Contents

Structured Finance

Capacity constraints

Covid-19 not yet posing solvency issues

Government and central bank actions have kept both the financial system and the real economy afloat in the short-term, amid the coronavirus disruption. The severity of this crisis for company and household finances will depend on the length of the current outbreak and political will, however.

According to Rabobank credit analysts: “Covid-19 is now an imminent issue for the real economy, but not directly a threat to the financial sector. In contrast to the recent major sell-off periods, Covid-19 is in the first place a health crisis for humankind, but the policy reaction to fight the virus - such as lockdowns - is directly affecting the real economy and are now mostly resulting in imminent liquidity issues for corporations. Solvency is directly at stake in some sectors, such as leisure and airlines, but for others, it will be mainly a function of how long the situation will last.”

The Rabobank analysts continue: “As such, we are currently not facing a financial crisis. Major solvency problems in the real economy could still result in one eventually; e.g. if banks have to take major credit losses on defaulted loans. Nonetheless, the starting point is good, as both defaults are currently low and the banking sector is very well capitalised.”

Indeed, the current situation is not yet as bad as the financial crisis of 2008-2009, when spreads were markedly higher compared to current levels. The levels observed recently were on average some 60% of the peak levels of 2008-2009.

The senior financials CDS index, for instance, widened to 170bp - a significant increase compared to the mid-40s that markets are more accustomed to. Yet compared to other more stressed environments for banks and as recent as 2016, this peak is not materially higher.

SRT investors, however, have raised concerns about SMEs and households where banks have exposures. SMEs enjoy a relatively high degree of protection offered by both banks and fiscal authorities; for example, in the form of liquidity lines and payment holidays. This should enable them to survive this crisis in the short run.

A similar conclusion currently applies to households; particularly those who are vulnerable to big shocks, such as the self-employed, entrepreneurs or workers with flexible contracts.

Hence, as long as the Covid-19 situation persists for a short period of time, Rabobank doesn’t foresee any major issues for the banking sector. Moreover, supervisors have already eased the capacity constraints in anticipation of the economic fallout of the virus.

As a result of government and central bank action, spreads have retraced somewhat from their peak levels and the primary market for new debt issuance has gradually reopened in recent days. Last week saw record investment grade supply of €34.6bn, beating the previous record from March 2016.

However, JPMorgan analysts offer a more cautionary note: “We think that the broader rally across the rest of the credit universe this week may not be sustainable. In our view, we still need to see more signs that the Covid-19 pandemic is close to peaking; and that social distancing measures can be removed without triggering another outbreak of the virus. While there is some mixed evidence that quarantines might be working in Italy, most of the rest of the world is still seeing accelerating case growth.”

The JPMorgan analysts continue: “Furthermore, there is little evidence as to what happens when social distancing measures are relaxed following a large outbreak, although we should soon know more, as the lockdown in Hubei is planned to be lifted by 8 April. Until we have more data here, we continue to think that there is a risk that social distancing measures may have to be at least partially maintained for a minimum of 12-18 months until a vaccine is ready.”

Nevertheless, JPMorgan notes that the default loss component of spreads has not jumped as dramatically as some investors may have believed. The firm analyses the implications of spread movements for default losses by decomposing credit spreads into two components: one for default losses and the other for market risk, which they proxy with equity volatility.

According to the bank’s model, today’s market can withstand a default rate of roughly 12% per year. For a static portfolio with five years to maturity, that’s nearly a 50% cumulative default rate, assuming defaults are uniformly spread out over time.

The Rabobank analysts note that the outlook has mainly to do with the starting point; just prior to the outbreak of Covid-19, corporate defaults were actually at low levels. Due to increasing headwinds and further leveraging, the outlook was already one of more corporate defaults, but Covid-19 will of course accelerate this trend.

“Some vulnerable sectors are easy to identify at this stage. For others, it is mainly a question of how long the Covid-19 situation will last. Nonetheless, we expect credit ratings to move down. Although ratings are through-the-cycle, any longer-than-expected liquidity issues will simply put pressure on companies’ debt metrics, which will likely become incompatible with current credit ratings. The first rating actions have already been taken on several companies,” they conclude.

Stelios Papadopoulos

RMBS

MBS market buffeted

'Unsustainable' hedges called out

MBS spreads to Treasuries widened again yesterday (1 April), giving those hedging margin calls on TBA shorts a breather. But it is not thought that the US Fed has been frightened off by the MBA’s letter on Sunday admonishing its actions in the previous week.

Agency MBS spreads have backed up again, but volatility continues to be the order of the day. Many in the US securitisation market suggest that far from easing dislocation, the US Fed - through its recent actions - has contributed to it.

The 30-year TBA versus Treasury spread closed the day at 187bp, while at the beginning of the week it had been as narrow as 125bp, say sources. In mid-February, before the Coronavirus panic gripped the market, it had been in the region of 95bp.

Spreads in the MBS market narrowed sharply at the end of last week, as the Fed came in to execute a large-scale buying programme to lower rates in the home loan market. It accomplished this goal, but in doing so left a great many mortgage lenders facing significant margin calls on hedge positions that were suddenly plunged under water.

The Fed bought US$183bn of MBS in the week-ending 27 March, to add to the US$68bn it bought in the week-ending 20 March. This two-week purchase of US$250bn represents US$84bn more than the Fed had previously bought in any four-week period during the financial crisis of 2009.

But what it gave with one hand it took away with the other. Suddenly, mortgage lenders faced a wave of fresh margin calls which, in some cases, they were struggling to meet.

Mortgage lenders typically short the TBA market forward before they sell new mortgage loans to the GSEs, in order to offset any losses that would accrue from rates trending higher. If rates do increase before they can sell the loan to Fannie Mae and Freddie Mac, they buy back the hedge at a profit which covers the loss.

Moreover, lenders often put on naked shorts, inasmuch as they have not yet acquired the loan let alone sold it to the agencies. Lenders will also usually aggregate loans before they pass them on and, in the current period of dislocation, this process is taking longer. Consequently, the lender is holding a naked short for a more extended period than is usual.

