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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
Welcome to the TCW Investment Perspectives Podcast, where our investment professionals share their insights and expertise on how to make the most of your portfolio. I'm David Vic, managing director in fixed income here at TCW. There's been a lot of conversation lately about asset backed finance, and we at TCW, of course, are right in the middle of it. ABF, as it's called, plays a critical role in helping to support the everyday economy from credit cards and mortgages to music royalties and data centers. Dylan Ross, TCW's head of asset backed finance, is here with me today to talk about this fast growing part of the alternative asset class and why it should be part of a balanced portfolio.
David Vick:Dylan, welcome to the podcast.
Dylan Ross:Thanks, Dave. Good to be here.
David Vick:Great. Well, let's start with a quick overview of ABF. What is it? Why is it important? What do you do every day?
Dylan Ross:Good question. We get this a lot. You know, first and foremost, it is really a common financing tool that's been around for decades. Only recently has it become fairly top of mind in many clients portfolios, and we can talk through why that is. But at its core, asset backed finance can be thought of as the private iteration of securitized product markets, which is it's a core tenant of that is the idea of bankruptcy remote lending.
Dylan Ross:You take assets, you take cash flows, credit card receivables, auto loans, student loans, mortgage credit, anything you want. You put it in this bankruptcy remote SPV, and we lend against that. That's the essence of securitized products and is the essence of asset backed finance. Asset backed finance just has the ability and affords the lender and the borrower to customize the loan to fit the borrower's unique needs.
David Vick:Got it. So you mentioned that it's become top of mind more recently. How has it grown? Why has it grown so quickly? Why is it becoming more favorable maybe to do private versus public versions of aspect finance?
Dylan Ross:Yeah, so it's, look, if the world of securitization has been around for, gosh, forty odd years, starting with the evolution of mortgage securitizations in the 80s, The development of private markets to finance these assets really began post financial crisis, where banks began to step away from their balance sheets, shrank, they simplified, certainly capital charges changed quite a bit. And over that over those past twenty odd years, increasingly borrowers that use securitization markets began to use private markets as a form of funding. So for example, a an auto lender who perhaps might only use the securitization market along with a bank financing provider increasingly will search for a diversification of their funding and look to private markets. That evolution was somewhat accelerated by the regional banking stress of '21, because regional banks were a large participant and funder of many of these assets that go into asset backed finance structures. And that stress really prompted borrowers to more proactively seek private market solutions to their financing needs.
Dylan Ross:Because remember, many of these businesses, many of these borrowers we're talking about, they themselves are finance companies. So they're in the business of originating a new loan. And every day, a consumer or small business needs to borrow money to do something, right, whether it be to buy a car, go to school, buy a home. So at all times, that borrower needs to have financing in place to fund that loan. So even if they're a scaled participant in securitization markets and TCW has been doing business with them for forty years, they if securitization markets are shut, they're not able to issue a securitization market on that day, they still need to finance that new mortgage origination.
Dylan Ross:And that's where asset backed finance steps in in increasingly greater scale. And borrowers now realize that it really is a flexible tool, and they're willing to pay a bit more for it. So that's sort of the supply side of the opportunity. Borrowers need this type of capital. And then the demand to provide this credit, you know, has really been a and you know this as well as anybody that you've had a few dynamics in fixed income markets.
Dylan Ross:First and foremost, this demographic need for yield that continues unabated globally. And then over the last three or four years, with the meaningful increase in interest rates, you've had yield and fixed income just afford very real value. So certainly, we've seen a meaningful shift in allocators' preference for securitized products broadly and asset backed finance specifically in their portfolios as a complement to all other parts of their fixed income allocations.
David Vick:Yeah. So you mentioned some of the reasons why a borrower might choose to do private based lending instead of public based lending.
Dylan Ross:Yeah. It's really about flexibility, certainty to close, and trusted guidance from, you know, capital markets participants who see the full landscape.
David Vick:So how do these deals are they the same as public? The same structures? They're a little different?
Dylan Ross:Talk about some the nuances there between maybe public and private. For sure. So the key thing to remember is that the foundations of asset backed finance and securitized product investing is lending to bankruptcy remote SPVs. Right? That is the same across both structures.
Dylan Ross:In public securitized product markets, you have a structure and a cash flow waterfall that is determined by an underwriter to satisfy a wide range of investor needs from the triple a down to the residual. In asset backed finance, you have the same cash flow diversion technology, which we can speak about, but it's really negotiated on a bilateral basis with the borrower and the lender. Tighter covenants tend to be worth that extra spread on the coupon, particularly in times of of uncertainty like currently. But both public securitized products and asset backed finance investments have the basic construct around cash flow diversion. So should losses in underlying collateral be higher than expected, delinquencies higher than expected, cash flow is diverted from the originator or the subordinate holder to delever the senior tranches.
Dylan Ross:That applies across both public and private. In private markets, one, those levels are again customizable. But two, we oftentimes will place covenants on the borrower's financial health directly. Now, those two dynamics are pretty correlated, right? The cash flows of the assets and their financial health are related, but it does give us additional ability to step in and transfer the servicing from that original originator and sponsor to a different servicer should their tangible net worth erode, should the equity that we've asked them to maintain on their balance sheet erode.
Dylan Ross:So asset backed finance is very similar to securitized product from a structuring perspective, but there's a few extra levers that we can pull to customize the risk and return profile candidly.
David Vick:Can you talk a little bit about the origination process, how you find deals, where they come from, like, how do we find things to do?
