A small broker-dealer based on Key Biscayne, an island off the coast of Miami, would hardly be the gambler’s choice for the broker most likely to make inroads into one of the riskiest and least understood portions of the securitization market. But in the first nine months of this year, United Capital Markets, founded by Key Biscayne-born John Devaney, has bought nearly $3 billion at current face value in subordinated asset-backed securities, commercial mortgage-backed securities and collateralized debt obligations, many of them distressed.
So it seems that, against all the odds, a firm that started life as a one-man outfit only five years ago has become one of the fastest-growing broker-dealers in a market plagued by headline risk and a conspicuous lack of liquidity.
United Capital Markets (UCM) operates by exploiting market inefficiencies. The benefit of trading the subordinated tranches of these high-yield structured finance products is that their secondary markets are among the most inefficient. As Devaney puts it, “The secondary markets for some of these bonds have an incredible disconnect between the current trading levels and the fundamental credit quality of the collateral pools backing the securities.”
This is partly because the market for high-yield structured finance products is considerably less mature than the high-yield market for corporate bonds. According to Thomson Financial, while the high-yield corporate bond market has seen some $994.3 billion of issuance since 1991, high-yield structured finance has only clocked up around $25.8 billion of issuance.
The relative youth of the market, together with a lack of transparency stemming from obscure deal structures backed by esoteric assets, has meant that many of the mainstream institutional investors who flock to buy structured finance products at new issue are not always familiar with what they are buying. Even the rating agencies have only recently tightened their methodologies to accurately assess collateral pools and projected loss rates.
One of Devaney’s clients, a portfolio manager at a fund that specializes in high-yield corporate and structured finance paper, says, “There is a significant level of crossover money that comes into securitization at new issue, buying products that the money managers for these funds don’t fully understand.” Part of the problem, adds the portfolio manager, is that many mainstream investors will buy new issues on the basis of ratings, but a number of securitizations with poor business models and flawed deal structures have been awarded higher ratings than they deserved at issuance. “Then when something goes wrong, that money is looking to get out as quickly as possible, creating a flood of supply,” he says.
Many institutional investors have learned this the hard way. While much of the securitization market has performed very well over the course of its history, since the late 1990s the market’s record has been blemished by a number of negative shocks, exposing a raft of poorly written deals, backed by defective business models and awarded erroneous ratings.
Securitizations backed by the manufactured housing sector are just one example. Between 1995 and 2002, the market saw $31 billion of new-issue bonds backed by loans for manufactured homes from companies like Conseco, Greenpoint, Bombardier and Oakwood Homes. By 2003, however, it became apparent that the model was flawed: the rating agencies announced multiple-notch downgrades, new issuance dried up and many of the major lenders filed for bankruptcy. Investors who had bought the bonds in the primary market were anxious to get out.
However, when investors want to sell, there are very few places to go: as few as five of the large investment banks will trade subordinated or distressed structured finance products in the secondary market. Liquidity for these products is so limited that most broker-dealers don’t quote spreads below the double-A level with any regularity—the market simply does not move enough to provide indicative levels.
And if, like in the manufactured housing sector, primary market issuance has dried up for a certain type of security, the underwriters on the original deals are often reluctant to commit capital to support them in the secondary market. Armand Pastine, managing director and trader at UCM competitor Maxim Group, says, “Underwriters tend to be more enthusiastic about the new-issue market than they are about participating in the secondary market for these bonds.”
A liquid entity
As a result, some regional dealers like Maxim Group and Devaney’s UCM have been very successful in exploiting this niche of the structured finance market by acting as liquidity providers. What makes UCM unique among other brokers operating in this space, however, is that it acts mainly as principal rather than agent in its deals, often long in the same bonds that it trades. Devaney says, “Acting as an agent as opposed to principal makes it too hard to tell where the prices should be, so I do a rigorous fundamental analysis on each potential purchase and only buy at a price where I would be happy to buy it with my own money and hold it on my own balance sheet.”
Devaney argues that this is the most efficient way of providing liquidity and securing the loyalty of a customer base which knows that Devaney’s own capital is at stake. And it’s certainly the case that his clients appreciate the level of credit assessment that goes into Devaney’s trades. Jim Kelsoe, high-yield portfolio manager at Morgan Keegan Asset Management, says, “I have found John to be very aggressive in his ability to find interesting trading ideas. Devaney is an analyst, salesman and trader in one, which is a much more efficient use of my time. He conducts detailed and in-depth credit work on unusual structures and it’s important for us that he is willing to commit his own capital to illiquid securities.”
However, while many applaud UCM’s success in gaining a strong market position by acting as principal on its deals, some argue that the strategy does not necessarily contribute to a more efficient market for all. Pastine at Maxim Group explains, “The liquidity in this market is manufactured rather than provided. And if UCM buys a bond for its own balance sheet, the act of taking on that risk means that it is likely to offer the bond at a higher price than if it was acting as agent. There is no problem with wanting to be compensated for taking on risk, but for those wanting efficiency, using an agent makes more sense.”