As rates suddenly dipped at the end of last week, lenders were forced to meet margin calls for the hedges that were suddenly and unexpectedly under water. “According to TBA guidelines, you have to post margin. So, when rates go down and bond values go up, you have to post margin because your short just got bigger. So, when the Fed comes in and artificially pushes it up, you lose, if you’re holding a naked short,” explains a market consultant.

At the same time, the actual sourcing of paper to deliver into a short becomes more difficult, as the Fed has hoovered up so much. The Fed is also often the buyer of the short position as well.

“There are various ways to satisfy a short, but in this case, every way has become more expensive,” the consultant adds.

Fed action at the end of last week elicited a vigorous response from the Mortgage Bankers Association (MBA). On Sunday it sent a letter to the Fed, claiming the US housing market is “in danger of large-scale disruption”, thanks to its intercession.

The MBA declined to comment in detail about its response, but instead pointed SCI to the letter it sent to explain its action. The letter went on to say: “The dramatic price volatility in the market for agency MBS over the past week is leading to broker-dealer margin calls on mortgage lenders’ hedge positions that are unsustainable for many such lenders.”

The fact that yields in the MBS market moved back out yesterday prompted some observers to speculate that the Fed had got the message and backed off. Others thought this less likely. Certainly, the Fed has not made any announcement on these lines.

Indeed, the spread widening is more likely due to the fact it was not part of a buying cycle by the Fed, and also because Treasuries rallied strongly as part of a risk-off trade as stocks plummeted once more.

The Fed’s actions across markets have aroused dissension from a number of quarters. In taking action in one area of the market, it has often not helped another, thanks to the law of unintended consequences.

In particular, Minneapolis Fed president Neel Kashkari’s 22 March comments on the widely-viewed and respected CBS current affairs show 60 Minutes excited particular disfavour. Extolling the Fed’s ability to spend out of the current cataclysmic collapse in market values, Kashkari said: "We're far from out of ammunition.... There's an infinite amount of cash at the Federal Reserve."  

These comments were greeted with ill-concealed incredulity by many on the Street. “It was completely inappropriate to suggest that what the government can do is unlimited. It isn’t. There are theoretical and physical limits to what they can do,” says one.

Simon Boughey

Structured Finance

Development finance

Securitisation mooted for SME house builders

SME house builders struggle to access finance, despite being responsible for around 13% of new builds. Development finance securitisation is therefore being mooted as one way of helping the UK government achieve its target of building 300,000 new homes per annum.

Gordon Kerr, head of European structured finance research at DBRS Morningstar, says: “We do think development finance lending is important and will be important as we go forward. There is a large percentage of building work that does come from SME builders and developers, as opposed to the big names.”

Processes for development finance differ to the processes involved in standard residential mortgage loans. This includes the application, underwriting, credit approval and repayment processes.

Mark Wilder, svp, head of European operational risk at DBRS Morningstar, notes: “For construction loans, there are additional requirements - such as planning permission - which are not typically required in a standard residential mortgage loan.”

DBRS Morningstar says: “We view the practices typically used in development finance as sound and believe that development finance will become more prominent over the coming years for the government to reach its house building target and with potential securitisation transactions.”

The typical RMBS structure will not be compatible with the potential development finance securitisations, however. Unlike RMBS, development finance securitisations are expected to be short-term loan transactions.

“The product is very different to a traditional mortgage. As a result, you do not have the same structure in terms of payments and the way that the loan itself is structured,” adds Kerr.

Indeed, lenders do not receive payments on capital or interest throughout the term of the loan. As such, a full bullet repayment must be made at the end of the loan term.

Additionally, development finance loans are released in stages, aligning with building milestones. DBRS Morningstar cites the completion of foundations, completion of damp-proof coursing, completion of external structure and roof frame, and the pre-plaster stage as some of the common build phases.

The agency recognises the various challenges which have had an impact on processes. “In today’s environment with regards to Covid-19, a standard valuation would be much more difficult to obtain. It is not possible to inspect the property or site,” says Wilder.

Furthermore, underwriters are trained specifically to review construction loans. Wilder adds: “The fact that you would not be able to physically meet with clients or brokers causes an issue. Entities have reduced staff, so they are unable to work at full capacity, which could result in longer processing times.”

The market conditions created by the virus are having a significant impact on development finance lending. “At the moment, development finance lending would probably be slow or even put on hold. I would expect that in the current environment there would be a number of challenges for what is already in the pipeline. For builders, delays in completion mean interest costs eating into their margins. For lenders, new lending will be difficult without site access and face-to-face contact,” Kerr concludes.

Jasleen Mann

Capital Relief Trades

ESG catalyst?

Positive impact SRTs gaining traction

Significant risk transfer is primarily associated with achieving favourable capital treatment. However, the utility of the instrument as a catalyst for ESG/positive impact financings - by enabling banks to redeploy capital from legacy ‘dirty’ assets into new ‘clean’ assets - is gaining traction, according to SCI’s latest CRT Research Report.

“The capital relief trade market has a track record of over 20 years and continues to grow in terms of application, originators and jurisdictions,” says Sanjev Warna-kula-suriya, partner at Latham & Watkins. “There is now real engagement with regulators, which view it as a useful technology to channel funds into the real economy – and this could potentially be harnessed in the fight against climate disaster. It’s a question of educating both issuers and investors as to the availability of SRT for different purposes.”

Mariner Investment Group md Andrew Hohns, for one, believes that SRT is catalysing impact finance in bank portfolio management. “We’re eager to do what we can with our Funds and our mandates and hope that over time bank capital management personnel will recognise the growing investor interest in positive redeployment deals and how this translates into a lower hurdle rate in terms of ROE, which enables banks to be more competitive and to book additional pro-ESG loans.”

He continues: “We feel it’s important to address non-ESG compliant loans that are already on bank balance sheets. The aim is to liberate the capital held against such loans and procure a commitment to redeploy it into pro-green lending. Conditionality requirements are ultimately a transfer pricing mechanism to reduce financing expense for such projects.”

