00:04.980 --> 00:08.370
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

01:02.630 --> 01:05.150
subordinate securities, you
know, whether they're insurance

01:05.150 --> 01:10.160
companies or hedge funds, they
will need this type of valuation

01:10.160 --> 01:13.340
work, both for financial
reporting purposes. And really

01:13.340 --> 01:15.920
also in the context of
transactions when they're buying

01:15.920 --> 01:20.420
or selling assets or, you know,
structuring facilities to to

01:20.420 --> 01:24.710
fund these types of these types
of assets. From an accounting

01:24.710 --> 01:27.860
perspective, everything that
we're going to discuss today,

01:28.010 --> 01:32.930
whether it's an MCA portfolio,
or securitization is going to be

01:32.930 --> 01:37.820
a level three asset. All level
three means is it's an illiquid

01:37.820 --> 01:41.360
asset. By the way, there is no
level four, and you need to rely

01:41.360 --> 01:45.050
on on observable market inputs,
you need to build a model where

01:45.050 --> 01:47.960
you project the cash flows use a
discount rate to calculate an

01:47.960 --> 01:51.890
NPV, as opposed to a level one
asset. An example would be a

01:51.890 --> 01:55.430
treasury bond or a corporate
bond, or a trade, trade equity

01:55.430 --> 01:58.550
where you can look up the last
trade and that's, that's what

01:58.550 --> 02:00.950
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

02:27.110 --> 02:31.250
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

02:51.590 --> 02:55.970
to be used when these funds are
cutting their NAVs for for

02:56.000 --> 03:00.500
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.

03:14.060 --> 03:16.070
Sean Murray: Perfect. Well, it
sounds like you're the person I

03:16.070 --> 03:18.380
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.

03:27.050 --> 03:30.590
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

04:58.550 --> 05:03.080
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

05:35.900 --> 05:38.030
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

05:48.890 --> 05:52.910
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

06:24.200 --> 06:28.280
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

06:39.650 --> 06:43.490
going to create some investable
securities out of that. In order

06:43.490 --> 06:45.500
to do that, we need to
understand the types of

06:45.500 --> 06:49.460
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

06:58.970 --> 07:02.960
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

07:15.920 --> 07:20.030
buying the subordinated bonds,
the securitization doesn't get

07:20.030 --> 07:25.040
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

07:36.860 --> 07:40.640
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.

07:59.000 --> 08:03.830
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

08:31.040 --> 08:34.250
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

08:46.880 --> 08:49.850
cheap to do these
securitizations. Yet, if you

08:49.850 --> 08:53.000
look at it from the originators
perspective, if you're able to

08:53.000 --> 08:57.050
access the securitization
markets, you now have access to

08:57.050 --> 09:00.260
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,

09:12.410 --> 09:15.920
borrower's perspective, or from
the consumer's perspective, the

09:15.920 --> 09:19.670
involvement of these larger
financial institutions, brings

09:19.670 --> 09:24.230
more liquidity to the market,
which makes credit and lending

09:24.230 --> 09:26.270
more available and accessible.

09:27.260 --> 09:30.080
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

09:33.650 --> 09:35.270
securitization structures then?

09:35.300 --> 09:37.850
Gunes Kulaligil: When we talked
about what makes a good

09:37.850 --> 09:43.310
securitization asset, we said it
needs to be a recurring cash

09:43.310 --> 09:45.770
flows and it needs to have a
longer term. You don't want to

09:45.770 --> 09:50.510
necessarily be securitizing a
three months consumer loan for

09:50.510 --> 09:57.140
example, that or a three month
MCA on its own, that prepays in

09:57.140 --> 10:00.860
three months and you know,
there's really not enough

10:00.860 --> 10:03.950
collateral to make the
securitization worth it right?

