Contents

Capital Relief Trades

CRT return for FNMA?

Supreme Court ruling on Calabria's future imminent

A US Supreme Court decision about whether President Biden can remove Mark Calabria as director of the Federal Housing Finance Authority (FHFA) may arrive as soon as next week, say well-placed sources.

Following recent precedent, it seems likely that the court will rule that Calabria can be removed by the executive ‘for cause’. This will have profound ramifications upon the governance of the GSEs and might lead to a speedy return to the credit risk transfer market for Fannie Mae.

Specifically, Calabria’s departure should lead to a rethinking of the draft capital rules, released a year ago, which afforded much less favourable capital treatment for CRT mechanisms. It is these rules which have led to a shunning of the CRT market by Fannie Mae for the first time since 2013.

“The number one priority for the Biden administration in this area is affordable housing. Is number two CRT? Well, it was the most commented on topic when the draft capital rules were released. Remember it was the Democrats who put CRT in place,” says a source with long experience of the GSE CRT market.

The Supreme Court began considering Collins versus Mnuchin in December. The case asks, among other things, the independence of the director of the FHFA. The case concerns whether it is constitutionally acceptable for the FHFA to be run by a single director with cause-based independence from the executive.

This is similar to the case brought before the court last year concerning the independence of the directorship of the Consumer Finance Protection Bureau (CFPB) and, in that instance, it was ruled unconstitutional for a single individual director, rather than a commission as in the SEC, to be immune from presidential edict. Thus, the director of the CFPB could be fired by the president, just as any other appointed official in the administration could be.

Though the two cases are not identical, they are similar enough for most lawyers to believe the same verdict will be reached - and, if so, Calabria’s days as FHFA director could be numbered. And with him could go the plans to release the GSEs from conservatorship and also the draft capital rules designed to prepare the GSEs for that exit.

Calabria, though a professed libertarian, was a Trump appointee. Though Calabria has said he wants to remain in the role, he might not be given a choice.

Upon his departure, an acting director would be appointed who would enjoy all the powers of a permanent director. Then the process of nominating a permanent director would begin, which culminates in Senate hearings. Thus the acting director could be in the position for a long time.

The importance of the Supreme Court’s decision, and the appointment of a new director, can hardly be overstated. The power the director wields over the government housing market is very significant and housing finance plays a leading role in the US economy. As Don Layton, who was ceo of Freddie Mac between 2012 and 2019, points out in a recent paper for Harvard University’s Joint Center for Housing Studies, inadequate regulation of housing finance institutions was a major cause of the  two biggest financial crises in modern times.

So the stakes are high. And one imagines that executives at Fannie Mae, who have eschewed the CRT market for over a year, will be waiting for the Supreme Court’s decision with bated breath.

“We’re hearing that this could be announced next week. If Calabria stays, then not much will change. If they get rid of him, what next?” asks a source.

Simon Boughey

Capital Relief Trades

Landmark SRTs finalised

Cash collateralised insurer deals debut

Credit Risk Transfer Solutions (CRTS) has executed three synthetic securitisations that have broken new ground in the market. Indeed, the firm has structured the first cash collateralised capital relief trades that involve insurer counterparties.

According to Andy Garston, director at CRTS: ‘’Most SRT deals require cash investors, which is problematic for insurers. But we now have a structure in place to allow them to bridge the gap.’’

Thomas Oehl, director at CRTS, notes: ‘’The beauty of our transactions is that rather than having a theoretical solution, we now have a practical mechanism to allow insurers to cover the credit risk for SRT CLNs. The first deal acted as a proof of concept in this respect and the two deals that have followed served to streamline and refine the process.’’

CRTS is an FCA authorised and regulated insurance broker, with a focus on structuring and arranging credit risk transfer - both primary and secondary participations - from banks to insurers, particularly in the context of significant risk transfer transactions. The firm had already gained experience in the primary market by tackling two challenges for insurer participation in the sector; namely, the nature of the contracts and ratings (SCI 16 April 2020).

The broker’s deals are generally mezzanine trades and involve an investment platform managed by CRTS that acquires and holds the related CLN. Insurers then cover the risk on the CLN but without having to deposit cash. In principle, insurers can deposit cash, but this is not something that is necessary or required.

Garston concludes: ‘’The insurer’s main risk is a shortfall in the redemption value of the CLN, reflecting a deterioration in the portfolio. This is largely the same as when writing direct cover, but there are some second order risks - such as the failure to receive the coupon - along with the explicit credit risk of the bank and the SPV. However, these second order risks should not prevent a transaction from going ahead, provided the underlying portfolio risk is acceptable.”

Stelios Papadopoulos

Capital Relief Trades

End of the line?

SRT issuers mull dropping synthetic excess spread

The requirement to fully capitalise synthetic excess spread is expected to result in SRT issuers dropping the feature from their transactions. This CRT Premium Content article weighs the relative benefits of synthetic securitisations versus those of full-stack cash deals, in which originators can use excess spread.

The EBA and the European Commission’s decision last year to fully capitalise synthetic excess spread will likely force banks to drop the feature from significant risk transfer transactions going forward (SCI 24 December 2020). While the new rules do not pose a threat to new issuance - especially when most banks do not use the structural feature - they will render capital relief trades less efficient and this is particularly true for existing deals. Nevertheless, the relative benefits of synthetic securitisations still outweigh those of full-stack cash deals, in which originators can use more excess spread.  

The new treatment of excess spread was first laid out in the EBA’s final report on significant risk transfer in November 2020. The report builds on the 2017 discussion paper and the lessons learned since then; most notably, the divergent regulatory practices in connection with SRT, which was particularly pertinent in the case of the treatment of excess spread.

Some supervisors believed that on day one of a transaction, banks should quantify excess spread and sell a portfolio below or above par. However, others thought that lenders should sell the portfolio at par, with any remaining income flowing back to the originator over time.

The key issue from the EBA’s perspective was ensuring that excess spread is not too high for the purposes of meeting the commensurate risk transfer tests. SRT tests are typically divided into two sets of tests. The first, dubbed the mechanistic tests, require banks to demonstrate that they have transferred 80% of the first loss tranche and at least 50% of the mezzanine tranche.

