An introduction to Secured Finance Andy Burgess

Agenda What is secured finance? How does it work? How can I use it? 1 2 How does it work? 3 How can I use it?

Weaker credit environment Where can I generate higher returns or more income? Where is risk-taking rewarded? More interest rate risk More credit risk More idiosyncratic risk Increases loss if yields rise Weaker credit environment illiquid in stress 100% reliant upon manager skill Not interest rate sensitive Investment grade risk Attractive asset class L0090 - STATIC

What are secured finance securities What are secured finance securities? Both liquid and illiquid instruments have similar characteristics Secured on ring-fenced assets / cash flows Bankruptcy remote from originator Typically floating rate note Complex to analyse, different skill-set But…underlying assets are familiar (house) Risk is to underlying individual borrowers

Why does this opportunity exist? Bank appetite to lend has fallen Regulation has reduced bank lending Banks looking to share ‘good’ risks, not dump bad loans Opportunities to work alongside banks Increasing direct opportunities L0090 - Quarterly. Updated by FIG product specialists

Residential and consumer Commercial real estate What are the different areas of secured finance? Asset-backed lending across a wide range of opportunities Residential mortgage backed securities (RMBS): Prime Buy-to-let/Non-conforming Credit card loans Auto loans Residential and consumer Residential mortgage warehouse Residential bridge lending Auto/credit card warehouse Commercial real estate Secured corporate Liquid/public Commercial real estate loans: Office Retail Hotel Corporate loan warehouse SME warehouse Collateralised loan obligations (CLO) Whole business securitisations (WBS) Commercial mortgage backed securities (CMBS) Illiquid/ private Often the same underlying assets L0090

How are asset-backed securities structured How are asset-backed securities structured? Residential mortgage backed security Pool of mortgages back a bond that pays interest and regular principal payments Various ‘tranches’ of bonds, senior is safer, but lower return Structure can apply to credit card payments, auto loans etc Collateral pool (e.g. mortgage loans) Losses Senior loan Junior loan/ equity Priority of payments Interest and principal from mortgages Interest from mortgages Principal from mortgages L0090

Loan-to-value (LTV) is one guide to protection Many different ways to improve safety Step 1: recourse and excess assets If borrowers fail to pay back their mortgages: Recourse to borrowers (not in US) Re-possesses the house and sells it Loan-to-value (LTV) is important metric Lower LTV = higher protection More generally, either: Value of asset > debt Amount of loans > debt Often called ‘Over-collateralisation’ or ‘OC’ Loan-to-value (LTV) is one guide to protection Source: Insight, for illustrative purposes only.

Additional protection significant and counter-cyclical Many different ways to improve safety Step 2: structural protection and diversification AAA Extra protection within the bond terms: More subordinated investors take losses first Excess spread: mortgage - bond coupon = expected loss * X Coupon step-up if principal bond repayments slow Asset triggers – income diverts from junior note holders AA A BBB BB Equity Additional protection significant and counter-cyclical Source: Insight, for illustrative purposes only.

Investment process overview The Insight approach Portfolio management Loan underwriting Asset valuation Bond structuring Quantitative modelling Mortgage underwriting expertise Leveraged finance specialism Commercial property valuation Whole loan appraisal Large fixed income team In house ratings models Market leading loan level forecasting Investment bank structuring experience L0080 – UPDATED MONTHLY THIS SLIDE IS STATIC

Takes longer, but terms are negotiable Public versus private secured finance markets Underlying assets are the same, what is different? Public markets Bond with prescribed terms (or ‘covenants’) Public information Active secondary market Private markets Bi-lateral agreement – more control, longer lead time Private information Limited secondary market Takes longer, but terms are negotiable

How much illiquidity premium do I need How much illiquidity premium do I need? More than just worrying about things going wrong Illiquidity premium

Attractive risk-adjusted returns Corporate spreads versus secured debt Diversified secured finance strategy Representative secured finance universe Investment grade corporate bonds +200 to 250bp Investment grade High yield Source: Insight. Data as at 31 March 2017. The spreads shown are for illustrative purposes only and are not indicative of the strategy spreads. European corporate bonds used to reflect corporate bonds. L0090 – quarterly/adhoc update from FIG

How can I use this asset class? Growth or income? Diversifying asset class Longer-term growth asset Expected return compensates for analytical complexity and illiquidity Not as sensitive to rising rates Income approach Contractual asset Cheaper than corporate bonds Get paid for sacrificing liquidity if you don’t need it Income rises with higher cash rates Can meet either a return or income requirement

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