Global Risk Transfer Report: Chapter three
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In the third of six chapters surveying the synthetic securitisation market, SCI tracks the evolution of the investor base
Synthetic securitisation, once tarnished by association with the global financial crisis, has long since come in from the cold. The regulatory framework has developed significantly in Europe since the introduction of the new European Securitisation Regulation in January 2019, culminating in the inclusion of significant risk transfer transactions in the STS regime in April 2021. This label has provided CRT deal flow with additional momentum, broadened the issuer base and helped to legitimise the market.
So, how has the landscape evolved since then? While Europe has historically been the centre of CRT activity, what are the prospects in the US and beyond? SCI’s Global Risk Transfer Report traces the recent regulatory and structural evolution of the capital relief trades market, examines the development of both the issuer base and the investor base, and looks at its prospects for the future.
Chapter three: growing the investor base
Given the complexity of the instrument, CRT was once a minority sport, involving only a small number of highly sophisticated investors. But the picture is changing, in line with a better understanding of the regulatory environment, as well as the risk and rewards involved.
Kaelyn Abrell, partner and portfolio manager at ArrowMark Partners, says: “Market dynamics support our belief that SRT is already exhibiting characteristics of more mature financial markets. Examples include the shift from predominantly bilateral transactions to club and syndicated deals, the development and growth of a secondary market – with a particular focus on the period following the initial onset of the Covid pandemic in 2020 – as well as increasing access to financing through various forms and counterparties.”
She adds: “All of these factors are representative of the maturation of the asset class and increasing acceptance by banks, asset managers and investors.”
Indeed, a significant number of new investors have entered the market in recent times, with (re)insurers also emerging as key participants. Jeffrey Krohn, mortgage and structured credit leader at Guy Carpenter, notes: “The US CRT market is supported by over 30 reinsurers, which will provide almost US$19bn in capital relief in 2022. Many of these reinsurers see the opportunity in the SRT market and are attracted to the thicker tranche requirements that better appeal to their appetite. The challenge is to attract this growing pocket of capital in a thoughtful way as we move into a Basel 4 world.”
Andrew Feachem, md at Guy Carpenter, adds: “We have seen a number of the junior tranche-focused investors raise mezzanine funds with lower target returns, a trend we expect to continue. Finally, new investors have also joined the market in line with the growth of new SRT asset classes, such as residential mortgages and auto loans.”
Relationship building
Increased investor appetite is driving a higher volume of deals, year on year, across a wider range of collateral types, originators and geography. At the same time, originators recognise the need to diversify their capital base, so they're actively building relationships with new counterparties.
Seamus Fearon, Arch MI evp, CRT and European markets, believes: “Relationships with the client are very important in Europe. Many of our clients want to deal directly with the insurer, rather than an intermediary. In comparison to GSE CRT, I think we will see a smaller number of large insurers in the space, potentially partnerships between insurance companies to combine capacity, more bilateral deals and potentially less intermediation.”
He adds: “New investors have specific risk appetites and, as there are a wider range of deals to pick from, different investors can build a diversified portfolio specific to their risk appetite.”
The growing demand for more diversified sources of capital may point to some issuers seeking multilateral transactions to aid new investors to enter the market and develop their appetite for SRT. Tim Armstrong, md at Guy Carpenter, notes that “the market is undoubtedly growing and third parties will be needed to grow investor and (re)insurance capacity in line with banks’ issuance needs. Increased investor and (re)insurance uptake will lead to a more balanced and transparent market, while also addressing the counterparty limit constraints already being faced by some issuers.”
Abrell agrees that the expansion of the issuer base and asset types allow investors to tailor their strategies, based on the risk/reward targets that they are trying to achieve, and provide greater choice in meeting those objectives. “We believe CRT continues to offer a unique and attractive value proposition for investors. The primary reason is the supply and demand dynamic,” she explains.
Overall, investors are now seeing CRT as a more sustainable asset class. As such, there is greater comfort in investing in building teams and the necessary modelling tools.
“Access to data and appropriate modelling tools are key – most SRT transactions are bespoke and so the usual off-the-shelf models don't really apply,” says Feachem.
