Esoteric or nontraditional assets are gaining momentum to claim a bigger piece of the ABS market.
As the securitization industry gets comfortable with what was once the unusual, esoteric bankers are ready to push the limits with newly found asset classes within the space.
According to a KGS-Alpha Capital Markets review of data published by Moody's Investors Service, 2003 had $505 billion of ABS issued, with the esoteric or "other" sector's market share comprising a much smaller part at 8.7%.
Fast-forward to 2011, and the pie of securitized assets has become much smaller. According to the above research, the market has shrunk to about $89.5 billion year-to-date. However, the esoteric share has become a much bigger piece of the pie, accounting for about 26.5%.
Year-to-date 2011, there has been more than $10 billion of esoteric issuance done in the 144A markets. September alone saw three deals each from stranded costs, fleet leasing and premium finance totaling more than $500 million.
"The overall pie has shrunk, but there is still a lot of liquidity in the ABS marketplace and much of that is going into esoterics," said Fouad Onbargi, head of origination and investment banking at KGS-Alpha. "People have seen these deals and they have proven themselves, so it's become a much bigger piece of the pie."
Onbargi is part of the team that left Aladdin Capital Holdings to join KGS-Alpha Capital Markets in July as part of the firm's expansion into securitizations of esoteric and commercial assets.
Bankers said they are willing to push for an even bigger piece of the action. Prior to the last credit crisis, the deals in the space were predominately wrapped and sold to a highly levered investor base.
"When these investors were forced to sell positions, it caused the market value to deteriorate substantially," said Cory Wishengrad, co-head of the securitized product origination group, Americas at Barclays Capital, speaking at the American Securitization Forum (ASF) sunset seminar on nontraditional ABS. "It signaled a disconnect between market value and credit performance, where the latter was extremely good and the risk return attractive."
In the last 12 to 18 months what has happened is that these nontraditional assets have found a new investor base, or rather, returned to their original buyers. These investors used to purchase these deals before the common use of monoline wraps and provided for a more stable source of liquidity for issuers.
"Off-the-run assets used to be dominated by insurance companies; then monolines came in and it became a much different market," said Michael McDermitt, vice president and team leader for commercial and esoteric ABS at Moody's. He was also a speaker at the ASF event. "With that going away there is a need for traditional buy-and-hold investors."
Without the support of the monolines, securitization is more expensive for issuers because they are selling a triple-B-rated security. However, the flipside of the coin is that it is cheaper for investors because they are buying securities with more yield.
"This is why investors are attracted to this space, because they earn more yield than they could otherwise find in traditional consumer ABS," said Wishengrad in an interview with ASR.
Another speaker at the ASF event, Ed Fitzgerald, a managing director at New York Life, said it is a welcome development because aside from the yield opportunity these non-traditional asset structures bring, investors can also take comfort in that if there is ever a bad economic event, the assets can be liquidated or sold to another party.
"Securitization is still an attractive form of financing for issuers relative to their alternative in the bank market and high yield bond market where the companies would generally be non-investment grade," Wishengrad said. "However, because of the benefits afforded to creditors by virtue of the securitization structure, issuers who could access the securitization market are generally able to achieve a higher rating and a lower cost of funds than they could in the corporate debt market."
The Sun Rises on ABS
Among the potential new asset classes that could put a real dent in volumes down the line are renewable energy projects.
A potentially emerging subset asset within this sector that has garnered a lot of talk in recent months is the area of residential and commercial solar financing.
Financing for renewable projects has traditionally depended on cash grants and tax credits, which must be renewed every few years by Congress. The investment tax credit, for example, is applied to a project immediately while the production tax credit is based on the amount of energy produced. As a result, projects have typically been financed via tax equity investors.
"Among the more interesting new things coming across my desk are deals that involve new financing structures to help clients fund energy efficiency projects," said Dan Passage, who joined Bingham McCutchen as a partner last month.
