United Capital Markets



United Capital Markets
Volume 2 Issue 10
November 2004
United Capital Markets
Structured credit’s king of liquidity
Six months ago,
this man was
running his
business out of a
residential house in
Florida. Now his
company is among
the fastest-growing
broker-dealers in
the country. John
Devaney, founder
of United Capital
Markets, reveals
the secret of his
success to
Saskia Scholtes
Photographs by Matthew Porter
small broker-dealer based on Key Biscayne, an
island off the coast of Miami, would hardly be
the gambler’s choice for the broker most likely
to make inroads into one of the riskiest and
least understood portions of the securitization market.
But in the first nine months of this year, United Capital
Markets, founded by Key Biscayne-born John Devaney,
has bought nearly $3 billion at current face value in subordinated asset-backed securities, commercial mortgagebacked securities and collateralized debt obligations,
many of them distressed.
So it seems that, against all the odds, a firm that started
life as a one-man outfit only five years ago has become one
of the fastest-growing broker-dealers in a market plagued
by headline risk and a conspicuous lack of liquidity.
United Capital Markets (UCM) operates by exploiting market inefficiencies. The benefit of trading the subordinated tranches of these high-yield structured finance
products is that their secondary markets are among the
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most inefficient. As Devaney puts it, “The secondary
markets for some of these bonds have an incredible disconnect between the current trading levels and the fundamental credit quality of the collateral pools backing
the securities.”
This is partly because the market for high-yield structured finance products is considerably less mature than
“I only buy at a price where I
would be happy to buy it with my
own money”
John Devaney,United Capital Markets
the high-yield market for
corporate bonds. According
to Thomson Financial, while
the high-yield corporate
bond market has seen some
$994.3 billion of issuance
since 1991, high-yield structured finance has only
clocked up around $25.8 billion of issuance.
The relative youth of the
market, together with a lack
of transparency stemming
from obscure deal structures
backed by esoteric assets, has
meant that many of the
mainstream institutional
investors who flock to buy
structured finance products
at new issue are not always
familiar with what they are
buying. Even the rating
agencies have only recently tightened their methodologies to accurately assess collateral pools and projected
loss rates.
One of Devaney’s clients, a portfolio manager at a
fund that specializes in high-yield corporate and structured finance paper, says, “There is a significant level of
crossover money that comes into securitization at new
issue, buying products that the money managers for these
funds don’t fully understand.” Part of the problem, adds
the portfolio manager, is that many mainstream investors
will buy new issues on the basis of ratings, but a number
of securitizations with poor business models and flawed
deal structures have been awarded higher ratings than
they deserved at issuance. “Then when something goes
wrong, that money is looking to get out as quickly as possible, creating a flood of supply,” he says.
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Many institutional investors have learned this the hard
way. While much of the securitization market has performed very well over the course of its history, since the
late 1990s the market’s record has been blemished by a
number of negative shocks, exposing a raft of poorly written deals, backed by defective business models and
awarded erroneous ratings.
Securitizations backed by the manufactured housing
sector are just one example. Between 1995 and 2002, the
market saw $31 billion of new-issue bonds backed by
loans for manufactured homes from companies like Conseco, Greenpoint, Bombardier and Oakwood Homes. By
2003, however, it became apparent that the model was
flawed: the rating agencies announced multiple-notch
downgrades, new issuance dried up and many of the major
lenders filed for bankruptcy.
Investors who had bought the
bonds in the primary market
were anxious to get out.
However, when investors
want to sell, there are ver y
few places to go: as few as
five of the large investment
banks will trade subordinated or distressed structured finance products in the
secondary market. Liquidity
for these products is so limited that most broker-dealers
don’t quote spreads below
the double-A level with any
regularity—the market simply does not move enough to
provide indicative levels.
And if, like in the manufactured housing sector, primar y market issuance has
dried up for a certain type of
security, the underwriters on the original deals are often
reluctant to commit capital to support them in the secondary market. Armand Pastine, managing director and
trader at UCM competitor Maxim Group, says, “Underwriters tend to be more enthusiastic about the new-issue
market than they are about participating in the secondary
market for these bonds.”
