Excess Spread — Running out of road, unappealing, how the other half live

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Excess Spread — Running out of road, unappealing, how the other half live

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

Excess Spread is on holiday next week

Running out of road

While we’ve been sitting here debating pipelines and exit strategies for the last several months, time has been ticking away in warehouse facilities. After the Covid crisis, CLO managers and equity generally sought longer, more flexible warehouse terms, and banks were mostly happy to comply — these are, after all, pretty good clients in a highly competitive business line.

But some facilities may be looking a bit stale. We saw a notice from an HPS Investment Partners vehicle, Aqueduct 7-2022, announcing that “it has come to the attention of the issuer that… a Reinvestment Period End Date occurred on 17 June 2022.”

That’s nine months after the warehouse, provided by Bank of America, was signed — a decent time to get a deal away, one might think. Unless you didn’t go in December, because liquidity was thin, and didn’t go in January, because you were still ramping, then didn’t go in February, because the market was getting worse…then kept on getting worse and worse and worse.

We’re not privy to the warehouse terms, obviously, but “Reinvestment Period End Date” seems pretty self-explanatory — it’s not so much that the facility is shutting down, more that it can’t be used for buying more loans or trading a portfolio. HPS has its portfolio in place; should it keep waiting or try to move?

Given the timing of the initial warehouse line, it’s a fair bet that this one is some way underwater, so it’s really just a version of the same dilemma many CLO shops are facing — what’s the least painful exit route for a portfolio? Liquidating the assets seems deeply unwise at current levels, so a term deal of some sort it has to be.

Speaking of which, we have the first example of a “sell-off static” priced in market: Sound Point IX, arranged by Deutsche Bank. The warehouse is newer than the HPS deal, active from mid-December, but it’s still the same basic problem — the assets were bought in good times and the liabilities landed in bad times. Sound Point is a manager known for active trading and, if anything, inclined to longer structures where possible. But as a one-off to solve a problem, a static works.

The deal got the classic static benefits, with a 32% par sub on seniors and greater efficiency through the stack. The coupon costs are still eye-watering — Deutsche didn’t circulate the discount margins, but even the coupons spreads of 160/276/371/541/732/1127 are frightening, particularly when one considers that the ‘F’ note has a turbo feature, last seen in Invesco Euro CLO VIII in May.

The turbo for Sound Point runs twice as fast, taking 40% of residual interest payments, though liabilities have taken a big leg wider in the intervening period, so it’s getting 40% of a much smaller residual interest pie.

Unlike Invesco, the class ‘F’ is unrated, instead of the conventional low single-B. The hedge funds active in this space, who often also play in CLO equity, have little need of a credit rating, but the lack of rating also reflects the high liability cost and low spread in the portfolio — it’s a tranche rating that’s very sensitive to the availability of excess spread under stressed conditions.

Costly though the class ‘F’ is, it helps cut the size of the equity cheque — which is the real benefit in doing a static deal.

Warehouse equity providers might not want to roll into a term CLO deal at the best of times, and right now, there are more exciting places they can put their cash. Instead of the €30m-€40m you might expect at the bottom of an active deal, the sub notes in Sound Point IX are just €13.2m for the €390m total deal, so that’s a fair bit of cash that can be taken off the table.

That does mean the equity is 30x levered, with a lot of sensitivity to any further declines in loan pricing, but it probably helps make the deal interesting for the equity that did roll in. The debt stack costs around 270 bps of blended coupon, inside pre-invasion loan spreads — this portfolio is paying a weighted average spread of 4.17%, according to Moody’s, with a weight average coupon of 4.68%.

Senior solutions

We talked last week about the limited investor base for static triple-A, and its reliance on the Large West Coast Asset Manager’s appetite. Sound Point, however, got a helping hand from its arranger, with “DB to hold a portion of the class A notes”.

Deutsche Bank has some form here — it has a substantial CLO book of its own, and participates not infrequently in the transactions for which it is arranger. In CVC Credit’s Cordatus XXII, for example, it disclosed a position in the €11m class B-2 fixed rate notes.

It may, in fact, have taken much more than that €11m tranche — flipping through the offering memorandum for that deal, we find a disclosure that a Deutsche Bank affiliate took €151m, implying a chunky ticket in the triple-A as well, which didn’t quite make it into the deal announcement.

There’s a compelling logic to this, if banks are sufficiently joined-up to make it work. CLO arranging desks are stuck with a ton of balance sheet out at uneconomic levels, while their treasuries are flush with cash.

