Asset-Backed Update

Administrators for Fairway Finance Corp. and PIN Capital LLC Asset-Backed Update U.S. Securitization Group May 2002 From the ABCP Trading Desk Waiting for the Fed Sentiment on the economy has shifted dramatically in recent weeks. In the business media, talk of a super-charged recovery has given way to talk of a “double dip.” However, most market participants are viewing the recent data as signaling weaker economic growth and feel the chances of a “double dip” are fairly remote. As expected the FOMC left rates unchanged at the May 7th meeting. Given the weaker economic data of late, market participants have priced in a zero probability of a Fed move in June and have priced in a 50% chance at the August FOMC meeting. In fact, there are some economists who are now speculating that the Fed will not raise rates at all this year. The market continues to be on data watch with each news release being dissected for clues as to the direction of short-term interest rates. As noted in the previous month, investors and issuers alike will be keeping a close eye on the projected shape of the Libor curve in order to best execute funding and investment strategies. Opportunities continue to exist for issuers and investors as the Libor curve adjusts to Fed expectations. Libor Floaters remain active with trades ranging from Libor –2 to –4 on a monthly re-pricing basis. Investor and issuers are both advantaged by this trade as it locks in a fixed spread for a fixed period of time. Issuers can utilize floaters to smooth out maturity concentrations and eliminate basis risk while investors are guaranteed a fixed spread to Libor for a set period of time. A win/win for both parties. Concerns over new FASB regulations continue to loom over the industry. Proposals have been made by FASB and are under review for discussion and comments. FASB intends to institute the new regulations in whatever final form they may take by August 1, 2002 for new entities, and December 1, 2002 for existing programs. This relatively quick turn around time will cause quite a bit of energy and focus to be extended over the next several months as industry players scramble to have their voices heard on these sensitive topics. Spreads for ABCP continue to be remarkably stable with one-month spread levels continuing to range from Libor –4 to –6. Investors continue to flock to ABCP due to its inherent advantages of diversification and structure. Liquidity remains strong with paper trading at fairly favorable levels for issuers and investors. This is a testament to the strength and depth of the market as investors continue to look at ABCP as a favorable investment due to structure, asset diversification and lack of event risk. Total outstandings for the ABCP market as of April 2002 declined to $723, down about 10 billion from last month and about 20 billion from year-end. The decline in outstandings may be due in part, to concerns regarding FASB regulations. U.S. Asset-Backed Commercial Paper Market vs. BMO Nesbitt Burns (U.S. only) BMO NB US CP Conduits US Asset-Backed CP $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 $800 $700 $600 $500 $400 $300 $200 $100 $0 1995 1996 1997 1998 1999 2000 2001 Apr 02 BMO NB US CP Conduits CP Outstandings ($MMs) US Asset-backed CP Outstandings ($Blns) Asset-Backed Update -2- April New Issues Strong, But So Were Paydowns After a record first quarter, some were expecting a détente from the supply avalanche that has flooded our market so far this year. April 2001 produced an anemic $13 billion in new supply, while this April we placed over $30 billion in new supply, continuing the pace that has not let up since October 2001. Approximately $24 billion in pubic issues were sold, along with another $6 billion in private/144-A transactions. Spreads also continued tightening in April, just as they had throughout the first quarter, in spite of the almost overwhelming supply pressures. There is no mystery to current spreads however, they are a function of total net term ABS supply. We must periodically remind ourselves, that the ABS bond market as a whole carries an average duration of less than 3 years at any given time, so the paydown of outstanding collateral has much to do with current spreads. For instance, through all of 2001 we absorbed $380 billion in new issuance (from all categories of ABS), while $232 billion of existing paper paid down, or 61%. In 2000 the paydown of existing collateral was 58% of new issuance that year, and in 1999 the figure was only 56%. So far this year however we have seen $92 billion in paydowns vs. $124 billion in new supply, or 74% in paydowns. In April that paydown rate was 80%. From the investment community’s perspective, the amount of available ABS paper to own has been nearly flat for the past year, with new interested investors