You can argue the toss on mortgage quality — it’s an owner-occupied portfolio and compared to prime, but it’s definitely “specialist prime” — but it looks to be coming materially inside LendInvest’s prime BTL deal Mortimer 2023-1, priced the previous week, which came at 200/300/405/584bps for class B/C/D/E, vs talk of 175-185/265-275/370-380/540-550bps.

This deal, the first of the Barclays-Kensington era, helps to underline some of the structuring absurdities that the market simply puts up with. The deal features the “credit weakness” of an unrated servicer, according to Moody’s. Now bear in mind that this is Kensington, which has £8.7bn of serviced assets. I suspect the lack of a Moody’s servicer rating has not proved an impediment to their capabilities so far? The agency does acknowledge that Kensington is now a subsidiary of Barclays, which mercifully does have a Moody’s rating, but just in case, corporate services provider CSC stands ready as “back up servicer facilitator”. 

I cannot prove it, but I strongly suspect absolutely none of the investors in this deal will derive the slightest comfort from the presence of CSC in this role (not because CSC is bad, just because their underwriting of the transaction is going to focus on the very experienced Kensington servicing). It’s a tick-box exercise for a particular idea of delinkage, but it’s still a tick-box that added time, negotiations and cost to getting a deal away.

Far more relevant, for potential deal buyers, especially the funds bidding at the bottom of the stack, is the policy on Product Switches. 

This variant of Gemgarto is deliberately focused on high LTV mortgages, with average original LTV at 85%, probably because these mortgages consume a lot of capital for Barclays. A relatively small fall in house prices will push these borrowers into the kind of range where mortgage products get thinner on the ground and expensive. The investor deck says that “Kensington customers will likely refinance with another lender after the end of the fixed rate period as they would have built sufficient credit history or track recoprd (e.g. self-employed) to attract a cheaper mortgage offer (>50% prepayment rate post reversion).

This is….potentially not true for the current cohort, which will be reaching reversion rate in the next couple of years against a weak housing market. The alternative to refinancing a 90%+ mortgage away from Kensington is a “Product Switch”, which doesn’t require re-underwriting the borrower’s income and property. Performing loans given a Product Switch will be repurchased from the pool at par, so the deal will keep paying down — as long as Kensington is happy to keep granting Product Switches...

Massive Bute

We noted last week that Nim Sivakumaran of Morgan Stanley was heading to a buyside job investing insurance capital — a bit of a fudge on our side, since this could have meant M&G, Axa IM, or indeed any of the alternative asset managers with captive reinsurers.

In fact, he is going to be co-head of origination and underwriting at UK lifer Rothesay. His fellow co-head is another marquee hire, Macquarie Asset Management’s Kit Hamilton, who had been co-head of private debt and before that co-head of MIDIS, Macquarie’s infrastructure financing unit.

Together, they couldn’t be a clearer signal of the direction of travel for the UK life insurance industry. 

We discussed the potentially seismic changes to come out of UK Solvency II reform the other week; TLDR it could become much more attractive for insurers to buy infra debt, commercial real estate, mortgage portfolios, callable bond debt and much much more. The existing “Matching Adjustment” framework requires certainty of fixed cashflows — scheduled amortisation or bullets — but the reform allows “highly predictable” cashflows, which opens the door to all manner of prepayable instruments. To skate over a lot of technicalities….if you can model it with reasonable confidence you’re all good.

Rothesay has already been an active participation in securitisation markets, both buying securities and originating mortgage flow. It had a funding arrangement for long term fixed rate with Kensington, through which it has originated more than £1bn, and an overall mortgage portfolio of £5.76bn. Prateek Sharma, the CIO, to whom the two new hires will report, has a background in structured finance trading and principal finance, having worked at UBS in this area before joining Rothesay.

It’s also growing very rapidly. I’m not super-close to the Bulk Purchase Annuity market (lifers buying out the defined benefit pension schemes of UK plc) but people that do follow it seem to think it’s going gangbusters, with 2023 likely to be a record year. The first half alone saw £20bn of deals, and just last week Rothesay announced a £4bn deal with Co-op (only slightly exceeded by the £4.8bn L&G-Boots deal announced the same day).

