Market Wrap

Excess Spread — Green in the red, IB muscles, victims of success

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

From Green to the red

What are your options if you’re a specialist lender and need some cash? How far would you go to raise £25m?

We’ve talked extensively about the troubles of the sector over the past year, most recently last week following the DealCatalyst conference. Swap rates have risen faster than mortgage rates; there’s been a race to balance origination, hedging and financing in an ever-shifting environment. Stop writing loans and you lose broker relationships and market trust; keep writing them without the right financing structure and you lose money on the loans.

So we’ve been expecting some changes, some consolidation, some portfolios to shake loose (any tips or winks my email is at the top).

An obvious place to start looking is those lenders which haven’t been in the market much this year. If you’ve gritted your teeth and paid the market spread, it might not have been pleasant, but it extends the funding runway, reloads the warehouse, and gives flexibility in these turbulent times.

Lots of lenders also have shareholders we’d assume are supportive — Foundation Home Loans is still securitising in the market, and still signing warehouses, but even if it wasn’t, Apollo has deep pockets — but others are rather more thinly capitalised.

Which brings us to Belmont Green (Vida Homeloans is the trading brand). We’ve heard that they’ve been exploring several options for raising cash, but we stumbled across an interesting financing that’s already closed.

The Companies House doc linked above shows that Belmont Green has pledged most of its securitisation equity positions (Z notes and residual certificates in Tower Bridge 2020-12021-1 and 2021-2) AND all of its warehouse equity (Belmont Green Funding 1,3,4,5) AND any future warehouse signed for Belmont Green Funding 7 as collateral for a £25m loan from Macquarie.

Tower Bridge 2022-1, placed in January, does not seem to be included….possibly the residual there has already been sold?

For a specialist lender that’s built a business around securitisation, this is pretty drastic stuff, especially the warehouse equity - one Excess Spread reader with a vivid turn of phrase described it as “eating your children”.

These are the crown jewels, the key to control of pretty much all of Belmont Green’s portfolios, so if it finds itself unable to cover the Macquarie facility, a drastic business model pivot beckons.

For distressed companies this is an ordinary part of the playbook — figure out what you have that isn’t nailed down, pledge it as security for new money. Whatever else it is, it’s not a sign of great corporate health.

In the short term, it also precludes outright portfolio sales (unless some of the collateral package can be redeemed).

In some ways, the future warehouse piece of the puzzle is most interesting. Belmont Green Funding 7 was incorporated in March, presumably with a view to moving fairly swiftly to becoming a useful financing vehicle. But no “charge” has been placed on the company (the usual signal that a secured financing is in place), so it’s been dormant for most of the year.

If there was a warehouse with decent terms in place, Belmont Green would have some origination runway, and presumably origination fees can keep the lights on, meet payroll and so forth.

So the financing looks like a bridge…. to something? £25m gives a lot of operational runway, if the company has origination capacity, but hope isn’t a strategy, and nor is expecting that the specialist lending business will get simpler or competition less fierce.

The business has been reputedly in play in the past, and there are some institutions on the acquisition trail that might be workable partners. Starling Bank was the underbidder for Kensington; it successfully bought Fleet in 2021 and it’s looked at other lenders besides. It would take a fair few Belmont Greens to fill a Kensington-sized hole in Starling’s ambitions, but maybe it can roll up others as well over the year ahead?

Also worthy of note is the kind of financing we’re talking about here. Pretty ballsy, in short.

The performance of the Belmont Green collateral isn’t really the issue, it’s more the wrong way risk. If Belmont Green, for whatever reason, doesn’t stick around, that will inevitably mean servicing disruption and general disorder, pushing the value of the residuals down. If you’re in trouble, it’s better to pledge securities which aren’t highly levered exposures to your own performance if possible. But perhaps none were available.

We understand that funds as well as banks were approached to do the deal, but Macquarie topped the bill.

Anyway, adding to the complexities of the Belmont Green situation is the upcoming call of one of its securitisations in December.