The commensurate risk transfer tests form the second set and are used to gauge whether the capital relief is proportional to the transferred risk. The issue is not that puzzling in the case of full-stack transactions, since banks achieve market pricing by selling the whole stack and therefore prevent any situation where excess spread could be artificially inflated to support the junior tranches.

However, what happens if an originator retains the senior tranche - as in the case of a synthetic securitisation - and how banks ensure that the coupon is correct in that situation was unclear. If it is too low, it implies that excess spread is being used to support the mezzanine and junior tranches. Banks therefore need to prove that the coupon is market priced and proving that is where the EBA’s SRT report offers a helping hand.

The final report does this by treating synthetic excess spread as a retained first loss tranche that is risk weighted at 1250% - which effectively amounts to a full capital charge, plus deduction, and captures lifetime expected losses. The resulting commensurate risk transfer tests then incorporate synthetic excess spread, since - if banks want to pass them - they should account for the nominal value of the first loss tranche and the retained synthetic excess spread position.

The European Commission incorporated the EBA’s proposals in its ‘quick fix’ regulation (SCI 31 July 2020), which was passed into law in December 2020 (SCI 24 December 2020).

The new rules are not expected to pose a threat to new issuance, but could reduce the efficiency of transactions. According to an arranger: ‘’If the EBA clarifies that future excess spread should only be deducted from capital if it’s higher than expected losses, then that’s something that can work, but excess spread isn’t the most important feature in a transaction. If the proposed regulation is not amended, there will still be issuers that opt for a synthetic trade, but with a thicker junior tranche and slightly higher cost of capital.’’

He continues: ‘’If I had to choose between true sale and synthetic, I would still opt for synthetics, given the costs of setting up an SPV; you just do the deal without the excess spread and build in a thicker junior tranche. However, a thicker junior tranche means that the economics will deteriorate, especially for existing deals with synthetic excess spread. Here, grandfathering would be essential, since you must account for both future excess spread and a thicker tranche - but that is unlikely to happen.’’

Another concern is the commensurate risk transfer tests. A structurer states: ‘’The new tests stipulate more conservative backloaded scenarios that would stop many deals from passing them. In fact, one of the tests requires severe backloaded scenarios that would kill pro-rata amortisation deals, even if they have triggers to sequential.”

The structurer adds: “The new scenarios effectively amount to sink hole insurance for a mortgage. Addressing this would require either relaxing the rules on the high cost of credit protection or softening the ones on pro-rata amortisation.’’

Indeed, the new rules will reduce capital relief and raise the cost of protection, since banks will now free up much less capital for the same coupon payments. EIF transactions are especially vulnerable, given how often the fund uses synthetic excess spread in its trades. 

Pablo Gonzalez Sanchez, structured finance manager at the EIF, explains: ‘’Unlike private investors, the EIF has a predefined risk appetite, depending on the mandates to be implemented. It is for that reason that we often need a minimum attachment point and/or excess spread to be able to guarantee a synthetic securitisation tranche. We do not have the freedom private investors have to attach at any point in the capital stack - including 0% attachment - and charge a fee according to it.’’

He continues: ‘’In other words, we cannot compensate risk-taking with pricing and therefore we often - but not always - need a little more protection on our tranches, so we need subordination and therefore excess spread. The current treatment is to limit excess spread to one-year expected loss in use-it-or-lose-it format, but the new rules will frontload excess spread to the point where it’s equal to lifetime expected losses and then capitalise it. This effectively double-counts reserves, both provisions and unexpected losses, so it’s going to be a sea change from today where you only provision annually.’’

If the SRT rules are not clarified and excess spread is eventually frontloaded and fully capitalised, many potential standardised bank deals are likely to be left out of the market and a gap in supranational SME funding could materialise. Still, if the transactions end up being in line with the cost of capital, then it is business as usual. Yet transactions without excess spread will reduce the flexibility of the protection.

The EIF will continue to grow its securitisation footprint under the new European Guarantee Fund (EGF). The latter is designed to support viable EU businesses that under normal circumstances would have been able to acquire a loan but are now going through challenging times due to the economic downturn.   

Sanchez confirms: “We are discussing with the relevant stakeholders the allocation of certain funds from the EGF to the EIB Group’s securitisation business, potentially allowing for guarantees on first loss pieces or mezzanine tranches with a much lower attachment, in exchange for a much higher commitment from the beneficiaries – banks – to deploy new lending to SMEs in the EU. The final decision on this facility is expected within the next couple of months.’’

The new rules offer a relative advantage to full-stack true sale deals, where excess spread can be used more freely and now also permit partially placed true sale securitisations that could offer more flexibility to originators that want to retain their senior tranches via cash structures. Another arranger says that the EBA would allow banks to retain the senior tranche, although the agency’s final SRT report does not clarify how to practically achieve market pricing.

The market may have to wait for the first deals and the reaction of NCAs to glean a clearer picture. Still, the same structurer is confident that granular and vanilla deals will pass the SRT tests.

He states: ‘’The potential use of partial placement is significant because some banks would rather fund their portfolios through other means and particularly TLTROs, since usually there’s not enough true sale origination to recycle cash. Partial placement will be of great use in this respect.’’

However, most lenders contacted by SCI have disputed the potential of partially placed transactions. One reason is that the ECB now just simply will not accept them, due to its preference for full-stack true sale structures.

This then leaves a window open for full-stack deals. But besides the attendant complexities of setting up an SPV and losing borrower relationships, non-granular asset classes that are typically referenced in synthetics - such as SME and corporate loans - don’t generate enough excess spread in the cash format. Yet the scenario is quite different for consumer and auto loans.

‘’We will likely see more full-stack true sale transactions for high-yielding consumer loans, where excess spread can be high, and with structures that allow banks to use more of it as a buffer against future losses. However, excess spread is limited in the case of SMEs and corporates,” says Sanchez. 

Perhaps more saliently, originators can continue to adhere to the synthetic format but just adjust their portfolios. Robert Bradbury, head of structuring and advisory at StormHarbour, explains: ‘’If you want to mitigate the more challenging provisions of the new SRT tests, including the excess spread rules, one way is to start from a high-quality portfolio for which excess spread is of limited use or not required when investors underwrite and determine the pricing.’’

