Bloomberg: Risk Retention Doesn't Improve CMBS Credit Profile, Analysts Say

(Bloomberg):  Risk Retention Doesn't Improve CMBS Credit Profile, Analysts Say

By Adam Tempkin and Charles Williams

(Bloomberg) -- 

Risk retention for CMBS has turned out to be more of a "marketing hook" than a feature that drives fundamental credit improvement in the securities, Guggenheim portfolio managers Peter Van Gelderen, Shannon Erdmann, and Simon Deery wrote in May 18 research note.

• CMBS retention structures generally have the same credit quality as deals done prior to the rule in 2015 and 2016
• The clamor for risk assets and yield have pushed historically conservative real money asset managers and insurance companies into more subordinated and riskier CMBS investments, compressing the spread differential between AAA and BBB tranches to post-crisis tights
• There’s also been a higher risk tolerance in short-tenor, floating-rate large loan and CRE CLO investment alternatives
• In many cases these securities are trading at a premium in the secondary market, despite being freely callable
• The risk of these securities being called and refinanced remains high, "and as a result we have generally withdrawn from those secondary markets"
• Lower-quality tranches outperformed during 1Q 2017
• In such a strong market, Guggenheim is finding relative value in pre-retention deals
• "There are many with similar or stronger credit metrics than their risk retention-compliant counterparts, and those pre-risk retention transactions trade at comparatively wider spreads and cheaper prices"
• Also remains active in floating-rate large loan and CRE CLO transactions, but has limited activity to primary markets

JPM Finds Conduit Loan Quality Weaker

• Conduit CMBS underwriting appears to be trending weaker despite retention, JPM analysts Gareth Davies, Chong Sin and Suying Liu wrote in May 19 research report
• “While underwritten LTVs and DSCRs for 2017 deals on average look similar to 2016 at 59% versus 60% and 1.96x versus 2.01x, respectively, rating agency stressed LTVs and DSCRs show deterioration”
• Average Moody’s stressed LTV for 2017 deals is 116% versus 113% last year and is also on par with the average 2015 deal
• Some deterioration from Moody’s can be attributed to increased office exposure in recent deals
• “Deal-to-deal office concentrations have been highly variable at between 15% and 56% for an average of ~41%, with nine of the 13 deals issued so far this year containing office exposures of 35% or more”
• Also notable is a 9 percentage point increase from 2016 in full-term interest-only (IO) loans, which account for nearly 43% of loans in YTD conduits
• YTD full-term IO loan concentration is second highest on record, only behind 2007 at 58%
• Is worth noting that underwritten LTVs for full-term IOs are lower in recent vintages versus pre-crisis

REUTERS IFR: Fannie Mae to roadshow its debut "risk-sharing" mortgage bond

By Adam Tempkin

Government-supported mortgage giant Fannie Mae will be officially kicking off the investor roadshow for its debut “risk-sharing” mortgage-backed security (MBS) over the next two weeks, according to three investors that have been briefed on the upcoming deal and one investment banker.

The transaction will closely mirror a similar inaugural US$500m deal from sister agency Freddie Mac that priced in July, known as the Structured Agency Credit Risk (STACR) bond. The purpose of this new class of so-called “risk-sharing” MBS from the GSEs is to sell off some of the default risk of their residential mortgage holdings to private investors willing to gamble on their pool of loans.

The new bond programs come after the Federal Housing Finance Agency (FHFA), a government regulator, directed both GSEs  to share out the risk on US$30 billion each of their loan portfolios, as part of a wider initiative to minimize their vast footprint in the US residential mortgage industry.

The two companies, which finance nearly 90% of the country's mortgages, were put into US government conservatorship in 2008 after heavy losses incurred in the subprime mortgage meltdown - but the government now wants to scale back its involvement in the mortgage business.

Bank of America will be lead underwriter on the Fannie Mae deal, but Credit Suisse, which led Freddie Mac’s STACR offering, will be heavily involved in the transaction as well.

Investors say that the FHFA strongly encouraged Freddie Mac to share its structuring technology with Fannie Mae in an attempt to make the new class of products as homogeneous and easily understandable to investors as possible.

Therefore, the Fannie Mae version will be structured similarly to STACR – as an unsecured general obligation of the GSE – rather than in a “trust” or “special purpose vehicle (SPV)” structure via a credit-linked note (CLN), which may disappoint some bond investors who held out hope that Fannie would use a different format than Freddie.

 “A ‘trust’ structure gives more certainty of protection to the investor because it better segregates the cashflows away from the GSEs, in case they were eventually to get wound down,” said one senior portfolio manager specializing in securitized products who was hoping the Fannie deal would be a trust. “An SPV, or trust, means you get repaid for the risk you’re taking from outside the Fannie Mae estate, which protects you in case the GSEs go away at some point.”