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

10:08.330 --> 10:14.030
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

10:19.460 --> 10:23.720
the senior and subordinated
bond, neither of them get

10:23.720 --> 10:27.920
principal for a period of maybe
one to three years, in which

10:27.920 --> 10:31.160
time the cash flows generated
from the asset pool are

10:31.160 --> 10:35.390
reinvested back into the asset
pool. In essence, originator is

10:35.390 --> 10:38.690
making new loans are new
advances and then putting it

10:38.720 --> 10:42.140
back, back into the collateral
pool. This is a very important

10:42.140 --> 10:46.010
feature and kind of brings up
the question is the

10:46.010 --> 10:50.030
securitization really bankruptcy
remote or, you know, forget the

10:50.030 --> 10:52.550
legal side of things, but what
is the exposure of the

10:52.550 --> 10:55.910
securitization to the
performance of the of the

10:55.910 --> 11:00.380
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

11:04.340 --> 11:07.790
seen in the last in the last few
months, so let's talk about that

11:07.790 --> 11:12.890
a little bit. In normal times,
if all goes to plan, and all of

11:12.890 --> 11:16.100
this, by the way, is explained
in the lovely 300 page

11:16.130 --> 11:19.280
prospectus document that comes
with a supplement in a pooling

11:19.280 --> 11:22.370
and servicing agreement, but
really what happens inside of

11:22.370 --> 11:27.470
securitization is if everything
is fine, after this revolving

11:27.470 --> 11:32.660
periods, first your senior bond
may be, it may be paid down then

11:32.660 --> 11:36.110
your subordinate and then to
whatever is left is released to

11:36.110 --> 11:40.040
the equity. But these
prospectuses are filled with a

11:40.160 --> 11:45.080
bunch of if-else statements. So
we're in that else area where

11:45.230 --> 11:49.670
things haven't really gone to
plan, gone, gone as planned, we

11:49.670 --> 11:54.050
have seen payment percentages
come down, delinquencies go up.

11:54.350 --> 11:57.470
So this is all planned and
written down, explained the

11:57.470 --> 12:01.220
prospectus as it says, at the
time of origination issuance,

12:01.220 --> 12:05.480
it's agreed that if certain
events happen, if certain rather

12:05.480 --> 12:08.810
limits reached wherever you're
talking about your 30 day

12:08.810 --> 12:14.390
delinquencies, cumulative losses
in the portfolio, or asset

12:14.390 --> 12:19.070
deficiency, certain events will
take place. So what has happened

12:19.070 --> 12:24.710
last couple, couple months is
the asset deficiency triggers

12:24.770 --> 12:28.070
have failed. All that means is
when you do an MCA

12:28.070 --> 12:31.940
securitization, you may issue a
you know, 50 million senior 30

12:31.940 --> 12:36.170
million sub eight million total,
but you back that up with 120

12:36.170 --> 12:40.460
million of right to receive or
outstanding balance, whatever

12:40.460 --> 12:45.050
you want to call it. So at the
end of the day, you agreed then,

12:45.620 --> 12:48.620
throughout the revolving period,
that there's going to be a

12:48.620 --> 12:51.170
certain amount of
over-collateralization available

12:51.170 --> 12:54.680
for both the senior and the
subordinated bonds. And if that

12:54.680 --> 13:00.110
doesn't happen, in you know, in
the holding period, the rapid

13:00.110 --> 13:06.050
amortization then happens or
takes place. All that means is

13:06.170 --> 13:10.400
there's no more reinvesting the
cash flows from the collateral

13:10.400 --> 13:13.940
back into the pool, all the
principal interest, whatever is

13:13.940 --> 13:17.210
coming from the pool in the case
of MCAs, obviously, it's right

13:17.210 --> 13:21.380
to receive our monthly, weekly,
the cash flows that- or daily

13:21.380 --> 13:24.530
cash flows that are coming in,
all of that is directed to pay

13:24.530 --> 13:29.210
down the principal on, on the
senior bonds. In a way the

13:29.210 --> 13:32.300
senior bond is happy, because
you can see the collateral

13:32.300 --> 13:35.030
deteriorating and you don't
necessarily want to see the

13:35.060 --> 13:38.630
losses eat up from the equity
all the way to the subs and get

13:38.630 --> 13:41.660
closer to you because as a
senior investor, you're not in

13:41.660 --> 13:44.300
the business of necessarily
taking credit risk, right? So

13:44.420 --> 13:48.110
this protection is in place. So
when the rapid amortization

13:48.110 --> 13:52.640
event happens, the senior bond
pays down very quickly. And you

13:52.640 --> 13:55.820
know, in this, in these days,
it's really not the worst thing

