Contents

CLOs

Direct lending securitisation faces barriers

Lines of credit to European direct lending firms, which borrow from banks and typically lend to middle-market firms, could be ripe for securitisation. However, the securitisation of these funding lines would bring added regulatory scrutiny and rating agency involvement, which would not be welcomed by all corners of the direct lending industry.

David Quirolo, partner at Cadwalader, Wickersham & Taft, explains the rationale for European banks: "The main motivator behind banks looking to securitise the direct lending channels is to more broadly syndicate the facilities to a wider number of investors. If these facilities are securitised and a rating is obtained, this may widen the investor universe. Additionally, they can also free up their balance sheets."

Graeme Delaney-Smith, md at Alcentra, feels that while direct lending securitisation could happen in Europe, it would be more likely to appear first in the US where the direct lending and middle-market sectors are more developed. He says: "I am not saying it will not happen but there are specific issues right now that make it unlikely in the short term."

Delaney-Smith continues: "We are late in the credit cycle and we are in an unstable geopolitical climate. It could perhaps happen once the direct lending sector has more time to mature but this could take 10 years. We have seen banks disposing of balance sheet positions but I am not sure that securitisation is better value at the moment than simply selling their loan books."

Quirolo adds that the process may face certain hurdles, particularly in the pursuit of ratings that go along with securitisation. "Rating agencies have a number of requirements that direct lending funds would have to comply with in order to get certain ratings. This could prove challenging for them and is not necessarily something they want to do."

There are also questions about the liquidity of such a product. Delaney-Smith suggests that middle-market lending benefits from being an illiquid asset class, something that might change due to securitisation.

He adds: "At the moment, if we undertake an investment, nine out of 10 times we are sole owner of the paper. We can sit down with the firm and move quickly and you do not necessarily want to have a large number of buyers on one loan as this adds to the complexity. You can pay a higher price for illiquidity but it works with direct lending."

Additionally, while investor appetite is strong in Europe for middle-market loans, he does not think that investors are seeking this in a structured format. Furthermore, investors may also not welcome the extra scrutiny that is involved in securitisation.

Delaney says: "Investors are looking at investing where they can get cash yield. What they do not want however is for the rating agencies to step in and, due to the restrictions imposed by them in order to get certain ratings, the cash being turned off."

Quirolo agrees that the end product would have to meet the same regulatory standards as a regular securitisation, which may not suit direct lenders. Delaney-Smith adds that direct lending benefits from less regulatory oversight than the CLO sector and this helps ensure the direct lending process is more streamlined.

Regardless of the hurdles to such a direct lending securitisation model emerging, it is generally agreed that it could happen, if not in the short term. Quirolo concludes: "While it is too soon to say about the timing of such a product, broader syndication of these loans is already happening but just not yet in a securitisation format - it is therefore not a huge jump to suggest that the loans could be securitised to open up the investor base further."

RB

Structured Finance

SCI Start the Week - 11 September

A look at the major activity in structured finance over the past seven days.

Pipeline
There were several additions to the pipeline last week, with ABS accounting for most of the activity. There were a dozen ABS added, along with four RMBS, a CMBS and a CLO.

The ABS were: CNY3.5bn Autopia China 2017-2; US$1.45bn DB Master Finance Series 2017-1; US$400m Exeter Automobile Receivables Trust 2017-3; US$1.058bn Fifth Third Auto Trust 2017-1; US$1.351bn Ford Credit Auto Owner Trust 2017-REV2; US$1bn GM Financial Automobile Lease Trust 2017-3; LaSer ABS 2017-1; NZ$220m MTF Sierra Trust 2017; US$418.2m OSCAR US 2017-2; US$527.12m SoFi Consumer Loan Program 2017-5; US$486m USAA Auto Owner Trust 2017-1; and US$325m Vistana 2017-1.

US$426.18m COLT 2017-2 Mortgage Loan Trust, Gosforth 2017-1, Sequoia Mortgage Trust 2017-CH1 and US$771.24m Starwood Waypoint Homes 2017-1 accounted for the RMBS. The CMBS was US$800m Stonemont Portfolio Trust 2017-STONE and the CLO was Cadogan Square CLO X.

Pricings
Fewer deals went the other way. The week's prints were confined to a pair of ABS, a couple of RMBS and four CLOs.