According to Passage, partners at Bingham (Jacob Worenklein among them) have been completing "first-of-a-kind" financings of loans and leases that enable residential and commercial property owners to install solar panels on their homes or businesses. "Those involve interesting multi-tiered capital structures," Passage said.
His law firm, Passage said, is also working on a multi-seller master trust structure that will include warehouse financing for and term-out notes issuances of PACE and C-PACE loans made by cities and counties throughout the U.S. These loans, which are secured and payable as tax assessments at core, also enable residential and commercial property owners to fund energy efficiency upgrades, often solar panel installations. The latter structure will be more like those used in many securitizations to date.
SolarCity, a full-service solar provider for homeowners, businesses and government organizations, is one solar distributor that has traditionally funded itself via tax-equity financings. Typically in these deals one tax provider has taken all of those cash flows, which come from government grants that provides 30% of the cash flow and various rebates that the utility providers give to the owner of the solar system.
"Traditionally the tax-equity investor would get the rebate, the government grant - which can happen either upfront or over time - and then the customer cash flows," said Michael Mittleman, director at SolarCity who spoke at the recent ASF sunset seminar. "Up until now we have been financing all cash flows through the tax-equity market."
Securitization could more efficiently monetize some of these cash flows. "Certain tax advantages aren't appropriate for securitization, but cash flows that involve customer payment or performance-based incentives like payments from utilities that happened over time - we see isolating these cash flows and securitizing them as basically being a way to get a lower cost of funding," Mittleman said.
He added that as government tax incentives begin to phase out - by 2016 that incentive ratio for federal aid will shrink to 10% from 30% - customer cash flows will increase as a percentage of the overall cash flows and become easier to securitize.
Additionally, there are mandates requiring utilities operating in certain states to deliver a certain amount of clean energy by certain dates, which is another reason why utilities have embraced the idea of solar.
SunRun CEO Edward Fenster told CNN Money earlier this year that the company is spending $40 million a month to keep up with demand. That means, according to the CNN Money report, that the $200 million tax-equity financial partnership SunRun announced with U.S. Bancorp in early May will be committed within a five-month period, or by October this year.
According to the company's spokesperson, Susan Wise, SunRun is thinking about securitization as a possibility for its future financing strategy, but nothing is confirmed at this time. "Our primary goal is to make solar more affordable for American families with a model they know and trust," she said.
Sol Systems, a Washington D.C.-based solar finance firm and the largest solar renewable energy credit (SREC) aggregator in the nation with more than 2,300 customers and more than 20 MW of solar capacity under management, recently announced its new solar finance platform called SolMarket.
"We talk to hundreds of solar developers about prospective commercial and utility-scale projects and unfortunately many of these solar projects are never built due to an inability to efficiently locate financing," said Yuri Horwitz, CEO of Sol Systems. "We have created SolMarket to help drive efficiencies into the solar market and connect investors and developers effectively. SolMarket will reduce the cost of financing transactions and enhance the tempo of solar project development."
George Ashton, vice president and CFO at Sol Systems, said that as the interest in projects increases, so have buy-siders become more keen. That, according to Ashton, has been the impetus behind the platform to create an organized way of bringing together solar developers and investors.
"Banks and institutional investors are starting to get more comfortable with solar projects, so they started financing these solar projects at much lower yields than private money would care to entertain," he said. "Private money has to look for the same yields but in smaller projects. The problem is that you need several of them to get to a notional amount that makes sense to pull together for financing purposes. Now you have increased project discovery costs and increased underwriting costs because finding the 10 projects that are well organized that can be put together in the fund is difficult."
With SolMarket, developers can group similar projects into one portfolio either by location or similar by host site. For instance, a developer can be doing a solar installation in branches of Walmart in Ohio, and the developers can group those projects into one portfolio to be financed.
However, Ashton pointed out that in creating a new security, some sort of standard in terms of underwriting and credit quality needs to be established. A very important quality of the securitization market is that it works best with normalized asset classes.