He adds: ‘’On the other hand, if this approach is not applicable, in the absence of excess spread for some pools, issuers are likely to pay more to hedge the same tranches, or alternatively may add retained first loss tranches. However, the retained piece will make the transaction significantly less efficient, all else equal.’’

The industry will have to wait until the publication of the RTS for more clarity. The nature and extent of the negative impact remains to be seen, as although it is expected that there will be a tranche that represents excess spread and will be risk weighted as a securitisation exposure, the calculation of that amount remains a mystery. The RTS is due to be published in the second half of this year.

Stelios Papadopoulos

Regulation

True lending truth

Senate vote to reject True Lender will not affect loan securitizations

Denounced as a brake upon consumer lending, the recent Senate vote to strike down the so-called ‘True Lender Rule’ is a storm in a teacup, say lawyers.

The rule had only become effective in December 2020 and had been the subject of state attorney general (AG) challenges from the outset, they point out. Moreover, the great bulk of loans that found their way into the secondary markets did not incorporate features that would have aroused challenge even before the True Lender ruing.

So the impact upon the securitized markets will be scarcely felt.

“A lot of people have been wringing their hands over this, but I’m not certain it will have much impact. Most secondary market participants have been careful to buy receivables that have been generated in such a fashion as would be unlikely to generate a challenge,” says Scott Cammarn, a partner and co-chair of the financial services group at Cadwalader, Wickersham & Taft.

Under the terms of the Congressional Review Act (CRA), on May 11 the Senate voted 52-47 (with three Republicans crossing the floor to vote with Democrats) to “disapprove” - meaning to rescind - the OCC’s October 2020 True Lender ruling. It now passes to the House of Representatives, in which it should also find a majority, and then to the President for sign off into law.

The True Lender rule attempted to give legal surety to loans originated by partnerships between national banks and non-bank lenders. In the last 20 years there has been a blossoming of such unions between fintechs, which sourced the loans, and national banks, which provided the capital.

State AGs, however, often viewed the model as unattractive as they skirted state licensing laws and sometimes charged usurious rates, while civil actions had been lodged claiming the lending agreements were unenforceable as the non-bank lenders were operating without a licence. The OCC True Lender ruling was designed to put an end to these disputes by ensuring the loans generated by the model were enforceable.

Those who liked the ruling - mainly though not exclusively on the right - said it was good for the economy and consumers as it opened up a new avenue of lending. Those who disliked the ruling - mainly though not exclusively on the left - said it was an abuse of state laws and exposed consumers to the exploitative practices of payday lenders and the like.

However, legal challenge before the True Lender rule could be circumvented by the insertion of arbitration clauses and by charging an APR lower than 36 per cent. The great preponderance of loans that found their way into the secondary markets did this already.

The Supreme Court has upheld the validity of arbitration clauses, and successful civil actions are very unlikely if disputes have gone through arbitration first. And although nothing is written in stone, state AGs have displayed unwillingness to intervene in defence of state law unless non-bank loans charge in excess of 36 per cent.

“So, for securitization vehicles that have brought loans of this type, which is the vast majority in 2019-2020 before the True Lender rule, there is no tangible difference as they already have protection in arb clauses and APRs below 36 per cent,” says Cammarn.

Jeff Taft, a partner at Mayer Brown, tends to agree. “The rule only became effective in December, and national banks weren’t relying on it. A law suit was filed almost immediately by several states. This takes us back to step one,” says Taft.

The real significance of the likely rejection of the True Lender ruling and the resetting of the clock to the status quo ante is the implication it holds for future treatment by Congress of pre-emption. The latter refers to the concept whereby federal laws supersede state laws. Pre-emption is held by many across party lines to be a good thing as it allows capital to flow freely across all 50 states without hindrance and thus fosters a stronger national economy.

However, the repeal of the True Lender rule once again asserts the primacy of state laws and can be perceived as a rejection of pre-emption. This perception will be thrown under the spotlight when the next Comptroller of the Currency is appointed. At the moment, Michael Hsu is acting Comptroller, but before long the Biden administration will submit a new name for Congressional approval and his or her views on pre-emption will be scrutinized.

“The potentially more significant issue is whether the CRA vote is a precursor to the nomination of a new Comptroller who shifts the OCC away from its decades long support for pre-emption,” says Andrew Olmem, another partner at Mayer Brown.

Simon Boughey

Structured Finance

SCI Start the Week - 24 May

A review of securitisation activity over the past seven days

Last week's stories
Gaining momentum
European solar ABS issuance tipped to emerge
Revving up
Strong demand continues for CRE CLOs
SRT boost
Barclays expands Colonnade platform

Other deal-related news

• OneMain has become the first US securitisation issuer to offer a SOFR-linked floating-rate tranche (SCI 17 May).
• US CMBS loan refinancings are likely to remain under pressure over the next 18 months, given continued business interruption at many properties, uneven reopening of the country, depressed in-place cashflows and secular shifts caused by the coronavirus pandemic (SCI 17 May).
• Angel Oak last week priced the first US non-agency RMBS that qualifies as a social bond - the US$231m non-QM RMBS Angel Oak Mortgage Trust 2021-2 (SCI 17 May).
• Auto finance provider 247 Money has completed its first private securitisation, which will help support the firm's strong origination pipeline (SCI 17 May).
• The Joint Committee of the European Supervisory Authorities has published an analysis of the implementation and functioning of the EU Securitisation Regulation, including recommendations on how to address initial inconsistencies and challenges, which may affect the overall efficiency of the current securitisation regime (SCI 17 May).
• The European Commission and the EIB Group have increased their cooperation to implement a new EU Sustainable Blue Economy policy (SCI 18 May).
• A new KBRA report shows that US CMBS appraisals were on average 30.2% lower than valuations available at the time of securitisation, based on 1,078 commercial real estate valuations from 1 April 2020 through March 2021 (SCI 18 May).
• S&P is requesting comments on its proposed methodology articulating the principles it applies to incorporate ESG credit factors into credit ratings analysis (SCI 18 May).
• A number of wholesale data centre securitisations issued in recent years carry elevated leverage that is inconsistent with the single-A rating category, Fitch suggests (SCI 19 May).
• The UK FCA has published a consultation on its proposed policy framework for exercising two of its new powers under the Benchmarks Regulation, which will be introduced by the Financial Services Act 2021 (SCI 21 May).
• KBRA reports that the Libor benchmark in two of its rated US CRE CLOs, AREIT 2020-CRE4 and BXMT 2020-FL3, has been replaced by SOFR (SCI 21 May).