While the primary motivation behind executing an SRT remains achieving capital relief, any way that ESG features can be incorporated is an additional benefit, according to Pascale Olivié, director, asset-backed products - advisory at Societe Generale. The aim with the bank’s Jupiter transaction, for instance, is to reallocate part of the released capital to new assets with positive impact features (SCI 16 October 2019).

“Societe Generale has adopted the highest standards in terms of governance and decided to exclude from its operations certain counterparties or transactions that do not meet environmental and social standards,” Olivié explains. “We adopted the UN Principles for Responsible Banking in 2019, so it’s a combination of the right management of our own operations, the right management and exclusion of certain counterparties or transactions that do not meet ESG standards and pushing on Positive Impact. A positive impact feature adds value to an SRT transaction, but only if it’s consistent with the Bank’s overall strategy in terms of ESG.”

In terms of identifying a suitable portfolio to reference in an SRT, she says it depends on the nature of the bank’s balance sheet and the available amount of assets that are potentially eligible for a trade. “While there is a broader trend within banks to originate more green assets or assets with impact, we still hold assets that aren’t necessarily green. Typically, banks don’t have enough assets to build an entirely positive impact portfolio, so first we can use reallocation of capital to support new origination of ESG/ positive impact assets.”

Amitji Odedra, associate director at Qbera Capital, agrees that synthetic securitisation can enable banks to redeploy capital from legacy ‘dirty’ assets into new ‘clean’ assets. “We have seen four ESG SRTs issued so far and the market is getting its head around this. However, one potential limiting factor in the near term is whether banks are able to originate enough impact assets to execute a deal.”

For synthetic securitisation to play a more meaningful role in addressing the climate crisis, Ingrid York, partner at White & Case, says that there needs to be greater awareness of the adaptability of SRT trades and the fact that they can be used for innovative purposes. “The pro-ESG movement is likely to keep growing in importance, bolstered by the EU Green Deal and ECB support. Ultimately, we’ll get to the stage where investors are asking issuers why their trade doesn’t have a climate feature. Then the market will move to a second phase, where the underlying is all ESG assets.”

SCI’s CRT Research Reports are published on a quarterly basis and aim to provide in-depth analyses of topical themes and trends being discussed across the risk transfer industry. This second report in the series will explore the processes and infrastructure involved in originating impact SRTs, as well as documentation and transparency issues, how to assess performance, incentivising/facilitating further volume and the role of ESG considerations in credit risk management.

To download the complete report, click here. For further information and subscription details, email jm@structuredcreditinvestor.com (new subscribers) or ta@structuredcreditinvestor.com (existing customers).

Corinne Smith

CLOs

Pressure drop

European CLO market update

Margin call pressures on European CLO warehouses appear to be subsiding. However, pricing levels remain volatile.

The leveraged loan market experienced a sharp repricing in recent weeks, due to coronavirus disruption. As of last week, European loan prices had dropped by circa 20% on average, while the percentage of distressed loans trading less than 90% and less than 80% cash price jumped to 93% and 55% respectively - up significantly from 6% and 1% at end-February. Such widening across the capital structure is equivalent to a generic average price drop of 10%, 15%, 20%, 30%, 40% and 60% respectively on European CLO AAA/AA/A/BBB/BB/B rated tranches.

“Prices are still moving around,” reports one portfolio manager. “Regarding price discovery, last week some participants were funding short-term. There have been margin calls, but a lot of the pressure has passed now.”

A recent disclosure by Chenavari Toro Income Fund, for one, reveals that in this unprecedented environment, its focus has consisted of “managing the cash position to be able to answer margin call requirements on both the leveraged loans warehouse and the repurchase agreements on triple-A CLO positions.” The fund has reduced its leveraged loan and triple-A CLO exposures to bring its leverage ratio under 1.1x (from 1.2x at end-February).

Meanwhile, Fair Oaks Income has suspended its declaration of dividend payments amid the current volatility. “In the near term the uncertainty will lead to rebased market assumptions as to credit performance, which is expected to materially constrain the company's income calculated using the effective interest rate methodology and therefore would mean that any dividends declared would have to be substantially funded from the company's capital. It is premature to seek to quantify the fundamental impact of the pandemic, which will depend on an array of factors - including the effectiveness of recently announced government intervention - but over time, there is risk of underlying CLO managers being required to divert cashflows from CLO subordinated notes to purchase additional loan collateral in response to increased credit downgrades and defaults,” the company states.

At the portfolio level, it says it has taken steps to minimise mark-to-market risk, retaining a “prudent reserve of cash” to cover any FX hedge and warehouse financing needs. Nevertheless, Fair Oaks anticipates the dislocation in credit markets to create future investment opportunities.

“CLOs have strong protection at the top of the capital stack. It would take phenomenal defaults to break them,” the portfolio manager observes.

Indeed, significant downgrades for rated European CLO notes are not expected in the short term. Sandeep Chana, director, structured credit/CLOs at S&P Global Ratings, says: “It goes without saying, we are living in unprecedented times. Naturally, the CLO market is no different from any other market - it is also impacted. In a post-Covid world, what might CLO structures look like at that point in time?”

He suggests it may be necessary to adapt structures in order to accommodate new types of risks arising from the pandemic and build in more protection to get deals done. “If you give investors the right price, they may likely invest. New risks presumably need to be priced.”

Looking ahead, when the European CLO new issue market returns, it is expected that initially all liability spreads will be wider than they were pre-Covid. CLO structures may also feature shorter reinvestment periods or none at all, if they are static. Additionally, S&P would not rule out the potential return of variable quarterly amortisation notes.

Jasleen Mann

Structured Finance

SCI Start the Week - 30 March

A review of securitisation activity over the past seven days

Transaction of the week
Northern Arc Capital and fintech platform CredAble have closed a trade finance securitisation backed by invoice receivables. The transaction is the first rated and listed invoice receivables-backed ABS from India.
Kshama Fernandes, md and ceo of Northern Arc Capital, says: "Banks and non-banking financial companies (NBFCs) have traditionally been present in this space and have been discounting these invoices directly. However, this exposes them to idiosyncratic anchor/vendor risks, since there is a single underlying exposure." See SCI 23 March for more.