The risk-sharing deals are considered “synthetic” or credit derivative-like structures because they reference a pool of recently originated GSE-guaranteed mortgages. For instance, the STACR bonds sold some of the risk of future losses on a nearly US$23bn pool of Freddie-Mac guaranteed residential mortgages to private bond investors.

Freddie Mac originally intended to use a trust structure when it was planning its deal last year, but encountered onerous registration requirements and costs under new Dodd-Frank rules governing swaps mandated by the Commodity Futures Trading Commission.  

The rules would have defined a proposed CLN structure as a “commodity pool” under CFTC guidelines, meaning an increased regulatory burden. The GSE opted for an unsecured general obligation structure instead.

Investors assumed that Fannie Mae might have more lead time to get the appropriate licenses from the CFTC to register as a derivatives user. According to investors, the GSE strongly considered using the SPV structure when the deal was in its planning stages this past spring, as the structure would  have broadened the appeal of the product, and hence the base of buyers.

However, bankers say that the structure just wasn’t feasible for the first round of STACR deals issued by the GSEs this year.

Freddie Mac intends to issue its second deal towards the end of the year, and both GSEs have ambitious plans for the STACR product and hope to become programmatic issuers of the new product by next year.

“In a way, it’s good that that the Fannie and Freddie deals are so similar in structure, because if they’re almost fungible, they will be more successful as a consistent, recurring product,” said another MBS investor.

The FHFA aims to transform the STACR bonds into a consistent, broadly distributed, liquid credit product.

The Freddie Mac deal was popular with investors, as it presented a rare opportunity for bond investors to tap into US residential-mortgage credit as the housing recovery is on an upswing, while also offering a better yield than similar risk products.

Investors have had very few avenues of access to US mortgage credit post-crisis, as the new-issue private-label MBS market all but disappeared, and is only now starting to make a comeback.

The Freddie Mac STACR deal was upsized at pricing to US$500m from US$400m due to increased investor demand. The transaction also has performed well in secondary-market trading since it was originally issued in July.

Spreads on the US$250m M-1 class, which priced at one-month Libor plus 340bp back in July, have now tightened in to Libor plus 291bp in secondary trading as of this past Tuesday, indicating a strong demand on the part of investors to own the bonds.

The FHFA referred calls to Fannie Mae.

“We are working with the FHFA to meet the goals of the 2013 Conservatorship Scorecard,” said Fannie Mae spokeswoman Callie Dosberg.

Bank of America and Credit Suisse declined comment.

IFR: Firm of mortgage-bond pioneer launches its first RMBS

By Adam Tempkin

-- US RMBS

--Ranieri’s Shellpoint Partners markets deal as Moody’s takes a swipe at lending platform

Shellpoint Partners, a company formed in 2010 with an investment from mortgage-bond pioneer Lewis Ranieri, this week marketed its inaugural non-agency US RMBS transaction.

S&P, Fitch, DBRS and Kroll rated the prime mortgage deal, a US$251.377m trade titled SAFT 2013-1. The US$235.42m 4.63-year a senior tranche received Triple A ratings.

The loans are being originated out of Shellpoint’s wholly-owned New Penn Financial platform. Wells Fargo is the master servicer of the transaction. The deal did not price by press time.

“This is New Penn’s first securitization and therefore the company does not have any securitization history,” Kroll wrote in a pre-sale report.

The Shellpoint deal came out  Thursday with relatively wide price guidance of interpolated swaps plus 240bp-245bp on the Triple A tranche.

Market experts said that last week’s FOMC/Bernanke announcement contributed to the spread volatility, although an ongoing supply/demand imbalance in non-agency MBS has buffeted the market as well, possibly affecting investor reception to the transaction.

Dealers are said to be long non-agency RMBS product, mainly as a result of the Lloyd’s US$8.7bn BWIC auction from two weeks ago.

“Pricing will no doubt be impacted by the recent Fed-induced wholesale retrenchment in asset prices, but I think also by some of the supply/demand imbalance engendered by the Lloyds sale,” said Christopher Sullivan, chief investment officer of the United Nations Federal Credit Union.

“So I would expect RMBS prices generally to come under renewed pressure as quarter-end draws near. It’s an interesting set-up here for this (Shellpoint) deal.”

Sullivan suggested investors would likely require a significant amount of concession on the deal to account for spread volatility.