This is an area of focus for Guy Carpenter, where provision of analytics is a key factor in engaging with unfunded investors. “(Re)insurers will reserve judgement on a given transaction until they are compared to other transactions in which they’ve participated. Thoughtful analytics and comparisons to other available data are essential to facilitate underwriters’ decisions,” adds Feachem.
However, Abrell notes that in order for investors to allocate capital to CRT, estimated returns must be in line with other comparable private assets or provide an illiquidity/complexity premium compared to liquid credit markets. “As a result, there is a floor on spreads that, if breached, would begin to limit the amount of capital available to deploy in the asset class.”
Barriers to entry
Indeed, complexity remains a key issue. Kaikobad Kakalia, chief investment officer at Chorus Capital Management, says: “Investors need to develop an understanding of banking regulation, in order to understand the issuer’s motivation and the transaction’s structure. They need to combine this with knowledge of structured finance and have the ability to analyse credit.”
Feachem agrees that risk takers need to get to grips with the underlying regulation, as well as which features in an SRT are a ‘must-have’ rather than a ‘nice-to-have’. This, in turn, speeds up due diligence and, critically, reduces execution risk from a bank’s perspective.
“This business is not designed with insurers in mind,” observes Giuliano Giovannetti, co-founder of Granular Investments. “The whole contract language and structures are similar to credit default swaps. It's very unfamiliar territory for a lot of insurance companies and requires a lot of education and investment on their side to get into this space.”
A further barrier to entry for investors is the ability to raise capital, with a seven- to eight-year lock-up for an illiquid and complex strategy that is not straightforward to explain to clients. The investor base is the constraining factor for bank issuance: the amount of assets on bank balance sheets is massive, compared to the amount of money that investors have raised to invest in those assets.
On average, large European and North American banks have used about 4%-5% of their corporate credit assets to issue risk-sharing transitions. Only a handful of banks have gone well above 6%-7%.
Roughly 50 to 55 banks have issued CRTs in the last five years, of which 40 are in the Eurozone and regulated by the ECB. This represents around 32% of the banks directly regulated by the ECB, so there is significant room for that number to grow. For banks with subsidiaries in different parts of Europe, SRT technology is expected to spread across geographies relatively quickly.
“Bank issuance is growing at a 25%-30% rate per annum. This allows the market to grow with proper controls and in a sustainable manner, while doubling in size every 3-5 years,” Kakalia says.
Representative of this dynamic, spreads at issuance have ranged approximately +/-200bp from 2013 levels, despite other areas of credit experiencing very different pricing dynamics.
Kakalia adds: “All the requirements for the growth of this market are now in place. As the market grows, we will see increased appetite from existing and new investors.”
Abrell notes: “We agree that the investor base will continue to experience incremental growth; however, we believe that sensitivity surrounding confidential bank information will always be a moderating factor.”
ESG potential
The potential for SRT to unlock ESG financing is particularly attractive to some investors. Adelaide Morphett, an associate at Newmarket Capital, says: “SRT represents one of the most catalytic, scalable investment opportunities pertaining to net zero. By investing in structures that free up regulatory capital, SRTs have the potential to unlock a significant amount of positive new impact lending.”
Newmarket specialises in turning brown finance green. Morphett believes that her firm is “the only private sector SRT investor that has embedded requirements for a bank counterparty to lend freed-up capital towards new positive impact.”
Referencing a pool that isn’t 100% green under the EU Taxonomy but incorporates some kind of on-lending requirement “is an innovative and creative approach to net zero,” she adds.
Importantly, issuers still need to improve data integrity and transparency to ensure ESG deals live up to their promise. Proposed legislation, such as the SEC’s ESG disclosures, and the requirements for SFDR Article 8 and 9 funds “suggest that expectations are shifting,” Morphett says. She continues: “More visibility into ESG criteria is a great step towards eliminating greenwashing, but it will be important to ensure standardisation does not come at the expense of innovation.”
Supranationals are key players in the CRT market, in terms of both facilitating ESG financing and stimulating bank lending to the real economy.
The EIF, for instance, has been investing in synthetic securitisations in different shapes and forms since the 1990s. SRT transactions enable issuers and investors to create more impact with fewer resources, according to Georgi Stoev, head of Northern Europe and CEE at the EIF.
