Contents

Capital Relief Trades

LTEL issue

SES highlights competitiveness concerns

The EBA’s final RTS on synthetic excess spread (SES) generally sparked optimism across the CRT market (SCI 6 May). Nevertheless, divergences around increased calibration and SES on certain portfolios highlight a broader issue of governance and competitiveness within the European regulatory apparatus.  

Recently, investors have been reporting of a potential structural shift, leading to a significant increase in concentration risk for SME portfolios. On this specific point, one SRT investor notes: “The one thing I’ve been saying throughout the year, and it is getting worse in my view, is that many European banks have got a lot of guarantee schemes on their SME books. Consequently, what’s left that they need to hedge is relatively limited.”

He continues: “We’ve seen many instances where banks show us the waterfall of available assets and then the ones in the deal, and there are barely any assets left. We are, in my view, taking a lot of concentration risk by sector.”

Anecdotal evidence also suggests that while the retained first loss used to typically always be one-year expected loss of the underlying portfolio, it is becoming more often than not a lifetime expected loss (and thus becoming more subordinated). The debate around the lifetime expected loss raises concerns that the absence of synthetic spread in certain structures results in an inefficient use of capital.

“The synthetic spread is a complex topic because it is open to various interpretations,” another SRT investor observes.

He continues: “Although the EBA’s final draft has certainly improved certain aspects, banks still have different interpretations of the draft. For the market, anything which is subject to interpretation is intrinsically negative. Therefore, some conservative banks opt not to do first loss with one-year EL, but rather with LTEL.”

However, outside of debates around technical interpretations surrounding the EBA’s wording, the investor points to a wider structural issue within the European block and its regulatory environment. He says: “From a bank’s perspective, it simply does not make sense to opt for LTEL because you are afraid of synthetic excess spread. Discussions around the synthetic excess spread are symptomatic of fundamental problems of governance within the European Supervisory Authorities, in this case the EBA.”

He continues: “If the final draft is adopted by the Commission, it will become a Level 2 measure and essentially becomes law. Europe has a clear issue of competitiveness and the governing bodies must ask themselves the question of why capital is not being efficiently allocated. To put bank capital against LTEL instead of EL is an example of such inefficiency.”

While the investor questions the supervisory authority’s practical vision, he remains hopeful moving forward. He concludes: “Although the synthetic excess spread is a clear example of drafting problems in regulatory proposals and more generally of broader systemic issues within European regulations, it is not too late for the Commission to act.”

Vincent Nadeau

Asset-Backed Finance

Producing results

PDP securitisations gaining traction

The number of transactions executed in the nascent proved developed producing (PDP) wellbore oil and gas ABS sector is expected to reach double-digits this year, as familiarity with the product grows. Raisa Energy closed the debut PDP securitisation in September 2019, amid a pull-back from traditional reserve-based lending (RBL) by banks, and the market experienced a meaningful increase in issuance in 2022 with seven deals totalling US$3.1bn.

“It was a case of issuers dipping their toe in the market with the first few PDP securitisations. The market began with a small investor base, but the floodgates have since opened and we now have a larger pool of investors and a dramatic increase in issuance volumes,” says Jonathan Ayre, partner at Orrick in Houston.

He adds: “At the time, the markets weren’t open for traditional oil and gas financings, so PDP securitisation was a meaningful alternative for operators. Fast-forward a few years and the concept has been proven and is now part of the financing menu.”

Unlike traditional oil and gas financings, PDP securitisations are secured by wellbores that have been drilled; in other words, they are already producing. Consequently, since investors are not lending into new drilling activity, geological and exploration risks are mitigated.

Meanwhile, commodity price volatility is mitigated by hedging arrangements that guarantee minimum prices for a given volume over a defined time horizon. The hedges are structured according to the maturity and amortisation profile of the underlying assets. For some deals featuring newer drilled wells with steeper decline curves, the hedge duration may be shorter because more amortisation occurs at the beginning of the transaction.

PDP portfolios often comprise a large number of wells and are diversified across asset types – such as natural gas liquids (NGLs), dry natural gas and crude oil – and maturity of the oil fields, as well as across different US states and oil field formations, although some deals focus on a concentrated hydrocarbon mix or geographic area.

Production risk forms an important part of investor due diligence, according to Ayre. “A third-party reserve report by an independent engineer is crucial, in order to evaluate production projections. This then is the basis for calculating the amounts that can be advanced on the deal,” he explains.

Operator due diligence is also important. Among other factors, investors favour a demonstrated track record, an experienced management team and strong capitalisation.

