fixed income perspectives - diamond hill

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Asset-backed securities (ABS) were introduced to the marketplace in the mid-1980s, when Sperry Lease Finance created a new type of securitization, one backed by computer equipment leases. Prior to the introduction of the Sperry ABS deal, mortgages served as the main source of securitization. Securitization begins with an agreement between a lender and a borrower as to the amount borrowed, interest rate paid, collateral used to secure the loan, and loan maturity. (For a more in-depth understanding of the process of securitization and the benefits to investors, please see our previous paper, “Mechanics and Benefits of Securitization”). The borrower’s obligation is then sold, or pledged, to a trust along with other similar loans, creating the securitized product. Since the initial ABS deal, the market has continued to grow and diversify through the implementation of new types of securitization, ranging from auto loans and leases to cell phone payments. Here, we will focus on the evolution of the ABS market and the emergence of new offerings over the past several years in response to the changing market environment since the 2008 Financial Crisis.

According to the Securities Industry and Financial Markets Association (SIFMA), the ABS market is currently a $1.6 trillion market1 that has seen substantial growth since its emergence in the mid-1980s (see Figure 1).

Fixed Income PerspectivesAN EDUCATIONAL SERIES

November 2018

The Evolution of the Asset-Backed Securities Market

Douglas GimpleSenior Portfolio Specialist

• Growth in the asset-backed securities (ABS) market over the past 10 years has provided diversification and strong risk-reward characteristics in a sector largely ignored by the Bloomberg Barclays U.S. Aggregate Index.

• As growth in some historic sectors of the ABS market slows, the emergence of new securitization sectors has expanded the opportunities available to investors.

• The Diamond Hill fixed income team is able to exploit some of the pricing inefficiencies in the ABS market through our bottom-up analysis, along with our deep understanding of deal structures and the companies bringing them to market.

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Automobile Credit Card Equipment Other Student Loans CDO/CLO*

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FIGURE 1: GROWTH OF THE ABS MARKET SINCE 1985

Source: SIFMA.*Collateralized Debt Obligations/Collateralized Loan Obligations.

https://www.diamond-hill.com/mechanics-benefits-securitization/

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FIXED INCOME PERSPECTIVES: THE EVOLUTION OF THE ASSET-BACKED SECURITIES MARKET

The ABS market peaked in 2007 at $2 trillion ahead of the Financial Crisis and subsequently began to decline post-Crisis, as issuance was greatly reduced and outstanding deals continued to pay down. The market didn’t begin to rebound until 2013, when securitization expanded beyond the traditional categories.

Although the ABS market has experienced considerable growth since the mid-1980s, it still remains the smallest subset of the fixed income universe, trailing treasury, corporate, mortgage-related, municipal, and federal agency debt (Figure 2). However, it is important to note that small does not mean illiquid, concentrated, or risky. On the contrary, the ABS market offers investors a chance to diversify by investing in a broad market comprised of a variety of asset types. Additionally, the manner in which these deals are structured allows an investment manager to determine the level of risk they are willing to assume when investing.

Autos

Over the years, the auto ABS market has evolved, offering a wide variety of structures and opportunities for investment managers that go beyond typical securitization using auto loans as collateral. The auto securitization market started with prime (borrowers with FICO scores greater than 720) and near prime (mid-to-high 600s to low 700s) auto loans. However, as those markets continued to grow, investment bankers realized they could expand the securitization market to auto fleets, floorplans, and other markets. The securitization of auto loans dipped into the subprime market (475-650 FICO scores) in the early-1990s, and this segment of the market has since become the third largest segment of the auto ABS market. The variety of auto ABS combined with the tranche structure within the securitization market provides investors with a broad selection of opportunities that appeal to their specific risk-reward appetite.

FIGURE 2: OUTSTANDING U.S. BOND MARKET

Source: SIFMA. As of June 30, 2018.

