Market Wrap

Excess Spread - JPM is back, collectively irrational CLOs, NPLs ahead

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

JP Morgan priced its long-awaited return to principal finance last week, securitising a slug of LendInvest loans under the “Pierpont” branding.

Pierpont, is of course, the “P” in JP Morgan — this guy

Pierpont of JP Morgan

In this it follows Citi and Goldman Sachs, which have long had principal finance shelves for European mortgages, Citi through the Canada Square and Jubilee Place (Citi’s London addresses) UK and Dutch shelves, and Goldman through its EDML Dutch prime programme. 

But naturally, there are a few twists. For one thing, the forward flow deal it signed with LendInvest has much greater firepower than Citi’s Canada Square programme, with more than £700m of lending capacity. That has not, however, meant a materially larger transaction out the gate — Pierpont is just £257m, a size that is likely to have left mezz tranches narrowly distributed and potentially illiquid. It was also a full capital structure deal from day one, whereas Canada Square deals tend to see debt tranches sold down in an ordinary syndication with residuals offered in a separate process.

JPM’s deal is also pure LendInvest mortgages, in contrast to Citi’s multi-originator approach. JP Morgan’s deal with LendInvest doesn’t add any additional criteria beyond LendInvest’s standard underwriting — there’s no ‘cherry picking’ — and LendInvest will continue to service the book as normal, making the underlying collateral essentially identical to that of one of LendInvest’s Mortimer Buy To Let (BTL) transactions.

The deal structure is also relatively similar, though Pierpont achieved a substantially lower advance rate at the senior level — 84.8% rather than 87.5% in the last Mortimer deal. Pierpont also features a much smaller X1 excess spread note, representing 2.6% of the capital structure rather than 4.25% in the last Mortimer. And, of course, JP Morgan is the risk retention rather than LendInvest.

JPM’s reluctance to wade into the broader warehousing market for specialist lenders keeps things clean and straightforward from a competition perspective. Citi’s Canada Square shelf must slot into market alongside Citi’s client flow business, and Citi’s principal shelf even securitises some of the same assets.

Just this week, Citi is in the market with the latest London Wall deal for One William Street, backed by a book of buy-to-let mortgages from Fleet — one of the same originators which backs Canada Square. Fleet’s sale to Starling Bank earlier this year, though, may mean the challenger bank has first dibs on the Fleet assets in future.

JPM’s team are keeping schtum about their plans for the shelf, so we’ll have to see if it’s a regular visitor. One source outside the US bank argued that Pierpont was best regarded as a pricing exercise, a demonstration to the bank’s credit and risk management teams that it was possible to sell down LendInvest mortgage risk at appropriate levels, justifying the decision to take and hold the rest of the portfolio. It’s recently launched a UK deposit-taking bank, so it’s bringing in sterling funding all the time, and what better assets to match that relatively high-yielding BTL mortgages? 

But the branding of the deal points the other way — why name a deal after the literal founder of the firm if you’re not planning to use it?

JP Morgan’s relative absence from the flow warehouse business, though, is a strange missing piece in the US bank’s business mix. I mean, this is JP Morgan we’re talking about. Top three in pretty much every investment banking product out there, and not shy about lending (if the returns justify it). 

Several people outside the bank have told Excess Spread it’s because the bank has historically refused to non-mark-to-market mortgage warehousing outside the US, though JPM’s team have always declined to discuss it, and it would be a bizarre policy if true — if it’s happy to say, run a $40bn European leveraged loan book, surely it has the risk appetite for a little bit of senior mortgage risk?

Nonetheless, the warehousing prohibition doesn’t seem absolute. The JPM show continued this week, with the announcement of Satus 2021-1, a UK auto ABS securitising Startline Motor Finance’s loans. JPM is a longtime lender to Startline, starting well before it fired up its mortgage appetite with the LendInvest and West One deals this year.

The auto hire purchase firm is owned by Seth Klarman, of Baupost Group, according to Companies House, with the board comprised of Baupost execs. This $30bn hedge fund may well be a JPM client (let’s assume past legal troubles have been forgiven and forgotten), but that doesn’t explain why JPM is doing this particular auto deal, having been essentially out of auto ABS in Europe for the best part of a decade.

The collectively irrational CLO market

It’s a pretty good time to be a CLO manager. Despite a record issuance year, both in new issues and reset/refis, equity arbitrage remains healthy, and may even be improving, with the slight softening seen in leveraged loans giving managers more choice, better spreads, and more robust documentation . New investors have come in to replace certain reluctant whales, and the buyer base has broadened down the stack, as nervous buyers put Covid worries behind them and jumped in with both feet. The only challenge appears to be the sheer stamina of the market, with arrangers, lawyers and rating agencies jammed with the sheer volumes of issuance.

