Contents

Structured Finance

TRS see sustained uptick

IHS Markit iBoxx TRS trading volumes have risen sharply in recent years by around US$10bn and activity shows no sign of slowing down (see below chart, which represents the growth of standardised iBoxx TRS volumes). Factors driving this trend include increased hedging activity across the credit spectrum, as well as a broadening investor base harnessing the benefits of the product.

“In June 2015, we saw monthly iBoxx TRS volumes reach US$8bn. This year in March, it was US$18bn. This was mostly two-thirds dollar instruments and one-third euro instruments, with high yield indices being the predominant instruments, as there is more volatility and they are generally traded to access underlying market beta,” says Max Ruscher, director of CDS indices, IHS Markit.

He adds that the product’s appeal for investors has risen alongside the introduction of the full first coupon trading convention, which has allowed for greater fungibility and simplified coupon processing. While iBoxx TRS were once subject to Libor volatility, the convention now ensures that the trades in a given period reference the same Libor rate and pay the same coupon, thereby simplifying the trade process.

IHS Markit’s move to standardise and publicise trade documentation further streamlined and simplified investor engagement. A major impact of this is that it enabled investors to trade a range of iBoxx indices, helping drive growth of TRS further.

Ruscher notes: “Prior to the creation of standardised iBoxx TRS, trades were not totally fungible, so this is a big draw for investors. Additionally, we’re able to track volume, which is something we previously couldn’t do as well.”

Vishwas Patkar, executive director at Morgan Stanley, comments that investors mainly utilise the instrument to obtain exposure to a product that closely matches underlying cash index exposure. He adds that growing use of the product has been driven by a growth in the hedging culture in credit more generally, along with the growth in the market this cycle.

There are signs too that the investor base is shifting away from the more nimble, typical hedge fund investor, towards asset managers trading iBoxx TRS. Additionally, insurers and endowment managers have been drawn to the product, finding it well-suited to their fund management strategy.

“The swap is an easy way to manage a big influx of capital into a fund, particularly when investors may lack the assets to put the money to work. Rather than turn away this capital, investors can utilise iBoxx TRS and - in the meantime - source and build up a pool of bonds over three months,” elaborates Ruscher.

He suggests that additional features of iBoxx TRS have boosted its appeal. “One driver of the growth in iBoxx TRS use is that it has also seen growing use by ETFs and we’ve broadened the product offering too. We now offer more indices to connect TRS on liquid AT1 dollar and euro indices, which has driven demand in the iBoxx TRS sector further.”

Furthermore, hedging instruments such as CDX have shown significant basis risk relative to corporate bonds, which has made them inefficient as hedges. For example, when credit markets saw volatility in 2015 and 2016, TRS proved a better hedge.

However, Patkar notes that the enduring challenge with TRS is liquidity, as it still “lags volumes in CDX by a fair margin.”

Ruscher counters that it isn’t a fair comparison to make, with CDX having been in place a lot longer and is a much deeper market as a result. Recently the entire CDS index market has been trading at roughly US$400bn a week.

Ruscher is optimistic that iBoxx TRS has the potential to “really grow and become a widely adopted index-linked product”. He adds that the product needs to reach critical mass, but believes it may “get there in one to two years.”

Similarly, the indices don’t necessarily compete with each other - CDS indices often sit alongside TRS in terms of a hedging product used by firms. In fact, says Ruscher, investors utilise a range of instruments and it isn’t uncommon for investors to trade iBoxx TRS as well as CDS indices, while also perhaps investing in an ETF.

While the growth of CDX trading prior to the financial crisis may have – in hindsight – hinted at the turmoil to come, the same isn’t necessarily true for iBoxx TRS activity. Ruscher suggests that its greater use doesn’t have to indicate a change in the credit cycle.

He concludes: “Additionally, growing liquidity in the TRS market isn’t necessarily driven by volatility, but [is] as much about the product growing from a small base and a growing uptake by more players, particularly as it was only standardised in 2012.”

RB

RMBS

RMBS to follow Irish mortgage sale

Barclays plans to securitise a €5bn legacy portfolio of Irish residential mortgages recently acquired from Lloyds. The deal follows hot-on-the-heels of the Durham RMBS transactions (SCI 11 May 2018), which priced last week.

Cecile Hillary, head of asset finance solutions at Barclays, comments that the bank worked with M&G Prudential on the transaction, along with another firm. The portfolio comprises legacy performing Irish residential owner-occupied mortgages and a small portion of buy-to-let mortgages.

Within the portfolio are a small number of impaired loans and they were all originated by the Bank of Scotland Ireland. Barclays purchased the portfolio whole from Lloyds, which is reducing its non-UK and legacy exposures, with the next step being securitisation of the portfolio.

“Like the Bradford & Bingley portfolio,” says Hillary, “we aim to securitise the mortgages in the coming months, but are currently putting the structure in place and going to the rating agencies for initial discussions.”

“However,” she continues, “we aim to have a significant number of triple-A rated senior notes and expect that it won’t be one large single deal, but multiple. It will be decided further down the line as to whether it is publicly or privately issued, or retained by the investors.”

