Contents

Capital Relief Trades

Reinsurance roll call

Call for new counterparties to avoid CRT overcapacity and widening prices

The reinsurance market has thus far soaked up the CRT extra volume thrust its way this year, but unless new names enter the space both capacity and pricing will be squeezed, suggest sources.

Around 30 reinsurers regularly absorb GSE product through the ACIS and CIRT programmes, but only 15 or so take risk from mortgage insurers (MIs).

“There’s definitely room for growth. There’s a stable source of transactions and a need for more reinsurers to jump in. The market has absorbed the increase in volume to date but this could be challenged if new reinsurers don’t enter the space,” says Jeffrey Krohn, mortgage credit segment leader at Guy Carpenter.

Some $7.3bn of CRT risk was placed in the reinsurance market in 2021, but that figure has almost doubled in 2022 YTD to $14.1bn. It is estimated that by year end it will have grown to $18.6bn. This is a dramatic increase from the $5.9bn seen in 2019 or $8.3bn in 2020.

These numbers are provided by Guy Carpenter, based on public data.

The GSEs and the MIs have historically placed a much greater share of their exposure in the capital markets, but prices have increased prohibitively in 2022. Indeed, only two mortgage insurance-linked notes (MILNs) have been sold this year, while Freddie Mac and Fannie Mae have pivoted to the reinsurance market as well.

For example, in January 2022, the M-1A tranche of STACR 2022-DNA1 was sold at SOFR plus 100bp, but the same tranche of STACR 2022-DNA5 priced in June came in plus 295bp - a 195% widening. The M-1Bs came in at plus 450bp in the June transaction compared to plus 200bp for the January deal - a widening of 125%. The rest of the June stack came in at between 82% and 170% wider than the January deal.

Moreover, the widening occurred in the face of higher attachment and detachment points for the June transaction. For example, the M1-A tranche of 2022-DNA5 attaches at 3.60% and detaches at 5.25% compared to 3.00% and 4.50% in 2022-DNA1.

These higher attachment points are as a result of the counter cyclical capital rule, which obliges the GSEs to hold more capital when home price increases exceed the long term trends. Consequently, the GSEs have tried to buy CRT coverage higher in the stack.

Pricing in the reinsurance market has also been buffeted, but not to same extent. The M-1 tranche of ACIS 2022-SP1 sold in January carried a rate of 95bp compared to 180bp for the same tranche of risk in the ACIS 2022-SP5 in July - an increase of 89%. The M-2 tranche widened by 110%.

See slide below, from Guy Carpenter.

Despite the drastic widening in the capital markets, two reinsurers, said to be Arch and Radian, are poised to come back into the MILN arena  in the near future. But this is a decision based more on a commitment to the market and its long term survival rather than strictly economic rationale, suggest onlookers.

"A couple of mortgage insurers are expected to come back to the MILN market, but they’re paying up and paying up handsomely to do so. The news this week that rates could rise another 75bp this month has not been helpful,” says one.

Nonetheless, although prices in the reinsurance sector have proved more friendly to CRT than the capital markets, they are now based largely on technical factors of supply and demand rather than underlying risk.

This is likely to get worse rather than better unless new names enter the fray.

Traditional reinsurers are said to be deterred by the unique business model of mortgage reinsurance, which requires firms to post a portion of their limit of liability at the inception of the deal. So, if a reinsurer puts on a line of $50m, it must deposit around 25% of this into a trust to be invested in safe, low-yielding assets. Clearly, this eats up working capital.

This structure was put in place in the GSE market in the wake of the 2008/2009 crisis as a way of safeguarding Fannie Mae and Freddie Mac should insurers fail to pay out for a claim. It has since been adopted in the private label insurance market.

 “It’s unique to this market. When reinsurers hear about it, it turns many of them off. This pressures rates, capacity and creates resistance to do more,” says Krohn.

Simon Boughey

Structured Finance

Setting the tone

European ABS/MBS market update

As the much-anticipated September restart begins to materialise, one deal managed to reopen the European and UK ABS/MBS primary markets. With additional deals being announced, investor demand and overall market conditions will be tested.

Yesterday the European Central Bank raised interest rates sharply, increasing its three key rates by three-quarters of percentage point - the biggest rise since 1999 - mirroring a similar tactic to reduce inflation as other central banks around the world.

