Excess Spread — Can the banks save us, underhedged, not now EU

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Excess Spread — Can the banks save us, underhedged, not now EU

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

Can the banks save us?

For the last 10 years or so the banks have been a smaller and smaller part of the securitisation ecosystem — they’re a smaller part of the client base, have smaller intermediary balance sheets, and even take a smaller funding role. Bank loans are provided by debt funds, dealers hold less inventory, alternative asset managers sprawl over all sides of capital markets and the investment banks are reduced to asking “how high” when Blackstone or Apollo says jump.

But the resolution of the current predicament relies heavily on the muscle of the investment banks, so let’s hope the sinews have not atrophied completely.

The major dealers have reportedly taken down very large chunks of the BWIC flow so far, and their hold horizon and risk appetite is going to be crucial to the recovery of the market.

Buyers have been sighted (in some cases, different pockets of some of the asset managers which have been selling), with bank treasuries and leveraged hedge funds in the frame, but these aren’t going to be sufficient to take down all the bonds disgorged since the “mini-Budget”.

For that, we need banks, and banks which can take a prop desk view, in large size. Exactly what has allegedly disappeared since the financial crisis.

The Bank of England’s interventions this week have been a mixed bag (Tuesday night can’t have been a fun shift for the BoE staff) but the special repo facilities (TECRF, or Temporary Expanded Collateral Repo Facility) announced on Monday suggest the central bank is at least aware it needs to ensure dealers are equipped with diamond hands — this broadens central bank collateral eligibility to allow pretty much all first charge RMBS from the UK and EEA, as well as ABS, CMBS, SME ABS, corporate bond securitisations and ABCP. This only covers senior tranches, but it should still help dealers to fund their senior inventory cheaply, and to rehypothecate some of the positions they’re funding.

Several sources suggested, though, that there’s still a second wave of pain to come. The first wave of LDI-driven forced selling focused on senior tranches across all the major securitised products. These bonds were closest to par, most liquid, and largest size, so first out for bid.

The scale and breadth of the selling seems to have surprised even market participants whose main business has been selling bonds to these guys….”they just seem to own a piece of everything”, per one source in sales.

But the sell-off continues, and it is and moving down the capital structure. Last week saw double A CLO bonds dominate; this week we’ve heard of big lists at the BBB level. The chaos this week and the Bank of England’s mixed messages made it very clear that caution was still advised….so the selling is going to carry on pushing down the capital structure. The bleeding might have slowed, but it hasn’t stopped.

CLOs are left out in the cold by the Bank of England’s new facilities, though, with “portfolios containing leveraged loans” not permitted, so it’s going to be a pure question of dealer capacity in this market. Everyone agrees European senior CLO paper is crazy cheap right now; what institutions have the capital required to hold these positions while the view plays out?

The other respect in which bank balance sheets can step up is in the provision of warehouse financing — specifically, warehouse financing that’s cheaper than the market rate for securitisations, and which will allow specialist finance sponsors of BTL and non-conforming RMBS to actually call their deals.

Trading levels for UK RMBS right now are wide enough that almost every call in BTL and non-conform is out of the money — it would be cheaper for every sponsor to skip their calls and pay the step-up spread.

Per Deutsche Bank research: “Isolating senior step-ups and comparing to current secondary market levels – missed FORD (first optional redemption) dates and late calls look like a distinct possibility for much of the near £10bn of paper across 29 deals maturing between now and the end of next year.”

If deals do get called, the market is crazy cheap — cheap enough that it’s even tempting tourists. We know of one CLO/loan-focused shop that’s discussing a move into UK ABS; presumably there are others.

But if most of the market gets extended, then the chaos will continue. The market will basically cease to function pending better macro news, and when will that occur? Late 2023? After the next UK election?

So far only Cerberus has actually missed a UK RMBS call, as discussed last week — and whichever fund bought the Canada Square 2019-1 residuals has honoured the option — but the last three weeks have made refinancings far more expensive.

For a repeat player in securitisation, a skipped call in theory harms reputations…but by how much? Imagine a hot market with 2x or 3x on the senior notes…..does the missed call costs 20 bps on the senior? 30 bps? If you NPV an extra 20 bps for your planned 2024 and 2025 deals, does that outweigh the brutal cost of a market level refi today?

Hopefully, this is where the banks come in.

