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Sunday, April 20, 2014

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Update Newsletter: Winter 2004 – Special Conference Issue

What Can Go Wrong? What Have We Learned?

The morning’s second panel session examined lessons learned from risky business models and differences in deal structure that led to investor losses. The session was led by Mark Adelson, Nomura Securities, with participation from Alexander Dill, Moody’s Investor Services, and C. Thomas Kunz, Skadden, Arps, Slate, Meagher & Flom.

Panel members reviewed several important “case studies” of asset-backed securities (ABS) transactions that ultimately led to investor losses. While the examples used were not specific to credit card ABS, the intent was to generally illustrate the importance of previously unforeseen elements, such as the risk of fraud or misappropriation, business model risk, and servicing risk. Among the failed structures examined were ABS issues from LTV Steel; Heilig-Meyers; NextCard; DVI, Inc.; Spiegel-First Consumers National Bank (Spiegel-FCNB); and National Century Financial Enterprises (NCFE).

The cases of NCFE, Spiegel-FCNB, and DVI were examples where fraud or misappropriation resulted in substantial losses. In each case, better oversight and monitoring of the issuers might have prevented or reduced the harm to investors.

In the case of NCFE, the monitoring failure was particularly significant because ratings agencies did not act on a series of three increasingly stern anonymous letters detailing fraud and other improprieties. Only years later, when the company was in financial distress, did the true character of the securitized pools come to light. While other cases may have been less dramatic, investors have learned that without regular audits or third-party oversight, an ABS issuer in financial distress may misrepresent the character (or even the existence) of securitized assets, manipulate amortization triggers, divert cash flows from deals, or otherwise misappropriate assets.

Even without misappropriation or fraud, financial distress presents acute problems for certain business models. Problems typically arise because the ABS issuer is generally also hired as the servicer. Hence, as one conference participant commented during the session, investors are “buying as much into the servicer as the receivables.”

Heilig-Meyers and DVI, Inc. were cases in which changes to idiosyncratic servicing and collection practices strongly affected the performance of the securitized receivables and resulted in investor losses.

The classic case of how idiosyncratic servicing and collection practices affect investor losses is that of Heilig-Meyers. Heilig-Meyers was a chain of furniture stores that sold on credit, collecting monthly payments at its store locations. When the chain closed its stores in bankruptcy, payment collections were significantly interrupted, resulting in defaults on Heilig-Meyers’ previously triple-A-rated ABS. Investors have learned that idiosyncratic servicing and collection procedures may directly link the performance of the securitized assets to the issuer’s business fortunes.

Recent experience with securitizations from failed issuers has also pointed out the risk presented when servicing fees are priced too low. This was a primary factor in investor losses in NextCard and Spiegel-FCNB.

In general, issuers have an incentive to price servicing fees low so that more cash can flow through to investors and hence more money can be raised from selling ABS. Aggressive issuers may set their servicing fees too low or subordinate the fees.

If the issuer fails, someone else must service the loans, even if only to provide a smooth amortization (to wind down the deal for investors). Thus, a deal’s servicing fee must be large enough to attract a successor servicer. If it is not, bank regulators might order an increase in the servicing fee. That is just what happened in the Spiegel-FCNB case. In the NextCard case, bank regulators were unsuccessful in trying to find a buyer for the portfolio.

The problem, of course, is that contractual servicing fees, especially in distressed situations, are rarely sufficient to cover costs. Without adequate compensation, the quality of servicing for a securitized pool will suffer. With no one diligently sending out late notices and collecting payments, it is not surprising that delinquency rates skyrocket and recovery rates on the collateral – the safety net for investors – plummet.

How far the recovery rates plummet, however, is also related to an ABS issuer's business model. Unusual or flawed business models greatly exacerbate challenging servicing environments.

In the case of DVI, Inc., the issuer leased medical equipment to health-care providers and securitized the leases. The issuer regularly repurchased delinquent leases from its securitization pools and also routinely substituted leases to allow lessees to upgrade their equipment. When the issuer failed, the performance of the securitized pools deteriorated because it no longer repurchased delinquent leases and because customers could no longer upgrade their equipment.

Similarly, in the case of NCFE, many health-care providers relied on National Century to provide working capital by selling future receivables for cash. NCFE relied heavily on securitization markets for their own funding. When financial difficulties precluded NCFE from financing its customers, many health-care providers also failed.

Such round-trip financing and heavy reliance on a single entity that funds itself almost exclusively through securitization were singled out as important elements of flawed business models in that the sources of investor payments were not independent of operations elsewhere in the business.

In summary, while credit card ABS markets are considered mature (in the sense of Wright's keynote address), the experience of NextCard illustrates that even the credit card sector is not immune to business model and servicing risk. It is important to remember that no ABS transaction is really "bankruptcy proof" and that the declining pool scenario (where new loans cannot be revolved into a deal) can happen. As noted in the discussion period, however, the ABS markets in general have experienced far fewer debt downgrades than corporate debt markets, and credit card asset-backed securities have experienced the fewest downgrades of any major ABS sector.