Asset Backed Indigestion

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					                                               Merganser Investment Memorandum
                                               Asset Backed Indigestion

     Having followed the market for asset-backed securities (ABS)
closely since its inception in the mid-1980s, Merganser is well known
                                                                                                     Product Highlight:

for its commitment to this sector. During 2002, market blow-ups and
                                                                                                    Merganser Core Bond
                                                                             Merganser’s disciplined value-oriented approach to fixed income has
credit events shook the ABS market to its very core. Were these iso-
lated events, or are ABS securities riskier than many investors             served our core bond clients well over the past five years. Our rigor-
believed? Now, more than at any time in the history of the ABS market,      ous, common sense approach to credit and structure research, coupled
investors are asking whether asset-backed securities are worth the pay-     with a prudent sell discipline, has generated consistent excess returns
up. In this investment memo we will review a few of the ground-shaking      relative to the Lehman Aggregate Index. If you are considering
events of 2002, we will attempt to answer these and other questions, and    changes in your fixed income allocations, we would be pleased to
we will review our strategy for this sector going forward.
                                                                            speak with you about our capabilities in core bond management.
2002 – A Record Year for Issuance, and for Downgrades…
       The ABS market tallied up another record year for new issuance       ated by S&P in this sector during the year.
in 2002. According to data from Salomon Bros., new ABS issuance in          Event Risk Reared Its Ugly Head
2002 was $424 billion, a 17% increase from the prior year. Although
this supply was comfortably absorbed, the market for ABS also experi-              Nervousness over this downgrade activity was exacerbated by sev-
enced quality ratings downgrades at a level unprecedented in its history.   eral blow-ups in the asset-backed market during the year. Suddenly,
                                                                            what had come to be known for over a decade as a safe haven was feel-
       S&P reports that it initiated 688 downgrades of asset-backed se-     ing decidedly unsafe. “Event risk,” a term once thought to be relevant
curities during 2002, which is approximately 2.8 times the previous         only to corporate and emerging market debt instruments, was revealed
year’s record of 245 downgrades. This exceeded the cumulative num-          as a force to be reckoned with in the ABS sector as well.
ber of downgrades recorded by S&P from the market’s inception in
1985 through 2001 (637 downgrades). The year’s 688 downgrades were                 The highest profile event, and in many ways the most interesting
initiated across 306 ABS transactions and impacted 14 collateral types.     (and most troubling), was the default in November 2002 of all National
The downgrades were highly concentrated in problem sectors. Corpo-          Century Financial Enterprise’s (NCFE) healthcare receivables securi-
rate defaults reached a post-depression high, with obvious negative         tizations. NCFE had grown to become the nation’s largest financier of
implications for CDOs (collateralized debt obligations backed by high       healthcare receivables by issuing asset-backed notes that were secured
yield bonds). Three hundred and thirty-two of the 688 downgrades, or        by receivables purchased from healthcare providers. Fraud and self-
48%, were for CDOs and synthetic transactions. The manufactured             dealing by the issuer on a massive scale went undetected by rating
housing sector, dominated by Conseco Finance, received 174 down-            agencies and NCFE’s bond underwriters. Although the facts are still
grades (mostly for Conseco’s subordinated tranches). The aftermath of       emerging, it is also alleged that the bond trustee for at least one of the
September 11 left the travel and tourism industries in distress, with two   transactions had allowed the issuer to withdraw cash reserves (ear-
major airlines and two rental car companies filing for Chapter 11 pro-      marked to protect bondholders) in violation of the indenture. Nearly
tection. Relative to market size, aircraft lease-backed bonds suffered      $3.5 billion face amount of bonds were held by investors, who will be
more downgrades than any other asset class, as the demand for aircraft      lucky to recover a few cents on the dollar.
sharply declined and has been slow to recover. Lower lease rates and               A second interesting occurrence involved the circumstances lead-
parked (i.e. unused) aircraft adversely impacted asset performance.         ing up to the early amortization of the NextCard trust, which was
While aircraft leases represent a small fraction of the ABS market, 63      considered to be a high-quality portfolio. NextCard (through a wholly-
securities, representing $9 billion in outstanding issues, were down-       owned subsidiary, NextBank) began originating and servicing VISA
graded in 2002. Problems in ABS backed by franchise loans expanded          credit card accounts in the late 1990s, relying almost exclusively on the
in 2002 from a few lenders to encompass most of the industry. Fran-         internet as a marketing channel. Poor credit underwriting and fraudu-
chise delinquencies, which began the year at 11%, rose nearly every         lent accounting resulted in the insolvency of NextBank, which was
month and finished the year at 20%. Fifty-four downgrades were initi-       closed by bank regulators in early 2002, and the FDIC was appointed

