The first of five essays compiled in SCI's inaugural SRT Journal investigates the momentum seen this year in US CRT and its impact on supply and demand

The US Fed’s FAQ on CLNs in September 2023 sparked anticipation that the floodgates would finally open for US bank CRT issuance, resulting in many new investors exploring the sector and an initial wave of transactions. The momentum subsequently seen this year in US CRT has altered supply and demand dynamics, with some describing it as a banks’ market, due to the deluge of new capital coming into the sector. Others, meanwhile, view these developments as a natural progression of the market.

Private credit funds last year raised an estimated US$200bn-US$300bn and are motivated to deploy that capital before the investment period ends, including in strategies with an CRT element. However, the supply side of the equation haasn’t changed much.

The initial wave of issuance following the Fed’s FAQ reflected a clearing of pent-up supply from the previous period of regulatory uncertainty, according to a recent Seer Capital Management research report. The deals primarily consisted of thick tranches referencing investment grade corporate loans and thin tranches referencing auto loans, which were placed with large investors at spreads in the mid-single digits. Notably, JPMorgan sought to complete a vast amount of issuance rapidly, therefore only engaged with large investors with ticket sizes of several hundred million.

“Although a few US banks have priced very large deals, there has yet to be a meaningful increase in the number of transactions being brought to the market. More investors competing for the same amount of trades has therefore driven spreads tighter,” explains one source.

Spread tightening
SCI’s SRTx Spread Indexes show that between December 2023 and July 2024, contributors’ pricing opinions fell from 1,278bp, 1,173bp, 1,173bp and 969bp to 1,033bp, 1,000bp, 919bp and 625bp across the US SME, European SME, European corporate and US corporate SRT segments respectively.

At the same time, now that a number of US banks have become repeat issuers and are comfortable with the regulatory guardrails, execution of certain types of US CRT transactions is becoming more of a pricing matter, rather than a structuring matter – which Eri Budo Uerkwitz, counsel at Mayer Brown, describes as a “natural progression of the market”. But one issue with moving towards pricing-based execution is that not everyone that is bidding may fully understand the product.

“Given there have been so few losses and credit events in the US CRT market, it is questionable whether all investors that seek an allocation nowadays know how to underwrite a portfolio. It wouldn’t be the first time that some investors in an overflow buyers’ market do not do, or are not capable of doing, the necessary diligence and end up driving pricing down,” Uerkwitz observes.

She adds: “And pricing may also be driven down by more sophisticated investors that have raised dedicated CRT funds and now sit on funds they need to deploy. So, it’s unclear whether some funds are investing in CRT because they need to execute or because it’s their investment thesis.”

The concern is that if deal terms are being driven by less sophisticated investors seeking allocations, the pricing may not be commensurate with the true risk being transferred. “Whether the risk is inappropriately priced is debatable. If a deal is executed, ultimately it means that the protection buyer and the protection seller must agree on the price,” the source suggests.

Matthew Moniot, co-head of credit risk sharing at Man Group, doesn't believe that new investors are pushing prices to unsustainable levels. However, he says it's evident that much of the margin for error has disappeared.

“Assuming CRT pricing has not impacted the quality of loan underwriting, the reduction in spreads will likely lead to a reduction in market returns. Some participants may utilise leverage to get back to higher returns, but that will only increase their sensitivity to credit risk,” Moniot observes.

Seer, for one, did not find the initial wave of US deals attractive relative to European SRT issuance. “Given mid-single digits pricing and high minimum ticket sizes for deals backed by large corporate loans and capital call facilities, and dramatic spread tightening of the thin junior tranches of auto loan CLNs, Seer has found US reg cap deals less compelling than reg cap from other jurisdictions thus far,” the firm notes in the research report.

The Seer research cites US auto CLNs as an example, in which issuers typically retain a small first loss (bottom 1%-3%) and issue many thin mezzanine tranches (0.5%-2.25% thickness) up to a 12.5% attachment. At the same time, the dramatic spread tightening in US auto CLNs has seen second loss spreads dropping more than 1100bp and third loss spreads dropping more than 400bp.

“With such thin tranches, if losses exceed expectations, investors in the second and even third loss tranches risk losing a significant portion of their investment,” Seer warns.

The firm notes that on the back of the hype around the US market, there has been greater demand for some European transactions in recent months, but spreads overall have remained in line with the past several years. “European issuers who have established issuance programmes over the past 10-plus years continue to transact with a limited number of longstanding partners, rather than with new players who express eagerness to join the market but are unlikely to be long-term participants. We believe that in time, many US banks of all sizes will take advantage of reg cap. As the market develops and supply increases, spreads in US reg cap should widen back to appropriate levels.”

