ASSET-BACKED FINANCEOPPORTUNITIES FOR PRIVATE CAPITAL IN THE ERA OF BANK RE-REGULATION

Brendan McAllisterSeptember 2014

ABOUT THE AUTHOR

Brendan McAllisterPartner & 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.

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These structural shifts are particularly pronounced in the provision of credit collateralized by hard assets, where big banks are cutting back for all but the largest clients and transactions. As a result, we are not likely to see a re-emergence of a large bank-driven finance machine with the scale and reach that we saw before the crisis. Back then, banks were active in nearly every rung of the ladder, providing wholesale credit to originators, feeding most of the loans into an aggressive pipeline for securitizations, and retaining the riskiest and most lucrative parts of the structure on their balance sheets. But now, big banks are finding it harder and harder to jus-tify participating in these balance-sheet-intensive activities in the same way that they did pre-crisis.

This is an important, if slightly unsettling, development for a broad swath of the economy that depends on the provision of asset-backed credit. But the good news is that there is room for private invest-ment capital to step in to take advantage of these opportunities, while simultaneously restoring the flow of credit in these parts of the economy.

PROFITABLE, BUT ORPHANED

In this new era for banks, the two key considerations when as-sessing specialty lending transactions are scalability and profitability. Banks often find that financing transactions for large companies can justify the resources and balance sheet these types of deals require. This is not only because of scale, but also because specialty lending is one of many highly profitable services that they provide to clients, including advisory, trade financing, access to primary capital markets and a host of other services.

But asset-backed credit arrangements for more niche players in the lending markets increasingly are not making the cut at larger banks. These are certainly profitable transactions, but banks just 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.

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RESTORING THE REPUTATION

It takes a long time to forget negative news. Given their role in the 2008 credit crisis, securitizations and structured fi-nance continue to carry a negative con-notation for many investors, regulators and the general public. And while it’s true that the machinery of securitization was one of the modes through which lax underwriting and greed of the pre-crisis era were expressed, it was the excesses – not securitization itself – that bear the blame.

In fact, securitization plays a critical-ly important role in financing essential consumer and business assets. When originators or specialty finance compa-nies need capital to extend credit to end borrowers, they turn to lines of credit or warehouse facilities. As groups of similar loans stack up, it often makes eminent sense to bundle the loans together, carve out various layers of risk, and distribute it to a broad array of investors that want to take varying degrees of risk within that capital structure. From the financ-ing counterparties to the loan origina-tor to the end-borrower to the eventual buyer of the risk in the capital markets, these constituents form an interconnect-ed chain that is often referred to as the “financing continuum.” At a time when many banks are playing a more limited role, building a refined infrastructure de-pendent on investor capital will be key to restoring the reputation and functioning of this important system.

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. It is largely dependent on the type of transaction, any regulatory or licensing constraints, the economics of holding loans versus selling or securitizing, the customary prac-tices in the industry that is being financed, the fundamental macro-economic climate, and any number of other variables. With so much to take into consideration, it requires ingenuity and maneuverability on the part of a manager to ensure the right initiation and commencement of the risk exposure for investors.

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For many types of deals where regulations permit, the starting point will literally be at the starting point of the credit continuum. Financing to fund origination, such as the initial purchase by a leasing company of a large airplane, can be committed and structured either directly, through specialty finance companies, or brokers. When origination occurs, the asset – generally equipment or some kind of cash receivable such as lease payments – becomes the collateral. In these cases, a well-structured deal will identify the steps required to recover and monetize the underlying asset in the event of a default. Similarly, warehouse fi-nancing to loan originators, particularly in the commercial mortgage market, is another logical starting point. Originators generally rely on relatively short-term revolving lines of credit to fund new loans to homebuyers. This warehouse line is collateralized by the new commercial mortgages, and is paid back once those mortgages are sold or securitized. Due to licensing and regulatory requirements, asset managers face significant structuring issues when putting financing in place at this first phase of the lending continuum and need to ensure that the structure supports the regulations applicable to the assets being financed.

There are also entry points further along the continuum, such as acquiring critical masses of similar cash-flow-related collateral that can be bundled together, sliced into various degrees of subordination and risk exposure, and sold into the bond market. The lender can get essentially paid back all at once and at a premium, but may often elect to retain certain parts of the structure, specifically the most subordinated portions that pay the highest yields.

Additionally, there are investments that can be made to ensure a healthy pipeline of structures to finance. This might include various types of financial partnerships with firms that have niche industry or sector reach and the expertise needed to get deals done. As a result, it may make sense for alternative asset man-agers to seek exclusive contracts or even make common or preferred equity investments in specialty finance firms, asset operators or servicers.