Compared to traditional oil and gas acquisitions, representations and warranties, title protections and indemnification remedies in the context of ABS are more robust, with the market appearing to have settled around terms that are protective of both investors and issuers. “PDP wellbores are a new asset class, which enabled us to structure the transactions to include many of the protections of a traditional securitisation structure, such as events of defaults, manager termination events, indemnities and representations and warranties,” confirms Leah Sanzari, partner at Orrick in New York.

Another characteristic of PDP securitisations is that they tend to be privately placed in the Section 4(a)(2) market, which Sanzari describes as a “win-win” for both investor and issuer parties. “Private placements allow issuers to get to know investors and develop partnerships with them, while investors are able to make knowledge-based decisions about operators and the assets. Together with more oil and gas securitisations, we expect to see more renewable energy securitisations executed via the 4(a)(2) market,” she observes.

Raisa closed its fourth PDP securitisation in July, surpassing a cumulative total of US$1bn of gross proceeds since it opened the market in 2019. The transaction marked an industry milestone by executing the first dropdown into the Raisa Funding I master trust programme, which was established in June 2022. Overall, the company has securitised around 13,000 wellbores under circa 100 operators, located in 60 counties across 10 states.

Diversified Gas & Oil, Presidio Petroleum and Riviera Resources are other operators known to have tapped the PDP securitisation market. Presidio marked its own industry milestone with its issuance in August 2021, which was the first such transaction to be privately placed with a syndicate of US-based institutional investors.

Looking ahead, as familiarity with the PDP ABS market continues to increase, Sanzari anticipates that deals will look to evolve into asset acquisition transactions. “The market would like to see securitisations be used in the context of asset acquisitions. Typically, issuers have to purchase the assets using a traditional RBL facility and hold them until the securitisation is executed. Closing simultaneously would be more efficient and could shorten the transaction timeframe significantly,” she concludes.

Corinne Smith

Capital Relief Trades

Basel 4 series: A swinging pendulum - video

Market participants share their insights into whether Basel 4 is in line with industry expectations

In the final instalment of SCI’s Basel 4 video series, ex-issuer Frank Benhamou provides a brief outline of what’s new in Basel 4 and SCI’s Kenny Wastell asks market participants about the extent to which Basel 4 is in line with expectations.

CLOs

Definition debate

Call to differentiate private credit CLOs

The private credit market is booming, encompassing US$1bn-plus mega-deals, as well as traditional direct lending in the middle market space. Against this backdrop, defining what a private credit CLO is would be helpful for investors.

“What’s interesting with private credit is that we don’t really have a uniform definition for it yet,” explains Arlene Shaw, md at Brightwood Capital Advisors. “It has become a buzzword used to lump in all of the middle market.”

The benefits of private credit CLOs are numerous, including higher par subordination and increased inter-manager diversification. However, these benefits are weighed against greater risks – such as lower liquidity and transparency – as private credit CLOs remain opaque versus their broadly syndicated loan CLO counterparts.

Portfolios backing private credit CLOs have greater asset spreads, lower ratings and fewer obligors per deal. But concentration limits are tailored for the differences in the underlying collateral.

“Traditionally, the CLO market has been the most efficient way for platforms like ours to seek efficiently priced debt, which allows us to deliver a better cost of capital to our LPs,” explains Shaw.

So far this year, private credit CLOs have accounted for US$22bn of the total US$99bn new issue CLO market – up 85% on last year. Although more and more obligors are turning towards non-bank lenders, not everyone in private credit is moving into the strategy straight away.

“It has been ambitious for us to follow the idea of CLO equity as an investment strategy, as there’s a lot of third-party equity that sits in the BSLs. So, we think there’s a lot of value creation in the middle market right now,” observes Shaw.

She adds: “We want to grow the availability of third-party equity for MM CLOs – we absolutely want to be in a position to help create a market for third-party CLO equity and find the partners who are interested in that. We want to be able to add something different to the space with a middle market CLO with a different underlying portfolio strategy.”

Historically, CLOs have held up as a solid product – even through the GFC – and could therefore show similar resilience through present and impending macro challenges. “Many CLOs proved to be good investments through the recession,” agrees Shaw. “But every financial product has its weaknesses, so it’s important to understand the advantages and disadvantages of CLOs to capitalise on your investment.”

Generally, the outlook for CLO triple-A tranches is positive, although there is greater relative value in private credit triple-As compared to BSL triple-As due to the structural benefits and point-in-time basis analysis.

