Market Wrap

Excess Spread — Subprime minister, specialist shakeout, deep green loans

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

This week’s Excess Spread will probably be a bit heavy on the mortgage content, as we’ve been at DealCatalyst’s excellent new UK mortgage finance conference. Thanks to all the firms who supported the event, and particular thanks to Société Généralé, who got the beers in afterwards. I have no hesitation in awarding them Bank of the Year for UK RMBS on this basis (it’s a very transparent awards methodology). A further thank you to the panellists for my session on “Fintech and the Future of Mortgage Finance”, Auxmoney’s Boudewijn Dierick, Clifford Chance’s Fadzai Mandaza, M-Qube’s Neil Marshall, and Proportunity’s Matthew Froggatt.

The conference tone was decidedly mixed. It seemed auspicious to see Principality Building Society on screen with a prime RMBS just as I was heading to the event, and it’s likely some of the other UK banks and builders will follow this autumn, as they look to get ahead of the roll-off of TFS funding. Issuers that typically print early in the year, like Nationwide and Clydesdale, might prefer to hit an open window at the back end of 2022 rather than accept the uncertainty of waiting through a hard winter of rationed energy in the hope of deeper liquidity in January or February.

Pleasingly we spotted potential new investors sniffing around the market, in the shape of European bank treasuries, and we hear some of the UK treasuries are eagerly putting money to work in triple-A — the entry levels, after all, are pretty good right now. Maybe the mezz is more expensive, but banks don’t issue it, and quite a few of the equity sponsors of specialist lenders have pockets where they can hold it themselves.

That’s the good news done — it was the fate of the specialist lenders that occupied much of the conference, in panel sessions and elsewhere.

The basic model of lending funded an investment bank warehouse, with equity from a hedge fund or PE shop, building a portfolio, and taking it out in the securitisation market is broken at the moment. Term deals are pricing wider than warehouses, and deposit funded-lenders are outcompeting securitisation funders both in their own origination and in the forward flow terms they can offer to other platforms. Depending on the terms of existing warehouses, rapidly rising rates have left some originators in the unenviable position of choosing between writing no business, or writing unprofitable business.

Is this temporary, or structural? The basic issues have been created by the rising rates cycle — capital markets pricing adjusted first and hardest, bank deposit rates are stickier and slower (though JP Morgan’s massive investment in building out its Chase product has introduced serious competition to the sector).

You could take the view that this imbalance will level out as banks hike deposit rates, and that credit spreads in securitisation are dislocated and will come down, in which case the smart move is to take advantage of this stiff competition to offer warehouse funding and wait it out.

But there are structural factors at play as well — lots of the “neobanks” have been very successful in gathering deposits but less adept at originating profitable lending. These firms are likely keen to take a slice of the forward flow financing that would traditionally have been destined for securitisation. The big ring-fenced banks are stuffed with trapped liquidity looking for a home. Neither situation seems likely to change in the near term.

Hedging mortgage origination has also caused problems for the specialist lenders and their equity partners — getting this right matters much more when rates are rising rapidly than in the sleepy decade before this year.

If a mortgage takes a month from offer to completion, which would be pretty speedy, swap rates might still have moved 120 bps, as they did in August. So hedging at offer for a forward start is the optimal structure, but this in turns means accurately predicting which offers will convert to funded mortgages. The mark-to-market on the warehouse hedge is also going to be pretty significant at the point when it needs to come across into any potential term takeout, raising the stakes for the smooth conversion of simple forward starting swaps in the warehouse into rating agency-friendly term securitisation swaps.

None of this is impossible, but it’s expensive, painful, and much easier for a large bank to cope with than a small specialist lender.

Predators and prey

The ultimate shape of the sector was also a big topic at the conference. Several of the storied names in the sector have been sold recently — Fleet Mortgages to Starling Bank, at a very nice exit level, Foundation Home Loans to AtheneTML to ShawbrookEnra to Elliott Advisors and of course, Kensington to Barclays this year. Some sort of exit or liquidity event for Together founder Henry Moser has discussed for a while, with rumours reaching Sky News. But we think any such plans are firmly back on the shelf — why would you sell your life’s work cheap by rushing to exit against the current backdrop?

Founder-owned Together is a special case, though, and firms backed by financial investors may not have the luxury of sitting tight and waiting for a recovery. If the specialist lending squeeze is going to keep going, better to sell proactively now, rather than wait until everyone is rushing for the exits. The IPO market probably isn’t much use right now, so trade sales (preferably to a well-capitalised or deposit-taking institution) are going to be the better option.

As in Kensington, it’s not necessarily the case that the originated assets travel with the platforms themselves. To take two possible examples, Lendco owns the equity in its securitisations (but could sell it), while Habito originates into Citi’s Canada Square shelf and originates long-dated fixed into a warehouse with CarVal as the equity.

Some warehouses heavy on last year’s origination are undoubtedly underwater, and these need dealing with as well — that means some motivated portfolio sellers may be coming to market. One reader suggests perhaps there’s a tip to be taken from the CLO market, which has been trying to cope with the same basic issue as in consumer products…how to finance assets originated at the old price, with liabilities at current spreads? CLO managers in this predicament have been splitting their warehouse lines, holding the old stuff back and trying to fill their term deals with newly purchased loans at today’s more attractive levels. Maybe something similar works in mortgages as well…..back book stays put, front book can come to market?

