Play it, SAM

Fancy a bond secured on a zero-interest, interest-only, life-long loan? With the Bank of Scotland, you can now borrow 25% of the value of your house and not repay a penny for the rest of your life. SBC Warburg is securitizing the mortgage and foretells this brand-new market will soon be worth hundreds of billions of dollars worldwide.

The shared appreciation mortgage (SAM) has just been launched by the Bank of Scotland, fully refinanced by SBC Warburg in advance of a securitization in the first quarter of 1997. But how interested will investors be in the securitization of an asset with no track record ­ because it has not existed before.

The concept is simple: the homeowner pays zero or low interest; the bank, in return, gets participation in any increase in the value of the house when it is sold. In the case of the zero-interest SAM, as opposed to a low-interest SAM, the bank sees a return on the original loan of three times the increase in house values. So if Bank of Scotland lends a homeowner 25% of the value of a property, it will receive 75% of any increase in value when the home is sold, plus the original 25% loan. If the homeowner pays 5.75% interest, then the 3:1 ratio reduces to 1:1. A mortgagee might borrow 65% of the value of a property and pay 5.75% interest on that for life.

When the property is sold, the Bank of Scotland gets 65% of the increase in value along with its loan back. In short, the homeowner, as well as issuing debt, issues equity.

This is the kind of risk which investors might well be happy with, but which no bank would like to see on its balance sheet. So SBC Warburg is securitizing it.

Craig Corn, director of global residential property markets at SBC Warburg, has been working on this project for the past two years. He brought in Bank of Scotland about a year ago. He’s evangelical about the benefits of the SAM. “For most people,” he says, “the future value of their houses is not at the front of their mind. What they need is cash flow. People need money to top up their pensions, to pay school fees, or something less financially responsible, like going on a cruise. At the moment, 80% of most homeowners’ portfolios is house: they really ought to diversify, especially given that historically equities have performed much better than house prices.”

Corn is banking on there being a lot of investors who want direct exposure to the retail property market. They’ve never been able to have this before, having to rely on substitutes such as equity in construction companies. Pension funds should be interested, because historically house prices have not only outperformed inflation, but matched increases in earnings; most pension fund liabilities are earnings-linked. Property funds should certainly be interested. And there’s enough equity in the bonds to encourage some equity investors as well, although the mortgages are being sold on the basis that stock markets have historically outperformed house prices.

Corn claims that the structure of the mortgage has been carefully designed to encourage holders to make improvements to their house and to maximize its value. And they won’t be able to buy high and sell low, doing sweetheart deals on the side, because the repayment amount is based on valuations and not capital gains. The equity participation is based on the difference between two prices: the lower of the buying price and the value of the property when the mortgage is taken out, and the value of the property when the mortgage is paid off. From this figure is subtracted any increase in value directly attributable to improvements made by the homeowner after taking out the mortgage.

The SAM has been designed as a remortgaging vehicle, rather than a house-buying instrument. It is aimed especially at pensioners, who may want a higher income but are not so interested in capital gains on their home on their death.

The 5.75% SAMs will be securitized into fixed-rate notes with a coupon of about 55% of the 10-year gilt yield; the zero-interest SAMs will be securitized into floating-rate notes with a coupon of about 60% of three-month Libor. Both will then pay a quarterly coupon of all the income from the mortgages that quarter, both capital repayment and shared appreciation. The maturities will be more than 50 years, although SBC Warburg will be able to “sweep up” outstanding bonds when 80% of the underlying assets are sold.

The reason that the zero-interest SAMs can pay floating-rate is that, by the time they are securitized, they will have been deleveraged. Sixty per cent of the price of the bond is invested in Libor-yielding securities, thus accounting directly for the coupon. This doesn’t add anything to the bond: it makes it look a little more like the securities investors already know.

But it isn’t like anything the capital markets have seen before. “It’s a convertible bond wrapped up in a securitization vehicle,” says Corn, who does find it difficult finding a useful analogy. “It’s a property-linked bond.” “It’s an equity securitization.” “It’s a mortgage-backed security.” “It’s equity in retail housing.” “If I had to pick one bond which it was like, I’d say it was most like an index-linked gilt, linked to house prices instead of inflation.”