Nevertheless, the private credit market is becoming increasingly more competitive. “There’s a market need for it – and I think if we position ourselves well, the same people who are buying private credit can buy us in the same box because we offer exposure to different assets at the underlying level. So, I think if you can make the case as to why someone wants you as a defensive play, as you’re offering a different risk profile, that’s great for you,” Shaw comments.

Having now closed its fifth private credit CLO, Brightwood aims to extend its CLO platform, with Shaw expressing optimism for future growth. “Eventually, the term ‘private credit’ will have to be better defined because it currently captures the mega-deals of a billion US dollars plus, as well as traditional direct lending in the middle market space,” she concludes. “When people say direct lending, everyone assumes middle market - people generally don’t think of the billion-dollar tranches. So, I think eventually in order to sell CLOs, you’re going to have to put a defining box around what that means, so that CLO purchasers can figure out what they’re buying.”

Claudia Lewis

ABS

New wings for aircraft ABS

Ashland Place issues first deal for many months

Ashland Place Finance, aided by arranger and bookrunner ATLAS SP Partners, has woken the aircraft ABS market from a deep slumber with the first deal in the sector since June 2022.

The transaction, designated APL Finance 2023-01, is the borrower’s first aviation loan ABS offering. The US$324.3m offering comprises four tranches, all of which are investment grade rated.  

The senior A notes, rated AA, are priced at 285bp over the interpolated yield curve, the B notes at plus 355bp, the C notes at plus 475bp and the D notes at plus 825bp.  

Ashland retains a US$25.7m residual value equity stake in the deal (the total loan is worth USS350m), thus fulfilling one of the major criteria deemed necessary for the aircraft ABS market to get moving again: that the issuer should have ‘skin in the game.’

The issue is backed by a static pool of loan facilities secured by 19 narrowbody aircraft, three widebody aircraft and four narrowbody host aircraft engines on lease to 12 lessees in 11 jurisdictions. There are 11 loan facilities comprised of 26 different loans.

There are other features which are said to have aroused the interest of investors, some of which had never participated in aircraft ABS deals before. Firstly, the issuer is not a leasing company. Ashland Place is the lender which writes the loans to the leasing company at a low basis.

The borrowers also have equity in the aircraft, meaning they have skin in the game too.

There are multiple layers of credit protection. The A notes represent 60%-65% of LTV versus the aircraft, for example, and have a maturity of only 1.6 years. The rest of the deal has a three-year maturity. This means that the investor doesn't have residual risk or any remarketing risk when the leases expire.

 Ashland Place also believes that the deal has a strong collateral pool, with the loan facilities being 100% primary origination, 100% sole lender and 100% secured.

The issuer was launched in 2021 and ATLAS SP has been working closely with it since then.

According to ATLAS, this deal is also the first 144a securitization of a portfolio of loans originated by an aircraft loan platform.

Ashland Place hopes to be a “perennial issuer” in the aviation ABS industry, says its press release.

Simon Boughey

Structured Finance

SCI Start the Week - 11 December 2023

A review of SCI's latest content

Last week's news and analysis
Basel 4 series: Levelling the playing field - video
Why further amendments to the Basel framework are required
CRT Market Update
Looking ahead
Digital download
Up, up and away for digital infrastructure market in 2024
Fix-and-flip fund debuts
Update on a new US bridging finance vehicle
Global Risk Transfer Report: Chapter six
In the final chapter of our report, SCI explores new frontiers for CRT
Job swaps weekly: EU finance ministers choose Calviño for EIB
People moves and key promotions in securitisation
Latest SRTx fixings released
Index values indicate gradual tightening in spreads
Salisbury sees momentum
Lloyds' latest SME SRT unveiled
SRT inspection
Lawmaker warns of perceived SRT risks
Plus
Deal-focused updates from our ABS Markets and CLO Markets services

Free Special Report available to download

SCI Global Risk Transfer Report 2023: New frontiers in CRT
Capital relief trade issuance witnessed another record-breaking 12 months in 2022, yet a number of regulatory challenges remained outstanding by the end of the year. SCI’s latest Special Report examines how the risk transfer community is addressing these issues – whether through regulatory fixes or structural enhancements – and the fallout from the turmoil in the bank sector in March. It also explores the new frontiers that are emerging across jurisdictions and asset classes, including by highlighting the potential of the Canadian and the CEE CRT markets.
Sponsored by Arch MI, Man GPM, Mayer Brown and The Texel Group, the report is available to download here.

Regulars

Recent premium research to download
Hotel CMBS – November 2023
The lodging sector is one of the few bright spots in the US CMBS landscape. This Premium Content article uncovers the reasons why.

