Q&A: Structured Securities in a Post-Crisis World

As a special addition to the Insurer Investment Forum, we spoke with Forum Speaker Jennifer Quisenberry, NEAM to explain “Structured Securities” and how relative to other fixed income assets, structured securities continue to offer incremental return and portfolio benefits for insurance companies.

You can watch the full interview discussion here. Below is the transcript of our discussion (edited for clarity and space):

Q:Can you give us some background on the securitization market? I think everybody knows about credit cards, auto loans being collateralized, but what are some of the other types of Asset Backed Securities out there?

In today’s market, does it tend to be more valuable at one time vs. another?

A: I think this is one of the most interesting aspects of the market, in terms of the development and resurgence of some of the newer asset types since the “Financial Crisis.” As we have been rolling through late-2010 into 2015/16, we’ve really seen a resurgence in non-traditional asset types.

Among them have been some of the more larger markets and those becoming more developed, which would be things like the “GSE Risk Transfer” market. This is where the Freddie Mac and Fannie Mae are securitizing a portion of their guarantee to the private market. That is developing to be a large market. The “reperforming” and “non-performing” loan space has been growing quite rapidly. These would be mortgage loans, subprime, Alternative-A and Option ARM loans that have been re-modified, restructured and have been securitized out of banks, and GSE’s as well.

We’ve had some corporate-type issuers – the likes of Verizon in 2016 did their inaugural issue of mobile device payment plans. We’ve had things on the more esoteric side, like solar panel securitization. That has been a relatively new development. Marketplace lending has also tapped the securitization market for funding. And then we’ve had the return of some of the old stalwarts, like “container leasing” and “aircraft leasing,” as well as some intellectual property-related franchise concepts – most notably in the restaurant space.

Q:Of all these different, newer asset classes – are the asset types you talked about 1% of the market? or 5% or 10%?

Have they taken over the ABS market?

A: In total, if we look at the 144a component of the market, most of those that I mentioned would fall into that category. That component of the market would be about 20%. It’s not insignificant. Then within any individual sector there would be a number of issuers, so there certainly is level of breadth of the market in terms of number of issuers and asset type.

Q:Going way back, the first unusual ABS was securitizing the royalty-flow of David Bowie’s music library. Are more of those types of things being done?

A: We haven’t seen much in the space of music-royalties. We have seen some drug-royalty transactions; those have been very few and far between. I think one of the issues with music royalties, on a fundamental basis, is the difficulty in structuring around the fact that an artist is effectively getting their cash out of the transaction upfront. A concept that I think is very important throughout securitization is the notion of risk-retention. How do you assure there’s some “skin in the game” by the sponsor. In hindsight, that proved to be a problem, at least in some of those music royalty transactions.

Q:How could you analyze all these different types of asset-backed securities transactions?

The words, “getting your hands dirty,” probably doesn’t do it justice.

A: I think there’s a disciplined approach and a consistent approach in reviewing all of these. At a very basic level it starts with the collateral itself – the consistency of the collateral, performance over time, the background of the origination. There is consistently a viewpoint of the review of the structure of the transaction. The degree to which the cash-flow can be stress-tested to withstand various scenarios. Consistently applied, I think one can approach these transactions in a somewhat consistent basis, despite the fact the collateral itself can be so varied.

Q:Do you/NEAM find value in these issues as primary or as secondary offerings?

A: I think the best opportunity for due diligence, the attention of the sponsor servicer, is certainly at the initial marketing of the transaction. The possibility for better allocation on a primary transaction would be beneficial. Certainly, opportunities in the secondary market do exist and we would be participating in those as well. It’s mostly a primary market from the standpoint of the information flow, again the attention and availability of management, and importantly the ability to have an input into the structure at the time it is being put together.

Q:“Input into the structure.” Does NEAM, at your size, have material input into the structuring of some of these more unique ABS?

A: Yes, indeed. In fact, we would have some input to, whether it be a structural provision or the way a particular trigger-mechanism may be working in the transaction, that is certainly an option for the investors. Particularly if they are a larger investor to have to input to that process. Also from a pricing basis. There are many ways an investor could have an input – the collateral terms, reserve funds, trigger levels – these are all really up for grabs. Particularly in some of these more esoteric and non-traditional structures.

Q:From your perspective, what do you find most difficult about analyze an ABS?

