In the fourth of six chapters surveying the synthetic securitisation market, SCI tracks the evolution of the issuer 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 four: growing the issuer base
Given the utility of SRT technology, combined with clearer rules and guidelines now in place in many jurisdictions, there has been an expansion of first-time issuers entering the CRT space in the last couple of years.
Robert Bradbury, head of structured credit execution and advisory at Alvarez & Marsal, says: “As the technology becomes more mainstream, you will naturally get smaller participants looking at this. There’s much wider awareness that this technology exists now, so I get calls from banks, from private equity funds, from investors, saying please explain this technology. There’s much more public awareness and they are keen to understand how it works.”
However, the initial set-up of an SRT programme can be a daunting proposition for a bank. In particular, smaller banks with smaller IT teams face capacity issues. Consequently, it’s important for a bank to take a long-term view of the benefits of establishing an SRT programme as a strategic pillar in capital management planning.
Bradbury notes: “Many banks I’ve talked to said that the hurdle that stops them issuing is largely resourcing and operational, nothing to do with regulation or pricing.”
The hurdles required to get an STS designation are even higher, adds Seamus Fearon, Arch MI evp, CRT and European markets. “There are challenges for smaller lenders. It typically requires in-house structuring expertise at the lender, which is often a challenge for standardised lenders in terms of systems and data requirements.”
Given that over 100 different criteria need to be satisfied in order to benefit from the label, he suggests that STS is a more suitable tool for the bigger IRB banks. “It’s just more accessible for them.”
The first transaction a bank does is a relatively lengthy process, with execution taking around two to three months and internal preparation taking another three months or so. “First, you need board-level approval. You have to explain to your board why this is the best way of using those assets and the most appropriate way of handling the risk mitigation,” says Gareth Old, partner at Clifford Chance in New York.
He adds: “You then need to make sure that you have the right operational framework in place internally to identify the portfolio, to manage the reporting and make sure that you are monitoring credit events and your credit position.”
Then there’s external scrutiny. Old says: “The regulators are intensely focused on making sure that the banks genuinely get the value of the credit protection that they are buying. They will be looking very carefully at the bank systems to make sure that the portfolio is a good portfolio.”
Given the resourcing and effort to establish an SRT programme, issuer motivations for undertaking an SRT transaction can extend to beyond achieving regulatory capital relief. For example, banks also enter into CRTs for the purposes of managing economic capital and concentration limits.
Andrew Feachem, md at Guy Carpenter, confirms: “In general, banks will try to capture a range of additional benefits beyond regulatory capital relief - including reducing IFRS 9 accounting volatility, managing concentration risks, freeing up credit lines and reducing MREL requirements. Furthermore, we expect to see certain types of non-bank issuers utilising SRT technology to manage credit risks, where the motivation would clearly not be for regulatory capital relief.”
As more first-time issuers have entered the CRT market, new jurisdictions have also opened up - including Poland and Greece, where a number of national champion banks have executed SRT transactions, with both supranational and private investor participation. For example, Project K2 - finalised by mBank and PGGM in March - marked the first Polish significant risk transfer trade sold to a private investor and the first STS synthetic securitisation in the country. The transaction references a PLN9bn portfolio of large, small and medium-sized corporate loans.
Another new jurisdiction to arrive on the CRT scene this year was Hong Kong. Standard Chartered became the first bank to achieve capital relief at a local level in the jurisdiction with its US$1.5bn Sumeru IV transaction. PGGM and Alecta invested in the deal, which references a global portfolio of corporate loans.
Issuance from Asian jurisdictions is expected to grow, but at a slower pace than that seen in Europe. Feachem says: “Currently there is only consistent activity, from a regulatory perspective, from Japan. However, transactions are infrequent relative to the size of the Japanese mega banks' balance sheets and part of that is down to a perception of the high issuance costs relative to more traditional forms of balance sheet management, as well as competing regulatory/liquidity priorities in recent years.”
He adds: “We do expect other jurisdictions to come on-line, although perhaps at a slower pace than the regional and local banks would like. In some cases, that is because of a historic negative view of synthetic tranched protection by the regulator - possibly stemming from the lead-up to the global financial crisis - and in other cases, because of limited regulatory experience in supervising banks with a more active approach to credit portfolio management. What is needed here is patient advocacy with the regulatory bodies.”
The largest potential impact on CRT supply could nevertheless emerge from the US, given the size of US bank balance sheets and the high quality/low yielding nature of the exposures. “The assets align strongly with the CRT market,” suggests Kaelynn Abrell, partner and portfolio manager at ArrowMark Partners.
However, over the last 18 months, there has been a pause in issuance among some of the larger US banks. Old indicates that the reasons for that remain “somewhat obscure”, but are likely to be around discussions with their regulators.