California concentration

Geographical concentration is also a risk for the deal, as it has been for several recent private-label RMBS deals. There is a high concentration of California-based loans (63% according to Fitch), linked to high home prices, in the portfolio. Some 13%, 12%, and 9.5% are in the San Jose, Los Angeles and San Diego areas, respectively.

“The pool has significant regional concentrations that resulted in an additional penalty of about 15% to the pool’s lifetime default expectation,” said Fitch analysts in a pre-sale report.

While 4.3% of the loans were originated to foreign nationals with no credit score, the weighted average FICO of 770 for borrowers with a credit score demonstrates a strong borrower credit quality, according to Kroll.

While high, the geographic concentration in SAFT 2013-1 is comparable to those seen in recent RMBS transactions, Kroll said.

The mortgage pool consists of 445 first-lien mortgage loans with an aggregate principal balance of US$261.57m. The pool is made up almost entirely of 30-year fixed rate mortgages.

The remaining loans have terms of 10 years (two loans), 15 years (14 loans), and 20 years (one loan).
There are five hybrid adjustable-rate mortgages (ARMs) in the pool - two 5/1, two 7/1 and one 10/1.
Approximately 97% of the pool is fully amortising, with the other 3% (thirteen loans) having a 10-year interest-only (IO) period.

Moody’s calls New Penn “below average”

Rating agency sniping reared its head again regarding the deal, this time directed by Moody’s at a mortgage-lending platform co-owned by Ranieri.

The ratings firm on Thursday published a critical assessment of New Penn Financial, the mortgage-origination platform bought by Ranieri’s mortgage-finance firm Shellpoint Partners two years ago.

The timing of Moody’s report is significant, given that Shellpoint’s deal was marketing. All of the loans in the offering, which are mostly prime jumbo, were originated off of the New Penn Financial platform.

Moody’s was not chosen to rate the deal. Standard & Poor’s, DBRS, Kroll, and Fitch each assigned the senior tranche of the transaction a Triple A rating with 10% credit enhancement. Credit Suisse declined to comment.

Moody’s said that New Penn’s mortgage-lending platform is too new and untested, and wrote a negative “originator review” of the Shellpoint-owned company. The ratings firm described New Penn as “a below average originator of prime, jumbo residential mortgage loans”.

Moody’s said the company, which was bought by Shellpoint two years ago, has “liberal lending guidelines that: allows foreign national borrowers, uses assets for income, and has debt-to-income (DTI) ratios as high as 58%.”

Additionally, the company had high turnover in its underwriting team in 2012, and “weak reserve requirements compared to other jumbo originators,” the agency wrote.

New Penn is a relatively new mortgage originator, having been in business for just five years. Shellpoint Partners LLC, co-founded in 2010 by Ranieri, has owned New Penn for about two years and is the driving force behind its origination growth of jumbo and other types of loans that are ineligible for sale or securitisation to Fannie Mae or Freddie Mac.

Lewis Ranieri was said to have coined the term “securitisation” when he headed up the mortgage-bond department of Salomon Brothers in the late seventies and early eighties, where he helped to price the first-ever private mortgage-backed security.

Moody’s admitted that New Penn adequately vets borrower income and employment, and has “good procedures for rooting out fraud for loans made to non-foreign national borrowers.”

However, “the number and seasoning of the loans are insufficient for Moody’s to give any weight to New Penn’s early loan performance at this time,” Moody’s said. The ratings firm regards New Penn’s loan performance as too recent to assess correctly.

New Penn originated just 158 jumbo loans during the review period — not enough for a meaningful assessment, Moody’s added.

Moreover, New Penn has a “small appraisal management team with no licensed appraisers on staff,” wrote a team of Moody’s analysts led by Kathryn Kelbaugh.

Pricing was expected on Friday afternoon. Shellpoint filed with the SEC last October to issue up to US$2bn in private-label RMBS, and intends to become a programmatic issuer.

Pool of buyers for riskiest CMBS slices grows

By Adam Tempkin

NEW YORK, June 11 (IFR) - There is a growing supply of purchasers for the riskiest slices of CMBS deals and as competition heats up, underwriting is deteriorating in the once-again booming commercial mortgage bond market, according to panelists speaking Tuesday at the annual conference of the Commercial Real Estate Finance Council (CREFC).

There were standing-room only crowds for every session at the trade group's annual New York conference at the Marriott Marquis hotel in Manhattan.

Members of the group, which represents all facets of the CMBS and commercial real estate markets, were excited at the renaissance of the US CMBS market, which may exceed US$75bn in 2013 after seizing up in 2008 after the financial crisis. Approximately US$56bn was issued in 2012.

So-called B-piece buyers, who purchase the bottom-most and riskiest level of the capital stack, historically garnered the highest returns and took on the most risk in CMBS deals. They were therefore awarded great control over each transaction and the loans in it.