Last week's stories
Closing the gap
Audentia Global answers SCI's questions
Cloudy outlook
RMBS perseveres amid market volatility
CRT deals disclosed
Intesa publishes capital management strategy
Forced selling
REITs struggling to meet margin calls
Liquidity risk
Pandemic pressure on NPL performance
PPIP call
CRT and non-agency MBS still in need of purchasing power
SASB stress
RWN action reflects hotel pressure
TALF response mixed
Fed facility could be found wanting
Testing times
MPL platforms addressing coronavirus impact

Other deal-related news

• The US Fed announced a slew of new measures to support the credit markets this morning, including the revival of the Term Asset-Backed Securities Loan Facility (TALF), first seen in the wake of the global financial crisis (SCI 23 March).
• The British Business Bank has launched the Coronavirus Business Interruption Loan Scheme (CBILS), which provides facilities of up to £5m for smaller businesses across the UK that are experiencing lost or deferred revenues, leading to disruptions to their cashflow (SCI 23 March).
• The US FHFA has authorised Fannie Mae and Freddie Mac to enter into additional dollar roll transactions, with the aim of providing increased liquidity to MBS investors (SCI 23 March).
• The New York Fed has retained BlackRock Financial Markets Advisory as a third-party vendor to operationalise its purchases of agency CMBS and transact with primary dealers on behalf of the SOMA (SCI 25 March).
• The CRE Finance Council (CREFC) and 12 other real estate trade organisations have submitted a letter urging the US Fed and Treasury to expand the TALF 2.0 to include agency and private-label CMBS and GSE credit risk transfer securities (SCI 25 March).
• Barclays Private Bank has closed North Dock No. 1, its first UK prime RMBS (SCI 26 March).
• KBRA has reviewed UK CMBS with exposure to purpose-built student accommodation (PBSA) assets and identified one loan with PBSA exposure, which serves as the collateral for the Taurus 2019-3 UK transaction (SCI 26 March).
• The EBA has issued a statement explaining a number of additional interpretative aspects on the functioning of the prudential framework in relation to the classification of loans in default, the identification of forborne exposures and their accounting treatment (SCI 26 March).
• S&P expects the COVID-19 pandemic to result in a material negative turnover impact for many UK whole business securitisation issuers (SCI 26 March).
• A portion (15%) of European CLO collateral is derived from the industries most vulnerable to the coronavirus pandemic, according to Moody's (SCI 27 March).
• An unprecedented 8% of US broadly syndicated loans (totalling around US$45bn) have been downgraded or placed on negative watch by S&P since the SF Vegas conference, according to BofA Global Research (SCI 27 March).
• A number of CDO manager transfers have been inked this week (SCI 27 March).
• FFELP student loan ABS are expected to exhibit higher borrower utilisation of forbearance in the short term as a result of the economic effects of coronavirus containment measures (SCI 27 March).

SCI NPL Securitisation Awards 2020 - new deadline
SCI NPL Securitisation Awards 2020 - new deadline As a result of COVID-19, the SCI NPL Securitisation seminar has unfortunately had to be postponed until 1 July, along with the NPL Securitisation Awards ceremony. Award nominations remain open and a have a revised deadline of 24 April. Further information and details of how to pitch can be found here.

MRT report
SCI has published a Special Report on the US Mortgage Risk Transfer sector – it can be downloaded for free here.

Data

BWIC volume

Secondary market commentary from SCI PriceABS
27 March 2020
USD CLO
A pick up in flow today with 20 covers, all mezz – 5 x AA, 5 x A, 8 x BBB and 2 x BB rated. At the upper end of the rating scale the AAs traded 339dm-464dm for 2022-2024 RP profiles (5.2-6.7y WALs), MV metrics being the biggest lever for levels with CVC's APID 2016-25A A2R at the tighter end 339dm / 6.7y WAL with a 111.65 MVOC and a good ADR level 0.35%, whilst a weaker manager Hayfin's KING 2018-8A B despite a healthy MVOC 113.03 and 0.21% ADR covers 420dm / 6.2y WAL. To put into context DMs for this cohort was in 170area context pre-vol.
The single-As (2022/2023 RP profiles) trade in a 470dm-559dm range, at the tight end is Octagon's OCT37 2018-2A B 470dm / 6.93y WAL which defies logic with the tightest DM amongst the cluster of single-As today despite a weaker manager record, weaker MV metrics and 1.28% ADR which is wider than it's average across all deals. At the wide end is ArrowMark's AWPT 2018-10A C 559dm / 6.7y WAL with the highest MVOC 104.81 and lowest ADR 0.38% whilst the best diversity 84, lowest WARF 2779 and sound manager record!
The BBBs trade in a relatively tight spread 849dm-879dm (2023/2024 RP profiles) versus pre-vol levels of 325dm-350dm for similar cohort, there was an outlier today MARNR 2018-5A D (Mariner) 715dm / 7.4y WAL – strong manager metrics whilst the deal itself carries 0.12% ADR, 4.75% sub80 assets and a good WARF 2726.
The two double-Bs traded today in a 1267dm-1319dm range (2023/2024 RP profiles), to put into context the DMs have doubled from pre-vol levels of 685dm-775dm for similar cohorts, the trades today have not any material fundamental issues, only dislocation in terms of distressed underlying loan prices and liquidity in this rating level.
EUR CLO
3 x BBB & 1 x BB today. First a note of caution. We have adjusted our scenarios to decrease CPRs and increase the amount of reinvestment that takes place thus lengthening the WALs. Therefore today's calculated spreads are not directly comparable with recent levels.
Two of the BBBs are DNTs and one is a CVR. All three prices represent spreads between 720dm and 800dm. The tight end of this range is from CORDA 4X DRR which has a shorter RPE Date than the others and hence shorter WAL and is the traded bond. The wider levels DNT. Previous recent BBB spreads have been 900H, but that is under the previous assumptions with shorter WALs.
The BB is CONTE 5X E which traded at 1219dm/9.5yr. This bond traded at 97 price in Jan 2020 and traded at 59 today, a fall of almost 40 points. In Jan 97 price represented 535dm / 6.73yr and today 59 represents 1219dm / 9.46yr.
SCI proprietary data points on NAV, CPR, Attachment point, Detachment point & Comments are all available via trial, go to APPS SCI + GO on Bloomberg, or contact us for a trial direct via SCI.