So far all the specialist lenders with front book operations have honoured their calls, some of them using bridging facilities, some of them leaning on relationship lenders or the big bank balance sheets to get private deals away (of which more later)…so the presumption has been that Tower Bridge 4 also gets called. RMBS deals can definitely get done today, at a price.

Re-racking into a new deal will definitely prove less economical, and may require, one way or the other, more equity (less spread in the modelled deal, worse tranching, more reserves, all that stuff)….but this is surely not what’s in mind for the £25m.

If you’re in enough trouble to pledge away all of your remaining residual notes…..go ahead and miss the call date! That’s much easier to bounce back from!

Anyway, we wish Belmont Green the best, and hope the bridge does indeed lead somewhere - there may be consolidation in the industry, but let’s hope the lights stay on across most of the market.

We reached out to Belmont Green and Macquarie for comment, but Macquarie hadn’t come back and Belmont Green declined to comment.

Which bit of the banks?

We’ve been assuming that bank treasury books were behind the recent spate of demand from financial institutions for senior paper across securitisation. But delving deeper, it seems that it’s actually the securitised products groups which are doing most of the heavy lifting.

As we’ve discussed, Citi and BNP Paribas are among the most prominent, but lately SG has joined the party. Rather more discreetly, Barclays and Lloyds securitised product groups are said to be out there buying bonds in size. Do write in if you’ve noticed any more. No specific info has yet reached our ears on the other big securitisation shops. Goldman and Morgan Stanley have been historically more inclined to buying portfolios on a principal basis rather than loading up on triple A; Deutsche Bank of old similarly, but the DB model is changing…we note with interest Deutsche’s mandate on Nationwide’s Silverstone RMBS.

Deutsche has not done an awful lot of flow these past five years or so, other than a smattering of BMW deals.

But the bank has been on a mission to change that; that’s what Matt Williamson went over there to do in his role as of head of ABS Capital Markets Coverage Europe. A four-handed master trust RMBS mandate for an issuer that doesn’t need any structuring work isn’t a particularly lucrative gig, but it’s very visible….and maybe it’s a segment that’s on the up over a multi-year horizon.

If UK clearers start using RMBS as a funding tool again in size, you want to be there or thereabouts; a scatter of basis points on 2010-11 style £4bn transactions is worth turning up for.

Silverstone isn’t the first master trust deal for the New Look Deutsche (that honour came with Holmes 2022-1 in July), but it’s an impressive mandate nonetheless.

The deal seems to have gone rather well (3.6x done at guidance on the minimum offer size of £500m, final pricing 2.8x on £750m, through the tight end of guidance), but it doesn’t signal a new dawn for UK institutions in RMBS….Nationwide is also tendering for notes from Silverstone 2018-1, 2019-1 and 2020-1 at the same time, so it’s more of a proactive maturity management play than an actual meaningful slice of new market supply.

Anyway, we digress. If the market is basically functioning now primarily thanks to the balance sheets of investment bank securitised products groups, what does that mean for next year?

Lots of the positions that we know about were bought in tighter market, and may even have been bought slightly through prevailing markets.

None of the European bank orders in CLO senior will have been wildly mispriced NoChu style deals, but still, if you pre-commit anchors with a two week execution window in a CLO market that’s mostly gone wider this year, you will tend to have bought inside secondary levels.

Then those will have been marked down, down and down again, as the year has gone on. It’s very unlikely, if you’ve been a diamond hands anchor order in seniors all year, that you’ll be looking at a profit.

We’re not saying that these are bad trades. Senior RMBS and CLOs are bulletproof bonds credit-wise, even if you might not be sure when you get your money back, the capital treatment should be good, and they’re floating rate, so the absolute coupons are now looking tasty. If you’re doing buy and hold positions, ignoring the mark-to-market is a perfectly valid approach.

But still the big question for 2023 is… there balance sheet available for the year ahead?

Let’s throw around some quick numbers.