Prior to this on Tuesday, LocalTapiola Finance reopened the public ABS market with the pricing of their latest Tommi Finnish Auto ABS. Given current market conditions, the deal showed decent demand, with both the A and B tranches showing 1.6x and 2.5x coverage ratios respectively.  Although the spread was able to come in from IPTs of mid 90s down to one-month Euribor plus 90bp, one European ABS/MBS trader views such levels as signs of significant widening:

“It priced wider than I expected. It is quite surprising that a such wide levels, demand was far from overwhelming. Are investors waiting for worse things to happen, or are they switching to other asset classes?”

Now that the public ABS/MBS markets have officially reopened - following its long summer hiatus - five further mandates have been added to the pipeline, with all deals expected to price next week. The list includes SocGen’s German unit BDK, with a new STS Red & Black deal; BNP Paribas’ STS auto ABS AutoNoria Spain 2022 and Pulse France 2022; Principality Building Society with a new RMBS deal from their Friary Prime programme (Friary 7); and non-conforming RMBS Parkmore Point RMBS 2022-1.

With auto ABS and/or deals that ticks all the regulatory boxes (STS, CRR, LCR) pouring in, the trend for now is clearly focused on plain-vanilla paper.

“Given the current environment, it is not a surprise,” views the trader. He adds: “However the question is: at these spreads, it is interesting enough for all parties to fund themselves? If you end up with high spreads on your liabilities in these ABS structures, it can become a problem and as we saw this week, even plain-vanilla deals are pretty expensive.”

Regarding the secondary market, the trader highlights decent levels of activity: “There was quite a few sec BWICs trading and from what I saw most of it was traded - at elevated levels of course but you would expect that at those levels that there will be some demand.”

He concludes: “The real test however will be the primary supply coming to the market and if spreads are high enough for investors to be lured back in. This will set the tone for the market.”

For more on all of the above primary deals, see SCI’s Euro ABS/MBS Deal Tracker

Capital Relief Trades

Risk transfer wave

Leveraged loan CRTs pick up

Synthetic securitisations backed by leveraged loan exposures have witnessed a significant pick up this year from both US and European banks. Issuance has received a boost following a regulatory push to address concentration risks on bank balance sheets. However, investors can also benefit from access to asset types that aren’t available in the CLO market.

Banks have substantially increased their exposure to leveraged loans. According to ECB data, between the first quarter of 2018 and the third quarter of 2021, aggregate leveraged loan exposures for 28 ‘’significant institutions’’ rose from less than €300bn to around €500bn- an increase of around 80%. The aggregate increase is in line with the 70% rise in the notional of the main European leveraged loan indices over the same period and is material in both absolute and relative terms.

Over the last few years, and particularly in 2021, highly leveraged transactions (HLTs)-deals where total debt is more than six times EBITDA at the time of the deal’s origination - have accounted for a very significant percentage of these increases. On aggregate, ECB analysis notes that HLTs accounted for around half of all new leveraged transaction volumes originated in 2019 and 2020, with that figure rising to more than 60% in the first and second quarters of 2021.

Consequently, the ECB has cautioned in a letter from March 2022 that ‘’high levels of HLTs on SIs’ hold books represent a concentration risk and a significant risk to institutions that needs to be managed appropriately.’’ Hence, the ECB expects ‘’lower levels of HLT origination to be reflected in a decline in HLTs’ share of the LT hold book, thereby substantially reducing HLT concentration risk over time’’ says the ECB letter.

Banks have been listening. Deutsche Bank has closed one leveraged loan CRT to primarily address concentration risks (SCI 30 August) and Societe Generale, Credit Agricole and Goldman Sachs are all readying their own deals (SCI 11 August). JPMorgan was also expected to close a leveraged loan CRT in 2H22 but the execution has been delayed (SCI 2 September).

The focus on concentration risk hedging is evident from the Deutsche bank trade according to arrangers and investors.

Robert Bradbury, head of structured credit execution at Alvarez and Marsal explains: ‘’If Deutsche Bank is getting capital relief, then it is unlikely to be as cost-effective as some of their other options and programmes, notwithstanding the relatively high-risk weight of the asset class. As such, it appears that this is a trade focused primarily on economic risk mitigation.’’

An investor comments: ‘’Deutsche Bank is paying 1900bps for the first loss to hedge the pool and that cost only makes sense for the bank if it expects to claw back a lot of it through losses. In particular, the bank pays the spread on the tranche to the investors but receives protection payments from investors. So, the higher the loss rate, the more the bank receives as protection payments and therefore the lower its net cost.’’

