Securitisation and structured credit investments are good business

Hybrid Structured Credit Funds: Securitisation moves into new paradigm

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The securitisation places the assets under the legal control of a separate entity usually known as a special purpose vehicle (SPV) or another type of structure (such as in Ireland, using the tax-efficient Section 110).

The structure of asset-backed securities (ABS) is intended, among other things, to insulate investors from the corporate credit risk of the sponsor that originated or acquired the financial assets.

The securitisation is essentially selling the assets to investors who rely on the repayment of their principal and interest from the cash flow generated by the underlying pool of assets and the residual (salvage) or market value of the assets.

These investors now essentially finance the assets and the company that securitised the assets off its balance sheet while it receives cash in exchange with which it can invest in new assets.

The company (sometimes known as the sponsor) may retain some contingent or indirect guarantee or recourse to the assets in the event of non-performance.

The transfer of the assets from the sponsor and the rights and responsibilities of participants (sponsor, trustee and administrator as well as the auditor) is set out in a pooling and servicing agreement which, when translated into a credit fund, is the prospectus.

This will detail what kinds of instruments the fund intends to purchase and will usually have limits on the sectors or types it can buy.

In offering ABS there is generally no business or management to describe. Information about the transaction structure and the characteristics and quality of the asset pool and servicing is what is most important to investors.

There is a good reason for securitising loans. By taking the assets off the balance sheet of financial institutions and providing them with cash, they now have capital to go out and make new loans (which they would not be able to do as quickly if the assets remained on their balance sheet until maturity).

This financing technique takes financial assets that in many cases individually are less liquid that are pooled and converts them into instruments that may be offered and sold in the capital markets.

By securitising assets into structures with various risk profiles and various interest rates and repayment schedules (tranches), the risk to finance those assets can be spread across a pool of investors and a corresponding larger amount of investment capital can be obtained.

Before the financial crisis, the natural sponsors of asset securitisations were banks, mortgage companies, finance companies and investment banks. The natural buyers for these instruments were institutional investors, including financial institutions, pension funds, insurance companies, mutual funds, hedge funds and money managers.

Generally, ABS is not marketed to retail investors. Now the credit funds are scooping up the most attractive of these remaining securitisations. Corporates who normally would use the securitisation market to raise capital are instead looking to the bond markets where there are attractive rates and spreads. Indeed, the market rates are so attractive many companies are raising over and above what they need at present because the terms are so good.

 However, there is a great deal of re-financing that is expected to hit the market over the next five years. It is unlikely companies will be able to get such favourable terms for bond issuance by then and the expectation is that the securitisation markets will have opened for business.

Now that hedge funds and investment managers in general have discovered the attractions of securitisations, it is also unlikely these types of hybrid credit funds will disappear, although they are likely to change shape. The assets in these funds need to be serviced during the lifetime of the securitisation.

The billing, collection and pass-through to investors of scheduled interest and principal payments, prepayments of principal, taxes, insurance and fees depend on the asset class. What makes this particularly tricky for the hedge funds and hybrid structures that now own these securities is that traditional hedge fund administration alone is not enough. To provide a comprehensive service, fund administration, private equity and corporate trust activities must be combined.

Few banks or fund administrators are in a position to provide this kind of service economically and efficiently.

This is a lucrative business.

Some of the functions that need to be performed include making sure the interest and principal payment is correctly allocated and distributed to the investors.

This is a tricky business given that there may be several securitisations within each underlying portfolio and a collection of investors that will want to know the net asset value of the portfolio and be kept regularly informed about the performance of the fund and its underlying assets.

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