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Asset-Backed Finance Opportunities for Private Capital in the Era of Bank Re-Regulation

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Asset-Backed Finance Opportunities for Private Capital in the Era of Bank Re-Regulation ASSET-BACKED FINANCE OPPORTUNITIES FOR PRIVATE CAPITAL IN THE ERA OF BANK RE-REGULATION Brendan McAllister September 2014 ABOUT THE AUTHOR Brendan McAllister Partner & Portfolio Manager Brendan is a Partner and Co-Portfolio Manager of the Pine River Fixed Income Fund. As Head of Mortgage Credit and Asset-Backed Trading, Brendan is a senior member of the team that led Pine River’s highly successful investment initiatives in Non-Agency Mortgage-Backed Securities in the wake of the 2008 financial crisis. He is also a lead- er of Pine River’s efforts in Asset-Backed Finance. Brendan serves as President of The Pine River Foundation and is a member of the firm’s Charitable Initiatives Committee. Prior to joining Pine River in 2008, Brendan served as an Institutional Fixed Income Salesman in the Se- curitized Products group at UBS Securities in New York, specializing in Non-Agency mortgage bonds. He received a BA with a double ma- jor in Economics and Political Science at the University of Rochester. INTRODUCTION It’s an often-fitting analogy to describe financial markets as a system of plumbing that facilitates the sup- ply, demand and movement of capital in the broader economy. Just as plumbing is woven intricately into a city and employs a complex array of supply lines, drains, reservoirs, conditioners and specialty fixtures, the credit market is a complex network of channels and structures through which capital gets from those who have it to those who need it. Perhaps most importantly, both plumbing systems and financial markets share the trait that the flow can be stressed and instantly clogged or even halted by a number of factors. The 2008 global financial crisis illustrates just how quickly everything in the system can fail. The water mains broke, the drains were clogged, leaks sprung up all over the place and questions arose about the toxicity of all but the purest water. The years since the crisis have in large part been spent both repairing and redesigning the system to ensure firstly that the economy can run, and secondly that such a serious breakdown of the system is less likely in the future. VARIOUS STATES OF REPAIR IN THE CREDIT CONTINUUM In the six years since the crisis, listed and over-the-counter securities from equities to high yield bonds to mortgages have reverted to what most people agree to be at or near full valuations. Even the legacy secu- ritization market that was once considered “toxic” has seen distress dissipate and prices have recovered from deeply discounted levels. The road to recovery was in large part a function of the attractive prices – far below their intrinsic value – that these securities reached in panic selling during the crisis. It was also helped by an extremely accommodative monetary policy which encouraged investors to chase yield, and by the resilience of the U.S. economy itself, where job growth and a housing recovery naturally lifted the value of mortgages. This recovery of distressed prices was a major first step on the “repair” side of the equation. But a good deal of the financial plumbing still remains either partly or fully broken and will require a sub- stantial redesign and new participants (i.e., private capital) to work again. In these cases, changes will be structural because vast new banking regulation put into place since the crisis is entirely reshaping the way that banks participate in many parts of the financing continuum. These new rules – particularly Basel III and Dodd/Frank – have greatly increased the amount of capital banks must hold against assets on their balance sheets and curtailed proprietary trading activity. The result is that certain areas of the continuum – particularly outside of the securities markets – will not revert to the old, “business as usual” way of doing things. 3 These structural shifts are particularly pronounced in the provision of credit collateralized by hard assets, where big banks are cutting RESTORING THE REPUTATION back for all but the largest clients and transactions. As a result, we It takes a long time to forget negative are not likely to see a re-emergence of a large bank-driven finance news. Given their role in the 2008 credit machine with the scale and reach that we saw before the crisis. crisis, securitizations and structured- fi Back then, banks were active in nearly every rung of the ladder, nance continue to carry a negative con- notation for many investors, regulators providing wholesale credit to originators, feeding most of the loans and the general public. And while it’s into an aggressive pipeline for securitizations, and retaining the true that the machinery of securitization riskiest and most lucrative parts of the structure on their balance was one of the modes through which lax sheets. But now, big banks are finding it harder and harder to jus- underwriting and greed of the pre-crisis era