But what used to be a small club of B-piece players has mushroomed into a much larger group as so-called fast money players, or hedge funds, are putting in bids for recent CMBS deals.

"B pieces are the high yield bonds of the CMBS market," said one panelist who worked for a new entrant in the B-piece space. "With all of these new players and competition heating up, the market is not as stable as it was."

At least eight mainstay industry players bought the B-pieces of one deal over the last year, while three to four new entrants participated in recent deals. At least seven other players are bidding on B pieces of CMBS deals in an attempt to get into a hot market.

Along with increased competition and an expanded pool of B-piece buyers, leverage has crept up and underwriting has declined in recent deals, panelists said.

Industry participants at the conference questioned whether hedge funds were getting into the business simply as a "trade" to make quick money, or whether there was a sense of dedication that means that some buyers would hold the B-pieces in their portfolios to term.

While several hedge fund managers said that they are dedicated long-term to the sector, one prominent asset manager said that his company's decision to play in the market is a "relative value" assessment.

"We don't have anything necessarily earmarked for the B piece market," he told an audience of hundreds.

"But if we see something we like, we kill it and eat it."

In other words, he said, "trade" might not be appropriate word for his company's strategy in the B-piece sector.

"It's a relative value decision as to whether we're in or out."

One asset manager who is a B-piece buyer said that while credit is loosening, "it's not that bad", and the real problem is "a simple supply and demand" issue.

With at least 17 B-piece bidders now in the market competing for a relatively limited number of deals, B-piece yields are going to continue to compress and underwriting might suffer, as newer entrants might be more reluctant to "kick out" a faulty loan from a securitized pool.

"That being said, considering the great cost and total work that it takes to competently manage a CMBS B-piece portfolio, getting into the business is just not cheap enough to be just a 'trade'," said one hedge fund manager. "This is only a business for us, not a trade."

Subprime auto bonds: should they be rated AAA?

By Adam Tempkin of Reuters IFR

NEW YORK, April 17 (IFR) - Rating agencies have openly conceded that US subprime auto-loan underwriting is loosening and that borrowers’ credit quality will get much worse this year, but they insist that their top investment-grade ratings on the recent surge of subprime auto bonds – many of which they have graded Triple A – are rock solid.

However, not everyone is convinced, including certain skeptical bond investors and rival rating agency analysts, who say that ratings on the white-hot asset class need to be more conservative. They claim that the gilded top rankings given to a spate of recent deals from smaller, second-tier lenders with no long-term asset-backed security (ABS) track record will be in jeopardy if there is another major downturn in the economy.

Still other bond investors have cautiously participated in the sector but are careful to perform their own due diligence on transactions and issuers rather than take the rating agencies' top grades at face value.

Subprime auto bond issuance has skyrocketed over the past year. So far in 2013, nearly US$7.5bn of new subprime auto ABS has been issued, roughly 32% higher than in the same period of 2012, according to Deutsche Bank. There was US$18.5bn in issuance for all of 2012, versus US$11.75bn in 2011.

The low interest-rate environment and tight yields on prime auto ABS have made subprime auto paper an attractive yield play for investors. But the disagreements on the risky asset class have led to some split ratings on senior tranches and a growing debate on the buy-side as to whether the creditworthiness and liquidity of top-rated offerings from second-tier and third-tier companies will hold up over time.

“We are confident that the ratings will hold,” said Mark Risi, a senior director of ABS at S&P, which was the only agency to provide ratings on all four of the subprime auto bond transactions that have been devoured by investors over the past two weeks. Another deal from Detroit-based Credit Acceptance Corp. is expected to be marketed this week, and so far Kroll Bond Ratings and DBRS have granted the deal AAA ratings.

S&P bestowed AAA ratings on two of the recent deals – from issuers AmeriCredit and Prestige Auto – while granting high investment-grade ratings to deals from Mason, Ohio-based Security National Automotive Acceptance Co (SNAAC), which returned to the ABS market last year after a ten-year absence, and Chadds Ford, Pennsylvania-based Flagship Credit Acceptance, which was bought out by investment manager Perella Weinberg Partners in 2010.

Rival agency DBRS actually granted the SNAAC deal a full AAA rating, resulting in a split rating on the senior tranche of AAA/AA (DBRS/S&P). Last week’s Flagship transaction, meanwhile, received a slightly higher rating from Kroll on the senior tranche, leading to another split: A+/AA– (S&P/Kroll).

“We have never downgraded a subprime auto ABS bond for credit reasons since we started covering the sector in 1991,” Risi said. “We’re comfortable with the stress scenarios we impose, as well as our loss expectations, the structural protections on the current deals, and especially the fact that credit enhancement grows as the transaction amortizes.”