Barclays is acting as arranger and sole sponsor and the bank will hold 5% risk retention in a vertical strip.

Hillary notes the transaction will likely take at least two months yet to complete and, unlike the Bradford & Bingley deals, there is no pre-packaged structure in place. As such, Barclays is in the initial stages with regard to structuring the deal and speaking with rating agencies and other parties.

Hillary adds that Lloyds sold the portfolio as part of a very competitive bidding process and very close to par as – a price the bank would have been “very happy” with. The sale was completed for a cash consideration of around £4bn and circa £4.3bn of gross assets were transferred.

In terms of what is driving this competition and investor appetite, Hillary says: “I think there is a trend in the market at the moment for institutional investors to come in and participate in legacy assets. Not only is there often solid performance and good returns on offer, but also because there isn’t much activity in other securitised asset classes.”

She continues: “Buying legacy assets and securitising them therefore makes sense, particularly when they are of the quality of these seasoned, performing mortgages from a jurisdiction that has a long solid performance history and a large amount of data as a result.”

In terms of Ireland, she says that the bank would be happy to continue involvement there, but it is also actively looking at a range of jurisdictions across Europe. The bank would also look to finance and securitise a range of asset classes, including non-performing loans.

Hillary adds that any activity in NPLs would be selective and based on an informed decision. This would depend on where data is available and where Barclays can get comfortable with the underlying collateral.

Additionally, while securitisation is an “ideal tool” for such transactions, Barclays is open to harnessing other funding tools. These include whole loan sales, privately placed tranches or may be being involved in warehousing functions with other banking partners.

On the whole loan sale side, the bank may be open to trading some portfolios on the secondary market. Ultimately, says Hillary, any decision comes down to the “objectives of our partners, circumstances, asset class and the economics.”

Barclays’ RMBS transactions Durham A and B, backed by Bradford & Bingley legacy mortgages (SCI 11 May 2018), are an approximate 50-50 owner-occupied and BTL split of the original £5.3bn portfolio. Durham A has an approximate pool value of £2.754bn and is backed by residential owner-occupied mortgages. It is rated by Moody’s and S&P respectively as Aaa/AAA on the £2.173m class A notes (which priced at three-month Libor plus 55bp), Aa1/AA+ on the £133.37m class Bs (plus 100bp), A1/A+ on the £160.04m class Cs (plus 120bp), Baa2/A on the £60.02m class Ds (plus 140bp), Ba3/BBB on the £46.68m class Es (plus 170bp), Caa1/BBB- on the £26.67m class F notes (plus 220bp) and Ca/NR on the £46.67m class X notes (plus 325bp).

Durham B, with an approximate value of £2.363bn, is backed by UK BTL loans. It is rated by Moody’s and S&P respectively as Aaa/AAA on the £1.805bn class A notes (which priced at three-month Libor plus 55bp), Aa1/AA on the £183.97m class Bs (plus 100bp), A2/A on the £114.98m class Cs (plus 120bp), Baa2/A- on the £45.99m class Ds (plus 140bp), Ba3/BBB- on the £51.74m class Es (plus 170bp), B3/BB on the £17.25m class F notes (plus 220bp) and Ca/NR on the £45.99m class X notes (plus 325bp).

Durham A is backed by 21,893 first-lien mortgages issued by Bradford & Bingley and Mortgage Express across the UK between 1994 and 2009. The portfolio comprises 7.73% of loans with previous county court judgements (CCJs) and 2.1% of loans to borrowers that have previously been declared bankrupt.

Durham B is backed by 14,801 first lien residential BTL mortgage loans to borrowers across the UK. The majority of the portfolio was originated by GMAC and Mortgage Express. Similar to Durham A, 7.6% of the portfolio comprises loans with previous CCJs and 2% loans to borrowers that have previously been bankrupt.

Arranger on both deals is BNP Paribas, with Citibank acting as cash manager and issuer bank account provider for both. Natwest is acting as collection account bank before the transfer date, also on both Durham A and B.

RB

NPLs

Landmark NPL securitisation closed

Banca Monte dei Paschi di Siena’s landmark non-performing loan securitisation, Siena NPL 2018, features several structural innovations that are expected to be replicated in future NPL securitisations. The €4.33bn transaction securitises exposures equivalent to a gross book value of around €24.07bn (SCI 11 May).

One structural innovation is that the transaction provides for a real estate operating company (ReoCo) to intervene in an auction, if it determines that the reserve is lower than the real estate prospective price in the open market. This feature has been employed in Siena NPL 2018 due to its large size, whereas it wouldn’t be cost-effective for smaller deals.

David Bergman, executive director, structured finance at Scope, says: “The costs of setting up the vehicle would not justify the needs for small deals. It’s important because in Italy you can’t repossess property.”

He continues: “The property title belongs to the owner, auctions are often illiquid and properties are difficult to value. Also, the low number of buyers at auctions can lead to minimum selling prices that are quite uneconomic for the banks.”

In the event that the ReoCo acquires a property, it would have to sell it within 24 months, although doing this requires a certain amount of financing provided by the issuer. “The rub here is that if the ReoCo intervenes frequently, its investment limit - which is less than 1% of the GBV of the loans - would be broken,” notes Bergman.