But this happy equilibrium has only been maintained by a similarly strong backdrop in new money loans from M&A activity. Even more than a year beyond “Pfizer Day”, a fair bit of corporate activity has been Covid-hangover-related — assets where the owner was waiting for clarity before selling, assets waiting for Covid effects to be flushed through LTM earnings, sponsors which eventually found an exit for some assets and now have their buying boots on again. The catch up has been broad-based and powerful, but can this level of activity continue?

Barclays research reckons there’s been €85bn of new money supply in 2021, comfortably in excess of CLO new issue of around €30bn — though taking into account repayments, net new supply of leveraged loans comes out around €24bn, suggesting the squeeze might be sooner than we think. The team expects around €65bn of new LBO financings next year, and similar repayment levels, with €15bn of net supply expected in the European loan market.

With nearly 60 CLO managers now in the market, let’s assume every one of them has a €300m warehouse, to make it simple….and that’s €18bn of demand, already enough to outstrip net supply.

The Barclays team acknowledge that LBO supply is a lumpy figure, and predicting it is difficult. If we’re feeling optimistic, assume take-privates for BT (Patrick Drahi is circling…), Tesco (arguably in play), and GSK Consumer Healthcare. Just those three probably need €40bn-€50bn of new money — so there’s definitely potential for another big year.

But base case, there’ll be a tick down in new LBO financings in six months, against a backdrop of record CLO warehousing, a larger pool of managers than ever before, and therefore a technical squeeze. Supply won’t be available to meet demand, and the whole market will be chasing loans tighter, handing the whip hand to sponsors on docs and leverage.

If the market could somehow agree to ease up on the issuance, then the good times might roll for longer — but each individual manager will want to print while they can. It’s a classic collective action problem, when individual rationality leads to a collectively damaging outcome. Get the AUM in the door, scrap for loan supply, and hope you win out. 

Smaller managers will spin their lower deal volumes as a strength, and they’re right, up to a point. A smaller portfolio is more nimble, less beholden to primary allocation, and better able to pick and choose assets. But scale matters too. Keeping the lights on for a big credit team means having a fair few deals under management. For a manager that’s below the requisite size, it’s better to print and risk poor performance down the road than struggle to cover your team’s costs for the length of time it takes for the market to rebalance.

With all that doom and gloom out of the way, let’s give a big warm European welcome to Nassau Corporate Credit, the latest in a long line of US CLO shops to cross the pond and establish operations. Nassau issued its first euro deal last week through BarclaysNassau Euro CLO 1, but landed, unfortunately, well wide of established manager levels at 105 bps on the senior tranche. Barclays didn’t disclose DMs down the stack, though the outright coupons are pretty close to discount margin levels for tranches usually sold at a discount in other deals — 939 bps on the class ‘F’, for example.

Maybe the level was locked a long time ago, but senior prints from Bridgepoint and Ares at 94 bps and 95 bps this week underline that it’s well off market.

Nassau has been building for a long time, hiring a pair of managers from Ellington Management, who had been working on the first “enhanced CLO” (higher risk, lower levered) in Europe before Covid hit and killed the project. It has captive insurance capital available from parent insurer Nassau Re, and an extensive US track record in credit management, but the 105 print suggests the debut manager’s premium is well and truly back with us. 

Managers launching European platforms last year, such as AlbacoreBlueBay, or CBAM, all succeeded in printing on top of or through the levels achieved by more established managers — particularly impressive in the case of Albacore, as, despite the team’s undoubted credit expertise, it had no US CLO shelf to point to.

The reemergence of a debut premium might reflect the broader supply dynamics at play — with the larger platforms all prepping multiple deals at once, and a veritable smorgasbord of CLO offerings available, there’s less reason to take a chance on a new platform if you’re not being compensated for it.

Nassau has chosen to build organically, but for managers looking to enter the European market, acquisition could be a better route. Cross Ocean Partners is just crossing the Ts on its purchase of the Commerzbank Bosphorus shelf, while Whitestar Asset Management has been reviewing whether to buy or build since it established London operations earlier this year. 

Time for public NPLs?

For a market which has been pumping out deals since 2016 or so, there are precious few actual examples of southern European NPL securitisations available to buy in the market, as the vast majority of issuance has come in GACS-or HAPS-guaranteed format.

