Portfolio Fitness Involves Minding Your ABS

In Episode 6, Peter Kaplan, Head of Structured Products at Merganser shares his perspective on the ABS market and the outlook for performance and liquidity in the most recent market cycle.

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Jeffrey Addis:
Welcome to our podcast. My name is Jeffrey Addis. I am the President and Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now on to our podcast. I'm pleased to introduce our Chief Marketing Officer, Mike Cloutier.

Mike Cloutier:
Welcome to the latest podcast from Merganser Capital Management. Today is Wednesday, November 4th, 2020. As we await the final results of the presidential election, I'm pleased to be joined by my colleague Peter Kaplan, the head of structured products at Merganser, to discuss some of the dynamics playing out in the ABS market. Welcome, Pete. Why don't we start with explaining to our listeners just a little bit about yourself, your career at Merganser, and how long you've been following the ABS market?

Peter Kaplan:
Hi, Mike. Thanks. I joined Merganser in 1986 and started off investing in money market securities when 90 day CP was paying 9% and then quickly transitioned into the asset-backed sector. I've been actively involved in investing in the ABS market since joining Merganser in 1986. Interestingly, the first ABS deal done was by Sperry Lease Corp and was collateralized by computer leases. That was in 1985. The first Auto ABS deal was brought by Solomon Brothers also in '85. Over 35 years, the market has grown substantially from credit cards and autos to deals backed by revenues from music and film royalties to tax liens in between.

Mike Cloutier:
Great. Thanks, Pete. So as we think about 2020 and reflect back on what's transpired, the onset of the Covid pandemic has clearly been the main theme driving markets, which was really began in earnest in March. Can you just talk a little bit about what you observed from the trading desk at that time and what the initial impact was to ABS and spreads and maybe digging a little deeper? Were there certain segments hit harder than others?

Peter Kaplan:
Sure. The onset of the Covid crisis caused a severe disruption in the markets, but particularly in the structured markets. And ABS was no exception. Starting in the first week of March, the market became bifurcated between sectors directly impacted by the virus such as aircraft, rental cars and other esoteric asset classes. Those traditional sectors perceived to be less impacted like bank, credit cards, prime autos, and equipment.

Initially in early March, the esoteric sectors were the hardest hit as liquidity all but dried up, while the traditional sectors saw spreads widen, but to a much lesser degree. By mid March, dealer balance sheets had evaporated with many dealers moving to the sidelines as they struggled to keep up with large volumes of bid wanted and mark to market losses while adjusting to the new work from home environment. That said, there was still approximately 11 billion of ABS issued in March, albeit at sharply wider levels.

During the third week of March, the market could best be described as completely dysfunctional. The virtual shutdown caused the Fed to announce a number of programs to support the capital markets, including the relaunch of the crisis era TALF program on March 23rd, which led to a dramatic shift in front end technicals. Demand for AAA ABS came back with a vengeance with two year ABS spreads retracing 40% of the widening by March 26th. During March, the markets were nothing short of ugly for structured securities. The spread volatility in March for AAA rated ABS, particularly credit cards and autos, was not driven by concerns over collateral performance, but was more a function of being one of the few things that could be sold outside of US Treasury Securities and agency MBS.

Mike Cloutier:
So you noted that swift recovery in spreads, and you cited that quick 40% retracement. It seems like we've really come back a long way since Q1 and the original market dislocation. What's the fundamental picture look like today, and what specifically are you looking for in terms of signals as to what direction we might be headed from here?

Peter Kaplan:
I'd say the fundamental picture is evolving. The labor market has added about 12 million jobs since April with the current unemployment rate dropping to about 7.9%. The reopening of the economy, along with the CARES Act, combined with steps taken by lenders in the form of loan extensions, deferrals and modifications, and the moratorium on auto repossessions has limited the deterioration in the fundamentals. That said, the expiration of the $600 weekly supplemental unemployment insurance and the failure by Congress to pass legislation to replace expired relief measures for the unemployed and other segments of the economy impacted by the pandemic will weigh heavily on overall consumer fundamentals.

