Contents

ABS

Esoteric ABS: Fragmenting industry - video

Revere Capital's Gary Miller speaks to SCI about esoteric ABS

Gary Miller, head of Revere Capital’s specialty finance team, speaks to SCI’s Simon Boughey about some of the latest developments in esoteric ABS. Miller discusses the types of asset classes that currently appeal to him, how those asset class types have changed over the years, the likely short-term growth areas, and more.

ABS

Speeding ticket

Rate of EV development compounds declining residual values and increased credit risk in auto ABS

Declining residual values of fully electric vehicles (BEV) and plug-in hybrids (PHEV) is leading to increased credit risk in auto ABS pools, according to a report by S&P Global Ratings. With BEVs also performing significantly worse than PHEVs, the agency is adjusting its analytical approach, with separate considerations and concentration limits for each technology.

“Electric vehicle technology is still quite new in relative terms, but we’re now starting to see more data on second hand prices coming through,” says Doug Paterson, a director in the ABS team at S&P. “We conduct regular reviews of that data. What it is telling us is that the depreciation rates for electric vehicles are worse – and in some countries significantly worse – than for fully hybrid vehicles (HEV) and internal combustion engine (ICE) vehicles.”

Paterson says there are a “multitude of factors” at play behind this trend. One major consideration is the rate of improvements in EV technology – such as increasing vehicle range and decreasing charging times – meaning consumer concerns around obsolescence in the market are elevated. 

This is exacerbated by the expected introduction of solid-state battery technology in the EV market, though Paterson anticipates it will likely be at least four years before this is introduced on a mass-market basis. Additionally, he says, consumers’ uncertainty surrounding battery degradation in used electric vehicles is not as easily addressed as mechanical concerns in ICE vehicles, where mechanics can provide diagnoses relatively straightforwardly. 

For battery electric vehicles (BEV) the impact of all these factors is somewhat more significant than it is for plug-in hybrids (PHEV). Consequently, S&P has introduced a concentration limit of 10% for BEVs in auto ABS pools in the US and European markets, above which it adjusts its recovery and residual value assumptions accordingly. Additionally, it is introducing a 30% limit on PHEVs in European pools and 20% in the US.

“With plug-in hybrids, you do have the fuel technology alongside the electric, so there is less range anxiety,” says Paterson. “Additionally, while there have been improvements in charging infrastructure – which varies by country and is dependent on factors such as rural versus urban areas – those improvements have not necessarily kept up with the increase in supply of electric vehicles.” Again, that is more of a concern for buyers of battery electric vehicles than plug-in hybrid buyers.

This divergence is reflected in S&P’s report, which shows that the trade residual value of BEVs as a percentage of list price is forecast to be between 30% and 40% in 2024. The residual value of PHEVs, in contrast, is forecast to be between 50% and 60%. The report forecasts that the gap between the two will converge in the next three years. However, it does not yet forecast a date at which the residual value of fully electric vehicles will overtake that of PHEVs, let alone HEVs or ICE vehicles – which are also anticipated to drop as we reach 2027.

Nevertheless, while S&P’s report acknowledges that “electrification is here to stay” and that a growing market share of BEVs and PHEVs will increase credit risk in auto ABS transactions, Paterson says the impact will not be drastic. In 2023, BEVs and PHEVs combined represented around 22% of new car registrations in Europe and just 9.3% of total US sales.

“There is a significant transition and long-term trend towards electric vehicles,” says Paterson. “But they still account for the minority of auto sales and generally comprise a relatively small proportion of auto ABS pools — currently typically within the 10% and 30% concentration limits we have applied for BEV and PHEV vehicles respectively.”

He adds: “It is also important to note that the credit risk is limited by the short weighted average life in auto ABS pools – these tend to be short-term loans that people pay off relatively quickly. So we believe our current residual value and recovery stresses address the additional credit risk that results from a growing market share of EVs.”

Kenny Wastell

ABS

In recovery

Recovery ABS is increasingly big business, despite caveats

Over US$2bn of recovery ABS has been issued so far this year, and though 2024 issuance is unlikely to surpass the record US$20bn seen in 2022, the market is flourishing as more and more states pass the necessary legislation.