Project finance CRT – November 2023
Synthetic securitisation is expected to play a key role in assisting Europe’s transition towards a more sustainable economy. This Premium Content article explores the significance of project finance SRT transactions within this context.

Data centre securitisation – November 2023
Insatiable demand for connectivity is fuelling a rise in data centre securitisation issuance. This Premium Content article tracks the market’s development.

(Re)insurer participation in CRTs – October 2023
(Re)insurer interest in CRTs is rising, but execution of unfunded transactions remains limited. This Premium Content article outlines the hurdles that still need to be overcome.

Utility ABS – October 2023
An uptick in utility ABS is expected as US utilities seek financial solutions for retiring the country’s aging fossil fuel fleet. This SCI Premium Content article explores how the proceeds from these transactions can be used to facilitate an equitable energy transition.

All of SCI’s premium content articles can be found here.

SCI In Conversation podcast 

In the latest episode, Matthew Bisanz, a partner in Mayer Brown’s bank regulatory practice, outlines how the Federal Reserve’s update on 28 September of the FAQs on Regulation Q is likely to impact the US capital relief trades market. The long-awaited guidance clarifies the definition of a synthetic securitisation and, crucially, states that a reservation of authority can be requested for direct CLNs. Bisanz, for one, anticipates an increased willingness – especially among larger CCAR banks – to enter into CRTs as a result.
The episode can be accessed here, as well as wherever you usually get your podcasts, including Apple Podcasts and Spotify (just search for ‘SCI In Conversation’).

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 Tauseef Asri 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
8th Annual Risk Transfer & Synthetics Seminar
1 February 2024, New York

SCI’s 3rd Annual ESG Securitisations Seminar
16th April 2024, London

Emerging Europe SRT Seminar
16 May 2024, Warsaw

2nd Annual Esoteric ABS Seminar
June, New York

CRT Training for New Market Entrants
14-15 October, London

Women In Risk Sharing
15th October, London

10th Annual Capital Relief Trades Seminar
16 & 17 October 2024, London

2nd Annual European CRE Finance Seminar
November 2024, London

Capital Relief Trades

Unusual structure debuts

Santander out with auto CLN

Santander Bank Auto Credit-Linked Notes Series 2023-B (SBCLN 2023-B) has hit the market, representing Santander’s second CLN transaction this year to reference a pool of US auto loans. The deal is unusual in that the source of principal payments for the notes will be a cash collateral account held by a third party with a rating of A2 or P1 by Moody's. In the unlikely event that the cash collateral account does not have enough funds, Santander will pay the principal.

The transaction also benefits from a letter of credit provided by a third party with a rating of A2 or P1 by Moody's. The LOC covers up to five months of interest in case of a failure to pay by Santander or as a result of a FDIC conservator or receivership. As a result, the rated notes are not capped by the long-term issuer rating of Santander Bank (Baa1).

The credit risk exposure of the notes depends on the actual realised losses incurred by the reference pool. The transaction has a pro-rata structure, which is more beneficial to the subordinate bondholders than the typical sequential-pay structure for US auto loan deals. However, the subordinate bondholders will not receive any principal unless performance tests are satisfied.

Moody’s has assigned preliminary Aaa through B3 ratings to the class A2 through class F notes of SBCLN 2023-B.

Corinne Smith

Capital Relief Trades

Polish SRT finalised

Bank Millennium closes largest synthetic to date

Bank Millennium has completed a synthetic securitisation referencing a portfolio of Polish unsecured non-mortgage loans with a total value of PLN7.2bn. This latest trade represents Bank Millennium’s largest-ever SRT deal.

The Polish bank transferred a significant part of the credit risk of the securitised portfolio to a single investor. As part of the transaction, Bank Millennium issued on 11 December CLNs with a nominal value of PLN489m. The bilateral trade has a final maturity date of 25 August 2036.

The transaction meets the materiality criteria for capital ratios of Millennium Bank, as it will increase the Common Equity Tier 1 by approximately 1.1% and the capital adequacy ratio TCR by approximately 1.4 points at the consolidated level when referenced to reported figures for the Group of Bank Millennium at end-September 2023. The full impact of the transaction on the capital ratios is expected to be recognised in Q4.

Additionally, the trade meets the requirements for significant risk transfer specified in the CRR Regulation and has been structured as meeting the STS criteria. UniCredit acted as arranger and placement agent for the transaction.

Vincent Nadeau

Capital Relief Trades

CRT Market Update

Closing days

As the final week before the Christmas break rolls around, the remainder of the Q4 SRT pipeline is making its way across the line.

