Contents

Structured Finance

Transitioning to green

Call for EU GBS to be extended to securitisation

In a new report examining how to foster transparency and credibility across the EU sustainable securitisation market, the EBA suggests that it would be “premature” to establish a dedicated framework for ‘green’ securitisation. Instead, the authority believes that the forthcoming EU Green Bond Standard (GBS) regulation should also apply to securitisation, providing some adjustments are made to the standard.

“The objective is to make the EU GBS workable and efficient for securitisations. As such, our recommendations don’t require a dedicated framework for securitisation, but should fit in with the existing framework,” says Mira Lamriben, policy expert at the EBA.

The key focus of the report is on how to apply the use of proceeds for securitisations in alignment with the proposed GBS, according to Lars Overby, head of risk-based metrics at the EBA. “The focus of the report has therefore been how to enable the market to facilitate the transition to a green economy, which is the key objective behind the Commission proposal. In addition, the information gathered indicates a lack of green assets to securitise. If the use-of-proceeds approach is not allowed at the originator level, the development of a market for green securitisations would very likely be constrained,” he explains.

He continues: “For now, we want to avoid the fragmentation of a having a separate regime for securitisation and other debt securities. For us, it is therefore an interim solution and in the longer term, once there are sufficient green assets to securitise, it might be revisited. How long the transition will take to a greener economy is, however, clearly uncertain.”

In its report, entitled ‘Developing a framework for sustainable securitisation’, the EBA notes that the application of sustainability requirements in securitisation “appears to require further clarification”. In particular, it points out that the EU taxonomy does not apply directly to securitisation transactions, while financial instruments issued within securitisation transactions are not ‘financial products’ as defined in the Sustainable Finance Disclosure Regulation (SFDR). Moreover, the implementation of sustainability in securitisation needs to consider several parameters, including multiple securitisation parties alongside various types of underlying assets and structures.

As such, the report focuses on three areas for which regulatory guidance was deemed relevant at this stage, considering that the overarching EU regulations on sustainable finance are still being developed and that the EU sustainable securitisation market remains at an early stage of development. These areas comprise: the application of the EU GBS to securitisation; the relevance, policy implications and possible design of a dedicated framework for sustainable securitisation products; and the nature and content of sustainability-related disclosures for securitisation products. The report also includes policy recommendations addressed to the European Commission in each of these areas.

The main challenges affecting the development of the EU sustainable securitisation market are identified as: a lack of available sustainable assets; the absence of a definition, standards and data to foster transparency and credibility in the market; and the limited attractiveness of securitisation products in general. The report argues that to ensure clarity in the application of the EU GBS and to ensure a level playing field across all types of green bond instruments, the EU GBS also needs to apply to securitisation. However, the application of the EU GBS requirements at the issuer/SSPE level, as envisaged in the proposed EU GBS regulation, would present several issues - including that it will not prohibit the originator from using the proceeds of the securitisation bond to generate non-green assets.

Consequently, the EBA recommends shifting the EU GBS requirements from the SSPE to the originator, so that the EU GBS requirements can be imposed on entities with broader economic substance. This would allow a securitisation that is not backed by a portfolio of green assets to meet the EU GBS requirements, provided that the originator commits to using all the proceeds from the green bond to generate new green assets.

Additional EU GBS disclosure requirements would, however, be necessary to ensure that investors are made aware of the green characteristics of the underlying securitised assets and to limit the risk of ‘adverse selection’ of green assets. Overby says there are two aims in this regard – to ensure that investors know what they’re buying and to enable the EBA to gauge how the sustainable securitisation market is developing.

Lamriben adds that such disclosures are already applicable in the area of sustainability. “Originators of sustainable securitisations will be required to disclose the green credentials of the underlying assets, as well as the green asset ratio of their balance sheets. The aim is to avoid the risk of adverse asset selection, since investors will know the greenness of the assets compared to the greenness of the originator’s balance sheet,” she explains.

In terms of sustainability-related disclosures and due diligence requirements for securitisation products, improved availability of more standardised data on the principal adverse impact (PAI) of securitisation investments on ESG factors is cited as being key to supporting the transition of the EU securitisation market towards sustainability. The Securitisation Regulation should therefore be amended to extend voluntary PAI disclosures to non-STS securitisations, while mandatory PAI disclosures should be considered in the medium term, once the EU sustainable securitisation market has further matured.

The report concludes that establishing a dedicated sustainable securitisation framework may become increasingly relevant once the EU economy has further transitioned, more green assets are available and the use-of-proceeds approach prevailing in the EU GBS becomes less relevant. To complement the EBA advice to the European Commission, the report also provides a list of high-level safeguards to be considered, should it decide to put forward a legislative proposal for the creation of a green securitisation framework, in spite of the EBA’s recommendation.