In fact, it’s a curious hybrid. The underlying assets are a combination of debt (the original loan) and equity (the shared appreciation). If this market takes off, it’s inevitable that the equity will be stripped out and traded separately; at the beginning, however, the two come together. The Bank of Scotland is taking no interest at all in its loans: 100% of the debt and equity from them goes to bondholders, with the Bank of Scotland receiving only a fee.

Trying to value the debt part of the bonds alone will be horrendously difficult. It’s secured on lifetime interest-only loans which have never been issued before, so there’s no data on when the sort of people who take out these loans either sell or die, or how good their credit is.

With typical mortgage-backed securities, the danger is prepayment of loans; here, it’s more likely to be the opposite. Furthermore, says Corn, “the prepayment rate is very different from normal prepayment rates. Normally, it’s driven by interest rates. Here, it’s driven by home turnover.”

But if trying to value a zero-coupon bond when you don’t know the maturity date is difficult, then trying to come up with a vaguely scientific method for predicting future house price rises is even harder. “The value of the bonds is the value of any appreciation in house prices plus the net present value of any future appreciation,” explains Corn. “The pricing is a trade-off between interest rates, house prices, actuarial calculations and other factors. But the main factor driving the market price of these securities will be what investors think house prices are going to do in the future.” He predicts a rosy future for housing analysts with experience of the hitherto largely useless art of working out what drives retail property prices.

The initial pricing will be based largely on SBC Warburg research, because few investors will be able to price the bonds themselves. This research will depend on a detailed breakdown from Bank of Scotland of who has bought the mortgages. The fixed income and equity desks at SBC Warburg will sell the securities. Eventually, however, the bonds will be traded more like equity, on price/earnings and debt/equity ratios.

SBC Warburg promises to make a market in its bonds, although they won’t be actively traded at first ­ Corn likens them to illiquid corporate debentures in this respect. He’s confident, however, that the market will become very large very quickly. “Look at the UK alone,” he says. “There’s £1.2 trillion ($2 trillion) of property value, of which £800 billion is net wealth.” Once SBC Warburg has started to tap this resource, other banks will want to get in on the act.

To do so, however, will require sophisticated risk management systems and a lot of capital. The mortgages have to be refinanced by the bank before they are securitized. At the moment, SBC Warburg is refinancing up to £100 million of very peculiar Bank of Scotland mortgages (£150 million to £200 million of bonds after deleveraging) with no guarantee that it will ever be able to shift them off balance-sheet.

But Corn is convinced that this will be a huge part of the international capital markets, from Europe to Asia and even the US, where the domestic housing market is worth $11 trillion. He foresees people being able to buy houses worth a higher multiple of earnings, because it’s not the amount of debt that lenders are worried about so much as the level of repayments.Felix Salmon

UK house prices versus inflation and earnings

CORPORATE BONDS

Putting on a natural hedge

The surge in investment-grade corporate puttable bonds this year, which Securities Data estimates totalled nearly $15 billion at the end of November, up from $8.9 billion last year, is being driven by investors who’ve turned to puttable bonds as the hedge of choice for their unpredictable mortgage-backed securities portfolios. That is providing bond issuers with the means to cut their funding costs through various put structures.

Big investors, including for the first time insurance companies, are turning to puttable bonds to reduce the negative convexity in their fixed income portfolios.

Greg Hopper, a portfolio manager for Bankers Trust Global Investment Management, explains: “If you bought something that has an embedded call option in it, like a callable corporate or a mortgage bond, where the underlying mortgages can prepay, what will happen is that as the market rallies the bond has a higher chance of being prepaid,” says Hopper. “The bond will not keep up with the rally. Then as the market declines, he notes, “there is less likelihood of it being prepaid so it will go down much more quickly.” In other words, callable bonds may offer a higher yield but they underperform straight bonds in a bull market and perform even worse in a falling market.

