News Analysis
Capital Relief Trades
Inflexion point
SRT market takes off despite regulatory turbulence
The SRT market is experiencing strong growth with both issuers and investors increasing their focus on the space, according to panellists at the 27th Annual Global ABS conference in Barcelona. However, despite strong European activity there remains a significant amount of uncertainty as the market grapples with regulatory changes surrounding Basel 4.
Credit Agricole CIB has noted significant growth in the SRT market over the past five years, on both the issuer and investor side, with an increasing trend for LPs to allocate capital to the space, said Thierry Collin, managing director at the bank.
“One investor who was doing his fundraising told me that when he was speaking to LPs previously, he would find a few were doing SRTs or would have SRT on their radar screen,” Collin said. “Now, at least 50% of the LPs he is talking to know about, have identified, or have already invested in SRTs. This market is growing and it is becoming more mature, which is beneficial for everyone.”
Jorge Lopez Herguido, vp and securitisation structurer at Santander CIB, said the Iberian market has picked up considerably, with activity likely to remain strong heading into 2024. “From the Iberian perspective, 2022 saw modest growth from the previous year, but 2023 began strong and with a healthy pipeline for the rest of the year,” he said. “While Q4 2022 saw a widening in terms of pricing, things now are getting more stable, particularly in the synthetic private market. We are seeing new issuers coming into play with strong interest in the product.”
SRT transactions are becoming a core tool for banks, in terms of managing risk sharing and concentrations, as well as recycling capital, said Alec Innes, partner at KPMG. This, he said, is driven by the fact that SRTs are one of the most efficient methods of increasing their return on equity. “We only see this market growing, and we see other geographic bank issuer markets coming in, whether that's eastern Europe or South Africa,” he said.
However, Innes said he is less certain about investor activity. “When I talk to investors, there is a mixed picture about current fundraising,” he told the conference. “Some investors, particularly the biggest investors with the longest track records, are raising funds, though perhaps [raising] less than they are targeting. But there are other newer investors with less track record who are struggling. So it is not totally clear to me how that supply demand dynamic will work this year.”
Broadening scope
The market is maturing to include a broader range of asset classes, panellists said, and attracting a wider spectrum of investor type. Until recently, the SRT market was primarily dominated by a handful of institutions, said Harry Noutsos, managing director at PCS and formerly global head of ABS at ING. These days, he said, “almost every player” is in the market, regardless of size.
“The type of asset classes used to be predominantly SMEs and large corporates,” Noutsos continued. “Now it's spreading to consumer loans, to mortgages, and other areas. If the latest regulatory changes in synthetics are finalised we might see a doubling potentially of the market.”
He added: “More crucially, in terms of quality, it has helped a lot of institutions to have a better understanding of their own portfolios and what they want to do with their book going forward into Basel 4.”
KPMG’s Innes said he has witnessed a “limited number” of insurers — particularly reinsurers — entering the space. These play a “valuable and growing role” and are “needed in the market”, particularly as more trades are done for standardised capital relief, he said.
“There are challenges for some banks, under some regulatory regimes,” Innes continued. “Central banks like the idea of a larger part of the market going to sophisticated investors who know what they are doing and are paid accordingly for it. But I am not sure how much central banks will tolerate it in the insurance sector.”
Innes highlighted what he described as a “schizophrenic approach” in insurance regulation that creates challenges. “If you were to take a securitisation exposure like STS on the liability side, it has a much more beneficial treatment than if you actually take it on the asset side. There is a real inconsistency in the insurance regulation around this.”
Regulatory pressures
Indeed, uncertainties around regulatory developments emerged as one of the key areas of concern for panellists. Of particular note was uncertainty surrounding the potential for the EU to grant a discount to the p-factor, following calls from the securitisation industry to lessen the impact of the Basel output floor.
The p-factor is an input into the SEC-SA and SEC-IRBA formula that governs the non-neutrality for the retained senior tranches of synthetic securitisations with the aim of addressing modelling and agency risks.
“The market is going to have to evolve,” said KPMG’s Innes. “It is at an inflection point with the standardised floor. The pace of change will depend partly on what the regulators do. There was a suggestion from a representative from the ECB that there might be the prospect of a 50% discount to the p-factor up to 2032. That would put the floor further away for a lot of banks in Europe. However the impact of Basel 4 is something we're all going to have to face and think about in this market.”
