An Investigation of Underwriting Fees for Asset-Backed Securities

Beginning of article

I. Introduction

One of the largest financial markets is the market for asset-backed securities (ABS). Despite the growth and size of the market, no research has been done, to our knowledge, on underwriting fees in this market. The topic of underwriting fees has been previously examined in debt markets. For example, Livingston and Miller (2000) find an inverse relationship between underwriter prestige (market share) and underwriting fees charged in corporate debt markets. Burch, Nanda and Warther (2004) find that loyalty (repeat business) leads to lower fees for common stock offers, but found the opposite holds true for debt offers. In this paper, we investigate whether the relations between underwriter prestige and underwriting fees and between loyalty and underwriting fees that have been found to exist in other debt markets exist in the ABS market.

The topic of underwriting fees for ABS is of interest for two main reasons. First, ABS is a relatively new financial market leading to relatively little prior research being done on it. Second, at least part of the financial crisis in 2009 has arguably been attributed to the growth in the market of these types of securities. To better understand ABS, may help better understand potentially one of the influencing factors of the financial crisis.

ABS are inherently different from other debt instruments since they are collateralized by specific receivables. The growth of the ABS market can be attributed to two main factors: demand by investors in search of spread (above "safer" fixed income securities such as government and corporate debt) and supply by lenders wishing to offload receivables. Using a proprietary database from Bloomberg LP this paper provides an overview of the ABS market that is more detailed than the existing literature. Further, using a methodology similar to that used in Livingston and Miller (2000), this study explores the relationship between ABS underwriter prestige and underwriting fees. This study presents two key findings. First, the relation between underwriter prestige and underwriter fees is found to be positive and statistically significant, indicating that more prestigious underwriters charge higher fees. Second, the analysis identifies a positive relation between underwriter fees and loyalty, indicating that the more an issuer uses the same underwriter, the higher the fees that are charged.

The rest of this paper is organized as follows. Section II provides an overview of the market for ABS. Section III provide a literature review and hypothesis formulation. Section IV describes the methodology, Section V describes the results, and Section VI concludes.

II. Overview of the Market for ABS

In this section, we first provide an overview of the market for ABS, and then take a more detailed look at ABS collateral types, underwriters, ratings and weighted average life. The source of all data is the Bloomberg Data License product. All non-private placement U.S. asset-backed securities issued from January 1st. 1999 through December 31, 2006 are included in our analysis. The period selected represent a period in which the data are richest and most complete, and spans a number of economic cycles.

Since its inception in 1985 with First Boston's sale of lease-backed notes by Sperry Lease Finance Corporation, the U.S. ABS market has grown considerably (van Eck 1995). In addition to the sizeable U.S. market, there are markets in Europe and Japan. Growth in ABS extends to other markets such as Korea, Taiwan, and Greece (Lester, Asaria and van der Linden 2002), (Park, Han, and Kim, 2002) (Pergamalis 2003). Table 1 shows the U.S. asset-backed securities market is large and growing as compared to the U.S. corporate bond market.

The growth of the market can be attributed to two main factors: demand by investors in search of spread above "safer" fixed income securities such as government and corporate debt, and supply by lenders wishing to off-load receivables. As the market grows, so does the ever increasing different types of ABS that are created by Wall Street. Investors in ABS are typically institutional investors of fixed income securities seeking portfolio diversification and/or higher yields. Individual investors also indirectly invest them as many bond funds will hold ABS.

ABS are financial instruments whose cashflows are "backed by" installment loans or other receivables. An issuer of an ABS forms a trust that consists of loans, generally characterized by some common factor; for example, automobile loans. From this trust, the issuer will create a series of classes (tranches) of securities that make up the deal. These classes receive their cashflows from the trust. The timing of the cashflows to an individual class depend on the priority of the class within the overall structure and the payment behavior of the underlying loans. The deal structure and rules associated with priority of cashflows impacts the payments received by the ABS investor.