Finally, regarding green synthetic securitisation and social securitisation, the EBA suggests that more time is needed to assess whether and how the specificities of each instrument should be reflected in a green framework. The authority therefore proposes that it is mandated to monitor the development of the EU green synthetic securitisation market and, if appropriate, further investigate the relevance and potential content of a framework for green synthetic securitisation. Additionally, it proposes to assess whether and how a social framework could be established, once the EU social securitisation market has further matured and after an EU social bond standard has been developed.

The report was developed in accordance with Article 45a(1) of the Securitisation Regulation. In conjunction with the review of the Securitisation Regulation and based on the outcome of the report, the European Commission will submit a report to the European Parliament and the Council on the creation of a sustainable securitisation framework, together with a legislative proposal, if deemed appropriate.

“As we show in the report, the EU sustainable securitisation market remains in its early phases of development, so we’ve taken a relatively cautious approach and we want to allow the market to develop. In terms of next steps, this is now up to the co-legislators, including setting appropriate monitoring periods,” Overby concludes.

Corinne Smith

For more on the use-of-proceeds approach and sustainable securitisation, join SCI at our inaugural ESG Securitisation Seminar on 16 March.

CLOs

Talking control

CLO control equity examined

CLO equity is back in vogue and is attracting attention for all the right reasons. As this Premium Content article suggests, for suitably prepared investors, taking a majority position can increase the benefits still further.

After years of uninformed press coverage setting up CLO equity as the catalyst for the next financial crisis, the bottom of the stack is now back in favour. Not least with most bank structured finance research desks, where it was pretty much everyone’s top tip for 2022.

For those who understand the sector, that is no surprise, and there is an argument for increasing investment in deals for which due diligence has already been undertaken. Undoubtedly a control equity stake offers many advantages, but taking such a leadership role is not for everyone.

“CLO equity performance in 2021 was very good historically, any way you look at it,” says Daniel Wohlberg, director at Eagle Point Credit Management. “A strong rebound in loan prices from COVID-related volatility and a fair difference between loan spreads and CLO debt spreads invites many investors into the asset class from the sidelines today.”

While Wohlberg is pleased to see growing interest in CLO equity investments, he stresses the need for caution before moving in full force. “People forget the immense diligence challenges and friction costs that come along with managing large blocks of CLO equity,” he says.

“For example, CLO collateral managers tend to pitch you on their default performance without mentioning par loss or market their cash-on-cash equity returns instead of internal rate of return. Equally, a misunderstanding of rating agency drags or arranging dealer specialities in navigating issuance or refinancing optionality adds many pitfalls for the uninitiated,” says Wohlberg.

“To really get the full benefit of control equity, you need to have the right resources in place,” says Miguel Ramos Fuentenebro, co-founder of Fair Oaks Capital. “It involves negotiating the structure, so you have to have structurers on board; in-depth analysis of the portfolios, so you need to have a team of analysts familiar with the loans; a thorough review of the legal documentation; and more. So, all of that really points to a more specialist manager.”

For its own part, Fair Oaks Capital has been a strong proponent of control equity since the firm launched in 2014. While the firm’s investor presentations have obviously evolved since then, the pages on control equity and its benefits throughout the investment process remain largely unchanged.

“You get some benefits from day one,” explains Ramos Fuentenebro. “The simplest of which is the impact on the economics of the transaction. If you can commit to underwriting an equity piece, that is clearly seen by the manager and the arranger as a significant reduction of risk and potentially time to market. Consequently, you can have a sensible conversation about the right level of management and arranger fees.”

He continues: “Even more importantly than the fees, control equity gives you a say in both a deal’s structure and its portfolio. In structural terms, it is understandable that a manager may favour the longest reinvestment period to potentially maximise their own economics. While that makes perfect sense for them, from an investor’s perspective that's not always necessarily the case.”

As a control equity investor, Fair Oaks has executed plenty of transactions that are standard and meet the manager’s typical goals. However, the role has also enabled it to bring to market opportunistic transactions, including the first « print and sprint » transaction in Europe, or, at times when the funding for a short maturity and shorter reinvestment period CLO made such deals make sense.

“Ultimately, there is very significant value in being able to design the right structure on day one while retaining control to take advantage of future refi or reset opportunities and this is often not recognised.” says Ramos Fuentenebro. “Having a control stake gives you a key say in the decision-making process. Equally, once you get to a point that you want to reset or refi, you can assess the optimal options for the equity. Being in control, you can have a regular dialogue with the manager and implement decisions efficiently and quickly, without the need to find consensus from a collection of minority investors.”

The control equity investor’s involvement in a deal’s portfolio is equally important. CLO managers often find it difficult to meet the requirements of multiple minority equity holders.   Some investors, for example, may want high distributions, so are looking for a high portfolio spread; whereas others could be seeking a more conservative transaction.

Ramos Fuentenebro observes: “A necessary condition to become a control equity investor and to underwrite a transaction is a clear understanding with the manager in terms of what the strategy for the transaction should be. This removes uncertainty and gives the manager the opportunity to discuss future trade-offs. Properly executed Investments by control equity investors should be a win-win situation for both manager and investor.”