So-called credit enhancement is the buffer structured into securitizations that protects senior bondholders in case the underlying loans begin to sour.  This "credit support" takes many forms in subprime auto ABS deals. 

This includes a reserve account, or funds set aside to reimburse the issuing trust in case of losses; overcollateralization, wherein the face value of the underlying loan portfolio is larger than the security it backs; subordination, where the lower tranches act as protective layers for the more senior tranches; and excess spread, where the interest rates received on the underlying loan collateral is greater than the coupon paid out to bond investors. 

Protected
 
Therefore, the deals are protected by structure, the agencies claim. Some bond deals from 2012 have rating agency-projected expected losses of as much as 25% to 26.5%, yet still received Triple A ratings.

“Structural features will buffer subprime auto ABS despite weakening collateral quality trends,” said Ellen Callahan, an ABS research analyst from Deutsche Bank, who noted that the credit support increases quickly on the deals.

"The ratings quality of these deals as a whole deserves the benefit of the doubt," said Dave Goodson, head of securitized-product investing at ING Investment Management.  "Consumer ABS had one of the most stable ratings profiles through the credit crisis.

"That being said, if it was something we participated in, we would need to do our own due diligence in order to reach a conclusion on a particular deal," he added.

S&P, DBRS, Kroll, Moody’s and Fitch have all published recent reports warning about a declining trend in subprime auto credit quality, but they have each taken slightly different stances on the matter when it comes to rating new deals.

Fitch and Moody’s have been willing to provide top ratings to the most established, well-known liquid names in the sector, such as GM Financial (formerly AmeriCredit) and Santander Consumer USA. But they have either been deemed too conservative by issuers (and therefore not hired) or have refused to rate several deals from lesser-known or unproven issuers.

Fitch, especially, has avoided a sector it believes is too risky. “We are generally more reluctant to reach AAA on subprime auto ABS for numerous reasons, among them the sector's innately more volatile performance history, operational concerns and often heavy reliance on securitization as sole source of funding” said John Bella, co-head of US ABS ratings at Fitch. “Stiffer competition and deteriorating underwriting in recent months are amplifying our concerns.”

Nearly 25% of the obligors in the recent SNAAC deal – underpinned by loans to military personnel – have no FICO score at all, meaning they do not have credit histories yet, according to DBRS. About 24% have ultra-low FICOs of between 500 and 550, according to S&P. Nearly 24% of the loans have loan-to-value ratios of 115% to 119.99%, meaning that these obligors borrowed more than their car is worth.

S&P said that it would not assign a rating to the deal higher than AA because "the company reentered the securitization market in 2012 after 10 years and has yet to establish a securitization track record; its SNAAC 2012-1 transaction has less than 12 months of securitization performance data."

Meanwhile, Utah-based Prestige Auto priced a US$350m subprime auto bond on April 3, with Triple A ratings from S&P and DBRS on the senior tranches. The company caters to borrowers who have recently declared bankruptcy. Specifically, Prestige lends to car buyers who have filed for bankruptcy and opt to purchase a vehicle prior to the closing or "discharge" of their bankruptcy.

The rating agencies said that the presence of so-called bankruptcy collateral actually helps the performance of the underlying pool, because many of the debts an obligor had were discharged as a result of the bankruptcy filing, or are being repaid in accordance with a court order. Court documentation allows Prestige to calculate a more precise debt-to-income ratio, according to DBRS.

The deal also featured a so-called prefunding account, a riskier structure not seen in ABS since before the financial crisis. The funds in the account will be used to purchase up to US$58m in additional collateral after the close of the transaction. The risk is that new auto loans delivered to the trust could be poorer in credit quality than those already in the pool. 

Buyer beware
 
John Kerschner, the head of securitized-product investing at Janus Capital Group, says that he prefers to stick to subprime auto deals from only the largest and best-known programmatic issuers.

“The gap between the biggest players and the smaller issuers is just massive,” Kerschner said. “The smaller second-tier players go to deep, deep subprime, in the range of a 500 FICO score. That may not be the person you want to lend money to.”

Kerschner says he has a better feel for predicting how the larger, liquid players’ deals will perform throughout all cycles of the market.

Officials at Prestige Auto beg to differ. "We have since 1996 issued more than US$2bn in subprime ABS, with no events of default or accelerations, notwithstanding the ensuing economic cycles," Aaron Dalton, senior vice president of structured finance and business development at Prestige Financial Services, told IFR.

He added that data show that Prestige's ABS deals have performed similarly to transactions from GM Financial and Santander.

