The squeeze on margins in the credit enhancement side of asset securitization was beginning to make the business unprofitable, but creative bankers have come up with a way to continue offering credit enhancement to their clients.
"Spreads in this business have gone from the 90 to 100 basis points that were available three years ago to the 45 to 55 basis point range now," said Charles Hindmarsh, a managing director at State Street Capital Corp. As a result, he said, the business had become "less attractive" for his company.
Bankers like Mr. Hindmarsh have helped clients securitize billions of dollars of credit card and other receivables, loans, and securities by issuing letters of credit. By last year, however, new techniques for providing credit support on these debt issues had opened up the market to more players, driving down profits.
In response, State Street and others pioneered a funding method that is making credit enhancement a profitable business once again. Through a different use of their commercial paper conduits, these banks have started to securitize the enhancement components of asset securitizations.
The payoff is cheaper funding and greater liquidity, not to mention good customer relations.
"From our point of view, it's a great advantage to be able to continue to provide service to our customers while also being able to move these assets off our balance sheet," said Mr. Hindmarsh.
For debt packages with adequate reserves, securitization of the credit support pieces may give the credit enhancement bank a better return.
Still, the deal must make sense and contain quality receivables. If those receivables turn sour, the bank could lose its investment.
The process begins when the bank providing the credit support buys a security from the issuer.
This security, called a collateral invested amount, or CIA, has a subordinated interest in the pool of receivables backing the overall securitization, said Andrew Silver, managing director of Moody's Investors Service structured finance group.
The cash flow on the subordinated interest is used if the senior securities experience a shortfall.
This is different from the way credit enhancement was handled before the early 1990s. Then, a bank would issue a letter of credit that would be drawn upon if the cash flow didn't meet expenses. But this tied the credit rating of the securitization to the bank's rating, said Carl Jackson, a senior member of the asset finance group at Credit Suisse, a bank that is one of the biggest credit enhancers this year.
"When you used a letter of credit in the past, the investor notes were subject to downgrade if the letter-of-credit bank was downgraded," said Mr. Jackson. "In a CIA, though, once you buy the tranche of receivables out of the trust, the cash flows from those receivables are subordinated to every other tranche in the deal."
From an issuer's point of view, he said, the structure of such a security can save about 2 to 3 basis points per year in servicing costs. As a result, nearly nine of 10 credit card securitizations now use this mechanism, he said.
After the bank owns the security, it can either hold on to it and earn a 45 to 55 basis point return, according to Mr. Hindmarsh, or it can sell the security to its commercial paper conduit.
If it decides to sell to the conduit, however, the enhancement will often get a second look from the rating agencies. Because the cash flow from the enhancement security provides a reserve for the overall securitization, Mr. Silver said, Moody's will often review the transfer and sometimes issue a rating to ensure it does not endanger the rating of the conduit.
Mr. Silver said the structure of some earlier enhancement vehicles had a greater risk of loss for investors. That is because these issues relied too heavily upon triggers to start accumulating cash flow, he said.
"If something happens quickly enough, there is the possibility that very little cash may have accumulated in the fund," he said.
As a result, credit card offerings are the most common type of deal using securitized enhancements. The strong performance of these portfolios in the past and the typical size of these issues - often between $500 million and $1.5 billion - make them ideal candidates for this mechanism, Mr. Hindmarsh said.
He says that by securitizing these pieces, State Street has found a way to boost returns enough to justify the risk.
"We think it's a very useful tool depending on the size of the deal and its spread," he said. "Because without the spread, you can't afford to pay the expenses of the transaction."
