Securitized Markets: Structured Thoughts

Welcome, everyone, to the Deutsche Bank Securitize podcast. The podcast is Securitize Markets, Structured Thoughts. And the topic for this podcast is residuals and securitize residuals.

So we recently published a note called Securitize Residuals, Where the Rubber Meets the Road. And we're going to go over some of the basics of the Securitize Residuals. We're going to make some links to the private credit market.

And we're going to talk about the challenges and opportunities ahead for Securitize Residuals. I'm joined today by my team in Securitize Research. We have Kayvon Deruyan, Bepo Sinha, Jamie Flanick, and Doug Grunty.

We cover all of the major sectors across Securitize. But I think maybe just jump into it here and thinking about defining the residual and how you define the securitization residual or first loss piece. Sure.

I'll take that one, Ted. Residual interests or resids, as they're more commonly known, are the equity portion of the ABS cap structure, junior to the subordinate bonds. They're also referred to as certs.

You might see that in Bloomberg if you pull these up, or certificates. They're the first loss piece of the deal and typically structured to receive excess spread if triggers are not being exceeded. In Zambia, just for clarity, residuals or first loss piece are often called BPs.

And we have a history of selling BPs to third-party buyers who are specialized buyers. It has a potential to provide high yield returns for absorbing tail risk. Yeah.

And in CLOs, the nomenclature here would be CLO equity, well-developed part of the market, in fact. And I think like all the other securitized products, it is first loss and typically is roughly about 10% of the market. I think that's helpful.

Each sector kind of has a different nomenclature around what they call this, but I just like to think of it as equity off of a capital structure. So it's first loss risk or equity. Sometimes we use the example of banks where a bank has a capital structure, senior debt, preferreds, and equity.

This is the equivalent of that, but off of a securitization deal. So in terms of what makes equity or first loss or residuals attractive right now, and we kind of highlight what the key issues are. And I think to contextualize it, we're looking at credit markets where you've got high yields, close to record tights, equities at all-time highs.

Yields and high yield are around 6.5, EM at 7. So any context for why equity tranches are attractive for investors right now? In CMBS, I believe that the market for CRE residuals is at an inflection point.

We have supply and dynamics at play. On demand side, we have private credit who are sitting on record dry powder, and they are looking for control-oriented double-digit returns. And on supply side, we have banks who are under regulatory pressure to deliver their CRE exposure.

So that makes it interesting for CRE. Yeah, I would say in CLOs, I mean, I think the CLO equity piece is a perennial attractive option for an investor. You know, I think one way to frame it is that if you look at the debt stack for a CLO, particularly the senior end, so AAAs, AAs, these are really more kind of lower-risk, almost low-beta type of investments, whereas CLO equity you could look at as really more of an alpha type of investment in the sense that they're being more upside than what you would have, obviously, in the senior part of the stack.

So I think, again, perennial attractive piece for the CLO market, oftentimes an investor can be targeting 12% to 15% yearly percent return in terms of cash flows, and I think the fact that these cash flows are quarterly distributed versus other alternative investments such as private equity, that continuous cash infusion, if you will, to portfolio managers is an attractive option. Yeah, on the ABS side, I'd just add that, you know, investors in the bonds have already taken the time to understand the structure and collateral, so they have familiarity with the assumptions required to price them. I'd also just point out, again, the potential for significantly higher returns, you know, at present you can find yields in the, call it low teens, to the high 20% area.

And Ed, in my sector, aviation, there's been a bit of a hibernation, there was a flurry of issuance from 2017 up into 2020 with the advent of COVID, e-note issuance, as we call it, definitely paused, market became far too volatile, far too much uncertainty, and far too many airline bankruptcies and decline in aircraft values to have an e-note be plausible. We are starting to see hints that the market may be ready to come back. I think you're going to talk a little bit later about performance, and we can talk about some of the hills that need to clumpy climb before we can get back to that point of issuing equity in the future.

Great. So, I think we've hit on the key points there. One is high returns, the expertise that some of our investors already have in looking at this collateral.