SECURITIZATION

LOAN ORIGINATION

BORROWERS / COLLATERAL

FINANCE COMPANIES / ORIGINATORS

ALTERNATIVE INVESTMENT VEHICLE BOND MARKET

LOANS

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*Due to certain regulatory requirements, laws may need to be evaluated and selected on an individual basis. State and federal regulations may prevent implementa-tion of this structure for certain types of assets.

COMMITTING CAPITAL

At any given time, an investment manager might have a variety of different transactions at various stages within this continuum. Because all of these involve multi-year periods and are relatively illiquid, it is most appropriate for longer capital commitments than the traditional quarterly liquidity of hedge funds. In general, we believe a grouping of these loans is best suited for a multi-year time horizon, which would allow a manager to fund and aggregate a portfolio, earn interest, and sell or securitize the underlying as-sets.

The longer-term horizon presents a bit of a challenge for the tra-ditional constructs of investors and managers. Many institutional allocators target investments arbitrarily by constructing “buckets” that contain investments with like characteristics. The hedge fund bucket typically has investments that offer monthly or quarterly liquidity, while private equity usually has longer 10-year liquidity.

At the same time, the skill sets and expertise needed to proper-ly value and structure these types of transactions are most often found in hedge funds and banks that are experienced in loan-level selection, complex structures and securitizations. It also requires extensive relationships on Wall Street and with specialty lending firms and substantial legal and regulatory input. Without all of these elements, the market is virtually inaccessible.

Put simply, the time horizon for this type of lending fits best with private equity, but the skill set fits best with a fairly narrow subset of the hedge fund community. As a result, it doesn’t necessarily find an obvious home within the common yet oversimplified “buck-et filling” approach. It is clear that the hedge fund community is best positioned to actually manage this type of risk, but it will likely take some education and ingenuity on the part of hedge fund marketers and allocators to make sure the opportunity gets placed in the right part of a portfolio.

THE “ODD LOT DISCOUNT”

By definition, the larger and more liquid

a security or transaction is – particularly

in the fixed income markets – the more

likely it is to trade at a uniform price with

a small bid-ask spread. But what about

smaller, more specialized, and less liquid

transactions? In general, they are subject

to a phenomenon known as the “odd-lot

discount” in which they are priced at a

discount when acquiring or originating

the position, but will cede a discount

when selling the same asset.

This presents a challenge for investors

who are interested in taking on the risk,

but don’t want to take a hit when they

sell the risk. The solution is to attempt to

capture the discount on the way in, but

exit in ways that don’t require ceding the

discount on the way out. For some trans-

actions, the solution will be to simply get

paid back at par at maturity, while for

others the solution will be to securitize

the risk for sale into the bond market. In

either case, the investor can capture that

odd-lot discount when originating the

transaction but get paid back at par or

even at a premium on the way out.

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KEY AREAS OF OPPORTUNITY

Since regulation is currently getting phased into the banking system, the infrastructure for much of the asset-backed finance sector is just now getting repaired and rebuilt outside of the banking system. That means that there are significant opportunities for investors that are positioned to source and structure deals with complicated debt structures. This is no small task, since it requires considerable expertise in trading, valuation, legal, regulatory, compliance, structuring, research and risk management. But for those managers that are qualified, there are a broad and growing number of opportunities.

• Fixed-Wing Aircraft• Aircraft Engines• Helicopters

• Shipping• Equipment Leases• Cell Towers

• Installment Loans• Student Loans• Affiliate Lending

• Credit Cards Receivables• Sub-Prime Auto

TRANSPORTATION & EQUIPMENT

CONSUMER FINANCE

• Non-QM Mortgages• Contracts for Deed• Manufactured Housing• Small-Balance Commercial• Franchise Location Loans

• Investor Property• CRE Loan Buyout• Single-Family Construction• Reverse Mortgages• Non-Performing Loans

REAL ESTATE: RESIDENTIAL & COMMERCIAL

For illustration, we can take a closer look at three key areas:

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CONCLUSION

The key takeaway is that the changes to the financial system driven by the response to the 2008 crisis have created new opportunities. While much of the financial system is now running smoothly and some of the lower-hanging fruit has been picked, there are areas where damage persists, especially in the asset-backed structured financing. Banks that had previously dominated the sector are less able and less willing to take the lead, which is good news for private capital, which can step in to help channel liquidity back into this vital part of the economy. Market-based financing driven by investors is uniquely suited to take advantage of these opportunities and hedge funds are best positioned given their mix of sector and financial expertise.

Residential real estate and consumer lending transactions will be the subject of the most onerous licenening and regulatory hurdles.

THANK YOU FOR YOUR CONTINUED SUPPORT AND INTEREST IN PINE RIVER.

Please contact us with any questions or to request additional information at investors@prcm.com.

This document or any portion hereof may not be reprinted, sold or redistributed without the written consent of Pine River Capital Management. We do not warrant its completeness or accuracy. There may be more recent information available. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice.

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