New York, for example, passed laws permitting issuance of recovery bonds last month, which now await only the signature of Governor Kathy Hochul. Over half the states in the union have now passed similar legislation. 

The first recovery ABS was issued in 1997, but volume has increased in the last few years due to the increasing severity of storm-related damage to utility infrastructure and, most particularly, from acute wildfires – often seemingly a result of poor forest management and arson.

For example, there is an outstanding SF-1 filing by Pacific Gas & Electric (PG&E) to issue up to US$1.2bn in wildfire recovery bonds later this year. Cleco, an electric utility serving nearly 300,000 customers in Louisiana, has also proposed a storm bond. 

Recovery ABS can also be issued to recoup costs incurred through the retirement of fossil fuel plants, making the structure popular with environmentalists. At the end of June, for example, the Missouri Public Service Commission issued a financing order that authorises Ameren Missouri to issue “securitised utility tariff bonds for energy transition costs and associated financing costs related to the early retirement of its Rush Island Energy Center” – a coal-fired plant. Missouri first authorised securitisation as a means by which utilities could recover costs in 2021.

However, it is also worth noting that there has been pushback from the utilities to plunge too far down this particular avenue. “The utilities think this isn’t always advantageous. They take the line, ‘This fossil plant isn’t fully depreciated, we’re giving up something we’re allowed to earn a return on and we have these people called shareholder,’” says a recovery bond expert.

The structure of recovery bonds is unique in structured finance. Interest and principal payment are backed only by a non-circumventable charge on customer bills. Legislation is required to empower utilities to collect the costs from the users. 

That legislation mandates an irrevocable financing order from the state utility commission, authorises the creation of an intangible property right and collection of “non-bypassable charges”. This is the only means by which payment of interest and principal are ensured.

“The bonds are backed by an intangible right to collect a monthly charge on every customer's bill. That’s it. So the legislation is very important. The collateral isn't tangible, like those for credit cards for instance,” Jeremy Traska, an md at Drexel Hamilton, a niche investment bank in New York.

The firm has been an underwriter of recovery bonds since 2015 and began its recovery bond advisory business in 2019. In February of this year, for example, it advised the State Commission of Virginia for its inaugural utility securitisation, which was a US$1.28bn bond issued by the Virginia Power Fuel Securitization. It has also acted as adviser for the Public Utility Commissioner of Texas in bonds issued by the Electric Reliability Council of Texas (ERCOT) and Entergy Texas.

Generally, the utilities then set up an SPV which sells the notes. It then adds an ongoing charge to the monthly bills, which are transferred to the SPV and distributed to the bondholders. 

In Louisiana, Oklahoma and Texas, however, the notes are issued directly by the utilities without the use of an SPV. 

Recovery ABS bonds are not uncontroversial. Normally the weighted average life (WAL) of these notes is less than 10 years, but the costs incurred, chiefly through devastating wildfires, in California have been so huge that bonds have not only been very large the WALs have been as long as 30 years.

This means customers who might not have been born when the damage occurred will still incur costs on their bills. This has led to criticism from poverty advocates who sometimes maintain lower income customers bear an unfair burden.

The extent of issuance by PG&E in particular has led to some credit concerns as well.

The structure and pricing are thus subject to rigorous examination and lawmakers can insist a bond is withdrawn after closing if it cannot be shown that it will offer customers long-term savings.

“Securitisation has to offer a quantifiable benefit on a net present value basis versus traditional recovery methods. Once the bond is priced, the utility will say 'securitisation resulted in a,' say, 'US$95m saving to the customer versus the traditional means.' That’s the math you have to do,” explains Traska.

Recent reports have also been critical of Bloomberg’s decision to reclassify recovery notes as ABS rather than bonds in its widely followed bond indices. This restricted the pool of potential investors as some are prohibited from buying ABS, and lowered prices and raised yields. The higher interest rate costs were then passed on to investors. 