Consequently, the expectation is for the ReoCo to be used not as a buyer of last resort, but as a vehicle for bidding up prices and expanding the number of buyers at auctions.

Another innovation is the existence of multiple servicers. In this case, there are four - which was regarded as a necessity, given the large size of the transaction.

All servicers are independently owned and feature different specialisations. This reduces disruption risk, which - in turn - reduces liquidity risk.

The final innovation is the interest rate cap for the mezzanine notes. Bergman explains: “The class A and B notes need to pay a floating [rate] coupon to get the GACS. The problem, though, is that recoveries are not linked to interest rates, which in turn generates an interest rate risk between the liabilities and the recoveries.”

He continues: “Accordingly, the cap would limit any potential variability in interest payments for the class B notes without having to pay for a derivative. As the cap automatically adjusts to the class B note’s size, it’s a better hedge than a derivative, which is usually linked to a notional schedule and not the actual balance of the note.”

According to Scope’s rating report, there are numerous positive rating drivers, including credit enhancement and the granularity and geographical distribution of the portfolio. An additional positive factor is the high proportion of proceedings that are at advanced stages.

Negative factors include the high proportion (60%) of unsecured loans, as well as liquidity constraints. Another negative rating driver is the fact that two-thirds of secured loans are indexed valuations.

“In this case you simply index a potentially very old valuation that doesn’t take into account the current status of the property. That is why we have applied a haircut for indexed valuations in the secured portion,” states Bergman.

The transaction still has to address cashflow uncertainty - a challenge common to all NPL securitisations. This is where the granularity of the pool can prove beneficial, with the 100 biggest borrowers representing less than 10% of the pool.

However, as there are 546,000 loans in the pool, linking assets and loans may prove challenging. Cross relationships - where one asset backs multiple loans, or where one loan is backed by several assets - might also be present.

“Extensive due diligence though has been carried out for this transaction, so data quality wouldn’t be an issue,” confirms Bergman.

Scope determined the cashflows for the secured portion of the portfolio on a loan-by-loan analysis. This takes into account asset values and security value haircuts -which consider both market value declines and fire sale discounts - in order to get to the price that a property could be sold for.

This is then compared to the gross book value of the loan, which points to the expected recovery rates. In terms of timing, the analysis considers whether a position is in bankruptcy or foreclosure and the stage of the loan in the court process.

Generally, a foreclosure procedure takes slightly more than half the time a bankruptcy procedure takes. The average time for a foreclosure process in 2016 was nearly four years, while the average time for a bankruptcy process was around seven years in 2016.

For the unsecured portion of the pool, the rating agency determined cashflows by initially looking into lifetime recovery rates, before adjusting them for seasoning since default for each loan. Specifically, the first five years after default show the highest yearly recovery rates for a portfolio of unsecured loans. On the other hand, when the portfolio ages, recoveries for each year are generally lower.

SP

NPLs

NPL financing hurdle highlighted

Financing non-performing loan resolutions remains the missing piece in efforts to tackle Europe’s troubled asset burden. While securitisation can help close the NPL bid/ask gap and broaden the investor base, the technology typically isn’t appropriate for volatile or deeply impaired assets.

There is currently no preferred transfer model for NPLs, nor discussion around different NPL asset classes at the EU level, according to Christian Moor, principal policy officer at the EBA. However, he suggests that the main issue is who will fund the financing of the NPL portfolios, regardless of whether it's via an asset management company (AMC) or other model.

“It makes sense for the more opaque assets - where there is a large market price discount, compared to the theoretical asset price - to receive some kind of public support via an AMC, but not for asset classes such as residential mortgages or consumer loans, where a well-functioning secondary NPL market can be developed, for example,” he notes.

Moor believes that securitisation can help close the NPL bid/ask gap in Europe and questions why the technology isn’t more widely discussed in the context of financing such exposures. “ABS has a chance to help, but the stigma around the product needs to disappear,” he observes.

Ganesh Rajendra, managing partner at Integer Advisors, suggests that while information asymmetry and execution costs are key factors in the bid/ask gap, differing return expectations between buyer and seller is the main issue. “There is currently around €300bn of capital dedicated to European NPLs. But this buy-side is still largely made up of a relatively small number of high-return players, each with significant capital to deploy.”

He continues: “The incumbent investors look to be increasing their buying capacity, more so than any material change in the number of new investors entering the market. Securitisation can help broaden the investor base by transforming the asset class into recognisable debt instruments – however, securitisation of NPLs remains challenging because technology requires predictable cashflows. Volatile or deeply impaired assets tend not to be readily securitisable.”

Equally, not all assets can be rated. “Seasoned unsecured and second- or third-lien real estate assets or development loans are unlikely to be given credit by rating agencies. Indeed, some sellers are deterred from securitising by the long ratings process or having to comply with risk retention requirements,” says Francesco Dissera, md at StormHarbour Securities.