However, control equity’s pre-eminent position can raise eyebrows. “Occasionally, we have had investors ask if this is a slightly confrontational approach and whether we are trying to second guess the manager,” says Ramos Fuentenebro. “The reality is that we are not. Obviously, we do the due diligence on the manager and only invest with them if we like their approach and confirm they possess the right team, infrastructure and track-record, but even once they are approved, it is key for the investor and valuable for the manager to have a second pair of eyes on the transaction.”

He cites the example of a loan that trades down from par to 95, giving the manager a quandary of how to proceed. “The manager might consider selling it but may hesitate assuming equity investors may not want to see an early par loss,” Ramos Fuentenebro says. “Having a dialogue with the control equity investor is helpful because we can confirm our preference and be the first to say, for instance, sell it – we get it, everybody makes mistakes and we'd rather you sell it at 95 than wait for it to go down further. I think that communication with the manager is very, very useful.”

So, from initial manager selection all the way down to individual loan management, Ramos Fuentenebro is convinced of the benefits of a control equity holding. “When you look at the kind of target return versus that for a minority equity, you see the benefit of lower fees, the benefit of a potentially more efficient structure, the benefit of getting full control of resets, refis and so on. It’s not trivial; it's actually a very meaningful improvement in terms of the return,” he says.

“There's nothing ambiguous or speculative about that; that’s a fact,” Ramos Fuentenebro concludes. “Beyond that, by working with the manager, you may also reduce potential defaults and credit losses and so may still enhance the value more throughout a deal’s life, but the benefits from day one are just very clear to us.”

Capital Relief Trades

Capital trouble

The final ECRF rule fails to remove impediments, say market experts

The FHFA’s failure to incorporate more far-reaching changes to the final Enterprise Regulatory Capital Framework (ERCF) rule, published on February 28, has excited considerable disappointment among some in the credit risk transfer market.

While the final rule of the new capital framework, which was initially unveiled in the summer of 2021, is much better than its predecessor, it still contains flaws and incorporates what many see as unduly punitive capital requirements.

The final rule replaces the prudential floor of a 10% risk weighting applied to any CRT exposure with a 5% risk weighting. It also replaces the fixed leverage buffer equal to 1.5% of an enterprise’s adjusted total assets with a dynamic leverage buffer equal to 50% of an enterprise’s stability capital buffer.

These digressions from the stipulations of the Mark Calabria era are welcomed, but they don’t go far enough to release the GSEs from burdensome and unnecessary requirements, say sources. In particular, the risk weighting floor appears to many a disincentive to execute CRT deals. The reduction to a 5% floor lessens the problem, but it does not take it away.

“The reduction of the floor to 5% is helpful, but 5% still isn’t justified. It’s a pretty hefty tax on something that is essentially risk free. It’s like putting a 5% tax on Treasuries,” comments a risk transfer market source.

Others made the point that for the 5% floor to become necessary, the world would have to go into meltdown as it did in 2008/2009, and at this point the government is sure to intervene anyway.

In addition, say market watchers, the influence of the floor becomes more pronounced over the life of the asset. “It detaches capital credit from actual risk and over time the capital requirement becomes more and more determined by the floor. It’s a small component at the beginning, but in four or five years it becomes the dominant component and is not indexed to risk,” says one.

The new broom evident at the FHFA with the assumption of the directorship by Sandra Thompson had led many to believe that it would listen in the future to expert advice - in contrast to the previous regime of Mark Calabria - so the failure to make these changes is doubly disappointing.

“While the FHFA made constructive changes to the prior version, we note that despite the 89 comments submitted, the final rule was unchanged from the draft,” says Jeffrey Krohn, segment leader for mortgages and structured credit at Guy Carpenter.

There were many comments about the risk weight floor. They ranged from requests for greater transparency about how the number of 5% was arrived at, to suggestions about making the floor sensitive to risk reduction achieved by CRT to calls to have the floor removed completely.

In a typical comment, Frank Nutter, president of the Reinsurance Association of America, said in a letter dated November 21, “The proposed tranche risk weight floor of a flat 5% on the risk weight assigned to retained CRT exposures is an improvement over the current ERCF, but it still distorts incentives over time..”

Hu Benton, senior vice president and policy counsel for the American Bankers Association, also said on November 23, “It is unclear how the proposed 5% prudential floor on the risk weight for a retained CRT has been calibrated. It is merely half as much as the previous 10% floor.”

Some respondents also called for greater incentive to purchase catastrophic risk insurance by the GSEs. In essence, the risk weighting floor is in place because the regulator is uncertain about the overall capital requirement so feels a back-up is necessary, affirm sources.

“They’re saying ‘in case we’re wrong about the capital requirement we’re going to cut your credit for reinsurance. A better way would be to encourage them to buy more. The uncertainty is treated as non-transferable but I think it is transferable and should be treated that way,” says one of them.

Recently inflated housing prices have increased capital requirements for the GSEs through the countercyclical adjustment mechanism, creating an incentive to transfer risk. But as house values settle the countercyclical mechanism will have less impact and the encouragement to transfer risk will dissipate.