Dylan Ross:Yeah. We get that question a lot. It's an important question because origination is, in private markets, is a foundational source of alpha. A primary tenet of our origination, and we can talk about them how the market views origination, because there's a few differences to how platforms have established origination, specifically around there's a decision to be made, do asset managers elect to own origination directly, or to have the widest possible lens? And there's not one right or wrong solution to that.
Dylan Ross:But we at TCW, as you know, we take pride in having a wide, the widest possible lens. We think about relative value all the time. It informs every portfolio decision made in the in the since the inception of the firm. So as it relates to origination, we have a very wide, we cast a very wide net. A primary source of origination flow in our asset backed finance business is that securitized product business that's been around for thirty odd years.
Dylan Ross:And the reason there's a particular degree of credibility to that is that that $90,000,000,000 business that has relationships with 500 odd origination platforms, every single one of those origination platforms needs multiple channels of financing at all times. And the historical legacy banking relationships they have are not there in the scale that they were before. So as you can imagine, as we underwrite a deal within the securitized product platform, and we get to know the capital markets team and the CFO, and we ask them what their financing needs are going forward, and they mentioned their need for private capital to replace a bank warehouse, that's a natural lead. So along with that, call it scaled origination of the biggest issuers, there is, you know, what I would submit is a fairly robust and growing network of earlier stage originators that myself and the team have built over decades investing. And that's sort of where the hustle really comes in to the space.
Dylan Ross:And that involves conferences, networking with some of the sponsors. You know, we have a pretty deep network of FinTech venture capital firms that have led to quite a bit of deployment on our behalf over the years. So, you know, we take the origination framework very seriously, and think at all times that we have anywhere from 20 to 30 deals in a pipeline of which we may only execute five to 10 of those transactions.
David Vick:So we've talked some about consumer, know, credit card lending, auto lending, student loaning, all those sort of things. Obviously very consumer related. Our view, as you know, the fixed income side, The U. Economy is likely to slow down, there's likely some more stress on the consumer front. How does that impact, if we do see rising delinquencies and things on the consumer front, how does that impact ABF investments potentially?
Dylan Ross:The data is pretty clear. Consumer credit specifically, it has been weakening, delinquencies have been increasing, recoveries for assets that are secured is going lower. So we see that. And certain positions in the asset backed finance capital structure will bear the brunt of that change. So we think it is a significant, that elevated dispersion and default risk impacts the junior most exposures within asset backed finance.
Dylan Ross:With that said, we think a common misconception amongst participants is you see a stat on consumer delinquencies increasing. You then, you know, the the corresponding decision is to reduce all consumer exposure nominally. LTV matters, right? Structure matters. Making a 50 LTV loan on a portfolio of consumer, you know, near prime credit cards, where we're seeing default rates might move 10 to 20% higher, that 50 LTV loan can withstand a five x of losses from there, multiples of the financial crisis.
Dylan Ross:And that's just a critical piece of securitized product and asset backed finance investing, is not just underwriting the collateral. Those would be table stakes as our, you know, as our boss likes to likes to say. A lot of data analysis in that, a lot of probabilistic underwriting of the range of outcomes. But then you need to consider the structure. How structurally levered are you?
Dylan Ross:How exposed are you to those defaults? And that the dispersion of manager performance, should we have that economic environment, will be vast. Because there are managers and portfolios that are a 100% private residuals that are directly exposed to increasing losses. And the order of magnitude is unclear, but it could mean you underwrote a portfolio to be a 15% loss adjusted yield, and it ends up returning like a three to four. So it'd be a lot better to be in the safer part of the capital structure that you underwrote to an eight or nine and just get your money back.
Dylan Ross:Exactly.
David Vick:Okay, so that's maybe a good segue to maybe the last question. So why do you think ABF is an attractive opportunity for investors? And how do you think it could fit in a portfolio, maybe relative to other private lending like private credit, which of course is all the rage these days? Any comments there?
Dylan Ross:For sure. On a relative basis, there is clear benefits to diversification, right? Diversification is a very well understood idea of risk management. And the factor risks that one is exposed to in direct lending, which is corporate cash flow direct lending, are foundationally different than the factor risks in the world of asset backed finance, namely consumer credit, mortgage credit, cash flows around hard assets. So there's diversification benefits of the factor exposure.
Dylan Ross:Additionally, the nature of asset backed finance investing and securitized products broadly is that when things go wrong, you tend to get your money back sooner. So coupled with that cash flow predictability point we mentioned earlier, there is this stability offered by asset backed finance in times of increasing stress that is a significant diversifier away from corporate related investing. Right? The evolution of secondaries market activity within private funds speaks to the fact that corporate cash flows are inherently uncertain, and refinancings can take longer than expected. So that's a diversification benefit alone.
Dylan Ross:And then the timing of those cash flows too, right? Asset backed finance investments not only are more predictable, tend to be shorter duration. So, you know, they tend to be a good place to be and and hang out in a for, you know, a defensive position. With that said, there's also this absolute, there's this return opportunity today specifically. Asset backed finance does tend to have a meaningful complexity and illiquidity premium that should be harvested by allocators, right?
Dylan Ross:If there's 40,000,000,000,000 of things that need to be financed with asset via asset backed finance technology in coming years, that's a lot of supply, and that lends itself to higher yields. So there's a degree of cheapness on an absolute and relative basis, in addition to just the basic diversification of cash flows.
David Vick:Great. Thanks so much. Very interesting topic. Thank you very much for your help. And I'm sure we'll be talking to you again in the future.
David Vick:Anyway, thanks for joining today.
Dylan Ross:Thank you, Dave.
David Vick:For more information on TCW strategies, please visit our website at tcw.com. Thanks for listening, and we'll pick up next time exploring more trends and opportunities that are shaping global markets.
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