The payment behavior of the underlying loan holders is important as well. Loan payments are generally differentiated by normal scheduled payment vs. prepayments. Further, prepayments are often differentiated by either partial prepayment or full prepayments. Scheduled payments are the expected monthly payment the borrower agrees to pay on a monthly basis that includes both principal and interest. The borrower generally has the right to either partial prepay, pay additional principal above and beyond what is required each month or can full prepay, pay off the loan in its entirety. In either case, the additional cashflow paid by the borrower which in turn is paid into the trust will often be "passed-through" to the investor of the ABS. This means the ABS expected cashflows and actual cashflows can vary greatly depending on the prepayment behavior of the borrowers.

Within the market of ABS, there are numerous deal types--overall characteristic of the loans or collateral that backs a particular ABS issue. Some of the more common deal types of ABS are home equity loans, home equity line of credits, automobile loans, and credit card receivables. Each of these deal types as well as the numerous others have subtle differences, but the common element is the cashflow paid by the loan borrower or credit card holder is ultimately used to pay the ABS investor. Please see Table 2 for details of outstanding and new issuance of ABS, by various deal types.

In addition to defining an ABS by the deal type, specific classes that comprise the overall deal structure are often defined by class or tranche descriptors. These descriptors are designed to provide the investor in a specific class a general understanding of the payment schedule/structure of the particular class they are investing in and how their bond relates to the overall deal structure. Each deal has associated rules for how to distribute the cashflow received from the underlying collateral. As the ABS market developed so did the complexity of the associated payment rules and in turn various terms/class descriptions used by the market. In some instances, class payment rules require the use of multiple descriptors to accurately provide description of the cashflow payment structure. The prospectus will often include some of the more market accepted descriptors as part of the description of the ABS.

One of the distinguishing features of ABS in contrast to other fixed income securities is the concept of prepayments. Unlike traditional corporate bonds that generally pay interest during the term of the bond and then pay the principal at maturity or if a bond is called, ABS pays principal along with interest throughout the term of the bond. In addition, the principal component of the cashflow is a function of the prepayment behavior of underlying collateral which greatly impacts the overall term of the ABS. Although ABS are assigned a maturity date at issue, ABS rarely will remain outstanding until their legal maturity date. In both MBS and ABS, market participants generally use another value to measure "term" of an MBS/ABS--weighted average life (WAL) which is defined as time weighted average time of receipt of principal. When an ABS is issued, it is quite common for the lead manager of the deal to provide an original WAL value which is calculated using an assumed average prepayment rate.

Similar to corporate bonds, ABS are often quoted in terms of basis points spread to a corresponding benchmark security. For example, an ABS with an original WAL of 5 years will often be priced as a spread to the U.S. 5 year treasury. Because the market for ABS is typically over the counter and cashflows are highly dependent on prepayment behavior of the underlying borrowers, there is much variability in terms of the price or value of a given ABS. Overall, there is less price transparency in ABS market as compared to other fixed income markets such as government bonds, corporate bonds, and municipal bonds.

Much like other fixed income securities, ABS deals are brought to market by an underwriter who is responsible for structuring the deal and bringing the deal to market. For the underwriting services, the underwriter will generally receive a fee that is based on percentage dollar amount of the individual class amounts. It should be noted that the underwriting firm will likely also receive compensation not only for their underwriting services but also in the form of commissions as they sell the bond into the primary market.

The ABS market experienced significant growth during late 1990's and early/mid 2000's. The growth in the ABS market coincided with the growth in the number of loans provided to subprime borrowers. Sub-prime borrowers is a term associated with borrowers with lower credit scores and generally considered more likely to potentially default on a loan. The increase in loans led to an increasing number of securitized securities such as ABS. However, beginning in late 2006 the market for ABS changed as these borrowers began to default on their loans. As borrowers began to default or became delinquent in payments, the values of ABS securities diminished significantly. This decrease in turn led to an overall downturn in the ABS issuance. Issuance in 2007 was $759 Billion, nearly $200 Billion less than the $943 Billion issued in 2006. We next turn to a more detailed overview of ABS collateral types, underwriters, ratings and weighted average life.

