Asset-backed bonds - New frontiers in securitization

Sicilian fishermen. Italy refinanced part of its social security fund with an asset-backed bond

Specialists in US asset-backed bonds talk as if their market has reached the height of development. It's certainly a big market, with around $250 billion in issuance last year and an expectation of 5% to 10% growth in 2000. The staple diet is the refinancing of mortgages, credit card lending, auto loans and corporate loans. Information about the behaviour of the various types of collateral is available to the US's well-informed and experienced investors.

As Phil Weingord, global co-head of asset finance at Credit Suisse First Boston (CSFB) says: "The strength of the US market stems from the diversity of asset types securitized and the diversity of issuers accessing the market. It is also significant that the motivations of issuers who access the asset-backed securities market varies. They include capital relief, balance sheet management, matched funding, improved liquidity and cost-effective funding. This leads to a broad issuer base which provides the market with a fair amount of stability and certainty that the level of issuance will continue."

In contrast, Europeans are still working to create regularity of issuance and templates for securitizing the classic asset types. But that is not to say that Europe is a primitive market. Rather, it is more eclectic, less commoditized. Investment bankers struggling for years with the absence of standard legal frameworks for securitization have developed a wide range of techniques, and without a constant flow of deals in the main categories they have sought out new and surprising places for one-off, customized securitizations.

Tariq Rafique, global head of securitization at ABN Amro, says: "In Europe the creative side is significantly ahead of the US. It is because you had all these barriers that were not making things easier, and that is paying dividends now. In the US, the securitization of the traditional assets has been growing at such a clip that people haven't been able to take a breather and say: 'I have this technique; where else can I apply it?' But the opportunities are there."

CSFB's Weingord agrees that Europe is an eclectic market, but argues: "If you take out the plain vanilla transactions from the US market, the amount of creativity and diversity most likely exceeds that of the European market, which is mostly comprised of one-off transactions. Because the US market is so large and dominated by the plain vanilla transactions, people tend to overlook the significant number of unique transactions in this marketplace." Good examples are the securitization of rental car fleets, student loans, franchise loans, catastrophe risk, music royalties, insurance premiums and synthetic CDOs (collateralized debt obligations). And the technical aspects of asset finance are fast-moving, too, says Weingord: "Much of the innovation in the US market is geared towards current issuers and previously securitized asset types. Here, we continue to develop structures that increase an issuer's flexibility and efficiency while broadening the appeal of these bonds to investors."

In a recent example, CSFB invented a structure that overcame a perennial problem of securitization: the issuers often have amortizing assets, but the bond market prefers bullet maturities. Typically, a transaction needs an amortizing tranche to take the slack caused by the bullet tranches. But last August, Weingord's team created a set of bullet-only securities out of amortizing loans originated by General Motors Acceptance Corp (GMAC). Four out of the deal's five equal tranches matured at six-month intervals, while the fifth tranche was issued from a special commercial-paper vehicle. The CP tranche acts as a conduit, receiving all the monthly cashflows to pay it down until the first bullet security matures. The conduit tranche is then reissued, and the proceeds pay off the bullets one by one.

Innovation in Europe is as much about unexpected applications as new techniques. On the technical side, the specialists are looking at ways to mix and match traditional and synthetic securitization. John Graham, head of European asset-backed for JP Morgan, says: "When we think of securitization, we think of it as one end of a spectrum of problem-solving tools that include funded transactions and derivative-type transfers of risk. You can use derivative tools as a way of securitizing assets when traditional securitization is difficult for regulatory or relationship reasons."

But the distinctive aspect of European asset-backed is the mix of issuers. Peter Shorthouse, head of European securitization at Warburg Dillon Read, says: "There are a huge number of transactions that are need-specific." A landmark deal in late November raised e4.65 billion ($4.68 billion) for the Italian government by securitizing the country's massive backlog of social-security contributions unpaid by employers. The government was thereby able to squeeze liquidity out of the illiquid asset pool of its social-security agency INPS (Istituto Nazionale della Previdenza Sociale). The structure was invented by Warburg together with Morgan Stanley and Istituto Mobiliare Italiana (IMI).

