Editor’s Letter

We begin this issue with four articles in the area of housing finance and mortgage-backed securities. Chris DiAngelo starts by bringing us up to date with respect to housing finance (including Fannie Mae and Freddie Mac) reform, which he cites as the largest piece of unfinished business from the financial crisis. Even though the U.S. Congress and the Administration remain stymied in this area, Mr. DiAngelo concludes that more progress is being made than the public generally believes. Next, Tom Showalter describes an analysis of mortgage borrower performance between 2009 and 2011 and finds that events beyond property depreciation (or appreciation), such as ill health, reductions in income, and/or job losses are having a profound effect on borrower default and foreclosure.

Richard Cooperstein observes that with all the volatility and uncertainty in the economy and the mortgage market, it should be clear that valuing distressed non-Agency RMBS with a handful of stylized scenarios is inadequate. He believes option pricing theory provides a theoretically sound but practical approach to determine risk-adjusted returns. Credit option-adjusted spread (COAS), he explains, can be calculated by simulating the cash flow impact of underlying factors such as house prices and interest rates as they, in turn, affect borrower behavior. COAS allows direct calculation of risk-adjusted return, which is a metric that enables direct comparison of investments with different risks.

Scott Anderson, Bernadette Kogler, and Diana Kim discuss their research on loan modification performance, looking at loan modification characteristics as well as the timing of the modifications to identify the key drivers of the re-default rate. The authors find evidence to support the widely held view that modifications that include principal forgiveness and result in significant reductions in payment requirements produce lower re-default rates. They also find evidence suggesting the better performance of recently initiated modifications is not just a function of more effective modification terms but also a function of the improving macroeconomic climate.

Sarah Davies addresses the process of validating risk models, particularly as they apply to credit ratings. In response to recently updated guidelines from Office of the Comptroller of the Currency, her objective is to offer industry participants a best-practices approach to model validation.

We have two articles on the current state of student loan ABS. Given the recent barrage of negative press on private student loans and the elimination of the Federal Family Education Loan Program in 2010, Vince Sampson and Samantha DeZur note that there has been some speculation concerning the perseverance of student loan ABS. By providing the details on the factors affecting the industry and explaining the context, they hope their article will help readers gain an understanding of the stability of the asset class, which will be around for years to come. In 2010, total outstanding student debt started to outpace outstanding credit card debt for the first time, Tom Arnold, Bonnie Buchanan, and Fiona Robertson observe. Last year, it was estimated that student loan debt could reach $1 trillion. The authors believe the current design of the student loan system in the U.S. has come into question as delinquencies on student loans continue to rise and high unemployment persists. In their article, they focus on Sallie Mae, the largest lender and servicer of student loans in the U.S. They use the economic concepts of the “lemons problem” and “capture theory” to illustrate how understanding informational asymmetry problems in Sallie Mae’s evolution can help shed light on future prospects for the student loan market.

In the first of three articles on specialized asset classes, Greg Cioffi and Jeff Berman observe a sustained resurgence of subscription loan or capital call lending facilities to private equity funds. Due to the importance of provisions in the underlying fund documents in connection with a subscription loan facility secured by the unfunded capital commitments of a private equity fund’s investors, the authors explain, underlying fund documents can be drafted to facilitate a potential lending facility and careful legal due diligence by a lender will mitigate complications and potential problems.

Next, John Joshi provides an introduction to solar energy securitization. “At the June 2012 United Nations Conference on Sustainable Development, Rio+20, the need for sustainable development and a reduction of carbon reduction continued to be the focus for all the participants,” Mr. Joshi said. “Renewable energy development, including solar energy, is a key element for reduction in carbon emissions and energy independence. Capital market strategies can be the catalyst for large scale development and deployment of renewable energy assets.”

Then Justin Pauley and Ken Kroszner bring us up to date on collateralized loan obligations. They wrote the article to show a broad range of investors that CLOs should not be confused with other types of CDOs hard hit by the financial crisis. The authors explain that CLOs invest in transparent, high quality and diverse assets, which helped them navigate through the recent downturn without a single default. With many performance metrics now at better than pre-crisis levels, they aim to show investors that the CLO structure works.

Finally, Christoph Rothballer and Christoph Kaserer discuss their research on the risk characteristics of infrastructure investments, which they undertook as part of a broader program funded by the European Investment Bank on the investment characteristics of infrastructure projects. The primary motivation behind this program is the rising interest and financial commitments of institutional investors toward this asset class, which is based on theoretical claims on its investment characteristics (low risk, inflation hedge) but not yet backed up by solid empirical studies. Among the authors’ findings are that infrastructure has low systematic risk and therefore contributes to portfolio diversification; that idiosyncratic risk is higher than expected and therefore adequate risk-sharing mechanisms, advanced risk management, and portfolio diversification are essential; and that the risk profiles of different infrastructure sectors are highly heterogeneous. If these issues are understood and addressed properly, with the help of this research, Rothballer and Kaserer believe the asset class may gain increasing attention in the investment community and attract more private funds, potentially helping to close the looming infrastructure gap.

All of this should provide some useful and enjoyable summer reading.

TOPICS: CLOs, CDOs, and other structured credit, asset-backed securities (ABS)

Henry A. Davis

Editor

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