Securitization limbers up for the oddball Olympics

Cogent Communications Holdings

08/05/2024 13:00

(The author is a Reuters Breakingviews columnist.  The opinions
expressed are his own.)
    By Jonathan Guilford
       NEW YORK, May 8 (Reuters Breakingviews) - Securitization
might sound exotic. The idea of pooling millions of IOUs like
car loans and mortgages and slicing them into new investments
has a whiff of tricky financial alchemy, even if, for some
assets, it’s been a commonplace trade for a while. But bankers
and asset managers are applying a new infusion of creativity.
Car loans are old hat; Taco Bell franchise royalties, Picassos
and internet address are the new frontier.
    Appetite for “esoteric” securitizations is growing
rapidly, with $151 billion of outstanding debt at the end of
March, having more than doubled since 2017, according to
JPMorgan. That’s much faster than the 11% growth overall in
sliced-and-diced investments. It’s based on the notion that
wherever there’s a cash flow that’s reasonably reliable, there’s
an opportunity to create new investments to cater to buyers that
span the risk-taking spectrum.
    In principle, securitizations all look similar. A company
takes a stream of future payments - like the ones that come from
car loans or airplane leases - and issues bonds with claims on
those payments. The large number of borrowers defrays the risk,
since even if some go bust, the more senior bonds will still get
their interest and repayment. Car and plane loans are ideal,
because there’s ample historical data about how borrowers
behave, and there’s a Toyota Corolla, Airbus A380 or other
assets with value that lenders can seize if things go wrong.
    Wily financiers have realized, though, that what matters
isn’t the actual asset but the cash flows that accompany it. As
long as they can be presented as dependable and predictable,
anything from legal settlements against tobacco companies to the
bundles of IP addresses securitized last month by internet
services firm Cogent Communications  CCOI.O  in a $206 million
deal can, it seems, fit the bill.
    There’s ample demand for this creative financing. Insurers
like Prudential and MetLife are sitting on giant pots of
policyholders’ premiums, which they must shepherd and ideally
grow in order to pay out on customer claims. They want low-risk
investments that bring steady payments, and ideally at
attractive rates. Money managers like Janus Henderson or
Neuberger Berman, similarly, have investor nest eggs demanding a
safe return.
    Asset-backed securities are appealing, because they come
with various terms to protect holders, as well as often
investment-grade status conferred by ratings agencies. Right
now, they offer a spread that’s sometimes lower than general
investment-grade company debt, but higher than super-safe
government bonds. Recently, one-year bonds backed by auto loans
and rated a gold-standard AAA charged interest of 44 basis
points over U.S. Treasury yields, according to JPMorgan.
    With a bit of spice, these securities can offer higher
returns, without losing their appearance of safety. That means
less focus on car loans, say, and more focus on unusual kinds of
cash flow, such as royalties from the comic strip “Peanuts.”
    Oddball securitizations involve some trade-offs. One might
be liquidity. It's easy for a holder of auto-loan-backed bonds
to find buyers for their investment, because that market is
huge. Some $146 billion of such debt was issued in 2023. A
first-of-its-kind securitization of revenue derived from the
antics of Charles Schultz’ lovable cartoon dog Snoopy might
tempt only a handful of investors.
    Lack of historical data is another potential compromise.
Toyotas number in the millions, as do the loans that back them.
Yet Pablo Picasso painted only one “Guernica.” That didn’t stop
the finance arm of auction house Sotheby’s securitizing a bundle
of loans against art by Picasso, Jean-Michel Basquiat and
Rembrandt, bolstered not by vast in-house data troves but by its
reputation as a pre-eminent auctioneer. It worked: Sotheby’s
Financial Services sold $700 million of bonds in April.
    Unusual as it may be, the Sotheby’s deal has a virtue: The
bonds get less risky over time as art collectors pay off their
loans, reducing the leverage of the pool. Loans to car buyers
are typically the same. Eventually, the last borrower has repaid
and the investment winds up.
    Not every payment stream is like that. Take Cogent. It holds
tens of millions of IP addresses, the numbers assigned to
devices that connect to the internet. These slots in the
internet’s address book have become valuable, because there are
only around 4 billion of them. In 1981, when the standard known
as IPv4 that created them was established, that seemed like
plenty. Now, it does not. By 2019, the world ran out. That
created a market for renting IP addresses, and thus cash flows
for companies like Cogent that have some to spare.
    The Cogent securitization is an example of how strange
assets invite strange risks. Buyers of the IP bonds are taking
the risk that demand for scarce addresses doesn’t track their
predictions. One potential reason could be that there’s another
address book, IPv6, that while in its early days and currently
incompatible with its precursor, could yet make IPv4 obsolete.
Moreover, the price of addresses is volatile, spiking way up
after the pandemic.
    Moreover, there’s no guarantee that the bonds will wind up
as borrowers repay. Securitized bonds can remain outstanding for
decades, especially when they’re not based on loans that have a
natural shelf life. It may be that the IPv4 addresses can be
sold to raise money if needed, but that’s a leap. The
deal’s relatively small size and BBB rating - the lowest rung of
the investment-grade credit ladder - indicate it’s something of
a test run.
    These esoteric transactions are going mainstream. One big
player is private-equity giant Apollo Global Management  APO.N ,
whose Atlas SP Partners helps other companies dice their
cashflows, from residential solar loans to long-term charters
for boats. Big insurers are joining: MassMutual in April took a
minority stake in Atlas.
    Firms like Apollo and KKR  KKR.N  see big future business in
creating investments that money managers, insurance companies or
hedge funds can stack onto their balance sheets to deliver a
higher return than the usual ultra-safe bonds. Already by the
end of 2022, U.S. insurers were exposed to roughly $570 billion
of investments tied to asset-backed securities and similar
structured products, according to the National Association of
Insurance Commissioners.
    Of course, what’s new is always old to some extent. As an
example of the perils and perks of esoteric securitizations,
it’s worth recalling so-called Bowie bonds. These instruments
were backed by royalties on pop megastar David Bowie’s back
catalogue, and in 1997, Moody’s rated the $57 million
securitization a top-of-the-range AAA, buoyed by the strength of
the Thin White Duke’s popularity.
    The problem turned out to be not Bowie, but the industry.
The rise of music-sharing service Napster scrambled the revenue
due to music license-holders; Bowie bonds’ ratings fell
and copycat deals disappeared, though the investors ultimately
got repaid as planned. Even so, fast forward over two decades,
and in 2022 Apollo pulled off a $1.8 billion securitization
backed by Concord, a music catalogue including work by U.S. band
R.E.M. As always, finance loves a new riff on an old theme.
    
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Asset-backed securities offer a menu of different yields
Asset-backed securities offer a menu of different yields    https://reut.rs/3UNE8ug
Esoteric assets are a big chunk of securitizations Esoteric
assets are a big chunk of securitizations    https://reut.rs/3Uyd2WU
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 (Editing by John Foley and Pranav Kiran)
 ((For previous columns by the author, Reuters customers can
click on  GUILFORD/  
Jonathan.Guilford@thomsonreuters.com; Reuters Messaging:
Jonathan.Guilford.thomsonreuters.com@reuters.net))