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Sean Murray: Today we are going
to talk about securitizations.

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So I'm here with Gunes Kulaligil
who is here from Methodical

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Management. Can you tell me what
your company does?

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Gunes Kulaligil: Sure, we
provide valuation and advisory

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services to our clients for
illiquid, esoteric and hard to

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value assets. There's a big
world of illiquid assets out

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there. We specialize in
structured products. For us,

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that means secured and unsecured
consumer and business loans,

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securitizations that use these
assets as collateral and

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servicing rights on these these
types of assets. The clients we

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serve will obviously include
originators of these assets, who

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may retain whole long
portfolios, servicers who have

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mortgage servicing rights or
other types of servicing rights

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that add value to it. And
obviously, investors who are

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active in the space, whether
they're investing in senior or

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subordinate securities, you
know, whether they're insurance

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companies or hedge funds, they
will need this type of valuation

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work, both for financial
reporting purposes. And really

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also in the context of
transactions when they're buying

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or selling assets or, you know,
structuring facilities to to

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fund these types of these types
of assets. From an accounting

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perspective, everything that
we're going to discuss today,

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whether it's an MCA portfolio,
or securitization is going to be

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a level three asset. All level
three means is it's an illiquid

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asset. By the way, there is no
level four, and you need to rely

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on on observable market inputs,
you need to build a model where

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you project the cash flows use a
discount rate to calculate an

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NPV, as opposed to a level one
asset. An example would be a

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treasury bond or a corporate
bond, or a trade, trade equity

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where you can look up the last
trade and that's, that's what

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the value is, right? So you
really don't need to build a

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model or anything like that
Right in the middle are level

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two assets, some type of
corporate bonds or munis, will

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fall into this criteria, they're
not as complicated as level

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three assets or they're not as
illiquid as level three assets

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yet also, obviously, not as
liquid as level one. And they're

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not as complex. So you can look
look at other assets to figure

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out their values. For what we
do, there's a lot more credit

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work, a lot more financial
analytics that goes into it, and

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being able to understand what's
going on in other markets that

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where you can triangulate some
of these unobservable inputs,

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whether that's your projections
were pre payments or defaults,

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or the discount rate that you're
going to use to, to discount

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these assets to today to
calculate the NPV that's going

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to be used when these funds are
cutting their NAVs for for

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quarter or year. Right. So these
are important numbers that get

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used when investors are getting
in and out of out of these,

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these funds. And therefore, you
know, we help asset managers and

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investors determine the fair
value of their portfolios.

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Sean Murray: Perfect. Well, it
sounds like you're the person I

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need to be talking to, because I
had questions about

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securitizations. Securitizations
have come up in the news over

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the last few months, a lot of
times with alternative lenders.

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And I think what everyone wants
to know is, what's the state of

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the securitization market right
now, because it's my

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understanding that
securitizations provide a very

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significant source of funding to
not just alternative lenders,

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but to all lenders in general,
is that right?

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Gunes Kulaligil: Securitization
is the process of creating

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investable securities, with
different risk return profiles,

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using pool of assets, cash
flowing assets as collateral.

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That's really all there is to it
at the end of the day. It's

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really a big and complicated
market. And I think it's really

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important to kind of understand
the components of it, as it has

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ramifications for really all
types of lending in the United

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States, whether that's consumer
lending or mortgage lending. So

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let's talk about what type of
assets actually make good

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collateral for securitizations.
At the end of the day we're

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looking for assets that make
periodic recurring principal or

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interest payments, and we're
looking for assets that are not

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too short term, right. So we're
not looking for assets that

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prepay in three months or five
months. We're looking for assets

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that hopefully will be around
for the next few years, right.