1. Collateral Type

ABS are typically structured by collateral type. Appendix A provides a table of the deal type classifications used by Bloomberg to classify ABS deals. These classifications are generally considered "industry standard" and commonly used not only by Bloomberg, but by the market in general when classifying particular ABS deals. There is significant variety in the types of loans/receivables that are packaged together when structuring an ABS ranging from automobile loans to receivables from utilities such as electricity companies.

Although there are numerous collateral types and ABS, the dollar amount issued varies significantly across different collateral types. Table 3 presents dollar issuance by deal type for all nonprivate placed U.S. ABS issued between 1999 through 2006. For example, ABS backed by home equity loans during the period dominates issuance at $2.3 Trillion followed by automobile loan ABS with $716 Billion, credit card ABS with $486 Billion and student loan ABS with $285 Billion. The remainder of the issuance is largely fragmented across nearly 30 other loan/receivable types.

2. Underwriter

Table 4 provides ABS underwriter rankings of the top 20 underwriters ranked by dollar amount underwritten during the period 1999-2006. A few observations can be noted. First, some underwriters such as Credit Suisse and Lehman were either top underwriter or in the top 5 underwriters for each during the period 1999-2006. Second, there are some underwriters that show significant growth in market share during the period--two notable examples are Barclays and Countrywide that had little or no underwriting activity prior to 2001, but show substantial and consistent growth year to year for years thereafter.

Table 5 presents the average underwriting fees charged for the same top 20 underwriters during the period 1999-2006. For example, consider Lehman Brothers. During 1999 through 2002, Lehman Brothers charged higher than average or average fees. However, during the periods of the most rapid growth in terms of issuance, 2003 through 2006, the fees they charged were lower than average.

3. Ratings

Credit ratings are often assigned to ABS. Table 6 shows dollar issuance of ABS by year and credit rating. Over half of the total dollar issuance during the period 1999-2006 has credit rating of A- or higher with the majority of it being rated AAA. The remaining issuance is relatively evenly distributed across the other, lower ratings.

Table 7 shows average underwriting fee by year and credit rating. ABS rated AAA typically have lower than average underwriting fee during each individual year, while lower rated securities such as BBB have higher than average underwriting fees. This suggests that underwriters charge higher fees for lower rated securities, suggesting relative difficulty in marketing lower quality securities.

4. Original Weighted Average Life

Table 8 shows ABS by weighted average life and amount issued during the sample period used in the study. During the sample period, nearly a third of all issuance had original WAL between 2.5 and 3.5 years and over 70% of the issuance had original WAL between .5 and 5.5 years.

Table 9 shows ABS by weighed average life and average underwriting fee. This data does not indicate a relationship between original weighted average life and average underwriting fees. This contrasts with the findings of Livingston and Miller (2000) who found a positive relationship between term/maturity and underwriting fees.

III. Literature review and hypothesis formulation

1. ABS literature

DeMarzo and Duffle (1999) note that issuers of ABS need to evaluate two costs when determining optimal security design: The opportunity cost related to holding assets with lower returns than those that could be sought if the issuer securitized these assets and used the capital raised to invest in higher-return assets, and the potential negative impact of including these lower returning assets in the securitization and the potential impact of lower demand for the security. DeMarzo and Duffie develop a framework for evaluating optimal security design.

Han and Lai (1995) note that securitization has been successful in markets such as mortgages and asset-backed loans; it has not been as successful for insurance products. They offer three reasons this has been the case: 1) it is more costly to securitize unstable cashflows from insurance products into fixed income securities, 2) regulations do not make it conducive to do so since regulators do not permit to take the securities assets/liabilities off their balance sheet, and 3) insurers have other ways to diversify their portfolio thereby reducing the need/attractiveness of securitization.

Plantin (2004) develops a model to gain insight into why firms issue asset securitization deals into separate classes or tranches. He points out that many ABS structures such as CDOs are split into senior and junior classes. He suggests that investment banks that sell these securities …