"The great thing about the market is that you hope it will derive liquidity, but you need to prove the performance of the assets, in a normalized fashion, down the line," Ashton said. "One thing we focus on is providing templates for some of the legal documentation and fairly well-defined project guidelines, all of that with the idea of creating one normalized asset class in solar energy projects."
According to Ashton, there is a significant step toward making solar energy projects an investment-grade class, and the next step is securitizing these projects.
"There are bond buyers and other investors with a keen appetite for these kinds of deals, and it appears to us that many can be done without obtaining a rating," Passage said. "Still, we expect to see our issuers obtain ratings for some of them to create the broadest investor base."
Moody's' McDermitt said that the agency has yet to rate this type of deal, but one concern that will be considered once a transaction surfaces is the issue of historical performance data. For issuers with less of a track record, aiming for lower advance rates and lower ratings could be the solution to gain access to the market, he said.
"One problem so far has been the low volume of loans made in this space to date," Passage said. "So far only maybe a couple hundred million dollars of loans have been done in this space. Our work in this space anticipates rapid growth in origination levels as the capital markets begin to make funding more readily available to counties and cities that are eager to ramp PACE and C-PACE lending. Obviously, increased volumes and more historical performance data will be critical for getting rating agencies comfortable with assigning ratings. I do think that there will be some rated deals in this space sooner rather than later, and that is definitely going to be positive for this marketplace."
Ashton believes that ratings would be great as the market matures, but right now the projects are being done on a private bilateral basis between two counterparties. "Within SolMarket we come to some exclusive rating that we apply to developers and projects in particular but we tend to provide information that investors can quickly assess credit quality and all the things a rating would secure," he said.
Passage noted that a number of funds are specifically focused on investing in a number of energy efficiency and clean tech projects and deals. Also, there is interest across separate groups within large-scale bond buyers who might normally focus on different segments of the debt capital markets - securitization versus public finance versus corporate credits. Some might be under mandates to get a certain percentage of their respective portfolios into green, clean tech or energy efficiency projects like these.
The short- and medium-term potential for securitized or structured financings of these kinds of programs may not be "mortgage lending large," but these kinds of deals will find a lot of interest and a lot of replication across different energy production and energy efficiency project classes. There is already substantial interest in solar and wind installation loans and leases.
"We expect to see continued support in the form of programs encouraging the deployment of these forms of energy production supported by communities, state governments, the federal government and the major utilities," Passage said. "If there are five to six deals this year - small or medium-sized issuances using several different securitization or structured finance structures - just in the solar panel space I wouldn't be surprised. There is certainly more than enough investor interest to support that volume and more."
Dodd-Frank Shifts View
Of course, a lot of the regulation and rulemaking affecting the ABS markets will also affect even privately and directly placed deals, and esoterics will be impacted.
With esoterics, issuers may have particular difficulty setting up to comply with rules and regulations concerning the production of historical and operating data, necessary diligence reports and certifications and functional cash flow modeling.
All of those considerations will obviously impact and shape what is going on with esoterics. "It is a different regime that we are all operating under, and Dodd-Frank has changed the regulatory landscape for these deals," Onbargi said. "Regulators have imposed new controls on the market, and market participants are getting their arms around these new requirements and working within them because they need to bring product to market."
There is the disclosure requirement as well as a more formal approach from the rating agency as dictated by Rule 17g-5.
"Pre-Dodd-Frank, you had the ability as an esoteric banker to brain storm with the agencies and talk about the viability of esoteric transactions," Onbargi said. "It was a very important feature in our space because esoterics are inherently about new asset classes. Although many of them are fairly well established in terms of rating methodology, as a good esoterics banker what you want to do is tackle brand new asset classes and see whether ABS constructs can be applied to these new asset classes."
