Market Wrap

Excess Spread — Muddy Ribbons, Scotch Mist

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

Muddy Ribbons

German real estate companies have been having a rough time this past year or two, as extensively documented by 9fin’s distressed debt analysts and reporters. The initial trigger was short seller Viceroy Research’s report on Adler Group in October 2021; it’s now in full blown restructuring. Worries have swirled across the sector; even large listed groups like Aroundtown are choosing not to call hybrids.

Pre-2008, most of the terrible German real estate leverage made its way into CMBS deals. Deals like Fleet Street 2 (KarstadtQuelle) were among the most challenging restructurings of the post-crisis period. Even resi-like multifamily transactions ran into trouble — GRAND, the biggest of them all, needed a €500m equity injection to bring it down to refi level.

Since around 2014-5, it seems like high yield has been the more tolerant and understanding market, but rising rates and rough refinancing conditions will stress the sector. The short-sellers don’t seem to be letting up either.

The latest report is from Muddy Waters (Carson Block), the big daddy of the “activist short” community, targeting Vivion InvestmentsRead it here….we’re not expressing any views on the contents within, but essentially it questions shareholder loans to the company, value extraction, property valuations, related party transactions……and whether the company’s reported vacancy rates stack up, especially given the heavy presence of a co-working anchor tenant which Muddy Waters argues is a related party.

Here’s Vivion’s holding statement, citing “numerous factual inaccuracies, provably incorrect statements, and flawed conclusions demonstrating a cursory and incomplete understanding of the Company and its operations.”…..presumably there’s a more fulsome response in the works.

Vivion has been a short target for a while — Bloomberg pointed out that short interest in the company’s bonds was extremely high early in 2021, but the shorts are laughing this week, with the 3% 2024s down 17% on Wednesday after the publication of the Muddy Waters report.

Everyone in German commercial real estate appears to know each other — Stefan Kirsten, the chair of Adler Group, who joined in February 2022, was formerly CFO of Vonovia, and also spent time on the advisory board of Vivion.

Asked about his Vivion activities on an Adler analyst call, he said: “I was advising Amir [Dayan, owner of Vivion] on obtaining the waivers for the CMBS in the UK, getting his accounts into a shape that we can go for a rating, getting a rating, and getting the first bond out. Afterwards, I stayed on the advisory board. I had, at no point in time, anything to do with Aggregate bonds”.

Oh yeah, that’s the other bit — Vivion had a joint project with Aggregate Holdings (a shareholder in Adler Group), the Fürst development in Berlin which was paid out in a complex mix of cash, bonds and “non-traded bonds”. It’s a bit of tangled web.

What does this all have to do with securitisation, one might ask?

Well, prior to Vivion’s 2019 bond debut, as Kirsten mentions, Amir Dayan and family sponsored Ribbon Finance 2018, a UK hotel CMBS arranged by Goldman Sachs, and financing the acquisition of a portfolio of Holiday Inn and Crowne Plaza hotels from Apollo. Apollo stuck around to provide some mezz finance on the portfolio.

Ribbon Finance securitised a £449.8m senior loan, the initial mezz was £69.2m, and the portfolio was bought for £742m (a valuer pegged it at £692m after subtracting the purchaser’s costs). Here’s DBRS’s presale for more details.

As a portfolio of hotels, it had a pretty terrible time in 2020, and the Dayan family injected cash a couple of times, as well as obtaining waivers of events of default related to LTV, NOI Debt Yield, Interest Cover Ratio. Apollo followed suit as well on the mezz, though this loan was repaid in July 2020. The senior loan waivers ran through to July 2022, but at that point, it successfully passed its LTV conditions, and the deal seems to be performing adequately.

The last valuation report gave the portfolio (minus two assets that were already sold) a valuation of £559.5m, against outstanding CMBS debt of £237.8m, for a very manageable 42% LTV. No info on the status of the mezz, but presumably it hasn’t amortised ahead of the senior. Even with the mezz loan, though, that’s only a 54% LTV.