Structured Finance

CECL delayed

EU banks await IFRS 9 relief

The US Fed, the FDIC and the OCC last week approved an extension of the new credit loss accounting standard CECL until 2022. No equivalent action has been taken for IFRS 9 on the EU side, however.

According to the US regulators’ joint statement, banking organisations that are required under US accounting standards to adopt CECL this year can mitigate the estimated cumulative regulatory capital effects for up to two years. This is in addition to the three-year transition period already in place.

Alternatively, banking organisations can follow the capital transition rule issued by the banking agencies in February. The changes are effective immediately, with comments on the CECL interim final rule accepted for 45 days.

However, the IASB, regulators and central banks in Europe have so far adhered to IFRS 9, simply asking banks to be flexible in their calculations given the current circumstances. The ECB, for instance, stated on 20 March that banks “avoid excessive procyclicality of regulatory capital and published financial statements.” Within its prudential remit, the ECB recommends that all banks “avoid procyclical assumptions in their models to determine provisions and that those banks that have not done this so far opt for the IFRS 9 transitional rules.”

Similarly, according to an IASB statement: “IFRS 9 does not set bright lines or a mechanistic approach to determining when lifetime losses are required to be recognised. Nor does it dictate the exact basis on which entities should determine forward-looking scenarios to consider when estimating expected credit losses. Entities should not continue to apply their existing ECL methodology mechanically.”

For example, the IASB suggests that extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in those instruments being considered to have suffered a significant increase in credit risk (SICR). To assess SICR, IFRS 9 requires that entities assess changes in the risk of a default occurring over the expected life of a financial instrument.

“Both the assessment of SICRs and the measurement of ECLs are required to be based on reasonable and supportable information that is available to an entity without undue cost or effort,” the IASB states.

The European Commission allegedly intends to provide further operational relief to the banking sector, although the next steps are currently unclear.

Stelios Papadopoulos

Structured Finance

Breathing space?

EU banks benefit from Basel 3 delay

The Basel Committee's decision last week to delay implementation of the final Basel 3 rules by a year (SCI 30 March) gives banks and supervisors some breathing space to respond to the coronavirus crisis. However, the delay is expected to be more beneficial for EU banks compared to US banks.

Fitch, for one, notes that the delay will ease the capital constraints that some banks might have faced and it will be particularly helpful for the larger EU banks, which have to apply a capital floor based on standardised approaches to their model-based capital requirements. However, the delay means that creditors will have to wait longer for enhanced comparability of banks' risk-based ratios, the agency says.

It adds: “Additionally, the delay renders hard any levelling of the playing field between the largest and most well-resourced banks, and smaller less sophisticated banks. Parallel disclosures across modelled and standardised outcomes, aiding transparency of calculations and fairer comparisons, are also delayed.”

The implementation date has been deferred to 1 January 2023, with transitional arrangements for the capital floor extended by one year to 1 January 2028.
The final Basel 3 standards aim to restrict the benefits of model-based RWA estimates in order to reduce excessive variability between banks' capital calculations and improve the comparability of capital ratios.

EU banks faced significant additional capital requirements due to the capital floor - 23.6% higher on a weighted-average basis. This would have meant a €125bn Tier 1 capital shortfall at end-June 2018 - assuming fully loaded total capital requirements, including Pillar two and national buffers.

On the other hand, large US or global banks typically faced only a small increase, or even a fall in capital requirements. “The differences partly stem from where low-risk mortgage assets sit in financial systems. Low-risk mortgages remain predominantly on banks' balance sheets in Europe. But in the US, they are largely passed on to government-sponsored enterprises, such as Fannie Mae and Freddie Mac,” states Fitch. Hence, US banks have higher average risk-weights than their European counterparts, arising in part from their different portfolio compositions.

Risk-based capital requirements are less important for banks in the US than elsewhere, reflecting the US's long-standing reluctance to embrace the concept. The US authorities have long included leverage ratio-based requirements and, under the Collins Amendment, US bank capital requirements are based on the higher of the modelled approach and the standardised approach.

Pressure on the Basel Committee to act following the coronavirus crisis sprang from the need to free-up operational capacity for banks and supervisors. Policymakers acknowledge that implementing the final Basel 3 rules would have had a negative short-term effect on credit intermediation, a central role for commercial banks in western Europe and the Asia-Pacific region.

The ECB has estimated that EU bank lending to the non-financial private sector could weaken most significantly in the third and fourth year after the introduction of the final Basel 3 rules, with banks retaining a higher share of earnings and reducing loan exposures to restore capital buffers. It said this could lead to average annual GDP growth being 0.2 percentage points lower over the first four years after implementation, before improving thereafter.

Looking ahead, Fitch concludes: “It is not clear that EU banks will be well-placed for Basel 3, even with the one-year delay. The pro-cyclicality of modelled RWAs during downturns highlights the importance of capital headroom. Bank profitability was already low before the coronavirus crisis and a prolonged period of near-zero policy rates and the likelihood of higher loan impairment charges could weaken it further.”

Stelios Papadopoulos

CLOs

Credit challenges

CLOs show resilience in stress scenarios

Central bank and government countermeasures are likely only able to offer short-term liquidity support to businesses during the coronavirus crisis. If the circumstances continue for a lengthy period of time, credit quality could experience significant pressure, says S&P.

In a recent scenario analysis, S&P applied 10 hypothetical stress scenarios of varying severity to a typical European CLO to provide an indication of how rising pressures among speculative-grade corporates could affect its ratings. The scenarios covered in the study included: an increase in triple-C category rated assets; asset defaults; widespread asset downgrades; lower asset recovery ratings; and higher correlation assumptions.