A: Again, I think it goes to the collateral itself. At the end of the day, that is going to be the most important determinant of success. I think the most difficult structures are those that potentially have a large unknown or some regulatory issue with them.

For example, in the area of property-assessed clean energy transactions, we have been uncomfortable with the notion that that obligation could be primed to a reverse mortgage. Within the area of solar panels, we have not been able to be comfortable regarding the long-term development of that technology and the degree to which its changing very quickly and potential impact on the willingness to pay in space of rapid technological development together with the question of the persistence of tax credits in that area. Those things become very difficult, and while transaction structure can address those issues, some of those are very large unknowns and are difficult to get your arms around as an investor.

Q:At NEAM, you’re focusing on insurance companies and their portfolios. Do you see any of your clients saying, “we want to have x percent in an ESG (environmental, social, governance) type of mandate?”

Do you see that at all from insurers?

A: Not particularly. From our standpoint and our recommendation to clients would be towards well-structured transactions. Adding value, with some liquidity should that be needed. While there may not be a great degree of liquidity in many of these types of transactions, the comfort level in the level of liquidity is certainly a consideration. Typically we don’t have a vocal point or allocation demand towards ESG.

Q:You hit on liquidity, which I think is huge for everybody. In my opinion, generally insurance companies tend to be able to sell liquidities in the market and they don’t do as much as they can.

In the ABS space, which securities are more liquid than others?

A: There’s a large part of the ABS market that is very liquid. I would put mortgage-backed securities in that category at the very highest ranking of liquidity within that space and quality as well. I would put CMBS in the very liquid category as well. It gets tricky as we go down in credit quality, again away from benchmark type securities.

Liquidity becomes a different story in a stress environment or in a a transaction which may be facing some challenges via a rating-watch or performance that is not as expected. During the crisis we saw liquidity at a very depressed level and intrinsic value and recovery value not being reflected expressly as a result of liquidity, not because of fundamentals. I think it’s something investors should be aware of.

Certainly, we do not recommend that our insurance company clients rely on their structured securities for their liquidity source. For incremental yield and receiving compensation for less liquidity and structural complexity, we believe that structured securities have a good role in the portfolio in that way.

Q:High-yield ABS, what is your opinion on those?

A: Anything that would be high-yield rated is going to be fairly down in the capital structure. We do see BB-rated traunches, for example subprime auto loans. We see them in CMBS. We see them in single-asset, single-borrower CMBS and on-down the capital structure. A couple things to be aware of in the below-investment-grade space: a high degree of collateral underwriting in the transaction and the BB-layers of the capital structure tend to be quite thin, which means when losses do incur up the capital structure that the BB/B classes don’t have a lot of cushion and can be easily wiped out of the transaction.

For all intents-and-purposes, it’s a relatively small part of the market. Certainly there are opportunities there, especially when a security might be downgraded to below investment-grade and does have potentially good prospects for recovery. Within the contest of “Risk/Reward” they’re a little bit of a different animal and a relatively small part of the market.

Q:Right now at NEAM, if you got a brand new portfolio – this is the mandate, certain percent of ABS – where are you investing?

A: Across the capital market, evaluations are to the rich side of fair value and that’s the challenge in the capital markets in general with the types of activities by the central banks around the world, asset price inflation, and so forth. I would say in the first instance, finding strong relative value across sectors is a little bit challenging in this market.

Having said that, within the structured space, probably the most interesting opportunities are within the floating-rate securities, if we look at our expectations for modestly rising interest rates and the protection that a floating rate security gives you in that environment – and within that space we would say the CLOs clearly are getting that benefit. They float to 3-month LIBOR, which is a little bit better than 1-month LIBOR, together with a thread that is triple-digits for that CLO obligation in the 6-7 average-life range. We see opportunities in the reperforming and non-performing loan space. Those transactions, which may also be floating or fixed-rate, are yielding in the low single-digit spreads and on upwards further down in the capital structure.

The CMBS part of the market tends to trade a little bit wider to A-corporate, but those two are pretty good traveling companions. We tend to see the yields to be fairly equivalent. Bear a little more caution around security selection and pool selection, but we also do see opportunities in the single-asset, single-borrower transaction where those typically have a lower LTD. So, a better attachment point to credit enhancement; still offering some incremental yield and on-down the capital structure.