Shorthouse says: "We had to develop an analytical basis for the rating agencies to assess [the deal], using historical data on the INPS portfolio. We divided it into subgroups of credits. Some groups had value, others were best left aside. The key was segmenting the asset pool to develop coherent cashflow projections, in order to then structure the bonds." The banks also advised on legal changes to enable such a financing. Unfortunately for Warburg and its partners, after inventing the structure of the deal they were outgunned in the hard-fought contest for the underwriting mandate, which went to a consortium of Paribas, Merrill Lynch and Caboto.

Does the INPS deal set a precedent for a new sector of government securitizations? Shorthouse says: "Other countries are looking to do it as well, not just with social security but with other assets, including tax revenues." In the first quarter of 2000, Warburg is looking to launch a financing for the UK authorities, securitizing government offices in London to fund their refurbishment and maintenance for 30 years.

Bring on the sports bonds

Besides deals for governments, Europe's bankers are studying the opportunities for those on behalf of corporates. The recent conversion of many diversified European companies to the gospel of shareholder value is leading them to rethink which assets they really need to own. With some assets, simple disposal may be awkward, for instance because of high tax charges, and thus securitization comes in as a means of selling assets synthetically. In the UK, a large number of companies including such top retail names as Marks & Spencer and J Sainsbury are looking at what to do with their large real-estate portfolios.

So far, however, they have not acted. Warburg's Shorthouse explains: "The problem with property securitization is that the typical deal structure has been amortizing. The property goes up in value over time, while the outstanding bond goes down. The issuer has to negotiate with the rating agencies about when security can be released, and the process can be inefficient. That's the issue that the investment banks discuss with property-holding companies."

Graham of JP Morgan says the corporate segment goes beyond real-estate holdings to any none-core activity: "The application of securitization technology to corporate needs will be one of the areas of interesting innovation in 2000." Last year, for example, Electricité de France securitized loans to employees.

Particularly in the UK, one-off deals for corporate clients abound, including securitizations of the revenues of island ferry services, motorway service stations, the pub industry, and even Madame Tussaud's celebrity waxworks.

Spectator sports are one area where European-based bankers have done more thinking than their US peers. Undeterred by the problem-strewn deal for Formula One motor racing, the banks are looking to help monetize the future value of sports franchises by securitizing media contracts. "The value of TV rights to various sports events is growing exponentially," says Shorthouse.

Warburg Dillon Read is working to prepare a deal for the game of rugby football, securitizing the TV rights to games between national teams and the European Cup club competition in order to create a lump sum to help rejuvenate the sport at grass-roots level. But the real jewel for the investment bankers would be soccer's World Cup, whose phenomenal global media profile dwarfs even the Olympics.

Last year's Rugby World Cup. TV rights to sports events are on the securitization agenda

Rafique of ABN Amro is clear on why Europe has become a strong market for assorted customized deals: "The drivers of growth are pressures on companies and banks to use their capital more efficiently and improve shareholder value. The reason for securitization is to make an organization more efficient. This is the perspective with which we go to clients." In addition, the barriers to deals have come down: several European countries have made legal and tax changes in recent years to enable securitization to happen.

But European specialists know the market needs to emulate the strength of the US: creating large and regular issuance in standardized formats. Since 1999, there has been an attempt to expand the commodity areas of mortgage-backed bonds and CLOs (collateralized loan obligations). Shorthouse says: "There is more standardization in transaction structures and the rating agencies' approach. The goal is to reach a point where investors can trade in and out of different maturities and buy new bonds without having to reanalyze the entire credit structure."

The most successful case in Europe of such a standardized format is the Pfandbrief market, which largely substitutes for a conventional mortgage-backed bond industry in Germany. The Pfandbrief has grown into a $1 trillion market, thanks in part to its regularity and its familiarity to international investors who no longer need to reanalyze every issue. As such, it is the nearest thing in Europe to the massive, commoditized refinancing industries in the US.

Pfandbriefe are an unusual form of securitization in that while they repackage cashflows as securities, the underlying mortgage and loan assets remain on the issuer's balance sheet. Alternatively, the specialized Pfandbrief banks can be seen as one big special-purpose vehicle. This is more explicitly the case with France's answer to the Pfandbrief, the obligation foncière (OF), a new market created by legal reforms in mid-1999.