Company and people moves

• Black Knight has acquired eMBS, which provides agency MBS performance data and analytics (SCI 17 May).
• Guy Carpenter has appointed Luca Tres as head of strategic risk and capital life solutions, EMEA, effective from 1 June (SCI 17 May).
• Peak Reinsurance has hired Sascha Bruns as director, head of global retrocession (SCI 17 May).
• RBC Capital Markets has hired Alex Hu as head of CLO structuring, based in New York (SCI 17 May).
• CIFC Asset Management has launched the CLO Initiative for Change, a philanthropic programme in connection with CLOs issued by the firm, dedicated to supporting organisations driving social, economic or environmental change (SCI 19 May).
• Blackstar Capital has appointed James Paul as head of sport, responsible for leading the firm's expansion into the sporting portfolio segment (SCI 19 May).
• The Investment Management Corporation of Ontario has closed a US$500m commitment with a new strategic partner, Ares Management Corporation (SCI 20 May).
• Conister Finance & Leasing has hired Marcus Gregory as its new executive director (SCI 20 May).
• Volta Finance has appointed Dagmar Kent Kershaw as an independent non-executive director, with effect from 30 June (SCI 20 May).
• Marcel Grandi has joined Twelve Capital's Zurich office as senior advisor, ILS, responsible for supporting the investment team with the sourcing of ILS transactions (SCI 21 May).
• W R Berkely has appointed Vincent Myers vp - alternative capital (SCI 21 May).

Data

Recent research to download
TCBI Deal Profile - May 2021
The Collins Amendment - March 2021
2021 Outlook - March 2021
CLO Case Study - Spring 2021

Upcoming events
SCI's 1st Annual CLO Special Opportunities Seminar
29 June 2021, Virtual Event
SCI's 3rd Annual NPL Securitisation Seminar
September 2021, Virtual Event
SCI's 7th Capital Relief Trades Seminar
13 October 2021, In Person Event

Structured Finance

Climate risks disclosed

EBA publishes landmark banking study

The EBA has published the first EU-wide pilot exercise on climate risk for the banking sector. The exercise shows that over half of banks’ exposures are allocated to sectors that might be sensitive to climate transition risk. However, the study qualifies that limited data availability and reliability can affect results in terms of comparability.  

The revised CRR/CRD package gives the EBA the mandate to develop appropriate qualitative and quantitative criteria, including stress testing processes and scenario analyses, to be applied by financial institutions to assess the impact of ESG risks under scenarios with different severities. As part of this process, the EBA has released the findings of the 2020 pilot exercise, designed to explore data and methodological challenges to categorise exposures, based on selected climate risk factors.

The exercise was run on a sample of 29 volunteer banks, which provided raw data on non-SME corporate exposures to EU countries and focused on the identification and quantification of exposures subject to climate transition risk. The scope of the exercise is narrowed to EU corporate exposures and considers only non-SME counterparties, for which climate-related information is more available than for SMEs.

According to the findings of the exercise, 58% of total non-SME corporate exposures to EU obligors are allocated to sectors that might be sensitive to transition risk. The latter mainly consist of manufacturing, electricity, gas, steam and air conditioning supply, construction, transportation and storage and real estate activities.

A parallel analysis, based on greenhouse gas emissions, reveals that 35% of the total non-SME corporate exposures submitted in the exercise are to EU obligors with GHG emissions above the median of the distribution. Regarding the green classification, banks are currently in different development phases for assessing the greenness of exposures. The exercise involves estimations using two techniques and the report shows the differences in outcomes.

More saliently, in terms of the quantification of the expected credit risk losses due to adverse climate risk scenarios on bank balance sheets, the framework employed in this exercise shows that there is dispersion across banks in terms of impact. The results are mainly driven by the impact on exposures to electricity and real estate. Non-SME corporate exposures to high carbon-intensive sectors, like mining and agriculture, represent less than 5% of the total exposures analysed in this exercise. As such, their contribution to the aggregate results is marginal.

Nevertheless, the report is clear on the caveats. The evaluation of climate-related risks requires a different and broader set of information with respect to standard risk assessment tools.

Consequently, limited data availability and reliability can affect results in terms of comparability. Progress in disclosing GHG emissions and transition strategies by companies or more granular client information collected by banks will help to bridge this gap and contribute to running more accurate and consistent estimates.

Indeed, the results should be interpreted with caution and only considered as a starting point for future work on climate risk. The focus of the report is to analyse different classification methods for mapping banks’ corporate non-SME exposures and identify advantages and limitations in terms of data and methodologies.

Stelios Papadopoulos

Structured Finance

Moving forward

Positive consumer sentiment emerging post-pandemic

As the European securitisation market moves beyond the coronavirus crisis, an overall positive picture appears to be emerging. However, the withdrawal of governmental support measures remains a risk for many jurisdictions in the region.  

“As we came out of the financial crisis in 2009, lending was picking up, both net and gross levels. The pandemic hit and there was a large drop in mortgage lending, largely due to the infrastructure linked to making offers and visiting homes. Since then, it has spiked up quite dramatically,” observes Gordon Kerr, svp, head of EU research, global structured finance at DBRS Morningstar.

House prices remain positive, supported by favourable lending rates and unemployment levels. Mortgage lending remains strong in countries, such as the UK and Belgium. Indeed, there has been high growth in most jurisdictions, but Ireland, Italy and Spain appear to be the exceptions.

Kerr says: “They are all quite positive numbers, with the exception of a few. As we look to go forward, it does not look like there is a risk of that collapsing, but it should slow.”

Certainly, consumer reactions have initially been strong and the loss of confidence has not been as severe as during the financial crisis. Nevertheless, Germany’s position has turned negative this time around.

Kerr observes: “In the sovereign crisis between 2010 and 2012, German consumers remained positive, but it did migrate into a negative position during this pandemic and has not fully recovered to where people felt in 2019.”

He claims that the reason for the positive outlook is due to the spike in youth unemployment levels recovering and the statistics remaining below historical highs. “They are beneath 2017 levels for a number of countries – for example, the UK in particular, was at record lows prior to the pandemic. The unemployment is coming from the youth and particular sectors, such as travel and tourism.”