13:55.820 --> 13:58.670
but obviously not something
you've planned for maybe you

13:58.730 --> 14:04.760
plan to earn this 4 or 5% coupon
for three years. In the case of

14:04.760 --> 14:10.070
the subordinated bond, you're
not happy. Well, it's hard to

14:10.070 --> 14:14.480
tell, right? Because it's all a
function of how big are the

14:14.690 --> 14:17.780
losses you're gonna start eating
from the equity and come closer

14:17.780 --> 14:22.400
to the subordinated bond. And
keep in mind, you know, when we

14:22.400 --> 14:24.620
talk about the senior
subordinated bonds, we're

14:24.620 --> 14:28.640
talking about coupons of 4% or
6%, that you paying for these

14:28.640 --> 14:31.580
bonds but the underlying
collateral in the case of MCAs,

14:31.760 --> 14:35.960
it's earning 50-60% APR is if
you want to talk about it in APR

14:35.960 --> 14:39.080
equivalent terms. So there's a
lot of excess interest in these

14:39.080 --> 14:43.010
deals that's actually helping
to, you know, act as the

14:43.100 --> 14:47.900
ultimate first loss, if you
will, to protect all the other

14:47.900 --> 14:52.250
tranches from, from losses. So
there's really a lot going on

14:52.250 --> 14:56.930
here in the securitizations, but
at the end of the day, you know

14:56.930 --> 15:00.470
these are happening because the
collateral deteriorated faster

15:00.470 --> 15:04.700
than expected. And it does bring
up some questions about Okay,

15:04.700 --> 15:08.330
what what to expect next? And
what else to watch out for?

15:08.990 --> 15:12.320
Sean Murray: So we've had some
triggers hit recently. So my

15:12.320 --> 15:15.350
question would be, you know,
what's going to happen next, are

15:15.350 --> 15:17.990
securitization is going to
become less common in

15:17.990 --> 15:21.800
alternative lending. What should
we be looking out for here with

15:21.800 --> 15:22.900
them?

15:22.990 --> 15:25.120
Gunes Kulaligil: Right. So what
does all this mean, at the end

15:25.120 --> 15:29.230
of the day, from the perspective
of the originator, investor,

15:29.920 --> 15:32.590
servicer, or many other
participants in the

15:32.590 --> 15:34.930
securitization sector? So yeah,
let's talk about that a little

15:34.930 --> 15:39.400
bit. From the originators,
originators perspective, the

15:39.400 --> 15:45.490
reason the rapid amortization
event is taking place, the

15:45.490 --> 15:48.520
reason asset deficiency has
happened is because the

15:48.520 --> 15:52.180
originator hasn't been able to,
or hasn't been willing to

15:52.240 --> 15:55.870
originate new loans or new
advances. Because in the

15:55.870 --> 16:00.100
revolving period, if the
originator was able to add new

16:00.190 --> 16:04.090
advances to the pools, some of
those triggers wouldn't have

16:04.090 --> 16:08.620
failed. Right? So, you know,
what does this mean for, for the

16:08.620 --> 16:12.070
status of the originator not so
great, right. And also, at the

16:12.070 --> 16:15.760
end of the day, from last, last
couple of months during the

16:15.760 --> 16:18.700
lockdown? You know, the
merchants weren't necessarily

16:18.700 --> 16:21.940
looking for small business loans
or advances, right, there was

16:21.970 --> 16:26.350
all the PPP money, as well as
the unemployment and all the

16:26.350 --> 16:29.950
stimulus that was going going
through the system. So that's

16:29.950 --> 16:33.670
really from the perspective of
the originator. Again, they may

16:33.670 --> 16:37.750
be unwilling or unable to make
new loans unwilling part is, at

16:37.750 --> 16:41.230
the end of the day, they are in
the product and in the business

16:41.230 --> 16:44.860
of making a spread from, you
know, what they lend and what

16:44.860 --> 16:48.010
they borrow, right? So if that's
present there, they may be, you

16:48.010 --> 16:51.850
know, unwilling to make loans.
And, but they may shift their

16:51.850 --> 16:55.600
business model to different
things. We've also seen a lot of

16:55.600 --> 17:00.610
these non bank lenders originate
a good amount of PPP loans

