Teachers Insurance and Annuity Association faces a difficult task. How does one prudently and profitably invest a cash flow of about $11 billion a year? Finding appropriate markets for this cash is a constant challenge to our senior management.
Typically, we invest in long-term public bonds, private placements, and commercial mortgages - because these assets more closely match the long-duration nature of our pension liabilities. Historically, we haven't been interested in conventional asset-backed deals because we haven't had need to give up yield by buying assets at the short end of the yield curve. But as the amount of investable cash keeps rising, we felt that we needed to explore new markets.
A Partial Solution
We found a partial solution to our problem by looking at asset-backed transactions of a more unusual nature, such as timeshare receivables. These transactions are considerably harder to analyze, have higher risk characteristics and lower liquidity. But they have yields, which, in our opinion, more than compensate for their shortcomings.
In effect, we found that we could buy a four-year, A-rated, asset-backed deal at an all-in spread considerably wider than the spread for seven-year, A-rated corporate credits.
What are these unusual assets? I felt that it would be convenient if I had a nice, neat acronym to describe them, such as TIGRS, CATS, and LYONS. I call them Totally Reasonable Assets, which are Somewhat Hard to finance - or TRASH, for short. I think it works.
We have been in the business of buying TRASH since shortly after my group was formed in June 1990. In that period of time, it has become an increasingly significant part of our investment mix.
To date, we have issued a total of 31 commitments, aggregating $831 million. The weighted average quality of the commitments was A, and the weighted average spread over the respective Treasury was 265. The weighted average life was approximately 4.75 years.
The range of assets has been fairly wide. It includes:
* Timeshare receivables, or vacation ownership as they are known in the trade.
* Manufactured housing.
* Nonstandard auto insurance premium finance receivables (talk about the need for an acronym).
* CMO residuals.
* Trade receivables.
* Commercial and multifamily mortgages pools.
* B- pieces in residential mortgages.
To date, we have been extremely pleased with the program, although the evaluation period has less than two years - not even through an entire business cycle.
We take some comfort from the fact that the recession officially started in July 1990, one month before we circled our first deal, and, so far, everything is holding up pretty well. In fact, we have not yet had an asset-backed transaction that has touched its credit enhancement, other than excess spread.
Times have been tough, but our loans are performing. It may be rash to conclude anything with certainty, but I believe that a diversified portfolio of these kinds of transactions will provide above-average returns over time.
The three principal risks that we see in this business - in the order of most likely to result in loss to least likely - are fraud, structure, and credit.
Fraud is always a risk in the investment world, whether in asset-backed deals or in corporate credits, but I believe the potential for fraud in these kind of transactions is greater.
First, there are lots of little pieces of paper and it is easy to envision a scenario where some of those pieces of paper might be fraudulent.
Second, the companies we are financing are usually small, young, and undercapitalized.
In dealing with fraud, we look closely at the issuer and the individuals connected to the issuer. We will usually run a Nexus or newspaper search on everybody connected to the company and a Lexus or legal review on the company. Sometimes we will retain an investigative firm to probe more deeply.
Role for Consultants
We also have extensive contacts within our own portfolio which we use quite liberally. We employ outside consultants who are familiar with the industry to see what they might or might not know about the character of the individuals whom we are financing.
During documentation, we check the paperwork as thoroughly as we can. We hire outside underwriters to sample the portfolio on a random basis. If we are analyzing a real estate oriented transaction, we will run title searches to make sure that the deeds have been recorded.
On some residential property deals, we have even gone as far as to call individuals and ask them if they are enjoying their new homes and if the mortgage service was satisfactory.
In spite of everything we do, fraud is a risk we have to live with. However, as our portfolio gets larger, becomes more seasoned and more diversified, the portfolio impact of a fraud should lessen. Structure Risk
Whereas fraud is probably a greater risk in TRASH investing than in conventional asset-backed financing, the structure risk is roughly comparable. The difference is that the probability of bankruptcy of the original sponsoring company will probably be higher and thus, the structure is more likely to be tested.
The Fact-Based Test
One of the things we do require if we're not going to have an annual rating requirement is the right to inspect the operations of the company on an ongoing basis. This is to ensure that the company is maintaining the separate operation that will be required for the bankruptcy remoteness opinion. As you are probably aware, if tested in court, this will be a fact-based test determined by how separate the company truly is. Do they maintain separate telephone numbers? Do they have meetings of the board of directors?
Less Risk than Expected
The good news, in my opinion, relates to credit risk. It may be heresy to say this, but I am starting to believe that notwithstanding the, shall we say, unusual nature of the assets we have been financing, credit risk is considerably less acute than we initially believed.
In part, I think this is due to the generally good job done by the rating agencies in approaching these asset-backed deals with a conservative bias. In part, perhaps there is more value in these assets than we gave them credit for.
Regardless of the assets being financed, there are three common elements of all of our deals. These are:
* The role of the rating agencies.
* Flexibility in documentation.
We view the role of the rating agencies as very important to the overall process. First, we have found their due-diligence and modeling techniques to be conservative and accurate.
Although it varies by agency, there is generally a well-thought-out approach to each deal. This is one of the reasons why, I believe, the credit risk is not as great as we once feared.