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Federal AgencySecurities

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Credit Cards

Securitization of credit card receivables peaked prior to the 2008 Financial Crisis, with roughly $323 billion of outstanding debt at the end of 2007. As consumers worked to deleverage post-Crisis and reduce their debt profile, the amount of outstanding credit card securitization dropped nearly every year from 2008 through the end of the third quarter in 2018. This deleveraging trend, combined with new innovations in the personal loan business, has led to continued decline in the reliance on credit cards. Bank credit card securitization is clearly the leader in this segment of the market, consisting of $108 billion of the $123 billion currently outstanding,1 with the remainder found in retail card securitization. Issuance in credit card securitization peaked in 2007 with an all-time high of $95.7 billion in issuance, followed by $55 billion and $51.5 billion in 2008 and 2009, respectively. In 2010, issuance plummeted to $6.5 billion, the lowest level since the early days of the market in the late-1980s. Since that low point in the issuance cycle, the industry has trended higher, averaging $36.7 billion in issuance from 2013-2017, with $25.8 billion issued year-to-date through September 2018 (Figure 4).

As of 12/31/88 As of 9/30/18

Fleet $0.0B $12.4B

Floorplan 0.0 32.2

Leases 0.0 25.1

Motorcycle 0.0 0.2

Near Prime 0.1 3.3

Prime 13.4 83.3

Rental 0.0 10.7

Recreational Vehicles 0.1 0.1

Subprime 0.0 51.5

FIGURE 4: CREDIT CARD ABS

Source: SIFMA.

Source: SIFMA.

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FIGURE 3: AUTO SECTOR BREAKDOWN



Equipment

As the name indicates, this segment of the ABS market is supported by cash flows generated by pools of equipment lease contracts. The equipment lease securitization market began in 1985, with roughly $300 million in outstanding assets by the end of that year. The growth of this market started off slowly through its first decade of existence before truly hitting its stride. From 1985-1995, the market expanded from $300 million to $12.5 billion and then grew to $49.4 billion by 2005. Today, the market is comprised of $64.3 billion in outstanding securities.1 The largest component of the equipment securitization market is transportation ($41.9 billion1), followed by leases ($10.6 billion). The equipment leasing industry has had its share of challenges, specifically the bankruptcies of National Century Financial Enterprises, DVI, Inc., and NorVergence. While fraud was the leading reason for the failure of these companies, investor confidence in this sector of the market was shaken. The period leading up to the Financial Crisis served as a cleansing of the industry, as 11 firms were acquired and left the business, seven filed bankruptcy, five ceased operations, and 16 no longer used securitization as a funding source. The remaining 20 or so firms that emerged from the Financial Crisis were better capitalized to move forward and compensate for the lost competitors.

Student Loans

According to the Federal Reserve,2 outstanding student debt is currently around $1.5 trillion,3 and an estimated $176.6 billion of these loans are securitized into student loan asset-backed securities (SLABS) and sold in the marketplace. SLABS include loans from the former Federal Family Education Loans Program (FFELP, terminated in mid-2010) that continue to be securitized into ABS offerings and private loan issuance from firms like Sallie Mae Bank and newer entrants to the market like SoFi, CommonBond, and Navient (spun off from Sallie Mae in 2014). In the years leading up to the Financial Crisis, SLABS issuance exceeded $50 billion per year, but post-Crisis, issuance has declined substantially (see Figure 5). This decline can be attributed to the demise of FFELP in 2010 and the federal government’s decision to implement its Direct Loan Program without securitization, using Treasury issuance instead. Stepping in to fill the void is a new generation of companies focused on assisting students in paying for school, and helping graduates refinance long-dated student loans. Companies like SoFi and CommonBond have built sizable student loan businesses by taking a unique approach in reaching clientele, focusing on social media and online models to target highly-educated, high-income borrowers. These companies look beyond the standard FICO score when determining creditworthiness of borrowers, though FICO scores do play a part in the process. As the private SLABS market continues to grow, opportunities are presenting themselves to investors willing to spend the effort and time to understand the intricacies of these deals and identify proper risk-reward metrics.