Warehouse funding has been inside capital markets levels for several months — plenty of banks planted a flag in securitised products before this year’s various crises took hold in earnest, and they’ve been keen to get some funding out of the door.

The increase in base rates mean that a big book of Sonia+ or Euribor+ assets are actually delivering a worthwhile return. A RMBS warehouse at 150 bps over is paying 3.6%, instead of 1.54% at the beginning of 2021, and the regulatory capital cost for a bank is exactly the same. In theory a bank funds at the floating rate….in practice there’s a lot of sticky current account money out there.

LendInvest, according to its trading statement on Monday, struck a £180m “financial partnership” with Lloyds in September, and increased its JP Morgan forward flow from £725m to £1bn. These were likely struck before the mini-Budget, and one assumes the terms for these facilities reflect the rising market rates, but the point is, there’s still bank funding out there.

Warehouse levels have a sort of loose tie to capital markets, but it’s plausible that they’ll stay inside public levels for some months to come. That means there’s another option for sponsors who’d like to honour calls but can’t stomach the horrible levels for the new issue UK RMBS today.

The landscape of warehousing has shifted this year, with more and more retail deposit-funded institutions undercutting investment banks. Challenger banks in the UK have done very well at gathering deposits; somewhat less well at originating mortgages, given the brutal competition in the UK market. So it’s easier for them to write a forward flow for £200m and let someone else do the origination.

But if this is the fate for a large number of RMBS trades, that’s going to hurt specialist lenders that are thinly capitalised, or backed by an institution that’s watching the wallet. Calling a securitisation that’s sold all the way down the stack into a warehouse is going to mean cutting leverage levels — where’s the equity coming from?

No more cheap options

Conditions in the CLO primary market are too depressing to contemplate in any real detail, so we’re going to try to throw things forward a bit, and consider what the market might look like on the other side of this situation — whether we might be on the cusp of a “CLO 3.0” evolution.

Maybe we’re already there. The structural gyrations required to shift deals this year have led to more variation in term structure than at any time other than post-pandemic.

Senior investors in particular have wanted short WAL bonds with limited manager flexibility, and equity investors have often rolled over and accepted these terms in order to get their warehouses out. Some have adopted hope as a strategy….call next year and perhaps the bad times will have gone away.

But perhaps a more radical rethink is needed in the current environment. In the before times, CLO debt investors were probably under-pricing the call option they give to equity, even though it was in or near the money. An option on credit spreads isn’t worth much if they don’t move much.

Today, they’re over-pricing the optionality, even though it’s way out of the money. It’s not just the call options. Much of the documentary innovation over the last couple of years has focused on ways to monkey around with the WAL test, with tweaks affecting who can confirm WAL test extensions, and the precise mechanics of the test. This is, in effect, optionality by the back door….not quite the binary of call / non-call, but the cumulative effect has been to give equity and managers more control over the repayment profile of the bonds.

Now debt investors are laser-focused on extension risk, and the shutters are coming down. Perhaps the market going forward is one which incorporates far less optionality for equity — and so has structurally lower liability spreads which sit closer to other instruments of comparable rating quality.

If CLO structures come with less equity discretion, that may also help to internationalise the market.

Much has been made lately of the cross-currency basis between euros and dollars — in theory, it’s massively in favour of US-based buyers wanting to buy euro CLO paper (already cheap to the US on absolute spread) and hedge back to dollars. You could expect 50 bps or so on top of the spread….if you can put the trade on.

In practice, optionality for equity means it’s difficult to get good cross-currency hedges, because the hedging needs to match unpredictable callability and repayment profile. Bodging it with currency forwards is fine for a large financial institution, less appealing for small shops which are supposed to be focused on credit work and managing currency basis risk.

One can, as certain Japanese institutions have in the past, obtain a fully fledged repack into a currency of your choice — but the investment bank providing it is probably going to suck out most of the benefit you hoped to achieve.

Bonds with less optionality are easier to hedge, allowing more funds to play across the relevant markets without taking currency risk — perhaps CLO 3.0 means the optionality pendulum swings back again.

When the going gets tough

For the CLOs already outstanding, tough times mean more dispersion in performance, and more focus on manager tiering.

In the loan market, one of the most interesting transactions out there is plastic shed-maker Keter’s amend & extend (likely closing this week). 9fin has a full legal analysis for subscribers, available to anyone who is private on the name (email legal@9fin.com for a copy) but the broad strokes are straightforward.