Other bond investors have participated in recent deals, but are sure to personally meet with management and understand the business model of a smaller subprime lender before investing in a transaction. "I do site visits and try to find out who really owns the company," said Mike Kagawa, a senior ABS portfolio manager at Payden & Rygel in Los Angeles.

"Do I trust ratings? No. But I take each deal on a case-by-case basis," Kagawa said. "I'm particularly wary of private equity involvement in the subprime auto sector. It's not a problem at the moment, but when the cycle turns, it could be a red flag."

"We like to have the opportunity to speak with management first," added a Boston-based ABS portfolio manager who invests in subordinate slices of subprime auto ABS deals. "We do our own assessments of the loan pool; we don't base it on the credit ratings."

In recent years, private equity companies such as KKR & Co, Warburg Pincus, Centerbridge Partners and Blackstone have bought stakes in various smaller subprime-auto companies.

Janus' Kerschner says that with investors hunting for yield wherever they can get it, and underwriting slipping, investors should be wary of smaller issuers who have no recent history in the ABS market.

“Credit rating agencies have their models and they usually work, but sometimes they’re just drastically off," Kerschner said. "For subprime auto, it’s the kind of model that works … until it doesn’t.

Reuters IFR: Kroll ascends to No. 3 in CMBS ratings business

Jul 19 10:36am By Adam Tempkin

 

NEW YORK, July 19 (IFR) -   Just one year after rating its first commercial mortgage-backed securities deal, newcomer Kroll Bond Ratings has grabbed the No. 3 market-share spot in year-to-date CMBS ratings, eclipsing some of its more experienced competitors, including Big 3 agency Standard & Poor's, according to IFR Markets deal data.
    The rating agency, started by storied corporate-investigations pioneer Jules Kroll only two years ago, rated about $10.6 billion worth of CMBS year-to-date via 11 offerings, including private-label deals issued by bank lenders as well as transactions backed by loans on multifamily properties underwritten by Freddie Mac, according to IFR Markets.
    This places the newcomer at the No. 3 market-share ranking following Fitch, which rated about $17.5 billion, and Moody's, which rated the largest amount of CMBS so far this year -- nearly $18 billion.
    Kroll also narrowly beat out two other more-tenured competitors who have been rating CMBS for years: Toronto-based DBRS, which captured the No. 4 spot for year-to-date market share, and Morningstar, which came in No. 5, according to the IFR Markets deal database.
    Kroll's ascendance was no doubt helped by the fact that Standard & Poor's, once a leader in CMBS ratings, found itself all but locked out of the market to rate CMBS offerings after a slip-up one year ago on a $1.5 billion deal cost it much of its market share.
    The episode, which involved discrepancies that S&P found in its ratings for a July 2011 deal, led to bonds being pulled from the market post-sale, and eroded S&P's credibility. The debacle also took S&P's share of the CMBS ratings market along with it, allowing relative upstarts like Kroll to steal away part of the sector's business. S&P has recently overhauled its ratings criteria in an attempt to regain a foothold in the market.
    But Jules Kroll, who points out that his agency rated its first CMBS transaction prior to the S&P incident -- and has now rated a total of 19 deals -- says that it is instead a focus on deep due diligence, insightful analysis, and very selective hiring of seasoned professionals that has allowed his firm to quickly gain investors' trust and attract issuers' pocketbooks.
    "Given my legacy, the tone we try to set is that due diligence counts," said Mr. Kroll, whom many credit with inventing the modern corporate investigations industry. "The incumbent rating agencies make a point that it's not their responsibility to do due diligence, that they're only reviewing what's presented to them. But the tone we try to set is that the ultimate goal is to give investors as much as we can give them to make their own judgments."
    Kroll Bond Ratings has already expanded into municipal-bond ratings and asset-backed securities, and plans to issue its first corporate rating in the Fall, continuing down that path with an emphasis on grading financial institutions. However -- sticking to its strengths -- it will not attempt to rate the debt of sovereign nations.
    "Our views, our approach, our embracing of due diligence over time with surveillance and detailed write-ups, are of people who are trying to restore trust," Mr. Kroll told IFR.