FIGURE 5: HISTORICAL SLABS NEW ISSUANCE

Source: INTEX, KBRA Research. 2018 data is year-to-date through September 30.

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Collateralized Debt Obligations (CDOs)/Collateralized Loan Obligations (CLOs)

While CDOs continue to wind down, with no new issuance in the sector since the Financial Crisis, CLOs continue to grow as a segment of the overall fixed income markets. CDOs have decreased in size from $206.8 billion as of September 30, 2008, to just $63.5 billion as of September 30, 2018. Over the same time period, the CLO market has grown from $266.3 billion to $597.8 billion. As of September 30, 2018, there was roughly $764.2 billion in outstanding CLOs, CDOs, and Other in the market, making up nearly half of the total outstanding assets in the ABS market.

While these securities are included in the ABS sector per SIFMA, they differ substantially from their ABS brethren. Traditionally, autos, credit cards, and other areas of the ABS market are securitized by grouping like assets, but CLOs are a diverse pool of senior secured bank loans made to businesses that are typically rated below investment grade. Even though CLOs share some structural aspects with the rest of the ABS market, such as overcollateralization and waterfall payment structures, there are aspects where they differ substantially. CLOs are actively managed, meaning that the manager of the CLO can add or remove positions from the pool in an effort to improve returns and/or risk characteristics. Research associated with CLOs involves not only the analysis of the structure of the deal but also an analysis of the underlying companies that provide cash flows for the asset. While CLOs are included in the ABS market by SIFMA, they are quite different from the standard areas of the market and require a certain level of expertise to identify potential risks and opportunities.

Other

While nondescript in its definition, the Other category in the ABS market is one of the fastest-growing segments of the market since the Financial Crisis, and an area that continues to evolve. Over the last 10 years,1 the overall ABS market has declined 17.7%, yet the Other category within the market has grown an astonishing 88.2%. Using the subcategories provided by SIFMA, note that four of the 12 categories were not in existence 10 years ago, and a fifth category was only $200 million in outstanding assets.

Next, we’ll explore some of the new areas in the ABS market and the opportunity set in this ever-evolving sector.

9/30/08 9/30/18

Cell Phone Contracts $0.0B $7.5B

Cell Tower Leases 5.7 12.6

Consumer Lending 0.0 28.5

Franchise 8.2 20.6

Insurance 33.6 60.1

Property Assessed Clean Energy 0.0 4.2

Small Business Administration 28.7 36.5

Servicing Advances 0.2 7.1

Solar 0.0 3.0

Structured Settlements 1.9 3.9

Timeshare 3.3 6.7

Utility/Stranded Costs 17.6 5.7

$99.2B $196.6B

Source: SIFMA.

FIGURE 6: GROWTH AREAS OF THE ABS MARKET



Cell Phone Contracts

In an effort to offset the rising cost of cell phones and extend client retention with multi-year contracts, phone carriers have moved away from subsidizing the cost of cell phones, instead charging consumers the full market price for devices. By amortizing the cost of the cell phones over the period of the contract (24-36 months), carriers create a monthly receivable due from customers. Verizon was the first company to leverage receivables from cell phone payments to access a cheaper source of debt financing and has issued six different deals since July 2016, totaling more than $7 billion with an additional $1.6 billion issued in October 2018. There are a variety of benefits to the carrier issuing bonds securitized by payment plans: liquidation of longer-term cash flows, reduction of the overall cost of debt in primary markets, stronger credit ratings awarded to the securitization over unsecured corporate debt, and freeing up capital to reinvest in infrastructure and the acquisition of additional services. These securities have performed well since their introduction to the market in 2016 and continued growth is expected, providing investors a source of diversification within the ABS market.