There is a significant amount of pressure on regulators to introduce a discount on the p-factor, said PCS’s Noutsos. “That's why we are getting multiple proposals from policy makers,” he said. “Everybody's realising that it'll make or break possibly current portfolios and the business model they have. In the US, or in Japan, applying the p-factor is one thing, because they have this huge off-balance-sheet vehicle called government agency paper where they can offload and manage their capital at least partially. We don't have that vehicle in Europe.”
Oliver Gehbauer, head of SRT securitisation at Deutsche Bank said: “There is a bit of a misperception that the SRT investor base is a continuum across the capital structure and there is sufficient bid for every tranche.”
Gehbauer highlighted that it is often suggested that, in order to counter the effects of the p-factor, an issuer can increase the thickness of the mezzanine tranche. “There is a lack of mezzanine money to be deployed. For me, that is one of the main challenges. One solution could have been reinsurance investors, but unfortunately unfunded reinsurance protection is currently not STS compliant. To find new investors for mezzanine tranches may require to get deals rated.”
STSeal of approval
One EU initiative that had yielded a largely positive outcome, the panellists agreed, has been the introduction of simple, transparent and standardised (STS) criteria. “The STS designation has seen a lot of success in the synthetic SRT market,” said James Plunkett, a director in Alantra’s securitisation business. “There has been some instability from a regulatory perspective regarding homogeneity and synthetic excess spread – which had transitory impacts on transaction structures – but we’re seeing stability again.”
Plunkett added: “Already STS has enabled transactions for portfolios that we would never have seen otherwise, which has been a boon for sponsors and both new and seasoned investors. If we were to see STS enabled for unfunded non-government protection providers then the landscape would change significantly, with insurers pushing out credit funds and investment managers.”
PCS’s Noutsos said that the introduction of STS has taken “stigma out of the market”, adding that the benefits have been notable. “Yes, STS is complicated,” he said. “But standardised allows for lower capital, allows for better treatment and allows for synthetics to be part of it. So there's a lot of benefit to it.”
However, the introduction of STS has not been without its challenges, said Credit Agricole CIB’s Collin. He added that, though the industry has navigated these challenges relatively well and that STS has benefited the market on the whole, many of its implications are yet to be ironed out:
“We are still struggling to apply some STS criteria, for example, for a less granular pool or a pool that is less standardised,” said Collin. “But we were the second bank to have STS for large corp issuance. Now it is systematic in our large corp programme to get the STS treatment, especially because of the benefits that we get from the capital.”
Kenny Wastell
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News
Structured Finance
SCI Start the Week - 19 June
A review of SCI's latest content
Last week's news and analysis
Compliance issues
'Compelling case' for reform of Article 5
Full stack comeback
BBVA finalises full stack SRT
Preventative intervention
UTP management gaining traction
Rental retreat
Rising BTL remortgaging risks eyed
For all of last week’s stories including ‘Market moves’ and ‘Risk transfer round-up’ click here.
Recent premium research to download
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‘Socialwashing’ concerns – May 2023
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European solar ABS – May 2023
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US CRT thaw – April 2023
The recent Merchants Bank of Indiana deal could herald a thaw in the US capital relief trades market, as this Premium Content article outlines.
All of SCI’s premium content articles can be found here.
Call for submissions: SCI CRT Awards 2023
The submissions period is now open for the 2023 SCI CRT Awards, covering the global capital relief trades market and the US credit risk transfer market. Nominations should be received by 5 July and the winners will be announced at the London SCI Capital Relief Trades Seminar on 19 October. Pitches are invited for deals issued during the period 1 October 2022 to 30 June 2023.
For more information on the awards categories and submissions process, click here.
SCI In Conversation podcast
In the latest episode, Vesttoo co-founder and chief financial engineer Alon Lifshitz outlines how the insurance-linked securities landscape is evolving from catastrophe bonds to a wider range of structures, bringing insurance risk directly to the capital markets. He also discusses ILS modelling approaches, the involvement of rating agencies in the insurance risk transfer space and a new index project that is underway.The podcast can be accessed wherever you usually get your podcasts, including Apple Podcasts and Spotify (just search for ‘SCI In Conversation’), or by clicking here.
SCI Markets
SCI Markets provides deal-focused information on the global CLO and Australian/European/UK ABS/MBS primary and secondary markets. It offers intra-day updates and searchable deal databases alongside CLO BWIC pricing and commentary. Please email Ronald Adjekwei at SCI for more information or to set up a free trial here.