While earlier in the week it had been reported that Bank Millennium and Santander (in the US) had finalised transactions, news has additionally emerged that both Eurobank and BNP Paribas have recently closed trades.

The Greek bank executed the latest transaction from its Wave programme. Wave 4 references a €1.5bn portfolio of corporate loans, with market sources reporting a pricing of Euribor plus 12.5%.

Meanwhile, BNPP completed another Proxima transaction – its second of the year – following Proxima 3 earlier in May. The latest trade – Proxima 4 – references a €1.4bn portfolio of French SME loans. As part of the bilateral transaction, the French bank placed the €106m mezzanine tranche. Furthermore, the transaction has been structured as meeting the STS criteria.

If last week it had been reported that a number of synthetic SRT deals were being postponed for Q1 next year, one SRT investor describes a very different context and outlook to last year’s.  “We’ve seen that happen (deals being postponed) in one or two cases,” he says.

He continues: "I think that they've been very, very specific reasons around that and for that reason, I do not see it as a general trend. If anything, there's been a lot of investor interest; we've seen the market become a little bit more sort of competitive as we’ve gone into Q4. Comparatively, at the back end of last year didn't like the price points and therefore pushed back the deals to Q1, Q2 the following year.  Additionally, the outlook right now versus the outlook from 12 months ago is much more optimistic from a risk point of view.”

Looking ahead into next, another investor points to the impending Basel 4 and the implementation of the final reforms as a clear trigger. He notes: “The feeling I have is that a lot of banks are looking at what they have on the books and are probably looking to start early next year.”

He concludes: “Most banks will have to move from the standardised approach to the new Basel 4 requirements and the cliff is very high. Therefore I think we will see a lot of SRTs next year to clear the bash before 2025, when you actually have to start phasing in.”

Vincent Nadeau

CMBS

Generating traction in a stalled market

Matteo Cidonio, managing partner at GWM Group, answers SCI's questions about European commercial real estate, real estate debt and CMBS

Q: The past couple of years have been a very difficult period for the CRE market globally. You recently said there are opportunities for investors who target the right real estate categories and more specifically segments, even in the current market. What would you see as being the top segments in Europe currently, and why?
A: Commercial real estate has been very much a stalled market since around the summer of 2022, when the first impact of interest rate movements started being felt. The initiation of the war in Ukraine brought consequences and the interest rate movement that followed was a clear dividing point for real estate across Europe. That essentially froze end markets for core longer-term investors who couldn't really price real estate as a direct consequence of the increase and volatility in interest rates and inflation, as well as prospects for the general economy.

There are still sectors that are relatively liquid and where we do see activity. Logistics is one, though it was a hot asset class before the most recent market turbulence. There have been and will be adjustments to valuations on logistics, mostly driven by cap rate expansion deriving from the increased interest rate environment, but the reality is that the fundamentals of the asset class are very strong. There's a lot of need for these types of assets, and it looks like demand for the space is going to increase a lot more with the advent of AI, so investors can and do take a view on the scarcity of the product.

Hospitality, in its different iterations, is another. It has benefited substantially from pent up demand from the lockdown and of the inherent increase in savings that happened during Covid. There is a combination of revived interest in hospitality where investors believe people will travel more, albeit more selectively, because of the experience of lockdown. 

But there has also been a systemic shift in interest in terms of types of hospitality. Traditional business hotels are more likely to be suffering because of reduced business travel and erosion of margins. The segments attracting investors’ interest are; efficient, cheap hotels also with smaller rooms and limited service; high-end hospitality; and lifestyle or experience hospitality driven by entertainment.

In addition to logistics and hospitality, the third area is anything related to new types of living, including student housing, senior accommodation, or build to rent. Across Europe, there's a need for renovation of residential stock and more energy efficient buildings. This is not just driven by ethical or emotional generational motivations, but by a strong economic component related to utility costs and consumption.

Q: The office space has been one of the hardest hit spaces in commercial real estate by the Covid-19 pandemic. A recent — albeit US-focused — report by DBRS Morningstar put the delinquency rate in CMBS portfolios at 4.03% in October, an increase of 121bp on the start of the year. What do you see as the current state of play in the European office space and the opportunities in the coming years?
A: What we've seen in Europe has been very different from what's happened in the US. In the US employers are having much greater difficulty in bringing employees back to the office. Generally this is less the case in Europe. Clearly there are exceptions, where greater challenges appear also in Europe, in locations such as Canary Wharf in London, La Défense in Paris and Frankfurt. But generally employees are happier going back to the office in Europe.

