Investors are lapping up everything from tequila to hurricanes to ageing pop stars
A new asset class has pushed its way into institutional portfolios. Companies worldwide are finding that securitizations, once exotic, are a key instrument in their financing arsenal. As sophisticated investors grow comfortable with the concept, and rating agencies get more adept at rating them, the assets and cash flows used to back issues are becoming curiouser and curiouser.
Cash flows converted into securities include railway rolling stock lease payments, earnings from exports such as liquor and international phone calls, and government tax receipts. There is even a market for insurance policies of Aids patients. What it all boils down to is that if you can measure cash flow, you can create securities to transfer risk and raise funds.
Indeed, the ripple that began in the US in the 1970s has turned into a global tidal wave with the securitization swing catching on in Europe and emerging markets. Last year some $100 bn of securitized bonds were issued in international markets - four times 1995's level.
Their buyers are mainly investment professionals with the technological tools to understand sophisticated instruments. To be sure, technology, along with the proliferation of pension and mutual funds, have profoundly changed the way people invest and the nature of investments they are willing to get into. One result of this is that companies now feel they can directly approach buyers with less help from an underwriter, which has obvious implications for bankers and other intermediaries.
But why securitize in the first place? 'Securitization is part of the global disintermediation process whereby originators and servicers of high quality assets can bypass traditional intermediaries and sell their assets directly to investors, thereby achieving cost-efficient financing,' sums up Ian Bandeen, managing director of structured finance and securitizations at Nesbitt Burns, the investment banking arm of Bank of Montreal.
By definition, a securitizer is someone good at identifying discrete pools of assets, carving them off, restructuring the credit profile into different investor classes, and selling the resulting securities to entities with different credit appetites. The benefit, says Bandeen, is that the collective price for assets rises.
In its purest form, a securitization involves raising money by pledging the income from 'hard' assets. For example, US banks have tapped capital markets by selling off credit card and mortgage loans for over 20 years. Here, money has been advanced which now must be repaid.
Today, mortgage products have hit the big time, taking their place beside corporate or government bonds. A fund manager survey by Capital Access International found almost 90 percent of respondent portfolios contained mortgage securitizations.
Besides standard mortgage securities known as 'pass throughs', US investors are buying more complex products such as Remics (real estate mortgage investment conduits). Remics combine pass throughs and whole loans to create different maturities and risk levels.
The international financial press - all shameless groupies - made a racket about the $50 mn issuance of securitized 'Bowie bonds', which were all bought by one insurance company. Secured against future royalties from the polymorphic pop-meister's old records, the transaction is best described as a future funds flow deal. Here, a discrete cash flow, based on a calculated gamble about demand assumptions, is used to satisfy a debt obligation. However, no-one is obligated to buy another note of Bowie's musical product. In the worst case, there would be no fund flow.
Global Growth
US banks were first off the block as they searched for creative ways around a cramped financial system, but European securitizers have leapfrogged traditional markets to become critical partners in company restructurings and privatizations like Ireland's GPA and France's Credit Lyonnais. Meanwhile, European governments have sold off mortgage debt in a bid to make the cut for membership in Europe's monetary union.
Emerging markets companies are taking a shine to future flow deals. By attaching a security to flows due from international obligors, securities can achieve a higher rating and attract investors otherwise put off by emerging market risk.
Pakistan, for example, is set to launch a $250 mn deal securitizing inbound call earnings from line rental agreements with foreign operators. Payment risk is spread among those foreign operators so money is cheaper. Mexican tequila purveyor Jose Cuervos raised $50 mn with a bond secured on US export earnings - at a rate effectively cheaper than the Mexican government's.
'The offshore dollar hard currency cash flow is key to these sorts of export finance deals,' comments Patrice Jordan, managing director for structured finance at rating agency Standard & Poors. 'Issues get a better rating than perhaps otherwise possible because they promise segregated offshore dollar cash flow. That mitigates country risk.' However, rating agencies do consider performance risk and the originator's credit, as product must be delivered before a receivable is created.