Currently bankers have to be more formal with their approach to the rating agency - that means no more brainstorming. "Under rule 17g-5, we are required to hire the rating agency and then engage in a formal dialogue with appropriate disclosure and appropriate checks and balances that 17g-5 has imposed on the market," Onbargi said. "It has made issuing deals backed by novel asset classes more challenging. They aren't impossible to do, you just have to be more formal in terms of interaction with rating agencies."
He added that in terms of disclosure, when a deal comes to market, there is a certain amount of required information that must be delivered to investors in these deals. The attorneys that run these transactions are very cognizant of the appropriate level of disclosure to the market. "Even though our deals tend to be 144A or purely private deals, we are all working within the ambit of these regulatory controls on disclosure," Onbargi said.
Ratings are still very much a part of the financial landscape "so for insurance companies often their investment guidelines have constraints in them with respect to the ratings of the securities they can invest in," Wishengrad said in the ASR interview. "By no means do they rely on the rating. They need to do their own credit work. However,it would be incorrect to say the rating is no longer needed as it's often embedded into their investment criteria and is in many cases a prerequisite to their participation.
Growth Limited by Several Factors
Yet for all the accolades this segment of the securitization market has received, it is still relatively limited by its growth potential. Wishengrad pointed out that part of its limitation is created by the fact that there is only a subset of this business that would fit with securitization as a viable form of financing.
Businesses might also be limited by the rate of economic growth. Unlike segments like the mortgage market, the non-traditional space just doesn't have a tremendous need for capital to drive volumes.
Another limiting factor are the costs of doing a deal and the time needed to set up programs relative to other sources of liquidity in the market - whether its bank debt or high yield bond market funding. "Prior to the last financial crisis, these deals were often getting done with bond insurance and as a result they could be executed more efficiently," said Wishengrad in the ASR interview. "They only needed to be structured to an investment grade rating. The marketing process was significantly shorter because the issuers were selling 'AAA'-rated debt. The entirety of the process was less involved."
Today, he said, the primary constraint is that the relatively long lead time to do one of these deals and the upfront costs makes it difficult for new issuers to choose to go down this path.
The alternative is usually in the bank market, which may require a higher interest rate but offers faster execution. "So as an alternative to doing a whole business securitization, a restaurant company may choose to access the bank market or the high yield bond market. Those markets have become more challenged in recent weeks given the issues in Europe and this dynamic could help boost volumes in non-traditional ABS. Prior to the recent market disruption, the bank and the high yield bond markets offered issuers a shorter execution timeline albeit at a more expensive rate."
"Whether you are a CFO or a treasurer, you are relatively conservative and the most important thing is getting the money - not necessarily how you get the money," McDermittt said.
Wishengrad also pointed out that the securitization market has also remained open to esoteric deals whereas many market observers believed that the market was highly correlated with the high yield bond market and "when the high-yield market wasn't there the securitization market wouldn't be their either." That just hasn't been the case.
"Over the last six to eight weeks in particular with the debt ceiling crisis and European sovereign issues, the secondary market for non-traditional ABS has held up relatively well on a yield basis and when compared to what you've seen in the leveraged loan and high yield index," Wishengrad said.
Passage stated that some of the most interesting and innovative recent deals have been formulated by people at the more active private-equity fund management companies."They have on their desks very talented managers who are focused on coming up with novel deals to fund the businesses of their portfolio companies and to create value around the distressed assets they are acquiring," he said. "So many of these managers are now very much involved in the structuring of deals beyond identifying deals that might fit the goals of the funds they manage."
The job of a good investment banker is to continuously look after his clients' funding needs and to consider if the structured finance market place is an appropriate place to look for liquidity, Onbargi said.
"Our job as esoteric investment bankers is to approach customers with the adaptation of technology," he said. "Take structured settlements for instance - they are commonly securitized via ABS. However, 20% to 25% of production is "life contingent." Can we as bankers take technology from the life settlement market where private placements are done and build that into traditional structured settlement ABS to give our issuers liquidity options? The role of a good banker is to wrap his or her brain around such a possibility."