GAINING TRACTION

    It's not an accident that the agency has excelled in CMBS. After initially spending money and time in 2009 developing non-agency residential mortgage-backed securities (RMBS) ratings models, Mr. Kroll finally realized that the sector was not returning anytime soon, and instead turned his attention to the nascent post-crisis renaissance in commercial mortgage bonds, another battered asset class.
    He sought out some of the most seasoned and well-known analysts in the industry to head up his new structured finance ratings business.
    "We offer more than a rating; what we view as a product is the insight into the analysis," said Kim Diamond, who joined Kroll in December 2010 to head up the firm's structured finance business.
    Diamond was a 21-year veteran of S&P who headed up the CMBS new-issue ratings group for years and eventually headed the entire mortgage-bond ratings unit during the tumultuous time after the crisis hit in 2008.
    Frustrated by some decisions that S&P upper management made in the aftermath of the crisis, Diamond left the firm in 2010.
    Diamond herself commanded the overwhelming respect of the CMBS investor and issuer community, making her a perfect choice to head up Kroll's new structured finance unit. "She was well known, seasoned, and emerged from the crisis with an unscathed reputation," Mr. Kroll said.
    Shortly thereafter, Diamond recruited another respected CMBS colleague from S&P, Eric Thompson, to head up Kroll's structured-finance surveillance efforts.
    "We were known entities to the industry, just resident in a different place. So there was a predictability of outcome" to what investors were getting, Diamond said.
    While many of the Kroll analysts have rating agency backgrounds, Diamond says that the firm has made a point to also recruit professionals from the buy-side, sell-side, bond-structuring professions, research, and appraisal and workout backgrounds.
    "Rather than taking the standard academic or didactic approach that many agencies take -- which tends to be very disconnected from the real world -- we brought in perspectives of those that had taken part in different parts of the business. That makes our perspective much more holistic at the end of the day," she said.

OVERCOMING A STIGMA

    Still, it was an uphill battle to gain the trust of investors or convince underwriters and banks to choose the upstart to rate new issues.
    "It was not written in the Bible that anybody had to put a Kroll rating on anything," said Mr. Kroll.
    One stigma that was hard to overcome: Kroll used the same pay structure as Moody's, S&P, and Fitch, the harshly criticized "issuer-pays" model. The conflicts of interest arising from this model -- the notion that the agencies were serving the wrong master in the run-up to the crisis and therefore were swayed to stamp toxic securities with Triple A ratings -- have been sharply lambasted by Congress, investors, and pundits.
    "It's become a bit of a shibboleth that that 'issuer-pay' doesn't work," Mr. Kroll said. "Well, what's the alternative? The investors don't want to pay."
    To get his start in the bond-ratings business, Mr. Kroll acquired an SEC-registered boutique credit rating agency in 2010, Lace Financial, that used an investor-pays model, but soon discovered that the pay structure was not viable.
    "It quickly became clear that investors didn't want to pay," he said. Mr. Kroll says his firm recognizes the inherent conflict that's involved with 'issuer-pays', so there is a tendency to be more conservative on some ratings, and "that has cost us some business."
    But company executives also point out that the investor-pays model has its own conflicts, including the fact that large, influential asset managers have their own vested interests: for instance, they don't like volatility or downgrades, they like access to analysts, and there could be the perception that they're receiving more information than smaller shops.
    "The reason that the issuer-pays model got a bad name is because it was combined with opaque criteria," said James Nadler, president and chief operating officer at Kroll, as well as a former executive vice president at Fitch. Pre-crisis, the rating agencies had unclear criteria, and therefore could rate securities however they wanted, saying that an issuer's rationale for a Triple A "generally fit" within the methodology, Nadler said.
"When the 'issuer-pay' model is combined with transparent criteria, and transparent analysis, there are fewer conflicts," he added.

EXPANDING THE BUSINESS

    Mr. Kroll feels that the quality of his firm's analysis is what distinguishes it from the Big 3 rating agencies, and that there is still opportunistic room for a boutique shop in the ratings business, especially after the pummeling that the large raters took over the last few years in the court of public opinion.
    "The level of criticism and condemnation that these folks have taken now for several years is non-stop," he told IFR. "If I was running one of these places, the first thing I would do is apologize. And offer an explanation."
    That may be hard to do for S&P, Moody's, and Fitch, however, Mr. Kroll said, as they are constrained by lawyers protecting them from litigation, regulators, and the Dept. of Justice.
    But the tattered reputation of the other agencies means that Mr. Kroll sees selective near-term opportunities in other areas where his ratings company can prove its analytical worth. The agency hopes to replicate the success it has found in CMBS this past year in other sectors, and has already rated a subprime auto ABS transaction, with two more in the queue, and is in the process of rating its first container-lease deal.
    Moreover, the bigger picture for Kroll Bond Ratings expands beyond just grading transactions and companies: Mr. Kroll intends to acquire an information provider/data company and combine it with the agency over the next year.
    "It is not our intent to only be a ratings business," he said.
    In order to make such an acquisition, however, and for it to be profitable, he has to make sure that there is a sturdy platform to build on.
    "I'm not doing this as a religious experience," Kroll said. "I'm doing this to achieve an economic return, and I think the marketplace will ultimately reward us economically if the product is viewed as independent and of high quality."
    "The minute it's not viewed as independent and high quality, we're toast."

adam.tempkin@thomsonreuters.com

Reuters IFR: New student-loan concept includes securitization plan

NEW YORK, April 5 (IFR) -- A San Francisco-based start-up lender named Social Finance (SoFi) is pitching a new concept in US student loans -- alumni-backed investments -- and is planning to securitize the product to reignite the student-loan asset-backed securities (ABS) market and help repair what it calls an "unsustainable" student-debt crisis in the US.