However, catastrophic risk insurance would operate if the market goes into reverse and values collapse.

“At the moment, the GSEs have to buy more protection when home prices go up. But they’re not incentivised to do if the world goes to hell,” comments another source.

Sources speculate that the rule changes were simply designed to get Fannie Mae back into the market, and if that was indeed the main purpose then they have succeeded. Fannie Mae signalled its intention to return to the CRT market within days of the announcement of the new rules.

“Maybe we were naïve to expect bigger changes. The change in tone at the FHFA encouraged us” comments a CRT source.

The FHFA says that the new rules underline its commitment to the CRT market and create incentives to execute risk sharing transactions.

“The final rule revises the risk-based capital treatment for retained CRT exposures by replacing the 10% prudential risk weight floor on these exposures with a 5 percent risk weight floor. This addresses concerns that the current floor unduly decreases the capital relief afforded to CRT and reduces the Enterprises’ incentives to engage in CRT,” it told SCI.

It added: “FHFA views the transfer of risk of unexpected credit losses to a broad set of global investors as an important tool to reduce taxpayer exposure to the risks posed by the Enterprises and to mitigate systemic risk to the housing finance market caused by the size and monoline nature of the Enterprises’ businesses.”

Based on adjusted total assets on September 30 2021, the FHFA calculates that Fannie Mae should hold $196bn of total capital and Freddie Mac $123bn. The Fannie figure derives from 2.7% total adjusted risk based capital (RBC) and a leverage buffer of 1.8%, while for Freddie there is total adjusted RBC of 2.2% and a leverage buffer of 1.4%.

A nugget of comfort to those disappointed by the failure to introduce bigger changes to the final rule is furnished by the apparent willingness of the FHFA to make continued refinements to the rule, should it feel they are justified.

“The FHFA did indicate that certain of the documented issues were complex and required further consideration over time, perhaps leaving the door open to additional rulemakings,” says Jeff Krohn.

Fannie Mae and Freddie Mac declined to comment for this article, but responded at length to the new ruling during the comment period.

Simon Boughey

Structured Finance

SCI Start the Week - 28 February

A review of SCI's latest content

Last week's news and analysis
Agency avoidance
Originators set to turn to private market as fees rise
Borrower beware
Cost of living crisis to have 'unequal impact' on UK RMBS
Compare and contrast
US auto CLN issuance examined
Drifting wider
European ABS/MBS market update
Trigger timing
Pro-rata rating volatility warning

For all of last week’s stories including ‘Market moves’ and ‘Risk transfer round-up’ click here.

SCI CLO Markets
CLO Markets is SCI’s new service providing deal-focused information on the global primary and secondary CLO markets. It offers intra-day updates and searchable deal databases alongside BWIC pricing and commentary. Please email Jamie Harper at SCI for more information or to set up a free trial here.

Recent Premium research to download
Stablecoin and securitisation - February 2022
Appropriate regulation of digital payment could pave the way for the issuance of securitisations in stablecoins. However, this Premium Content article argues that further standardisation across the blockchain ecosystem is needed for the technology to reach a critical mass.

US auto CLNs - February 2022
Santander’s recent auto CRT echoed those previously issued by JPMorgan Chase. This Premium Content article examines the similarities and differences between the transactions.

Irish & UK Banking Evolution - October 2021
Consolidation among lenders and the proliferation of fintechs is driving change in the Irish and UK banking sectors. This Premium Content article investigates the impact on the jurisdictions’ RMBS markets.

Defining 'Risk-sharing' - October 2021
Most practitioners agree that ‘risk-sharing transactions’ is the most appropriate moniker for capital relief trades, but there remains some divergence around the term. This CRT Premium Content article explores what it means for investors and issuers alike.

SCI Events calendar: 2022
SCI’s 1st Annual ESG Securitisation Seminar
16 March 2022, London

SCI’s 6th Annual Risk Transfer & Synthetics Seminar
27 April 2022, New York

SCI’s 3rd Annual Middle Market CLO Seminar
June 2022, New York

SCI’s 4th Annual NPL Securitisation Seminar
September 2022, Milan

SCI’s 8th Annual Capital Relief Trades Seminar
October 2022, London

Capital Relief Trades

Risk transfer round up-28 February

CRT sector developments and deal news

Bank of Montreal is rumoured to be readying a synthetic securitisation that is backed by Canadian commercial real estate loans. The bank’s first such transaction was finalized in June last year (SCI capital relief trades database).

Stelios Papadopoulos  

Capital Relief Trades

War time blues

International turmoil adds to CRT distress

If January was bad for the GSE CRT market, February was a lot worse.

To add to the seemingly deep-seated problems of the US economy, a full-blown war between Russia and the Ukraine broke out in the waning days of the month.

The CRTx Aggregate, flagship index of market-leading consultancy and data provider Mark Fontanilla and Co, lost 100bp in the month. This was the worst return since February 2016, with the single exception of the first month of Covid 19.