Over the next few months, we'll get a clearer picture of the impact of the loss of unemployment support on collateral performance. While we expect an uptick in delinquencies and defaults, we feel that the traditional ABS sectors, prime autos, credit cards, equipment, floor plans and device payment plans have adequate levels of credit support to withstand any increases that occur. So what are we looking for? We would look at the delinquencies in the housing market, both by owners and renters, delinquencies in subprime auto and unsecured consumer loans, as well as a general level of economic activity as a harbinger of collateral performance more broadly. We believe that the subprime auto sector is especially vulnerable here, particularly for second and third tier issuers.
Mike Cloutier:
You alluded to watching for these delinquency and loss trends. I'm just interested in terms of order of magnitude. Do you expect with the roll off of the stimulus and what consumers are faced with and the prospects that they're looking at in terms of the economy in the next 6 to 12 months, do you expect losses to approach those levels seen in '08 in the prior crisis?

Peter Kaplan:
We don't, no. While the unemployment rate is at record levels, I'm not expecting the delinquencies and losses to reach levels seen in 2008. During the great financial crisis, delinquencies and losses on credit cards reached an astronomical 16 to 18%. Current charge offs on bank credit cards right now from money center banks are at 2%, which is a long way off from the levels reached during the great financial crisis. Similarly, defaults on prime autos, which reach 15% during the great financial crisis, are currently under 1% for many of the prime auto issuers. We don't expect to see that kind of deterioration in the consumer financial wellbeing that occurred during the great financial crisis.
Mike Cloutier:
How have issuers responded in this most recent cycle? Have they taken any steps to allay investor concerns about potential stresses in consumer ABS?

Peter Kaplan:
Yeah, they have. So it's important to remember that the traditional ABS sector is dominated by programmatic issuers. We've seen the floor plan issuers adding credit support to existing transactions and the auto and equipment issuers increasing the levels of credit enhancement on new issue securitizations. So let's think about that. Programmatic issuers took steps to support existing transactions as they did back in the great financial crisis, and for new securitizations, they've increased levels of credit enhancement. That speaks volumes about the nature of the ABS market and the responsiveness of issuers in that market. Additionally, issuers have tightened underwriting standards for loans originated after the Covid outbreak in March, and we'll look to see deals with that collateral going forward.

Mike Cloutier:
We've had a lot of conversations with both existing investors and new potential investors with Merganser and that the topic of liquidity keeps coming up over and over again, both with respect to what occurred back in March and then what's transpiring today in the IG markets and structured in particular. Can you just talk a little bit about what liquidity looks like right now and just the level and depth of the market as you see it?

Peter Kaplan:
I'd say liquidity is excellent, Mike, in the traditional ABS segments, and really more broadly. [inaudible 00:08:28] have tightened through pre-Covid levels and new deals that are coming to market are heavily oversubscribed. That speaks to how much cash is sitting on the sidelines and the perceived relative value for AAA ABS versus other high quality assets such as corporates. In addition to traditional ABS issuance, we've seen a number of new issues coming in the timeshare, container, rail car, insurance premiums, structured settlements, and even movie royalties, which are all part of the more esoteric segment of the ABS market. Even those have seen strong demand from investors. I would say that the liquidity in the ABS market is incredibly strong right now, and we see that versus other high quality assets, the ABS market provides good relative value opportunities, particularly when you consider that about 80% of consumer ABS has the highest quality ratings of AAA and about 80% of issuance is in the zero to three year average life space, which fits well for a short duration mandate.

Mike Cloutier:
That kind of directly corresponds to my next question, which was, in light of everything that's happened this year, are you still seeing good relative value and good opportunities in ABS? And do you anticipate maintaining the allocations within strategies at Merganser?

Peter Kaplan:
I do. I think that, as I said earlier, that the relative value opportunities in the ABS are great and the ABS segment are great. We have to remember that the asset-backed market is an important source of financing for consumer loans, the importance of which has been supported by government health programs. While there have been downgrades in ABS securities since the recent crisis, they have largely been outside of the traditional ABS segments. It's been more in the esoteric segments in aircraft and student loans and other non-traditional segments. I feel and we feel that the traditional ABS securities have adequate levels of credit support and can withstand the economic stresses from the crisis. As was the case in the great financial crisis, we expect these securities to pay in full and on time and feel comfortable with maintaining our current exposures in the sector, if not increasingly.

Mike Cloutier:
Well, Pete, that wraps it up for my questions. I want to thank you so much for your time. Obviously you bring a tremendous amount of experience and knowledge to Merganser and greatly appreciate it and your insights and look forward to continuing the conversation on future podcasts. So thank you.

Jeffrey Addis:
This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.