The first OF bonds were launched in October last year. They were full-blown securitizations using SPVs: the originators of the assets placed them in dedicated subsidiary banks whose names the OF bonds bear. The issues performed for Crédit Foncier de France were backed by mortgages; those for Crédit Local de France by municipal loans. Both issuers set precedents that other French financial groups are almost certain to follow, including Société Générale and Crédit Agricole.

The French method of creating bonds that look very like Pfandbriefe, but using SPVs, may provide an answer to the limits exhibited so far by Europe's municipal bond sector. Several European regional and city authorities have tapped the unsecured Eurobond market since the late 1990s, prompted by the declining willingness of commercial banks to grant them loans and the growing trend for local authorities to take on more responsibilities for investment in economic infrastructure and social services.

The problem with the conventional method of issuing municipal bonds has been that there are too few such entities whose borrowing patterns allow them to issue regularly and in sufficient size to provide investors with the liquid assets they prefer. A refinancing industry such as France's OF market, on the other hand, can effectively put municipal borrowers in closer contact with capital markets, without requiring them to issue bonds that meet investors' requirements. The great advantage of securitization as a form of funding is that the volume and structure of assets can be transformed. It doesn't matter if credits are illiquid mortgages or amortizing municipal loans: you can bundle them up and morph them into a security that's tailored to what the market wants.

The most obvious area where Europe's regional and city authorities face a growing investment task is public transport. Shorthouse says: "The big area where we see quite substantial growth in public-sector securitization is infrastructure." It is a declared goal of the EU to modernize the continent's infrastructure, and numerous regional authorities are involved in state-of-the-art public transport projects. Common ventures are high-speed train links between major cities, often across borders; and urban trams or metro systems to relieve traffic congestion.

Such projects can require large-scale finance at long maturities, which is the style of funding securitization is designed to raise. In London, the popular left-wing politician Ken Livingstone is campaigning to become the city's first elected mayor, despite the hostility of his Labour-party colleagues in government. The voters share his opposition to privatizing the dilapidated London Underground metro system. Instead, "Red Ken" argues for using the bond market to finance improvement. The city's investment bankers could soon be exploring a high-profile securitization.

London politician Ken Livingstone has raised the idea of bond finance for the Underground

Managing credit exposures

For banks in Europe and the US, the background to growing use of securitization is the evolution of risk management. As Graham says: "Many banks are looking at the real economic risks of their business, and the real capital they need to set against it." Economic capital may differ significantly from regulatory capital, although the revision of Basel guidelines aims to bring the latter more in line with banks' sense of their own risks.

JP Morgan was perhaps the most visible bank to undertake a reassessment of its economic risks and capital needs. In 1998-99, the firm set about cutting its economic capital for its credit book by 50%. An important method for doing so was securitization: JP Morgan created the so-called Bistro bonds, a $10 billion programme of non-funded CLOs using credit derivatives. The first bond, for instance, laid off loan exposure to around 300 North American and European corporates. Graham says: "Our experience is something that many banks have wanted to come and talk with us about."

Shorthouse agrees that banks worldwide will increasingly use securitization, but cautions that the new Basel rules will have a double-edged and unpredictable effect. They could favour securitization, because triple-A and double-A-rated assets are due a 20% risk weighting in future, compared with 100% now in many cases. "That will make asset-backed bonds more attractive, and will lead to many securitizations. Banks will want to hold securitized assets because of the low capital charges," say Shorthouse.

Against that, the Bank for International Settlements' idea of allowing sophisticated financial institutions to use their own internal risk models for allocating capital will reduce the pressure to get capital-intensive assets off balance sheets. And the reduction of charges for top-rated credits will also reduce regulatory pressure to securitize high-grade loans.

Despite the BIS changes, Shorthouse is optimistic that banks' demand for his services will increase rather than decline, because the real question is economic risk, not regulatory capital. "Securitization breaks up exposure to credits, especially following banking consolidation," he says. "If the overriding objective is risk transfer rather than capital relief, there will still be a huge need for bank securitizations which have nothing to do with regulatory capital."

Banks in Japan are also beginning to use securitization to clean up their balance sheets. In 2000, a potentially vast new market may arise, signalling the globalization of asset-backed bonds.