But, say those in the business, there were good reasons to reclassify recovery ABS. “The typical corporate investor doesn’t like amortising bonds and utility securitisations are fairly illiquid as well, so the rationale to kick them out was there,” says one. 

Others note that pricing analysis conducted before and after index exclusion was somewhat opaque so to draw concrete numerical conclusions about how much more customers are now obliged to pay is tenuous. 

Despite the caveats to the process and structure, there are more advocates of recovery ABS than naysayers. The number of states authorising issuance backed by collection of fees is growing. There is about US$31bn currently outstanding in recovery ABS, and that seems likely to grow rather than diminish.

Simon Boughey

Capital Relief Trades

Regional rapture

Pressures combine to make CRT the dream ticket for US regionals

Capital relief trades make even more economic sense for the larger regional banks than they do for the GSIBs, according to a new report by Fitch.

Usage of the mechanism is expected to increase across the board, but the US regionals represent perhaps the biggest growth area.

“Though Basel III endgame (B3E) rules will be less strenuous than originally proposed, it is still likely that there will be a capital increase for all banks over US$100bn. Coupled with higher long-term rates, notwithstanding there might be rate cuts later in the year, Street portfolios are still very much under water. There is a pretty meaningful capital impact on larger regional banks,” Julie Solar, one of the authors of the report, told SCI.

In a recent earnings call, Truist reported that the fair value of loans held for investment at the end of Q1 was US$8bn less than the book value. Truist was approved by the Fed to issue a CLN in a letter of March 12 2024, but as yet it has not issued in the market.

There are other reasons why the regionals are increasingly likely to look at CRT. One is the probable inclusion of unrealized losses in the calculation of capital ratios. This has been one of the least controversial areas of B3E and has received little pushback from the industry.

The impact of losses in accumulated other comprehensive income (AOCI) was at the heart of the banking crisis in spring of last year, and its inclusion upon CET1 calculation would also bring the US into line with global standards. In the past, banks with assets over US$250bn were caught by the Federal Reserve’s more onerous strictures, but the threshold is now US$100bn. This new cutoff point captures around 25 US banks.

By opting out of including unrealized losses in capital calculations, regionals have raised their CET1 ratios by, on average, 200bp. “While the final rule likely will be phased in over time, it will materially impact some banks and will likely drive increased RWA optimization,” notes the report.

In addition, loans comprise an average of about 54% of assets on balance sheet at regionals compared to 26% at the GSIBs. This means that use of CRT could have a proportionally greater effect on RWA.

Finally, the letters of approval for use of CLNs as synthetic securitizations posted by the Fed to supplicant banks says, “this action applies only to the CLN transaction and other substantially identical CLN transactions up to an aggregate outstanding reference portfolio principal amount of the lower of 100% of (the bank’s) total capital or US$20bn.”

A floor of US$20bn represents a much greater chunk of the balance sheet for regionals than for GSIBs. Regionals can issue proportionally more CRT deals than their bigger cousins, with a greater impact on capital relief.

Fitch offers several caveats to the use of CRT transactions. Firstly, although spreads have contracted significantly this year, coupons are still more juicy than in most other areas of the bond market. The recent Ally deal, for example, paid between 5.68% and 12.75% according to tranches.

The agency also warns against use of the proceeds for share repurchases or to increase leverage, both of which could create negative ratings pressure.

But the tailwinds for regional bank CRT significantly outweigh the headwinds.

“The run rate for US banks does seem to be a lot higher. There seems to be a lot more activity on the US bank side vis-à-vis the usual EU banks,” Monsur Hussain, a co-author of the report, told SCI.

Simon Boughey

Structured Finance

Job swaps weekly: Proskauer lures A&O Shearman co-head of global banking

People moves and key promotions in securitisation

This week’s roundup of securitisation job swaps sees Proskauer Rose snapping up two A&O Shearman partners for its global finance practice. Elsewhere, Womble Bond Dickinson has added a Latin America-focused partner to advise on capital markets and structured finance, while Anchor Health Properties has lured a structured finance-focused senior vice president.