The ABS were £369m Driver UK Six and US$1.3bn Navient Student Loan Trust 2017-5, while the RMBS were US$427m Mortgage Fund IVc 2017-RN4 and US$250m Ocwen Master Advance Receivables Trust Series 2017-T1. The CLOs were US$1.5bn Colonnade Global 2017-3, €517m Jubilee CLO 2014-12R, US$519m Madison Park Funding 2017-26 and US$673.31m Octagon Investment Partners 24 2015-1R.

Editor's picks
Cohen and Co adds to Ukrainian NPL deal flow: Erste Group Bank has successfully sold a Ukrainian portfolio, consisting of €240m of corporate loans and €95m of commercial real estate (CRE), at a significant discount to nominal value. The transaction comes at a time when investor interest in Ukraine is gaining traction (SCI 25 August)...
Swap solution for Cyprus NPLs: Cypriot banks are increasingly using debt-to-equity and debt-to-asset swaps to reduce their non-performing loan portfolios, facilitating deal flow in a relatively dormant market. For investors, the swaps are also a useful tool for bridging the gap between bid and ask prices...

Deal news
• Barclays has closed its third Colonnade global significant risk transfer trade (SRT), Colonnade Global 2017-3 Financial Guarantee. In unusual fashion for capital relief trades the credit protection covers both principal and accrued interest.
• Stonemont Financial Group has sponsored its inaugural CMBS, backed by a portfolio of office, industrial, retail and bank branch properties across 20 US states. The US$800m CMBS conduit, dubbed Stonemont Portfolio Trust 2017-STONE (see SCI's deal pipeline), is collateralised by a two-year, floating-rate, interest-only mortgage loan securing 94 properties and a leasehold interest in one property.
• Middle-market CLO issuance has picked up again, following a summer lull, and spreads have ground tighter. Investors will be keeping an eye on how tight spreads get, and also on the risk of credit issues as competition for assets intensifies. When TCP Whitney CLO 2017-1 priced at the start of August it did so at the tightest triple-A spreads for a middle-market CLO all year.

RMBS

UK lender markets debut public RMBS

Together Financial Services is marketing its first public securitisation. Dubbed Together Asset Backed Securitisation 1 (see SCI's deal pipeline), it has a current mortgage portfolio balance of £301m and comprises 4,535 first- and second-lien UK owner-occupied and BTL residential properties.

The loans in the transaction were originated by Blemain Finance, Together Personal Finance and Together Commercial Finance, which all belong to the Together Group. The transaction marks the first public securitisation under the Together brand, as the firm was formerly known as Jerrold Holdings and undertook a rebranding in September 2015 which consolidated a number of brands.

Although this is the group's first public securitisation, it has a long history of utilising this funding strategy. "The group launched its first private securitisation, the double-A rated Charles Street ABS, 10 years ago. Together has private securitisations, senior secured notes and banking syndicate facilities in place, so a public securitisation was a logical next step and diversifies the group's funding structure," comments one source.

DBRS has assigned provisional ratings to the transaction of triple-A to the class A notes, double-A to the class Bs, single-A high to the class Cs, triple-B to the class Ds and double-B high to the class E notes. The size of the tranches has yet to be confirmed.

DBRS comments that mortgage loans by the originators are typically offered to borrowers who may otherwise be unable to obtain credit from a mainstream mortgage lender either because of their adverse credit history or because of the nature of the mortgage product that suits their specific requirements. This includes a high proportion of self-employed borrowers.

"Many lenders increasingly use a scorecard-based approach to lending which does not cater for large numbers of customers. This approach can exclude customers with multiple incomes, self-employed and partners in, for example, professional service firms whose income may be significant but could include large bonuses or profit shares, resulting in an irregular or lumpy income profile," comments the deal source.

They continue: "Equally, customers who are seeking to buy a non-standard property may also be rejected by lenders. The scorecard approach can also exclude customers who might have a minor blip on their credit history when, for example, a credit payment might have been missed due to error, dispute or other reason."

In terms of the portfolio, the average balance per borrower is £66,551, average weighted seasoning is 1.3 years and the average LTV is 56.9%. This LTV ratio is consistent with Together's lending approach and a factor in how it lends to borrowers who cannot typically get a loan from a mainstream lender.

The source says: "Together focuses on conservative LTV lending, with the weighted average LTV on its loan book being below 55%. This means that, on average, Together's customers have around 45% equity in their property. Combined with the group's detailed and individual approach to underwriting, this explains why Together has very low levels of impairment: currently around 0.1%."

DBRS highlights several notable elements of the transaction, including the fact that the portfolio consists of first- or second-charge loans, with the latter accounting for 60.4% of the portfolio. Monthly repayments can be interest only. Furthermore, 72.6% of the loans in the provisional portfolio are either for debt consolidation or withdrawal of the borrower's equity in the mortgaged property.

