Market Wrap

Excess Spread - Cap costs, BTL battering, bruised not broken

Owen Sanderson's avatar
  1. Owen Sanderson
10 min read

Costing caps

Fresh from their much-deserved “CLO Arranger of the Year” at the GlobalCapital Awards on Wednesday, the Jefferies CLO team priced the two primary issues of last week on Friday, the reset of CSAM’s Madison Park Euro Funding XV and Spire Partners’ new issue Aurium X.

Both deals scored a 115 bps senior print, which seems very much the market benchmark level for now. More surprising was the term structure — both are full-blooded 2 year non-call, 5 year reinvestment period deals. Pre-war, 1.5/4.5 was the standard, while several of the post-war trades are 1/3 structures like the post-Covid CLO crop.

That sounds like good news, but it depends how you read it — if equity doesn’t expect a market normalisation in a year or so, allowing a reset tighter, then why not give up a longer non-call and receive a more flexible deal with a nice long reinvestment period?

Both Spire and CSAM and opted to issue capped triple-A notes to manage their fixed rate hedging, rather than a separate fixed rate double-A tranche (a trend we discussed in our IMN conference writeup here) — the already-thin investor base for the fixed tranche is charging more, on a mid-swaps basis, to participate in the new issue CLO capital structure, pushing managers and equity to seek alternative routes to matching their 10% fixed rate buckets to their liability structure.

But we had an interesting debate about the dynamics behind this move this week. Rates volatility has massively shot up (Jefferies only started adding the capped tranches since the ECB meeting on 3 February signalled coming rate hikes) but the value of the cap is still miles out of the money - it’s arguably only worth 5-10 bps.

Given there’s a 35 bps basis between the regular triple A and the capped triple A, this is definitely offering a premium to the investors that can take on a capped tranche (some triple-A buyers are mandate-constrained). This premium, however, may be lower than premium for issuing a fixed rate double-A in current markets.

So is the decision to split the triple-A actually a way to carve out more generous terms for a marginal senior buyer? Or is it a clever hedging solution?

Why not both? The market value of a cap, stripped out of a structure and sold on by an investor, may be 5-10 bps, but its value to the CLO manager might be considerably higher if it, indeed, allows a better tranche structure which can accommodate more fixed rate assets.

We also note the presence of Mizuho as a bookrunner on the Spire Partners deal, an unusual presence as a European CLO primary bank, despite an attempt to build out a primary business a few years back. Stefan Stefanov joined from Commerzbank in 2019 for that purpose, but has since left for Natixis, while Andrew Feachem and Juan-Carlos Martorell, who ran the London structured credit group, are now with Guy Carpenter and Munich Re respectively.

Mizuho seems to have been providing warehousing and risk retention financing to Spire on the deal, so it’s probably a reflection of that role, rather than an indication of an anchor order like the StanChart deals. As we bothered digging out the docs on this deal, we might as well add that equity in the warehouse seems to have been a vehicle of Elliott Advisors, which is a CLO player in its own right via US subsidiary Elmwood.

Jefferies’ warehousing arrangements have been a rather niche interest of mine since the Jefferies team joined from Citi in 2020. A previous Jefferies attempt to build a European CLO shop had planned to partner with a German bank on warehousing, though this eventually fell through.

The Jefferies balance sheet is too expensive to take on commercial bank behemoths like BNP Paribas or Citi on cost of warehouse funds - the natural spot for Jefferies is in the deep mezz or even equity, where it has arrangements with CQS, TCW and Carlson Capital

So partners of various sorts have always likely been in the mix, and the most likely money to do this is a commercial bank without much of its own CLO operation. Santander and Commerzbank, for example, have lots of cheap balance sheet and a fondness for senior CLO paper, so backing out Jefferies warehouses wouldn’t be a huge stretch. Mizuho would also fit the bill very nicely!

Perhaps the whole idea of a partnership is to overly formalise matters though. If Jefferies can reliably distribute the warehouse facility to any number of banks, does it need a permanent arrangement in place? That’s the Jefferies model right there — underwriting and moving risk, not sitting on it.

Is the CLO arb actually broken or do managers just love complaining?

The brokenness of the CLO arbitrage was a constant refrain a couple of weeks back, at IMN’s CLO and leveraged loan conference in London, and managers with open warehouses are certainly looking carefully at finding issuance windows....but just how broken are we talking here?

The debt stack for Spire Partners is costing 230 bps or so, and new loans are at 450 bps (Refresco, a a much-loved middle of the fairway B2/B+ credit, looks likely to land at 425 bps / 99 OID). That’s a respectable margin, lever it 10x and you’re looking at a decent return, generously into the IRR incentive fee zone.

This is very quick and very dirty maths (please do not write in and complain) but it’s not totally wrong....there are, however, a few assumptions baked in.

First, will there be good loan supply at these levels? There’s a lot of underwritten primary waiting to come, but precious few new issues actually launched into general syndication. Just as CLO managers are waiting to time the market hoping to lock in a nice level, loan underwriting banks are hoping to avoid going into their fees as they work through their book.

Second, how much is already in the portfolio and at what level? Spire has been an active manager this year, printing Aurium IX via Credit Suisse on February 23 and Aurium X just over two months later. But it’s not a post-invasion print and sprint — the warehouse was open late last year, though perhaps hadn’t been filled extensively.

Managers that opened warehouses and bought assets aggressively at the back end of 2021 or in January are likely looking more worried, but there’s still a fair few deals in marketing. Bruised, let’s say, not broken.