This means that the Italian or Greek government guarantees the senior tranche in a securitisation, which must be investment-grade rated. The sovereign wrap then makes it attractive for the bank selling the NPLs to keep hold of the senior tranche (because it’s treated just like BTPs or GGBs on balance sheet), selling the junior out to a specific investor. The bank may also repo the guaranteed tranche privately, raising funding as well as deconsolidating bad loans.

What we haven’t seen much of is non-guaranteed securitisations — an investor buys a book of NPLs with some financing, the financing is taken out in a distributed securitisation bond format, with no state guarantees involved. If you’re a regular bond fund manager looking to participate in the NPL action, there’s not a lot you can do.

There’s been a trickle of deals, usually in semi-private format — Evora Finance/Hefesto in 2017, Bayview and CRC’s Belvedere SPV in 2019, KKR’s ProSil Acquisition in 2019, Hoist Finance’s Marathon, Varde / Guber Banca’s Futura in early 2020 — but the market's never fully taken off. Deloitte has a rundown in here.

Northern Europe has been a slightly different picture, with Irish NPL/RPL deals in public format regularly emerging from the Morgan Stanley/Lone Star dream team, and more recently, via Apollo and Goldman.

Now there’s a Cypriot deal on the screen, financing Pimco’s purchase of the Helix 2 portfolio from Bank of Cyprus. Alantra and Barclays are arranging Hestia Financing, offering a €475m triple-B rated (Scope and DBRS) class A to market.

The deal includes a €1.725bn subordinated note, reflecting the €2.2bn gross claimable value of the portfolio, but Bank of Cyprus said total consideration for Helix 2 was €560m, suggesting there’s a more reasonable €85m of economic equity in the deal.

We’re hearing more NPL securitisation supply in the pipeline, potentially also in public and distributed format — it’s a natural market evolution as more portfolios trade in the secondary market, more banks in more jurisdictions sell down NPL risk.

Regulation should also help (or at least, be less restrictive than in the past). I’m not going to go deep into the weeds here (read this primer from Freshfields instead), but Europe’s securitisation rules were basically drafted for performing loans sold at par or thereabouts, and struggle with the big discounts in NPL sales. But the “quick fixes” to the rules, passed this year, solve some of the most onerous parts, and should support the growth of the market in future.

Duking it out

Barclays obtained a rating for a curious vehicle last week — Duke Global Funding, a £4bn balance sheet CLO — meaning a package of loans securitised from a bank’s balance sheet, rather than aggregated and financed by a CLO manager.

The bank is a very regular user of the synthetic risk transfer market, using the Colonnade shelf (Barclays investment bank is based at 5 North Colonnade) to sell on deals predominantly backed by large corporate exposures to the market. It’s also done CRE-backed deals and last year launched a shelf called Churchill (Barclays UK is based at 1 Churchill Place) to transfer risk from its UK ring-fenced entity. 

Here’s a few of them that made it to listed security status, and one that DBRS rated a few years back.

These are private deals and shrouded in mystery (and risk transfer people wonder why the press gives them a hard time...), but the concept is pretty simple — a junior guarantee/CDS/insurance policy to sell on the risk of a loan portfolio, which allows the bank to cut capital requirements while still holding the loans on balance sheet. Borrowers don’t notice any difference, and banks can recycle capital into new lending.

But this is a different animal, aimed at raising funding, rather than capital. It’s in cash format, and will be retained, with the senior tranches of £1.16bn and $1.94bn, assigned Aa2 by Moody’s, likely used to raise repo funding

Barclays group as a whole probably doesn’t need the cash — and will, in any case, have plenty of government bonds and other HQLA-eligible (high quality liquid) assets which can be pledged for secured funding. 

But this trade likely packages up corporate loans originated in the investment bank, outside the UK’s “ring-fence” regime, and with a higher cost of funds. Term repo on securitisation bonds (these have a two-year replenishment period) probably gives useful cost-effective term funding for an entity that can’t rely on covered bonds or other term secured instruments.

The counterparty, of course, is not disclosed, but it seems unlikely another systemically important bank would do this deal….if you were putting on a big sterling repo trade, wouldn’t you go to a bank like….Barclays? It’s not great central bank collateral either, however, with a mix of jurisdictions in the portfolio that make it ineligible for the Bank of England. It’s not compliant with EU risk retention rules, so European counterparties are unlikely. Quite the headscratcher. Barclays, of course, declined to comment.

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