This is driven by the relatively smaller size of cities and the nature and quality of office stock, with either historic or relatively modern buildings, so people feel good in them. The US also has a much greater proportion of pure office districts compared to Europe. The greater work-life balance and attention to ESG criteria has brought the setup of office areas in town closer to where European cities have traditionally been.

Last but not least, transport infrastructure and commuting time are big factors. US employees typically face longer commuting times vis-à-vis their European peers, with relatively less capital invested to modernise non-road infrastructure in the US versus Europe. In Europe commuting is generally quicker and easier, and that is positive for the commercial real estate sector.

Q: You've spoken before about the need to distinguish between modern stock and stock that is perhaps a bit outdated. How does that factor in?
A: There obviously is that distinction, which will only increase, between modern office buildings and buildings that need to be modernised. There's a huge investment opportunity in the office sector to modernise buildings that are not up to standard and which institutional tenants would currently not want to move into.

Tenants have become very selective because — not only are they conscious of their communication strategies — but employees have become selective and employers need a best-in-class office to attract and retain office-based talent.

Speaking to various tenants of our office portfolio, we understand that typically senior management wants their teams back in the office. They value the social element of the office space, which helps foster corporate culture, internal and external networking and exchange of ideas — and generally contributes to the creation of value for the company. There is a feeling that, in order to enhance corporate culture and affiliation, and create that positive energy, people need to spend time together. 

We generally see a need to occupy similar or slightly reduced square footage as before — for a similar number of employees — but where the space is organised in a different way, and includes more social areas, including break areas, lounges, etcetera. 

The office sector is going to provide very interesting investment opportunities because of this dislocation between high-quality and low-quality offices and the possibility for experienced operators to shift an asset from one category to the other and create value. 

Q: To what extent are those opportunities that capital market investors are responding to?
A: Now that is the key question: When is the office sector overall going to be appealing again to long-term investors — to the insurance companies and pension funds of this world? They're cautious because of what's happening in the US and the impact of remote working, so there is a general feeling that there is a need to wait and see what happens. 

We do not believe the sector in general will be under-invested for the long run, firstly because it still is the largest sector in commercial real estate, secondly because most investors — as most own offices in their portfolios — will be able to assess the performance of good quality assets. It will be a much shorter recovery, compared with how long the retail sector is taking to come back from the shadows of e-commerce and the pandemic. 

Q: In terms of your commercial real estate debt strategy, what parts of the capital stack are proving most popular with investors currently and what is driving that?
A: Given the increase in interest rates and the pressure from central banks, traditional banks in Europe are somewhat retrenching from commercial real estate lending. This is cyclical and it provides today for a great opportunity for alternative investors to gain exposure to the sector, whether that is senior debt, mezzanine, or pref equity. 

Real estate values have been and are still going down, mostly driven by the increased interest rate environment, but also the asset class has and will prove to go back to its fundamentals of providing a relatively safer haven for inflation protection. Pre-global financial crisis, we had higher interest rates and top real estate assets were trading at cap rates that were in line with long-term interest rates. I believe that once the market stabilises and volatility normalises, we will have to go back to that metric.

In the aftermath of the GFC, where interest rates trended to zero and commercial real estate debt was cheap, investors had been looking at real estate as a means to gain yield, as this could not be achieved in the credit markets. Even with a very low asset yield the investment would have generated a favourably comparable levered yield. We feel today we are back to the basics of real estate investment, where leverage on high-quality real estate is used mostly to boost its inflation protection nature as opposed to generating greater running yield. 

Q: How is that outlook reflected in your strategies?
A: We have been investors in real estate performing and distressed credit since inception. Today we manage two separate strategies, in two funds. The first is a commercial real estate senior lending fund, CREDO, which is lending on low risk strategies, and targets — on an unlevered basis — low double digit returns, with a quarterly yield distribution for our investors. The second is a real estate special situations fund, RESS 3, where we take more risk, and positions typically in the mezz and pref equity space, as well as distressed debt, which is targeting net high teen returns for our investors.

If you think about refinancing an asset of up to 60% to 65% loan to real value, that's suitable for a senior lending fund. In this case we would only finance assets where we see a minimal risk of default.

In our special situations strategy, with the RESS3 fund, we always assess the risk of potentially owning the asset if the loan goes into default, and investing through debt allows you to have a lower basis than the perceived fair market value of that asset today.

Of course, that's a very particular case. Generally, if you're backing a good sponsor they will be able to create value at the asset level. You're not really banking on the current value of the asset, but on the projected value of the assets. That would facilitate the repayment of the loan through a sale or refinancing.