In short, there’s a lot of funds to deploy, a regulatory tailwind, a supportive mandate to do lots of interesting illiquid investments. One might think running securitisation and mortgage trading at Morgan Stanley is a pretty sweet gig (and one with a lot of capacity for taking principal positions). But positioning oneself at the sharp end of a huge gusher of life insurance cash is an even sweeter gig, and it’s probably free of a certain overlay of big bank management unpleasantness.

Separately, we’re following the activities of 777 Partners in the equity release mortgage space with some interest. Rudy Khaitan and team have been aiming to intermediate the heavy flow of equity release mortgages into the insurance companies through a platform known as “Senior Capital”.

Insurers have bought equity release portfolios in vast quantities (Rothesay bought nearly £900m out of the UK bad bank in 2018, and has £5.5bn of lifetime mortgages, according to its latest investor reporting). 

These are mostly structured into internal securitisations, carving out a tranche which works well with the Solvency II Matching Adjustment (because it has fixed cashflows), and allocating the uncertainty associated with equity release / lifetime mortgage prepayments (which correlate to mortality) elsewhere in the structure.

This, however, still works out expensive for the insurers, with a large piece left to fund from their internal resources. Benefits of holding equity release mortgages for UK lifers are capped by what’s known as the “Effective Value Test”, which can make the equity piece of an internal securitisation expensive. Creating a matching adjustment tranche means allocating any variability in cashflows to another part of capital structure, which also has to be held by the insurer in a less efficient manner.

In the Senior Capital structures, dubbed TAMI Securitisation and rated by ARC Ratings, the insurer can buy just the matching adjustment tranche, with the other senior positions financed by a Bermuda-based reinsurance vehicle and the junior piece retained. It has a flow arrangement from a specialist equity release originator, senior financing from a US investment bank, and a ready-made demand base in the UK lifers.

“If they buy externally rated matching adjustment note, without any of the equity residuals, their capital requirements are much much lower, and you don’t have the Effective Value Test, which basically says if you fund whole loan mortgages and do an internal securitisation, you’re still holding on to the equity piece in your shareholder funds, and in your non-matching adjustment portfolio, so you’re exposed to 100% of the risk. So you will hold capital against these assets as though you’re exposed to 100% of the risk. So it’s basically a capital optimisation trade for them,” said Khaitan.

He continued: “We’re trying to create a genuine secondary market. As we do that, it’s only going to attract more and more funding into this market, including from overseas investors such as US, Canadians, Australians. That cash is going to go to releasing equity for Britons, unlocking that equity into the system and creating the velocity of capital that Britain really needs.”

Senior Capital is currently in market with its third securitisation deal.

Feeding the beast

Which came first, the chicken, the egg, leveraged loan supply or CLO demand? The loan market has been on an unseasonable tear this week, with BMC Software launching a $3bn-equivalent dual currency A&E, Innio launching a €900m+$500m A&E, friends and family add-ons from Euro Ethnic Foods, Toi Toi and Kereis, refinancings plus “modest dividend” from Weener Plastics, refinancing plus “FundCo repayment” for Euroports, and a brand new issuer to the institutional loan market, Schoen Klinik. Still on the slate for this year (though not yet formally launched) is the take-private debt for Cinven’s buyback of Synlab.

The pipeline should mostly be cleared by the end of next week, but it’s still a surprisingly late flowering. Thanksgiving is sometimes seen as a book-end for the capital markets. Price before Thanksgiving week if you want decent liquidity, otherwise investors will be closing their books and heading out for some festive good cheer in December.

A broadly benign market backdrop helps, but so does the forceful technical bid from the heavy CLO supply in October and November. I count 15 European deals which have yet to settle, and which are presumably still pedal-to-metal completing their ramps. Even by the end of next week there will be 11 deals between pricing and closing.

A deeper look at the supply picture still shows a dearth of classical new issue LBO material. Amend & extend transactions do offer some new money, as lenders that can’t roll drop out to be replaced by new vehicles, but still, Schoen Klinik is the only really new entrant. The €100m taps from Euro Ethnic Foods, Toi Toi and Kereis are new money, and the distributions from Weener and Euroports help, in the sense that they’re dividend or releveraging deals, but they’re an expression of the lack of new money from elsewhere; sell into the CLO bid (keep it simple with existing lenders) and take a cheeky payout before wrapping up the year. 

