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Securitization: in search of the next big thing by Adam W. Glass, Partner July 2004

Adam Glass surveys the prospects for securitization lawyers and their clients as the market searches for the next innovation. Recently the author was asked where the most innovative, challenging and lucrative transactions are likely to be found in the US securitization market. It would initially seem to be easier to explain why these transactions will not be found. Formerly high margin transactions like commercial mortgage securitization face increasing price pressure. Complex synthetic collateralized debt obligations (CDOs) are being farmed out to regional law firms that compete effectively on price. And with interest rates probably headed up and mortgage refinancings down, the huge volume of residential mortgage securities transactions of 2002 and 2003, facilitated as it was by Alan Greenspan’s easy money policy and a 1% federal funds rate, cannot be expected to continue. Whole-business securitization, once thought to be the next big thing, turns out to work only in England and Wales. Otherwise, the insolvency laws are uncooperative. Enthusiasm for securitizing ever expanding, and ever more exotic, asset classes (Bowie bonds, deathbacked bonds, film receivables, credit card chargeoffs) has faltered. Bowie bonds (securitization of song royalties) turn out to be very hard to reproduce. A prominent sponsor of death-backed bonds (securitization of funeral home receivables) filed bankruptcy, causing losses to junior holders of its securitizations. Film receivables got a bad name from the Hollywood Funding transaction, where the films failed to generate the required proceeds and the triple-A rated multi-line insurer of the deal turned out to have a defence to payment. And securitization of uncollectable credit card bills has left a wake of fraud, losses and lawsuits behind it, most notably in the case of CFS, where one of the country’s largest securitization law firms has been slapped with a lawsuit by over 150 investors, including many of its clients, who allege that they purchased the securities in reliance on a fraudulent 10b-5 opinion. Since the development in the late 1990s in Europe and America of funded credit linked note transactions backed by a portfolio of credit default swaps, a really big innovation that can drive market volumes and law firm profits has been missing. The author means something on the scale of private label residential mortgage securities (1978); collateralized mortgage obligations (early 1980s); commercial paper conduits (early 1980s); commercial mortgage securities (1980s); credit card securitization (late 1980s); and collateralized bond obligations (late 1980s and early 1990s). While synthetic and cash CDOs remain popular, they have in many cases lost the novelty value that made them premium-billing transactions for law firms. Plus, the available arbitrage has been compressed by tightening of credit spreads generally at this point in the cycle. The funded credit linked note versions of Securitization: the next big thing by Adam W. Glass

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the popular credit default indexes, Trac-x, i-Boxx and their predecessors, are long on innovation, but may actually reduce the potential for blockbusting structured deals by arbing away bid-offer spreads. From where the author sits, while life will go on in bread-andbutter securitization land, some of the thrill is gone. Much of securitization will in the future be no more innovative than plain vanilla corporate debt. The most promising opportunities may lie outside the realm of traditional securitization in one-off transactions that apply securitization techniques. These may include special purpose operating companies that use securitization techniques for financing but lack the brain dead status of traditional special purpose vehicles (SPVs). Specialized financing companies that use securitization techniques to structure and control risk in an operating business can be looked at as de novo whole business transactions, where the lack of any prior history as an operating company with a wide range of creditors makes a degree of isolation and special purpose-ness possible even though entity profitability depends on management skill. In other cases, a transaction may be something entirely different than a traditional securitization, but part of it will require the application of securitization techniques, and securitization lawyers will work on or even run the deal. Examples follow. Credit derivatives operating company: Primus. Primus Financial Products, LLC, is the world’s first (and only) triple-A rated credit derivatives operating company. It was capitalized in March 2002 with a $155 million equity offering to three insurance companies and a pension fund to act solely as a seller of single name credit protection on corporate and sovereign risk. At the end of 2003, it reportedly had $6.3 billion of credit derivative contracts outstanding, representing exposure to 350 single names. Its parent holding company has filed with the SEC for an initial public offering (IPO). The company also plans to move from writing single name trades to portfolio credit default swaps and structured products. Promotional material on the company’s website is reminiscent of a CDO marketing book, describing the company’s portfolio as consisting of a diversified group of investment grade corporate and sovereign credits with a weighted average rating of A/A2 and a weighted average term of approximately two years. But unlike a brain dead Cayman Islands CDO issuer that relies on an unaffiliated portfolio manager, Primus is a real company with offices and employees, and its portfolio manager is a sister company, Primus Asset Management, Inc. The theory of Primus is that an unregulated seller of credit protection can operate with a triple-A rating within strict guidelines set by the rating agencies, more cheaply than a bank (no bricks and mortar, no advertising, no regulatory capital overlay). Like a structured investment vehicle (SIV), Primus provides weekly verification to the rating agencies that it has enough capital to meet an AAA/Aaa standard and is in compliance with its portfolio operating guidelines. Unlike an SIV, Primus assumes credit risk through a single instrument, the single name credit default swap, and is located not in Ireland or the Channel Islands, but in New York. Primus is not an SPV because it has employees, office space and other creditors besides its credit default swap counterparties. One could think of Primus as something like a monoline, in that it takes investment grade risk, and has credit, risk and pricing committees that meet frequently to oversee risk management and underwriting policies and evaluate business opportunities. Its investors include monoline parent companies XL Capital Ltd and Radian Group Inc. Yet it is not a regulated insurer, like a Securitization: the next big thing by Adam W. Glass