The origination will continue until morale improves

Last week we looked quickly at the ugly situation developing in UK buy-to-let, where (some) securitisation-funded lenders are now seemingly writing loans below their cost of capital, thanks to the blowout in RMBS spreads and, much more serious, the sharp widening in UK swap spreads. To keep market share now means originating loans cheaper than they can be funded, a business model with, let’s say, a limited shelf life.

I put together a quick Twitter thread on the subject, which garnered lots of interest...I had two journos from mortgage rags get in touch to interview me, and a few specialist lenders reach out to offer some extra thoughts. One interested reader was able to send me the broker grid for current BTL rates, helpful for getting a better sense of where the trouble is going to be most acute.

A name that keeps cropping up in these discussions is Landbay, which I guess you’d call a rather seasoned startup at this point — it started in 2014, and has been an active participant in securitisation markets since, feeding mortgages into Citi’s Canada Square shelf, into a Davidson Kempner-sponsored programme (taken out in January via Stratton BTL Funding), and also originating for Atom Bank (£500m) and Allica Bank (£200m). Landbay mortgages also feed the Twin Bridges securitisation shelf sponsored by Paratus (now Apollo-Athene owned).

You may notice that’s quite the number of funding partners....diversified funding is normally seen as a good thing, but that’s a lot of mouths to feed, a lot of facilities to maintain, and some difficult incentives to manage. All good in the good times, not easy in the bad.

Sure enough, it’s bottom of the broker grid — the only specialist lenders offering lower BTL rates than Landbay are deposit-heavy institutions like West Bromwich Building Society, State Bank of India, Aldermore or Paragon.

The lowest rate we saw was 3.19% for a five year — compare that to 2.106% five year Sonia swaps, and add securitisation funding on top (call it a 120 bps Sonia spread based on last week’s prints) and there ain’t a lot of juice left in those mortgages.

What really matters for struggling specialists is their exact arrangements with their funding partners.

Is the forward flow partner obliged to keep buying loans, and on what terms, at what level? Can the forward flow provider change the lender’s rate grid (at least, for the loans it is buying)? Forward flow arrangements may also have excess spread covenants, or other protections for the mortgage buyers.

Put simply, if the forward flow provider has to keep buying loans at 102 when they’re worth 96, it’s very much their problem, but if it can stop, it’s very much the lender’s problem.

Longer term, both situations end up being the lender’s problem — a forward flow partner forced to lose five points on every loan it buys is unlikely to be a good relationship once the situation improves.

So what are the options?

It depends very much on the equity position of the lender — is there an M&A exit, and is it at a level equity can tolerate?

Fleet Mortgages sold for £50m to Starling, a very tidy sum given 2020 operating profit of £2m, but that’s a multiple that’s likely out of reach in today’s markets. It’s also a multiple of an actual positive figure, which is not a given for many of the startup lenders. There’s nothing wrong with being a high growth startup with negative Ebitda (we certainly wouldn’t throw stones from 9fin Towers) but when the high growth dries up it’s not so great. How valuable, exactly, is the shiny origination tech and user-friendly website?

The endgame has to be higher rates, and probably sector consolidation in some way. The natural partners for struggling asset owners are likely the deposit-heavy “neobanks”. The likes of Monzo have pretty much cracked the liability side of banking, but seem to be pushing hard to originate Buy Now Pay Later loans — a bit of respectable mortgage lending could be a nice addition.

Watching Wells

For the less discerning, a phrase like “crack team of ex-Lehman securitisation bankers” probably has something of the flavour of “crack team of ex-Enron accounting executives”, but within European securitisation (and within these pages), a bit of Lehman on the CV is an actively good thing.

That’s certainly how Wells Fargo seems to be seeing it, as the buildout of its European securitisation operation continues.

Three securitisation MD hires in the last year constitutes a major investment, and it’s brought a few of the Lehman band back together — Francesco Cuccovillo, heading EMEA markets, investments and solutions, who joined from Nomura, Ankur Goyal, head of international ABS, and Steve Hulett, head of spread product sales in EMEA, the latter two hired out of Jefferies.

We haven’t stumbled across any Wells warehouse lines yet, but we understand that it’s out there offering highly competitive repo financing on investment-grade securitisation positions, with ambitions to get down and dirty in the deep mezz in the future. Financing is a good place to start in building out a business — a sticky investor client list, and a good sense of who owns what at what level are solid building blocks for a platform which prioritises the “moving business, rather than the storage business”.

Negative selection in ESG

We sat down with a CLO manager the other day to talk ESG matters (it’s everywhere), and they reckon that only around a third of obligors in their book give good data on carbon emissions.

I say “only” a third, but perhaps that’s surprisingly decent, given the veil of secrecy drawn over such basic metrics as LTM Ebitda in loan-only companies. It’s also definitely up on previous years, as sponsors and loan buyers alike start to put their reporting where their mouth is on ESG matters. Carbon disclosure is difficult, especially when it gets to Scope 3 emissions, which result from activitites not owned or controlled by the reporting organization. For small companies, the admin burden to providing meaningful disclosure of these could be extremely high.

But that still leaves two-thirds of loan obligors without their own emissions reporting, forcing ESG-conscious portfolio managers to use sector-wide assumptions if they want some idea of the emissions from their portfolio.

This approach, however, could end understating emissions if, as seems plausible, the lowest-emitting companies in a given sector are also the ones which have put in the effort to report individually.

Companies that do reporting carbon emissions might have a generally greater focus on environmental matters (leading to lower emissions than sector average), but perhaps laggard companies are putting off their own emissions reporting, knowing that they’d rather be assessed at sector average than on their own poor performance?

Of course, it’s hard to assess if this is true or not — we need the data! — but it’s a potential minefield for portfolio managers doing their best to offer CO2 transparency.

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