Asset-backed securities field guide
Financial services are not immune to the civilisational sweep of the information revolution. As the consumer world glommed onto digital watches, space invaders calculators, Donkey Kong and the graphic user interface so was the banking world being rocked by a Cambrian explosion of sophisticated financial engineering. Swaps, securitisations and investment management mushroomed in the nineteen-eighties.
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The Law and Lore of Repackaging
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Transformation
The revolution was, at first, curiously non-technological. Egged on by the sweet sirocco breeze of economic liberalisation, the pioneering financial innovations of the eighties owed little to the digital age beyond perhaps a willingness to look at old things in a new way. The technology inside a swap was ancient — loans — the innovation was simply to juxtapose offsetting loans, in different currencies, between the same parties, and then do some clever monkey-business to calculate a net present value.
Electronic booking systems made it easier to manage complicated cashflows, but to that extent, technology only sped up the derivatives market but did not actually enable it.
The JC’s nascent view: the technological sine qua non of financial innovation was the humble word processor. Once you could type things on a computer, it just became easier to draft, to mash up, to iterate, to duplicate and propagate. You didn’t have to re-type every page from scratch. Once you could send your files electronically — even by fax — everything became easier still. Bummer for sub-60 couriers and everything, but hey: Deliveroo.
Suddenly we had quite heavily structured derivatives, a neat way to aggregate and resell portfolios of small, idiosyncratic assets, and even ways to reallocate the portfolio risk among different classes of investors with different risk/return profiles. A brave new world beckoned. For the most part, it hasn’t disappointed.
Laterality: OTC versus traded
For all the explosion in innovation, some things stayed the same. In financial markets there has always been a fundamental distinction between the private and bilateral on one hand, symbolised in financial circles by the counter, and the public and unilateral on the other hand, symbolised by the exchange. The OTC contract and the traded instrument.
Bilateral: over-the-counter
The bilateral world is the one of private, two-party (or definable, small number of parties) “over-the-counter” contracts. Contractual counterparties know each other, have a business relationship, are bound into a long-term commitment which they are at liberty to discuss and, if circumstances change, adjust, to meet their common needs. They can see the whites of each other’s eyes. These products are things like loans, swaps, guarantees and securities financings: instruments one cannot trade “on exchange”.
Indeed, one does not typically transfer them at all. While you can transfer the economic risks and benefits of an OTC contract, by novation, assignment or sub-participation, doing so is fiddly. It often requires the borrower’s consent, due diligence and legal documentation. Chin-scratching. KYC. It is laborious.
The “officious bystander” has none but a voyeur’s interest in these arrangements. They are none of her business.
Unilateral: traded
Unilateral contracts are available to all the world. We are in the land of carbolic smoke balls: on obligor creates a financial instrument gives it corporeal form that it can make its own way in the world, wishes it well and — against payment of subscription price — lets it go. It might periodically come back, but on to collect interest or for final redemption. It is, in one way or another, negotiable.[1] These are products like shares, bonds, warrants, futures and options.[2] The instruments themselves may or may not have a term, but individual investors make no formal commitment to hold for any period. They can buy and sell at any time.
Unilaterality has its pros and cons. traded products are, by definition, more liquid: I can get in and out of a position without the borrower’s knowledge, let alone permission, by buying selling in the secondary market. We have no relationship at all: the borrower neither knows nor cares who I am. It grants me no special favours. Exchange-traded products tend towards standardisation of terms, to encourage liquidity. This has regulatory advantages: many institutions can only make investments they can easily get out of, and tradable securities more easily meet that requirement.
Meeting of the twixt
Just as, on our ad hoc theory, it revolutionised finance so did the word-processor bridge the divide between the “private, fiddly, and bespoke” bilateral contracts and “public, plain and standardised” unilateral instruments. The technology to obliterate that divide, with electronic clearing, distributed ledgers and so on perhaps now exists, but if it does, is emerging slowly.
For the time being there are over-the-counter contracts, and there are traded ones. But some of the traded ones have a lot more of the characteristics of OTC contracts than they ever used to. An asset-backed security is often just a portfolio of bilateral contracts — loans, derivatives, options, guarantees — rounded up and put into a special purpose vehicle, which brings no credit exposure of its own, but simply “securitises” the asset swap package, converting it into a traded instrument.
Hence the manifold varieties of asset-backed security: the securitisation, the collateralised loan obligation, the collateralised debt obligation, the credit-linked note, and the humble repackaging.
Challenges across the bridge
But, as ever the immovable object of substance meets the irresistible force of form. Simply securitising a bilateral contract doesn’t take away the natural nervousness counterparties have to its customised terms. If they are connected bilaterally and a lender can see the whites of the borrower’s eyes it can intervene, push back and make representations should the borrower go about exercising its rights, calculating its rates, or performing its obligations in an unconscionable way. There is a communication channel through which such differences of opinion can be aired and resolved.
But once that relationship is intermediated by a traded note, that channel goes away. The borrower need not even know who its lenders are. Its lenders may change, at any time, and there may be a host of them. Before the advent of clearing systems, notes could just be lost forever. And even if you do know who all the holders are, what if they disagree? What if some care, and some do not? What if you can’t get some of them to pick up the phone, or to present themselves at the offices of the Luxembourg paying agent for a meeting of Noteholders?
When notes were definitive physical format this problem was truly insurmountable. Now they are electronically cleared, there is at least a way of reliably communicating with all holders for the time being, but it is cumbersome, and getting them all to understand, or agree is something else.
The traditional solution has been to appoint a trustee or fiscal agent of some sort to represent noteholders interests. This isn’t really much use as trustees won’t lift a finger except to take action that is categorically in the interests of all noteholders — they don’t get paid enough, they say — and the sorts of arguments parties to bilateral contracts get into are shaded, nuanced, and not the sorts of things trustees can get comfortable with taking a position on. The other parties to the structure who might have a view, and the capability to make complicated calculations, tend to have interests that are not aligned with Noteholders’. A swap counterparty, for example, is generally the other side of the trade to the Noteholders.
Repackagings
This is a fairly insurmountable problem for widely-held, really publicly traded ABS transactions like securitisations and CLOs. Noteholders just have to take a view, that the people originating and sponsoring the deal are good people, and will not take the proverbial.
But in smaller scale repackaging deals, things are different. These tend to be tailored deals made to order for a specific investor. They are not usually listed or publicly quoted, the original investor takes down the whole deal and, for the most part, sits on it, perhaps financing it in the market, but staying long the economic risk of the transaction.
These trades are in concept tradable, but they don’t really trade: no-one in her right might would actually buy one in the secondary market without all the due dilly, negotiation and documentation you’d expect for an OTC novation.
Using the cumbersome note mechanics to manage valuation disputes, amendments, and unexpected contingencies of the sort that often arise on early unwind is possible, but there’s generally a better means of resolving these, bilaterally, with the original purchaser standing in for “the noteholders for the time being”. This is theoretically problematic — what if the original purchaser has in the mean time on-sold all or part of its holding? — but not in the ordinary course practically so as, for the reasons given, it won’t have. And it can be resolved by some representation, required at the time of any consultation, that it is the sole noteholder, or speaks for all outstanding noteholders, or in any event indemnifies the arranger and transaction parties for lossed caused from anything done at its suggestion should it turn out not to be.