“With SRT, for a single euro, we are able to support more lending in the European economy. A €100m SRT investment would result in anything between €400m-€1bn of loans, of which the green share could be upwards of 10%. We're moving towards expecting the originators to commit to 10%-30% to be composed of green loans,” he says.
In fact, the EIF has begun moving towards a system where new portfolios are formed of loans that allow various climate-related issues to be solved. “We very much want to support leases or loans, where the SME wants to invest in an electric vehicle fleet or insulate its buildings, or exchange old equipment for new energy saving equipment,” Stoev explains. “If we enter into a transaction with e.g. Santander Leasing Poland on a portfolio that comprises leases for diesel cars, we can ask them to build a new portfolio - e.g. five times the invested amount - which is entirely used for loans for electric cars. That’s ‘use of proceeds’: we invest in something that could be as brown as it can get, but the outcome must be green.”
Stoev is confident about the future of the ESG SRT sector. “Growing awareness that climate action needs to be taken as soon as possible makes me a firm believer that the share of use-of-proceeds specifically targeted for climate-related issues can only grow. Such commitment over and above the payment of a guarantee fee or insurance premium for protection provided was not the norm in pure market-driven organisations up until a couple of years ago.”
However, Newmarket sees some potential dangers ahead. Morphett says: “It largely depends on regulatory considerations. Regulations could certainly hold back ESG SRT issuance, due to potential thresholds and limits.”
An EBA report from last December raised the question of whether synthetic securitisation needs its own sustainable framework, or whether issuers can adhere to existing frameworks. Morphett notes: “The main tension when it comes to sustainable securitisation is whether the underlying reference pool must be green as per the EU Taxonomy, or whether the use of proceeds - meeting certain green standards - can qualify a securitisation as sustainable.”
She adds: “The volume of ESG investments increasing will largely depend on where that regulatory conversation lands. My hope is that the market will continue to support green redeployment, as well as transactions that embed greening over time, through replenishment or a pricing incentive for certain ESG-aligned KPIs.”
She cites as an example Newmarket’s 2021 Project Boquerón transaction with Santander, which references a €1.6bn pool of renewable energy assets and champions ESG lending through three features, both at inception and during reinvestment.
Not only is the portfolio focused on ESG assets at issuance, coupon incentives also exist to replenish the portfolio with further ESG assets during the revolving period. Additionally, the trade includes coupon incentives for utilising the capital released to further grow Santander’s lending to new ESG assets.
A pilot exercise on climate risk, published by the EBA in May 2021, estimated an average green asset ratio of just 7.9% for a sample of 29 EU banks. Against this backdrop, Morphett emphasises: “There isn’t enough supply of assets to sustain a green SRT market, when we are exclusively looking at underlying reference portfolios.”
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The (re)insurer perspective For the typical, fully funded CRT investor, there are times when the price of their protection can be influenced by exogenous factors that have little to do with the underlying risk of a specific asset class or geography. These factors, including liquidity risk and increased duration, are currently at play in the US credit risk transfer market where funded spreads have widened up to 200% while the underlying risk outlook might only be up 10%-20%. Unfunded pricing has widened up to 80%, but a large component of these increases is due to the increased demand for and reliance on unfunded solutions. According to Jeffrey Krohn, mortgage and structured credit leader at Guy Carpenter, unfunded issuance is three times of that prior to the pandemic. In contrast, the (re)insurance market provides more stable pricing over time, reflecting the underlying fundamentals of risk. As such, originators need to have relationships with (re)insurers to take advantage of the pool of capital when they need it most. Andrew Feachem, md at Guy Carpenter, says: “The participation of (re)insurers has ensured that thicker tranched deals continue to be economic for the banks to issue. A key reason is that they aren't constrained by the usual performance return hurdles that funded investors have. The DNA of (re)insurers is long-term partnership at their core and this makes them strong partners to banks, as they are better able to weather short to medium-term volatility.” He adds: “The participation of (re)insurers is certainly not to the detriment of funded investors. We see that each class of investor is able to access the risk/reward profile they are seeking from the market.” In fact (re)insurers are also playing a role, behind the scenes, in facilitating banks that are looking