Q: GWM’s Commercial Real Estate Debt Opportunity Fund realised its first investment last month with the full repayment of a €10m loan. To what extent do you view the securitisation market as a potential exit route going forward?
A: I don't see a big CRE securitisation market in Europe currently, with investors interested in buying tranches of different loans put together — what was the CMBS market. I believe longer-term investors that may previously have looked at the securitisation market may potentially invest as syndicated partners in larger loans. 

CMBS buyers may historically have been insurance companies and pension funds. A lot of these players today have their own debt strategies, either through their own fund or via a strategy where they participate side by side with banks or alternative lenders on selected loans.

The CMBS market in Europe is very different from the one in the US. It's a lot smaller and it's become a niche market after the global financial crisis when whatever was viewed as a structured product was considered toxic. A lot of investors backed out of the sector and have only just been coming back in the last few years.

But if you look at the universe of European CMBS, there are not many CMBS deals out there and most of them are fairly simple — either secured on one deal or for example on three loans from the same sponsor. They're almost like a syndicated loan in terms of collateral, in the form of a securitisation.

I don't envisage securitisation as a way of refinancing our commercial real estate debt portfolio. Syndication, bringing individual investors into a sub-portfolio, could instead be an option. It would likely be one or two investors and could even be through a securitisation structure, but I wouldn't call it a real securitisation.

As far as our credit exposure in CREDO, we always target assets that we believe may be in a position, at maturity of our loan, to either be sold or be refinanced on the traditional banking market. The assets we like lending to are transitional assets — assets where value is being created by the sponsor. We believe this strategy brings you more opportunity in terms of refinancing. 

If you're financing assets where there's an underlying strategy of value enhancement, you end up having a different product at the end of the lifecycle of the asset. If that revamp goes well, your loan to value is going to be substantially lower because the value of the asset has gone up. That puts you in a position to have both a sale opportunity and a refinancing opportunity.

Kenny Wastell

Structured Finance

Basel 3 'roadmap', reporting ITS published

Market updates and sector developments

The EBA has published its roadmap on the so-called Banking Package, which implements the final Basel 3 reforms in the EU. The roadmap aims to strengthen the prudential framework, as well as ensure an international level playing field. It also seeks to provide clarity on how it will develop the mandates implementing the legislation and finalise the most significant components ahead of the application date, on 1 January 2025. 

Additionally, with the objective of supporting the green transition, the Banking Package includes new rules requiring banks to systematically identify, disclose and manage risks arising from ESG factors as part of their risk management. Furthermore, it provides stronger enforcement tools for supervisors overseeing EU banks.

The EBA roadmap confirms that the development of regulatory products will follow their legal deadlines, most of which will be consulted on and finalised within the two to three years after the entry into force of CRR3 and CRD6. Indeed, the first batch of regulatory products have simultaneously been published for consultation. These include two draft implementing technical standards (ITS) amending Pillar 3 disclosures and supervisory reporting requirements, a discussion paper on the Pillar 3 data hub, an amended draft regulatory technical standards (RTS) on the standardised approach for counterparty credit risk and an amended RTS on the treatment of FX and commodity risk in the banking book, the profit and loss attribution test and the risk factor modellability assessment.

The consultations on the draft ITS amending Pillar 3 disclosures and supervisory reporting requirements run until 14 March 2024. In line with the Roadmap, the EBA will follow a two-step sequential approach to amend both the Pillar 3 disclosures and supervisory reporting ITS – prioritising, in step 1, those changes necessary to implement and monitor Basel 3 requirements in the EU. Later in 2024, as part of step 2, the authority will develop reporting and disclosure requirements that are not directly linked to Basel 3 implementation, together with those requirements with an extended implementation timeline. 

In particular, the draft ITS seek to implement the changes related to the output floor, credit risk - including immovable property (IP) losses - capital valuation adjustment (CVA), market risk and leverage ratio. The amendments related to the new operational risk are not covered by these consultation papers but will be consulted on together with some policy products at the beginning of 2024. 

A public hearing on the draft ITS will take place on 23 January 2024. Following the consultation period, the two draft ITS will be finalised, with the expectation that they will be submitted to the European Commission by June 2023.

In other news…

BBB rolls out ABL scheme
The British Business Bank has launched an asset-based lending variant of the Recovery Loan Scheme, with the aim of broadening the support available for small businesses in the UK to access finance while making use of a broad range of business assets. The bank’s guarantee and wholesale division worked closely with UK Finance and asset-based lenders to develop this variant.