NPL securitisations are typically structured either as an originating bank selling NPLs directly to an SPV or a fund acquiring a portfolio and then securitising. In the first model, the servicer is only appointed a few months before execution. In the second model, the servicer is well established in the fund’s strategy and often the fund owns the servicer.

No matter what the model, Dissera notes that rating agencies employ more prescriptive criteria about what they require in an NPL securitisation compared to before the financial crisis. Specifically, they rely more heavily on external servicers having a proactive collection policy, whereas pre-crisis they were comfortable for the originating bank to service the portfolio.

Rajendra nonetheless welcomes policymaker efforts to institutionalise the NPL market, citing the GACS scheme as one way of commoditising the sector, with the guarantee effectively underwriting the inherent risks.

Dissera estimates that up to eight Italian banks are currently considering using the GACS guarantee for securitisations. “GACS is useful when a portfolio is able to be rated because the senior tranche can be guaranteed by the Italian state, provided certain conditions are met, including that an external servicer is used for the collections. A significant benefit of the guarantee is that the seller can retain the senior tranche and achieve a 0% risk weighting, thereby partially bridging the gap between the purchase price and the accounting price of the portfolio,” he observes.

StormHarbour recently ran a simulation that showed that, depending on the rating of the senior tranche, on average the indicative cost of a three-year GACS guarantee is circa 0.81% at present. Some sellers prefer to retain the guaranteed senior tranche, some choose to finance it bilaterally with other players, while others sell it on. Still others prefer to issue notes without the guarantee.

Other potential publicly-sponsored NPL resolution models include public-private partnerships to co-invest in NPL portfolios or securitisations - whereby the state may co-invest in junior tranches and/or provide senior debt financing to equity owners, depending on the profile of investor appetite. However, the moral hazard of such bailouts and the question of how quickly taxpayer money can be repaid remain key issues.

Meanwhile, auction platforms – such as DebtX and Debitos – appear to be appropriate for the disposition of small granular assets.

Development of a secondary market and increased transparency are necessary for the European NPL market to grow further, as indicated by the European Commission action plan, according to European DataWarehouse business development director Marco Angheben. He points to two aspects that are currently under discussion as part of these efforts – an indication to report information to one or more dedicated platforms and incentives for issuers to report information according to the EBA NPL templates.

Angheben notes that while the EBA’s recently introduced NPL data templates are voluntary at present, the European Commission is considering using them for reporting purposes in the future. “The idea is to mitigate information asymmetry between buyers and sellers,” he explains. 

In this context, European DataWarehouse is conducting a test phase with NPL issuers and servicers to help familiarise them with the new EBA NPL templates. The ED test phase will conclude at the end of June.

Dissera agrees that there is a need to ensure greater transparency in the collateral, but suggests that more investors should be encouraged to participate in junior and mezzanine tranches as well. A further boon to the market may occur if the ECB changes its eligibility criteria to include NPL ABS – although he doubts that regulators will broaden the STS framework to include NPEs, given its emphasis on performing assets.

Last year was a record year for NPL and non-core asset disposals in Europe, with volumes totalling €144bn, according to Deloitte figures - of which around 20% was securitised. However, the EBA estimates that around €1trn of such assets remain on bank balance sheets, so direct disposals as well as securitisations are expected to continue. Further NPL securitisations are likely to be issued not only in Italy, but also in Greece and Portugal, as well as potentially in Spain and Austria.

However, Dissera doesn’t anticipate further large issuances of a similar size to Monte dei Paschi’s recent deal (SCI passim). Rather, securitisations are likely to be around €1bn-€2bn GBV, with senior tranches accounting for 25%-35% of this figure and mezz and junior tranches accounting for around 10%.

“We could see smaller transactions emerge from smaller players, but they would have to weigh up the fixed costs of issuing a securitisation versus an outright portfolio sale,” he concludes.

For more on this topic, view SCI’s recent webinar on the outlook for European NPL securitisations.

CS

Structured Finance

SCI Start the Week - 21 May

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

Pipeline
The transactions remaining in the pipeline by the end of last week were spread fairly evenly across ABS, CMBS and RMBS. A whole business securitisation was also marketing.

The newly-announced ABS comprised US$500m Ally Master Owner Trust Series 2018-2, US$221.94m Avant Loans Funding Trust 2018-A, US$2.25bn Honda Auto Receivables 2018-2 and US$676.29m MMAF Equipment Finance Series 2018-A. The RMBS consisted of Charter Mortgage Funding 2018-1, US$329.05m Flagstar Mortgage Trust 2018-3INV and Green Apple 2018-1 NHG, while the CMBS were US$370m Braemar Hotels & Resorts Trust 2018-PRME, US$713.1m JPMDB 2018-C8 and US$730.4m UBS 2018-C10. The US$1.05bn LNCR 2018-CRE1 CLO and US$1bn Hardee's Funding/Carl's Jr Funding whole business securitisation rounded out the deals that were marketing last week.

Pricings
ABS once again dominated last week’s prints, split between autos and other assets. A number of CLOs and RMBS also priced.