But then……the portfolio comes in for a mild pasting in the Muddy Waters report.

“In our opinion, the rents paid by Vivion’s related party hotel management companies are artificially high and non-economic, even based on pre-pandemic business levels. In the stub year of 2019, on an individual basis, 42 of the 45 related party OpCos lost money post-spin off…The 19 OpCos operating the Ribbon portfolio lost £9.6m, which was -17.9% of the hotels’ revenue in the stub year of 2019.55 In 2019, all of the 19 related party OpCos lost money post-separation. The rents now paid for the Ribbon properties equate to a 7.1% cap rate, even after taking the fair value gains, otherwise, the cap rate would be 4.9% if there had been no rent inflation..

Even if you buy the Muddy Waters argument in this respect, it probably doesn’t matter too much. Haircut the value of the hotels if you want, and you still get a low LTV transaction.

That’s particularly important….because Ribbon is up for refi in April 2023, so there’s probably already something in the works. Vivion has been pushing to switch its financing structure to an unsecured, bond-based cap stack (the company filed an EMTN shelf last month), but even at Thursday’s level with the bonds rebounding from their short-seller-inspired lows, that’s going to cost a lot (unsecured debt is trading at 14%+).

The loan in Ribbon, meanwhile, pays 319 bps, and features other beneficial goodies like a 2% cap on the benchmark rate. The original mezz loan paid 625 bps and had the same cap and maturity date. If Vivion goes back to the secured market, the Ribbon portfolio is surely financeable, but not on anything like these terms, and some potential lenders may simply wish to walk away while the company is still wrangling short sellers.

Scotch mist

The UK is using its brief and uncharacteristic spell of functional government to push through some changes to financial services regulation. Big changes could be coming to messy EU-driven measures like PRIIPS, MiFID II and Solvency II, as well as to the UK-inflicted own goal that is ring-fencing retail banks from investment banking.

Securitisation is getting a tune-up too, with a package of tweaks proposed to the inherited European securitisation rules. Here’s the draft Statutory Instrument, (h/t to PCS for the link).

Much will remain the same — there will be an Simple Transparent and Standardised Securitisation (STS) regime, with details delegated to the FCA, which may leave the way open for a synthetic STS regime. This was introduced in the EU, but after the period in which EU rules were copy-pasted to the UK, so would bring the UK regime more closely into line.

PCS: “Intriguingly enough, with the criteria for STS having disappeared from the draft legislation and, in the absence of a definition of “non-ABCP securitisation”, the proposed text appears to leave open the possibility of synthetic securitisations being STS. This seems now to be in the gift of the FCA.”

The last point is kind of interesting — the reforms generally push more decision-making down to the regulators rather than hard-coding everything in legislation (there is, for example, the possibility of a US-style “no action” letter). Given that many of the problems with EU regulation generally and the Securitisation Regulation in particular come from a badly drafted or awkward “Level One” text which is virtually impossible to amend, this has to be a good thing.

Here’s a note from Clifford Chance which lays out a little more.

There’s also an equivalence regime for STS, which the EU has rejected — so it looks like equivalence will end up being “one way only”. SPVs can be outside the UK, though originators or sponsors must be UK-based.

For some reason, resecuritisations may be allowed again, though pre-approved on a deal by deal basis….it’s not clear to me who might want this and why, but I guess there might be a few deals that become technically easier to do as resecuritisations…..a transaction like the US Texas Capital Bank SRT on mortgage warehouses looks much like securitising a bunch of securitisation exposures and I can see a bank like Barclays, Santander UK or Lloyds being interested. in SRT on their mortgage warehousing. Given the deal by deal approval hurdle, it’s not going to be much use for credit-enhancement repack-type arrangements, and I doubt whether the classic CDO of ABS structures are coming back.