Meanwhile, bankruptcies are another concern for Spain. They are up across all sectors, but particularly in the service-orientated sectors. “This is where we are concerned that things could spike up and we could see a rise in bankruptcies and delinquencies in lending,” Kerr notes.

Overall, he believes that the outlook remains positive as the market starts to emerge from the pandemic, albeit the risks related to the withdrawal of support measures remain unclear. 

Angela Sharda

CLOs

Focal point

Arb rather than NAV in focus

European CLO equity performance has held strong despite the unprecedented Covid shock and significant shifts in loan market pricing in the last 12 months, supporting the view that a diversified portfolio of CLO equity can deliver strong and consistent returns through the credit cycle and attract new investors. To build on that, CLO managers now need to shift their focus, according to a recent report from Nomura’s European ABS strategy team.

Freddie Robinson, ABS strategist at Nomura, says: “The pandemic caused a significant shock in asset prices, but deal NAVs have since recovered to pre-Covid levels and equity distributions have remained stable. In general, CLO performance has been steady.”

However, the report notes that over the longer-term equity distributions have been declining thanks to a rising average liability cost and a lower WA asset coupon. Average liability costs have been rising steadily since mid-2018, averaging around 167bp over 2019 but rising to around 175bp on average since then, although a few bp of management fees on average have been cut as well.

Robinson adds: “The market is now moving back to pre-Covid dynamics. The CLO arbitrage after management fees is around 160bp, but the focus now will be on how managers maintain a good arbitrage while avoiding defaults.”

Indeed, the report argues that biggest issue for equity investors going forward should now centre on the achievable equity arbitrage in primary, rather than NAV performance. Those managers that have outperformed through the crisis are also likely to benefit from continued interest in their equity and achieve strong debt spreads in primary, so manager tiering should remain a dominant trend in the near term and strongly impact the arbitrage.

Robinson concludes: “A lot of focus has to be on how manager’s deal with the arbitrage – as asset spread compression will likely lead some managers to rotate into weaker credits.”

Angela Sharda

Capital Relief Trades

Actuarial approach

Alphidem co-founder Ken Sutter outlines how the quantitative modelling of capital relief trades can help investors assess the risks of their investments

In light of the current regulatory and interest rate environment, it could be assumed that capital relief trades enjoy great popularity, even outside of the dedicated investor community. However, despite growth and positive market trends, the asset class still leads a niche existence and sticks to its esoteric label. This is even more astonishing considering that many alternative credit managers struggle to address increased volume requirements for their target sector, while the desired exposure sits on bank balance sheets waiting to be tapped.

This circumstance can partly be explained by the structural complexity and the actuarial nature of the CRT asset class. Therefore, the subsequent sections of this article shall briefly discuss the quantitative modelling of a generic CRT, thereby alluding to some of the basic elements relevant for due diligence.

It should be noted that this essay does not aim for an academic discussion on individual modelling approaches and their peculiarities or limitations. Rather, it is about showing what insights such modelling yields in practice and to what extent it can help investors to better assess the risks.

Setting the scene
We start by defining a generic transaction structure, as illustrated in Figure 1. While detachment point D of the tranche sold is linked to the estimated unexpected loss of the reference portfolio, the specific shape of the portfolio loss distribution remains vague. Apart from that, the even greater uncertainty for investors arises from the securitisation structure and its terms regarding amortisation, replenishment, call options and so forth.

Furthermore, there is also a time component involved. So, the key question is, to what extent all these elements affect the noteholder’s performance and risks, and how can they be represented? For the sake of simplicity, we use the note’s estimated IRR and loss distribution and its associated metrics as a measure to assess the above.

Our generic portfolio consists of 1000 corporate loans, with each reference entity having the same weight of 0.1%. We sample the probability of default (PD) and loss given default (LGD) of each loan from two normal distributions, namely:

What is still missing is an assumption regarding the correlation structure of the portfolio. Correlation is notoriously hard to estimate, yet the Bank for International Settlements (BIS) proposed some references as part of its advanced internal ratings-based approach (A-IRB).

Under this approach, the mutual correlation ρ between two loans depends on the type of exposure (corporate, mortgages, retail etc) and the PD of the loans. For two corporate loans with same PD, it is given by:

We will use the above approach to derive our portfolio’s correlation structure.

What still needs to be defined are some terms of the securitisation; most notably: the attachment (A) and detachment (D) point of the tranche sold, the coupon paid (CP), the amortisation type (sequential, pro-rata or hybrid), replenishment conditions and call options. While many of the above terms are subject to negotiations, there are those that are largely specified by the regulator.

Accordingly, we will first define detachment point D=8%, which we approximate based on BIS’ SEC-IRBA securitisation framework. Furthermore, we opt for a static portfolio without replenishment and sequential tranche amortisation. That is not to say that other structures cannot be modelled; rather, it is about keeping this generic example as elementary as possible.

With this in mind, we also choose our maturity structure to be nine years non-call three (9YNC3), knowing that there is a high chance the transaction will be called soon after the non-call period. Furthermore, we assume a bullet repayment of the reference loans.

What remains to be specified is the coupon paid and attachment point of the tranche; probably the most discussed terms in practice. This is also the reason why we include these two parameters in our sensitivity analysis later, although we would otherwise just focus on parameters that exhibit uncertainty by nature (e.g. PD and LGD). By default, we set A=0% and CP=10% p.a.

The following section will briefly illustrate the modelling results based on the above assumptions before we conduct some sensitivity analysis. Generally, it should be noted that we do not cover any issuer side related topics, such as the efficiency of the risk transfer. Furthermore, we assume that all the above data will be made available to investors as part of their due diligence process and subjected to careful examination.

Modelling results
As previously mentioned, we will consider the estimated probabilistic IRR and loss distribution of the notes to assess the transaction outlined. Figure 3 depicts the two corresponding distributions, together with their summary statistics.

A transaction tenor t=3 years has been chosen, assuming the issuer calls the structure soon after the non-call period. Due diligence wise, this is a rather conservative assumption.

We know the risk profile would likely improve for longer durations, as the amortising loans raise the detachment point of the tranche, as depicted in Figure 4. This duration thematic will be discussed more extensively in the specific sensitivity analysis section.

