970s, fears that savings and loans wouldn't be able to finance a growing demand for housing led to the creation of the first mortgage-backed securities. When S&Ls went bust in the '80s, Resolution Trust Corp. turned to securitization to clear the books of beleaguered banks.
In a sense, though, the principles behind securitization were nothing new. At Citicorp, for instance, the process began as an outgrowth of a traditional business known as "factoring," in which manufacturers raise cash by selling receivables, says Alvin G. Hageman, managing director at Citicorp Securities Inc. That led Citi to begin thinking in the 1980s about buying other assets and trading them. "It was a garment-center business," Hageman says. "We said: `How can we take the business upmarket?"'
In the '90s, the practitioners of securitization took the process upmarket--and down. The biggest asset-backed markets have been consumer finance, mostly credit-card and home-equity loans. They grew from $50 billion in 1990 to $184 billion last year. Moody's Clarkson estimates this year's total will reach $220 billion.
As investors scooped up paper, lenders sprung up in droves to give them more. In the mid-1990s, dozens of companies were created to make subprime home-equity and auto loans and securitize them. "The old wisdom that you had to be of mid- to high-investment-grade quality to compete in the finance business was turned on its head by securitization," says Scott J. Ulm, managing director of Credit Suisse First Boston.
At the same time, new asset classes emerged, some with little or no history on which to base estimates of expected payments. Perhaps the most notable example was the high-loan-to-value (HLTV) products that enabled consumers to borrow up to 125% of the value of their homes. Billions of dollars in paper backed by such debts has been sold.
FIERCE COMPETITION. But the flood of money into the subprime sector led to problems. Fierce rivalry for borrowers resulted in faster-than-expected repayments of subprime loans. And that reduced the profits for companies making loans.
The issuers' problems stem from the structure of asset-backed loans. The slicing and dicing of these securities entitles some investors to get paid before others. At the top of the feeding chain, ratings are AAA, yields are low, and buyers include pension funds and insurers. As you move down, ratings fall, returns rise, and hedge funds get interested. The issuer usually keeps the last piece of the pie--and makes its profits based on how much of that last piece materializes.
However, as prepayments pick up, that last piece keeps getting smaller. Across the industry, companies had to write down profits, and share prices fell into the pennies. "The industry is getting annihilated," says Steven Eisman, analyst at CIBC Oppenheimer Corp.
Moreover, as the markets soured, lower-rated tranches in these deals have lost value, particularly in already-controversial assets like HLTVs. "There isn't a market for any of those," says Michael Hoey, portfolio manager at Dreyfus Investments. "It's almost like buying a lottery ticket."
Now, investors are becoming increasingly worried about issuers failing. Issuers typically collect the loans, and investors fear interruptions in servicing could prove dangerous. "Investors prefer a stronger name...to a weaker credit issuer," says Beth Starr, a Lehman Brothers Inc. research manager. "There's a flight to quality."
For critics such as economist Henry Kaufman, these market upsets underscore a risk--"the illusion of liquidity." They worry securitization is based on a false premise--that because you can make a loan tradable today, you can trade it tomorrow. "There is this feeling that I can now buy a marginal asset and as long as I can trade it off, my risk isn't so great," says Kaufman, a former Salomon Brothers Inc. economist who now runs his own New York consulting firm.
Practitioners, however, argue that liquidity hasn't dried up. Michael J. Malter, managing director of Chase Securities Inc., notes that nearly $25 billion in asset-backed securities was issued in September--compared with about $12 billion in high-grade corporate bonds. "In the context of the most stressed fixed-income markets we have seen, we have this shockproof durability of the asset-backed market," he says.
ContiFinancial Corp. offers a case in point. Its stock tumbled from from $38.5625 to $2.9375 in October. But during that fall, on Sept. 25, Conti issued a $2.1 billion asset-backed bond. "We had a major financial event and the securitization market didn't shut down," says Conti CEO James E. Moore.
However, consumers may wind up paying the price. Securitization links borrowers to the markets. The Fed is lowering rates, but with spreads widening on asset-backeds, companies like Conti are raising theirs. "The capital markets are very clearly driving the rate to the customer," says Moore. "We have been able to pass on our capital market cost to the consumer."
It's a change. For years, as rates fell, securitization made credit cheaper and more available. "We have had great times with securitization," says Northwestern's Kendall. The question is whether those times have ended.