to provide fund financing facilities. “Ultimately, the US credit risk transfer market indicates the direction of travel, where now the GSEs and mortgage insurers can freely choose whether to execute entirely via the capital markets or via the (re)insurance market,” observes Feachem. Since Arch MI participated in the first European unfunded CRT (Simba, with ING DiBa) in 2018, there have been around 20-30 transactions with insurance counterparties. “Insurers generally are not very active in the credit space: about 1% of the premium of insurance companies in Europe comes from credit risk,” says Giuliano Giovannetti, co-founder of Granular Investments. “On the other hand, 85% of bank capital is held against credit risk. So, insurers can get a benefit as they diversify into other lines of business beyond their core areas, as long as they underwrite the risk properly.” Certain types of risks are naturally more geared towards insurance, such as mortgage insurance. But generally the more run-of-the-mill a risk is, the easier it is for insurers, which are still relatively new to the market. Insurers with bespoke competence in one area, such as aircraft finance or infrastructure, may be prepared to join with other investors in a deal. Giovannetti says: “In general, the investment process for insurers is quite lengthy and thorough, especially for the first transaction, which makes them sometimes slower to begin with. There is a learning curve and it also requires a bit of patience from the bank. But it's an investment that pays off; once the insurer gets comfortable with the bank and its processes, they can provide a lot of capacity.” Seamus Fearon, Arch MI evp, CRT and European markets, anticipates some growth in the number of insurers participating in European CRTs, but not to the extent seen in the US market. “European SRT is a much more heterogeneous market across many countries,” he says. “There are a lot of different originators and many different asset classes. That requires additional analytical and legal time and resources, which may not be worth it for an insurer who wants SRT to be a small part of what they do.” The wide variety of transactions available to insurers can be a bit overwhelming to new entrants; however, the benefits to issuers of new entrants are difficult to understate. With thoughtful quantitative approaches, intermediaries can facilitate wider participation and improve issuer economics. Krohn further notes that with the expected reduction in GSE CRT volumes next year, (re)insurers will be focused on deploying their established expertise in associated asset classes, such as SRT. |
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ArrowMark’s story The drivers behind such growth include dedicating considerable time and resources to educating institutional investors, consultants and individual investors on the asset class. Initial conversations typically focus on the nature of the transactions, issuing bank motivations and market dynamics, before shifting towards how exposure to the asset class can fit within a broader investment portfolio. Investors are increasingly recognising the ability of capital relief trades to complement traditional credit exposure, with a full understanding of liquidity differences, and other commonly-held private exposures. The benefits of floating-rate income and the shorter investment life of CRTs can provide material value to a private asset allocation, despite not offering the same advertised returns as private equity. One of the most significant changes in recent years is the establishment of dedicated private credit allocations. Particularly among institutional investors, this has created a natural home in investor portfolios for CRT exposure. There are investors that have allocated to all the fund vintages, with ArrowMark funds representing a core allocation within their portfolios. The firm also engages with investors and consultants that are newer to the asset class. Investment managers are “agnostic” on CRT asset type and/or geography, according to ArrowMark partner and portfolio manager Kaelyn Abrell. “If we have the internal analytical capability to understand and evaluate collateral risk, we are willing to consider and invest in a variety of transactions. Ultimately, we are searching for a specific risk/return profile,” she explains. She continues: “For us, the goal is to generate a reasonable rate of return in a more benign macroenvironment, while also demonstrating an ability to preserve principal in a severe economic scenario. As our platform has grown, so has the CRT market. Market growth has allowed us to increase our activity while remaining selective.” Overall, the increased ability to raise capital in the CRT space - including capital from investors with differing risk/return objectives and time horizons - has facilitated even stronger collaboration with the firm’s issuing bank partners. |
SCI’s Global Risk Transfer Report is sponsored by Arch MI, ArrowMark Partners, Credit Benchmark and Guy Carpenter. The report can be downloaded, for free, here.
*For more on the outlook for global risk transfer activity, watch a replay of our complimentary webinarheld on 2 November.*