The study shows that notable rating changes would generally be greater further down the capital structure. Indeed, the triple-A tranche rating appears resilient and senior notes were only impacted in the severe hypothetical scenarios. The triple-B rated tranches remain investment grade in most of the hypothetical scenarios that were applied.

However, the double-B minus rated tranche rating would be downgraded by one to three notches in nine out of 10 of the scenarios. In scenarios where all underlying obligors are downgraded or 10% default, all ratings may be downgraded by one to three notches, according to the analysis.

Nevertheless, S&P stresses that in reality, the changes to ratings would depend on structures, portfolios and managers of the various transactions.

Jasleen Mann

Structured Finance

Real asset focus

Stephane Delatte, ceo and cio of Pierfront Capital, answers SCI's questions

Q: How and when did Pierfront Capital become involved in investment?
A: Pierfront Capital was established in 2016. We have deep experience and expertise in structuring private credit investments in the Asia Pacific, with an investment team with an average of 15-20 years of relevant experience, with specific expertise across the real assets sectors. Our first fund, PCMF, which was established in 2016, has committed close to US$400m in 15 investments with four exits to-date, achieving over mid-teens gross internal rate of return.

Q: What are Pierfront’s key areas of focus at the moment?
A: We focus on Asia-Pacific real asset sectors and favour companies which are backed by strong and committed sponsors/stakeholders, with a defensive business model and resilient or contracted cashflows throughout economic cycles - the latter two being key characteristics of real asset sectors.

Q: What part of the capital structure do you typically focus on and why?
A: We are a Singapore-based fund manager that offers bespoke private credit and mezzanine financing solutions in real asset sectors globally. These are privately negotiated debt instruments. Our solutions have a high degree of flexibility and comprise debt instruments across the private credit spectrum (between traditional senior debt and equity) and in varied financing situations to meet borrowers’ unique requirements.

Q: What is Pierfront’s strategy?
A: Pierfront Capital has a differentiated private credit investment strategy focused on debt solutions to corporates or projects predominantly in real asset sectors of the Asia-Pacific region to generate attractive risk-adjusted returns. Real asset sectors include and are not limited by infrastructure, real estate, offshore marine, transportation, energy and natural resources.

Q: What differentiates you from your competitors?
A: Flexibility and range. Pierfront Capital provides bespoke solutions compared to most traditional lenders.

Pierfront Capital aims to provide debt solutions to corporates or projects predominantly in real asset sectors of the Asia-Pacific region, where such financing needs are not met by traditional commercial banks. Unlike most of our competitors, we shy away from consumer, tech and general manufacturing business, and our key sector focus is on businesses that exhibit defensive infrastructure-like features, such as hard asset collaterals and predictable cashflow that are inherently less volatile.

Q: What has the impact of a partnership with Keppel been?
A: Our long-term strategic partnership with Keppel has significant positive bearing on our real asset investment focus, given its extensive networks and in-depth operating experience in our sectors of focus. The ability to leverage Keppel’s capabilities and networks to gain access to a wider pool of deal opportunities and enhanced market intelligence, especially in times of uncertainty, puts us in good stead to continue executing private credit investments that provide attractive risk-adjusted returns to our investors.

Q: Why is there now an increase in demand for alternative lending solutions?
A: We have observed a steady demand in recent years for alternative lending solutions as traditional banks in some Asia-Pacific regions pull back from certain sectors, such as real estate or infrastructure, while companies still require a significant amount of capital to grow and develop new projects.

Q: What is your outlook on private debt as an asset class?
A: We believe private debt would be a growing asset class in Asia Pacific as sponsors get more familiar with such alternative sources of debt capital, which offer flexibility and are non-dilutive to equity.

Q: Are there future challenges that you expect will arise?
A: The Covid-19 outbreak has placed significant downside risk to the global economy and lock-downs instituted globally have disrupted usual business conduct. In the near-term, there could be a slowdown in deals as people adjust to a new working format. Conducting due diligence on borrowers may also be challenging, given inability to have face-to-face meetings with management teams

Q: What opportunities do you expect in the future?
A: We believe that in the long term, a significant financing gap in the Asia-Pacific real asset sectors will remain and there will still be a strong demand for capital due to rapid economic growth and limited funding ability. This supports the Pierfront Capital strategy of providing specialist intermediate capital to companies and projects in real asset sectors – sitting in between traditional senior debt and equity in the capital stack. While the primary focus of Pierfront Capital is on origination and execution of privately negotiated debt transactions, we may opportunistically look at private credit secondaries transactions, given current dislocations in the market.

Jasleen Mann

Structured Finance

Basel 3 implementation deferred

Sector developments and company hires

APAC fund launch
Pierfront Capital Fund Management has been awarded its capital market services license for fund management by the Monetary Authority of Singapore. It has also announced the first close of the Keppel-Pierfront Private Credit Fund, which aims to provide debt solutions to corporates or projects predominantly in the real asset sectors of the Asia-Pacific region. Sponsored by Pierfront Capital Mezzanine Fund (PCMF) and Keppel Capital, each has committed US$100mn in the first close of the fund. PCMF is 90.91% and 9.09% held by Temasek and Sumitomo Mitsui Banking Corporation respectively. Keppel Capital acquired a 50% stake in Pierfront Capital from PCMF in November.

Aussie ABS support fund
The Australian Office of Financial Management (AOFM) has launched an A$15bn Structured Finance Support Fund, under which it will invest in Australian dollar-denominated rated primary market securitisation positions issued by smaller authorised deposit-taking institutions and non-ADI lenders, alongside securitisation warehouse financings over a 12-month period. The aim is to enable customers of smaller lenders to continue to access affordable credit amid the spread of coronavirus. The funding will complement the Reserve Bank of Australia’s A$90bn term funding facility for ADIs that will also support lending to SMEs. The AOFM is expected to be able to begin investing in ABS and RMBS by next month.