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In the case of, for example,
mortgages in the United States,

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clearly a huge securitization
market. There's about 11

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trillion of mortgage debt
outstanding. 9 trillion of that

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is securitized just to kind of
give you an idea about the size

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of the market, right? The reason
that many mortgages are

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securitized is obviously 30 year
fixed rate mortgages in the

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United States. They pay monthly
principal interest payments. I'd

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said deep enough market
obviously, and there's so much

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history to be able to analyze
it. But mortgages are not the

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only assets that do get
securitized. Student loans,

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consumer loans, or marketplace
lending loans are the different

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types of assets that get that
gets securitized on the

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mainstream type side of things.
Other esoteric type assets also

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do get securitized, for example,
billboard revenues, right?

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There's about 160,000 miles of
highways in the United States. I

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just looked it up the other day.
So there's thousands of

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billboards, somebody is earning
some revenues on that, that do

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get securitized. Music
royalties, right then when you

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listen to your favorite song
next time, just think that your

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artist may have monetized the,
the royalty on those, on those

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songs. So it's a big and
complicated market. But at the

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end of the day, these are the
types of assets that serve as

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good collateral for, for
securitizations. And we said

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we're looking for a pool of
assets, right. So in the case

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of, for example, $100,000 small
business loan or a $300,000

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mortgage is not a investable, is
not an investable security and

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it's really not predictable when
it comes to the default or the

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prepayment behavior. But when
you pool hundreds or thousands

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of these assets, you now have a
you know, 100 million dollar

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pool where you can go ahead and
actually issue some bonds on

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them right. So now with our pool
of cash flowing assets, we're

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going to create some investable
securities out of that. In order

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to do that, we need to
understand the types of

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investors that are active in the
securitization market. Deep

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enough market obviously, there
are many different types of

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investors interactive, but for
the purposes of this discussion,

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let's just say there's an
insurance company, obviously

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risk averse and then there's a
hedge fund with a bigger risk

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appetite and wishing for higher
yield, right. So when we're

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thinking about investable
securities, we want to be able

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to appeal to both of these
investors, because without the

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insurance company buying the
seniors and the hedge fund

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buying the subordinated bonds,
the securitization doesn't get

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done. So the goal of then the
process of securitization is to

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take these cash flows from the
pool of, pool of assets that we

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securitize and slice it dice it
in a way that you can create a

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senior security whether it's
rated or whether it is it has a

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certain term that is appealing
to the investor, to the

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insurance company. Right. And it
obviously insurance companies

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look for some credit protection.
So therefore we have a

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subordinated bond that is
buffered from losses to protect

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the senior bond right in case
the cash flows from the pool is

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not enough, which we're going to
talk about in a few minutes.

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Under all that is the bottom
piece, which is the residual,

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the equity piece
over-collateralization, whatever

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you want to call it, that is
essentially the skin in the game

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of the originator. That is the
definitely the first last piece

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on everything. So if there's any
shortfalls principle write

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downs, or any kind of losses
being generated from the

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collateral pool will hit that
bottom piece first. So that

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essentially skin in the game
creates incentive for the

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originator to really make good
loans in the first place. If

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not, obviously during the first
loss position, they will take

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losses as well. So that in
essence is what securitization

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is and what it does, at the end
of the day, why go through this

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trouble? Because you know, it is
complicated. It's not easy or

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cheap to do these
securitizations. Yet, if you

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look at it from the originators
perspective, if you're able to

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access the securitization
markets, you now have access to

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a longer term and potential
lower cost of funds and you can

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originate more business. From
the investor's perspective, as

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we talked about, you can access
securities that are tailored to

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your risk return expectations.
And from the, you know,

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borrower's perspective, or from
the consumer's perspective, the

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involvement of these larger
financial institutions, brings

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more liquidity to the market,
which makes credit and lending

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more available and accessible.

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Sean Murray: So it's amazing how
many things can be securitized,

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so my question would be can you
give us a quick refresher on

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securitization structures then?

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Gunes Kulaligil: When we talked
about what makes a good

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securitization asset, we said it
needs to be a recurring cash

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flows and it needs to have a
longer term. You don't want to

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necessarily be securitizing a
three months consumer loan for

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example, that or a three month
MCA on its own, that prepays in

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three months and you know,
there's really not enough

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collateral to make the
securitization worth it right?

