Copying and distributing are prohibited without permission of the publisher.


Crisis Talk – with Joseph Lau of Lord Capital

By Max Adams
28 Apr 2020

The coronavirus crisis looks to be a once in a career event for many who work in capital markets in terms of just how much of the economy is being impacted. It has frozen some markets, heightened illiquidity and the shut off of a primary pipeline that, before the pandemic, was expected to produce another robust year of new issuance across securitized assets.

The nature of the economic crisis, particularly its heavy toll on consumers and employment, has made the risk models investors in many ABS asset classes use almost obsolete overnight. Lacking historical precedent and dealing with mounting uncertainty around the length of the shutdown and the pace of economic reopening, securitization professionals are trying to move forward and assess heightened risk in even the most plain vanilla asset classes.

GlobalCapital's Max Adams spoke with Lord Capital managing director and COO Joseph Lau about the outlook for the new economy, modeling risk in unprecedented times and the securitization landscape past the pandemic.

The pandemic hit the brakes on an economic expansion that had been heavily driven by consumer and household spending in the post-2008 recovery years. How are securitization investors looking at the various consumer ABS asset classes and how have risk assessments changed for people on the buy side? 

Right now, it is extremely challenging to determine the impact. What many of us originally viewed as a reasonably short term, and potentially not a national situation for quarantine, has grown into both, stretching into months with no clear end in sight. 

The effect on unemployment is certainly dramatic, and no consensus exists on everything from total unemployment levels and time frames for returning to ‘the new norm’. It is understood the current filings numbers and existing new unemployment filing underestimate the total number of those both unemployed and underemployed, which ultimately means severe strain on the consumer. Furthermore, depending on which media outlet or ‘expert’ you listen to, the US is opening imminently, or the lock down will persist for many months to come.

These factors directly drive concerns about consumer ABS, but cannot be quantified. Pressure on individuals is certainly acute and is leading to two key challenges: how long should investors assume this persists and what is the period-by-period effect on ABS. In the context of securitization, we are looking at several individual factors.

The first is the assumption for duration. Initially, it was not anticipated the entire US economy could be closed for any period of time, though the creep of lock downs has led to all-but the entire economy closing. The result leads to questions about when will lock downs end, and when can investors expect businesses will be properly up and running again, with employees being paid and able to service debt. While states are already discussing reopening part or all of their economies, the lag to have economic activity return to ‘normal’ is anticipated to be much longer, with many businesses never reopening. Furthermore, as we now move into the summer, parts of the country, such as the northeast coast, have raised the prospect of not opening beaches and other tourist areas this summer, meaning no sanctioned economic activity.

The second is the direct effect on ABS. Cash flows for many asset classes will be directly affected, passing through such exposure directly to the investors. Credit cards, auto loans and unsecured installment loans may not be identified as ‘delinquent’, but a definition does not change that cash flows will be reduced if borrowers do not have the ability to pay. While delinquency statistics are certainly relevant as they are one of the factors affecting whether trusts go into early amortization, ABS investors are acutely concerned about cash velocity, whether that be payment speeds on auto or credit card transactions and the ability to service current interest. Current concerns remain around those who are unemployed and other financially exposed segments of the economy, who may find taking advantage of forbearance programs now and reserving cash is a better option than making payments.

Is there any sort of useful precedent that the structured finance community can look to for guidance? People often cite the experience of 9/11 as a similar sudden disruption to markets and business. Is that a useful comparison or are investors in completely uncharted territory?

It's very difficult to find any comparison in the US economy for such a situation.  9/11 was an immediate disruption, but the time frame involved was small and did not include a complete shutdown of such a substantial part of the US economy. I don’t know that I have a good comparison across all markets given other situations have entailed performance in specific sectors, such as hurricanes affecting Florida or Texas, rather than across geographies and credit spectrums.

Can you discuss what you believe are some asset classes that are particularly at risk from this crisis and why? Conversely, do you see any sectors that are protected against the effects of a prolonged economic slowdown?