I would also add here that it's uncorrelated with other sectors, and there's a significant amount of diversity of underlying collateral that you can access in the residual market, ranging from subprime auto loans to consumer loans, to transition loans, to direct loans in Jamie's market, aircraft leases in Doug's market, all of these markets ebb and flow. And I think we're kind of in a flow phase, so maybe if we can touch on a little bit about why we're talking about residuals right now, like how does this topic come up today in the market for Securitest? Well, maybe start first with CLOs.

It's actually quite interesting that you kind of led off just kind of stating some of the comps across other asset classes, and just really how strongly bid things such as equities or high yield bonds are currently. And interestingly enough, in CLO equity, one kind of meme I think that's kind of been going around in the industry is just how challenged CLO arbitrage is currently. And maybe this is similar across all sectors, but within CLOs, the ARB is essentially the money coming in via the loan pool, so the underlying collateral for a CLO, versus the money going out to the debt holders.

And that spread between the two has been atrophying over time, in large part just simply due to how well-bid loans currently are in the market. So I would say one kind of high-level talking point around CLO equity is that even though traditionally you can target those 12 to 15% year-over-year returns, right now we're tracking closer to 12.5, so it's been a little bit of a challenge. The upside here is that depending upon where you think rates and where you think the market may head over the course of the next year, CLO equity could actually fare very well if there is a market sell-off due to the labor market falling or cooling off a bit more, heading into 2026, or GDP falling quite a bit too.

That's actually typically when CLO equity performs the best, is when you have a market sell-off. So challenging, I think, set up right now for CLO equity, but presuming upon where you think the market is heading over the course of the next 12 months, could be an opportune time to consider this part of the asset class. Sure, so I would just add two contextual points, and just to try to bring in private credit here as well.

Private credit today is around five to six trillion, but there's expectations that it can grow to as high as 20 trillion. So as Kayvan mentioned before, these are investors that have deep expertise in the underlying assets and they want to increase AUM, and this is also a very attractive fee proposition for some of the private credit sponsors. So I think that's an important part of the dynamic here, is that private credit is growing quickly.

This is a chance for assets to move from traditional places where they are originated and held into the private credit space, and I think that relates to a change in how loans are originated and held. So think about this as the balance sheet light model for banks and specialist lenders. They really specialize in origination and underwriting, and they want to get paid the fee for that, but they don't want to hold onto the risk forever.

So I think those are two things that I would highlight, is the growth of private credit and a deep investor base, and the balance sheet light model as well. So just in terms of the evolution of the residual market, what sectors are we seeing active today? Doug mentioned not as active, but potential to grow.

Where are you seeing activity in residual market in each of your sectors, and any key changes in structure, risk return profile, anything to note around what's happening? Yeah, I'd say for ABS, the most active sectors, at least in secondary, are consumer loan ABS, student loan ABS, subprime auto ABS, and solar. And just for context, roughly half of what we've seen trade this year would be consumer loan ABS.

In CMBS, we are seeing activity in SASB and CRE CLOs. They have surged in recent years. Yeah, and I'd say in CLOs, maybe looking at it from a different angle, just because it's all corporate debt, essentially, that underlines the CLO.

But in terms of looking at the liquidity of equity being traded in the secondary market right now, it's actually gone up marginally year over year. Big picture over the last 10 years, in looking at what our trading desk typically is selling, roughly 10% in line with the CLO equity outstanding is how much they're moving on a yearly basis on average. Last year, it was around 13%, and this year, it's tracking right around 15%.

So I think a fairly strong bid for CLO equity right now, and it's trading well in secondary. And then any common misconception that you encounter when you're talking to investors about residuals or first loss across markets? Sure.

I mean, on the ABS side, I'd say in the past, it would have been something like, how can sponsors sell residues? I thought risk retention was supposed to prevent that. Regardless as to whether an issuer uses horizontal, vertical, or a combination, L-shaped risk retention to satisfy these requirements, they can still sell off a portion of the residual interest.

You can maximize that by holding a vertical, theoretically, you can sell 95% of the resid. In CMBS, one common misconception among investors is that BP's returns are very low due to high CRE losses, but that's not true. Currently, BP's are being sold at steep discount, roughly 50 to 60 cents on a dollar, and we have seen that most of CRE losses are backdated, that is at maturity.