bidding up the price of the sector. This is primarily just coincidence, and possibly due to a little poor planning on the part of issuers and their advising banks. Between the glut of 5-year credit cards issued in 1997, and the popular 3 year maturity of choice in 1999, along with faster mortgage related ABS prepayments overall, 2002 is going down in history as the big paydown year. The common 3-year maturities chosen in late 1998 through the first half of 1999 were the result of post-Asian-crisis liquidity concerns, responding to investor inquiries for “shorter-is-better” terms. Another related development has been the paydown wave within the CDO sector due to collateral defaults, and other accelerated senior tranche payments due to performance triggers. Since 1997, the CDO sector has mushroomed, with most deals providing principal payment lockouts for at least 3 years…you do the math. Expectations for net ABS growth for the remainder of 2002 is unfortunately difficult to predict, though scheduled bullet amortizations within the credit card sector show a slowdown for most of the year, with spikes only in the 3rd quarter. Considering mortgage related ABS prepayments have probably peaked, the rational conclusion is that supply may begin a reverse back to a higher rate of net-growth over the remainder of the year. Some spread pressure could likely result before year-end. New supply last month was fairly balanced, with nearly $10 billion in new auto paper, $9 billion in home equity loans, $4.5 billion in credit cards, and just over $1 billion in each of both manufactured housing and student loans. The month included auto transactions from Daimler, Nissan, Onyx, Capital One, and AmeriCredit. Credit card issuers of note were American Express, Discover and Fleet. Retailers also placed paper at fairly respectable levels, like Nordstrom’s 5-year bullet at Libor +27 basis points, and Circuit City’s 3-year bullet at Libor +19 basis points. Other ABS events in April included Spiegel’s battle to stop the early amortization of its two outstanding credit card securitizations, initiated by MBIA under the terms of the deal indenture. It was only two months ago that NextCard Bank’s insolvency prompted the FDIC to exercise its omnipotent powers to squash the contracted early amortization of its credit card securitizations. In this case, the battle has begun in a traditional courtroom, not in Washington, D.C. MBIA informed both Spiegel and the Trustee, The Bank of New York, that they planned to begin immediate and full amortization of its credit card securitizations, based on performance triggers being hit (the master trust was enduring charge-offs of nearly 19%). The very next day however, Spiegel managed to garner a temporary restraining order against MBIA and The Bank of New York, based on an argument over which charge-offs were credit losses (which is specifically what the performance trigger covers) versus losses caused by fraud. Like the FDIC in the NextCard case, MBIA insists that a meaningful percentage of the trust’s losses that Spiegel had classified as fraud (and hence should remain outside of the early amortization triggers), were in fact simply credit losses. Spiegel contends that most of its charge-offs from newer accounts represented nothing less than fraud, by borrowers who never Asset-Backed Update intended on repaying their debt. Like NextCard, this is a fight that few of us would support, a loss is a loss, and the accountability of that loss rolls back up to the original credit decision made to extend credit to those individuals. The entire argument sounds almost childish, as both sides are playing a tug-of-war over semantics. Spiegel is trying to expand the loophole created for fraud within the deal documentation, in order to dilute its total loss-rate, exactly the tactic that brought down NextBank. The case is however terribly important as a precedent will be set, and we will probably see new language written in to credit card indentures as a result, with very little flexibility allowed with regard to fraud. Since the LTV Steel case in Ohio, most of us are touchy when we hear of a judge granting an injunction, reversing the terms of a clear and concise agreement between two parties, within the realm of securitization. Another troubled credit card issuer, Providian Financial, made major steps in April to restructure and rebuild its business. The company managed to shed over $8 billion in credit card assets through the sale of its Providian Master Trust, including over 3 million consumer accounts. The company also managed to generate nearly 500 thousand new accounts over the past quarter, moving upmarket into a less risky borrower base. The firm officially returned to profitability last month, improving its net interest margin and improving loan loss reserves, and