Convert an illiquid and stuck IG position into a liquid (not actually, but for regulatory purposes) triple-A, let the mezz fall where it may, and everyone can move on with their lives. Plenty of European and US bank treasuries dabble in (and occasionally anchor) CLOs, and some of these banks’ CLO arranging businesses are long underwater warehouses.

What about the banks that aren’t sufficiently joined-up to make it work?

Plenty of European banks have liquidity to spare, and if they can be persuaded to get involved, that makes a much healthier market. The European CLO market has been through periods of depending on exactly one Japanese bank account, and graduated into a mature state of relying on a small handful of funds for the triple A. Even at its best, the triple-A market is not what you’d call a real, healthy, competitive market.

Bank treasuries also have another potential role. A treasury bid is a helpful leg-up for firms trying to break into the business — coming with a captive bid for the senior notes means one piece of the CLO puzzle is already solved, and offers a way for banks to differentiate themselves in an otherwise fairly commoditised business.

That could be an advantage if StanChart sets out its stall….but it’s not there yet for Société Générale, unfortunately.

SG has a decent CLO trading franchise, a decent US CLO arranging franchise (including selling into Europe), structuring chops, balance sheet to play with, a leveraged lending and loan trading business. For years, the only missing piece has been European CLO new issues.

Apparently we’re not the only ones thinking this — SG has already started sniffing around the business, even marketing a deal during the February/March period.

One assumes the strategic decision to target European CLOs came in the good times of 2021, when most of the established desks had more business than they knew what to do with, and bottlenecks were emerging in law firms and rating agencies trying to handle the sheer volume of resets and refis, as well as new deals.

The deteriorating market put SG’s debut European trade on ice. But when the market bounces back, there’s another player in town.

Waiting on warehouses

With that deal in the rear-view mirror, Sound Point can get on with adapting to the current market — and clearly it plans to keep printing. Company records from Ireland show that Sound Point X, XI and XII have already been registered.

Sound Point X has had a warehouse open from March 25 — in retrospect not the perfect entry point, but late enough to ensure a fair bit of bad news would be already in the portfolio price. No facilities are yet recorded for XI and XII, but a print-and-sprint might be possible, if the right investors can be found.

For other deals in various stages of marketing, Sound Point can serve as a (pricey) example. There are seven or so live transactions, but every manager with a pre-March warehouse is looking at options and formats, and is undoubtedly open to enquiries at attractive levels. It’s a target-rich environment for investors with some cash to spend.

Just to give a brief rundown, we see pre-invasion warehouses (based on the Vienna Stock Exchange, at least; there are probably others too) for ChenavariWhiteStar, two for Carlyle, two for HPS, one for BlueBay, one for PGIM, one from Sculptor, one for Alcentra, one for Axa IM, and one for BNPP Asset Management.

Managers with in-house equity (or no desire to sell minority) have more options for remaining private, so this is definitely an under-estimate. Even so, it’s a long list, and not everything needs to go right now — but some of their warehouse providers will be getting itchy feet.

How the other half live

While European insurers struggle to get off the starting blocks in securitisation investment, hobbled by regulations that make it more cost effective to buy underlying assets directly than to buy in securitised format, US insurers are miles ahead (at least for now).

But the NAIC (the US national insurance regulatory body, which brings together all the state-level insurance regulators) wants to amend the rules in a broadly European direction, increasingly capital costs for insurers wanting to buy CLO tranches.

The Loan Syndication and Trading Association, the US lobby group for leveraged loans, is very much on the case, with an explainer and initial response. There are some interesting figures in the NAIC’s study — insurers in the US had $193bn in CLO investments in 2020, up from $157bn in 2019. That’s an appreciable fraction of the $1trn or so of total US CLOs outstanding.

Insurance companies in the US also hold $10bn of CLO equity “oftentimes related to investments in their CLO manager affiliates”, according to the LSTA — let’s assume that supports $100bn or so of CLOs outstanding, with debt placed elsewhere.

The core of the NAIC’s criticism is the divergence between the capital charges for a portfolio of single-B rated loans, which clocks in at 9.54%, and the capital charges for a vertical strip of CLO tranches (i.e. exposure to a portfolio of single-B loans), at 2.92%.

The NAIC argues that there’s therefore an arb to be had by securitising a portfolio of loans — precisely the reverse of the situation in Europe, where securitising is basically a reverse arbitrage for insurers, who find it more costly to hold tranched senior securitisation exposures than they do underlying asset pools.

Under the European Solvency II regime, a five-year single-B corporate bond or loan attracts a 37.5% capital charge, compared with 500% for an equivalent securitisation.