SRTx benchmark
SCI has launched SRTx (Significant Risk Transfer Index), a new benchmark that measures the estimated prevailing new-issue price spread for generic private market risk transfer transactions. Calculated and rebalanced on a monthly basis by Mark Fontanilla & Co, the index provides market participants with a benchmark reference point for pricing in the private risk transfer market by aggregating issuer and investor views on pricing. For more information on SRTx or to register your interest as a contributor, click here.
Upcoming SCI events
Esoteric ABS Seminar
12 September 2023
Women In Risk Sharing
18 October 2023
SCI's 9th Annual Capital Relief Trades Seminar
19 October 2023, London
News
Capital Relief Trades
Capital boost
Canadian regulator ratchets up capital requirements
The Canadian financial supervisor, the Office of the Superintendent of Financial Institutions (OSFI) has today raised the so called ‘’Domestic Stability Buffer’’ (DSB) by 50 basis points to 3.5% of total risk-weighted assets, effective from November one, 2023. It follows a move in December by the regulator to increase the buffer to 3%. More saliently, the decision is made at a time when Canada frontloads the Basel output floor and amid a flurry of Canadian capital relief trade issuance with the latest rise in the DSB likely to raise the profile of synthetic ABS technology even further going forward.
Peter Routledge, Superintendent of Financial Institutions at OSFI notes: “By raising the DSB to 3.5%, we are taking action to enhance the resilience of Canada’s largest banks against vulnerabilities. This change will help Canada maintain a resilient financial system. The DSB is a safety buffer for the banking system that can be lowered when appropriate, such as during economic downturns.”
The DSB is a capital buffer that Canada’s six largest ‘’Domestic Systemically Important Banks’’ (D-SIBs) are required to set aside to be able to cover losses during financial uncertainties. The buffer level is set twice a year, in June and December, although it can change any time when needed. For example, on March 13, 2020, OSFI lowered the DSB from 2.25% to 1% in response to the COVID-19 pandemic.
The D-SIBs that have to comply with the buffer are Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and Toronto-Dominion Bank.
OSFI cited various vulnerabilities to justify the decision including ‘’high household and corporate debt levels, the rising cost of debt, and increased global uncertainty around fiscal and monetary policy, coupled with Canada’s financial sector showing strength throughout the winter and spring has presented the opportunity for OSFI to build more resiliency in the system.’’
Capital levels at the six largest Canadian banks remain strong, with an average CET1 capital ratio of 13.1% in 2Q23, down 60bps sequentially. According to Moody’s, the decrease was primarily due to the higher capital deduction for goodwill and intangible assets related to BMO's acquisition of Bank of the West and TD’s acquisition of Cowen Inc., as well as losses related to hedging strategies by these two banks related to US acquisitions, partially offset by strong internal capital generation, share issuances through the banks' dividend reinvestment plans and positive impacts from the implementation of Basel three reforms. CET1 ratios for all these banks are comfortably above the regulatory minimum of 11%, which became effective on one February 2023.
Canadian synthetic risk transfer issuance has experienced a notable rise this year with the first transaction from Toronto Dominion in February followed by CIBC and RBC later in the year (see SCI’s capital relief trades database). Indeed, there’s another Canadian bank with a trade in the works.
The pickup in the Canadian market is not surprising given that OSFI stipulated in an official letter that was published on January 31, 2022, that the Basel output floor would have to be effectively frontloaded this year. According to the letter, the implementation of the 72.5% Basel output floor will be phased in over three years beginning in fiscal 2Q23.
Stelios Papadopoulos
News
Capital Relief Trades
Risk transfer round up-21 June
CRT sector developments and deal news
mBank is believed to be readying a synthetic securitisation of consumer loans that is expected to close in 3Q23. This would be the Polish lender’s third ever significant risk transfer trade following its debut SRTs last year (see SCI’s capital relief trades database).
Stelios Papadopoulos
News
Capital Relief Trades
Risk transfer round up-22 June
CRT sector developments and deal news
Lloyds is believed to be readying a synthetic securitisation of UK SME loans from the Salisbury programme. The last Salisbury transaction closed in 2021 (see SCI’s capital relief trades database).
Stelios Papadopoulos
News
Capital Relief Trades
Full cap stack SRT launched
EIF finalizes Bulgarian synthetic ABS
ProCredit Bank Bulgaria (PCBB) and the EIB group have finalized a synthetic securitisation of Bulgarian and Greek SME loans. Under the financial guarantee, PCBB pledges to supply €416m to SMEs and mid-caps over a three-year period.