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Not enough collateral sticks
around. So in order to deal with

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this issue in a securitization
is use a revolving structure,

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really all it is, is after the
securitization is issued, both

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the senior and subordinated
bond, neither of them get

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principal for a period of maybe
one to three years, in which

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time the cash flows generated
from the asset pool are

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reinvested back into the asset
pool. In essence, originator is

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making new loans are new
advances and then putting it

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back, back into the collateral
pool. This is a very important

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feature and kind of brings up
the question is the

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securitization really bankruptcy
remote or, you know, forget the

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legal side of things, but what
is the exposure of the

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securitization to the
performance of the of the

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originator, so it brings up a
lot of questions and, and it's

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actually related to the rapid
amortization events that we've

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seen in the last in the last few
months, so let's talk about that

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a little bit. In normal times,
if all goes to plan, and all of

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this, by the way, is explained
in the lovely 300 page

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prospectus document that comes
with a supplement in a pooling

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and servicing agreement, but
really what happens inside of

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securitization is if everything
is fine, after this revolving

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periods, first your senior bond
may be, it may be paid down then

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your subordinate and then to
whatever is left is released to

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the equity. But these
prospectuses are filled with a

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bunch of if-else statements. So
we're in that else area where

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things haven't really gone to
plan, gone, gone as planned, we

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have seen payment percentages
come down, delinquencies go up.

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So this is all planned and
written down, explained the

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prospectus as it says, at the
time of origination issuance,

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it's agreed that if certain
events happen, if certain rather

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limits reached wherever you're
talking about your 30 day

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delinquencies, cumulative losses
in the portfolio, or asset

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deficiency, certain events will
take place. So what has happened

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last couple, couple months is
the asset deficiency triggers

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have failed. All that means is
when you do an MCA

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securitization, you may issue a
you know, 50 million senior 30

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million sub eight million total,
but you back that up with 120

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million of right to receive or
outstanding balance, whatever

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you want to call it. So at the
end of the day, you agreed then,

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throughout the revolving period,
that there's going to be a

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certain amount of
over-collateralization available

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for both the senior and the
subordinated bonds. And if that

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doesn't happen, in you know, in
the holding period, the rapid

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amortization then happens or
takes place. All that means is

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there's no more reinvesting the
cash flows from the collateral

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back into the pool, all the
principal interest, whatever is

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coming from the pool in the case
of MCAs, obviously, it's right

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to receive our monthly, weekly,
the cash flows that- or daily

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cash flows that are coming in,
all of that is directed to pay

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down the principal on, on the
senior bonds. In a way the

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senior bond is happy, because
you can see the collateral

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deteriorating and you don't
necessarily want to see the

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losses eat up from the equity
all the way to the subs and get

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closer to you because as a
senior investor, you're not in

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the business of necessarily
taking credit risk, right? So

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this protection is in place. So
when the rapid amortization

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event happens, the senior bond
pays down very quickly. And you

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know, in this, in these days,
it's really not the worst thing

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but obviously not something
you've planned for maybe you

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plan to earn this 4 or 5% coupon
for three years. In the case of

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the subordinated bond, you're
not happy. Well, it's hard to

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tell, right? Because it's all a
function of how big are the

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losses you're gonna start eating
from the equity and come closer

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to the subordinated bond. And
keep in mind, you know, when we

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talk about the senior
subordinated bonds, we're

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talking about coupons of 4% or
6%, that you paying for these

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bonds but the underlying
collateral in the case of MCAs,

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it's earning 50-60% APR is if
you want to talk about it in APR

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equivalent terms. So there's a
lot of excess interest in these

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deals that's actually helping
to, you know, act as the

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ultimate first loss, if you
will, to protect all the other

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tranches from, from losses. So
there's really a lot going on

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here in the securitizations, but
at the end of the day, you know

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these are happening because the
collateral deteriorated faster

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than expected. And it does bring
up some questions about Okay,

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what what to expect next? And
what else to watch out for?