Merganser Capital                     99 High Street, Boston, MA 02110-2320             tel: (617) 494-1000         fax: (617) 528-4899
Management LP
Asset-Backed Indigestion                                                                                     Merganser Investment Memorandum

as receiver. Inexplicably, an early amortization (commencement of im-         Our motto has always been “When in doubt, leave it out!” We are proud
mediate principal repayment, designed to protect bondholders), which          that our discipline to steer clear of collateral that is not transparent has
should have been triggered by the insolvency, was initially delayed by        kept us out of healthcare, airline equipment, franchise loan, and CDO
the regulators as they searched for a buyer of the portfolio. The FDIC        deals, to name just a few of the troubled areas we avoided last year.
then terminated cardholders’ ability to charge new purchases on                      A second point worth making is that headline risk doesn’t neces-
NextCard credit card accounts, and shortly thereafter, transferred serv-      sarily mean the same thing across all collateral types. In securities
icing responsibilities for the trust to another bank. In the wake of this     backed by closed-end, static pools of hard assets originated by experi-
decision, many of the higher credit quality card holders paid off their       enced servicers (auto loans or home equity loans, for example), negative
account balances, leaving behind a concentration of weaker obligors.          headlines and resulting wider spreads can result in opportunities for in-
Performance triggers subsequently were breached due to climbing char-         vestors who have done their homework on the collateral and the issuer.
geoffs, and early amortization has commenced. The situation is still          ABS investors should be much more sensitive to headline risk concerns
unfolding, but it appears that senior bondholders will probably be re-        if the securitization structure is open ended and the collateral base is
paid. Mezzanine and subordinate holders are unlikely to receive full          not static. The more esoteric and dynamic the underlying assets are, the
repayment. Certainly, after several years with minimal disturbance,           greater the link between the health of the servicer and the performance
early-amortization risk to credit card transactions has reappeared on         of the collateral, and the more difficult it is to transfer servicing in the
every ABS investor’s radar screen, and not just regarding sub-prime           case of insolvency. In these situations, the bankruptcy remoteness of the
deals.                                                                        securitization may be of little use, since the collateral can disappear
If the Downgrades and Blow-Ups Don’t Keep You Awake at                        when it is needed the most. With this type of collateral, surveillance and
Night, the Headlines Will...                                                  internal control issues (and early intervention when necessary) may be
       ABS, more than ever before, are being impacted by events in the        better achieved with a monoline insurer, with its capital at risk, pro-
unsecured corporate credit markets. The consumer finance sector is a          viding the credit support.
case in point. Household Finance, Capital One, and MBNA were among            Looking Ahead
the afflicted names in the unsecured corporate bond market during the                The market blow-ups last year were painful for many, but they
fourth quarter 2002. ABS spreads in these names widened in sympa-             are probably healthy in the long run, since they are likely to engender
thy, at times dramatically, in spite of very solid collateral performance     more discipline on the part of investors. Tiering in ABS spreads (i.e.
and reputations for strong servicing capability. Another example is the       wider spreads for names in the news) is likely to become a permanent
auto sector. The domestic captives (e.g. Ford Motor Credit) have been         feature of the market. This tiering should be more pronounced for col-
large borrowers in the unsecured market, and headlines about the              lateral that is more susceptible to servicer linkage. We plan to prudently
health of balance sheets caused corporate spreads to widen very sub-          take advantage of historically wide spreads in off-the-run transactions
stantially. ABS spreads followed suit, in spite of the fact that prime        with high-quality collateral, especially for client accounts that don’t
autos were one of the best performing collateral types, and one of the        need liquidity. For those that do, we will continue to identify and man-
few ABS collateral types not hit with downgrades. Additional key ABS          age a portfolio of core credits with strength and liquidity that provide
players with unflattering headlines last year included Citigroup/Sa-          us with a high degree of confidence that performance will remain sta-
lomon Bros., Sears, JPMorgan-Chase, Metris and MBIA.                          ble regardless of the timing of the economic recovery. We will continue
So, What Does It All Mean?                                                    to avoid structures with collateral that has a greater risk of scrutiny by
       First, it is important to note that event risk has always been pres-   a bankruptcy court for preferential transfer (such as automobile fleet fi-
ent in the ABS market. It has always been important to “know your             nance ABS, which are the principal operating assets of the company),
collateral,” to understand your credit support, and to do your home-          or questionable assets (healthcare receivables, lottery winnings, 12b-
work on loan underwriting and servicing by issuers. Too many market           1 fees, and tobacco settlements, etc.).
participants have blindly relied on the ABS market’s reputation for
being a “safe haven” as an excuse to avoid doing the mundane, but
necessary, due diligence on purchases. In the case of National Century,
how well did investors (and for that matter, the rating agencies) really
understand the mechanics of healthcare reimbursement? How much
did they really know about the seller/servicer? Some of what has been
learned ex post about the company and its principal owner perhaps                                                      Douglas A. Kelly
should have signaled an early warning. How much did investors in trou-                                                 Winter 2003
bled CDOs really understand about the secondary market for high yield
and distressed debt, or about the expertise of the collateral managers?

                            For additional information contact:
                            John C. Clavin, Director of Marketing
 Merganser                  (617) 528-4861

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