Credit Suisse’s business, we know thanks to the Apollo sale, is about $75bn globally. Given the relative sizes of US / European markets, maybe a quarter is European, so $20bn give or take? CS is not a balance sheet monster by any means, and so a bank like Citi could easily be two or three times as large (agency MBS can absolutely wreck these sorts of back of envelope calculations so health warning).

Citi’s principal business originating for the Canada Square and Jubilee Place shelves was on a fairly tight leash, or so it seemed from the outside, with a term takeout and reload every £200m-£300m in the case of Canada Square.

But buying senior bonds is evidently a different matter, and despite the noise around the bank bid, there might be quite a lot of ammunition left among the various securitisation groups.

If we look just at loan notes, supposedly the preferred exposure format for Citi, there’s been around £1.8bn this year in consumer products, and roughly €1bn in CLOs.

I’m using Finsight’s database, which might have missed a couple of designated loan notes (Together’s second lien transaction included a £257m senior loan note, for example, which is not listed).

And it’s worth noting, as in the Together second lien case, that loan notes does not necessarily mean Citi. BNP Paribas took a piece of that deal, but was basically indifferent between loans and bonds.

Loan notes in CLOs, meanwhile, have been bought by other North American institutions, including BofA treasury and State Street in the CLO market — so again, it’s not all Citi and perhaps we should haircut that figure a bit.

So we’re talking about a lot of money deployed by Citigroup this year, but probably of a volume in each product that’s single ticket territory for JP Morgan CIO in its early 2010s pomp. If you’re running a $50bn business, squeezing out a couple of billion to buy some high carry triple-As in the year ahead should be possible.

Multiply that by the number of decent-sized investment banks which are actively buying bonds, without the need for a loan note carveout, and you have a pretty good basis for getting some transactions done next year, at least at the senior level.

There’s just the small matter of the mezz, however, which probably still depends on the shaky confidence of the UK real money funds that puked in September/October. We hear signs that they’re playing, tentatively, and there are a few alternative credit/hedge fund types with cheap bids out there…but a sustainable market is one where an Insight will bid for whole mezz tranches and take fat slices of a given capital structure. Tentative is not what’s needed.

But, it’s Thanksgiving, the traditional end of Good Execution Windows for the year, and few funds will be inclined to put on decent risk in December. Let’s see in 2023 brings them back.

Victims of success

Kat Hidalgo and Laura Thompson of 9fin’s loans team have been digging into some of the star performers in the European loan market, and finding that, despite successfully passing through cost increases and beating earnings guidance, loan prices have not kept pace.

Read this piece on Ahlsell and this piece on Stark for earnings reports and analysis, both CVC-owned building materials companies, which seem to be knocking it out of the park. Building materials might not be the most recession-proof sector, but since both firms raised acquisition facilities in early 2021, they’ve done well.

But it hasn’t helped loan pricing….largely because they’ve successfully hit a double round of margin ratchets, and ESG KPIs as well, and both facility are now paying 292.5 bps. This has left the loans trading at 92ish and 91ish respectively.

Margin ratchets triggered by leverage cuts and strong performance shouldn’t, from first principles, mean a big price cut. Clearly you’re getting less yield so being “market rate” for a single B means a lower trading level…but surely the outperformance deserves a lower credit spread?

Well. The margin ratchets in both of these deals were added in the heady days of early 2021, so it’s quite likely they were “mispriced” as far as the dark gloomy end to 2022 goes. That is, the triggers for the stepdowns may have been too easy to hit, so the outperformance isn’t enough to lift the loan price.

Just as important is the concentrated investor base in the European loan market.

In the pre-2022 world, you could make CLOs work with loan margins at 350 bps. Now you’re looking at maybe 550 bps? So sub-300 bps collateral really doesn’t make the grade. Perhaps this can be tolerated for an occasion liquid double-B like Ineos, but it’s punchy even for a well-performing single B.