Basel timeline extended
The Basel Committee has endorsed a set of measures to provide additional operational capacity for banks and supervisors to respond to the immediate financial stability priorities resulting from the impact of coronavirus on the global banking system. The implementation dates of the Basel 3 standards, the accompanying transitional arrangements for the output floor, the revised market risk framework and the revised Pillar 3 disclosure requirements have been deferred by one year to 1 January 2023, 1 January 2028, 1 January 2023 and 1 January 2023 respectively. The revised timeline is not expected to dilute the capital strength of the global banking system, but should provide banks and supervisors additional capacity to respond immediately and effectively to the impact of Covid-19.

Notice of default
The Elizabeth Finance 2018 CMBS servicer has obtained an updated valuation of £68.9m in respect of the Maroon loan properties (SCI passim), which represents a decrease of £17.1m when compared to the previous valuation in January 2019. Based on the updated valuation, the Maroon LTV is 96.4%, whereas the Maroon obligors are obliged to ensure that the LTV does not exceed 75%. As such, a notice of default dated 17 March 2020 was served on the Maroon obligors providing a period of 15 business days to cure the default.

SBOLT ratings watch
KBRA has placed three classes of Small Business Origination Loan Trust 2018-1 on ratings watch developing and four classes of SBOLT 2019-1 on watch downgrade, due to the economic effects of coronavirus. The agency expects the two marketplace lending securitisations to be negatively impacted by Covid-19 containment measures in the UK, after conducting a hypothetical scenario analysis that considered stresses to default levels.

Structured Finance

Advancing assistance programme prepped

Sector developments and company hires

Advancing assistance mooted
Ginnie Mae is tailoring the existing disaster pass-through assistance programmes to more suitably scale to the needs of mortgage issuers in response to the Covid-19 liquidity squeeze (SCI 30 March). The GSE anticipates implementing within the next two weeks - via an All Participants Memorandum (APM) - a Pass-Through Assistance Program (PTAP), through which issuers with a P&I shortfall may request that Ginnie Mae advance the difference between available funds and the scheduled payment to investors. This PTAP will be effective immediately for single-family programme issuers, with corresponding changes made to Ginnie Mae’s MBS Guide in due course. The GSE anticipates publishing PTAP terms for HMBS (reverse mortgage) and multifamily issuers shortly thereafter. In return for any payments advanced under the PTAP, issuers will be required to repay the advance within a specified time period, subject to extension requests.

Strategic agreements
Angel Oak Capital Advisors has entered into a strategic distribution partnership with Bury Street Capital, a capital-raising and placement agency, to expand its international outreach efforts in structured credit. Through the new partnership, Bury Street plans to bolster its distribution efforts by growing its employee head count, and to expand efforts in Latin America and Asia by targeting an array of institutional investors and top-tier regional wealth managers. Angel Oak will work closely with Bury Street to strengthen the marketing of its investment solutions in these regions.

Ares Management Corporation, Sumitomo Mitsui Financial Group and Sumitomo Mitsui Banking Corporation have reached a strategic agreement to collaborate on future business opportunities. As part of this agreement, SMBC will make a US$384m equity investment in the publicly traded shares of Ares Class A common stock, equivalent to a 4.9% stake in the firm. Together, Ares and SMBC Group plan to collaborate across three highly-accretive growth areas – strategic distribution, investment opportunities (including private credit) and capital markets collaboration (including leveraged finance).

Structured Finance

CRR compliance for NHG guarantee

Sector developments and company hires

EMEA
Addleshaw Goddard has hired structured finance partner Rachel Kelly from McDermott Will & Emery. Kelly has three decades of experience at major international law firms, including as a partner at both Clifford Chance and Macfarlanes. Her work has been across the full spectrum of structured finance and debt capital markets transactions, public and private, national and international, advising the full range of market participants. Kelly will be joined at AG by legal director Kerry Pettigrew, with whom she has worked since 2015.

Euro retail exposure eyed
In light of recent social distancing measures, KBRA has reviewed loans with exposure to retail assets that serve as collateral for the European CMBS it rates. The agency identified two loans with retail collateral accounting for more than 9.6% of the allocated loan amount. The underlying collateral for EOS (ELoC No. 35) has a retail exposure of 22.6%, while one of the two loans (Big 6) securing the Kanaal CMBS Finance 2019 transaction has a retail exposure of 78.1%. For EOS, the estimated DSC would be 2.08x (versus 2.8x currently), if all of the retail tenants were to stop paying rent. For Kanaal, the Big 6 loan represents 50.4% of the transaction balance and is secured by five retail properties and one mixed-use retail/office property in cities across the Netherlands. Based on KBRA’s analysis, tenants accounting for approximately 46.5% of the total collateral area of the Big 6 loan remain open, 26% are closed and 21.6% are vacant, with the status of the remining 6% indeterminable.

Libor replacement service
As servicer on a number of CMBS and facility agent on a large number of multi-lender CRE loans, Mount Street has joined forces with Paul Hastings’ real estate finance practice to create a streamlined, process-driven service offering to replace Libor in existing CRE loan documentation. The combined team is able to offer lenders a legal and operational framework for advising on the challenges and impact of Libor replacement, as well as making the necessary changes to the documentation once the change has been agreed with borrowers. The team will be led by Mount Street’s European head of primary servicing Serenity Morley and Paul Hastings partner Miles Flynn.

NHG guarantee updated
The Dutch mortgage guarantee fund NHG has updated its terms and conditions, including the option to cover the expected loss of a defaulted loan within 20 months from the default. As such, the NHG mortgage guarantee is now compliant with both IRB and standardised approaches under the CRR, according to Rabobank credit analysts. The new terms and conditions are applicable from 1 June 2020, except for the conditional pay-out of the loss (which was enforced as of 31 March 2020), and applies to both existing and new guarantees.

NZ capital rules welcomed
Moody’s expects the postponement of new capital rules in New Zealand, by a year to 1 July 2021, will give the country’s four largest banks - ANZ Bank New Zealand, ASB Bank, Bank of New Zealand and Westpac New Zealand – “ample” time to build capital and meet the new requirements. The new rules will mean that the minimum CET1, Tier 1 and total capital adequacy ratios for the four banks will rise significantly to 13.5%, 16% and 18% from the current levels of 7%, 8.5% and 10.5% respectively. If they retain all profits, Moody’s anticipates that ASB could meet the new rules by 2022, followed by ANZNZ, WNZL and BNZ, each with a one-year interval. However, the four banks are likely to utilise the full seven-year transition period granted by the RBNZ.