Second, the rating agencies' role in prescreening a transaction is very helpful. If it weren't for their efforts, I would spend most of my time spinning my wheels on transactions that weren't likely to occur.
Finally, since the agencies look at many more transactions than we do, we find them an invaluable information source.
All of these transactions require flexibility in documentation - which is why we like to lead or be the total buyer. Flexibility could be a timing issue, either requiring a quick turnaround or staged closing, or it could be overcoming some small wrinkle that invariably crops up with these kinds of deals.
One example of the kind of problem that can occur happened in December 1991. We had been working on a $45 million, A-rated transaction for almost four months that had to close by yearend.
Two weeks before closing, the rating agency concluded that the amount of credit enhancement was insufficient for an A rating. In fact, another 5% or so was needed just to get a triple-B.
Rates had dropped 80 basis points since time of circle so we were reluctant to lose the deal. We concluded that the rating agency was being very conservative, took the extra 5% in credit enhancement, increased our return by 15 basis points, and closed the deal as a triple-B, all in two weeks.
Management Is Critical
In any investment, management is important. In these investments, management is critical. We try to evaluate both the capabilities and the character of management.
We have walked away from any number of transactions, many rated double-A or better, because of concerns over either of those two issues. In cases where our positive assessment of management is wrong, we hope the structure and assets will protect us.
The Timeshare Business
With these common elements in mind, I'd like to focus in a little more depth on one specific asset type - timeshare receivables. Timesharing, or "vacation ownership" is the use of identified accommodations for a specified period in a recreational resort.
The theory behind timeshares is quite logical. The average family only pays for the use of a facility for the the few weeks per year it is actually vacationing. From the real estate developer's standpoint, the cost of development can be spread over a larger number of purchasers at a premium price that left ample room for profit.
Time-sharing developed a terrible reputation in the early 1970s, much of it deserved. Beginning in the latter '70s and early '80s, larger, better-capitalized developers came into the market with high-quality resorts specifically developed for timesharing.
At the same time, increasingly stringent regulations began to develop at the state level to control the worst elements of the industry. Today, the industry is over $2 billion in annual sales, and the large developers are taking a growing market share.
The physical quality of the resort is one of our principal underwriting characteristics. What amenities does it have? How will repairs and maintenance be handled? Are there customer satisfaction surveys, and what do they say about quality? We believe the owner's perception of the value of the asset is an important determination to the default rate.
A Look at Marketing
We also look at the method of marketing: Do they use a hard sell or soft sell? Ideally, we like to see purchasers who have spent time at the resort and are satisfied as to its quality. We turned down one transaction where the resort was in a foreign country and 60% of the timeshare purchasers had never visited it!
This is possible in timesharing because of one unique feature to the business. There exists an active exchange network when one owner can swap a week at one resort with another owner at a different resort for a different week. Many timeshare owners purchase with the intent only to swap. There is nothing wrong with this, but our preference is to finance resorts where owners want to stay at least most of the time.
Some other questions that we ask ourselves are: a) Is there a fully funded, functioning ownership association that will operate the resort if the developer fails? b) Are existing owners adding to ther investments by buying additional weekly intervals? c) Is there too much geographic concentration to the owners? d) How well are receivables underwritten and what are the collection procedures for delinquency defaults?
As a general rule, the rating agencies do an excellent job of taking and stressing historical delinquency and default rates, and determining the proper level of credit enhancement to achieve the desired rating. In our underwriting we attempt to gain an edge by focusing on some of the intangible aspects of the transaction that will hopefully ensure that those delinquency and default statistics won't deteriorate over time.
So far, we have invested in five timeshare transactions, totaling $192 million, and have committed to two others for a total of $80 million. The pools have been paid down about $45 million, and, as in our other asset-backed deals, we have not yet had to resort to our external credit enhancement.
Investing in TRASH has been extremely interesting and, to date, quite rewarding. We are constantly being challenged with new assets to become comfortable with, and hopefully, finance.
We try to analyze carefully, diversify our investments, monitor them carefully, and stay flexible. We believe that we are well rewarded for our efforts, but at the same time, issuers are able to obtain capital at an all-in cost that is manageable.
MICHAEL T. O'KANE Managing Director Teachers insurance and Annuity Association
Michael O'Kane is a managing director, private placements, at Teachers insurance and Annuity Association. He head up the structured finance team, which specializes in various asset-backed and mortgage-backed structured transactions, as well as project finance, secondary private placements, and hybrid credit-real estate transactions.
Mr. O'Kane began his career in private placements immediately following business school. With the exception of a two-year period as chief financial officer of a small manufacturing company, he was worked continuously in the field for over 20 years. In addition to Teachers insurance and Annuity, he has worked at Prudential insurance Co., Paul Revere investment Management Co., and Westinghouse Credit Corp.
Throughout his career, Mr. O'Kane has worked on a variety of transactions ranging from small subordinated investments in leveraged buyouts to tax-exempt industrial revenue bonds. in June 1990, he established the structured finance team at Teachers insurance and Annuity Association, and the team has issued commitments in excess of $ 1.5 billion since that time.
Mr. O'Kane is a graduate of Lafayette College with a bachelor of arts degree in economics. He also has a master's degree in business administration from Rutgers Graduate School of Business.