Approximately 30% of the financing is allocated to projects aligned with climate action and environmental sustainability. The enhanced lending capability of PCBB is made possible through the unfunded protection provided by the European Investment Bank (EIB) and the European Investment Fund (EIF). More specifically, the EIF is providing protection to a mezzanine tranche (€41m) and a senior tranche (€254m) of a €300m revolving portfolio of SME loans. Close to half of the EIF’s exposure is in turn counter-guaranteed by the EIB and allows the redeployment of PCBB’s capital to support the real economy.
The portfolio features both Bulgarian and Greek SME loans although 90% of the exposures are Bulgarian. The junior tranche has been retained unlike the senior and mezzanine, but the EIF still classifies the transaction internally as a full cap stack guarantee. Full cap stack transactions aren’t used that often by the supranational and the last one was executed last year in the Baltics. Credit enhancement is present in the form of a synthetic excess spread mechanism.
Stelios Papadopoulos
Talking Point
CLOs
Mezz opportunities
Pretium structured credit and CLO liabilities MD Ian Wolkoff and Director Marty Young argue that mezzanine CLO bonds should be on the radar screens of most asset allocators with long investment horizons
US CLO mezzanine debt offers high expected return rates, with yields maintained under a default scenario more extreme than the GFC credit cycle and with upside potential in a market recovery scenario.
CLO debt offers strong long-run expected returns with bounded downside
In the current market context, macro uncertainty and the potential for a growth downturn loom large while valuations across many sectors still screen as relatively expensive. Given this set-up, asset allocators are searching even more actively than usual for investment opportunities which offer high potential yields but with contained downside protection in bearish scenarios. CLO mezzanine debt is a sector which appears to offer this combination.
The US CLO market has grown to over US$950bn in outstanding balance, with over US$160bn of balance in mezzanine (single-A through single-B) tranches[i]. As a result, a CLO mezzanine debt strategy addresses a market large enough to allow investors to allocate selectively while still targeting high yields with contained risks.
Yields on CLO mezzanine debt securities have moved up sharply over the past two years; double-B CLO bonds purchased in the secondary market offer average lifetime quoted yields of 14.4% as of June 2023 versus 7.7% in mid-2021[ii]. The current baseline yields for double-B CLOs compare quite favourably to the yields available from other similarly rated fixed income assets: double-B leveraged loans and double-B corporate bonds, for example, currently yield just 7.6% and 7.2% respectively[iii].
The extra yield earned by double-B CLOs versus double-B corporate bonds does not appear to reflect added default risk as the comparison holds debt ratings constant; indeed, during the 2008 financial crisis episode, CLO bonds had significantly lower default rates than similarly rated corporate bonds[iv]. CLO transactions are designed so that the bond classes can withstand elevated default rates on the underlying loan portfolios without taking principal losses; the double-B CLO bonds benefit from multiple structural protections, including overcollateralisation and excess spread that absorb losses before they can be passed to the double-B bonds.
A price-yield analysis of a double-B tranche from a sample 2021 vintage CLO transaction indicates that the double-B bond yield remains in double-digits under a scenario in which 28% of the underlying loan assets default over the next five years with a 60% recovery rate[v] – a default intensity over 1.6 times the five-year cumulative default rate experienced following the global financial crisis[vi]. Indeed, the double-B tranche yield remains positive, even if the assumed five-year cumulative loan default rate rises to 35%, more than 2x the level seen during 2007-2013[vii]. CLO double-B bond yields remain positive in this high default rate scenario, despite the fact that much of the bond principal would be projected to be written down in such an event, as the high projected coupon payments over the lifetime of the bond would compensate for the principal loss.
CLO debt offers upside potential in a market recovery scenario
Per above, double-B CLOs can offer around 14% yields under a moderate recession baseline scenario. The bonds can maintain these double-digit yields in a loss scenario comparable to that experienced during the global financial crisis and can continue to earn positive yields in scenarios significantly more extreme than in 2008. Thus, the long-run downside risk for the majority of bonds in the double-B CLO sector, while not zero, appears bounded.
At the same time, the bonds provide meaningful potential return upside in a scenario in which double-B CLO spreads partially normalise relative to their current wide levels. Double-B CLO spreads are currently trading 250bp above the level that would be predicted, given their historical relationship to high yield corporate bond spreads. If 60% of this pricing anomaly were to be slowly corrected over a two-year period, the double-B CLO horizon yields would be expected to reach around 18%, with 14% of the yield coming from coupon income and 4% from price appreciation[viii].