He continues: ‘’However, for the investor, the pricing only delivers high single digit returns after base case losses and to get a decent return in a higher stress scenario, you would need a higher spread.’’

However, the portfolio of the Deutsche Bank transaction is backed by revolving credit facilities (RCFs) and capital for these exposures goes up when they are drawn. This dynamic occurred during the Coronavirus crisis for corporate exposures, and it amounted to a major driver behind the CRT market’s reopening after the stress of 1H20.

As another investor notes: ‘’we’re seeing a fair amount of pressure on company margins and working capital, which makes RCF utilisation more likely. This will in turn be a stress on bank capital. Moreover, when you consider the pending 2024-26 maturity walls in the leveraged loan market, it makes sense that the banks would be focussed on this.''

RCFs are more attractive for lenders for various reasons. Most importantly, RCF deals typically reference the exposure at default (EAD) which is the predicted amount of drawn exposure a bank may be exposed to when a debtor defaults on a loan. This matters simply because banks buy protection on just a portion of the notional.

The same investor states: ‘’with RCFs you typically hedge the EAD. It’s how you remain efficient since that’s what is capitalized, but then you need to effectively scale up and down your exposure as the RCFs are drawn and the EAD changes.’’

He continues: ‘’The same applies in an LBO SRT if the portfolio includes RCFs, although there is perhaps a greater need to over-hedge in anticipation of future draws. RCFs are often shorter dated, can be super senior and will usually have covenants, which should lead to better risk weights, albeit the capital will still be much higher than for IG credit exposures.’’

The factors determining the pricing of synthetic securitisations backed by leveraged loan exposures are several. First, concentration risks are crucial. Indeed, single name credit analysis plays a much more important role on pricing than in more granular transactions, since concentrations represent a significant proportion of the protected tranche notional amount.

‘’Although banks would prefer a range of credits and credit qualities in each pool, for pricing purposes they typically would not want the lowest credit quality exposures to be towards the higher concentrations’’ says Bradbury.

Another consideration is homogeneity since if a lender wishes to avoid “modelling to worst”, then the pool must be consistent to avoid leaning on one credit. The final factor is the mix between revolving credit facilities (RCFs) and term loans.

Leveraged loan synthetic ABS makes sense from an originator perspective. Yet one lingering question are the motivations from an investor perspective. Specifically, why would an investor buy a 10% first loss tranche for 19% as in the case of the Deutsche Bank deal, when they can buy CLO equity in the high double digits?

In fact, for some investors there’s no premium for leveraged loan CRTs. The underlying leverage loan market has sold off significantly over the last few months so the CLO market can be a better way to capture both upside-either in secondary or new warehouses-as well as provide strong downside protection by buying discounted mezzanine tranches, through the protection of portfolio excess spread, the ability to exit underperforming names and build back par.

However, leveraged loan CRTs have other advantages. First, they are backed mostly by RCFs which have had high recoveries historically. CLOs on the other hand invest in term loans and include lower rated borrowers.

Moreover, with CRTs, banks and investors can shape the portfolio and access a wider pool of core lending books that include multiple jurisdictions. This is important in a deteriorating environment. Deals are now being worked out with static pools, thicker tranches and pricing that compensates for the additional risk. Finally, CRTs are bespoke, benefit from an illiquidity premium and are less driven by ratings.

Stelios Papadopoulos 

Capital Relief Trades

Full stack SRT prepped

BDK readies capital relief trade

Bank Deutsches Kraftfahrzeuggewerbe (BDK) is marketing a full stack capital relief trade that references a static €600m portfolio of German auto loans. Dubbed Red and Black Auto Germany nine, the trade differs from previous ones from the programme given lower levels of excess spread following higher funding and hedging costs.      

Rated by Fitch and S&P, the transaction consists of AAA/AAA rated €567.3m class A notes, AA/AA- rated €7.5m class B notes, A+/A- rated €9.6m class C notes, BBB/BB rated €12.6m class D notes and €3m unrated and retained class E notes.

The latest transaction from the programme is similar to previous trades but there are two key differences. The most salient one pertains to the amount of excess spread in the deal. Interest on the fixed-rate assets has remained largely constant, whereas the weighted average costs of funding on the notes and hedging costs have increased materially compared with the predecessor deal.