producing analysts “buy” signals all over Wall Street. Hopefully this removes some of the tarnish on other sectors of the subprime lending arena. In other April news, PNC Financial Services Group, a subsidiary of PNC Bank and administrators for the $5 billion ABCP conduit Market Street Funding, announced a $50 million liquidity charge due to fraud. A -3corporate client apparently obtained $50 million in funding through Market Street to purchase fraudulent or non-existing assets, a first for the ABS conduit industry. Both the FBI and the OCC are investigating the allegations, while PNC has chosen to provide funds to cover all maturing CP over the next six weeks, no draw to the program credit enhancement will occur. The write down has been transferred onto the bank’s balance sheet as a non-performing loan. PNC has remained understandably quiet regarding the identity and other details of the transaction. This is an event which couldn’t have come at a worse time, as the industry battles regulatory agencies over off-balance-sheet funding, and the concept of implied recourse. One sector of the ABS market which we recommend watching closely is the multi-family CMBS sector. For the entire history of the CMBS market, multifamily assets have been the darling of all sub-sectors, providing the most predictable cash-flows and credit performance. We have however experienced a national phenomenon of first-time home-buying during the past year, the breadth of which we have never encountered before. As you would expect, apartment vacancies are up…way up. According to the U.S. Census Bureau, apartment vacancies are nearly 10% on a national average, the highest level they have ever recorded, since taking on the responsibility of tracking this data in the early 1960s. This severity of this event is also confirmed by the National Multifamily Housing Council in Washington, D.C., and the National Apartment Association in McLean VA. We don’t anticipate a negative effect on the economy as a result, but we do anticipate some serious stress to occur within the MF CMBS market. ABS Issuance vs. Paydowns 400 300 200 100 0 1999 2000 2001 YTD 2002 New Issue ABS (Billion) ABS Paydowns (Billion) Source: Bloomberg Financial Markets Asset-Backed Update -4- Tobacco Bonds, Not Technically ABS Since the landmark settlement agreement in November 1998, between the top four tobacco producers, and 46 U.S. states and territories, “Tobacco Bonds” were born into the worlds of Municipal and ABS fixed income securities. This Master Settlement Agreement (MSA) was reached in 1998, after the tobacco industry waived the white flag, in the face of an avalanche of lawsuits filed by more than 40 State District Attorneys offices, which came as a result of evidence that the industry had suppressed medical evidence of the physical dangers of tobacco use. The public was outraged, the government and the medical community were outraged. Everyone realized however that suing the industry out of existence would bear no fruit, and would be legally akin to prohibition. The conclusion was reached, that a “workable” fine should be imposed, and distributed to all U.S. states and territories, based on formulas that measure tobacco usage, both historically and ongoing. This fine, $206 billion paid over 25 years, could conceivably make this sector of the market comparable in size to that of the auto loan ABS or home equity loan ABS markets. All but 13 states immediately pursued ABS structuredsettlement technology in constructing bond issues that would provide them and immediate portion of their total ultimate share of the settlement. The unique wrinkle in this sector is the individual state’s option to create a “revenue-based” municipal security, or fully nonrecourse based asset-backed security. To date, most have been issued as municipal bonds, similar to limited tax revenue municipal bonds. Politically it has been popular for states to participate in this financial trial of such an undeniable “bad-guy,” the tobacco industry. Their admission of suppressing evidence had laid them prostrate to an angry public aspiring to live with “less tobacco.” If you ask the man in the street, he would likely agree that the toll tobacco has taken on the health of Americans should be the liability of the tobacco industry. At the very least, the drain on the healthcare industry, including Medicare and Medicaid should be reimbursed, let alone the pain and suffering of surviving loved-ones. That isn’t necessarily the wrong that the MSA has set out to right. By the time of the MSA’s construction, only one individual “medical costs and pain and suffering” lawsuit had been won in the United States, for a grand total of $1 million. In the wake of the Master Settlement Agreement, other such lawsuits continue to thrown out daily within the lower courts. With the