The auto ABS new issues consisted of: US$1.1bn AmeriCredit Automobile Receivables Trust 2018-1, US$450m Credit Acceptance Auto Loan Trust 2018-2, US$1.27bn Drive Auto Receivables Trust 2018-2, US$223.06m Flagship Credit Auto Trust 2018-2, US$1.58bn Ford Credit Auto Owner Trust 2018-A, £405m Globaldrive UK 2018-A and €400m RevoCar 2018. The other ABS prints included: US$900m American Express Credit Account 2018-4, US$622.41m American Express Credit Account 2018-5, US$774.88m CNH Equipment Trust 2018-A, US$196m Global SC Finance IV, US$187.8m HERO Funding 2018-1, US$521m Navient Private Education Loan Trust 2018-B and US$565.63m SCF Equipment Leasing 2018-1.

The CLO pricings were made up of refinancings and new issues: US$726.13m ALM XII (second refinancing), US$1.26bn Ares XXXIR CLO (second refinancing), €418.5m Cadogan Square CLO VII (refinancing), US$487.8m Carlyle Global Market Strategies CLO 2015-2 (refinancing), €455.9m CVC Cordatus Loan Fund III (refinancing), US$510.55m HPS Loan Management 12-2018, €410.85m Milltown Park CLO, US$513m Regatta XI Funding 2018-1 and US$504.19m Trestles CLO II. The RMBS prints comprised: £2.735bn Durham Mortgages A, £2.357bn Durham Mortgages B, €588m Green STORM 2018-I and the US$567.85m-equivalent Resimac Premier Series 2018-1. Finally, the US$901.17m BANK 2018-BNK12 CMBS was issued last week.

Editor’s picks
IFRS 9 first-time impact gauged: Banks have begun releasing their first quarterly results for this year, with the reports suggesting a limited impact from the first-time adoption of IFRS 9. However, the lack of a requirement to restate comparative figures means that the potential volatility in reporting generated by the accounting standard’s three credit stages will have to be monitored over time. Furthermore, banks appear not to be disclosing details around the categorisation of stage one and two assets…
Split-mortgage securitisation mulled: Permanent TSB has pulled €900m of split mortgages from its Project Glas portfolio sale of approximately €4bn of distressed Irish mortgages. The need to maintain borrower relationships and regulatory challenges over the treatment of split mortgages raise the prospect of the securitisation route for these loans…
NPL servicing still needs strengthening: Inadequate servicing capability for non-performing loans - largely in Italy and Greece - is hampering securitisation activity and stemming investor inflows, according to panellists at SCI’s recent NPL securitisation event. Nevertheless, improvements are gradually being made to bolster servicing infrastructure, supported by regulatory changes and European Council proposals…
Securitisation 'right tool' for NPL disposals: Participants at a recent SCI seminar on non-performing loan securitisation were optimistic about the role of ABS in facilitating disposals of troubled loans across Europe, with or without government guarantees. Concerns persist, however, that work still needs to be done in several jurisdictions in terms of professionalising servicing capabilities and standardising securitisation procedures…

Capital Relief Trades

Risk transfer round-up - 25 May

Standard Chartered is expected to roll over two existing trade finance capital relief trades in 2H18. In particular, Shangren 3 and Sealane 3 will be rolled over into two new deals: Shangren 4 and Sealane 4. Shangren 3 – in which Dutch pension fund PGGM was the investor - is a bilateral deal, while Sealane 3 is a syndicated one.

Overall, market sources note that there are six to seven risk transfer transactions being marketed at the moment, with two of them being from Southern European jurisdictions. The latter are believed to be from Italy and Spain.  

CLOs

Sterling CLO boosts Euro diversity

The announcement of a rare sterling-denominated deal has further boosted the growth and diversity of the European CLO market. PGIM Fixed Income’s latest transaction - Dryden 63 GBP CLO 2018 – is the first sterling CLO since 2013 and could pave the way for further such issuance in the coming months.

NatWest Markets is sole arranger on Dryden 63, which is expected to feature triple-A to single-B rated and unrated sterling tranches. The pool will comprise sterling-denominated and euro-denominated non-investment grade bonds and loans.

One portfolio manager suggests that the issuance is driven by a combination of reverse enquiry from one or more sterling accounts - which possibly are restricted from buying euro assets - and the view that the economics on the cross-currency basis are favourable. He estimates that by including euro assets in a sterling deal, investors can currently pick up 13bp. In contrast, they would give up around 13bp with the inclusion of sterling assets in a euro deal.

If the transaction receives good subscription levels and performs well in the secondary market, it is conceivable that other CLO managers may tap the sterling market, according to the portfolio manager. “However, the European investor base is deeper than the sterling investor base. The sterling market is generally longer-dated and five- to 10-year floating rate bonds may not have a natural investor base in sterling,” he notes.

Indeed, the depth of the European CLO investor base has attracted three new US managers – Guggenheim Partners (with Bilbao CLO I), Bain Capital Credit (Bain Capital Euro CLO 2018-1) and Voya Alternative Asset Management (Voya Euro CLO I) - to the sector in as many months. Varying investor perceptions of manager quality, portfolio and deal structure have, in turn, generated tiering at the triple-B level of around 30bp – up from 10bp a few months ago – according to TwentyFour Asset Management figures.