Hence, modelled lifetime excess spread becomes negative in the considered stressed scenarios. However, this is offset by higher available credit enhancement via a larger cash reserve.

Eberhard Hackel, senior director at Fitch ratings notes: ‘’the loans were granted on average ten months ago, but interest rates have risen during this period so there’s a mismatch between the liability costs and the yields on the underlying assets. Higher liability costs include both higher funding and hedging costs. The result is significantly less available excess spread to cover losses. Nevertheless, the bank has offset this through a higher cash reserve.’’

He continues: ‘’The mismatch is temporary if we think about future transactions since the underlying assets will reprice at some point but it’s unclear how long will the status quo hold. Banks may well postpone any asset repricing and keep lending rates low to protect their market share.’’

The second key difference compared to past deals is the amortization triggers. Classes A to D will switch from sequential to pro rata amortisation if class A overcollateralization (OC) reaches 10%. According to Fitch’s modelling, full repayment of the notes is dependent on the length of the pro rata period, which is not only driven by the level of credit losses, but also by the timing of losses and prepayment rates.

The switch to pro rata is expected to occur at a later point in time compared to predecessor transactions given that the starting OC for class A is lower. Fitch views the performance triggers as effective in ending the pro rata period in the event of a significant deterioration in performance.

Societe Generale is acting as the arranger in the transaction.

Stelios Papadopoulos 

Structured Finance

Sustainable Fitch launches Leveraged Finance ESG Scores

Sector developments and company hires

Fitch Group’s ESG hub, Sustainable Fitch, has announced the launch of its ESG Scores for Leveraged Finance – the first high-coverage ESG solution for the leveraged finance industry. The ESG scores will equip the CLO investment community with an absolute scoring system which will allow for the granular assessment of environmental, social, and governance factors across leveraged finance entities and labelled issuance.

The ESG Entity Scores (ESG.ES) will offer an independent view on leveraged finance issuers’ impact on all three ESG factors, while the ESG Framework Scores (ESG.FS) will provide a view of the use of proceeds for soundness while also monitoring and tracking certain key performance indicators. These ESG.ES and ESG.FS scores will be provided on a scale from 0 to 100, and to date, have provided scores for more than 430 individual borrowers in the European market and offered an ESG view on over 75% of the portfolio in an average Fitch-rated European CLO.

This ESG data coverage is expected to be expanded into the North American CLO market and is on target for reaching 80% coverage for US CLO portfolios by the close of 2Q23. The firm hopes that its ESG Scores for Leveraged Finance will offer CLO managers an independent asset-by-asset view of a business’s impact on all ESG factors, while also allowing for comparison between issuing entities across different business activities, sectors and regions.

EMEA

Alexis De Vrieze is set to join the team at ArrowMark Partners, having spent the last 13 years at Citi. Alexis will join ArrowMark’s London office as md, and will continue to focus on SRT in his new role as he had previously in his role at Citi as a director.

Macquarie Asset Management has appointed Peter Glaser as its new global head of private credit and asset finance. Glaser brings his expertise to the asset manager from Alcentra, where he served as head of European direct lending and portfolio managers for its European direct lending funds. Glaser joins Macquarie during a period of growth, with hopes his knowledge in private credit and portfolio management will help aid the expansion of the business into new areas and beyond its current US$11.4bn in assets under management.

North America

Sun Life is set to acquire a majority stake in independent US retail distribution firm, Advisors Asset Management (AAM). Sun Life’s institutional fixed income and alternatives asset manager, SLC Management, hopes to establish AAM as its own retail distribution arm in the US. AAM currently holds 10 offices across eight states in the US, a team of 270 professionals, and oversees US$41.4bn in assets. In the transaction, Sun Life will acquire a 51% stake in AAM for US$214m and will also commit to investing up to US$400m to launch SLC Management alternative products for the US retail market to be distributed by AAM. As part of the transaction, AAM will also receive exclusive rights to offer and promote SLC Management alternative investment products to the US retail market.

Capital Relief Trades

Risk transfer round up-8 September

CRT sector developments and deal news

Deutsche Bank is believed to be marketing a synthetic securitisation of corporate loans from the CRAFT programme. This would follow the recent execution of a leveraged loan CRT called LOFT 2022-1 (SCI 30 August). The last CRAFT transaction closed in September 2021 (SCI capital relief trades database)

Stelios Papadopoulos