The LSTA is planning a robust defence of the industry status quo, and there is some logic to it.

A CLO is not just a bundle of loans, it’s a bundle of actively managed loans, with structural protections (interest cover, diversion of excess spread, and so on) which should make it safer. Plus, it’s diversified. Market values of loans might be dragged up and down together, but retailers, oil, tech and healthcare have different default drivers.

In other words, if the playing field is going to tilt, it should tilt towards securitisation. Who knows if the LSTA will be successful in convincing the NAIC of this, but it’s the kind of problem that Europe’s securitisation industry would love to have.

Unappealing

The hunt for Rizwan is still on, though judges in his appeal case on Wednesday suggested he might well be in Pakistan, which would make it tricky for the UK police to exercise their arrest warrant. He’s still filing legal cases, as we’ve seen, but his lack of attendance in court will make it tough to push them ahead.

The appeal hearing is an attempt to get the contempt of court judgement against him thrown out, with an unfortunate legal aid barrister tasked with arguing the case. The original judgement was for breaching injunctions against interference with the BMF transactions, and basically turned on whether the various names and identities used to attack these deals after Rizwan got out of prison were in fact him, or linked to him.

The judge was pretty definite on the subject: “I am satisfied to the criminal standard that Mr Hussain orchestrated the steps taken since 30 March 2021 against the Issuers. He has used the names of Mr Artemiou and Kipling and others to make communications and carry out other actions which, if they had been done openly in his own name, would have indisputably constituted breaches of the Injunction. I am satisfied to the criminal standard that the facts are inconsistent with any other conclusions.”

But an appeal followed nonetheless, giving the poor barrister a bit of an uphill struggle. The main appeal arguments were that the judge appeared to be biased, plus a bunch of procedural issues — an incomplete bundle of documents prior to the trial, certain evidence that was produced late and therefore wasn’t admitted, and technical points about how the process for serving an injunction wasn’t followed properly.

We didn’t sit for the whole thing, but it seemed like the appeal court was not feeling terribly sympathetic.

Persuading a panel of judges that judges shouldn’t be allowed to express their views in forceful language was always going to be a challenge — Rizwan’s barrister suggested that Mr Justice Miles describing the BMF attacks as a “corporate assault” was a bit strong, and suggested the phrase “a sustained campaign” might have been more acceptable.

The appeal judges seemed to find this vaguely amusing. This part of the appeal was dismissed, as was the appeal over the missing pages in the trial bundle.

Long and wrong?

Last week, UK prime minister Boris Johnson took a break from office-based leisure activities and the crisis in his government last week to float a scheme for even longer mortgages — which could pass between generations — as a possible route to expanding access to home ownership.

Events have moved on rather quickly since then, and he won’t be around to implement this or anything else, but we still thought it was worth a quick look. After all, the UK might even have a CDO structurer stepping in to run things before too long (at the time of writing 10/1 outsider odds).

Going ultra-long isn’t a new idea. It’s one of the big levers you can move to get monthly payments down and boost borrowing capacity, and a few private sector providers are already figuring it out.

Watch two of the most prominent, Arjan Verbeek of Perenna and Alex Maddox of Kensington, react to the proposal — courtesy of DealCatalyst, which is launching a new conference on UK mortgage finance this September.

The obvious question with a new mortgage product is: how should it be funded? And can you securitise it?

Perenna’s approach is inspired by the Danish covered bond market. Kensington is originating long-term fixed-rate mortgages in partnership with life insurer Rothesay, while Habito’s ‘One’ product is going into a warehouse arrangement with CarVal and Barclays.

Long-dated mortgages need several features to work well — prepayability and portability are most important. Few people can commit to owning a single property for 40 or more years, and circumstances change and evolve, so there must be some way out, and ideally the product will give people flexibility to move house during the period.

Prepayment is easy enough to figure out. It’s the sort of exercise that’s well within the wheelhouse for mortgage structurers, and the UK government (unlike the US) has not legislated against prepayment. Nor has it nationalised most of its mortgage industry.

Portability between properties is harder, from an underwriting perspective. It will become even harder if a mortgage is to be portable between generations.

My two year-old is extremely precocious, but her ability to service my mortgage debt is still unclear. She does currently want to be a doctor, so I have high hopes, but it’s still a bit of a judgement call.

In practice, the answer is probably to ignore the inter-generational aspect at the point of origination, but that’s also unsatisfactory; banks probably shouldn’t be writing loans in the hope that future income emerges to service them. Long mortgages are good, ultra-long is difficult.

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