That means there’s an arb available for loan funds which aren’t fighting the constraints of the CLO structure. Good loans are trading cheap, there’s some value to be extracted from the quirks of the main bulk of the European leveraged loan investor base. There’s no easy catalyst to realize this (CVC is not going to refi 2028 loans paying <300 bps for the fun of it) but value there undoubtedly is.

The Barclays research team flagged another technical wrinkle for the European CLO market in their piece last week (worth a read as always, despite the inspirational title “Q4 Equity Distributions: Europe outperformed US”).

They’ve looked at frequency switching and the timing of rates moves, which have had a pretty meaningful impact on CLO economics. Pre-2022, the Euribor curve was flat and dull (plus loans and CLO tranches alike had Euribor floors, making them fixed rate). Now, there’s 55 bps between 3M Euribor and 6M Euribor.

For now, that’s a boon for the CLO market. Around 25% of collateral is based on 6M Euribor, so there’s more cash coming through deals to pay 3M-based coupons. But many of these issuers can shift their payment basis, and the number of loans paying 1M Euribor margins is rising.

The timings of CLO liability payments also makes a difference. Per Barclays “Heightened rate volatility, which helped European CLOs enjoy healthy distributions in 4Q, will likely hurt payouts in coming payment cycles. The three-month rolling liability cost suddenly spiked to 2.3% recently, from 1.8% in July, because of the increase in 3m Euribor, and the increase in asset coupon has yet to catch up. This caused excess spreads falling to about 1.4% from 1.6% in July.

Perhaps the real headline from the note isn’t the technicals of payment frequency, but the actual level of that excess spread. According to Barclays, it’s at the lowest level in five years. And yet still the deals keep printing.

Lower margin loans used to be a speciality of Palmer Square Capital Management, whose business model of printing static deals made for far more efficient capital structures with (mostly) lower liability spreads. This, in turn, allowed Palmer Square to make their deal arbs work with collateral of exactly this sort - low margin good quality names that couldn’t support a conventional cashflow CLO.

But now a broad swathe of managers are printing, let’s call them “involuntary statics”. That is, static deals from managers who’d rather be doing an active print, but have been constrained by circumstance into static transactions.

Onex Credit Partners is the latest in a distinguished line beginning with Sound Point Capital Management in July, and continuing into the autumn with Axa Investment Management and Napier Park Global Capital. The trade is not so much about opportunistically accessing low margin value pockets neglected by the active managers, but about partially redressing the arbitrage through a more efficient liability stack.

Onex successfully broke through the 220 bps barrier that’s prevailed in recent prints to score 215 bps at the senior level, though landed slightly outside Blackstone Credit’s (active) Edmondstown Park down the stack. Tikehau VIII didn’t disclose discount margins, a trend we deplore in general.

In a static, though, it’s really the lower par subs (32% on the senior for Onex) which are doing the work to improve the economics. By the look of it, the motivation here is probably more about improving the arb than (as in the case of Sound Point) cutting the equity cheque required. Onex has not opted to print a single B tranche, the obvious move for the equity constrained. It wouldn’t have been huge in any case, but every couple of million helps if you’re trying to make the equity jigsaw work.

Onex has been a fairly infrequent issuer, and this is an old transaction. The SPV was incorporated in November 2021, during the good times, so presumably the portfolio has been hanging about a fair bit.

Clearing an old transaction by Thanksgiving the following year is a decent goal, and, market-wide, we’ve seen a fair bit of the legacy overhang of warehouses print or exit in some form or another.

That’s definitely good news….there might still be a ton of warehouses out there (most managers we talk to seem happy to keep opening them despite the conditions) but there’s likely little collateral in them, and they’re warehouses for the optionality, rather than for meaningful ramping.

Less overhang is a better place to start 2023 (there’s still a reasonable pipeline of 2022 deals to exit in the next couple of weeks), but will the overall backdrop improve?

We’re sharpening pencils for the 2023 Outlook pieces - give us a call if you want to be featured.

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