At a macro level, to thoroughly answer this question you have to estimate time frames. Different assets are going to have different runways for loss, with defaults cascading and the timing dictating how people’s fears are confirmed or allayed. If a situation persists long enough, we always see markets - capital, consumer or otherwise - revert to a correlation of one, as is reinforced through every crisis. So the key question will remain how long do we have until we hit that correlation, if we have not already given the size and scope of the economic slowdown at hand. 

At a minimum, we expect aftershocks to reverberate at least into the fall, so we are going to feel these effects into the medium term which will affect all asset classes.

The result is all ABS asset classes face some degree of risk so long as the US economy remains in this state of limbo. Sticking specifically to the consumer, while prime borrowers may be expected to have higher savings levels to assist them through a period of months, and are able to support ongoing payments on existing debt levels, non-prime and near-prime borrowers are at greater risk due to general demographics around job prospects, savings and debt loads, which would limit access to additional resources.

Lower credit tier unsecured consumer and auto-related transactions would be higher exposure markets now, given the elevated unemployment situation, as well as the risk of lower savings in general for these classes of borrowers. We have even begun to see rating agencies put transactions in these sectors on watch.

What are the challenges facing issuers returning to market as the ABS pipeline reopens? Is it merely the inability to sit with investors in person to walk them through deals, or is there a more fundamental hesitation around credit risk in these assets that will have to be overcome?

Certainly both create challenges. 

The uncertainty around credit risk gives many investors pause about participating in the markets, as well as pricing such risk. The lack of clarity on the duration of shutdown and return to an open economy leads many investors to very conservative assumptions on how and when we will see certain parts of the US economy open up, namely hospitality and travel. 

Many people fear getting this wrong now and, just like after 2008, when you are faced with getting it grossly wrong or doing nothing, many find it easier to sit on the sidelines and wait for the world to settle further.

As for continuing to be in quarantine, there is no substitute for meeting in-person to discuss concerns. While technology always helps us communicate, in uncertain times like this, roadshows and conferences help, as it gives us an opportunity to more fully ask our questions and address concerns. 

What do you anticipate will be the lasting effects of this event on ABS markets? Will there be an enduring change to the way these markets operate, such as road showing or syndicating deals? Could this be an opportunity for securitization markets to prove themselves as a vital source of funds for the real economy? 

I believe securitization has already proven itself a vital source of funding for the real economy, and this crisis does reinforce that. The government’s quick response, through both reinstituting TALF and discussing how to expand the program, appears to be an acceptance that securitization is an important source of capital for the broader markets, and must be maintained alongside corporates, money markets and government bonds.

As for the lasting effects on how markets operate, the initial impact on market liquidity – or lack thereof – reinforced what many of us had been saying for years: increased regulation of broker-dealers has also increased the risk of volatility in markets by reducing market makers’ ability to act in that capacity. It’s unclear what will be the outcome, but liquidity and transparency in secondary markets remains a very important consideration for investors, and once the nature and scope of this crisis became clear, it also crystallized the need for dealers to facilitate orderly trading.

Another factor which already existed, and should be an ongoing expectation, is the need for a third party to stand in during transactions, such as a Control Party under IFRS 10. This counterparty maintains certain control features which, while not necessarily impacting the day-to-day activities of the funding vehicle during good times, has a substantive, independent role when material events occur around the SPV. 

This role goes beyond trustees or other service providers, in that a control party would be able to act for the benefit of the SPV in extraordinary circumstances, such as we saw during the last US credit crisis, and today. Examples exist in the mortgage market, but consideration should be given to expanding this throughout ABS. We at Lord Capital have played this role in the past and understand where it enhances investors’ value, in situations where either issuers need to rush to gather parties for voting or investors are concerned about possible technical issues impairing the value of bonds, such as we are concerned with occurring today.

By Max Adams
28 Apr 2020