The portfolio yield is comparatively high, with the weighted average coupon at 7.8%, which is a mix of different variable rates set by the originators that may vary depending on the Together Group's cost of funding. DBRS suggests that this is the result of the loan products and potentially borrower credit history and adds that there is an optional redemption date and coupon step up in September 2021.

The rating agency also highlights the turbo and sequential amortisation features of the transaction as a significant strength along with the low LTV. Equally, for all loans in the pool the borrower income has been assessed on a full income verification basis.

Challenges in the transaction include the relatively high number of second-charge loans, which are typically exposed to higher losses compared with first-ranking loans, although this is mitigated by the low average LTV. Additionally, there is added risk in the low seasoning of the pool, with 88.3% of the loans originated in 2015 and 2016, and the mortgage portfolio could have multiple layers of credit risk.

DBRS also notes that there are a large number of self-employed borrowers, at 57.9% of the portfolio. Another 35.2% are employed borrowers and 7% are pensioners.

While self-employed borrower income is typically more prone to fluctuations, the agency says that the historical performance of the lenders' originations suggest that the borrowers are able to keep up with the monthly mortgage payments.

The rating agency adds that 14.4% of the loans in the provisional portfolio are also to individuals who have had county court judgements in their credit history at the time of origination of the loan. The firm says this is mitigated by the default probability adjustment it applies to the loans when rating the portfolio.

Each of the originators will be servicers of the loans they have originated. Capita Mortgage Services is the standby servicer.

RB

CDO

What rhymes with synthetic CDO?

DealVector coo and co-founder Dave Jefferds suggests that synthetic CDOs may fulfil their potential if investors can solve three issues

Now that synthetic CDOs are back in vogue (SCI 15 August), will history repeat itself, or only rhyme? Over the last two years, volumes have grown from US$10bn to US$30bn for the instrument widely blamed for causing the 2008 global financial crisis. What gives, and should we be worried?

To answer this question, it is important to understand what makes synthetic CDOs attractive instruments. Two words: customisation and leverage.

Perfect customisation of risk is something that everyone should agree is a good thing. Synthetic CDOs allow an investor to tailor exactly the basket of credit risk they want, including maturity, diversification and subordination. This precision is very difficult to achieve by investing with cash bonds.

Trading cash bonds is 'lumpy' and slow. For example, I may want to take an exposure in Company A until March 2019 exactly, in an amount of US$5m exactly. But there may exist only a bond that matures in January 2020 and, after hunting around, perhaps the only position available for sale is a block of US$7.3m.

To accomplish my risk preference goal, I would need to buy the US$7.3m, immediately sell US$2.3m and then sell the remaining US$5m in March 2019. Both extra steps incur transaction costs and uncertainty.

Multiply this inefficiency by 100, if the aim is to assemble a diversified portfolio of exposure.

Further, synthetic CDOs allow investors to calibrate perfectly their leverage. They may dial up their risk and return by taking the first loss of a portfolio, increasing their leverage.

Conversely, they may take a more secure and safe senior position in the basket for a lower return. In this case, they are deleveraging.

Some point in the middle would be equivalent to the simple return on the portfolio with neither lending nor borrowing. The point is that these choices allow for single-stop shopping and total customisation of the exact portfolio that is desired. The process provides significant efficiency for portfolio managers.

So what is the catch? The catch is the counterparty risk.

Both parties to a synthetic CDO contract (that is, the investor and the bank that provides the service) must live with each other over the life of the transaction. In the example above, the two parties would depend on each other to perform through March 2019.

By contrast, in any cash bond trade, settlement is in three days and neither party sees each other again. So in a synthetic CDO, as with any swap, guarantee of performance over time is critical.

To ensure performance, investors commit to a variety of contractual terms that are fraught. The bank, for example, determines the value of the contract at any point in time.

The value of the contract, in turn, determines how much cash must be wired between the parties as margin to guarantee continued performance. A global credit support annex (CSA) between the parties determines how much additional cash must be wired when the mark-to-market value on all contracts together (not just one) decreases by specified amounts.

Imagine if the bank could tell you the value of your house on any given day, and the valuation the bank provided then determined how much additional money you had to wire to the bank that same day. Furthermore, imagine the bank had a veto over who could buy your house, based on the bank's assessment of the buyer's creditworthiness. In any drop in housing prices, your options would be very limited and the likely result would be that the bank would own your house for a song.