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monoline. It operates in a much narrower field, and by entering into swap contracts rather than issuing insurance policies, it avoids state insurance regulation. The author prefers to think of Primus as a securitization with a PhD. Repo trading operating companies: CMET. Capital Management, Engineering and Trading LLC (CMET) is a holding company set up to own intermediate holding companies that in turn own specialized broker-dealer trading entities. Each broker-dealer is set up to operate in a very narrow sector of the finance markets, trading repos and reverse repos on government securities. So far two have been created:Three Rivers Securities and South Street Securities. CMET was formed to establish and administer, for its own account, portfolios of repurchase agreements and reverse repurchase agreements involving US government securities, US government agency securities and US government agency mortgage-backed securities. When the author first broached this concept with an experienced repo lawyer colleague, the colleague was sceptical. Citibank and JP Morgan Chase are in this business, with billions of dollars of capital behind them and access to corporate treasurers around the world. What competitive advantage is a start up specialty finance company going to have? The answer, it appears, is capital efficiency. Reportedly, the CMET repo trading business with its CDO-like capital structure can leverage invested capital 1.6 to 100 (each $100 in repos supported by $1.60 in capital). A bank competitor only leverages its repo trading 5.8 to 100 (each $100 in repos supported by $5.80 in capital). So, as long as its repo counterparties believe the credit rating (which, of course, is supplemented by the fully collateralized nature of repo trades), a CMET broker dealer can write the same business as a bank for a more than three-fold greater return on invested capital. Like a securitization, each CMET repo trading programme has a limited life. Also like a securitization, the CMET broker-dealers are very dependent on rating agency approval to maintain their AAA/Aaa counterparty ratings, and therefore their viability as repo counterparties. To maintain these ratings, they cede substantial control over their business to the constraints laid down by the rating agencies. Like Primus, CMET’s investors and service providers include participants from the insurance, securitization and credit default swap worlds. Also like Primus (and unlike a typical securitization), CMET and its broker-dealer subsidiaries are real companies with employees, offices and general creditors. Turning a silk purse into a sow’s ear: FIN 46 expected loss notes. One reaction to the adoption of FIN 46 has been the creation of a new class ofsecurities called expected loss notes (ELNs). These generally represent an approximately 10 basis point first loss position in a commercial paper conduit that permits the conduit sponsor to avoid having to consolidate the assets and liabilities of the conduit on its balance sheet, because the sponsor does not have a majority of the expected losses – the ELN purchasers do. The structuring and sale of these ELNs has created an interesting interface between hedge funds and high-yield investors, on the one hand, and that plainest vanilla staple of securitization, the asset-backed commercial paper conduit, on the other. Effectively, the ELN becomes a yieldy piece of paper created by carving out a first loss tranche in the otherwise boring, highly rated, overcollateralized liabilities of the conduit.

Securitization: the next big thing by Adam W. Glass

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The expected loss note has to be structured with careful attention to FIN 46’s requirements, including limitations on transfer that will ensure the notes find a permanent home with an appropriate consolidating entity, and that any hedges put on by that entity of its exposure to the ELNs do not vitiate its status as an appropriate consolidating entity. Everybody’s talking: cell tower deals. The prospectus for the June 2004 IPO of Global Signal, Inc, a real estate investment trust specializing in the ownership of wireless communication sites that recently emerged from a Chapter 11 bankruptcy reorganization, reveals that after its reorganization the company refinanced its balance sheet through a $418 million cell tower asset securitization in February 2004, which provided the company with low cost fixed rate debt. The company’s prospectus states that its capital management strategy, which supports the financing of new cell tower development and cell tower acquisitions, is to finance newly acquired assets, on a long-term basis, using low cost fixed rate debt obtained through the issuance of mortgage-backed securities combined with other funds. This focus on securitization as an integral part of financing the ownership of cell towers is unique. ‘Tis a phar, phar better thing: pharmaceutical royalty deals. As reported, biotech royalties have been securitized with a triple-A monoline wrap. All the author knows about these transactions he learned from a partner next door with a very penetrating voice. However, that has been enough to know that these transactions are in no way, shape or form commoditized deals. Insurance trust preferred CDOs. A plethora of these deals were offered in the spring of 2004. Not all of them made it to the finish line. The volume of activity shows, however, that these transactions meet an identifiable need for greater financing opportunities for smaller insurers and insurance holding companies. These companies cannot offer surplus notes or trust preferred securities in size sufficient to support a standalone offering, but are good candidates to offer into a pooled CDO transaction. Farewell, my lovely: life insurance/life annuity arbitrage. Life insurance/life annuity arbitrage transactions represent another new securitization structure. These transactions tap a great unused asset, the unused insurability of many Americans. The author, for example, cannot take out an insurance policy for $20 million (his likely future earnings do not justify such a policy as a reasonable replacement for his earning capacity should he meet a premature end). But there are many ultrahigh earners who do enjoy an insurability of $20 million or more. Often, these prosperous individuals may not have taken out a policy in the full amount of their insurability, because, frankly, they (or more properly their heirs) don’t need the money. In a sense, their scarce asset, their unused insurability, is going to waste. Because of differences in the mortality tables used for annuities and those used for term life policies, opportunities arise to induce such individuals to take out policies specifically for transfer to a life insurance/life annuity securitization pool. In such a transaction, the promoter will identify a group of potential insureds and will obtain their agreement to take out life insurance policies and assign, for example, 95% of the proceeds to the pool. In return, the pool will borrow funds to purchase a life annuity on the same individual that will generate sufficient proceeds to fund the premium on the newly issued insurance policy. The borrowing will be secured by expected proceeds on the insurance policies. If properly structured, the structure will provide for a free insurance benefit to a named charitable or other