So as long as investors are able to collect coupons, they are able to recuperate their investment and make decent returns. I'd say in CLOs, if an equity investor can target roughly, on average, 3% to 4% per quarter from the investment, I would say maybe one misperception, perhaps, for some investors is that sometimes you might actually get 0% return to on a quarterly basis. That's actually something that we've seen or we've been tracking over the last two years.

It's just the number of CLO deals paying 0% equity has been increasing. In Q3, we had that number roughly about 8%, and I think that's typically not top of mind for investors. I think the other, I'd say, misconception that I've heard is mixing and matching SRT, or synthetic risk transfer, with residuals.

So when we're talking about residuals, we're really talking about cash flow deals, just a different structure. I think the economics can be similar in terms of taking first loss risk, but this is a cash flow deal and not a synthetic risk transfer off of banks. So maybe moving into who the investors are for these residuals.

These are typically our investor counterparts on the investor side, and if we could go through some of the names of investors, whether or not they sell them or hold them. So certainly, Doug, in your aircraft, there's people who are holding onto these residuals for now, but if you could go through some of the names of active sponsors, holders of the residuals in your space, you could do that. Sure.

Yeah. So I'm on the ABS side, hedge funds, money managers, and the main buyers, and secondary. Using Bloomberg data, we've seen resids end up in ETFs, open and close end, fixed income, fixed allocation, alt funds, and then some of the names are names everyone's heard of.

PIMCO, Lyons Bernstein, TCW, Payton, Angel Oak, Columbia, Williams Street, Voya, Thornburg, First Trust, they all have ABS resids in various funds. In CMBS, we have different set of buyers for different product type. For Conduit, we have a specialized BP buyers, such as Rialto, Argentic, and most often they have a special servicing arm, which provides operational synergy.

In SASB, Blue Owl is the largest player after its acquisition of Prima. Being single asset, it is easy to underwrite SASB, so we see the largest pool of buyers in SASB. In CRE CLOs, the managers hold the equity, and some large players are MF1, Bridge Investments, Arbor Realty.

That's it. You know, I'd say from the CLO perspective, maybe just piggybacking on some of what Kayvon and Bipol have mentioned, certainly when looking at this part of the capital structure, hedge funds and specialized credit funds really play well there, but increasingly this has grown into private wealth channels, into pension funds, as more and more CLO managers, particularly the larger ones, are developing captive equity funds, which is essentially them going out into the market, raising roughly $500 to $600 million, which is going to roughly fund about 10 deals, 10 CLOs coming to market, and then selling a minority stake of those to, again, to pension funds, sovereign wealth funds, and to high net worth individuals. This has been increasingly, I think, a theme of that part of the market.

When the aircraft ABS market came back to life after the global financial crisis, the equity in the deals was retained by the servicer, the large aircraft lessor, who was using aircraft ABS as a funding mechanism to acquire aircraft. In 2017, we started to see the introduction of the tradable e-note. The purchaser, I'd echo Kayvon, many of the names that he mentioned either looked at or were involved in taking e-notes in the sector.

People looking for levered returns on hard physical aircraft assets. And I'll just round it out on the resi side. Some of the names that Kayvon mentioned for sure.

We have it active across the space in non-QM, fix and flip, HELOC, and second liens. And in the mortgage space, and this isn't meant to be an advertisement for anyone, but just some of the bigger players, Carlisle, Angel Oak, Ares, Cerberus, KKR, Ellington all have shelves for securitization where they retain the residual off of collateral, non-QM collateral most commonly. And typically have a correspondent lending network that is originating the collateral according to their criteria.

Just in terms of filling in with what Jamie said in terms of the end investor, I might also just say the high net worth channel is definitely one of the more powerful demand drivers here for the ultimate owner of the residual. So the companies we're mentioning are managing the residual, choosing the collateral. But high net worth has been a big sponsor of residuals looking to get that uncorrelated return with a double digit type return on equity.

So obviously we've got some very high return bogeys in the residual space, but things can go wrong as well, and they have gone wrong historically. So maybe we can highlight some of the things that went wrong, and I'm going to lead here with Doug because he seems very excited to go through some of the challenges in the aircraft sector and Class E tranches. Yeah, thanks, Ed.