17:00.910 --> 17:03.970
throughout throughout the
pandemic. So, you know, that's

17:03.970 --> 17:07.060
the general status of the
originator. If you think about

17:07.060 --> 17:11.950
the servicer, which is often a,
you know, affiliated entity with

17:11.950 --> 17:16.120
the originator, they are doing a
lot of modifications, you know,

17:16.330 --> 17:20.260
we are seeing delinquencies go
up, payment percentages go down,

17:20.260 --> 17:22.810
I mentioned those, but they're
also positives as well,

17:23.260 --> 17:26.680
servicers, originators, and the
entire trust really has vested

17:26.680 --> 17:32.290
interest in, in these businesses
coming back online and receiving

17:32.290 --> 17:35.740
revenues again, so that the
trust can also get paid, right.

17:35.800 --> 17:38.200
So they have vested interest in
that. And for that reason,

17:38.200 --> 17:43.420
they're modifying these loans,
whether that means reducing the

17:43.450 --> 17:48.070
payment percentage, or extending
the term or maybe reducing the

17:48.130 --> 17:50.800
amount that needs to be paid
back. So there's all kinds of

17:50.800 --> 17:55.540
modifications. So servicers have
vested interest in getting this

17:55.540 --> 18:01.060
done. Bond investors is we
talked about, for the most part,

18:01.120 --> 18:05.110
seniors may get paid and get out
of the way for the subordinate

18:05.110 --> 18:10.060
or some of the junior investors
is to be seen case by case. And

18:10.060 --> 18:14.890
I certainly don't want to make
any kind of huge generalization

18:14.890 --> 18:18.610
here and any more than I have.
But all of these are all unique,

18:18.850 --> 18:22.570
it's a huge market, they all
have different type of exposures

18:22.570 --> 18:26.200
to different geographical areas,
different industries, you know,

18:26.200 --> 18:29.320
you may be Texas,
California-heavy or you may have

18:29.350 --> 18:34.420
more exposure to trucking or
leisure. Right. So some trusts

18:34.420 --> 18:38.230
will do better than others and
that's true for merchant cash

18:38.230 --> 18:41.950
advances and same thing for
really, for mortgages or, or

18:41.980 --> 18:47.110
really for any other any other
collateral type. And, you know,

18:47.410 --> 18:51.700
so also from the perspective of
the investor, you've seen all

18:51.700 --> 18:54.460
these things going on in this
certain this asset class, you

18:54.460 --> 18:57.190
probably think twice when you're
investing in this again, right?

18:57.190 --> 19:02.470
So it may take some time to make
some new, you know, generate

19:02.470 --> 19:05.140
some new collateral and, you
know, start doing some

19:05.230 --> 19:09.040
securitizations, especially for
the MCA or small business type,

19:09.730 --> 19:12.550
type deals. On the other hand,
though, we have seen

19:12.550 --> 19:15.970
securitization come back for
many mainstream assets who are

19:15.970 --> 19:19.900
some of the ABS type assets
whether that's mortgages,

19:19.930 --> 19:25.480
commercial real estate or some
mortgage credit deals we have

19:25.480 --> 19:30.010
seen them get done in the last
few months. There was only a few

19:30.010 --> 19:34.600
in April but I think in June
over 40, 45 deals I believe

19:34.600 --> 19:37.210
we're done so you know things
are things are starting to

19:37.210 --> 19:40.600
happen but I don't necessarily
expect new origination new

19:40.600 --> 19:45.460
issuance will return to the MCA
markets when it comes to the

19:45.460 --> 19:46.330
securitizations.

19:46.630 --> 19:49.420
Sean Murray: Well, I think you
explained that very, very well.

19:49.450 --> 19:51.490
Thank you very much for
answering my questions about

19:51.490 --> 19:52.270
that today.

19:53.440 --> 19:54.880
Gunes Kulaligil: Thank you, my
pleasure Sean.

19:55.300 --> 19:57.940
Sean Murray: Okay, and that's
all the time we have today.

19:58.360 --> 20:01.780
Again, that was Gunes Kulaligil
with Methodical Management.

20:03.040 --> 20:03.400
Gunes Kulaligil: Thank you