Even the large cap slate is pretty unpromising. Cinven’s take-private of Synlab is a buyback of an asset Cinven already owned and sold. It relies on Cinven’s intimate knowledge of the company, and execution rests on its 43% shareholding. Bankers anxious to look busy will hint that they’re on the verge of many take-private attempts, but there have been precious few bids launched this year for financing in the syndicated market. 

Said bankers should get paid off the back of sale processes for Techem and Stada, two of the chunkier cap stacks in European levfin, but CLO managers are already well invested in these companies; the modest releveragings for secondary buyout will add only incremental new money.

There are a few flickers of secondary activity — this year has seen the beginning of CLO deals actually being called and liquidated, rather than rolled to infinity. This week saw Oak Hill 3 liquidated, releasing €172m of CLO-friendly positions (the only real rubbish on the list appeared to be Vue Cinemas and Flakt Woods) into the market, while we have seen short-dated deals from Redding Ridge, Napier Park and Sound Point called earlier this year.

So can the CLO market survive on these kind of opportunistic crumbs? Shortly after its market debut, Sona said it had no difficulty accessing collateral, which must be a nice place to be in (I did a piece on debut managers here for 9finsubscribers). Other managers are already working on their Q1 trades. If it’s a worry, it’s not affecting behaviour much; if it’s still possible to ramp deals, the market will keep on trucking.

Senior year

The frost is on the ground, the country’s sheds have been repurposed into ‘Christmas markets’, Mariah Carey is on the radio, and so the 2024 Outlooks have started landing. We’ll be doing one for CLOs and one for the broader asset-backed universe.

The key determinant of market success in 2024 is likely to be demand for senior tranches. 2023 already saw the pool of senior capital constrained in various respects; the withdrawal of the European Central Bank weighed on Simple Transparent and Standardised euro deals, the banks which gorged themselves in the aftermath of Liz Truss have pulled back, investment banking books became more selective in the support they offer. Big cross-product anchor accounts like Standard Chartered have been picking their spots; loan notes have become more scarce. 

Difficult deals have resorted to awkward expedients. Funds which are keen to get full fill on mezz notes or junior have been stuck with senior as the price of entry, for example. 

The new year will help. New allocations, new risk limits, another period of prepayments and so on. But what, if anything, can change the overall picture?

The ideal thing is leverage of some kind. My CLO colleagues report that at least one big US bank treasury is back looking at CLOs (in the US), so that’s a promising development. If all the money center banks back up the truck for CLOs, that’s a plausible catalyst for senior tranches to move through their range-bound 2023 levels, bring more resets into the money and get things properly moving again.

As we’ve discussed, even a tiny switch in European bank HQLA allocations would be sufficient to flood the prime STS end of the market with senior capital. But big institutions move slowly, and the problem with the rising rates cycle is that government bonds and corporate bonds also now pay a meaningful nominal yield. 

ABS has got more attractive as Euribor has swung into positive territory, but there’s less reason to reach for incremental yield. There’s also been relatively thin supply for much of the year. If investors like the yields on offer, and liked the supply coming out in September, it would still take a few months at best to staff an investment team and obtain credit approvals. Still, there’s probably a trickle of capital that will come in this way.

What would be really ideal is the recovery of the leveraged fund investor base. A quick walk around the halls of DealCatalyst’s Specialist Lender Finance event a couple of weeks back is sufficient to underline the depth of demand for mezz and equity in both public and private format; if a few of these funds pivoted towards buying the same assets at a senior level and meeting their returns with external leverage, instead of relying on the structural leverage in securitisations, this would help senior demand no end.

But this is likely to be controversial with LPs. A fund doing junior mezz and equity, with 2x external repo leverage (plus some hidden fund-level leverage too?) — totally fine, uncontroversial, especially if it’s a “private credit” asset-backed fund or “fintech lender” instead of an out-and-proud securitisation hedge fund. A fund that’s doing all triple-A with 5x leverage; bad, smells like a SIV, the Big Short, Margin Call, Gillian Tett etc etc. It’s not the risky things that mess up markets, it’s the safe things that have been made more exciting with leverage. Regulation also limits the possibilities, with the Alternative Investment Managers Directive and its coming update capping fund leverage

There is a meaningful difference between structural (term, non-M2M) and repo leverage, so this aversion isn’t unreasonable. Senior ABS really should have a fair degree of price stability, as it doesn’t have much credit risk or much duration, but even post-GFC, the LDI puke shows that this might not always be true in practice.