Jordan notes a strong rise in Asia-Pacific securitizations: Australia's highly developed securitization market has seen another record year; activity has picked up in Hong Kong; and there are deals from Indonesia and Thailand in the pipeline. 'Japan has enormous potential if regulators decide to widen the scope of the market,' she adds. 'The banks talk about it daily, but it is a traditionally unpredictable market.'
Better Balance Sheets
That leads to another major international trend keeping the rating agencies busy: banks repackaging their exposure. For these institutions, asset management is a constant concern and securitization is the vogue.
Slow off the mark, the Canadian market seems particularly fertile ground for a spurt of securitization. At the end of July, Nesbitt Burns closed the biggest domestic non-sovereign debt issuance ever - a C$1.35 bn securitization backed by Bank of Montreal credit card receivables. Some 70 Canadian institutions bought the privately placed, triple-A rated investor certificates. Nesbitt bumped the issue into the highest rating zone (a notch better than Canada's sovereign rating) by backing the trust with an irrevocable line of credit from State Street.
This is the first major foray by a Canadian bank into domestic non-mortgage related securitization and Bandeen believes it heralds a wave of Canadian bank securitizations. 'Demand is enormous. Traditional bond product suppliers - governments - are now starting to run surpluses. Few high quality assets are left. Highly-rated securitizations are the natural surrogates.'
Bandeen has preached the securitization gospel for eleven years and has a unique window on the phenomenon. The Nesbitt Burns team co-founded the Canadian mortgage backed securities market in 1986 and now structures Canadian securitization programs for Chrysler, Citibank and GMAC. Bandeen says securitizations, once a luxury, are now a necessity for any corporation with balance sheet concerns.
'Any provider of consumer or corporate finance services that continues to finance on balance sheet will readily become uncompetitive in global capital markets,' states Bandeen. In the credit card deal, responsibility for funding debt is taken off the bank's books, while it still takes a fee for running the credit card program.
Rather than being cut out of the action, Bandeen says smart banks will redefine their roles and embrace securitization. He notes that originating, servicing and financing are the basic components of providing consumer or corporate debt: 'Properly understood, these roles are ideal for large banks in general and Canadian banks in particular. Because of their economies of scale and advanced electronic banking systems, they have a competitive advantage.'
New Asset Group
As securitizations look for innovative alchemy, rating agencies play a key role in building investor confidence in both the public and private markets. For its part, S&P has set up a separate team called the New Asset Group to analyze 'nontraditional' securitizations, including exotica like film rights proposals and catastrophic risk bonds.
With hardly a glance at a balance sheet, agencies largely ponder legal structures when determining ratings for the new asset class. 'When people come in the door with new ideas, the first question we ask is to what degree can the securitized assets be legally segregated from the originator company's solvency,' says Jordan. 'Often, that's not an easy question to answer.'
S&P is seeing more and more proposals from major film studios looking to securitize advertising or production costs. Typically a special purpose company is set up to buy film rights from a studio, going to capital markets to do so. In many cases, film distribution rights are licensed back to the studios (who happen to be very good at distribution). Then investors hope for box office - or video store - boffola.
'Is there any guarantee in this business?' asks Heidi Oster, associate director at S&P's New Assets Group. 'No. We have to look at past performance. None of these deals is plain vanilla. Given the nature of the industry, it's rather less predictable than a credit card loan. That adds flavor to the job.'
Going into high gear next year is another potentially huge market - the utility sector. Utilities must amortize the cost of under-used facilities. Many do so by adding a premium to rate payers' bills. The idea is to segregate those premiums and use their future cash flow to collateralize a bond. Whether this will lead to cheaper electricity bills is unclear.
The securitization phenomenon throws up many questions for investor relations, not least because IROs will increasingly have to be able to explain the interplay between securitized interests and the equity valuation of a company. Indeed, while equity holders will remain at the top of the list for a while yet, to do their jobs properly in future IROs are going to have to learn more about their company's entire investment community.