Editor’s Letter

Lauris Rall provides an update on the student loan asset-backed securities (ABS) asset class, including the principal loan types and programs, securitization structures, and regulatory issues. He describes an asset class that is experiencing a rebirth, performing well, and at least coping with the new Reg AB II and risk retention burdens. But to better accomplish the public mission of student loans and to supplement the federal programs, there is still a need for greater private-sector participation. Mr. Rall sees some encouraging signs.

Laurie Goodman, Jim Parrott, Ellen Seidman, and Jun Zhu examine the economics of determining the guarantee fees (g-fees) that Fannie Mae and Freddie Mac charge lenders in response to a request from the Federal Housing Finance Agency (FHFA) for input from the public on g-fees. The authors explain their methodology for calculating g-fees based on the government-sponsored enterprises’ (GSEs’) after-tax return on capital, how much capital the GSEs require, and the GSEs’ expected losses on the mortgages—each factor requiring judgment. They contend that g-fee determination is an art, not a science, and that transparency in the g-fee pricing process is essential. They recommend that guarantee fees on the least risky borrowers (highest FICO score, lowest loan-to-value mortgages) should not be increased; doing so will drive those mortgages away from the GSEs and onto bank balance sheets. The authors also argue that because g-fee setting is very assumption driven, once the total g-fees are set to cover expected losses under stress, expenses, and the payroll tax surcharge, the GSEs’ mission, including the duty to serve, should be taken into account in g-fee determination by assuming the GSEs require less of a capital cushion than private lenders do and by permitting the GSEs to earn a lower return on loans to low- and moderate-income families than for other GSE activities.

Allen Schulman addresses the interplay between the final U.S. Credit Risk Retention Rule, which requires the sponsor of any ABS to retain at least 5% of the credit risk of any ABS issuance that is transferred to a third party, and FASB Accounting Standards Codification (ASC) 810–Consolidations, which defines most securitizations as variable interest entities (VIEs) and requires an interest holder such as a securitization originator to consolidate a VIE if such interest holder has the power to direct the VIE’s most significant economic activities and also participates to a significant extent in the VIE’s gains or losses. The author shows how an originator’s choice of credit risk retention method can have a bearing on whether the securitization’s SPV must be consolidated.

Lewis Cohen and Kristen Lam summarize an ABS Vegas 2015 panel discussion that reviewed efforts, originating in Europe, to establish a high-quality securitization (HQS) label that distinguishes certain securitizations from past, discredited underwriting practices and qualifies them for preferential regulatory capital and liquidity requirements. Although the panel generally agreed that something like HQS will become an international standard in a few years, there are still numerous definitional, regulatory, and implementation issues to be resolved, and the movement has less momentum in the U.S. than it does in Europe.

Stephen McLoughlin, Matt Hedigan, and Callaghan Kennedy examine the key regulatory issues for U.S. managers and arrangers who are structuring CLOs using Irish special purpose vehicles (SPVs) as issuers or co-issuers. They note that more than 70% of the European CLOs priced in 2014 used Irish issuers established under Ireland’s securitization regime, commonly known as “Section 110.” Their impression is that market participants becoming more familiar with the regulatory landscape have contributed to the increasing level of European CLO issuance in the last several years and the increasing use of Irish SPVs as issuing vehicles.

Michael Bennon, Ashby Monk, and Caroline Nowacki examine the role pension funds could play in filling a greenfield and growth-stage infrastructure financing gap. They note that a confluence of macroeconomic, political, and regulatory trends has led to a widening of the infrastructure-financing gap and increased pressure on governments globally to identify new sources of capital for infrastructure development. In particular, up until the global financial crisis, the vast majority of financing for privately financed infrastructure projects, such as public–private partnerships (PPPs, also known as P3s), was provided in the form of syndicated loans from global banks. Following the financial crisis, and later the implantation of the Basel III banking regulations, capital markets for project financing changed dramatically. Facing requirements to deleverage, most U.S. and European banks turned away from long-term and illiquid project finance lending. This gap creates an opportunity for institutional investors, such as pension funds, to step in and fill the void. In this article, the authors examine the conditions that can enable pension funds to make direct investments without financial intermediaries in greenfield and growth-stage infrastructure projects. They examine a growth-stage project, a Dutch toll-road expansion, for which two pension funds provided the equity and a majority of the takeout financing.

Amira Mustafa observes that Sub-Saharan Africa (SSA) lags behind other regions in infrastructure and that lack of financing is the principal constraint. Although public–private partnerships provide an alternative for infrastructure provision, the private sector has yet to embrace them fully in SSA because they perceive numerous “soft risks.” The author provides an analysis of soft risk categories in the seven largest economies in SSA and finds significant differences among the countries in terms of political stability, strength of institutions, property rights/contract enforceability, and control of corruption. PPP investors could benefit from a detailed understanding of which SSA countries score best in this comparative soft-risk analysis.

Julie Kim and John Ryan provide two consecutive articles on “Value for Funding” (VfF), an analytical approach they have developed to improve the comparison of public–private partnerships (P3s, also known as PPPs) with traditional public-sector procurement for infrastructure projects. They note some of the limitations of the widely used “Value for Money” analytical framework, a net-present-value type of analysis designed to determine which infrastructure delivery alternative requires the least amount of overall resources from the public sector to deliver a similar outcome. They then introduce VfF as a useful additional analytical dimension to determine the impact of a choice between a P3 and public-sector procurement on a public-sector entity’s overall fiscal metrics. Such metrics include credit rating, annual budget surplus or deficit, revenue volatility, proportion of fixed versus variable costs, and overall or implied debt levels. In their first article, the authors introduce and explain VfF rationale and basic methodology. In the second, they apply that methodology to demonstrate conceptually how a P3 might be evaluated with respect to reducing deficit risks for U.S. state and local public-sector infrastructure project sponsors.

Anastasios Katsikas argues that a financial projection model is not a very good tool for testing the viability of a project or deciding whether or not to lend to it. The project will never perform the way the model predicts anyway. But the model requires many judgmental assumptions and generally raises more questions than it answers. And that’s where the author sees the value in the model for the lender: to start identifying and answering those questions, to understand the structure of the deal, and to focus on the key factors that could make or break the deal. The model provides the lender a vehicle to think through, to internalize, and to really understand what drives a project and what could cause problems over the life of the project.

Enjoy your summer reading. Feedback on this journal’s content, ideas for articles, article submissions, and other questions or issues are always welcome.

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

Henry A. Davis

Editor

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