There was also much speculation about whether the macro environment changes the overall size of the specialist lending sector. Stretched household budgets might mean more households fall out of the “prime” category and become “complex prime”, while a steepening yield curve should allow the High Street banks to make good money while remaining conservative in their lending. Or they could use the money they’re making to invest in better technology and more specialist underwriting, and push down the credit curve. Perhaps the Barclays-Kensington purchase piles on the pressure for the other High Street firms?

Subprime minister

In troubled times like these, the British must take their national pride wherever they find it, and it is with that in mind that the Bank of England’s latest stats stuck out — particularly the part noting consumer credit (cards, autos, personal loans) growing at the fastest rate for more than 17 years (h/t to Bank of America’s European Credit Strategy publication for the tip).

We just love borrowing, it seems, and even this startling figure may even understate the scale of consumer credit, as it’s not clear how many of the burgeoning BNPL firms are included in the survey.

Many of the readers of this newsletter are basically in the business of financing consumer credit, one way or another. Growth in lending, all else being equal is a handy tailwind to the securitisation industry. This, however, is a scary stat, because it suggests that the initial impacts of the cost of living crisis and high UK inflation are being funded by one of the most expensive credit sources out there.

For most of the year investors have been nervously looking out for the impacts of the squeeze on household incomes to show up in financial data, and ABS is a good place to start — reporting is usually more frequent and more detailed than corporate reporting, and the payment behaviour of thousands of borrowers offers a firmer basis for decision-making than vague management remarks on earnings calls. TwentyFour Asset Management wrote in May about the merits of this data source, though it was signalling, at the time, that UK consumers had mainly been paying down debt since the pandemic.

Even surging payment trouble doesn’t necessarily mean junior ABS investors are in trouble — excess spread takes the strain when the defaults start, and the shelves that might be useful signals, such as NewDay’s programmes, and the non-prime auto deals from Oodle, have plenty of it.

We’re not the experts in combing through payment data, but we understand it’s all quiet so far, with Q1 2023 the likely time to watch.

The new UK government and proposed energy bailout package could make a huge difference to the picture though. Leaks about the package dribbled out all week, with a formal announcement on Thursday that the government will cap household energy costs at £2.5k for the next two years. Read your preferred sellside economist for a more nuanced take, but it’s not clear to us how a demand side measure can solve a supply-side problem….and the package could easily import more inflation through the currency, even as it holds down nominal domestic energy costs.

Whatever the macro picture, it probably does help performance at the spicier end of the securitised products market — some borrowers will undoubtedly stay current thanks to the bailout. Some struggling consumers may prefer to leave energy bills unpaid rather than other consumer credit products. Energy companies cannot disconnect electricity and gas under certain circumstances, such as if there are under 16s in the house and it is during the winter months, if a borrower has health problems or is over a certain age….so it may be that the stresses actually show up in mounting energy NPLs, rather than in the books of lenders.

Aiming high

Mandatum Asset Management, the asset management arm of Finland’s Sampo insurance group, has launched a leveraged loan fund, an ordinary enough activity for a fund management business. What makes this one special is that it is an “Article 9” , or “Dark Green” fund, under Europe’s sustainable finance disclosure regulation, meaning it is targeting a positive net impact on society.

The modest Finns haven’t claimed this as a market first, but I don’t know of any others….do write in if I’ve missed one.

In plain English, that’s the top sustainability grade out there, and it’s a difficult target to hit — most of the existing sustainable loan funds (M&G’s Sustainable Loan Fund, Invesco’s Senior Loan ESG funds for example) are “Article 8” or “Light Green” funds, meaning they promote environmental and social outcomes, a considerably easier bar to clear than positive net impact on society.

It’s still a challenging road, especially in leveraged loans, where data availability is patchy. Sponsors are cagey enough about circulating earnings figures, so granular info on safety, supply chains, emissions and so on can be hard to come by. Quality data is even more important if you’re trying to show a “positive net impact” (Article 9) — you need some way of assessing a company’s overall

For regulatory reasons (CLOs aren’t funds, and would enter a world of pain if they were), CLO vehicles themselves cannot be “Article 8” or “Article 9” — the best they can do is offer to be “Article-8 aligned”, as some of the most ESG-friendly managers, such as NIBC and Fidelity, are already doing. This typically means, in practice, a heavy-duty exclusions list, plus a proprietary scoring methodology and enhanced ESG reporting.

Article 9, however, would be harder still to achieve in CLO format — Mandatum is using its own resources, but also the modelling tools provided by fellow Finns at the Upright Project. This covers all Finnish listed firms, over 15000 companies globally, and it’s used by Swedish PE shop EQT, among others. But it’s a fact of life that the Nordic leveraged finance market is ahead of the broader European leveraged loan universe on disclosure, and that’s partly what Mandatum is relying on to make sure it can shoulder the heavy data burden of Article 9-level compliance. A pan-European CLO deal probably needs to be more granular and diversified than is possible while meeting the Article 9 data standards, but a loan fund is a step in the right direction.

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