The metrics marked with a percentage prefix (e.g. 95% IRR) in Figures 3 and 5 represent the limit of the respective confidence interval and should therefore contribute to a better assessment of the downside risk. Figure 5 depicts the estimated cumulative tranche loss over time.

The slopes of the two lines are equal to the annual losses already reported in Figure 3, which is straightforward to verify. The linear behaviour itself is what we would expect for the portfolio, given its granularity and correlation structure.

It should be mentioned that the shape of the IRR and loss distribution shown in Figure 3 can be different in the general case. It is predominantly driven by the underlying portfolio’s granularity and correlation structure, as discussed in more detail in the respective sensitivity analysis section. Consequently, the shape of the distributions should also be considered when comparing different scenarios or transactions with one another.

In the case of the subsequent sensitivity analysis, comparisons are permissible because the range of the parameters that are examined is relatively narrow. However, the subject is pointed out where necessary.

Sensitivity analysis
Because in practice our transaction is based on different assumptions and we cannot be entirely certain of PDs, LGDs, correlations and so forth, we aim to better understand the impact of such uncertainties on our risk profile. For this reason, we will briefly summarise and comment on the results of various sensitivity tests in the following sections.

PD and LGD
To check our transaction’s sensitivity regarding PD and LGD estimates, the mean of our portfolio’s PD and LGD distribution shall be varied, as illustrated in the right column of Figure 6. Since we are applying five different mean values for PD and three for LGD, we have 15 different combinations to model. It turns out that we can reduce PD and LGD to the expected loss (EL), given by: EL=PD*LGD.

This simplifies the illustration of the results, which are presented on the left side of Figure 6. We take the expected IRR and 95% IRR as an example to show the impact of different PD and LGD distributions, expressed in terms of their expected loss.

We notice that the 95% IRR is quite sensitive to changes of PD and LGD. A credit investor focused on downside risk protection would therefore put special focus on the PD and LGD estimates provided.

Correlation
Since in practice the correlation structure is particularly difficult to estimate, we pay special attention to the sensitivity of our portfolio towards it. To properly understand our results, we first examine the influence of different values of mutual correlation on the shape of a generic portfolio loss function, as depicted in Figure 7. Although the loss distribution functions shown are subject to simplified assumptions, the qualitative conclusions we draw are generally valid, including that the variance of the portfolio loss distribution increases with higher correlation.

In the two extreme cases when ρ≈0% and ρ≈100%, we therefore find the probability density to be concentrated around PD or the two poles. This behaviour explains our portfolio’s modelling results shown in Figure 8.

We first note that the 95% IRR decreases for higher values of mutual correlation, which is caused by the loss distribution’s variance increase. At one point, however, the 95% IRR improves again and climbs to even higher values than before.

We can explain this trend reversal by studying the extreme case when ρ≈100%; in other words, investors lose either all their investment or nothing on a single transaction. Statistically speaking, this means that the expected loss of the portfolio is distributed over a few individual cases which suffer a total portfolio loss.

This has a statistically positive effect on our first loss investor’s 95% IRR, as their loss is limited by the detachment point of the tranche - meaning the residual loss occurs higher in the credit hierarchy; something that is very rarely the case for lower values of mutual correlation. On the other hand, the resulting binary risk profile and thus increased total loss probability are, of course, undesirable from a risk management perspective.

Finally, it should be noted that there is an opposite interaction between correlation and granularity. An uncorrelated portfolio with low granularity also tends to have a binary risk profile. Conversely, portfolios with low granularity are also less sensitive to changes in correlation.

Transaction tenor
As we do not know the specific tenor of our transaction at inception, it makes sense to check our risk profile’s sensitivity against this parameter as well. We already mentioned that the risk profile is expected to improve for longer tenors, as the sequential amortisation raises the detachment point of our tranche over time (see Figure 4).

Figure 9 quantifies this assumption, expressed in terms of 95% IRR and 95% tranche loss. To get a better intuition about the strength of the deleveraging effect over time, one may consider Figure 10. Even though we expect the issuer to call the transaction shortly after the non-call period, it is also helpful to understand the potential influence of the non-call period and our portfolio’s loan tenors on our risk profile.

Attachment point and coupon
Even if there is no uncertainty about the attachment (A) point and coupon (CP), we still want to briefly explain the influence of these two variables on our risk profile. On the one hand, due to their substantial influence. On the other hand, because tough negotiations often precede their determination. A sensitivity analysis can therefore help to set the right priorities.

At this point, it should be noted again that this analysis only relates to the investor’s risk profile; the issuer side is not examined e.g. in relation to the capital relief efficiency. Even if the interests of the two parties largely contradict each other in this case, the fact that - depending on the investor’s risk preferences and the regulatory handling on the part of the issuer - some optimisation potential may exist should not be ruled out.

As we want to examine variations in two dimensions, we use contour plots to visualise the change of our risk metrics. Figures 11 and 12 show the results for the expected IRR and 95% IRR.

We are certainly not surprised that extreme values can be found at both poles; yet more interesting is the fact that the course of change varies for different metrics. The above analysis can be helpful for the due diligence and negotiation process, and it may even enable investors to set specific negotiation targets to compensate for other uncertainties resulting from the sensitivity analysis.

Conclusion
The aim of this short essay was to show how the quantitative modelling of capital relief transactions can help investors to assess the risks of their investments. We also explained how to deal with uncertainties regarding various risk parameters and how the downside risk can be estimated.

Even if this article only provides a rough overview and results may vary for different transactions, it is hoped that credit investors outside the core community will find pleasure in the statistical nature of the asset class and thus enrich the entire market. The prospect of gaining access to the multitude of assets sitting on bank balance sheets across the globe should be an incentive.

About the author:

Ken Sutter is co-founder of Alphidem AG, a Swiss-based company specialised in financial engineering. Alphidem develops modelling software products and advises various investors on capital relief trades. Contact details: ks@alphidem.com.

Structured Finance

CLO conflicts of interest eyed

Sector developments and company hires

CLO conflicts of interest eyed
IOSCO has issued four questionnaires for industry participants on conduct risks in leveraged loans (LLs) and CLOs targeting bank lenders, CLO investors, CLO managers and LL sponsors. Through its Committee 3 on Regulation of Market Intermediaries and its Committee 5 on Investment Management, IOSCO is conducting work to understand the potential conflicts of interest and misaligned incentives among participants in the LL and CLO markets across the chain of intermediation, from credit origination to the sale to investors. 