Year to date, JPMorgan CLO analysts calculate that 24 European new issue CLOs totalling €10.12bn have priced, together with 15 European CLO refinancings totalling €6.27bn. Given the recent strong growth of the market, they expect supply to hit a post-crisis record of over €20bn in 2018.

CIT Asset Management completed the last CLO to feature all sterling tranches – CIT CLO 2013-1 – in October 2013 (see SCI’s primary issuance database). Since then, Credit Suisse Asset Management’s Cadogan Square CLO VI from May 2015 comprised both euro and sterling tranches.

Separately, PGIM priced its latest euro CLO – the €415.1m Dryden 62 Euro CLO 2017 - last week.

CS

Structured Finance

Risk-based pricing after IFRS 9

Raymond Zhu, senior manager, and Jan-Hinnerk Fahrenkamp, director from Deloitte's Financial Services Risk Advisory Practice introduce Staging Value Adjustment (SVA) as a price-optimisation technique, to reflect IFRS 9 impairment impacts into pricing in the banking book

When IFRS 9 came into force in January 2018, many in the credit risk world thought the hard part was over. After all, conventional wisdom suggested the new standard would cause a one-off shift in expected loss provisioning and life would return to normal.

However, as firms are now rapidly gaining experience with the first generation of models, a number of practical implications have sprung up with far reaching consequences on business models beyond the challenge of accounting for potential credit losses. One such challenge is the adequate pricing of the implied economic costs of credit under the new standard.

The IFRS 9 learning curve
The most obvious way to exploit the insights generated by IFRS 9 is to incorporate into pricing engines the forward-looking loss estimates it generates. After all, such estimates should be much more transparent and accurate than relying on Basel 3 or IAS 39 estimates of loss. Any bank using risk-adjusted returns on capital (RAROC) should find it prices risk more accurately if it uses the IFRS 9 expected loss curve as an input, instead of the flat estimates generated under Basel 3.

Not all firms are that sophisticated. But even those which are can sometimes show an odd lack of co-ordination.

The ‘right hand’ may know that the average loan within a credit portfolio front book has a certain chance of ‘significant increase in credit risk’ that would classify it as Stage 2 under IFRS 9. That, in turn, would mean recognising a lifetime expected loss on the balance sheet against the loan and holding capital to absorb such a loss. However, the ‘left hand’ sometimes ignores that knowledge when deciding minimum acceptable returns to cover the risk.

There is, however, another economic cost that we think banks and building societies should consider to sharpen their pricing and attract the right customers at improved margins. It also pivots around the three-stage credit deterioration model for calculating impairment, but with a twist.

On probation
The point to bear in mind is that credit assets will be moving back and forth between IFRS 9’s first and second stages, as credit quality deteriorates or as accounts cure. Much will depend on the way in which firms define and put into practice their understanding of the term ‘significant increase in credit risk’.

But regardless of the definition and frequency of calculation, there is a real chance that accounts could end up oscillating between Stages 1 and 2. And, depending on the staging threshold, economic scenario and product, the impairment at Stage 2 will be significantly higher than at Stage 1.

This impairment volatility would be enough to cause material volatility in balance sheets, profit and loss statements and capital requirements. To mitigate this volatility, firms generally deploy a ‘probation period’ lasting between six and twelve months before restoring an account from Stage 2 back to Stage 1.

Consider the following example: for an account that moves from Stage 1 to 2 and back to 1, the capital consumed during the lifetime of the loan will look like the grey line in Exhibit 1.

The shaded grey area represents the capital cost borne by IFRS 9 stage migrations for accounts that move from Stage 1 to 2 and then back again. Note that this capital cost is in a sense of profit line effect, which by extension, temporally freezes parts of retained earnings (CET1).

Its width represents the length of time such an account is in Stage 2, plus the probation period before it is returned to Stage 1. Its height represents the differential in impairment between Stages 1 and 2, and the slope of its top and bottom sides represents the rate of amortisation.

Weight for it…
Some loans in a portfolio will follow the grey line, meaning that overall, the portfolio will never follow the simple green path. Here’s where a Staging Value Adjustment (SVA) comes in.

The SVA combines the two expected loss curves (green and yellow) into a single, Stage-weighted EL curve (orange) that takes into account the expected CET1 capital cost and can be used to price risk more accurately (see Exhibit 2).

Remember that IFRS 9 effectively causes banks and building societies to set aside additional CET1 capital, over a probation period minimum, to compensate for the fluctuation of lending creditworthiness. It is worth noting that this CET1 capital cost is at the cost of equity, not the cost of debt for the industry, hence an expensive source of burden. If this part of economic cost is not considered properly, certain products might be seriously mispriced in the new accounting world.

As is readily apparent, SVA will be sensitive to:

• product type and maturity: the SVA yields different results for revolving or amortising loans;
• risk volatility: the more the underlying risk indicators tend to fluctuate, the longer the probation period is likely to be; and
• economic conditions: if the long-term economic trajectory improves, this will be reflected in lifetime expected losses before they show up in 12-month expected losses. The SVA picks up this change and can feed it into pricing.