Losses were seen across the board, apart from seasoned lower mezzanine non-REMICS such as old M2s and M3s. These notes were boosted early in the month by Freddie Mac’s latest $1.7bn tender offer, which also settled before the most damaging declines of the month.

CRT spreads were also pushed wider by record monthly issuance of $3.2bn, and net new supply was $571m. The most recent STACR 2022 DNA2 was the biggest ever seen in the GSE CRT market.

An additional worry is what the Fed will do next. After the inflation readings in December and January, the market began pricing in five hikes in interest rates. However, the war in the Ukraine, surging energy prices and tumbling stocks throw this strategy into doubt.

In light of the turmoil, Fannie Mae is reported have delayed sale of the next planned CAS deal, and this morning it has been reported that non-QM deals have put on hold. New issue pricing had pushed wider in the last few weeks even before the war in the Ukraine, and are likely to be ever wider now.

On February 9, Fannie Mae closed CAS 2022-R02, with new issue spreads of SOFR plus 120bp, 300bp, 450bp and 765bp for the M1, M2, B1 and B2 tranches respectively. This compares to plus 75bp, plus 155bp, plus 310bp and plus 600bp for equivalent tranches when it closed CAS 2021-R01 on October 27 2021.

It also appears that the GSEs are making increasing use of the reinsurance market rather than the capital markets. In the last few months, the ACIS and CIRT programmes have accounted for around 43% of losses covered through CRT rather than the more traditional 25%, say sources.

JP Morgan, in a report on CRT and RMBS at the end of last week, suggested that Fannie and Freddie are still likely to exercise the call options in CAS and STACR deals despite the recent collapse in prices and spread widening. The bank concludes that “that these deals will likely be called even if spreads remain elevated, as the capital rule provides little benefit to transferring risk on de-levered loans.” Even modest home price improvement quickly de-levers the underlying loans and thus makes call exercise more likely.

The report also revisited the analysis of how far spreads would have to widen before CRT deals become non-ROE accretive. Three weeks ago, it suggested that despite recent spread widening, CRT levels would have to back up by up to 600bp for the mechanism to be no longer ROE accretive. In the most recent report, it added in a tax rate of 20% and Fannie Mae’s capital buffer of 1.8% and ran the numbers again - producing the conclusion that spreads would have to widen by between 115bp and 120bp across the whole capital stack for the structure to be no longer ROE accretive.

This is still a sizeable move, but considerably less so than the original analysis.

Simon Boughey

Capital Relief Trades

Ramp up continues

BMO completes leveraged loan SRT

Bank of Montreal (BMO) has finalized the third synthetic securitisation from the Sauble programme. The significant risk transfer trade references a portfolio of US leveraged loans. The programme was launched last year and further expands the lender’s SRT issuance (SCI 12 July 2021).   

The transaction features a 20% tranche thickness and was priced in the mid-teens in line with the previous two deals from the programme. Following the construction of the initial portfolio BMO will add to the pool as new loans are originated over a two-year period, but subject to investor approval. The latest Sauble deal shares risk via a first loss tranche. 

One innovative feature of the Sauble programme is the ability to extend the revolving period and maturity date on an annual basis. After the end of the revolving period, the portfolio will amortise on a pro-rata basis, but with triggers to sequential amortisation.

Sauble was initiated last year along with the Boreal programme which is backed by Canadian commercial real estate loans (SCI 15 June 2021).   

Stelios Papadopoulos 

CLOs

Which probability is the probability of default?

Jack Xu, founder of Modtris Financial Modelling, outlines two ways of conceptualising probability of default and the challenges associated with both

Probability has been used to define, measure and price risks in the financial market for a long time. For CLO managers and investors in particular, default risk is firmly equated to the probability of default. The meaning of probability may be self-evident from the example of counting faces and tails in coin tosses, but is the probability of a company’s default just as trivial and straightforward? This article reviews two ways of conceptualising probability in the case of default – one attributes the probability to a large group of companies, and the other attributes the probability to a single company without reference to a group.

Probability and repeatable observations
Probability is always associated with a method of repetition because it is observable only when a sufficiently large number of trials are repeated. “The probability that a coin is tossed to face is one half” means that, if we toss a coin sufficiently many times, the percentage of getting a face becomes very close to half of the total tosses made. Of course, the repetition works only if the coin returns to the same initial state after each toss.

Conceptually, if the coin is such that it self-destructs whenever it is tossed to face, then the repetition becomes undoable with a single coin. But we can get around this problem if there are a large number of coins of the exact same kind. The probability of tossing a face can then be observed by tossing many coins at once and counting the coins that implode into smoke.

Probability of default of a group of companies
A company can be considered to be like the combustible coin. If a company defaults, it is gone and cannot be again used to observe another default. So, the probability of default of a company is normally associated with a large group of companies, which - for the purpose of observing default probability - are considered all identical.

However, unlike coins, companies are intrinsically individualistic. Hence a company must first be de-individualised, based on various contraptions of rules, before it is assigned to a group.