Asset-based lending will allow lenders to provide loans secured by assets, such as inventory, accounts receivable, equipment or other property owned by the borrower. Recovery Loan Scheme asset-based lending will be delivered by established asset-based lenders and the British Business Bank welcomes asset-based lenders to consider applying for accreditation.

Investor survey ‘broadly positive’
Responses to KBRA’s fourth European securitisation investor survey reveal a broadly positive picture for the industry, with market participants indicating that spreads are poised to improve in the next six months and issuance is likely to increase. However, one-third still believe that market volatility and negative moves are possible in the near term.

In fact, KBRA reports that investor expectations are the most positive since its first survey in June 2022, with most respondents anticipating a tightening bias in European securitisation markets. This is especially true for investors in CLOs, ABS and RMBS.

Meanwhile, a large pipeline of new issue transactions are anticipated in the New Year, with most investors predicting an improvement on current levels.

The UK remains the region of greatest concern for credit performance. However, some of the focus has moved to other regions, with general pan-European concerns increasing significantly from the prior survey.

ISDA launches DC review
ISDA has launched a review of the structure and governance of the credit derivatives determinations committees (DCs), appointing Linklaters to conduct an independent assessment and recommend any changes to maintain the integrity of the DCs in changing economic and market conditions. Once complete, a report will be published on ISDA’s website and opened to a market-wide consultation to determine which of the potential changes have broad support from market participants and other stakeholders. ISDA will then work with members to develop specific implementing changes that will be recommended to the DCs for action.

The process for developing the report will involve interviews with market participants and other stakeholders, such as regulators and academics, to determine what steps might be taken to improve the functioning of the DCs. The review will begin in December 2023, with the market-wide consultation expected later in 2024.

The DCs have been in operation for nearly 15 years with the same fundamental structure put in place in 2009, but the number of firms willing to serve on the DCs has declined steadily in recent years, according to ISDA. “While there is no minimum number of DC members and the DCs function effectively and can continue to do so, we think now is the appropriate time to consider whether potential changes could be made to maintain a robust, centralised and transparent mechanism for the determination and settlement of credit events, which is vital for the central clearing of credit default swaps,” comments Scott O’Malia, ISDA’s chief executive.

Structured Finance

PRA publishes first Basel policy statement

Market updates and sector developments

The PRA has published the first of two near-final policy statements covering the implementation of the Basel 3.1 standards for market risk, credit valuation adjustment risk, counterparty credit risk and operational risk. The near-final policy statement takes into account feedback received to the PRA’s consultation paper (CP) on the Basel 3.1 standards published in November 2022.

The PRA says it received 126 responses to the CP and had extensive engagement with interested parties during and after the consultation period. As a result, the authority has adjusted its original proposals in a range of areas to: amend the proposals where respondents provided evidence suggesting they did not appropriately and/or proportionately reflect risks; facilitate policy implementation where feedback suggested prudent but less burdensome alternative approaches were available; enhance the relative standing of the UK as a place for internationally active firms to operate; and improve the clarity of rules.

Among the most material of these adjustments is the removal of market risk internal modelling for the default risk of exposures to sovereigns, aligning the market risk and credit risk frameworks and addressing capital requirements for some sovereigns put forward under the original proposals. There is also added flexibility in the CVA risk framework through the introduction of an optional transitional arrangement to reduce the operational burden on firms.

In the CP, the PRA stated that when introducing Basel 3.1 it intended to avoid any potential double-counting of capital requirements with existing firm-specific Pillar 2 requirements. The policy statement reaffirms that intention and describe how the authority will approach it in practice by prioritising adjusting firm-specific Pillar 2 capital ahead of implementation in July 2025.

Based on its latest data, the PRA estimates that the impact of Basel 3.1 requirements will be low and result in an average increase in Tier 1 capital requirements for UK firms of around 3% once fully phased in (in 2030). This is lower than the EBA’s estimate of a Tier 1 increase of around 10% in the EU and the US agencies’ estimate of a CET 1 increase of around 16% for US firms.

The near-final rules aim to narrow the gap between the risk weights calculated under internal models and the standardised approaches, while supporting international competitiveness by aligning with international standards. They also seek to make capital ratios more consistent and comparable.

The PRA intends to publish its second near-final policy statement in 2Q24 on the remaining elements of the Basel 3.1 package, which includes credit risk, the output floor, reporting and disclosure requirements. The timeline for Basel 3.1 standards implementation is on 1 July 2025, with a 4.5-year transitional period ending on 1 January 2030.