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Update Newsletter: Winter 2004 – Special Conference Issue

The Investors' Perspective

The first panel session focused on investors’ perspectives. Karen Weaver, Deutsche Securities, Inc., moderated the discussion with Robert Franciscus, Merrill Lynch Investment Management; Paul Grillo, Delaware Investments; and Susan Troll, T. Rowe Price. Among the topics discussed, three major themes emerged: asset-backed securities (ABS) investment strategies, credit card issuer consolidation, and the special importance of issuers’ business models.

The panelists discussed general approaches to incorporating credit card ABS in fixed-income portfolio strategies. As they noted, the asset class can serve as short-term cash substitutes, provide portfolio diversification, and generally present yield spread opportunities. Panelists acknowledged, however, that they make an important distinction between low-risk AAA-rated securities and higher-risk BBB tranches. All three firms noted that they are less active in the more risky BBB-rated portions of credit card ABS.

AAA-rated credit card ABS provide higher yields for lower perceived risk than similarly rated corporate bonds. The relatively high yields make AAA ABS useful as cash substitutes or as short-term investments in common fixed-income barbell investment strategies (where portfolio holdings are concentrated in very short-term and very long-term maturities).

The panelists indicated, however, that risk management policies in most firms generally limit portfolio concentrations of any one issuer’s ABS to about 2 percent of assets under management. An interesting discussion ensued about how that 2 percent is computed. Panelists noted that some firms treat investments in ABS and corporate debt of the issuing firms as separate exposures, while others aggregate the two. It appears that the practice of consolidating the corporate debt of the issuer and the ABS for portfolio limits is becoming more common as investors have come to better understand that the performance of ABS — especially revolving ABS such as credit cards — is not entirely uncorrelated with the credit conditions of the issuing firm.

Consolidation in the credit card industry has given rise to a number of new investor concerns. On the bright side, industry consolidation has often resulted in weak pools being purchased by stronger firms. After the purchase, better servicing facilitates performance recovery.

The larger pools underlying ABS sold by the large credit card acquiring banks are now more diverse than ever, resulting in better performance predictability. On the other hand, there are fewer issuers' ABS to choose from; therefore, creating customized diversification (i.e., fine tuning the correlations of the portfolio's components using ABS) is increasingly challenging.

The panelists also noted that their firms restrict investments in ABS to liquid securities from well-established issuers. Hence, these firms tend to be less active in BBB-rated securities issued by well-established firms but also generally avoid untested sectors, such as subprime lending.

The topic of avoiding subprime and other specialty lending sectors led to the discussion of issuers' business models. While in practice credit card asset-backed securities have performed very well, the panelists noted that proprietary (issuer-specific) underwriting practices make credit card ABS susceptible to the issuer's business model risk.

While business models are a concern for all collateral types, the revolving nature of credit card ABS (where new loans must continually be added to the collateral pool to facilitate an investment maturity longer than the average underlying collateral maturity) carries with it a risk that the business model could change over the life of the investment, affecting pool performance over time. In a revolving structure, if the issuer's business model fails (and therefore cannot originate any more loans using its "secret formula"), no comparable loans can be revolved into the pool. In the best case scenario, the ABS will then amortize, and investors will be repaid earlier than expected. As also noted in the next panel's discussion, a number of recent examples suggest that failed issuer business models can also lead to loss of principal.

An important thread ran through the panelists' comments: They were less concerned with the sort of collateral underlying the ABS, per se, and more concerned about how one issuer's business model (or way of originating and managing that collateral) differs from the industry norm. As such, disclosure and transparency around business practices become important analytical tools.

Investors also noted that some firms even avoid pools that contain blends of loans originated from different business models, such as prime and subprime loans. The concern is that the pool's composition could change adversely during the revolving period — the important point being that because of the revolving structure and the importance of a good servicing platform, what you're buying today may not be what you get tomorrow. If different quality loans are revolved into the pool or if servicing practices change, investors may find themselves with substantially different pool performance over the life of the security.