Summary
Mezzanine CLO yields are currently elevated relative to the yields available on comparably rated corporate bonds. While CLO bonds may experience short-term mark-to-market price volatility, over a longer-term horizon, yields would be expected to remain in double-digits across a wide range of loss scenarios - including scenarios featuring default rates more extreme than those that were realised during the challenging 2007-2013 period.
At the same time, mezzanine CLO bonds offer realistic chances of return upside if bond spreads partially revert back to more historically typical levels. Given this favourable risk/return profile for mezzanine CLO debt, Pretium believes the sector should be on the radar screens of most asset allocators with long investment horizons.
Based on Pretium’s research, data and estimates from publicly available sources. Statements throughout these materials, including those regarding the market, represent the opinions and beliefs of Pretium. There can be no assurance that these will materialise.
[i]
Source: Bank of America, Pretium, data as of 31 May 2023.
[ii] Source: Bloomberg, JP Morgan CLOIE, Pretium, data as of 1 June 2023.
[iii] Source: Bloomberg, Credit Suisse, Pretium, data as of 1 June 2023.
[iv] Source: “CLO Performance”, Federal Reserve Bank of Philadelphia Working Paper No. 20-48.
[v] Source: “Loan and HY Defaults, Recoveries and Repayment Rates”, Bank of America, data as of 31 May 2023.
[vi] Source: Bank of America, LCD, Pretium.
[vii] Source: Pretium, data as of 1 June 2023. Scenario analysis assumes 100% of loans trading below US$80 default over 12 to 36 months, with incremental 0% to 8% annual defaults for loans trading above US$80, 20% annualised prepayment rates, and recovery rates at the lower of 60% and the current loan trading price minus 10 points.
[viii] Source: Pretium internal calculation.
Market Moves
Structured Finance
Securitising impact in Africa
Market updates and sector developments
Africa50 and Blue Like an Orange Sustainable Capital have launched a structured finance- and mezzanine-focused partnership to fund sustainable infrastructure in Africa. The announcement was timed to coincide with the recent New Global Financing Pact summit held in Paris, which focused on climate, development, debt and “innovative financing” for infrastructure to support economic growth.
Africa50, a pan-African infrastructure investment platform, and Latin American private debt firm Blue Like an Orange, intend to leverage their global and regional networks to source and secure private capital. The partnership will target African infrastructure-focused companies and projects, with the aim of delivering strong risk-adjusted returns and capitalising on opportunities across the continent.
The types of initiatives cited at the Paris event included traditional infrastructure such as water, green energy, transport and mobility, as well as social infrastructure such as health, education and financial services.
Market Moves
Insurance-linked securities
Seventh heaven
Market updates and sector developments
Seventh heaven
Fannie Mae has executed its sixth and seventh reinsurance deals of the year, designated CIRT 2023-6 and CIRT 2023-7, for a total of US$786bn of mortgage risk. Both trades were brokered by Aon, and the risk was shared by 21 insurance and reinsurance companies.
The two loan pools referenced through this brace of deals have an unpaid principal balance of approximately US$26.6bn. The largest, CIRT 2023-7, refers to a loan pool of US$16.9bn and has around 51,000 single family loans.
Meanwhile, CRT 2023-6 refers to a loan pool of US$9.65bn and around 30,000 single family loans.
Fannie Mae retains risk on the first 130bp of loss on CIRT 2023-6. If this retention layer, equivalent to US$125m is exhausted, then 20 insurers step in to cover the next 405bp up to a maximum of US$391m.
In CIRT 2023-7, meanwhile, Fannie retains risk on the first 155bp of loss. If the US$262m retention layer is exhausted, then 20 insurers step in to cover the next 235bp to a maximum of US$398m.
Fannie Mae has issued four CAS deals this year, covering unpaid principal of around US$101.8bn and for a total face value of US$2.1bn.
The seven CIRT deals, meanwhile, cover an almost identical amount – US$102.2bn – revealing that the reinsurance market takes 50% of GSE CRT risk and is now an equal partner alongside the capital markets programme.
In other news…
EMEA investor-placed issuance soars in May
Investor-placed securitisation issuance rose to €9.5bn in the EMEA region in May, an increase of more than 100% on the same period in 2022, according to figures released by S&P Global. The figure brings the total amount issued in the region to €36bn since the start of the year, a decrease of 21% compared with last year.
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