A liquid entity
As a result, some regional dealers like Maxim Group and
Devaney’s UCM have been very successful in exploiting
this niche of the structured finance market by acting as
liquidity providers. What makes UCM unique among
other brokers operating in this space, however, is that it
acts mainly as principal rather than agent in its deals,
often long in the same bonds that it trades. Devaney says,
“Acting as an agent as opposed to principal makes it too
hard to tell where the prices should be, so I do a rigorous
fundamental analysis on each potential purchase and only
buy at a price where I would be happy to buy it with my
own money and hold it on my own balance sheet.”
Devaney argues that this is the most efficient way of
providing liquidity and securing the loyalty of a customer
base which knows that Devaney’s own capital is at stake.
And it’s certainly the case that his clients appreciate the
level of credit assessment that goes into Devaney’s trades.
Jim Kelsoe, high-yield portfolio manager at Morgan Keegan Asset Management, says, “I have found John to be
very aggressive in his ability to find interesting trading
ideas. Devaney is an analyst, salesman and trader in one,
which is a much more efficient use of my time. He conducts detailed and in-depth credit work on unusual
structures and it’s important for us that he is willing
to commit his own capital to illiquid securities.”
However, while many applaud UCM’s success
in gaining a strong market position by acting as
principal on its deals, some argue that the strategy
does not necessarily contribute to a more efficient market for all. Pastine at Maxim
Group explains, “The liquidity in this
market is manufactured rather than
provided. And if UCM buys a bond
for its own balance sheet, the act of
taking on that risk means that it is
likely to offer the bond at a higher
price than if it was acting as agent.
There is no problem with wanting to
be compensated for taking on risk,
but for those wanting efficiency,
using an agent makes more sense.”
Nevertheless, the strategy of acting
as principal has undoubtedly contributed to UCM’s success in the five
years that UCM has been in business. Since
it was founded in February 1999, the firm
has grown from a one-man bond shop with
only $500,000 of capital to a firm which,
when combined with Devaney’s real-estate
interests, surpasses the net income of Raymond James, a rival Florida-based brokerage
with a 32-year track record.
The broker-dealer has 18 employees,
including professionals poached from Wall
Street—Devaney’s cohort on the trading
desk is a former ABS trader at Bear Stearns,
Sean Kirk. The firm has three bond salesmen, including Devaney’s best friend Jeff
Ward, and two research staff, Evan Kestenberg and Steve Finnk, formerly of Canyon
Capital Advisors and AIG Global Investment
respectively. Three years ago, as a move to add diversity to
the firm and balance the risks in UCM’s other markets,
UCM also launched a collateralized mortgage obligation
(CMO) trading desk based in California run by Dan
Steuer, formerly of Countrywide Securities.
In 2003, UCM traded $5.115 billion, measured at current face value, in subordinate ABS, CMBS and CDOs.
The firm’s CMO desk bought approximately $6 billion in
CMOs at current face value. In 2003, UCM also completed its first primary market issue: a $233.4 million private placement of repackaged small business loans.
Devaney’s successes do not come without taking on
risk, however. UCM has been involved with some of the
most distressed sectors in the asset-backed universe,
including bonds backed by high loan-to-value (LTV)
mortgages, aircraft leases, loans for manufactured housing, sub-prime credit cards and loans for franchise
businesses. Devaney will not discuss publicly the
credits he is currently invested in, but says he still
finds value in many of these sectors.
“The sub-prime credit card sector is one recent trade
that we’ve been very happy with,” he says. “We
bought $1.5 billion in Metris, First Consumers and NextCard bonds after these
securitizations went into early amortization or were trading at distressed levels:
we felt that the loss rates on the cards had
been miscalculated by the Street.”
But for many investors, Devaney
takes on more risk than they themselves
would be comfortable with and even
very sophisticated investors in subordinated and distressed ABS confess that
they would not touch sectors like franchise or health-care receivables because
of holes in the business models.
A finance and English graduate from Colorado State University in 1994, Devaney
developed a relationship with risk-taking
in his sophomore year. After learning
about stock options in one of his finance
classes, he opened a discount brokerage
account so that he could buy out-of-themoney calls on Motorola using his student
loans. “I couldn’t believe that the upside
was unlimited and that you could only lose
100% of your money! I was so drawn to the
principals of leverage that I had to get
involved,” he says.