exception of Westchester Country, NY, no single state or municipality has taken steps to determine how this windfall of revenues is to be spent. Most have already directed their payments to their respective general funds, with many having already admitted they intend to use these revenues to shore up shortfalls in their regular fiscal budgets. The infighting within the states and their respective municipalities has just begun. The U.S Department of Justice has been remarkably quiet, busy deciding their own strategy. In September of 1999, the federal government filed its own civil suit, calling for $20 billion annually, without any clear termination, twice the annual burden imposed by the MSA. The federal government’s suit makes clear the intention to fund medical care resulting from tobacco. The federal government also filed a suit under the RICO act, claiming that the industry conspired to defraud the public, which was upheld by a federal judge in September of 2000. Analysts point out that the Department of Justice’s budget is insufficient to cover tobacco litigation without additional funding from congress. By March of 2000, the four remaining states (Minnesota, Mississippi Texas and Florida), which had not previously participated in the MSA, struck their own deal with three of the four top producers, to the tune of $40 billion. Then one year ago, finally a class action suit emerged from the state of Florida (Engle class, FL), finally and directly recognizing individual claims of citizens. This agreement was reached in trial at the state court level, which ensured the $145 billion settlement would be staid throughout any appeals process. That equates to a maximum of $36,500 to the average individual smoker represented within the suit, an industry bankrupting precedent. Nearly all but that first $1 million settlements are still under appeal. In October of 2001, an almost freakish $3 billion was awarded to an individual, Richard Boeken, for individual damages from smoking, reduced by a jury to $100 million and still under appeal. That’s $390 billion already signed off on by the respondent, about one and a half times the size of the entire credit card ABS market outstanding, and potentially over a trillion dollars in suits now pending as the public realizes the success of these non-beneficial state lawsuits. $300 million has already been placed in Asset-Backed Update escrow voluntarily by R.J. Reynolds, Brown and Williamson and Phillip Morris in the Engles case. By reading and speaking with ratings agency analysts in both the structured finance sector and the equity sector, it becomes clear that the agencies have been forced to take an “all other things remaining equal” approach to their inventory of the tobacco litigation crisis. They admit that the state of litigation has begun to appear so overwhelming (the one thing the MSA set out to avoid), that several extreme outcomes have become believable. For one, the MSA itself may be declared unconstitutional. Another likely outcome that could avoid decimating the entire industry, is congressional intervention, exercising its rights over state’s powers, and imposing a unique federal regulation over the industry. The only thing that is certain is the amount of legal fees that will be paid throughout this process. Most petitioners in the MSA have contracted to receive their entire legal bills rendered due and payable upon a “securitization” of that revenue stream, no coincidence that 33 states have already responded to their attorney’s encouragement to pursue securitization. Participants in the tobacco-settlement issue have strapped in and are preparing for a legal battle that could easily go on for a decade. The federal suit pursuing reimbursement for medical damages under Medicaid was thrown out by a federal judge, while their RICO accusation stands, again thwarting the chance for the intended medical disbursement of these funds to be managed by the medical community. A win on the RICO grounds would flow straight to the general fund of the U. S. government through the Department of Justice. Lawsuits continue to stream in on the heels of the MSA, from foreign countries like Japan, the UK, Canada, Korea and Indonesia. Although all foreign suits have been thrown out by U.S. courts so far, the foreign tobacco industry has been consolidating at an alarming rate, as if gathering the clans for battle. -5The basis for the securitization of these revenue streams comes from structured settlement ABS technology, which was born of corporate and individual litigation. The ability to pay is carefully assessed, either by the established cash flow of a corporation, or an individual’s garnished income, with appropriate respect given to the degree of burden imposed by the settlement on the enterprise or individual. In all cases, risk issues