were expressed, it was the excesses tify participating in these balance-sheet-intensive activities in the – not securitization itself – that bear the same way that they did pre-crisis. blame. This is an important, if slightly unsettling, development for a broad In fact, securitization plays a critical- swath of the economy that depends on the provision of asset-backed ly important role in financing essential credit. But the good news is that there is room for private invest- consumer and business assets. When originators or specialty finance compa- ment capital to step in to take advantage of these opportunities, nies need capital to extend credit to end while simultaneously restoring the flow of credit in these parts of borrowers, they turn to lines of credit or the economy. warehouse facilities. As groups of similar loans stack up, it often makes eminent PROFITABLE, BUT ORPHANED sense to bundle the loans together, carve out various layers of risk, and distribute In this new era for banks, the two key considerations when as- it to a broad array of investors that want sessing specialty lending transactions are scalability and profitability. to take varying degrees of risk within that capital structure. From the financ- Banks often find that financing transactions for large companies ing counterparties to the loan origina- can justify the resources and balance sheet these types of deals tor to the end-borrower to the eventual require. This is not only because of scale, but also because specialty buyer of the risk in the capital markets, lending is one of many highly profitable services that they provide these constituents form an interconnect- ed chain that is often referred to as the to clients, including advisory, trade financing, access to primary “financing continuum.” At a time when capital markets and a host of other services. many banks are playing a more limited role, building a refined infrastructure de- But asset-backed credit arrangements for more niche players in pendent on investor capital will be key to the lending markets increasingly are not making the cut at larger restoring the reputation and functioning banks. These are certainly profitable transactions, but banks just of this important system. don’t see loans of that size as being strategically important because their balance sheets are more constrained and there is little room for inefficient use of this precious com- modity. At the same time, smaller regional banks are not eager to take the business because they are con- centrating on simpler lending within a very tight credit box. 4 Put simply, there are highly profitable opportunities to extend asset-backed financing that are essentially being orphaned as traditional lenders have stepped away. For alternative asset managers with the credit and structuring experience, the specialty finance arena presents an opportunity to help to finance and aggregate cash-flows in a less liquid form which might then be converted into a more liquid form via securitization. A number of legal and regulatory challenges still exist for private capital participating in the securitization space, but there is an opportunity to offer clients attractive potential returns by stepping in to serve a segment of the market that became impaired by the large banks’ exit as a result of the regulatory response to the financial crisis. As we examine the broadly defined area of asset-backed lending, it is worthwhile to step back and define the characteristics of the transactions we are discussing and how they fit into the lending continuum. ATTRIBUTES OF ASSET-BACKED TRANSACTIONS • COLLATERALIZED BY HARD ASSETS: Asset-backed transactions are backed by physical assets such as equipment, or by cash flows such as lease contracts or mortgages. This contrasts with many sorts of traditional “lending” in which capital is backed only by the credit of the borrower. • STRUCTURED: Because of the complexity of applying hard-to-value cash-flow producing assets as collateral, these transac- tions tend to be highly structured to ensure that risk, cash flows and recovery are all accurately defined to ensure certainty and protection to both the borrower and the lender. • VARYING DEGREES OF LIQUIDITY: At the finance and origination level, transactions are illiquid relative to the securities markets because they are unique, complex and difficult to accurately mark-to-market. This is not a simple buy-low/sell-high market, but one which requires considerable expertise in which to enter and exit transactions. In some cases, it may be attractive to hold these loans, collect interest, and get paid back at maturity. In other cases, it makes sense to sell or securi- tize the transactions, taking a group of less liquid financing transactions and transforming them into more liquid securities. A RANGE OF ENTRY AND EXIT POINTS What are some of the strategies that investors can use to participate in asset-backed transactions? For funds that can raise money specifically for specialty and asset-backed lending, there are many logical entry points throughout the credit continuum.
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