Within each group, one can observe the percentage of default over any chosen time period and apply that to any similar group of companies. This is normally how CLO managers view default probability within a portfolio of credits.

There are a few challenges with this approach that must be addressed by portfolio managers.

1. Group size. The group used to observe a default percentage normally contains a much larger number of companies than an actual portfolio does. It is essential then to observe how strongly the default percentage of subgroups in similar size as the portfolio deviates from that of the entire group.
2. Time-dependence. The default percentage observed within each group should ideally be time-independent or follow a predictable time series. If neither is true, portfolio managers have to contend with how much the percentages of default observed in the past will hold in the future.
3. Interconnectedness. Portfolio managers need to compare how interconnected the companies are in the groupings and in the actual portfolio. This may come up as “default correlation”, but I refrain from using the term here before discussing the concept in a follow-up article.

These challenges rise when a company is de-individualised into a group. The grouping is a method of approximation which transforms a large portfolio of company obligors into a much fewer number of groups. The simplification makes it numerically feasible to quantify default risk, but the drawback is that it may miss out the details essential to the default risk - both of individual companies and, in aggregate, of the entire portfolio.

It is worth imagining if the risk of a portfolio can be derived truly from the ‘first principles’ – by aggregating the default risk of each individual company.  This requires first a meaning to the default probability of an individual company, without any reference to a group.

As discussed, probability requires repetitive observations, but default is not an event that a single company can repeat. However, if a good understanding of the causes of a company’s default can be achieved, it is possible to link a company’s default dynamically to other events of the company that do repeat over time.

Probability of default of a single company
For the sake of argument, let’s assume that company XYZ’s default is determined completely by and only by its sales performance; specifically, the ratio of sales to new inventory which is observed quarterly. Suppose that the future path (or paths) of the sales ratios that will lead XYZ to default has been determined exactly.

Since the event of sale is repeated quarterly, the probability of a given value of sales ratio can be defined from the distribution of the observed values. Consequently, the probability of any given future path that the sales ratio follows can also be defined. Finally, the probability of default of XYZ is the probability of that path (or those paths) leading to default.

Default probability defined this way does not rely on assigning XYZ to any group; rather, it depends only on repeatable conditions of XYZ itself. Additionally, default risk defined this way depends not on just one quarterly result, but on specific trails of the quarterly result - meaning that not only the levels of performance, but also the specific timing of them impacts the default outcome.

It is helpful to put the idea into perspective with two other long-standing approaches – fundamental credit analysis and structural models. For fundamental credit analysts, using a company’s individual financial data to assess its default risk is what they do. The difference is that the fundamental analysis does not link causally the outcome of default to a process or a path leading to the default, so that both the risk and the timing of default can be quantified and aggregated across a portfolio.

Tying the default probability of a single company to a process is not a new idea either. Structural models - which began with Merton’s work in 1974 - define the default of a company as the occurrence that a company’s total asset value, in mark-to-market terms, falls below the company’s debt level which is assumed to be fixed.

In this way, the default probability of a single company is tied to the probability that the total asset value would follow a path that crosses the fixed debt level at some point in the future. The problem is that for non-financial companies, total asset value is seldomly ever marked to market, let alone repetitively, and is not at all the reason a company defaults.

This leads us to the challenge in the ‘first-principles’ approach of modelling the default probability of a single company. To make an analogy to animation software, the structural models animate the human motions but do so by simplifying the human figure into a ball shape, while the fundamental credit analysis draws the full anatomy of a human body but cannot animate how the different body parts move together. The challenge is how to combine the two approaches and realistically model the dynamics of a company’s multi-dimensional financial state.

Summary
There are two ways of defining the probability of the non-repeatable event of default of a company – grouping many companies together, or causally linking default to other repeatable events. The first approach simplifies the complexity of a large credit portfolio and allows quantitative risk assessment.

However, it faces the challenges highlighted in this article. As the economy changes more and more rapidly and companies become more and more inter-connected, these challenges can become serious problems for making truly forward-looking forecasts.

The second approach attempts to understand the causes of default of a company from its intrinsic financial conditions and aggregate the risk of a portfolio from ground up. It is still a work-in-progress, as the fundamental credit analysis has not been widely incorporated into dynamic models.

In my view, the failure is in part due to the collective abhorrence of the quantitative community towards understanding financial accounting. However, major progress is being made.

Before diving into the details, I will discuss in a follow-up article another concept that is as important as it is confusing – correlation.

Structured Finance

Team building

Brian Roelke, president and cio of Kuvare Insurance Services, answers SCI's questions

Q: What were the motivations behind the launch of Kuvare Insurance Services’ new third-party asset management business (SCI 8 February)?
A: Unlike a lot of entrants into this space, Kuvare Insurance Services (KIS) started as an insurance-focused asset manager, as all of our activities today are focused on our affiliated insurance balance sheets. The announcement of the new platform signifies that, for the first time, we are open to investing on behalf of unaffiliated balance sheets - providing access to our differentiated pipeline of private credit investments for those like-minded investors. The reason we think this is attractive for our platform is that by increasing our all-in check-size, through bringing in unaffiliated capital, we’ll open our potential pipeline of investments even further - thus creating additional value for all of our clients. 