The jurisdiction faces a number of constraints, including the FDIC’s broad ability to repudiate any obligation of a bank if it is appointed as a receiver or conservator. This means that any portfolio transaction has to satisfy the securitisation safe harbour or the participation safe harbour – both of which are largely predicated around a true sale context - in order to offer investors assurance that the FDIC will not exercise its repudiation rights.
Fearon believes that there is unlikely to be broad adoption of private CRT in the US, absent regulatory changes. “The regulators need to keep it simple,” he warns. “We have seen some private deals from a handful of players, such as JPMorgan, but the timeline and the regulatory cost burden to get transactions approved is particularly onerous. The banks would need more confidence that they can get their deals approved before taking them through various different regulatory bodies.”
Tim Armstrong, md at Guy Carpenter, agrees that the regulatory picture for private CRT in the US remains unclear, as there is no clear recipe for regulatory capital credit. “It's a complex regulatory environment with multiple regulators involved and the shadow of GFC failings still hangs heavy. From an unfunded perspective, while technically capital credit is allowed, the current regulations severely limit its applications. However, with recent regulatory developments, there is optimism for additional clarity.”
According to Old, the US credit portfolio management market is very different from other jurisdictions and so private CRT should be viewed within that context. “The cash alternatives to CRT transactions are much deeper and more prevalent than they are in most of Europe. So, the motivation for doing a private CRT transaction - which is quite a complicated thing to do - is rather different,” he explains.
A few regional banks have nonetheless entered the US CRT market, the first being Texas Capital Bank in March 2021 with a mortgage warehouse deal. Western Alliance Bank has since executed three transactions, referencing mortgages and capital call facilities.
More recently, in September, California-based Pacific Western Bank entered the market with a four-tranche CLN referencing residential mortgage assets. Unusually, the deal was a one-off, not the beginning of a larger programme. PWB is not a mortgage originator or warehouse lender, but acquired residential mortgages from other lenders because the assets fit its risk/return requirements.
Old indicates that there are a couple more regional bank deals in the pipeline for late 2022 or early 2023. “I can think of at least five regional banks that are looking quite carefully at the product, but very critically. There's a very significant investment that is required before you start putting together CRT transactions. You’ve got to have confidence that not only is there a case for the current portfolio, but also that you will come back to the market again.”
In terms of reference pools, one area of focus is relatively high-quality assets that have a good credit story behind them and are available in some depth. “So far, there are three different asset classes, but discussions are going on around more or less anything the bank has on its books in large volumes - for instance, auto loan transactions or more consumer loans,” Old notes. “There has been discussion about doing synthetic credit card transactions. We’ve spent a lot of time figuring out how they would work, but it’s a stretch to figure out whether that's better for the bank than the cash transaction.”
Armstrong agrees: “We have seen a sharp increase in inquiries from a variety of risk holders who are looking to CRT to diversify sources of capital and manage a variety of regulatory objectives across an increasing range of asset classes.”
The most recent Western Alliance deal was done on a principal protected basis, marking a first for the market. Old suggests that it will be interesting to see whether that feature is repeated and develops into being essentially a mandatory feature of any regional bank-issued CRT programme, or whether it's something done through a pricing uplift.
Looking ahead, he is optimistic about the prospects for the US private CRT market. “There are a lot of economic headwinds, but capital remains king and we are confident that CRT is going to be able to hold its own against competitors. Because it is very directly focused on maintaining the deep relationships between the banks and their customers and asset bases, while also developing the risk transfer capabilities shown in the European CRT markets for the last decade.”
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.*
Case study: data and portfolio optimisation
Mark Faulkner, co-founder, Credit Benchmark, investigates how Credit Consensus data can help support growth in SRT activity
In times of flux, prudent risk management is of critical importance. After a stretch of relative calm in the world of credit risk, a stronger focus on risk management is crystallising across the capital markets, including in the business of significant risk transfer (SRT).
This change is being driven by a combination of distressing geopolitical and macroeconomic events. After the initial shock, the coordinated accommodative economic policy driven by central bankers in response to the global pandemic created conditions for a relatively ‘benign’ credit environment. These conditions have proven to be the lull before the storm.
The scale of the unprecedented action by central banks protected much of the global economy and companies from default. However, as liquidity and fiscal support are now inevitably being withdrawn, we find ourselves adjusting to a ‘new normal’; positioned at the epicentre of a dramatic economic storm.
Rising inflation, interest rates and ongoing supply chain challenges are having a major impact upon all aspects of the economy and are inevitably concerning to investors. In this increasingly ‘malign’ environment, analytically and empirically grounded composure is an invaluable asset.
