SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy. The main article for this March edition, "Following the Hammurabi," highlights collateralized lending, a practice as old as Mesopotamia. Today, assets like cars, credit cards, shopping malls, and condos, in the form of securitized products, provide investors with diversification and protection that Hammurabi would approve of.
Following the Hammurabi
Timothy A. Lee, CFA, Senior Credit Analyst
In ancient Babylon, lenders commonly received property from borrowers as protection from defaults. Under the Code of Hammurabi, allowable collateral included land and houses, as well as wives and children. Thirty-eight hundred years later, lenders now loan money by the billions on an unsecured basis. This is exemplified in the corporate debt market where money is given to a business with simple faith, and some scrutiny by analysts and rating agencies, that the funds will be returned as promised. Instead of taking one-sixth of a shekel of silver as interest, debt investors receive an additional percentage of money as interest.
Collateralized borrowing, however, remains widespread in 2014, most prevalently in the form of securitized products which include asset-backed securities (ABS) and mortgage-backed securities (MBS). Typically pledged assets these days include motor vehicles, credit card receivables, student loans, hotels, shopping malls, and combines — though homes continue the Hammurabian tradition of being the most visible collateral type. Collateral is protected through securitization, which usually means placing assets in a bankruptcy-remote, special purpose entity for the benefit of the money lenders.
Securitization also allows for cash generated from these assets to be divided and assigned according to maturity needs and risk appetite. For example, investors with lower risk tolerance or a shorter investment time horizon may have priority to receive interest and principal in a more reliable timeframe in exchange for a reduced rate of return. Conversely, investors willing to bear losses first or tolerate a longer or more unpredictable maturity schedule may receive a higher interest rate.
Securitized products are constructed to withstand a certain amount of losses, similar to a building that is designed to survive an earthquake of certain magnitude. The Great Recession of 2007-2009 exposed the inadequate construction of some securitized transactions, particularly those with poorly underwritten borrowers and collateralized by homes with tumbling value. Simultaneously, the Great Recession also substantiated the architecture of most securitized products to absorb losses. For example, according to Moody's research, no losses have been incurred in the last 10 years, through the end of 2013, on ABS collateralized by auto loans or credit card receivables that were originally rated Aaa by Moody's. For the same period on MBS secured by commercial real estate (CMBS), the percentage of bonds originally rated Aaa by Moody's that experienced a loss was far below one percent.
Optimizing risk management and achieving outperformance with investments in securitized products require projections for future collateral value and future borrower payment behavior. Even where historical defaults have been minimal, as with MBS guaranteed by a U.S. government agency or with prime auto loan ABS, disappointing investment returns occur when estimates of scheduled principal and interest payments are materially inaccurate. For instance, if cash is returned earlier, less interest than expected is earned, while slower repayments may elongate the original expected final maturity date.
Despite idiosyncratic challenges, securitized products may add incremental return to similarly rated bonds such as U.S. Treasuries and US. Agencies, provide complementary diversification to corporate credit exposure, and enhance loss mitigation efforts by providing identifiable, tangible assets to benefit creditors.
While not as valuables having Babylonian spouses as collateral, Hammurabi would be unlikely to frown upon much of the hard assets backing today's securitized products.
Guide to Securitized Products
Eric Souza, Senior Portfolio Manager
Asset-backed securities (ABS) are bonds backed by financial assets consisting of consumer receivables such as auto loans and credit cards. 90% of issues are rated AAA and have durations of around two years.
Sample Issuers: Honda, Nissan, Ford, Toyota, Hyundai
Mortgage-Backed Securities (MBS) are bonds backed by home mortgage loans. Homeowners' monthly mortgage payments are passed through to bondholders who receive both principal and interest monthly. Typically, bonds pay coupon payments periodically (monthly/semi-annually) and then principal at maturity.
Sample Issuers: Fannie Mae and Freddie Mac
Collateralized Mortgage Obligations
Collateralized Mortgage Obligations (CMOs) are bonds backed by mortgage-backed securities. These bonds were developed to offer investors a wider range of when they will receive monthly principal and interest. A CMO is created by bundling mortgage-backed securities into different tranches whereby a homeowner's monthly mortgage payment is allocated to different CMO tranches based on average live profiles, and not on a pro-rata share.
Sample Issuers: Fannie Mae and Freddie Mac
Commercial Mortgage-Backed Securities
Commercial mortgage backed securities (CMBS) are bonds backed by mortgages on commercial and multifamily properties such as office buildings and hotels.
Sample Issuers: JP Morgan, Citigroup, Freddie Mac
Investors seeking additional diversification from corporate credit risk may look towards the securitization market. At SVB Asset Management we like ABS and CMOs for our client portfolios. These bonds have high credit quality ratings of AAA and generally offer higher yields relative to other similar rated bonds such as U.S. Treasuries and agencies. Since the bonds we purchase typically have short durations of two years or less, any volatile moves in interest rates do not have much of an effect on these securities. The securitized sector allows the opportunity to diversify portfolios away from typical short duration/corporate cash investments such as corporate bonds and commercial paper.
