by Savvas Charalambous, Investment Analyst
I recently explained to my friend Liz what I do and thought it would be a good idea to share our conversation in the hope that others find this short article a helpful introduction to structured credit. Happy reading!
Liz is another mathematician who works in statistics. We talked about how she became a mathematician, her career, and how she got her current position. We met at a coffee shop because it was close to her work as she was getting off work early. She was in banking herself and wished to get ideas on how to improve her career. Towards the end, she wanted to learn more about my field of work, prompting the following questions.
I have known you for a long time, and I admit I am not confident in what you do. What is structured credit?
Structured credit, also called "securitized credit", is an asset class available for investment, similar to stocks, bonds or a buy-to-let house. The name comes from the fact that loans are structured in a way that makes them easy to trade in a debt format, i.e. an investor like you and I can buy and sell bonds secured by loans and expect a regular income and some form of capital appreciation in the future. This process is called securitization.
Buy bonds secured by loans? What does this mean?
In the beginning, structured credit starts with simple loan agreements. A Bank issues loans and then sells them because its ultimate bread and butter is to give loans and handle deposits. For example, they might decide that they do not wish to keep 30-year buy-to-let loans on their books but instead want to raise cash to lend in other areas of the market. They can then sell those loans to other investors looking for a steady income and capital appreciation in a debt format. The name comes from this process - the investor buys debt in the form of bonds secured by the loans the Bank sold.
This last part is a bit confusing. How can loans trade in a debt format?
Let's assume that the Bank does not want to keep so many buy-to-let loans in its books. How can they remove the risk and raise cash? They can sell loans!
Firstly, the Bank approaches an Asset Manager to negotiate a sale. After negotiations, the Asset Manager takes ultimate ownership of the loans in exchange for cash to the Bank. People who took buy-to-let loans are effectively paying the asset manager instead of the Bank (technically, people pay the Bank, and the Bank pays the Asset Manager). The loans are thus sold to the asset manager. The deal is done, and the Bank no longer has 30-year buy-to-let loans risk in its books and has the cash to issue new loans in the market!
What happens next?
At this point, the Asset Manager steps in to securitize the loans. They aim to find investors who wish to have exposure to the buy-to-let market, and the Asset Manager will charge them a fee for its service. However, not everyone wishes to have the same return. Some investors want to invest long-term with minimal risk, and others wish to have shorter investments with more risk and higher returns. The Asset Manager can sell bonds backed by the income of the loans mentioned above to both investors using the waterfall structure.
Wow! Before you continue, what is the waterfall structure?
Let's assume that I wish to borrow 300€ from my three friends, Ava, Beth and Chloe and promise to pay them back their money plus 10€ in interest each at the end of the month. To clarify, each of my friends gives me 100€, and I give them 110€ back.
In an ideal world, they all agree and lend me the money with the promise to pay them back. However, Ava refuses and says: "Look, I will lend you the money, but I want to get paid first, before anyone else. As a trade-off, I only want 2€ out of the 10€ you promise as interest, and you can give the remaining 8€ to Beth and Chloe in exchange for waiting and taking the risk that you won't have enough to pay them back". Luckily, Chloe interrupts and says: "I will take that! Ava is paid the first 2€, then Beth 10€ she is due and I will wait to get paid last and receive everything else, 18€."
I just created a waterfall structure. By paying my three friends in order, I raised 300€ with my desirable interest (10%) and relieved the concerns of my friend Ava. Chloe is taking the risk that I won't have enough to pay her back after I pay back Ava and Beth, but she is compensated by receiving the promise of a higher payment. For example, if I only have 320€ available to pay in the future, Ava and Beth will receive their money back plus interest, but Chloe will only receive 8€ on top of her money. By waiting to get paid last, Chloe took a higher risk. However, if I pay back 330€ on time, Ava will receive 2€, Beth 10€ and Chloe 18€. Chloe's return is a whopping 800% more than Ava's.
How does that fit with what the asset manager is trying to achieve?
The Asset Manager does the same thing! Remember that the Asset Manager bought loans for cash from the Bank. The Asset Manager's business is to take these loans, find investors and get paid a fee for the service. The buy-to-let loans they bought from the Bank pay interest and will eventually pay back the entire loan amount. The Asset Manager can then go and find investors that wish to be exposed to the buy-to-let market and use the waterfall structure to distribute returns.
For example, some investors want the highest possible return with the lowest risk, like my friend Ava, while others want to be compensated more for higher risk, like Chloe. Using the waterfall structure, the Asset Manager can accommodate both.
In reality, no asset manager has enough cash to buy the loans from the bank. The process usually happens in reverse, i.e. once investors are found, the asset manager uses the money from the investors to pay the Bank and the loans are finally securitized! The investors receive bonds which are tradable assets with desirable characteristics, and the Bank no longer owns the buy-to-let loans.
Can I buy these bonds if I want to invest in the buy-to-let market?
You are probably indirectly invested already, through your pension! Institutional investors can buy these investments directly from asset managers or other investors. It’s common for pension funds and insurance firms which like Ava buy the bonds with little risk and for hedge funds which like Chloe buy the risky bonds but with a higher return.
ABS, RMBS, CMBS, CLO? What are they?
Finance loves acronyms. These names describe what type of loan is used to securitize the bonds.
ABS: Asset-Backed Securities. Ultimately, every bond (the “security”) is backed by a pool of “assets”. Hence "asset-backed" and "securities".
RMBS: Residential Mortgage Backed Securities. The original loans are residential mortgages, like your mortgage or mine.
CMBS: Commercial Mortgage Backed Securities. The original loans are commercial mortgages, like the loan to the developer to build the mall down the road.
CLO: Collateralized Loan Obligation. The original loans were issued to big companies, like ASDA, Morrisons and Burger King!