Q: What makes now the right time to establish the new platform?
A: We focus on four niche, specialised areas in private credit: private corporates, private ABS, structured credit and commercial mortgages. Over the last 15 years, private credit has become an area of increased focus for insurance companies and other investors. Largely, as a result of the persistent low interest rate environment, insurance company balance sheets are allocating to illiquid investment categories, including the four niche private credit areas where we focus.

We believe that private credit continues to be an attractive investment area for our insurance balance sheets and would be for our unaffiliated clients as well because, even in a rising interest rate environment, the yield premium that’s available could remain attractive. More importantly, the downside protection available in private credit structures adds meaningful value over the long term, in the form of either hard security or maintenance financial covenants, or both.

Q: Which opportunities are you seeking to capitalise on with the new business?
A: We are seeking to expand our origination capabilities in those four areas, as we believe that there will continue to be attractive investment opportunities for the short and medium term. As we have seen traditional bank and finance channels move away from providing capital directly to these sectors, insurance companies and other speciality private credit investors have stepped in to fill those gaps.

We think many of the factors that have influenced those changes will be persistent - it is difficult to see a lot of those reversing themselves anytime soon. As a result, we think there will be a permanent role for speciality private credit investors in the global financial markets.

Q: How do you intend to differentiate the platform from those of your peers?
A: First, we invest on behalf of our affiliated balance sheets and, in all of the transactions that we execute, the expectation would be that - subject to guidelines and our allocation policies - unaffiliated clients would be investing directly alongside us. That’s a clear differentiating factor in today’s marketplace.

Second, we have a highly experienced team of individuals, who bring to the table decades of experience in analysing these specific transactions – which is very important, as we are entering into these investments with the expectation that these are buy-and-hold investments. Our bottom-up approach to underwriting that takes place on the front end relies heavily on the experience level of the teams originating those investments.

Just as important are the networks that each of the members of our team brings to the table. Those networks enable us to drive differentiated originations in these asset classes.

Our team also brings to the table decades of insurance industry experience, which is an important input in the underwriting process.

Q: Do you anticipate any challenges for the new business in the immediate future? If so, how do you intend to overcome them?
A: The biggest challenge relates to the human capital side of our business. However you phrase it - the great renegotiation, or the war on talent - our business relies heavily on the experience level of our team and the specific individuals who we’ve brought together here at Kuvare.

A large part of my job will continue to be attracting and retaining high-calibre talent on our platform. In our recent announcement, we announced that Ana Morales has joined us from Goldman Sachs, Thomas Pasuit from MetLife and Joseph Orofino from Further Global, enhancing the talent we already have in place.

One of the most attractive aspects of working at Kuvare is that our team is directly aligned with the long-term success of our business. Our team members are also aligned with each other, and we have a highly collaborative workplace environment.

We believe that the alignment of interests provides for not only a differentiating factor in the marketplace, but also represents an attractive aspect of working here. I’ve had more than one of our investment professionals at Kuvare tell me this is their favourite job they’ve ever had – and it’s my goal to make sure that every one of our team members feels that way. I challenge myself to continue to find ways to make that true.

Q: What are your hopes for the future of the business?
A: We have historically been, first and foremost, stewards of our affiliated balance sheet capital. For us, success is continuing to find strong risk-adjusted returns for our portfolios in the process, as our origination capabilities have begun to expand beyond our internal demand.

So, by bringing in unaffiliated investors and providing them with the opportunity to invest alongside our affiliated balance sheet, we hope to drive a more stable platform for continued success in insurance asset management. Our long-term success will be determined by how successful we are in not only sourcing attractive transactions, but also the resulting track record and success of those individual investments.

Q: What are your expectations for the securitisation market more broadly this year?
A: The biggest trend we’ve seen, certainly for 2022, would be the transition from Libor-based loans to SOFR. There was obviously a lot of activity in the fourth quarter of 2021 in advance of those changes and, so far, it seems like the transition is proceeding quite smoothly.

The broader geopolitical environment remains high on our list of areas of focus - as credit investors, we look at things from both the top-down and the bottom-up. Uncertainties are quite high in markets right now, and we’re seeing that in a number of different ways. But hopefully we’ll get more clarity over the next couple of months and that can have a material impact on broader economic themes, as well as on our originations and portfolio more specifically.

Claudia Lewis

Structured Finance

ERCF final rule published

Sector developments and company hires

The FHFA has published a final rule that amends the Enterprise Regulatory Capital Framework (ERCF) by refining the prescribed leverage buffer amount and risk-based capital treatment of retained credit risk transfer (CRT) exposures for Fannie Mae and Freddie Mac. The amendments reflect the feedback the FHFA received last year and aim to advance its mission of ensuring the enterprises are able to support the housing market throughout the economic cycle.