The purpose of the questionnaires is to support IOSCO’s project by furthering its understanding of the LL and CLO markets. In particular, the questionnaires seek to determine where potential conflicts of interest and conduct issues may exist and how they are managed by the respective market participants. IOSCO will consider the questionnaire responses when formulating any report regarding LLs and CLOs.

The submission deadline for responses is 30 June 2021.

North America
Jason Merrill has joined Everest Re as senior portfolio manager, structured credit investing, after a three-month stint as vp, structured securities at Kuvare Insurance Services (SCI 8 February). Before that, he was an investment specialist responsible for trading and analysis of ABS, CLOs and non-agency RMBS at Penn Mutual Asset Management, which he joined in March 2013.

Rob Russell has been appointed head of Greystone Special Servicing. As president of this group, he will focus on its continued growth and will further integrate special servicing with Greystone’s existing primary servicing division, led by Sharon Briskman. With a tenure of almost a decade at Greystone, Russell has been overseeing the production and operations of the firm’s CMBS lending platform and has spearheaded the launch of a number of specialised debt products, including Greystone’s CMBS mezzanine platform.

Loomis Sayles has promoted Stephen LaPlante and Jennifer Thomas to portfolio manager for two securitised strategies managed by the mortgage and structured finance (MSF) team. In their new roles, the pair will manage the Loomis Sayles Investment Grade Securitized Credit strategy with Alessandro Pagani, head of the MSF team, and join Pagani and Stephen L’Heureux in co-managing the Loomis Sayles High Yield Securitized Credit strategy. Both LaPlante and Thomas will retain their senior analyst roles and responsibilities until suitable replacements are identified.

Thomas joined Loomis Sayles in 2007 and has 19 years of investment experience. She specialises in ABS, with a focus on consumer ABS.

LaPlante joined Loomis Sayles in 2017 as a mortgage and structured finance analyst and has 11 years of investment industry experience. He specialises in RMBS and covered bonds.

Under the leadership of Pagani, the MSF team helps oversee US$31.1bn in securitised investments across the firm in both dedicated mandates and as part of broader investment strategies (as of 31 March 2021).

Structured credit fund closed
Alcentra has announced the final close of the Alcentra Structured Credit Opportunities Fund IV at US$484m. The fund’s objective is to generate attractive absolute and risk-adjusted returns through opportunistic investing in structured credit debt and equity securities in the US and Europe. The fund’s investors include leading sovereign wealth, public and corporate pension funds, not-for-profits and insurance firms from Asia, Europe and the US.

Led by Cathy Bevan and Hiram Hamilton, Alcentra’s structured credit platform consists of eight specialists located in London and New York, including md Brandon Chao, who acts as co-portfolio manager on Alcentra Structured Credit Funds. This latest fundraising brings assets under management for Alcentra’s structured credit platform to over US$8bn across a combination of open and closed end funds and separately managed accounts, and firm AUM to US$42.4bn, as of 31 March 2021.

Structured Finance

CLO manager ESG policies polled

Sector developments and company hires

CLO manager ESG policies polled
A recent survey conducted by Fitch shows that 84% of the 117 CLO managers it polled have a stated ESG policy, while 60% are part of an organisation that is a signatory to the United Nations Principles for Responsible Investment (UNPRI). Managers reported generally sparse ESG information for leveraged loan issuers, but some responses highlighted steps that individual CLO platforms and industries are taking to improve the information gap. Many CLO managers believe that their credit analysts are in the best position to assess ESG impact within their coverage, with larger institutional firms with substantial resources being more likely to have specialised teams to facilitate consistency of their ESG approach throughout the various business units.

Global
Mayer Brown has elected structured finance practitioner Jon Van Gorp as chair, effective 1 June. He will take over from Paul Theiss, who has served in this role since 2012.

Van Gorp is a partner in Mayer Brown’s New York and Chicago offices and has held several leadership positions at the firm, including a seat on its management committee since 2017. He previously co-led the firm’s banking and finance, capital markets and structured finance practices.

Mayer Brown has also elected partners Sally Davies (managing partner in the firm’s London office), Raj De (managing partner in the Washington, DC office) and Jason Elder (registered foreign consultant, New York) as new members of its eight-person management committee.

Italian moratorium extension ‘credit positive’
The Italian government last week enacted a new decree that extends until December 2021 a debt-payment moratorium to include the self-employed, artisans and professionals whose income losses exceeded 33% in 2020 versus 2019. Additionally, the new decree extends an existing debt moratorium on SMEs to December 2021 from June, limiting the moratorium to the principal component only.

Moody’s notes in its latest Credit Outlook publication that the extension is credit positive for Italian RMBS, ABS and SME transactions because it will support debtors for a longer period, allowing more time for financial conditions to improve for Italian consumers and SMEs affected by the coronavirus pandemic. According to the Bank of Italy, the self-employed and artisans represented around 40% of all requests for mortgage relief up to August 2020. A significant portion of Italy's debt payment moratorium granted in March 2020 is still outstanding, with €121bn of loans to Italian SMEs still in debt moratorium as of 7 May, according to the Taskforce of the Ministry of Economy.

Italian leasing association Assilea reported that, as of February 2021, 63% of the initially granted moratoriums had not yet resumed payments. Loans and leases in debt moratorium in ABS SME transactions Moody’s rates account for around 45% of total portfolios, although in some portfolios the percentage decreased substantially in 1Q21.

Meanwhile, the new measures are improving access to credit for first-time buyers under 36 years old, who will be exempt from paying transfer, mortgage and financing taxes subject to certain conditions. The decree also introduces a government guarantee of 80% for mortgages with an LTV higher than 80%, which will be available also to temporary workers. This is positive for house prices and improves affordability for a segment of the Italian population more affected by coronavirus-related job losses, Moody’s notes.

North America
T. Michael Johnson has been appointed head of investor relations for Carlyle Global Credit, based in New York. He was previously partner, head of business development at Pretium, and has also worked at Paulson & Co and Citi Alternative Investments.