Consumer Lending

Since the Financial Crisis, marketplace lending and brick and mortar lending have emerged as alternative forms of financing to unsecured loans from traditional financial institutions, growing into a $28.5 billion area of the ABS market today.1

The marketplace lending business began with a British firm, Zopa, in 2005. Born from an idea that combined the financing aspects of the bond market with the innovation of the largest marketplace in the world, eBay, Zopa created an online marketplace for consumer loans. Essentially, the firm utilized technologic advances to bring together borrowers and investors. In doing so, two needs were met: borrowers found a way to finance their debt in a quick manner without the red tape of bank approvals and forms, while investors were able to generate attractive returns while diversifying risk amongst a variety of borrowers. The success Zopa experienced in building a book of loans led to the launch of counterparts in the U.S., such as Lending Club and Prosper, in 2006. Thus, the peer-to-peer lending industry in the United States was born.

As the Financial Crisis spread throughout the economy, individuals turned to peer-to-peer lending companies for borrowing needs as banks put a hard ceiling on the size of their loan portfolios. However, this growth was a double-edged sword. Due to the Financial Crisis, borrower default levels increased, which raised investor concerns and lead to higher interest rates for borrowers to compensate investors for the additional risk.

As the peer-to-peer industry grew, it also evolved from simple loans between borrower and investor. Institutional investors (hedge funds, insurance companies, etc.) began to fund loans for various entities that had emerged from the ashes of the Financial Crisis to originate consumer and small business loans. These firms were filling a void created by the departure of large financial firms that were focused on shoring up balance sheets. As the business model evolved, so did the nature of the companies participating in this industry. Previously, marketplace lenders were bringing together individual borrowers and investors and serving as the facilitator (for a fee). Post-Crisis, new entrants in the market (SoFi, Earnest, Avant) were functioning more as traditional lenders and utilizing funds raised through forward purchasing agreements with institutional investors.

Brick and mortar lending serves consumers by providing physical locations in which to conduct the business of applying for and making payments on loans. This service appeals to customers that value face-to-face interaction when conducting business and are looking for guidance through complex financial transactions.



Servicing Advances

In an effort to reduce leverage, operational risk, and cost, mortgage lenders can sell mortgage servicing rights to specialized firms. Mortgage servicing firms are paid a portion of mortgage payments to handle the logistics of servicing mortgage loans and can help reduce delinquency levels by working directly with borrowers in times of stress. Mortgage servicing firms’ responsibilities include, but are not limited to, acceptance and recording of mortgage payments, calculating variable rates on adjustable mortgages, payment of taxes and insurance, workouts and modifications, and supervising foreclosures. A component of mortgage servicing rights is servicing advances, which are reimbursable cash payments made by the servicer if a borrower fails to make a scheduled payment, or to support the value of the collateral property. These payments are not meant to serve as credit enhancement, but to provide liquidity to the underlying securitization. Servicer advances are traditionally repaid from receipts associated with mortgage loans and represent a separation of a component of the mortgage servicing rights, securitized as a stand-alone credit.

Property Assessed Clean Energy (PACE)

PACE began in one of the most environmentally conscious communities in the United States: Berkeley, California. In November 2007, the Berkeley City Council took an innovative approach to assist residents interested in joining the green energy movement. Berkeley First was a new program to facilitate solar energy system installation by establishing a voluntary, long-term assessment on an individual’s property tax bill. Berkeley established the Sustainable Energy Financing District to fund the installation of solar electric systems and repay the financing through property tax bills over a preset time period of 20 years. As the innovator in this new field, the program delivered four distinct advantages to homeowners trying to reduce their reliance on fossil fuels:

• Little upfront cost to the property owner.• Capital costs would be repaid through a voluntary tax on the property, avoiding any

impact to the property owner’s credit.• Cost of the system would be comparable to financing through a home equity line of

credit or second mortgage as the bond is secured by the home.• Obligation for the loan transfers with the property.