The traditional remedy for this problem is what’s called a delta hedge. That requires buying treasuries as the market goes up to maintain the overall duration of the portfolio. Duration, a combination of an issue’s maturity and coupon, is a measure of the sensitivity of a bond’s price to movements in interest rates.

In practice, delta hedging can be difficult and expensive particularly in the choppy and volatile markets of recent years. If the market rallies by half a point, and an investor buys the treasuries, but then the market declines, “then you bought at the top and are losing money on the hedge”, says one investor.

Puttable bonds, on the other hand, are “sort of a natural delta hedge,” claims Hopper. If an investor buys a 30-year bond, with the right to put it in 10 years, it will cost only about 20 more basis points than a 10-year bond. Some yield is sacrificed. But if interest rates start falling, the puttable bond will rise in value, extending the portfolio’s duration. “The whole problem of duration has become such a hot topic and so important to portfolio managers over the past few years, that they’ve discovered this tool,” Hopper says.

In the past embedded options have been undervalued. And since market volatilities have been higher than the assumptions on which the puts have been priced, “buyers are getting a better deal than the issuers”, argues Salomon Brothers bond strategist Dennis Adler.

Adler notes that historically high levels of puttable bond issuance have occurred during periods of low interest rates and flat yield curves. In such an environment, if rates go up, the bond will be put. In the case of, say, a 30-year bond with a 10-year put, the issuer will have got, say, 10-year money, for 20 basis points less than if he had issued a straight 10-year bond.

In the past, the lower yields associated with puttable bonds have been anathema for many investors, particularly the insurers. “Two or three years ago, they would not have wanted to give up the yield. It’s a sea change of thinking for them,” says Adler. Much of the new interest in puttable bonds has been foisted on the insurers, however. It is driven by a capital charge the rating agency Standard & Poor’s began calculating in early 1995 when assessing the creditworthiness of life insurance companies. “The reason there’s a demand for puttable bonds is because of S&P’s convexity test. It only started after we said ‘look what’s going on here’,” says Patricia McWeeney, the director of insurance rating services. “When you see what the numbers look like, it makes sense to hedge it.” S&P’s methodology attempted to extract the option risk in the mortgage-backed securities by stressing interest rates and comparing them to single-A non-callable corporates under the same conditions.

Life insurers are snapping up the puts to help cover the inherest risk of their mortgage-backed securities. Their aggregate investment in those securities amounted to over $273 billion at the end of 1994, according to S&P. With the outstanding puts at about $30 billion, estimates Adler, there’s plenty of room for more puttable bond issuance.

Insurers started buying the mortgage-backed securities in the early 1990s, after being stung by the credit risks associated with the real estate downturn and a deterioration in the credit of high-yield bonds. At that time, insurance companies were being forced by regulators to capitalize their credit risk only, not the interest risk, making the securities attractive investments.

Before the mortgage-backed securities market meltdown in 1994, many insurers had about 50% of their portfolio in mortgage-backed securities. Today the percentage is between 15-25%, with the largest firms having a higher percentage, estimates S&P.

The 1994-95 markets hurt the performance of insurers’ portfolios, says McWeeney. During 1994, interest rates rose dramatically, causing the securities to underperform. “During 1994, insurers were losing 2-10% on the mortgage-backed securities relative to corporates,” she says. The following year, rates rose, creating a surge of prepayments. “The numbers were larger than people expected.” Holders of callables were hit hard by negative convexity.

This year has been relatively calm. But with the 10-year treasuries below 6.25%, that could trigger a surge of refinancings by homeowners who bought their homes some time during the past two years, says John Nolan, portfolio manager for Bankers Trust Global Investment Management.

Puttable bonds have been particularly useful for portfolio managers who don’t want to sell the mortgage-backed securities they may be holding, particularly if it would mean booking a loss. Moreover, when puttable bonds are designed to be a mirror image of what a mortgage security does, “you can create something like a traditional bond with a lot more yield,” says Nolan.

While the puts themselves have a lower yield than a regular bond would, when combined with another security, that’s not the case. He says the combined yield might be 20-40 basis points higher than a traditional bond. “The pitch has been that there’s value there,” says Nolan, adding that’s because “there’s some risk because there’s not an exact fit between the two.”

