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ASSET-BACKED GAMBLING?The sector is more hazardous than many investors realize. In a downturn, that could be troubleSecuritizations are all about guesswork. First, companies guess how much revenue they can expect at a particular time. Then they guess how much of that money they will need to back their bonds safely. Finally, they guess how much cash will be left over--and book that as profit. And guess what? Sometimes they guess wrong. So far, though, the bad guesses haven't permanently damaged the investors who have bought hundreds of billions of dollars' worth of asset-backed bonds. Investment bankers have done a good job of figuring out how much cash is needed to back the paper. And there has never been a default in any public asset-backed deal, rating agency executives say. But there is nagging evidence that the guesses could be more off the mark than most players in the market think. To this point, this has hurt companies that issue asset-backed bonds and their shareholders. For example, subprime home-equity lenders--the fastest-growing sector in the asset-backed market--have made terrible guesses about their expected profits and have seen their stocks crash as a result. The worry is that investors in asset-backed bonds may see problems. If the economy slows sharply, analysts fret, assumptions about loan losses could also prove incorrect. ''Unlike the last recession, when asset-backed securities did just fine, we could see collateral underperform,'' says research analyst Janet Braggs at Scudder Kemper Investments Inc. in Boston. ''If that happens, there will be more downgrades.'' Moreover, critics worry that securitization depends on a particularly risky assumption--that the markets will always function. ''Securitization creates the illusion of unlimited liquidity and marketability,'' says Henry Kaufman, the former Salomon Brothers Inc. economist who is now president of his own consulting firm, Henry Kaufman & Co. ''This, of course, does not prevail all the time--as has been demonstrated in recent weeks. There are hidden risks in securitization that from time to time result in very substantial losses.'' So far, the biggest threat to asset-backed securities hasn't been loan delinquencies but prepayments. In the home-equity world, with so many subprime lenders stumbling over each other to offer better deals to consumers, borrowers took advantage of the bargains and began prepaying their loans at faster speeds than expected. The loss of anticipated income forced issuers to write down their future profit assumptions. Those revisions unnerved investors who bought stock in the belief these guesses were gospel. ''Although it was generally disclosed in the footnotes to the financial statements, I don't know that investors understood what it meant,'' says David N. Thrope, a partner at Arthur Andersen & Co. The good news in the subprime debacle is that while issuers suffered, their bonds survived. ''There has been a huge correction in the aset-backed market, but it has been among issuers,'' says Philip N. Weingord, a managing director at Credit Suisse First Boston. Still, the failure of issuers could wind up harming the bonds down the road. That's because companies that issue asset-backed bonds usually collect the loans as well. If they go under, someone else has to step in--and that could be a particular problem in some of the new asset classes with few players. What may be the most controversial part of the market is bonds backed by high-loan-to-value (HLTV) loans, which let homeowners borrow up to 125% or more of the value of their homes. According to the General Accounting Office, 10 companies dominated an $8 billion market last year--with one, Dallas' FirstPlus Financial Group, doing a third of the volume. What's more, it's hard to say how such loans will perform in a downturn. ''A lot of the rating methodologies are very hypothetical because you are looking at a lot of issuers and securities and asset classes that have a three- to five-year history,'' says Jon Prestley, an assistant vice-president at Hartford Investment Management Co. ''They haven't been through a recession yet.'' The consolation for investors is that rating agencies run computer simulations on loan pools that assume an outright cataclysm--something on the order of the Great Depression or the collapse of Texas oil in the 1980s. But the triple-A ratings that result from these exercises have a flaw--they reflect only the certainty that an investor will see the return of principal. The possibility of prepayment--and the loss of interest income--is not part of the calculation. And there have been cases of early payment in the asset-backed market involving bonds backed by credit-card loans. Investors in these bonds are paid back early whenever losses in the collateral reach a trigger level. Ironically, this occurred in the first credit-card securitization--RepublicBank Delaware's $200 million issue in January, 1987. The bank went bust the next year, and the Federal Deposit Insurance Corp. paid off investors early. In other cases, too, banks have added to collateral to calm worried investors. The worry now is that loan pools are showing signs of weakness. Meanwhile, some finance companies have gone bankrupt. If these trends continue, there may be no one around to shore up pools of troubled loans in a downturn. And that could mean losses for investors in asset-backed bonds. So there are cracks in the guesswork. And they could get bigger.
By Gary Silverman and Debra Sparks in New York RELATED ITEMS
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Updated Oct. 15, 1998 by bwwebmaster
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