The final rule: replaces the fixed leverage buffer equal to 1.5% of an enterprise's adjusted total assets, with a dynamic leverage buffer equal to 50% of the enterprise's stability capital buffer; replaces the prudential floor of 10% on the risk weight assigned to any retained CRT exposure, with a prudential floor of 5% on the risk weight assigned to any retained CRT exposure; and removes the requirement that an enterprise must apply an overall effectiveness adjustment to its retained CRT exposures. The final rule also makes technical corrections to various provisions of the ERCF that was published on 17 December 2020.

The effective date for the ERCF amendments and technical corrections in this final rule will be 60 days after publication in the Federal Register.

In other news…..

North America

Elementum ramps up its investment team in Bermuda with the hire of a new vp. Alaina Cubbon joins the team as vp of portfolio management from the Hiscox ILS investment team in Bermuda. In her previous role, Cubbon was responsible for portfolio construction, reporting, valuation, and the development of systems and products. She will concentrate on portfolio construction and underwriting for the firm’s CRI-inclusive funds, as well as helping the firm enhance its ESG management framework and approach. Cubbon brings extensive experience in ESG as well as the reinsurance market, having also held roles as vp of analytics and research at Hiscox Re in Bermuda, and as a member of the property underwriting team at Catlin underwriting in London.

Structured Finance

Pemberton hires head of new CLO platform

Sector developments and company hires

Pemberton, the alternative credit specialist, has announced the appointment of Rob Reynolds as head of its new CLO platform. The new CLO platform, which is subject to FCA UK regulatory approval, compliments existing lines of strategic focus. Reynolds will lead its expansion into the European CLO market, using his European CLO and leveraged loan markets expertise to build the new business into an innovative platform. Reynolds joins Pemberton from Spire Partners, where he most recently served as partner, and is the latest of several appointments at Pemberton as it expands its global offering.

In other news..

North America

Churchill Asset Management has hired Wells Fargo veteran, Bennett Love, to lead the development of the firm’s leverage strategy. Taking on the role of principal and head of fund finance, Love will also maintain responsibility for sourcing, execution, and monitoring of financing across the platform. Love will be based in Churchill’s North Carolina office in Charlotte, and will focus on public and private debt solutions, including CLOs, as well as all other forms of bilateral and syndicated lending facilities. He joins the firm having spent 12 years at Wells Fargo, most recently serving as director of corporate debt finance, and will report to the asset management firm’s cfo, Shai Vichness.

Hildene Capital has entered into a strategic relationship with Jefferies Financial Group division, Leucadia Asset Management. The transaction involves Leucadia acquiring a non-controlling financial stake in Hildene, which the firm hopes will enable new Hildene vehicles and businesses going forward. The team at Hildene, along with its investment strategy and day-to-day operations, will remain unchanged as the firm works to further its growth with the support of new relationship with Leucadia.

Structured Finance

SLC continues expansion

Sector developments and company hires

SLC Management has promoted Bryan Rowe, Daniel Lucey, Jacqueline Gallant and Jeffery Meyer as the firm continues to expand its business and investment capabilities. Effective from 26 March, the four will work as senior mds at the firm. Firstly, Rowe has been promoted to senior md for global portfolio management, having spent more than 15 years at the firm, and will oversee the global team responsible for the development and execution of investment strategy reviews. Rowe will be based in the firm’s Waterloo, Ontario office alongside Meyer, who will undertake the role of senior md for private securitisation finance having spent 28 years at the firm. Lucey has been with SLC since 2009, and will continue to manage the team’s bond strategies from its office in Wellesley, Massachusetts, in his new role as senior md and senior portfolio manager. He will also oversee the management, research, and trading for the firm’s ABS, CMBS, MBS and CLO portfolios. Lastly, Gallant, will step up to the role of senior md and head of institutional marketing and communication after working with the organisation for more than two decades, and will be based in Toronto.

In other news....

North America

Churchill Asset Management has named Kelli Marti as its new senior md and head of CLO management. Marti has been responsible for the growth and management of firm’s middle market CLO platform since joining the organisation in 2020, with the platform growing to almost US$2bn under her leadership. Marti’s promotion is the latest of several made across Churchill’s investment teams as it strives to diversify its overall expertise.

CarVal Investors has announced the establishment of a new mortgage conduit, Mill City Loans. The new business is set to prioritise relationship building with originators and will focus on liquidity and technology as it works to broaden its services offered to clients. The team will be led by mortgage veterans Trey Jordan, Mike Peterson and Kent Usell. Jordan joins the firm from New York Mortgage Trust, where he served as general counsel, Peterson joins from TCF Bank where he led its capital markets team, and Usell joins the team having previously worked as a mortgage and investment banking leader at multiple firms including New York Mortgage Trust and Oak Hill Advisors. Under the leadership of this executive team, Mill City Loans will work to acquire residential mortgage assets through a number of different strategies, ultimately broadening CarVal’s product offering.