Nolan notes that a lot of mortgage securities act like a three-year security in a rally, and a 10-year one when rates rise, he says. If such a security was paired with a 10-year bond with a put at three years, the combination of the two would offset each other. However, most puts aren’t designed that way. The most popular this year has been a 30-year bond with a 10-year put, although bankers are coming up with a variety of structures that might prove more useful to investors.

The most interesting are “step-ups,” in which the coupon is increased if not put, or multiple-year puttable bonds. Deutsche Morgan Grenfell’s 30-year bond for the Province of Quebec, which is puttable every year after 10 years, or Morgan Stanley’s Tennessee Valley Authority bond, which matures in 2036, but is puttable at years two and 10 ­ the so-called put-put bond ­ are the types of structures investors are clamouring for. Michelle Celarier

EURO COMMERCIAL PAPER

Back from the dead

Euro commercial paper (ECP) always seems to get a raw deal. It’s forever regarded as the poor relation of its American cousin, and is only known for the withdrawal from the market of several major banks at the turn of the 1990s, and its very tight margins. These usually represent no more than two or three basis points of a deal.

Two more banks left the ECP market this year: Chase started to pull out at the time of the merger with Chemical in March, and Bank of America pulled out over the summer. While this might appear to bode ill for the market, the remaining banks are hopeful that it will help to alleviate chronic overbroking: “We’re not looking for a cartel,” said one dealer. “But we do want the market to be as economical as possible.”

This year has seen other developments to encourage the remaining participants. The latest figures released by Euroclear show ECP outstandings for the first 10 months of 1996 at $106 billion: not a large amount compared to the US market which has $750 billion outstanding, but it does represent an increase of 18% over 1995. It has moved the market away from the stasis of $80 billion which had dogged it since 1991.

There is also an impression of shortage of supply. Pieter van Dyck, director and product manager of ECP and EMTNs at SBC Warburg, widely regarded as the ECP market leader, estimates this could be as much as $100 billion, although the present excess demand is limited to certain high-grade names.

Those banks still active in ECP maintain they have a strategic commitment to what they regard as an essential part of the capital markets. “Any house that is serious about offering a comprehensive service to its customers must have a strong ECP desk,” says Warburg’s van Dyck, . “The ECP market offers such a diversity of short-term product that all investors with significant cash balances want to be in it. Also, in respect of mergers and acquisitions, ECP is increasingly becoming part of the scene, so how can you act as an M&A adviser if you don’t have an ECP desk?”

One reason for the increase in outstanding paper is the expansion in the number of issuing currencies over the past four years. The main change has been the loss in market share of dollar-denominated paper in favour of European currencies, especially the Deutschmark and sterling. The dollar share has declined to 55% this year from 84% in 1992, according to SBC Warburg. Non-European currencies have also grown in importance, especially the Australian dollar, the yen, and the Korean won, which is seen as relatively low risk since Korea was granted OECD associate status. Most of the main ECP houses expect issues in other Asian currencies such as the Thai baht and the Malaysian ringgit to become more frequent as investors begin to search for paper yielding more than the traditional currencies.

The diversity of currencies has led to a deeper ECP market: up to 50% of the market is now based on synthetic ECP, allowing participants to arbitrage spot and forward foreign exchange.

ECP is also becoming a more competitive and attractive source of funding. Dominic Surry, executive director and head of CP and FRNs at Lehman, mentions one aspect: “This year we have seen increasing demand from central banks for ECP as new sovereign programmes have come on line and comparable investments have become less attractive. The huge net redemptions and increasingly tight spreads, relative to Libor, in the floating rate note market are a major factor contributing to this trend.”

Commercial paper should also benefit from the growth of the repo market: “With the Bank of England making the repo market its intervention tool of choice, the importance of eligible bills will probably be reduced,” says Jonathan Boyd, head of money markets and repo at Deutsche Morgan Grenfell (DMG). “So bank appetite for holding them, especially bills of acceptance, will drop and they will not be such a cheap source of funding for corporates. Commercial paper would be the ideal alternative.” Antony Currie

Euro CP by currency 1996