I suspect there is considerable latent desire to raise finance against CLO equity, especially through the risk retention funds. Structured leverage on a risk retention fund seems like the kind of thing that could get caught by the resecuritisation ban, though perhaps not like the kind of thing regulators would actually want to sign off on. That said, they’re seemingly pretty chill about Nearwater’s 100% non-mark-to-market risk retention financing, so flexible about how much skin remains in the game.

Perhaps more consequential than the explicitly securitisation-based points are the changes to the ring-fencing regime, and the changes to the building society funding model. Tweaking ring-fencing might not mean a full tear-up of the separations splitting up the likes of NatWest, HSBC, Barclays and Lloyds, but presumably any change will move in the direction of less trapped liquidity in the clearers (and hence a less distorted prime mortgage market).

Building society funding sounds like a very dry and technical topic, but one change that is on the cards is carving repos on HQLA (high quality liquid assets) out of the “funding limit” calculation for the builders. This would tend to make senior tranches of prime RMBS, for example, a more attractive investment for the builder treasury books.

There’s another tweak about capital treatment of non-performing loans on UK bank balance sheets, but this doesn’t seem like a massive deal…they will no longer be a capital deduction, which sounds fine and reasonable. Actually, this was already in train last year, but the UK government “welcomes” the work that its banking supervisor the PRA is doing on this.

Is this a missed opportunity? If one could redraw the securitisation rules from the ground up, and aimed to create a vibrant diverse market like the US, what would be different about the UK regime?

Securitisation is the act of transforming into securities, turning illiquid, untradeable assets into tradeable ones. The trend of the last few years, if anything, has been to extend the domain of financial markets directly into those illiquid, untradeable assets through the rise of private credit, private equity and alternative asset management. Is this a symptom, in part, of the fact that securitisation has been gummed up by regulation, and the channel blocked off?

Would it be a better use of everyone’s time to hold off on the “Big Bang” of financial services reform (part of the Conservative Party’s Thatcher tribute act) and do it properly?

No hope from EIOPA

Speaking of missed opportunities, we must turn to the European Supervisory Agencies Joint Advice to the European Commission….(sorry for the regulatory double-bill; it’s the season when rule-makers try to clear their desks).

To recap, this is basically the three big pan-European regulators, looking after banks, markets and insurance respectively, offering their views on how to improve the EU Securitisation Regulation.

There was some hope for easier capital treatment, some hope for better liquidity treatment, and hope for a bit of a general tune-up to the most egregiously burdensome parts of the Regulation.

So, how’d they do?

Here’s the report. We’re going to cite PCS again, because Ian Bell is a man of great wisdom and distinction, and also because he’s reliably first with his takes on new regulation. I’d expect various law firms will also offer their takes in the days and weeks ahead - ping them over if you see a good one.

As they have just been published, we have yet to read the full conclusions. But the EBA announcement page  gives some indication as to the proposals (or lack thereof) contained in the documents.”

(PCS, my emphasis).

PCS continues to be puzzled by the assertion that the Solvency II calibrations are fit for purpose when the capital requirements for an illiquid pool of whole mortgages remains lower than the capital required to purchase a highly liquid AAA rated senior tranche of a securitisation benefiting from substantive credit enhancement of the same pool of mortgages.

PCS hopes that careful reading of the two reports may yield better news but we are not optimistic.

(PCS, PCS emphasis)

The Association for Financial Markets in Europe, usually inclined to moderate language (it does, after all, have to lobby the various regulatory bodies and stay friends), was also unimpressed.

We are very disappointed on first reading of the report. There is a weight of evidence supporting recalibration of both the bank and insurance prudential frameworks, but the ESA’s recommendations conclude that no real change is needed at this stage. Postulating that it is probably not worth making calibrations more risk sensitive and proportionate because they cannot quantify the benefit is no justification for inaction.”