Those who can cascade the loss insights properly through the customer lending rates will be able to ensure that the margins accurately reflect the risk and capital consumption, and enjoy a competitive advantage on a risk-adjusted basis. Firms that are not able to transparently price the SVA will find risk-adjusted returns diminished when adverse conditions increase the capital consumption of the credit portfolio.

The SVA applied to retail mortgages
To see how these factors affect a real portfolio, we compare the outputs of two pricing engines on a retail mortgage book. Both pricing approaches used RAROC simulations, but one featured standard flat-lining IRB expected losses, while the second used IFRS 9 expected credit losses that factored in a SVA.

With the assumption of the same RAROC hurdle, we found that in our IFRS 9-SVA model, the pricing of higher-risk lending was significantly more sensitive to the trajectory of economic outlook introduced by the new standard than that of low-risk lending. This was largely caused by the higher proportion of risk cost relative to interest and fee income for these products.

Depending on the level of conservatism that banks have already priced in and the position within the economic cycle, our results suggest that aligning IFRS 9 expected losses within pricing can cause sizeable variations in customer rates (and up to 60bp higher for high-LTV mortgages).

For our sample portfolio, layering in the additional SVA, the customer rates grew by up to 30bp for the higher-LTV lending, depending on staging weights and the anchoring base price.

The pricing impacts for unsecured lending are larger, reflecting the nature of utilisation uplift of the undrawn commitments as the economy deteriorates.

What next?
Accounting under IFRS 9 has started to lead to capital markets and investment managers considering their loan asset valuations.

Cascading the loss insights properly through the customer lending rates will enable margins to accurately reflect the risk and capital consumption.

Through strategic lenses, we see that incorporating IFRS 9-SVA is an initiative to start a wider price-optimisation programme across functions and stakeholders.

Structured Finance

Market moves - 25 May

Analytics acquisition

IHS Markit has signed a definitive agreement to acquire Ipreo for US$1.855bn from private equity funds managed by Blackstone and the Goldman Sachs merchant banking division. The acquisition is expected to close in 2H18, subject to customary closing conditions and regulatory approvals. Following a detailed review of its financial services businesses, the firm has also initiated a process to sell MarkitSERV, its derivatives processing unit.

CDO manager transfer

Dock Street Capital Management has replaced Structured Finance Advisors as collateral manager of Structured Finance Advisors ABS CDO III. Dock Street proposes to replace the employees of SFA who are actively involved in the management of the deal with two of its employees – David Crowle and Jeffrey Holtman. For other recent CDO manager replacements, see SCI’s CDO manager transfer database.

ESN hearing due

The EBA is set to hold a public hearing to outline its draft answer to the European Commission's call for advice (CfA) on European Secured Notes on 26 June. The hearing comes ahead of the publication of the EBA's final report, which is expected by mid-July 2018. The CfA asked the EBA to assess whether a dual-recourse instrument similar to covered bonds may provide a useful funding alternative to banks engaged in lending to SMEs and infrastructure projects, to advise on the potential structure of this new product and to determine an appropriate EU framework and regulatory treatment.

Europe

Citi has promoted Peter Keller to md, head of structured products sales, EMEA. He was previously md and co-head of global structured finance and securitisation at the bank.

Ocorian has launched a new corporate trust offering with the appointment of three professionals from the banking sector – Sally Gilding, Chris Wilson and Sinead McIntosh. Gilding has deep experience of SPV structures and joins as senior consultant and non-executive director, having previously been co-chief executive of Deutsche Trustee Company in the UK and a non-executive director at Intertrust. Wilson (formerly at Citi) has been named director, transaction management and McIntosh (formerly at HSBC) as associate director, product development. Their arrival follows the appointment of Alan Booth as md of Ocorian's UK business in February, having previously served as global head of product management within Deutsche Bank's corporate services division.

Porterbrook has appointed Stefan Rose as head of structured finance, responsible for the firm’s relations with the financial community and managing the financing of the business. He will join the firm in July from the infrastructure debt team within UBS Asset Management, bringing over 18 years of experience in pan-European infrastructure projects, including financing a number of landmark projects in the rail and rolling stock sector. He has also worked at Edmond de Rothschild and Mizuho in their infrastructure teams.

Fairhold trustee scrutinised

Clifden IOM No. 1 has been appointed as agent in respect of any correspondence and discussions with the note trustee for Fairhold Securitisation noteholders that have tendered their notes (SCI passim). As such, it wrote to the trustee in respect of its £3.15m fees stated in the issuer's April distribution report, which Clifden believes are potentially excessive and not commensurate with the fees incurred over the last few reporting periods. The trustee’s response stated that all of its costs were properly incurred in accordance with its rights and obligations under the trust deed and that the cash manager is expected to issue an update that will provide a breakdown of the April 2018 trustee fees. Clifden says it continues to reserve all of its rights, including seeking injunctive relief against the trustee and to bring a claim against it in respect of any breach of duty

HLTV refi option updated

The GSEs have updated their high loan-to-value streamline refinancing option in support of the single security initiative. One of the main changes is an increase in the minimum LTV ratio on a one-unit principal residence to 97.01% from 95.01%, reflecting the convergence of Freddie Mac offerings with those of Fannie Mae. The other main change is the introduction of loan level pricing caps. Wells Fargo structured products analysts note that generally, below 105% LTV, there are no price breaks and borrowers will continue paying normal LLPAs. However, from 105%-115% LTV and below 680 FICO, pricing breaks start to kick in. Above 115% LTV, pricing breaks kick in almost immediately below 740 FICO.