Nevertheless, the strategy of acting as principal has undoubtedly contributed to UCM’s success in the five years that UCM has been in business. Since it was founded in February 1999, the firm has grown from a one-man bond shop with only $500,000 of capital to a firm which, when combined with Devaney’s real-estate interests, surpasses the net income of Raymond James, a rival Florida-based brokerage with a 32-year track record.
The broker-dealer has 18 employees, including professionals poached from Wall Street—Devaney’s cohort on the trading desk is a former ABS trader at Bear Stearns, Sean Kirk. The firm has three bond salesmen, including Devaney’s best friend Jeff Ward, and two research staff, Evan Kestenberg and Steve Finnk, formerly of Canyon Capital Advisors and AIG Global Investment respectively. Three years ago, as a move to add diversity to the firm and balance the risks in UCM’s other markets, UCM also launched a collateralized mortgage obligation (CMO) trading desk based in California run by Dan Steuer, formerly of Countrywide Securities.
In 2003, UCM traded $5.115 billion, measured at current face value, in subordinate ABS, CMBS and CDOs. The firm’s CMO desk bought approximately $6 billion in CMOs at current face value. In 2003, UCM also completed its first primary market issue: a $233.4 million private placement of repackaged small business loans.
Devaney’s successes do not come without taking on risk, however. UCM has been involved with some of the most distressed sectors in the asset-backed universe, including bonds backed by high loan-to-value (LTV) mortgages, aircraft leases, loans for manufactured housing, sub-prime credit cards and loans for franchise businesses. Devaney will not discuss publicly the credits he is currently invested in, but says he still finds value in many of these sectors.
“The sub-prime credit card sector is one recent trade that we’ve been very happy with,” he says. “We bought $1.5 billion in Metris, First Consumers and NextCard bonds after these securitizations went into early amortization or were trading at distressed levels: we felt that the loss rates on the cards had been miscalculated by the Street.”
But for many investors, Devaney takes on more risk than they themselves would be comfortable with and even very sophisticated investors in subordinated and distressed ABS confess that they would not touch sectors like franchise or health-care receivables because of holes in the business models.
A finance and English graduate from Colorado State University in 1994, Devaney developed a relationship with risk-taking in his sophomore year. After learning about stock options in one of his finance classes, he opened a discount brokerage account so that he could buy out-of-the-money calls on Motorola using his student loans. “I couldn’t believe that the upside was unlimited and that you could only lose 100% of your money! I was so drawn to the principals of leverage that I had to get involved,” he says.
Devaney also used his student credit card to apply for a no-money-down real-estate purchase, on which he then took out a second mortgage using a non-qualifying assumable loan. By charging his roommates rent, he covered the mortgage payments for a three-bedroom house for the four years of his college career.
After college, Devaney took a job as a commission-only retail stockbroker at a small Florida-based firm called Capital International. However, says Devaney, very few retail investors were interested in buying from a 23-year-old college graduate and the pickings were slim. So, relying on a strong track record with the Motorola stock options of his college days, he placed all $125,000 of his savings on one Motorola stock option. “I figured that if it was successful, I would buy my own business, and if not, it would force me to find a job where I could earn some real money,” he says. He lost.
Devaney admits that the experience taught him an important lesson in risk management: the value of a diversified portfolio. So he moved back in with his mother and turned to bonds.
He took a job as a trading assistant on the bond desk of a small fixed-income brokerage firm called Suncoast Capital, later becoming a salesman for mortgage-backed securities and opening a number of accounts that he still has to this day. Two years later, despite having no trading experience, Devaney went back to Capital International, with a proposal to start a bond desk to trade CMOs for the firm in partnership with the owner. Eighteen months later, the desk employed six people and had hired a further five to start another office in Tampa.
It was during his time at Capital International that Devaney had his first dealings with asset-backed securities. A customer from the Midwest called for a bid on $3 million dollars of single-A rated high LTV securities that had come to market at about par just two months before. Intrigued, Devaney examined the prospectus to get to grips with the structure of the bond and understand the real value of the collateral pool.
Two days later, Devaney had come to the opinion that the credit risk of the bonds was minimal: it was not the junior-most bond, but a single-A rated piece with significant protection at new issue and 15% of subordination. He made a bid of 90 cents on the dollar, bought the bonds and went on to sell them back to the underwriter Bear Stearns for 99 cents on the dollar. Devaney recalls the reaction of the traders at Bear Stearns when he contacted them about the bond: “Who are you? How did you wind up with this thing? And you’re saying you own it?”
After securing that level of profit in one clip, Devaney has never looked back. The next day, he sent out a Bloomberg to his customers which read, “Looking to make markets in asset-backed securities, looking for mezzanine, AA, A, BBB-rated, any asset classes.” Within a week, he says, he had more bonds to study than time. “This was when hedge funds were being forced to liquidate their portfolios of subordinate ABS and MBS because of the fallout from the Russian monetary crisis and the LTCM scandal. Investors were all withdrawing their money from leveraged funds.”