There is a bit of good news - low risk weight for the senior tranches of STS (simple, transparent and standardised) securitisation, down from 10% to 7%. That’s a round trip all the back to Basel II (though the B2 risk weight was for all triple-A securitisation under IRB, not just STS) and should help bank demand. As we’ve discussed already in these pages, a much bigger factor in stepping up bank demand this year has been good old fashioned price, both higher credit spreads and meaningfully positive interest rate benchmarks, but capital treatment doesn’t hurt.

With a bit of regulatory support, can prime RMBS crank in from a 50 bps credit spread to a pre-2008 10 or 12? Maybe, but the crucial part of the return is Sonia at 2.3% and Euribor at 2.5%, vs 0% or -0.5% this time last year.

The absolute dumbest part of the ESA report, as PCS notes, is the sheer pig-headed assertion that Solvency II isn’t what’s stopping insurers investing in securitisations in Europe.

EIOPA asserts that, since the original introduction of STS in Solvency II did not lead insurance companies to buy STS securitisations there is no value to the regime. We would suggest an alternative conclusion: since the introduction of the STS regime in Solvency II was accompanied by grossly excessive capital requirements, it gave no incentive whatsoever for insurance companies to purchase high quality securitisations. It was not the introduction of the STS regime that led to the absence of insurance investors but the failure to see through the STS reform to its logical conclusion by the introduction of the correct and appropriate capital requirements”

(PCS again)

It’s not like we have to indulge in wild speculation to imagine a market where insurers regularly participate in securitised products in meaningful size - the US capital markets offer a very clear and obvious example, in which it is absolutely routine and expected for insurers to invest in ABS, CLOs, CMBS, RMBS alongside their books of corporate bonds, financials, government and everything else. The US has its own regulatory disputes (see the ding-dong between the insurance supervisors and the Loan Syndication and Trading Association for one example), but from a baseline of high and sustained involvement in the market.

Insurance-aligned asset managers are among the biggest players in European securitised products — consider an M&G or Axa Investment Management — so clearly there would be ready conduits for insurance capital to pour into the sector. It’s just that the returns don’t stack up.

To PCS’s point about how whole loan portfolios attract better capital treatment….this is also a thing that doesn’t need blue sky thinking! You can go to Dutch insurers and discuss the whole loan books they are funding! Or ask the UK lifers about their mortgage investments! It’s right there in front of you! Regulatory nonsense is actually encouraging insurers to purchase less liquid, riskier asset portfolios instead of securitisations.

PCS also cites a missed opportunity over the treatment of RMBS in the liquidity coverage ratio. Now this one seems trickier to me. It’s true that, if you compare prime RMBS to e.g. covered bonds or corporate bonds, the asset class stacks up nicely.

But the point of the liquidity coverage ratio is basically to help prop up banks at times of market stress. We saw in September/October that dumping a couple of billion in senior RMBS and similar in senior CLOs absolutely smashed both markets.

There were undoubtedly cheap bids out there to be found (we’ve talked about Apollo), and you can argue the toss about whether October’s markets actually showed the surprising strength of securitisation liquidity, but for an idea of scale, Lloyds has £120bn or so in HQLA, the eligible portfolio for the Liquidity Coverage Ratio). Most of this has to be made up of govvies, but maxing out the 15% RMBS exposure gives £18bn AT A SINGLE INSTITUTION.

Pause for a second and think about what would happen to conditions if there was a bit of a wobble about the soundness of a major UK clearing bank, and that bank also dumped £18bn of asset-backed paper in the market over a month or so……this is simply not a sum that can be sold in the market, never mind in a time of stress.

If the purpose of the LCR / HQLA designation is actually what is claimed; that is, to give a buffer of emergency sellable liquid stuff to get a bank through a month long bad patch, it shouldn’t have RMBS, covered bonds, corporates or really any credit in. If it’s a fuzzy label meaning “the sort of thing that bank treasuries ought to like and we approve of”, then sure, more RMBS, whatever, who cares.

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