Sponsor BC Partners tried to float the business last year, just as the IPO market was closing. Back to the drawing board, and it launched a refinancing in late January at 425-450 bps and 99.5. The deal did not go quite to plan, and the refi was postponed until happier times…..which never arrived.

Now it’s contemplating a loan maturity in 2023, and proposing an amend & extend package, involving a new second lien, €50m equity injection, a margin uplift and paying down some senior debt. The punchy part is that, if the deal goes through, any lenders that didn’t take the deal will be left in a stub loan which will see its covenants stripped, effectively subordinating them to lenders that did take the package.

Keter is likely not the only company contemplating something similar in the months ahead — and this is exactly the sort of thing that various new CLO documentation features are supposed to tackle. More flexibility to handle aggressive liability management, to participate in priming debt, to inject new money, should mean more value maintained in CLO structures.

As one manager pointed out this is a fix for a problem that the CLO market created. The growth of European CLOs in the 2.0 era, both by manager numbers and absolute volumes, ensured the supply-demand imbalance which allowed loan documentation to degrade as far as it has. Sponsors are only able to contemplate pulling collateral out of their security packages and priming existing lenders because loose docs let them do so.

Situations like this can be highly differentiating. Watching large cap stack loans bopping along between 99 and 101 is not going to deliver much outperformance however much bottom up credit analysis is performed and however much experience the PMs have. But stressed situations give much more opportunity for trading and workout skills to come to the fore.

Many CLO investors have their own version, but we’ve been very much appreciating KBRA’s analysis of CLO manager styles in these tough times — the chance to put some real numbers around the fuzzier concepts of “market reputation”. Who is conservative, who is opportunistic, and how are these approaches performing?

Aside from these reputational issues, we’ve been particularly interested in the question of cash balances, as this year’s crisis has unfolded. Average levels have ticked down slightly, but there’s still very very little cash held in CLOs. The structures themselves incentivise managers to maintain par, and sure enough, par value metrics have held up reasonably well this year.

But perhaps this is an unhelpful incentive — just as in fund structures, difficult times should mean higher cash balances. It’s actually a good time to be burning some par, staying nimble and looking for opportunities, not staying maximally invested….and certainly not swapping out one beaten up credit for another at a similar price in the hope of keeping par metrics up.

Underhedged, underwater?

European CMBS is a bit of a backwater at the moment, running at a single digit deal volume for the year…with nothing at all since the summer. It was, to be fair, also something of a backwater in 2021, 2020 and 2019, though the emergence of the Starz CRE CLO in autumn last year looked like the green shoots of a new asset class at the time. This week, Aeon Investments popped round a press release confirming last month’s Bloomberg story. It says, in short, that Aeon has a £900m line from Credit Suisse (arranger of Starz) for three further CRE CLOs, enough to make up an actual micro asset class. But I doubt they’re gonna be exiting any time soon.

But despite its small size, it could be one of the worst-hit pockets of the securitised product universe. CMBS is inherently more fragile than consumer securitisation and CLOs; it is not self-liquidating, and it is a lot less diversified than a CLO portfolio.

The hilariously fragile UK commercial property funds have already started throwing up the gates (every sell-off throws up the mismatch between daily liquidity and literally owning buildings, but yet they continue) as a sign of the sentiment towards the asset class. Goldman’s research desk expect a 15%-20% price fall in the UK to the end of 2024.

Pretty much all European CMBS 2.0 comes in at LTV levels that shouldn’t be touched by this kind of decline — but that doesn’t necessary mean it will be easy to refi these out, and there are a lot of loan maturities peppered through early 2023.

Barclays research has a nice rundown, and flags up the particularly crucial issue of hedging extensions for CMBS loans.

Over to them: “Loans tend to have interest rate hedges in place only until the first maturity and put in additional hedges as and when extensions are granted. However, due to interest rate volatility, particularly in short-term rates, hedges have become significantly more expensive compared to the start of the year. For example, a standard one-year euro fixed-to-floating swap (EUSA1) now costs 247bp vs -49bp at the start of the year (or an increase of nearly 3 percentage points). Therefore, we now wonder whether loan extensions are too expensive for borrowers, such that they may either prepay deals that are too expensive or try to refinance them through other means. Either way, we expect the cost of borrowing to eat into equity returns for borrowers, increasing the risk of sponsors walking away from loans, allowing them to default.”