Over recent years, SRT transactions have grown in popularity as banks look to release and redeploy regulatory capital, with investors happy to take on the higher returns of bank-owned high-yield assets. Banking business models are increasingly factoring in the ability to originate and distribute risk to investors via strategic risk-sharing programmes. This growth is likely to continue, given current market conditions, and should be supported by appropriate risk-related data to ensure the sector can operate efficiently and at scale.
It is clear that investors are seeking a higher level of informational transparency than that currently available as standard. This is in response to the changing market conditions and to ensure that they invest in portfolios that reflect their particular risk/return profile.
This case study explores some themes around how data can optimise portfolio construction now and in the future. The recent Credit Benchmark whitepaper, ‘Credit Consensus Ratings and Risk Sharing Portfolios’, provides a more in-depth technical analysis.
Risk versus reward
Observations on the sample CRT portfolios above:
Investors in the world of SRT are a diverse group, ranging from sovereign wealth funds to hedge funds and all types of asset managers in between, and this diversity lends strength to the market. The ability to identify portfolios that meet these diverse needs and to monitor their changing risk profiles is essential to reassure investors, especially for new market entrants.
Credit risk information is valuable at the initiation of a transaction and throughout its lifecycle, to support both portfolio construction and ongoing portfolio monitoring and surveillance. Other enhancements – such as the ability to receive automated alerts when portfolio risk changes - can only serve to improve risk management practices in the SRT business.
However, issuer-provided data is not always easy to come by in certain jurisdictions and in certain segments of the market. Where transparency is lacking, aggregated data at a sectoral or geographical level can supplement entity-level ratings. For both disclosed and undisclosed portfolios, the ability to complement issuer-provided information with a richer source of externally available data is likely to become standard market practice.
Portfolio diversification impacts risk and return
Figure 3 shows the range of credit risk correlation estimates across a sample of 29 sector aggregates. In effect, this shows whether a particular sector will remain stable when other sectors are experiencing deterioration. Some sectors show very similar credit risk profiles in all market conditions; others may be independent or even negatively correlated.
There are many ways to estimate sector similarity – they all involve a correlation estimate, but these can be based on similarities in PD changes, in ‘tails’ (% of an asset class in the b and c credit categories over time) or on market risk measures, such as OAS. The error bars in the chart show the range of estimates using different measures of correlation – for some sectors, such as the ‘catch-all’ aggregate ‘Global Corporates’ (second from left), the range is very narrow – most measures give similar results. For others – such as ‘Belgian Corporates’ – the range is very large, while the average correlation measure is low. So Belgian corporates may look like a way of diversifying a portfolio, but there is a lot of uncertainty about their behaviour across the credit cycle.
Alternative sources of correlation estimates are patchy – CDS indices cover a limited range of names and many of them are illiquid; OAS are more widely available but restricted to traded bond assets subject to the short-term swings in market sentiment and credit/liquidity risk premiums. They also tend to be positive and high – close to a value of +1 (implying perfect correlation) – in all but the most unusual market conditions.
By contrast, Credit Consensus data provides a set of regular and consistent time series, including risk estimates for legal entities that are not publicly traded. They are also stable over short periods, while showing trends and turning points over longer time periods.
Correlation matrices may also be used in various portfolio risk calculations and re-estimated for different time periods to assess their stability. These are likely to be utilised more widely as credit becomes more volatile.
What kind of information will support and assist the growth of the SRT business?
As the SRT market grows, additional credit intelligence can only be a good thing, benefiting banks and investors alike and helping to build and maintain confidence in the asset class. Recognising complementary sources of data that maintain necessary levels of confidentiality could ensure that risk sharing continues to function smoothly.
Diversity of portfolios and varying levels of regulatory-approved issuer disclosure implies a need in the industry for any available data to be contextualised, comparable and consistent. Standardisation or achievable industry-wide protocols could help, but establishing these presents a challenge – though one not beyond the wit of this innovative growing market, and with the potential for great benefits.
The provision of information from issuer to investor is not without cost to the former. To maintain the dynamism of the industry, it is important that this provision is not too onerous to banks, nor is it requested by investors for information’s sake. Alternative sources of data could ease this informational burden between parties.
As the pace of change in global markets accelerates, transition matrices may be more widely adopted to project PD term structures and future default rates for SRT portfolios. Additionally, overlaying point-in-time (PIT) data upon through-the-cycle (TTC) data could help investors make better informed decisions that consider current and expected market conditions amid increased risk volatility.
The widespread adoption of appropriate levels of data provision will ensure the continued future growth of this increasingly important market. These are challenging times and the need to avoid surprises is essential. A greater understanding of the risk/return profile of a portfolio from inception to maturity can only be a positive force for all SRT practitioners.