I guess aviation is a poster child of what can go wrong with equity when you take a thin strip of equity, lever it up, and then impose on the industry generating the cash flow a 10 or 15 standard deviation event called COVID, which no one anticipated in any of their worst case scenarios of what could happen with cash flows with these deals. As you would expect, with the onset of COVID, there was disruption in the airline industry. Airlines went bankrupt.

They stopped making lease payment. Aircraft values went down. And as the residual security, the residual security stopped receiving cash flows, and there was a dramatic effect on pricing.

In many cases, pricing went from the 90s down into the single digits. As cash flow shut off, bonds on top of the equity started to pick, increasing the loan balance that needed to be paid off before the equity had any chance of receiving anything. But there has been a bounce back.

We've seen a number of transactions move from low single digits back in 2021, 2022, to five-handle trades in the 50s. So it shows that equity has a big beta, and transactions are idiosyncratic, and that transaction structures, counterparties, airlines, and advance rates really matter, and really matter in particular for equity. I would say that in CMBS, unlike ABS and CLO, CMBS structure is top-heavy.

Top three loans account for 10% of the pool, and the top 10 loans account for 60% of the pool. So if some of these big loans go down, it can quickly wipe off BP's returns. Yeah, I'd say, you know, in ABS, you know, something could go wrong.

Very simple, you can just misjudge collateral performance. So in like subprime auto transactions, the resid doesn't receive excess spread until the deal reaches its target OC level, and if it doesn't maintain it, cash flow is shut off. You know, there's a period after deal closing where you wouldn't expect the resid to be cash flowing, typically a year, year and a half.

But the expectation is that after that point, the deal will have delivered enough and hit the OC target. If that doesn't happen, you'll see, you know, no cash flow, very choppy cash flow, you know, weak performance like we've seen in the 21 through 23 vintages can definitely put a dent in those plans. I'd say in CLOs, certainly loan losses, I think, is the major pothole for CLO managers to actively manage out of and to avoid any sort of distressed credits.

You know, when looking at this current credit cycle within the left loan market, right around November 2022, we were sitting around 1.5% in terms of the default rate. That has gone up over the last two years to roughly 4.4%. And it's been hanging above four for about a year now.

So I think this credit cycle has been one that certainly, for one, is not as pronounced as COVID in terms of reaching, you know, 5% or 6% defaults. But that being said, it certainly has been extended over the period of months. Yeah, so I think when I look back at some of the performance of the residuals, there's the concept of the wrong asset class at the wrong time.

I think that fits Doug. I think high-yield CBOs early days, that was also the case there. Obviously, some of the subprime and Alt-A type mortgage pools had that wrong place wrong time as well.

I guess, is there anything that the manager can do to lift performance? So fees on the product are relatively juicy. What is the manager providing in terms of value added for buyers of residuals?

I guess in my sector, the servicer is paramount. You know, airplanes are very complicated assets. They need to be monitored.

They need to be leased. They need technical evaluations. And the servicer also needs to know when to hold them and when to fold them.

When is the right time to sell? When is the right time to release? How do you maximize economic returns across the entire transaction?

So servicer is critical. And I think COVID reminded people in the market, both for Aircraft ABS as well as Aircraft ABS Equity, keep an eye on the servicer. Good ones do well.

Others, perhaps, don't do what was expected. In CMBS, one of the most important structural feature is control, where like BP's buyers have a right to appoint and replace special servicer. And they also approve or reject any major loan modifications.

Hence, they have an operational control and they minimize CRE losses. So in some ways, a similar aspect as what we see in aircraft is the servicer and the ability to kind of work, do workouts. Look, I think I have here, I have defined in the credit box initially.

So that is choosing the collateral that goes into the pool. I think sometimes the contrarian views are helpful here. So you can say that you don't want to do certain types of non-QM loans.