ILS

TigerRisk Capital Markets and Advisory, the insurance-focused investment banking subsidiary of TigerRisk Partners, has formed Panthera Re, to facilitate access to capital markets for TigerRisk’s insurance and reinsurance company clients. Panthera Re is a Bermuda-domiciled vehicle which allows clients to access third-party capital investors in an efficient manner. The vehicle has the ability to transform a wide variety of risks and contract types, making them accessible and tradeable to institutional investors. Panthera Re offers standardised documentation which helps streamline the process, but can also be utilised for more customised transactions. 

Twelve Capital has hired Jamie Rodney as director of ILS analytics. Rodney was previously divisional director, catastrophe analytics at Willis Re.

Libor replacement progressing

ISDA is expected to begin a consultation regarding synthetic Libor - the credit spread between an Ibor and the related risk-free rate (RFR) - next month. The three options reportedly under consideration are: a static add-on credit spread using the basis between the Ibor and RFR levels that existed the day before a public announcement triggering fall-back clauses; a static spread using the historical mean of the same basis over a given period of time; and a dynamic forward-rate approach, based on observed market prices for the forward Ibor-RFR spread. Meanwhile, CREFC reports that it has joined the US Fed’s alternative reference rate committee (ARRC) securitisation working group, which is putting together a list of key trigger events that would precipitate a move away from Libor to an alternative benchmark. The next step in the process will involve tackling fall-back language for both asset- and securitisation-level loan documents.

North America

Apollo Investment Corp has appointed Howard Widra - who has served as president of the company since June 2016 - ceo, succeeding James Zelter. Zelter will continue to serve as a director and Widra has also been named a director. Tanner Powell has been appointed president of the company, filling the vacancy created by Widra’s appointment. Powell will also continue to serve as cio for the company’s investment adviser.

Barrow, Hanley, Mewhinney & Strauss has announced that it will be launching a bank loan strategy as of June 2018 and it will be managed by new hires Nick Losey and Chet Paipanadiker who were both previously portfolio managers at Whitebox Advisors where they helped to launch a CLO platform. They will report to to Mark Luchsinger and Scott McDonald, the co-heads of fixed income at Barrow Hanley.

Capitala Group has opened an office in Manhattan and hired Kelly Stotler as director, focused on sourcing, executing and monitoring new transactions for the firm. Stotler has over 15 years of middle market loan origination, underwriting and portfolio management experience, having previously served as md - head of loan originations for Czech Asset Management. Before that, he worked at HIG Whitehorse and GE Capital Corporate Lending.

Co-ceo Oliver Wriedt has left CIFC with immediate effect to pursue other opportunities. He is replaced by Steve Vaccaro, a founding member of the firm and who has served as co-ceo since 2014 and cio since 2011. Vaccaro will become sole ceo.

Milbank, Tweed, Hadley and McCoy has hired Sean Solis at the firm’s structured finance and securitisation group in Milbank’s New York office. Solis' practice is focused on structured products and other similar capital markets transactions, the formation and representation of credit funds, and capital markets regulation, with a focus on the risk retention regulations in both the EU and US.

Permira Debt Managers has hired Pierre Driant from Oz Management, formely Och-Ziff, to join the new CLO strategy that launched this year. Driant, who has significant experience as an analyst responsible for CLO structuring at Och-Ziff, US Bank and BNY Mellon, will be responsible for structuring the new Providus CLO platform.

NPL sale

AIB Group has agreed to sell a non-performing loan portfolio to Everyday Finance under a consortium arrangement with Everyday and affiliates of Cerberus Capital Management. At 31 March 2018, the loan portfolio had a gross balance sheet value of €1.1bn and AIB will receive a cash consideration of €800m at completion of the transaction. The portfolio comprises approximately 3,700 investment asset properties, with around 90% of them over two years in arrears.

Partnerships

Ostrum Asset Management and Natixis’ corporate and investment banking arm have joined forces to set up a co-investment offering on real asset private debt. The three main strategic sectors will be real estate, infrastructure and aviation. Ostrum has also appointed Denis Prouteau as real asset private debt chief investment officer. Prouteau was previously head of global markets research at Natixis.

SBBS rules unveiled

The European Commission has unveiled new rules designed to facilitate the market-led development of sovereign bond-backed securities (SBBS) by removing what it describes as “unwarranted regulatory obstacles”. SBBS would be issued by private institutions as claims on a portfolio of euro-area government bonds, without involving mutualisation of risks and losses among euro area member states. The aim is to help investors diversify their sovereign portfolios, leading to more integrated and stronger financial markets. The proposal would grant SBBS the same regulatory treatment as national euro-denominated sovereign bonds, providing they meet precise eligibility criteria.