SoFi has already tested the waters with a $2 million pilot program at Stanford University Graduate School of Business, in which 40 of the school's alumni invested in the mezzanine tranche of a loan pool raised for student consolidation loans, which are used to refinance existing debt where loan amounts range from $5,000 to $200,000.

The company is now looking to expand the consolidation-loan program to 40 mostly top-tier universities, with a target of $150 million in originations for 2012, and hopes to scale up to $1 billion by 2014. A separate program for new or matriculating students is also being rolled out. Interest rates are competitive to, or even slightly lower than, government-based loans.

"We are using the capital markets as an effective medium to perpetuate a market-based solution to a social problem," said Mike Cagney, SoFi CEO and chairman. "By offering alumni the opportunity to invest in students from their schools, we are restoring the historical norms of community-based lending."

"Students get a lower interest rate and alumni get a way to support their university while earning a financial return. Both sides are vested in one another’s success."

Feasible, but unproven

The current US student loan market is broken, said Cagney, a former head of proprietary trading at Wells Fargo. With education costs on the rise and $1 trillion in outstanding loans -- student debt is now the second largest consumer segment behind mortgages -- more students are graduating with debt than without, and borrowers face high interest rates and a challenging job market.

 The "social" piece of the puzzle is what’s missing, SoFi believes. Cagney claims that a school-specific alumni-based investment vehicle provides mutually beneficial interactions that would make students less likely to default. Moreover, alumni will be empowered to offer advice, mentorship, and career support to students, although it’s not yet clear exactly how that connection will take place, or whether an alumnus will know the exact identity of a borrower.

"You are planting the seeds for lifetime engagement," says Cagney.

Alumni investors buy into the loan pool with a so-called certificate of participation -- basically, an asset-backed security -- and earn nominal returns of 5% to 8%, depending on the level of risk they take in their investment. Alumni can invest directly or through their individual retirement accounts, meaning that investing does not affect alumni donations to the school.

The proposed ABS will have a senior/subordinate structure where the alumni investors mainly have a stake in the mezzanine notes. The senior tranche goes to institutional investors – many regional banks are interested, Cagney said – and SoFi takes the equity piece, which is the riskiest. The lender retains 50% of residual cashflows for a reserve account.

The social aspect "creates positive selection among borrowers and increases the credit quality of the pool", Cagney added. In fact, he claims the senior notes would have roughly the same coupon and comparable subordination, or credit protection, as a traditional private student-loan ABS, except the SoFi alumni-backed product would have better underlying credit quality.

 There is one problem, though. Rating agencies will not rate the product, due to its lack of a track record. "We hope to get it shadow-rated by a bank. We think it has Triple A capitalization," Cagney noted.

More thought required

But some student loan ABS experts are skeptical. "While in theory this may be a viable product, there are serious legal implications that need to be thought about, investigated, and complied with," said Steve Levitan, a securitization partner at Bingham McCutchen.

Firstly, complying with the new set of regulations laid out by the Consumer Financial Protection Bureau will be an uphill battle, Levitan said, and cherry-picking the better students from mostly top universities with a postgraduate refinancing loan offering will cause certain classic lenders such as Sallie Mae to respond aggressively with similar products.

"Somebody has a loan to these people already; no company likes to have their best loans taken away from them," Levitan said.

Moreover, while community-based loans are a unique concept, it's not yet clear whether the connection to alumni is enough to guarantee borrowers will stay current on their loans, says Scott Weingold, the co-founder and head of College Planning Network, LLC, a college admissions and financial aid servicing and advisory center.

"At the end of the day, the question is, does the alumni tie-in really make a student less likely to default than if the loan was written somewhere else?" Weingold said. "That's unproven. Ultimately, it all comes down to whether a borrower has the money to pay the loan back."

And lastly, the market needs more details on how the "social connection" works. For instance, if an alumnus ends up calling a student to put moral pressure on him to pay his debts, that makes the alumnus a debt collector. "And there are legal ramifications to that,” Levitan said. "You need a license to do that."

Adam Tempkin