To some people, securitization is a dirty word. Small wonder, given its role in the meltdown of the financial system six years ago. The technique made it easy to spin dross into fool’s gold, say critics, pointing to the issuance of billions of dollars of worthless mortgage-backed securities. Nowadays, anything that smacks of financial engineering is guilty until proven innocent — and that goes in spades for securitization.
It may come as a surprise, then, that securitization is making a comeback. While private MBS issuance may never approach the levels it reached from 2005 to 2007, when hundreds of billions in securities were sold, other kinds of asset-backed securities issuance rebounded in 2012 and 2013. Indeed, the market is on track to top $200 billion in 2014 and possibly have its biggest year since 2007 (more on this below).
Experts insist that securitization is nothing more than a tool, with a host of beneficial uses. Among other things, it can lower funding costs, better utilize financial institutions’ capital, and “[transform] pools of illiquid assets into tradable securities, thus stimulating the flow of credit,” writes Shambo Dey of Vinod Kothari Consultants in a recent white paper. Indeed, despite the experience of the past seven years, Dey suggests that “from a conceptual perspective, a sound and efficient market for securitization can be supportive of the financial system and broader economy.”
But it may be some time before securitization is fully rehabilitated. Market watchers recognize that the technique has significant drawbacks, writes Dey, including “contribution to excessive credit growth outside of the formal banking system; principal-agent problems that amplify perverse incentives; the complexity and opaqueness of certain products which make efficient pricing problematic; and the heavy reliance of the industry on credit ratings.”
While regulators continue to work on reforms, the volume of securitizations continues to grow, albeit more slowly than before the recession. Can issuers wield the tool safely this time around? Can investors trust what they are buying? Will we see securitization misused again? The answer to all three questions: it depends.
Receivables : Well Received
“The subprime mess reminds the market that it matters what you securitize,” Adrian Katz, CEO of Finacity, an asset-backed financing company, told CFO a few years ago. “A securitization is ultimately only as good as the ‘security,’ the collateral.”
For nonfinancial corporations, that’s good news: as in other areas of credit, investors and banks are thirsty for corporate paper. So receivables securitizations have risen to the top of the charts. “Corporate receivables have performed very well, including in the thick of the Great Recession,” Katz tells CFO. “The asset class went from being a choice to in many situations the preferred choice.”
Investors and banks like the short duration of receivables, which reduces the risk of the price volatility that hurt 30-year subprime mortgages. In addition, “it’s not an artificial or derivative kind of financial activity,” says Katz. “You have a real company that makes widgets, from which [a bank] can do other business and generate other free revenue. … The securitization technologies are pretty advanced, but the concept of relying on an asset like this is pretty fundamental, pretty old-fashioned,” he says.
For the banks that advance funds against the receivables, a securitization is also “an easier entrée” to providing credit to certain risky industries, says Katz. For example, in the last five months, Finacity has closed three deals with global shipping companies. In shipping, the bulk of the financing is usually long-term and collateralized by the ships themselves, “but that’s been a challenging asset class and industry for lenders for some time,” says Katz.
Even highly rated industrial companies may start tapping securitization structures. In March, Finacity launched a €280 million global trade receivables securitization for Archer Daniels Midland. “They’re single-A rated, so for them it’s about rounding out their liquidity sources,” says Katz, as opposed to a “credit arbitrage” — getting better pricing by structuring an investment-grade securitization for a non-investment-grade company.
In a small way, some small-business lenders (and their borrowers) are also benefiting from the availability of securitization structures. Newtek Business Services, a nonbank Small Business Administration lender, securitized $64 million of SBA loans in 2013. The securitizations involved the portions of 7(a) loans that are not insured by the U.S. government.
“Unlike a credit union or community bank, we don’t have FDIC-insured deposits, so our sources are equity capital, bank lines of credit, and securitization,” says Barry Sloane, Newtek’s CEO. “Securitization really proves to be an attractive form of financing, because it’s match-funded and it’s long-term in nature.”
The securities attract investors because they are floating-rate assets and have a duration of four years, says Sloane, “which is a sweet spot for a bank or insurance company.” In addition the loan balances are small (averaging $250,000), so investors get good diversification of credit, industry, and geography, he says. Crucially, at least for investors, these securitizations have beefier structural protections than in 2007 and 2008, providing a thicker barrier to potential losses for senior investors, says Sloane.
But Newtek’s deals will probably remain rare, since under accounting rules the assets stay on its books. Bank issuers would have to hold capital against them. “A bank in today’s environment wouldn’t have any reason to do this, because they have very inexpensive liabilities and they wouldn’t get sale treatment from the financing,” says Sloane.
Still, over in Europe, regulators are eyeing securitization as a means of supporting start-ups and other businesses trying to recover from the region’s economic downturn. Reviving the securitization market, according to the European Union and the European Central Bank, could wean European economies off their reliance on bank funding.
Here Comes the Sun
The problem with securitization (and other Wall Street innovations) is that banks never keep it simple and low-risk for very long, especially if they can use it to fund risky cash flows cheaply. Last November, Credit Suisse put together the first securitization of rooftop solar power leases, worth $54.4 million, for a company called SolarCity. The BBB+ rated, 13-year deal “was a major milestone that many … have eagerly awaited,” wrote Vinod Kothari’s Dey.