Structured Finance

PEFF pay-out anticipated

Sector developments and company hires

PEFF set to pay out
The calculation agent on the World Bank’s CAR 112 catastrophe bond is expected to report by 9 April, with the A and B tranches likely to pay out in the next two to three weeks (SCI 3 March). Lane Financial estimates that the B tranche will likely pay out in full for US$95m, while the A tranche will pay out US$37.5m, or a sixth of its par value (US$225m). Against this, the bank will have paid an accumulated US$72.7m in premiums for a net gain of US$59.8m on its bonds. Additionally, US$105m of private swap arrangements will generate another estimated US$71.8m for the bank’s Pandemic Emergency Financing Facility (PEFF).

In other news…

Call for TALF expansion
A bipartisan group of lawmakers from the US House Committee on Financial Services has sent a joint letter to the Fed urging it to expand the TALF 2.0 programme to include unsecured consumer loan ABS as eligible collateral. The move would support the availability of responsible consumer credit at a time when bank funding lines are not being extended to non-bank lenders and fintech platforms. The letter notes that since 2008 and the establishment of TALF 1.0, the market for consumer and small business credit plays a “much more vital role in the economy” than it did 12 years ago.

CRE relief requests
Over 2,600 commercial real estate borrowers - representing US$49.1bn of mortgage loans - have sought potential debt relief during the first two weeks of the US coronavirus outbreak, according to Fitch. These figures include borrowers in 42 single-asset/single-borrower CMBS secured by hotel and retail assets. Hotel assets represent approximately 47% of relief inquiries, followed by retail assets at 30%. While these inquiries are not directly linked to default, 87 CMBS loans totalling US$2.8bn have already transferred to special servicing. More material transfers to special servicing are expected in May and June, as servicers respond to missed loan payments and additional relief requests. The most common relief requests to date include payment forbearance, reallocation of reserves to pay debt service or fund operating expense shortages, and waivers of default for closed businesses. Borrower hardship inquiries cite non-payment notices from tenants and closed businesses due to government restrictions.

EMEA
Together has appointed Steven Harrison as securitisation manager in its loans, mortgages and finance unit in London. He was previously sector head - European ABS at LibreMax Capital in New York, which he joined in September 2015. Harrison has also worked at Cairn Capital and UBS.

First SFSF investment inked
The AOFM intends to invest the first tranche of US$250m under its Structured Finance Support Fund investments in securities issued by a warehouse vehicle sponsored by Judo Bank, subject to satisfactory completion of the documentation process (SCI 30 March). The AOFM also intends to invest a further US$250m in a different security class issued by the same warehouse facility on a temporary basis. Challenger Investment Partners and Herbert Smith Freehills acted as advisers to the AOFM on the Judo Bank warehouse transaction. Société Générale acted as structurer and arranger of the transaction. The AOFM had intended to announce a call for a second round of SFSF proposals prior to 1 July, but will make an assessment of market conditions in early July before proceeding.

‘Modest increase’ for Chinese delinquencies
S&P reports that the delinquency rates for the Chinese ABS and RMBS it rates increased modestly from a low base in February. For the 11 auto ABS the agency rates, the weighted average 1-30 days past due (dpd) ratio rose to 1.5% in February from 1.1% in January - higher than 0.9% over the Lunar New Year (LNY) break in 2019, which fell in February 2019. The weighted-averaged 31-60 dpd ratio increased to 0.13% in February from 0.04% in January, compared with rates that went no higher than 0.03% throughout 2019. With respect to the five RMBS S&P rates, the weighted-average 1-30 dpd ratio rose to 0.8% in February from 0.3% in January - and also 0.3% over the LNY break in 2019. The weighted-average 31-60 dpd ratio increased to 0.14% in February from 0.04% in January, the range it averaged throughout 2019. “The data for February are especially critical as they reveal a full month's impact from Covif-19 on securitised portfolios, as well as the effects of financial relief measures provided to obligors who have applied and been accepted. Nonetheless, we expect asset quality of the auto ABS and RMBS we rate to remain under pressure over the next three to six months,” the agency notes.

Moratoria requirements clarified
The EBA has published more detailed guidance on the criteria to be fulfilled by legislative and non-legislative moratoria applied before 30 June, with the aim of clarifying the requirements for public and private moratoria to help avoid the classification of exposures under the definition of forbearance or as defaulted under distressed restructuring. In this context, the guidelines clarify that payment moratoria do not trigger classification as forbearance or distressed restructuring if the measures taken are based on the applicable national law or on an industry or sector-wide private initiative agreed and applied broadly by the relevant credit institutions. In addition, the guidelines recall that institutions must continue to adequately identify those situations where borrowers may face longer-term financial difficulties and classify exposures in accordance with the existing regulation, with the requirements for identification of forborne exposures and defaulted obligors remaining in place. 

Servicer communication guide
CRE Finance Council has issued a guide for CMBS borrowers on how to communicate with servicers, which urges borrowers to contact their servicer directly to open the line of communication regarding interruptions to cashflow as a result of Covid-19. The guide provides tips and best practices for streamlining a challenging process, including highlighting operational capability, disclosing any significant issues and offering a detailed plan for moving forward. Requests must be reasonable and fit the circumstances of the property, loan structure and borrower, as well as meet the credit requirements of the lender and the terms of the PSA for the specific CMBS trust, according to the association.

Volcker RFC extended
The CFTC, FDIC, OCC, SEC and US Fed have extended by a month the comment period on their proposal to modify the Volcker rule’s general prohibition on banking entities investing in or sponsoring hedge funds or private equity funds, known as ‘covered funds’ (SCI 31 January). As such, they will consider comments submitted before 1 May to provide more time to analyse the issues in light of potential disruptions resulting from the coronavirus.