Pre-GFC, the situation with CMBS was almost exactly the reverse — some transactions were spectacularly over-hedged, with 20 year swaps stuck on five year deals, and the mark-to-market once rates hit the floor helped wreck several transactions. Gemini (Eclipse 2006-3) was one of the most disastrous, if memory serves…..though the deal performance wasn’t helped by the revaluation of the underlying properties from £1.14bn at origination to £437m six years later.

Now we have under-hedged transactions which will struggle to extend maturities because of the rising rates environment.

The Barclays folks have a nice rundown of exactly which loans could come under pressure — we’ll be watching closely.

Magic Mike

The dribble of information leaking out of the sales process for Credit Suisse’s securitised products unit is becoming more like a stream. As we suggested a few weeks backBNP Paribas is apparently no longer a runner (and that makes any other bank bid also unlikely; we understand other shops have been eager to sniff around the data room, but Credit Suisse has not indulged all of these fishing exercises).

The latest Bloomberg leakage suggests PimcoCenterbridge (acting for a captive reinsurer, Martello Re), and Sixth Street are now in the frame….no further info on whether Apollo, as previously trailed, is still in process.

Sixth Street, of course, recently set up a securitised products investment business under Mike Dryden….the former head of the Credit Suisse securitised products business. Like Centerbridge, there’s a reinsurer in the background, Talcott Resolution. All else being equal, that should make for a compelling bid.

No doubt all the potential buyers have extensive info available in the dataroom, but Dryden really knows it, knows which key staff to keep, how to make the teams function properly, where any bodies are buried, and probably has a ton of ideas about how to make it work better. Any serious bidder will get a good look at what CS has financed and on what terms; Dryden will know which deals it passed on, which it lost, and why, and presumably there’s a fair amount of personal loyalty to him as well.

Pimco, Centerbridge and Apollo would be prudent, as with any acquisition, to haircut their best case to reflect the unexpected, the uncertain, the things that didn’t emerge in diligence. Dryden and Sixth Street should be able to have a pretty good stab at knowing those issues in advance, or at least knowing exactly which diligence buttons to press to to shake it out.

Not now, Europe

It’s been a big week for regulation, with the European Commission’s report on the functioning of the Securitisation Regulation dropping on Monday.

PCS came out hot with a pithy take on the subject, saying “PCS and many market participants though reject the notion that the rules are too recent to be changed and would be loath to see this argument trotted out to justify inaction on the prudential front where incontrovertible cases for change can be made.”

Here’s Afme’s takeFreshfieldsArthur Cox — other law firms are available and will doubtless be publishing on the subject over the days ahead.

To us, it seems a baffling document, prone to apparent self-contradiction.

Overall, respondents felt that the Securitisation Regulation has so far brought no tangible benefit to the real economy and SME lending….The Commission is of the opinion that the Securitisation Regulations seems overall to be fit for purpose”.

Ok so….the Regulation is providing no benefit….and it’s fit for purpose. What?

Let’s look again.

The Commission observes that to date no securitisation regime in a third-country jurisdiction could come close to being considered equivalent to the EU’s STS framework. The UK is the only jurisdiction outside the EU that has an STS regime in place, following its adoption of the EU’s own STS regime after it left the EU.”

HANG ON WHAT — so the Commission agrees the UK regime is a copy-paste of the EU regime at the time but somehow...not close to being considered equivalent? My head hurts. Apparently equivalence will have to wait for “the peer review of the implementation of STS requirements”, which has been postponed to 2024.

Much of the substantive comment in the piece is focused on the requirements for “private” securitisation transactions, with the Commission asking ESMA to “draw up a dedicated template for private securitisation transactions tailored particularly to supervisors’ need to gain an overview of the market and of the main features of the private transactions”.

Market participants are rightly unhappy about the definition of “private”, and the disclosure burden that falls on private deals.

It does seem strange to me that CLOs (the most widely distributed, most active, most liquid and largest European securitisation market) are “private”, so they can be listed on unregulated exchanges like the GEM or Vienna MTF, and that they are, regulatorily speaking, as “private” as ABCP trade receivables deals, which are effectively bilateral bank lending.

Of course, in the face of absolute absurdity like this, the Commission’s view is that “it does not seem appropriate to change the definition of private securitisation in the Securitisation Regulation”.

I give up.

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