For some securitization veterans, innovation is a dirty word.
“I don’t want innovation,” says the head of structured credit and ABS at one major US investment manager in New York. “Our market has matured into a place that carries on functioning during challenging times, which didn’t used to be the case, and it’s because we’ve a proven way of doing things that has withstood several crises.
“In the old days, every week or two we’d come up against banks getting too clever on some feature or the other. Thankfully, we’re seeing less of that today.”
Yet the investor admits he may be jaded from seeing securitization “constantly attacked” by those who are unfamiliar with the industry; he believes the perception, liquidity and regulation of the market suffers as a result. What critics might not realise is that innovation in structured products is not some racy experiment: it is one of the most important financing tools in the US economy.
“The importance of innovation in ABS is to uncover ways that the capital markets can provide more efficient financing than had previously been provided in the bank market, while simultaneously giving institutional investors opportunities for exposure to asset classes that they didn’t previously have access to, which can be positive from a risk/return and diversification standpoint,” says Cory Wishengrad, head of fixed income at Guggenheim Securities.
After all, ABS doesn’t innovate just for the sake of innovating.
“A lot of the innovations that we see in the ABS market exist because they are solving a problem,” says Patrick Dolan, a partner at Norton Rose Fulbright. “Take the utility stranded cost securitizations, and look at the way they have morphed from recouping sunk costs into rate reduction bonds that cover the costs of events like California wildfires.”
Indeed, as climate events have become more frequent, so has activity in rate reduction bonds, which are typically issued by US utility companies to finance urgent infrastructure repairs. The asset class grew out of the stranded cost securitization founded in the late 1990s to compensate electric utilities whose regulated assets had been affected by deregulation.
All about the assets
Ken Martens, a senior director in the ABS ratings group at KBRA, has an answer to the contrasting views on the role of innovation.
“On the liability side — how you pass through the cashflows — I think investors like tried and tested structures,” he says. “But there has been innovation on the asset side.”
Within commercial ABS, Martens highlights the remarkable growth of solar ABS since 2017, and he also expects C-Pace originators to bring more transactions to market.
New segments of the market are appearing all the time; Guggenheim alone says it has introduced 22 new asset classes to ABS since 2014. Yet innovation is about more than just securitizing a new set of assets: it requires creative thinking from the sell-side to structure them in the right way, and it requires an investor base willing to think out the box.
“The ABS market is good at adapting to new asset classes,” says Dolan. “At one point, it would have been a stretch to think that you could securitize rental units across state lines, and this was an early issue with rating agencies, but today this is what happens commonly in the single-family rentals securitization market.”
Indeed, innovations are not restricted to the asset side of the equation. Martens’ colleague, Melvin Zhou, a managing director at KBRA, highlights how the emergence of solar assets required modifications to the capital structure, given the longer terms of solar loans versus other consumer assets.
“For example, the senior class of notes may be paid down at a slower speed than other transactions, as using a strict sequential structure would make the payoff window for the junior classes much longer, making it hard to find investors for the lower tranches,” says Zhou. “These structural changes are all ultimately driven by the characteristics of the underlying assets and investor demand.”
In paths untrodden
Predicting which will be next sectors for ABS investors to get their heads around is tricky, and something that those working on deals are understandably reluctant to reveal ahead of time. But logic suggests that there is huge potential for growth.
While corporate bond markets, for example — or indeed more traditional areas of the securitization market like RMBS or credit cards — effectively function in line with the fluctuations of the US economy, esoteric ABS still has plenty of untrodden paths to explore, no matter how GDP evolves.
“There are large segments of the economy that are not using securitization today, and some of them have the necessary characteristics — whether long-term predictable cashflows, discernible asset value, and the ability to servicing functions — that mean securitization can become an attractive funding source for them,” says Wishengrad.
Add in the demand side: the increasing need for fixed income instruments as baby boomers extend into their retirement years, and there’s compelling reasons to believe ABS will become an ever more important tool.