Credit Vista: An Air of Uncertainty
Kyle Balough, Credit Research Analyst
According to U.S. regulators the 2010 money market fund reforms were not enough to protect investors adequately. After the June 2013 proposals, influenced by the Financial Stability Oversight Council (FSOC), the Security and Exchange Commission (SEC) continues to deliberate on additional protections and implementation timeframes.
Several months have passed since the public comment period ended on September 17, 2013. Many market participants believe a decision from the SEC could happen as soon as late March, although Q3 2014 is more realistic. Recently appointed SEC Chair Mary Jo White has stated, "Completing these reforms with a final rule is a critical priority for the Commission in the relatively near term of 2014."
The SEC has received hundreds of letters with a range of differing views on pending reform delaying the process. Additionally, it is rumored the FSOC favors floating NAV while the market is widely opposed. The SEC has the difficult task of balancing pressure imposed by section 120 of Dodd-Frank, requiring them to address proposals from the FSOC, with overwhelming market reform opposition.
To recap, there are two main proposals along with the addition of proposed transparency enhancements. Alternative one, called the Floating NAV or (FNAV), would require funds to price their NAVs daily according to the market prices of underlying assets rounded to the nearest fourth decimal place. The SEC estimated compliance deadline would be two years. Alternative two requires funds to impose liquidity fees or gates during times of stress that could amount to two percent of the redemption, or a possible 30-day hold back on investor redemptions. The compliance deadline would be one year.
Both alternatives produce challenges for the investor. Whether it is liquidity concerns from fees and gates or tax and accounting implications through FNAV, the industry continues to wait with an air of uncertainty.
Economic Vista: Cold Start
Paula Solanes, Portfolio Manager
Federal Reserve Chair Janet Yellen's inaugural FOMC meeting kicked off without too many surprises. The Fed pushed on with its tapering program with round II of tapering, bringing the balance down from $75 billion per month in asset purchases to $65 billion. Towards the end of the month, the Fed minutes were in line with some of the recent speeches from Fed presidents; however the minutes revealed the committee will focus on the exact cause of recent drop in the unemployment rate and how forward guidance policy should take form.
Frosty weather continued to take a bite out of economic data this past month. As many economists' anticipated non-farm payrolls came in lower than expected with only 113k jobs added against 180k anticipated. In addition, the prior two months were revised upwards by 34,000. Hopefully, as conditions begin to thaw out payroll numbers will improve. The unemployment rate dropped further to 6.6 percent but was largely due to continuing decline in participation rate. The drop in the unemployment rate is driving the Fed to reassess its forward guidance language and metrics.
Housing was again impacted by cold weather. Sales of previously owned homes hit the lowest level in a year at a 4.62 million annual rate, again, due to terrible weather coupled with weak supply. New home starts increased only 880,000 a 16 percent month-over-month drop due to cold weather.
Retail sales were meek to say the least, excluding auto sales, and retail activity was flat hitting the lowest point for the sector since June 2012. Once again the main culprit was the cold weather, but also the uneven improvement in the labor force.
Inflation continues to be benign, giving the Fed time to focus on growth. The consumer price index increased 0.1 percent in January, following a 0.2 percent increase in December. Apparel stores and auto dealers were among retailers reducing prices in January to entice shoppers dealing with paralyzing weather conditions.
The second revision to fourth quarter GDP revealed that the economy did not grow as fast as initially estimated. Gross domestic product expanded at 2.4 percent versus the first estimate of 3.2 percent. Smaller gains in consumer spending, inventories and exports hampered growth. On the bright side, business investment climbed 10.6 percent compared the first estimate of 6.9 percent.
Trading Vista: U.S. Bonds Outperform Due to Weakness Abroad
Eric Souza, Senior Portfolio Manager
The bond market outperformed in January due in part to disappointing labor market and manufacturing data in the U.S. The outperformance can also be attributed to flight-to-quality trades as emerging market concerns stemming from soft data releases from China as well as central bank activity in Turkey and South Africa added to demand for U.S. assets. The Turkish central bank took the most aggressive steps by hiking a variety of short-term rates 400 to 500 basis points to help soften currency declines Causing even more emerging market disruptions was the Fed's decision to continue tapering its purchases of Treasuries and mortgage-backed securities as both the U.S. stock market and emerging markets have been one of the biggest benefactors of the Fed's stimulus package. The stock market underperformed in January with the S&P 500 falling over 3% while the bond market was up close to 1.5 percent. Credit and mortgage-backed securities were the two best performing spread sectors in January returning both around 1.5 percent.
Treasuries rallied across the curve with the 2 year Treasury yield rallying five basis points to 0.33 percent while the 10-year Treasury rallied 38 basis points to 2.65 percent. In the one to three-year part of the market, credit and automobile asset-backed securities were the two best performing sectors returning 27 basis points each while one to three-year Treasuries returned 16 basis points.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable, but which have not been independently verified by us and for this reason we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.