Securitization: the next big thing by Adam W. Glass

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beneficiary of each participating insured, sufficient funds to pay off the initial loan, and a handsome residual return to the transaction sponsor. Although this market is of recent vintage and has had almost no exposure in industry conferences or the industry press, it received thorough coverage in a recent article in the National Report section of The New York Times (June 5 2004). Widows and orphans line up here: derivatives and hedge funds for the masses? Derivatives for the masses may be something that the US is not ready for, but credit-linked note offerings to retail have already been done in Australia and elsewhere. And hedgefund linked products have reportedly enjoyed a wave of popularity in Europe. In contrast, credit-linked notes are almost exclusively a Rule 144A qualified institutional buyer market in the US, with the exception of SEC-registered single-name credit-linked notes offered by UBS AG from its MTN shelf. The UBS offerings seem to have dried up, however. Footnote 62 in the release accompanying the SEC’s asset-backed securities proposed rule also indicates that securities backed by a pool of credit default swaps are not asset-backed securities – a conclusion that knowledgeable practitioners disagree with. While bond mutual fund investors have plenty of exposure to credit default swap product, as a review of fund prospectuses will disclose, undiluted direct credit default swap exposure is currently offlimits to the US retail investor. SEC animosity to credit default swaps is in marked contrast to the freedom with which SEC-registered equity-linked and equity index-linked note products may be sold to retail investors. The SEC’s position seems paradoxical, in that equity volatility is generally higher than the volatility of a credit default swap on the same company, given the wider range of variables that can affect equity returns. On the other hand, equity securities have been around a lot longer (since at least 1285, when a statute of Edward I authorized the licensing of brokers in the City of London) than credit default swaps (1997), so perhaps the SEC can be forgiven its crotchety attitude. Another securitization oriented product, equity index-linked publicly offered swap trust repackagings whose tax deferral feature is threatened by proposed IRS regulations, may also have fallen victim to Footnote 62. But that will not stop inventive securitization lawyers from going back to the well. As the examples of equity indexlinked securities offered as asset-backed securities on Form S-3 and private equity and hedge fund collateralized fund obligation transactions have shown, equity and hedge-fund linked products are natural product line extensions for securitization lawyers who, as this article goes to press, are busily figuring out ways to expand the offering of hedge-fund linked products in the US. We will continue to be involved in expanding the universe of products and investors for financial products until we retire or all our associates are hired away by investment banks and hedge funds, whichever comes first. Conclusion: keep on chooglin’. Although no megaproduct looms on the horizon, lucrative niche opportunities will continue to present themselves. Finding and capitalizing on them will require the right client base, the right skill set, and a fair measure of luck. One feature of the new crop of high-profit

Securitization: the next big thing by Adam W. Glass

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opportunities will be bad news for some: they require specialized legal knowledge outside the purview of even the most versatile securitization specialist. The cell tower deals can’t be done without deep real estate expertise. The pharma deals require a serious understanding of biotech intellectual property. Insurance trust preferred transactions require a thorough knowledge of the regulated insurance industry, at least for the lawyers handling the collateral side of the transaction: likewise for life insurance/life annuity arbitrage deals. Equity and hedge fundlinked products can’t be executed by a law firm that doesn’t have deep equity derivatives, CFTC and hedge fund expertise. The level of expertise required can’t be learned on the job, faked, or easily hired. Thus, a securitization boutique, lacking the support of a full-service law firm with real lawyers in the ancillary areas of expertise, may not be the best positioned to capitalize on the new trends in structured finance. Who knew? In sum, while it may not be the best time to pigeonhole oneself in a narrow, commoditized specialty, for those securitization lawyers willing to think outside the box, to paraphrase Creedence Clearwater, the securitization gravy train may just keep on chooglin’, and that big wheel may just keep on turning, for one more year.

Securitization: the next big thing by Adam W. Glass