which are specifically addressed include enforceability of the sale of receivables, untested in anything like tobacco securitization. Bankruptcy of the provider of that annuity stream of income is risk number two, the direction to which this landslide of litigation appears to be headed. Never has a structured settlement transaction been constructed which led to this outcome, plaintiffs normally don’t cut off the hand that’s going to feed them. Diversion of that annuity stream by other claimants is probably risk number 3, addressed in most structured settlement transactions. In this case, we are considering the federal government most likely becoming the claimant, over a potentially unconstitutional agreement between states. Other enforcement and anti-assignment clauses become laughable when we are considering the federal government fighting the states. When the dust has settled the supreme court is likely to find in favor of a settlement which benefits either the medical community, or individuals…who will no doubt be dead by the time this great waste of legal minds has ended. By our own industry’s definition, there must be some rational expectation of the strength of an asset’s validity, in order to construct an asset-backed security. Tobacco settlements are a long way from reaching the status of “assets” by the definition and scrutiny of existing structured-settlement ABS technology. April 2002 ABS Issuance ($billions) $0.6 $0.8 $5.6 $4.4 Cards Autos Home-Eq MFH Student Ln Other $9.7 $9.1 Source: Bloomberg Financial Markets Asset-Backed Update Public ABS Market Window for April 30 , 2002 Credit Cards Date 4/25/02 4/24/02 4/24/02 4/24/02 4/22/02 4/18/02 4/11/02 3/28/02 3/28/02 3/26/02 3/25/02 Issuer MBNA 2002-A4 Bank One 2002-B1 Circuit City 2002--1 Nordstrom 2002-1A Fleet 2002-A Amex 2002-2 Capital One 2002-2A Household 2002-1 Household 2002-2 Chase Credit 2002-2 MBNA 2002-3 Size $1 Billion $250MM $300MM $220MM $800MM $851MM $611MM $485MM $499MM $1.4 Billion $750MM Ratings AAA/Aaa A/A AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa AAA/Aaa Term 5 Year 5 Year 3 Year 5 Year 3 Year 5 Year 5 Year 5 Year 5 Year 3 Year 10 Year Spread 1ML +11 1ML +38 1ML +19 1ML +27 1ML +5 1ML +11 1ML +13 S +16 1ML +17 1ML +5 1ML +24 th -6- Comments Subs placed separately Also BBB’s +96 Subs @+90 Subs @+70 Subs @+34 and +90 Subs @+39 Subs placed privately Subs @L+55 and L+120 Subs @L+55 and L+120 Subs @ +33 and +90 Subs placed separately Vehicle/Equipment Leases/Other Date 4/30/02 4/26/02 4/16/02 4/16/02 4/15/02 4/09/02 3/20/02 3/13/02 3/13/02 3/12/02 3/12/02 3/8/02 3/6/02 Issuer Onyx 2002-B Food Sv. Am 2002-1A Capital One 2002-A Navistar 2002-A CARAT 2002-2 Harley 2002-1 CNH Equip 2002-A Hyundai 2002-1X National City 2002-A ACAS 2002-1A WFS 2002-1 Mitsubishi 2002-1 UAC Auto 2002-A Size $400MM $100MM $1.265 Billion $500MM $1.78 Billion $586 MM $1 Billion $160MM $1.1Billion $147MM $1.8Billion $1.75 Billion $300MM < 1 Year 4ML -2 3ML -3 3ML –1 1 Year E +15 E +16 E +19 E +12 E +15 1ML +33 E +13 E +15 E +18 E +18 2 Year S +19 S +24 S +7 4ML +3 S +27 S +15 1ML +50 S +22 S +27 S +12 S +34 S +15 1ML+150 S +23 1ML +28 S +27 3 Year S +24 5Y L+57 S +30 4 Year Collateral Auto Loans Trade Receivables Auto Loans Trucks Auto Loans Motorcycle Loans Equipment Leases Auto Loans Auto Loans Business loans, subs A1 Auto Loans Auto Loans Autos, subs @ S +45 4ML -3 4ML -3 2ML -2 Home Equity/Manufactured Housing Date 4/25/02 4/23/02 4/19/02 4/17/02 4/17/02 4/05/02 3/25/02 3/25/02 3/25/02 3/22/02 3/21/02 3/13/02 3/13/02 Issuer Equity One 2002-2 Option One 2002-3 Morgan Stanley 2002-AM2 Chase Funding 2002-1 Conseco 2002-B Conseco 2002-1 Chase 2002-C1 Equicredit 2002-1 Residential 2002-KS2 GMAC 2002-GH1 Madison Ave. 2002-A Centex 2002-B Novastar 2002-1 1yr 1ML +15 2yr 3yr 1ML +28 1ML +27 1ML +33 S +50 4yr 5yr 7yr 10yr Collateral Home Equity Home Equity Home Equity Home Equity Home Equity MFH Home Equity Home Equity Home Equity Home Equity Home Equity Home Equity Home Equity S +43 1ML +23 1ML +14 1ML +14 1ML +35 1ML +26 1ML +30 S +45 1ML +30 S +57 Private S +60 S +59 S +87 S+250 S +60 S+90 S +53 1ML +27 1ML +30 Generic Secondary Trading Spreads Spreads to Swaps/Libor Swap Spreads (float-to-fixed) Auto (Owner) Cards (Fixed) Cards (Flt, 1Month LIBOR) 1 YR EDSF +8 1.8YR 2YR 39 7 6 4 3YR 62 7 7 5 5YR 53 10 11 7YR 66 15 16 10YR 58 24 24 Asset-Backed Update -7- Asset Securitization Team Director of Securitization Jeff Phillips, Executive Managing Director (312) 461-7282 Origination & Structuring David Kucera, Managing Director (312) 461-3893 Pete Walsh, Managing Director (312) 461-2332 Funding Coordination Ron Kirchler, Vice President Lou Galassini, Vice President (312) 293-8005 Conduit Management Kristi Riffe, Vice President (312) 461-5640 Marketing & Research Derek Rose, Vice President & Editor (312) 461-8993