This is the position that hedge funds found themselves in during 2008. Synthetic CDOs were marked down (across the board).

Hedge fund monthly performance suffered. Simultaneously, banks asked for more collateral to guarantee the trades.

Also simultaneously, hedge fund limited partners wanted their money back because of the poor performance. So hedge funds then had to liquidate these synthetic CDO swaps at prices they thought were ridiculous on a fundamental basis.

In essence, using synthetic CDOs, hedge fund investors on the one hand tailored their investment assets perfectly. But they totally screwed up their hedge fund liabilities.

They left themselves open to needing cash exactly when the cash would not be available to them. This is called asset-liability mismatch.

So, will history repeat itself? The volumes of new synthetic CDOs printed now are trivially small compared to what we saw during 2007 and 2008, when the annual volumes exceeded US$1trn and the aggregate volumes were over US$10trn.

So, there is no systemic risk issue at the moment. The real question is, if these volumes grow, will investors be able to negotiate terms that more effectively balance their asset-liability risk?

To do so, they will need to address at least three important issues. First, they will need to make sure they have terms with LPs that match their investments.

Planning to invest in synthetic CDOs with four-year maturities? Better make sure they have some ability to lock in their cash for that period of time.

Second, can they obtain objective third-party analysis on mark-to-market? During the 2008 crisis, the typical method for ensuring good marks was to get three quotes from brokers.

But in a world where all the brokers were similarly situated and the number of desks that even had the ability to price such instruments could be counted on one hand, this was no protection. It will be important that investors address this risk and it is not an easy issue to solve.

Third, investors will need to negotiate stronger CSAs that will mitigate the risk that they will be 'carried out' by margin calls before the investments can realise their true fundamental worth. This issue is also a tricky one in a world where there are relatively few bank providers of synthetic CDOs and these few are heavily concerned with regulators. The best solution here for investors probably is to confine their risk taking to short durations, where the mark-to-market discretion is less likely to become the primary issue.

If investors can address these issues, history will rhyme but not repeat. Maybe this useful product will fulfil its potential and mature into something more robust that benefits rather than destroys the market.

Structured Finance

Job swaps round-up - 15 September

EMEA

Golden Tree Asset Management has opened an office in Sydney, hiring Russell Taylor as md to lead the office. Taylor was most recently md at JPMorgan where he was head of institutional sales for Australia and New Zealand. He worked at the bank for 30 years in a number of roles, including across credit derivatives, structured credit, securitisation, loans and rates.

Blackrock/GSE loan financing has hired Steven Wilderspin as non-executive director to its Jersey office where he will assist in the running of its listed fund investing in CLOs. Wilderspin has served on a number of private equity, property and hedge fund boards as well as commercial companies. He currently sits on the board of 3i Infrastructure where he is chairman of the audit and risk committee. Previously, from 2002, Steven was a director of fund administrator Maples Finance Jersey where he was responsible for fund and securitisation structures.

North America

Post Advisory Group is launching a CLO management business to be headed by Bill Lemberg. Lemberg recently joined the firm from Alcentra where he was md and head of the company's US loan business.

Alexandria Capital has hired Stephen Park as principal, executive director. He was previously an md at Deutsche Bank.

Morgan Stanley has hired Arvind Bajaj as senior banker. He was previously cio at Anbau Enterprises and has previous experience in CMBS at Blackstone, Credit Suisse and Morgan Stanley.

Acquisitions

Trepp has acquired New York-based Cerulean Analytics, a firm delivering advanced performance and attribution analytics and data for CLOs.

Settlements

Credit Suisse has reached a final settlement with Massachusetts Mutual Life Insurance Company related to its RMBS business that was conducted through 2007. The agreement with MassMutual settles claims related to the sale of 19 residential mortgage-backed securities certificates in 2006 and 2007. Credit Suisse will take a pre-tax charge of approximately US$79.5m in addition to its existing reserves against this matter.

Clearing

CME Group is to exit the company's CDS clearing business by mid-2018, freeing up US$650m in clearing member capital. In future it will focus its OTC clearing services on interest rate swaps and foreign exchange as well as developing further capital efficiencies for market participants. CME Group will work with CDS open interest holders and regulators to ensure an efficient and seamless transition for the credit market. During this transition, CME will continue to provide full clearing services so that participants can continue to manage their risk, including the roll to CDX 29. Pending regulatory approval, the company will provide fee waivers on CDS clearing, as well as facilitate the bulk transfer of open positions. Following the transition, CME will dissolve CME Clearing's CDS guarantee fund, which will return US$650m to CDS clearing members.