Market bifurcation
In the meantime, banks appear to be capitalising on the current demand dynamic. Sagi Tamir, partner at Mayer Brown, suggests that in this environment, two markets for US CRT transactions could emerge – a ‘straightforward’ one and a bilateral, bespoke one. The former will involve the more syndicated transactions, while the latter will evolve as it solves for unique situations, such as new asset classes, riskier portfolios of proven asset classes and unique confidentiality or proprietary challenges.

Indeed, Moniot suggests that a bifurcation is already emerging. “There is a clear distinction between the more straightforward trades, which attract non-specialist investors, and the bespoke trades that involve a genuine partnership between investor and issuer. As such, investors who leverage structuring knowledge and creativity will differentiate themselves from those who simply buy fully baked deals.”

Uerkwitz agrees that in the current environment, investors are more likely to thrive if they can overcome these differences by being creative, thoughtful and open to figuring out solutions together with an issuer. “A ‘helpful’ investor will look through to the substance of the economics of a transaction and recognise that the economics can be the same, even if the terms of the structure are different to what they are used to,” she explains.

She indicates that investors can still compete on deals that are bespoke in structure and/or reference non-standard asset classes. “Investors can maintain their market share by looking for assets that are difficult for banks to syndicate. In these scenarios, investor-issuer partnerships have real value.”

Although the US Fed’s guidance regarding Regulation Q in September 2023 provided clarity in connection with direct CLN issuances, it also placed a limit of the lower of 100% of capital and US$20bn on the principal amount of assets with respect to which a banking organisation may transfer risk via direct CLNs (SCI 29 September 2023). Since the G-SIBs are likely to blow through the US$20bn limit very quickly, it begs the question of which books banks are willing to subject to the direct CLN route.

Perhaps more saliently, indirect CLN structures that do not consolidate to the banks are consequently becoming appealing to banks that need to manage this US$20bn cap, according to Tamir. He adds that a growing number of investors are taking on responsibility for the SPV - an arrangement that is viewed as a win-win for those investors and related banks. For investors who can do this, it provides a way to win a significant allocation (up to 100%); for the related bank, it provides a route for an issuing vehicle that isn’t consolidated onto the bank’s balance sheet and, therefore, does not count towards the US$20bn cap.

“However, not every investor has the capability to do this. We are seeing some more sophisticated investors ‘market’ this ability as a way of differentiating themselves. Ultimately, banks are more likely to bid deals out to investors who can actually provide a service,” he notes.

Relative value
The CRT market has previously witnessed periods when new investors enter, attracted by the relative value on offer, which then exit when other opportunities arise. “We have seen cycles in which pricing tightens before, but eventually supply and demand dynamics balance out. This time around, however, I expect more of the new investors to stay,” the source observes.

The source suggests that one reason is because there is more visibility in terms of the supply side, compared to before, which is – in turn – due to there being more regulatory visibility. Another reason is that funds aren’t in the business of changing their strategy every year.

“The new entrants will have spent a lot of time and resources raising dedicated capital and explaining their CRT strategy. Consequently, they are likely to have a more consistent approach to the market today,” the source indicates.

Meanwhile, given the heightened interest in CRT from funded protection sellers, some new originators currently appear to be dedicating fewer resources to unfunded issuance. However, this may also be a function of the need to further develop and demonstrate the value of the unfunded side of the market more generally, since the number of (re)insurance players with CRT expertise remains limited.

According to Mehdi Benleulmi, head of credit – Europe at RenaissanceRe: “As a (re)insurance company, we view CRT as a partnership with our banking clients. We seek to renew our trades with the same counterparties – which makes a difference in terms of pricing, as we can approach it on a through-the-cycle basis, rather than at a given point in time. As experts in bringing efficient capital to our clients, we’re here to stay, which minimises long-term balance sheet management risk for our counterparties.”

Benleulmi, for one, hasn’t noticed any changes in the level of transparency and disclosures provided by banks in connection with CRT transactions. He suggests that while it is arguably currently a bank-oriented market, this environment could always change.

“Will the new counterparties still be there for issuers when the market turns? We expect that banks will continue to execute bilateral trades alongside widely syndicated deals. Banks utilise CRT as a tool to manage their balance sheets and therefore need to ensure that they can continue to do so in various market environments,” Benleulmi concludes.

Corinne Smith

SCI’s SRT Journal is sponsored by Arch MI and Mayer Brown. All five essays can be downloaded, for free, here.