Freddie Mac has announced a couple of senior appointments. Michael DeVito has been named ceo, effective 1 June. At that time, interim ceo Mark Grier will resume his duties as a full-time member of Freddie Mac’s board.

DeVito brings more than 30 years of experience in the mortgage and financial services industry to Freddie Mac. He spent over 23 years at Wells Fargo, rising to the level of evp, head of home lending, where he was responsible for all aspects of the company’s mortgage and home equity business. He retired from Wells Fargo in 2020.

Additionally, Freddie Mac has appointed Jason Griest vp of multifamily securitisation, responsible for leading the structuring team that includes managing the multifamily loan pipeline and multifamily credit risk transfer executions. Griest has more than 20 years of experience in the financial services industry with and has been with Freddie Mac Multifamily since 2013. Previously, he held capital markets and securitisation roles with Fannie Mae, Bank of America and JPMorgan.

Risa Itoshima has joined HPS Investment Partners as vp. She was previously vp - CLO structuring at Morgan Stanley in New York, having joined the firm in June 2014.

Alternative reinsurance platform Vesttoo has appointed Robert Schumaker vp of capital markets, based in New York. Schumaker will lead Vesttoo's insurance-linked programme, which offers asset managers and pension schemes the opportunity to earn long-term, sustainable alpha by pledging securities to support short- and mid-term life and P&C alternative risk transfer transactions. He was previously md and head of business development, alternative financing solutions at State Street Bank and has also worked at Credit Suisse in the prime brokerage sales and trading team.

Structured Finance

ETL waiver requested following cyberattack

Sector developments and company hires

ETL waiver requested following cyberattack
European truck lease provider Fraikin SAS was subject to a ransomware attack that started on 11 May. S&P notes that the credit quality of its two securitisations - FCT Eurotruck Lease II and FCT Eurotruck Lease III (ETL II and III) - is unlikely to be affected, providing the company can make a swift return to normal operations.

To contain the threat presented by the cyberattack, Fraikin took some of its systems and applications offline. It also had to activate its business continuity plan in France, where it is based and which represents about 60% of its revenue, in order to continue to operate without the support of its main business management software in its French agencies.

The company believes that the attack has not resulted in any data breach or losses. In particular, the last backup of its data and systems was performed on 9 May and is uncorrupted. S&P understands that Fraikin’s UK and Spanish subsidiaries were not affected and continue to operate as usual.

Fraikin anticipates a return to normal business operations within four weeks. However, it does not expect to be able to compute the borrowing base for the upcoming 15 June payment date, as required under the transaction documents for ETL II and III.

As such, it has requested noteholder consent to freeze the computation of the borrowing base and to grant a waiver for any resulting facility event of default. Given that there is a cure period of three business days, it must receive the waiver by 3 June to avoid a facility event of default and thus avoid early amortisation of the transactions.

The company expects the processes related to the securitisations will be back to normal by the beginning of June and therefore expects to be able to determine the relevant borrowing base for the July interest payment date. If it gains noteholder consent and the borrowing base is frozen, it would only need to pay the interest and fees due and payable on 15 June on the two transactions' facilities and notes.

In other news…

Covid cost of risk compared
The cost of risk (CoR) of EU banks rose from 0.45% in December 2019 to 0.82% in June 2020, while the CoR of US banks jumped from 0.54% to 2.16% in the same period, according to EBA figures. The authority has published a thematic note comparing provisioning practices in the US and the EU during the peak of the Covid-19 pandemic.

Based on data from the past 13 years, following an economic shock, loan loss provisions of EU banks tend to be less volatile than those of US banks. In a similar vein, in the first two quarters of 2020, the CoR of US banks was much higher compared to that of EU banks. However, in 2H20, the CoR of US banks fell more rapidly compared to their EU peers.

The impact of the pandemic on macroeconomic variables helps explain some of the differences in CoR. The US suffered a higher increase in unemployment in the early stages of the pandemic that might contribute to the sharper rise in CoR, compared to EU banks. Similarly, a faster economic recovery in the US might explain the faster fall in 2H20.

A preliminary analysis also reveals a riskier loan portfolio composition of US banks. The share of the portfolios potentially more affected by social distancing and containment measures, such as commercial real estate or consumer credit, over total loans granted is higher in the US. This could be a further explanation for the higher CoR at the onset of the pandemic.

Different accounting rules can also lead to differences in CoR. Under CECL, banks recognise lifetime ECL for all financial assets, whereas under IFRS 9 the 12-month ECL is recognised for Stage 1 loans. At the onset of a crisis, the IFRS 9 impairment model presumably resulted in a rise in CoR because of loan migrations from Stage 1 to Stages 2 or 3, for which lifetime ECL were recognised. However, this effect seems to be less material than the impact of applying the CECL approach to all financial assets.

Malt Hill tender offer underway
UK Mortgages (UKML) has completed the sale of the second portfolio of loans originated by the Coventry Building Society that had been securitised in the Malt Hill No. 2 RMBS. The proceeds (net of expenses and future commitments) will be distributed through a tender offer and the subsequent repurchase of ordinary shares by the company.

Having carried out a full review of its liquid resources, future cash requirements, commitments and costs, UKML has concluded that the tender offer will comprise a capital return of £20m. Under the offer, up to 13% (or 26,666,666) of the ordinary shares will be repurchased at a price of 75p per share, which represents a 7% discount to the net asset value per ordinary share of the company.

The tender offer opens today (28 May) and closes on 21 June, with the results announced on 22 June.

RFC issued on synthetic STS reporting templates
ESMA has published a consultation paper (CP) on draft regulatory technical standards (RTS) implementing the amended Securitisation Regulation (SECR), in connection with the requirement that STS securitisations must be reported using standardised templates for STS notification published on ESMA’s website. The CP sets out ESMA’s proposed draft RTS and implementing technical standards (ITS), specifying the content and the format of the standardised templates for STS notification of on-balance sheet (synthetic) securitisations.

It builds on the existing technical standards for STS notification of traditional securitisations, while taking into account specific features of synthetic securitisations. The CP also includes targeted technical amendments to the STS notification templates for traditional securitisations.

ESMA has published interim synthetic STS templates that may be used on a voluntary basis until the RTS becomes applicable. The consultation is open for feedback until 20 August and the draft RTS and ITS will be submitted to the European Commission for endorsement by 10 October.