“Well structured and highly performing investment grade assets that will satisfy the needs of investors will be well sought after,” says Wishengrad. “On both sides of the equation, this bodes well for the innovation and growth of the non-traditional asset classes in the securitization market.”
According to Finsight — which classifies esoteric ABS as all securitization except RMBS, CMBS, CLOs, auto, student loan, credit card and equipment deals — esoteric ABS account for 12.4% of securitization issuance so far in 2022. This is the segment’s largest share since 2011, back when the CLO market, today the largest segment of securitization, was barely functioning.
At first glance it may appear surprising that esoterics have been so resilient in a torrid year for credit markets; after all, yield is far more readily available in easier to understand assets today than it was a year ago. But this is in fact when innovation is most urgently needed.
“As leveraged loan, mezzanine lending and other alternative markets become more expensive amid macroeconomic headwinds, certain issuers that may not have wanted to go through the process of doing a securitization in good markets may find it more compelling [today],” says Wishengrad at Guggenheim. “Our market tends to be less volatile than others, and remains open and functioning today.”
Moreover, relative to the alternatives, ABS is as appealing as ever for certain issuers, says Wishengrad.
“The basis between where a borrower can raise funding in the high yield market versus the ABS market expands in challenging markets, so the savings available by accessing the securitization markets are greater in times like these versus when markets are flooded with liquidity,” he says.
Despite its complexity meaning it can appear opaque not just to laymen but even to people in other areas of capital markets, ABS is — perhaps ironically — arguably at its best when financing the rather unexotic day-to-day straightforward activity of the economy: restaurant chains, rental cars, or wireless towers. Difficult days are not the time for structurers to be putting away their thinking caps.
Collateralized Loan Obligations
CLO land set for shake-up as trading tech arrives
If some see innovation as engrained in the DNA of the securitization industry itself, there is not the same enthusiasm for the topic in the CLO segment. CLOs had a record-breaking 2021, with over $400bn of issuance, but it was extraordinary due to volumes and not because of any game-changing structures.
And for such a large market, secondary trading volumes are pitiful. While the $1.5tr US high yield bond market, for example, sees around $3.6tr of trading each year, secondary trading in the $1tr CLO market is just $185bn.
Part of this is because CLOs have not kept up with the modernisation of trading processes that has taken hold elsewhere. Yet this is changing.
At least three firms have laid out plans for potentially transformative electronic trading platforms: KopenTech, which launched its DirectBidding product in June; Octaura, born this year out of an earlier tie-up between Citi and Bank of America known as Project Octopus; and a fintech focussed on structured credit called IDX Markets.
“Despite the fact that the CLO market has traditionally been doing the same thing for the last 20 years, there is innovation happening and it’s coming in the form of direct bidding — allowing investors to trade directly and anonymously with each other,” says Jill Scalisi, chief engagement officer at KopenTech. “Nobody has done this before in CLOs.”
KopenTech attracted attention in 2021, when Trimaran Advisors used the firm’s applicable margin reset (AMR) platform to carry out the largest CLO refinancing without an arranging bank. It has now become the first firm to begin CLO trading on its electronic platform, and is encouraged to see other parties launching similar products.
“The fact that we have major broker-dealers coming together to create a product validates the necessity of what we have been developing,” says Scalisi. “KopenTech has automated the entire process of trading, which previously was based on inefficient communication.”
Scalisi says that KopenTech values its broker-dealer relationships “equally” to its buy-side relationships, and recognises that each house brings its own strengths to the market. But she highlights that the DirectBidding platform, as well as bringing efficiency gains, gives investors access to a wider network.
“If I’m a seller of CLO paper I’m now able to go out not just to all the broker-dealers, but also reach — directly and anonymously — the 150 investors on the platform,” says Scalisi. “As well as being a better, more automated process, buy-side clients can trade with each other without that party knowing who they are, and KopenTech sits in the middle as settlement agent.”
This is something that can be expanded into other structured product asset classes.
“Our first aim is to be operating in all products that fall within the vertical of CLOs, but we will eventually look to be involved across the structured product universe,” she says.