But I think sometimes there are opportunities to pick collateral that other sponsors might not like as much and have offsetting risk factors for that collateral. So again, if you're investing in the residual, you can't be too conservative in terms of what goes into the collateral pool because otherwise you won't be producing very high returns to the residual. So you always need to take some chances in the collateral pool in order to pay the residual, whether that's second liens and CLOs or low FICO borrowers and subprime mortos or maybe some aircraft that aren't that mainstream.

But that's kind of where the juice comes from for some of these residuals. But certainly servicing for all of these sectors is a critical component for managers once the credit has been selected. Just I think in the interest of time, I'm going to skip over the topic of liquidity and maybe just highlight what the future of residuals are.

So what are the challenges and opportunities for securitization residuals over the next three to five years? You mentioned the balance sheet light model, the demand growing, the potential for the market to get to 20 trillion. What do you see as the opportunities and what could prevent that growth from materializing?

Yeah, I'd say it's hard to sort of determine what the size of the ABS resid market is. But if we look at subprime model and consumer loan and assume the resids make up 5% to 20% of the cap structure, you're looking at potentially 20 billion. So I think that's probably a good starting point.

Challenges, I think we need to see the availability and quality of pricing data improve, which I think would help expand the investor base. Liquidity is still going to be a challenge, but that makes sense given the lack of ratings and the relatively limited investor base. Again, I'd just say, you know, improvements in pricing data, you know, the availability of it will be very important.

In CRE, the biggest opportunity I see is in transitional loans as banks have pulled back from CRE lending. And in terms of challenges, banks again ramping back their CRE lending or tighter regulation on private credit, which might restrict their growth. Yeah, Ned, I'll slightly reframe the question being, you know, what are the challenges for CLO equity in the US is almost what are the challenges for US CLOs more broadly moving forward?

And it's really been the lack of net new loan issuance coming into the market via LBOs and MNAs. This is obviously due to the high interest rate environment that a lot of these operators have been in over the last, you know, two plus years. But as we get past this business cycle and as rates start to come down, that should be accretive to not only CLO equity, but also just the overall growth of the CLO market.

And in terms of opportunities, I'd like to highlight just some of the work that our European colleague Conor O'Toole has done in looking at and benchmarking the European CLO equity returns. You know, in the US last year, we reached 15 percent. So, you know, kind of more or less in line with what US investors should be expecting.

However, in Europe, it was much higher. It was closer to 18, 19 percent. So, you're getting quite a, you know, a lot of upside, you know, as a domestic investor looking abroad right now at European CLO equity.

I guess in my sector, the first obstacle is going to be recent history and performance of the asset class. When something goes from 95 to 5, the first question of an investor is going to be, why should I try this again? There are obviously reasons why you should.

The deals will be structured differently. Collateral will be selected more thoughtfully. Advance rates will be more restrained.

Counterparties will be much more selectively added. So there are a lot of things that will be done to make equity potentially distributable. But there are certainly the obstacles of what happened last time around.

I think the big issue is going to be the assumptions that underlie future deals. As you pointed out, Ed, you need to have things in the pool that are juicy enough to make sure there's money that gives the equity a return, but not so juicy that potentially the deal turns sour. So people are going to be looking to appraisers and to the structurers to ensure reasonable assumptions, reasonable estimates of aircraft values and lease rates from the appraisers.

But I suspect it's being worked on even as we speak. I suspect sometime in the next two years, we will see equity distributed once again from an aircraft ADS securitization. Great, and I have a couple as well.

I think new sectors is definitely the opportunity. So music royalties, infrastructure debt, data centers, CRA transitional loans. You don't get to $20 trillion without expanding the scope of what is included in securitizations or in private credit.

And I think challenges is the whole loan bid, certainly in RMBS. So insurance companies sometimes buy these assets themselves and want to hold the assets on balance sheet themselves. And then also I think regulatory oversight.

So private credit has not had a whole lot of regulatory oversight, but I think that is a potential risk down the road. So look, I think with that, we've gotten to about 30 minutes, which is a good amount of time for a podcast. And I'd like to thank you for joining us.

Highlight again the piece, Securitization Residuals, Where the Rubber Meets the Road. If you haven't seen it, please reach out to us and ask for a copy. And we'd love to hear from you about the podcast and the piece.

Thank you. Thank you.