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Sean Murray: So we've had some
triggers hit recently. So my

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question would be, you know,
what's going to happen next, are

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securitization is going to
become less common in

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alternative lending. What should
we be looking out for here with

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them?

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Gunes Kulaligil: Right. So what
does all this mean, at the end

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of the day, from the perspective
of the originator, investor,

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servicer, or many other
participants in the

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securitization sector? So yeah,
let's talk about that a little

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bit. From the originators,
originators perspective, the

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reason the rapid amortization
event is taking place, the

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reason asset deficiency has
happened is because the

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originator hasn't been able to,
or hasn't been willing to

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originate new loans or new
advances. Because in the

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revolving period, if the
originator was able to add new

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advances to the pools, some of
those triggers wouldn't have

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failed. Right? So, you know,
what does this mean for, for the

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status of the originator not so
great, right. And also, at the

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end of the day, from last, last
couple of months during the

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lockdown? You know, the
merchants weren't necessarily

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looking for small business loans
or advances, right, there was

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all the PPP money, as well as
the unemployment and all the

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stimulus that was going going
through the system. So that's

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really from the perspective of
the originator. Again, they may

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be unwilling or unable to make
new loans unwilling part is, at

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the end of the day, they are in
the product and in the business

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of making a spread from, you
know, what they lend and what

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they borrow, right? So if that's
present there, they may be, you

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know, unwilling to make loans.
And, but they may shift their

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business model to different
things. We've also seen a lot of

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these non bank lenders originate
a good amount of PPP loans

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throughout throughout the
pandemic. So, you know, that's

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the general status of the
originator. If you think about

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the servicer, which is often a,
you know, affiliated entity with

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the originator, they are doing a
lot of modifications, you know,

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we are seeing delinquencies go
up, payment percentages go down,

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I mentioned those, but they're
also positives as well,

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servicers, originators, and the
entire trust really has vested

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interest in, in these businesses
coming back online and receiving

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revenues again, so that the
trust can also get paid, right.

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So they have vested interest in
that. And for that reason,

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they're modifying these loans,
whether that means reducing the

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payment percentage, or extending
the term or maybe reducing the

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amount that needs to be paid
back. So there's all kinds of

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modifications. So servicers have
vested interest in getting this

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done. Bond investors is we
talked about, for the most part,

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seniors may get paid and get out
of the way for the subordinate

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or some of the junior investors
is to be seen case by case. And

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I certainly don't want to make
any kind of huge generalization

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here and any more than I have.
But all of these are all unique,

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it's a huge market, they all
have different type of exposures

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to different geographical areas,
different industries, you know,

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you may be Texas,
California-heavy or you may have

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more exposure to trucking or
leisure. Right. So some trusts

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will do better than others and
that's true for merchant cash

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advances and same thing for
really, for mortgages or, or

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really for any other any other
collateral type. And, you know,

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so also from the perspective of
the investor, you've seen all

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these things going on in this
certain this asset class, you

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probably think twice when you're
investing in this again, right?

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So it may take some time to make
some new, you know, generate

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some new collateral and, you
know, start doing some

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securitizations, especially for
the MCA or small business type,

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type deals. On the other hand,
though, we have seen

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securitization come back for
many mainstream assets who are

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some of the ABS type assets
whether that's mortgages,

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commercial real estate or some
mortgage credit deals we have

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seen them get done in the last
few months. There was only a few

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in April but I think in June
over 40, 45 deals I believe

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we're done so you know things
are things are starting to

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happen but I don't necessarily
expect new origination new

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issuance will return to the MCA
markets when it comes to the

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securitizations.

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Sean Murray: Well, I think you
explained that very, very well.

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Thank you very much for
answering my questions about

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that today.

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Gunes Kulaligil: Thank you, my
pleasure Sean.

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Sean Murray: Okay, and that's
all the time we have today.

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Again, that was Gunes Kulaligil
with Methodical Management.

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Gunes Kulaligil: Thank you