Though PACE programs, both residential and commercial, have grown substantially over the last decade, the securitization of these loans is still in the early stages. Unlike most other ABS deals, the collateral associated with a PACE transactions is not a loan or lease, but a voluntary tax lien agreed upon by the residential or commercial property holder in order to finance energy-efficient improvements. The first securitization for commercial-PACE was completed in September 2017 by Greenworks Lending. This was a private deal arranged by investment management firms and, while not publically available, illustrated the feasibility and appetite for such deals.

Residential PACE’s first securitization, HERO 2014, was completed by Renovate America on behalf of the Western Riverside Council of Governments (WRCOG). The WRCOG had to complete this securitization through state and federal legal channels due to reservations and objections from the Federal Housing Administration (FHA). Due to this legal wrangling between the FHA and the PACE industry, less than 40% of the mortgages linked to the residential properties in the deal were financed by government-sponsored enterprises. This initial $104 million deal was rated AA by Kroll and delivered a coupon of 4.75% with significant excess spread, overcollateralization, and a liquidity reserve of 3.0%. Participation in the deal was described as “big and chunky,” as the transaction was not broadly distributed, but more focused on specific investors. This initial foray into securitization was followed by the second PACE securitization seven months later, which was issued on behalf of the WRCOG and the San Bernardino Associated Governments.



According to industry group PACENation, the size of the residential PACE securitization market has grown from the first two deals in 2014 totaling over $230 million to nearly $1.5 billion in 2017.

Solar

Growth in the alternative energy market has resulted in significant migration to solar panel utilization. Prior to the introduction of securitization, the solar sector had been dependent upon investment tax credits and other subsidies to finance projects. Much like the other sectors discussed in this paper, securitization of solar panel financing has made this sector more accessible to investors. Regulatory limitations prevent master limited partnerships and real estate investment trusts from participating in the market, making securitization the most effective and efficient method of exposure to this sector. Since its introduction in 2013, the solar securitization market has grown exponentially, finishing the third quarter of 2018 with $3.0 billion outstanding, an increase of $900 million from the previous year-end. Even as the market grows, the basis of the securitization has changed. Initially, securitizations were dominated by purchasing power agreement leases, but have shifted to solar loans. A purchasing power agreement is a contract where an individual or business permits solar panels to be installed on their property and agrees to purchase the power at a preset rate over a contracted period of time. The process of securitization in this market is still in its infancy, and there are obstacles ahead that may hinder the pace of growth. Going forward, the most important challenges to overcome are the lack of a steady market and the necessity of expansion beyond residential solar securitization. But, as the world turns more to renewable energy and investors focus on green investing, the potential for solar securitization continues to grow.

Emerging ABS Markets

As investors look for additional diversification and investment opportunities, the ABS market continues to evolve beyond the previously mentioned categories. Securitization deals ranging from diamonds, to agricultural crops, to venture capital have emerged over the past few years, and investors can expect even more innovative offerings in the future.

Opportunity for Diligent Managers

The Diamond Hill fixed income team is able to exploit some of the pricing inefficiencies in the ABS market through our bottom-up analysis, along with our deep understanding of deal structures and the companies bringing them to market. Meeting with firms that issue these deals on a regular basis provides insights into the issuing firm’s history, philosophy, background, and financial stability. We combine the qualitative aspects of understanding a company with the quantitative methodology of breaking down deals to their basic components to truly understand how they are structured and where risks may reside.

Capacity discipline also plays a very important role in the ongoing management of our fixed income strategies. Our smaller size allows us to take advantage of securitization deals that larger firms would not consider, as the size of the deal would be a negligible addition to a very large strategy. At Diamond Hill, portfolio managers are solely responsible for determining capacity estimates for their strategies. The key consideration when determining a strategy’s capacity is what asset size may hinder our ability to add value over a passive alternative. Our portfolio managers have the authority to close their strategies before they reach an asset size where they believe that they can no longer add sufficient value.

The views expressed are those of Diamond Hill as of November 2018 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

¹ As of September 30, 2018.² https://www.federalreserve.gov/releases/g19/current/default.htm.³ As of June 30, 2018.

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