Devaney also used his student credit
card to apply for a no-money-down realestate purchase, on which he then
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took out a second mortgage using a non-qualifying
assumable loan. By charging his roommates rent, he covered the mortgage payments for a three-bedroom house
for the four years of his college career.
After college, Devaney took a job as a commissiononly retail stockbroker at a small Florida-based firm called
Capital International. However, says Devaney, very few
retail investors were interested in buying from a 23-yearold college graduate and the pickings were slim. So, relying on a strong track record with the Motorola stock
options of his college days, he placed all $125,000 of his
“The blowups have galvanized
issuers into better disclosure”
Mike Wade,Barclays Capital
savings on one Motorola stock option. “I figured that if it
was successful, I would buy my own business, and if not,
it would force me to find a job where I could earn some
real money,” he says. He lost.
Devaney admits that the experience taught him an
important lesson in risk management: the value of a diversified portfolio. So he moved back in with his mother and
turned to bonds.
He took a job as a trading assistant on the bond desk
of a small fixed-income brokerage firm called Suncoast
Capital, later becoming a salesman for mortgage-backed
securities and opening a number of accounts that he still
has to this day. Two years later, despite having no trading
experience, Devaney went back to Capital International,
with a proposal to start a bond desk to trade CMOs for
the firm in partnership with the owner. Eighteen months
later, the desk employed six people and had hired a further five to start another office in Tampa.
It was during his time at Capital International that
Devaney had his first dealings with asset-backed securities. A customer from the Midwest called for a bid on $3
million dollars of single-A rated high LTV securities that
had come to market at about par just two months before.
Intrigued, Devaney examined the prospectus to get to
grips with the structure of the bond and understand the
real value of the collateral pool.
Two days later, Devaney had come to the opinion
that the credit risk of the bonds was minimal: it was not
the junior-most bond, but a single-A rated piece with
significant protection at new issue and 15% of subordination. He made a bid of 90 cents on the dollar, bought
the bonds and went on to sell them back to the underwriter Bear Stearns for 99 cents on the dollar. Devaney
recalls the reaction of the traders at Bear Stearns when
he contacted them about the bond: “Who are you? How
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did you wind up with this thing? And you’re saying you
own it?”
After securing that level of profit in one clip, Devaney
has never looked back. The next day, he sent out a
Bloomberg to his customers which read, “Looking to
make markets in asset-backed securities, looking for mezzanine, AA, A, BBB-rated, any asset classes.” Within a
week, he says, he had more bonds to study than time.
“This was when hedge funds were being forced to liquidate their portfolios of subordinate ABS and MBS
because of the fallout from the Russian monetary crisis
and the LTCM scandal. Investors were all withdrawing
their money from leveraged funds.”
Some two and a half years after founding the bond
desk at Capital International, Devaney left the firm after
it experienced financial difficulties relating to failed
investment banking transactions. It was then that he
bought a small brokerage firm and founded United Capital Markets, to exploit the subordinated ABS, CMBS and
CDO niche he had discovered.
His colleagues on the bond desk at Capital International—which shut down two months after Devaney’s
departure—felt that it was too much of a risk to join
Devaney in his new venture, so he was on his own.
Devaney admits that with only $500,000 of capital to
invest in the new firm, “my ability to position securities
was limited, but I had developed a client base from my
time at Capital International and Suncoast.”
In-depth analysis
Devaney argues that from the very start, the key to his
trading approach has been in-depth research and analysis
of each potential opportunity in order to find the right
price, sometimes buying into a small portion of a deal in
order to gain more detailed information from the servicer
or trustee before getting in any deeper. “There are three
central factors which go into my analysis,” he says, “the
fundamentals, the level of supply and demand and the
influence of fear or confidence.” Devaney’s experience
with subordinate bonds backed by the high LTV sector is
one example of how his analysis fits together.
In terms of fear and confidence, in the late 1990s
confidence in the high LTV sector had hit rock bottom.
