Aurora Borealis
1 August 2013 CFA Institute Journal Review

U.S. Structured Finance Markets: Recent Recovery, Post-Crisis Developments, and Ongoing Regulatory Uncertainties (Digest Summary)

  1. Servaas Houben, CFA

A renewed interest for U.S. structured finance products has occurred recently. This increase in demand can be explained either by a return to pre-crisis excessive risk taking or by investors looking for value investments that have been restructured and improved after the crisis.

What’s Inside?

The issuance of structured finance products expanded significantly until the financial crisis. Since the crisis, the market has recovered for some specific products, such as asset-backed securities (ABS) and collateralized loan obligations (CLO), but for other securities, such as those related to mortgages, there has not been a similar recovery. The amount of documentation for these securities has improved since the crisis, but it has not always resulted in more transparency. In addition, implementation of the Dodd–Frank Act is still ongoing, which leads to uncertainty about structured products (e.g., the Volcker rule could limit banks’ investments in special purpose entities [SPEs] and, hence, limit the products themselves). Finally, there is still uncertainty around the definition of materiality in relation to recent SEC proposals on conflicts of interest, which makes it very difficult to predict how this market will develop in the future.

How Is This Research Useful to Practitioners?

An exception to the general decrease in the issuance of structured finance products is insurance-linked securities (ILS). These products earn interest on the collateral provided and on insurance premiums while paying for insurance claims. ILS issuance has been rather stable, even during the crisis. A new type of ILS issuance is coming from government-owned and government-sponsored issuers. The ILS asset class provides diversification and high yields compared with other credit investments.

Improvements have been made in the structured finance market since the crisis—for example, CLOs now have better documentation and more transparency on contractual items. Also, CLO contracts have adjusted their trigger processes to prevent collateral managers from buying the cheaper junior tranches during turmoil, thereby avoiding triggers for the senior tranches. Additional criteria have been added for the conditions on CLO “amend and extend” transactions. Furthermore, the collateral in which CLO managers can invest has been better defined.

Those working directly in structured finance markets as well as portfolio managers looking for products to enhance yield and provide diversification benefits will benefit from the authors’ research.

How Did the Authors Conduct This Research?

The authors use U.S. structured credit data from varying time periods: ABS data are from 1993 to 2012, CLO data are from 2005 to 2012, ILS data are from 2003 to 2012, and mortgage-related data are from 2000 to 2012. The data are from various data providers.

They begin by explaining the concept of a structured product. ABS products, such as auto, credit card, and other loans, are usually offered in tranches with different coupon payments and risk levels and issued by an SPE. One particular ABS product is the collateralized debt obligation, which uses bonds and loans as its underlying securities.

The authors then show how issuance for each of these products has developed over time. Overall, ABS issuance has recovered since the crisis. The CLO market has also recently received renewed interest after it imploded in 2008. Surprisingly, the recovery of CLOs in 2009 also occurred when default rates increased and recovery rates declined. Furthermore, institutional investors left the CLO market in 2008 but have now returned. Nevertheless, the general market recovery for ABS has not occurred for all ABS securities. Issuance of mortgage-related securities has shown no recovery yet, and it is unlikely to see recovery in the near future. Leading to the crisis, covenant-light loans gained popularity because of the higher expected returns and a low interest rate environment, and they have made a comeback in the current low interest rate environment.

The authors highlight that although design changes have taken place since the crisis, the changes have not always been beneficial for investors (e.g., despite these improvements in availability, more information does not always lead to more transparency). Also, the renewed ABS interest might be related to other factors, such as investors’ interest in the underlying asset classes instead of the products themselves. The current regulatory changes have not been fully implemented yet, which means uncertainty for investors. It could also lead to regulatory differences between the United States and other markets, resulting in regulatory arbitrage opportunities.

Abstractor’s Viewpoint

The authors consider specific investment products and provide a good historical overview of developments in the past few years. Multiple graphs make it easy for the reader to visualize the developments. They also highlight the market rebound in the years after the crisis. The question of whether the recovery has occurred because of a return to excessive risk taking or because of a better product design is left unanswered, although the authors do stress the importance of the effect that the final regulatory framework will have on the long-term prospects of structured finance products.

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