Some two and a half years after founding the bond desk at Capital International, Devaney left the firm after it experienced financial difficulties relating to failed investment banking transactions. It was then that he bought a small brokerage firm and founded United Capital Markets, to exploit the subordinated ABS, CMBS and CDO niche he had discovered.
His colleagues on the bond desk at Capital International—which shut down two months after Devaney’s departure—felt that it was too much of a risk to join Devaney in his new venture, so he was on his own. Devaney admits that with only $500,000 of capital to invest in the new firm, “my ability to position securities was limited, but I had developed a client base from my time at Capital International and Suncoast.”
Devaney argues that from the very start, the key to his trading approach has been in-depth research and analysis of each potential opportunity in order to find the right price, sometimes buying into a small portion of a deal in order to gain more detailed information from the servicer or trustee before getting in any deeper. “There are three central factors which go into my analysis,” he says, “the fundamentals, the level of supply and demand and the influence of fear or confidence.” Devaney’s experience with subordinate bonds backed by the high LTV sector is one example of how his analysis fits together.
In terms of fear and confidence, in the late 1990s confidence in the high LTV sector had hit rock bottom. High LTV loans generally had around 110% loan-to-value ratios: the value of the loan was greater than the value of the collateral backing the loan. At the same time, he says, “small specialty finance companies with limited capital and no experience of lending were created purely to take advantage of the market for high LTV securitization. Wall Street extended enormous loans to these companies in order to earn investment banking fees from the securitizations.”
In 1999, a number of high LTV lenders went bankrupt, most notably First Plus Financial, which had about $4 billion of high LTV bonds outstanding, Empire Finance and Keystone Finance. “People were saying that Wall Street had really screwed up and that all the subordinate bondholders would lose everything,” says Devaney.
Which brings us to supply and demand. The level of headline risk and loss of confidence in the sector created substantial supply as investors tried to get out, pushing prices into freefall. Devaney says that one Wall Street dealer unloaded every high LTV bond on its balance sheet, amounting to $1.5 million of securities.
Finally, the fundamentals: Devaney’s call was that none of the bankruptcies would affect any of the bonds, that not even the junior-most securities would ever lose any money.
“My view was that there was so much excess spread in these securitizations that the bonds would survive provided prepayments on the loans paid off the transactions earlier than expected,” he says. “So I looked at the collateral pool. High LTV loan customers were generally good-quality borrowers with high Fico [Fair Isaac & Company] credit scores. Borrowers were also paying 10–12% on their loans, so had a strong incentive to prepay or refinance, even if interest rates rose.”
Devaney believed that the high LTV sector was mispriced and bought almost $700 million of the B1, B2 and M2 bonds at between 50 and 60 cents on the dollar. “People were prepared to sell at prices significantly lower than what they had paid in the primary market, but there were very few people who were prepared to buy for their own balance sheets. I had cultivated accounts that could absorb hundreds of millions of dollars of high LTV, so I bought as much as I could,” he says. In just 12 months, those bonds rose to around 90 cents on the dollar, cultivating a 30–40% annualized return for the customers he sold them to.
Over the last five years, Devaney’s client base has thus grown to include hedge funds, mutual funds, money managers, major Wall Street dealers and insurance companies. Accounts that sell him bonds far outnumber the accounts that buy bonds from him, with roughly 350 selling accounts and 25–30 downstream accounts. However, Devaney argues that he only needs this number of sophisticated downstream accounts to offload his inventory, and some of these have been remarkably successful.
One of Devaney’s most valued customers is Jim Kelsoe at Morgan Keegan Asset Management, whose RMK Select Hi Income fund invests almost exclusively in high-yield structured finance products and was the top-performing high-yield mutual fund as rated by Morningstar in the first year of operation and for three years running.
However, there are signs that the inefficiencies that have plagued the markets for high-yield structured finance products are slowly being resolved and that this in turn may taper UCM’s margins. Richard D’Albert, co-head of the securitized products group at Deutsche Bank, says, “The credit crises of recent years have broadened investor understanding of how to value positions in these markets and brought pressure to bear on structurers to improve the quality of the collateral underlying these deals.”
Mike Wade, head of the ABS group at Barclays Capital, agrees that the market is seeing changes. “The blowups have galvanized issuers into better disclosure, rating agencies and bankers into being more conservative with credit enhancement levels and investors into being much more selective about what deals they will buy,” he says. The regulatory agencies are also working towards implementing new rules for the asset-backed market that would call for increased disclosure from servicers, originators, sponsors and trustees in the asset-backed market.
But Devaney is still optimistic. Six months ago, UCM moved out of the residential house and into a Key Biscayne’s largest office building; the company owns a 142-foot corporate yacht with a crew of nine, a Gulf Stream G400 helicopter and a corporate jet.
Devaney is also branching out with a real-estate company, an aviation company to run the corporate aircraft and a boat charter company for corporate getaways. He makes the most of his marketing dollars at the big securitization conferences by hosting rock concerts with names such as Blues Traveler, ZZ Top and Counting Crows and has made repeated attempts to get Sheryl Crow to perform. But despite offers of several hundred thousand dollars, Crow still refuses to do it.
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