High LTV loans generally had around 110% loan-tovalue ratios: the value of the loan was greater than the
value of the collateral backing the loan. At the same
time, he says, “small specialty finance companies with
limited capital and no experience of lending were created purely to take advantage of the market for high
LTV securitization. Wall Street extended enormous
loans to these companies in order to earn investment
banking fees from the securitizations.”
In 1999, a number of high LTV lenders went bankrupt, most notably First Plus Financial, which had about
$4 billion of high LTV bonds outstanding, Empire
Finance and Keystone Finance. “People were saying that
Wall Street had really screwed up and that all the subordinate bondholders would lose everything,” says Devaney.
Which brings us to supply and demand. The level of
headline risk and loss of confidence in the sector created
substantial supply as investors tried to get out, pushing
prices into freefall. Devaney says that one Wall Street
dealer unloaded every high LTV bond on its balance
sheet, amounting to $1.5 million of securities.
Finally, the fundamentals: Devaney’s call was that
none of the bankruptcies would affect any of the
bonds, that not even the junior-most securities would
ever lose any money.
“My view was that there
was so much excess spread
in these securitizations that
the bonds would survive provided prepayments on the
loans paid off the transactions
earlier than expected,” he says.
“So I looked at the collateral
pool. High LTV loan customers
were generally good-quality borrowers with high Fico [Fair Isaac
& Company] credit scores. Borrowers were also paying 10–12%
on their loans, so had a strong
incentive to prepay or refinance,
even if interest rates rose.”
Devaney believed that the high
LTV sector was mispriced and bought
almost $700 million of the B1, B2 and
M2 bonds at between 50 and 60 cents
on the dollar. “People were prepared to
sell at prices significantly lower than
what they had paid in the primary market, but there were
very few people who were prepared to buy for their own
balance sheets. I had cultivated accounts that could
absorb hundreds of millions of dollars of high LTV, so I
bought as much as I could,” he says. In just 12 months,
those bonds rose to around 90 cents on the dollar, cultivating a 30–40% annualized return for the customers he
sold them to.
Client base
Over the last five years, Devaney’s client base has thus
grown to include hedge funds, mutual funds, money
managers, major Wall Street dealers and insurance companies. Accounts that sell him bonds far outnumber the
accounts that buy bonds from him, with roughly 350
selling accounts and 25–30 downstream accounts. However, Devaney argues that he only needs this number of
sophisticated downstream accounts to offload his inventory, and some of these have been remarkably successful.
One of Devaney’s most valued customers is Jim Kelsoe
at Morgan Keegan Asset Management, whose RMK
Select Hi Income fund invests almost exclusively in highyield structured finance products and was the top-performing high-yield mutual fund as rated by Morningstar
in the first year of operation and for three years running.
However, there are signs that the inefficiencies that have
plagued the markets for high-yield structured finance products are slowly being resolved and
that this in turn may taper UCM’s
margins. Richard D’Albert, cohead of the securitized products
group at Deutsche Bank, says,
“The credit crises of recent
years have broadened investor
understanding of how to value
positions in these markets and
brought pressure to bear on
structurers to improve the
quality of the collateral
underlying these deals.”
Mike Wade, head of
the ABS group at Barclays
Capital, agrees that the
changes. “The blowups
have galvanized issuers
into better disclosure,
rating agencies and
bankers into being
more conser vative
with credit enhancement levels and investors into being
much more selective about what deals they will buy,”
he says. The regulatory agencies are also working towards
implementing new rules for the asset-backed market that
would call for increased disclosure from servicers, originators, sponsors and trustees in the asset-backed market.
But Devaney is still optimistic. Six months ago, UCM
moved out of the residential house and into a Key Biscayne’s largest office building; the company owns a 142foot corporate yacht with a crew of nine, a Gulf Stream
G400 helicopter and a corporate jet.
Devaney is also branching out with a real-estate company, an aviation company to run the corporate aircraft and
a boat charter company for corporate getaways. He makes
the most of his marketing dollars at the big securitization
conferences by hosting rock concerts with names such as
Blues Traveler, ZZ Top and Counting Crows and has made
repeated attempts to get Sheryl Crow to perform. But
despite offers of several hundred thousand dollars, Crow
still refuses to do it. ■
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