Philip Bowden has left his role as partner and co-head of global banking at A&O Shearman after 25 years with the firm to take up the role of partner in Proskauer Rose’s global finance practice. His practice focuses on leveraged acquisition finance, structured finance and investment grade event-driven acquisition financings.

Proskauer simultaneously announced the hiring of Megan Lawrence – also from A&O Shearman – as a partner, with particular expertise in the syndicated and leveraged loan markets. She spent a combined eight and a half years with the firm across two stints, and also previously worked at Davis Polk & Wardwell, Baker McKenzie and Werksmans Attorneys.

The development comes almost three months after Allen & Overy and Shearman & Sterling completed their merger and announced a rebrand as A&O Shearman. 

Meanwhile, Womble Bond Dickinson has hired Hogan Lovells veteran David Contreiras Tyler as a New York-based partner in its finance, bankruptcy, and restructuring practice. In his new role, Contreiras Tyler will advise on US and cross-border transactions in capital markets and structured finance, with a particular focus on Latin America. He leaves his position as local partner in Hogan Lovells’ São Paulo office after 13 years with the firm, having previously had spells at American Express, Inter-American Development Bank and Dewey & LeBoeuf.

Anchor Health Properties has appointed Todd Graham from real estate investment firm Veyron as senior vice president, debt capital markets - structured finance, based in Houston. Graham joined Veyron as senior md in July last year, having previously worked at Cantor Fitzgerald, MHT Partners and First/Third Capital Group.

Aon has appointed Lloyd’s of London’s head of member services, Ed Thomas, as head of Lloyd’s Capital within its reinsurance solutions capital advisory team, based in London. In his new role, Thomas will lead the firm’s Lloyd’s-focused capital advisory services, focusing on capital-raising and capacity-enhancing initiatives. He will also support the creation of new syndicates and deliver risk transfer and capital optimisation programmes. Thomas leaves Lloyd’s after five years and previously worked at Deloitte, The Ardonagh Group and Chubb.

Banque du Caire has promoted Mostafa Al-Fooly to head of project finance division – debt and structured finance. Based in Cairo, Al-Fooly has been with the bank for six years and is promoted from team leader. He previously worked at Bank Audi, AlexBank and Banque Misr.

Experienced Societe Generale CIP professional Sylvie Pilate has transitioned into a new role as director for structured finance - norms and regulations. Based in Paris, Pilate has been with the bank since 2007 and moves on from her position as program director for risk - regulatory data management. 

CDP Cassa Depositi e Prestiti has made two promotions in its structured finance team. The Italian state-run development bank has elevated Francesco Cammarano to corporate and structured finance associate and Giovanni Manenti to corporate and structured finance senior specialist, both based in Rome. Cammarano joined CDP in 2019 and is promoted from analyst, while Manenti joined the group three years ago and is also promoted from analyst.

And finally, A&O Shearman’s Michaela du Toit has left the firm to take up the role of legal broker in the structured and bespoke solutions team at The Texel Group, based in London. In her new role, du Toit will report to Alan Ball, a director and head of structured and bespoke solutions at Texel. She leaves her position as associate in the derivatives and structured finance practice at A&O Shearman after almost three years with the firm, and previously worked at Cliffe Dekker Hofmeyr.

Kenny Wastell

Capital Relief Trades

CAS five

Market updates and sector developments

Fannie Mae has priced its fifth CAS deal of the year – a US$659m REMIC designated CAS 2024-R05. The transaction is underwritten by Wells Fargo and Morgan Stanley.

It consists of two US$283.86m M1 tranches (2A-M1 and 2M-1) rated Aa3/A and A2/A respectively. Both have been priced to yield 100bp over SOFR.

In addition, there is a US$183.47m M2 tranche, rated Baa1/BBB, yielding SOFR plus 170bp and a US$67.59m B1 tranche rated Baa3.BB yielding SOFR plus 200bp.

The reference pool consists of 61,000 single family mortgages with an unpaid principal balance of US$21.5bn. The high LTV loans were acquired between June and December 2023.