According to Dey, such securitizations have the potential to “make solar cheaper than the utility bill for more new customers more often.” But they are not a slam dunk. Rating agencies, according to a November 2013 assessment by PricewaterhouseCoopers, have concerns, including the facts that there are at most four years of historical performance data on solar panel installations; solar panel prices are declining; and newer, cheaper technologies are emerging.
“If solar panel prices continue to decrease and technological innovation continues to rise, it is difficult to assess how consumers will behave if they are bound to costs of power that may be above market rates,” says PwC.
Moreover, while solar contracts are increasingly standardized, some still have unique characteristics. “Investors are typically interested in standardized contracts with predictable cash flows to fund securitized bonds, yet solar contracts have limited recourse provisions upon default and performance conditions that change borrower payments,” says PwC.
While solar panel securitizations are bound to remain a niche market, such “esoteric” securitizations are likely to be the preferred sector during the next 12 months, according to a January 2014 survey by credit rater DBRS. While the Federal Reserve keeps interest rates ultralow, the higher yields on securitizations of timeshare loans, franchise loans, structured settlements, and solar and renewables securities will make them attractive to asset managers and insurance companies. In consumer and commercial ABS securities, meanwhile, yields are expected to remain “extremely low,” says DBRS.
Another Housing Bubble?
A sector that seems primed for growth in securitization — and where, perhaps, the sins of securitizations past could most likely be repeated — is consumer housing. But this time it is single-family rental (SFR) homes whose cash flows will be packaged for investors.
In one of the first securitizations of this type, in October 2013, Invitation Homes, a subsidiary of Blackstone Group, borrowed $479 million from Deutsche Bank that was secured by a pool of 3,000 single-family rental homes. Deutsche Bank repackaged the loan into a security and then sold it to investors. The investors receive the monthly rental payments from the homes. Other outfits, including American Homes 4 Rent and Colony American Homes, the second- and third-largest single-family landlords, are arranging similar deals. Banking analysts Keefe, Bruyette & Woods forecast the SFR market to grow to as much as $900 billion.
While SFR securitizations differ from RMBS and have shorter durations (presently two to five years), Standard & Poor’s has already sounded the alarm about these structures. In February, S&P said SFR transactions have large operational risks in particular and do not warrant the highest investment-grade ratings.
According to S&P, the “cash flows from the underlying properties depend heavily on the ability of their owners to manage large numbers of single-family homes, which are often geographically dispersed and uniquely constructed. The properties require ongoing maintenance that can’t be implemented with a one-size-fits-all approach, and are likely to be leased (or rented) multiple times during the course of a given securitization’s term. The management complexities are unique, and shouldn’t be underestimated.”
In addition, said S&P, institutional owners of SFR properties have no track record of managing large pools of rental properties through an extreme economic downturn. If a property manager fails, S&P noted, “there is no guarantee that an adequate replacement with sufficient experience to oversee a large portfolio of SFR properties could be found.”
Among the wider economic concerns about such securitizations are that they will drive up rental rates and crowd out potential owner-occupants of single-family homes.
Reforms on the Way
Credit-rating agencies have made strides in providing some transparency around securitization ratings, stiffening their rating models, and investors are demanding more information on deals. But any kind of securitization can still hold dangers for the banking system, the financial markets, and the economy. Securitization enables lenders and other companies to build up high levels of leverage. And, in the case of loan securitizations, they also create incentives for lenders to skimp on underwriting practices.
Regulators are still lagging behind. While the Dodd-Frank Act contained what appeared to be a good solution to some of the problems that cropped up in the mortgage industry — the “skin in the game” requirement that the issuer retain an economic interest in a portion of the credit risk of an asset it sells — U.S. regulators haven’t had the courage or desire to force it on the banks yet.
“If we forced securitizers to eat five cents for every dollar of loss in [a] securitization — they could never get away from it — that will change their behavior in the kinds of loans they originate,” said Sheila Bair, former chair of the Federal Deposit Insurance Corp., in a speech last October. “It will change their behavior and motivations when they have a troubled borrower and it comes time to try to work with them to mitigate losses. At this point, it doesn’t look like we’re going in that direction. The government firmly encouraged securitization — and it’s still not fixing it.”
There have been steps forward. For example, the final version of the Basel III capital bank guidelines for the United States imposes new due diligence requirements on banking organizations that invest in securitizations, and establishes a floor for how much capital must be held against them. But changes on the issuer side have been lacking. For example, it is still possible for an issuer to shop around a securitization to multiple credit-rating agencies until it gets the results it wants, but not disclose that to investors.
Issuers and investors would like to believe that, overall, securitizations are safer today. For the most part they are. But how long will the safety last? In some markets, investors demand that these deals be simple and transparent, and that the collateral be of high quality. In others, the lack of substantial reforms poses a real vulnerability.
One thing seems certain: as the low-interest-rate environment continues, more and more investors will be attracted to the higher yields of securitizations. If so, let’s hope this time around there’s a happy ending.
Vincent Ryan is editor-in-chief, digital platforms, of CFO.