Asset-backed securities field guide
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The Law and Lore of Repackaging
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Transformation
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.
The revolution was, at first, curiously non-technological.
Egged on by the sweet sirocco breeze of economic liberalisation, pioneering financial innovations in the 1980s owed little to the digital age beyond a willingness to look at old things in a new way. The technology inside a swap, for example, is ancient — loans — the innovation being simply to juxtapose offsetting ones, in different currencies, between the same parties, and then do some clever monkey-business to calculate a net present value. Even mark-to-market accounting that facilitated this had been around since before the great depression.
Electronic booking systems made it easier to manage complicated cashflows, but to that extent, technology only sped the derivatives market up: it did not enable anything you could not have done with paper and pencil. Likewise, dematerialised clearing arrived in securities markets in the late 1970s, but had remarkably little impact on how deals were documented or the market infrastructure felt about them. It still doesn’t: indeed, bond market infrastructure is still predicated on the uneasy fear that clearing might be just a fever dream, or is liable to be rendered permanently inoperable by some kind of electromagnetic pulse whereupon the world will have to return to its old analogue security-printed ways, festooned with paying agents, coupons, talons, Belgian dentists, and Balearic benders.[1]
Lawyers are, after all, good at studiously ignoring progress when it promises to put them out of work, and just as adept at embracing any progress that promises to create more of it.
Therefore, the JC’s unfashionable view: sine qua non of financial innovation in the 1980s was the word processor.
Once you could type things on a computer, it just became easier to type out more things; to redraft, mash up, iterate, duplicate and propagate. You didn’t have to re-type every page from scratch. You didn’t need to faff around with carbon paper. Once you could send files electronically — you know, fax — everything became easier still. It was bummer for sub-60 bike couriers, but hey: Deliveroo.
Suddenly we had quite heavily structured derivatives, tediously documented, 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, and all thanks to the ease of putting words on paper.
For the most part, it hasn’t disappointed.
Laterality: private OTC versus public traded
For all that explosion in innovation, some things stayed the same. There has always been a fundamental distinction between the private and the public.
Private is basically bilateral; symbolised in financial circles by the counter. Public is unilateral, can be held by any number of unconnected investors with no common interest; symbolised by the exchange.
Private is an OTC contract and the public a traded instrument.
Private: 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.
Public: traded
Public contracts are available to all the world. We are in the land of carbolic smoke balls: an obligor creates a financial instrument, gives it corporeal form such 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 only to collect interest or for final redemption. It is, in one way or another, negotiable.[2] These are products like shares, bonds, warrants, futures and options.[3] 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. Here there really are lots of noteholders, they do not act en masse, so individual noteholders just have to take a view, that they have no realistic seat at the table should things go wrong. Theirs is the bet that those sponsoring the deal are good people, and will not take the proverbial. This trust was found to be misplaced in the global financial crisis.
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 products are in concept tradable, the same caravans in a trailer park are mobile: they don’t really trade: no-one in their right might mind would buy one of these things in the secondary market without all the due dilly, negotiation and documentation you’d expect for an OTC novation.
Remember the basic proposition of tradable public securities: they are homogenous, standardised, and their failure risk comes down to the ongoing business prospects of the issuer. There is a term, an interest basis, a coupon cycle. Aside from that, it's all about the issuer ’s financials.
None of that is true of an asset-backed security. The one thing that won’t happen — literally, can’t — is issuer insolvency. The rate will be generated from a raft of interacting assets, all of which has its own idiosyncrasies, credit exposures, volatilities, and liquidity profiles. And overlaying that will be the legal terms, which are guaranteed to be Byzantine. All of that needs careful examination by trained professional credit ninjas.
To the purchaser is most likely stuck with the note. But it expects to be. Generally, it has commissioned the note format not for the liquidity it offers — for a repack note, it doesn’t — but to ease troubled minds in its operations team responsible for booking, risk managing, hedging and complying with accounting policies and so on.
Really, this is a private, bilateral, over the counter contract, just dressed up, like a pantomime dromedary, to look like something it is not.
Using the cumbersome note mechanics to manage valuation disputes, amendments, and unexpected contingencies of the sort that often arise on early unwind is possible — anything’s possible — but there’s generally a better way, 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 its holding? — but not, in the ordinary course, practically so as, for the reasons given, it won’t have. And the risk it has — again, anything’s possible — can be resolved by 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, trustee and transaction parties for losses caused from anything done at its suggestion should it turn out not to be.
Another excellent application for an indemnity, by the way: as long as you are telling the truth, it presents no risk at all.
See also
References
- ↑ For those reading who may be of that belief, here is the thing: if such a catastrophe were to befall the securities market, and its worst consequence were the permanent failure of the clearing systems, there would not be the printing capacity on the planet to produce the necessary definitive notes, and that would be true even if the proprietors of said printing businesses weren’t spending their waking hours scavenging the post-apocalyptic streets for uncontaminated dog meat.
- ↑ Why did we cross our cheques “not negotiable” back in the day? Does anyone know?
- ↑ There are OTC options as well, of course.