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Spot the arbitrage

Who should lend mortgages? I mean, anyone that wants to, within reason; jump through the relevant regulatory hurdles and off you go. But lending the largest sum most people ever borrow requires a lot of capital, and you have to get it from somewhere.

Deposits are a good answer, and deposit-taking institutions lend nearly all of the mortgages in Europe. Giant government-owned-but-not-exactly semi-guaranteed lenders is a weird answer but it seems to work basically okay for the world's largest economy. Securitisation is the most intellectually satisfying answer, since it very directly relates mortgage pricing to the market pricing of mortgage risk, but it isn’t for everyone.

Anyway, JP Morgan is firing up its principal finance programme in Europe, which securitises under the Pierpont brand, to new heights, with a £2.5bn forward flow facility for MT Finance (£1bn upsize from the last arrangement), which will see it buying roughly £500m in loans a year from MT Finance, funding its prime BTL origination and its newly launched tier two BTL offering.

Can we just take a moment to note the relative grace of the Pierpont label? The JPM mortgage deals in the US are called stuff like JP Morgan Mortgage Trust 2025-NQM1… taking the name from the founder is a classy move.

The existence of these principal finance businesses signals facts about the world.

The profitability of these deals relies on funds buying a full stack of securitisation bonds for more than JP Morgan paid for the assets. That stack includes X notes and residuals, which aren't backed by the principal of the mortgage underlyings, but this should pretty much come out in the wash; an X note is just a way to monetise a portion of excess spread up front, and, if an investor bought these mortgages, they could structure their own X note, or DCF the future interest payments to a present market value. Structuring shouldn't really create value, and yet somehow it does.

Let's try to identify the arb. JP Morgan plausibly has better origination teams, a stronger brand name, and more structuring capabilities than Securitisation Fund Capital Management LLC or whoever else is out there trying to sign forward flows. Apart from legals, it doesn’t pay fees outside to arrange bond deals or warehouse. But are these different capital sources so very different?

If the goal is to develop a relationship with all of the specialist lenders doing more than £500m a year in BTL, you could make a pretty good start in a single afternoon in Barcelona. They’re not hiding! Funding teams generally find space in their calendars for investors who have money, even if they’re not looking to put on a trade right this minute.

Securitisation Fund Capital Management will need a warehouse, its warehouse lender will have any name of smart and capable structurers around who are working with the same rating agency models as JPM, and they will tend to produce the same sort of capital structure for takeout.

JP Morgan might have a cheaper funding cost, but that’s unknowable from the outside. Its Chase brand in the UK is massive — £17bn of deposits at the last reported accounts for December 2023, including a few quid from me — but the asset side is opaque, £16.3bn of “loans and advances to banks”. It’s a fair guess, though, that the broader JP Morgan group is a counterparty for much of this line, so it’s possible that the central treasury desk is distributing this funding indirectly through to SPG.

On the takeout, though single originator transactions tend to price a little better than the mixed originator principal finance deals, and some bond investors dislike the auction of the call rights/junior notes; they'd rather know that a specific originator is hanging in there for the long term and has their reputation on the line.

It’s hard to back out the JP Morgan economics from the Pierpont docs, since “how much is the residual worth” is very much the major line item, but I think the arbitrage is mostly (lucrative) payment for work.

It genuinely is quite time-consuming and painful to sign up a forward flow. The relationship part might be straightforward, but the negotiation and legal work is time-consuming and bespoke. It needs to be a partnership, but a partnership with guardrails, eligibility criteria wide enough to write a lot of business and reassuring enough to build a business around, but narrow enough to give the flow provider certainty that the arrangement will be profitable.

Buying a residual, meanwhile, is just one person and their Intex model. It’s a more consequential and riskier decision than clipping €5m of the triple A, but at the end of the day it’s still buying a bond.

So for JP Morgan, with a limited pool of securitisation bankers and a very deep well of capital, what’s the best use of their time in any given day? Much of the grunt work on DD and legals to sign a warehouse paying 120bps will be similar to the grunt work involved in putting on a forward flow, but the profitability per banker hour will be much higher if it’s directed at the principal shelf.

Despite the blurring of the lines between private and public, there remains an origination (and doing work) premium in asset-backed markets, but it helps to have a JP Morgan-sized balance sheet if you want to access it.

Picks and shovels

Servicing is essential to securitisation. It’s all very well abstracting cashflows into demateralised book entry bond fragments, but real people need to be involved in collecting money from loans and getting it into the machine.

It’s particularly essential when borrowers can’t or won’t pay, and third party servicing platforms have been the essential scaffolding of the efforts to clean the balance sheets of Europe’s banks. Many of them have been owned by the funds most involved in the NPL purchasing business — indeed, some of the larger bank portfolio sales were often packaged with the relevant credit management unit and sold to the same buyer. Fortress, for example, bought UniCredit Credit Management alongside a portfolio of NPLs in 2015, which formed the core of what is now doValue, while Blackstone bought (and still owns) CatalunyaCaixa Inmobiliaria in 2014 alongside the €6.4bn Project Hercules loan portfolio, renaming it Anticipa Real Estate

A decade on, these firms are looking for the exits — with the most recent example Davidson Kempner’s sale of Prelios to the ION Group, a financial technology and data provider (which competes with 9fin in some corners of the business).

Servicers do indeed have a ton of data, arguably the best data of all when it comes to granular info on corporate performance and real estate; the “data lakes” of a big servicing platform are an unparalleled real time window into economic reality across SMEs and consumer credit.

But the most lucrative use for this data is selling it to bidders for NPL portfolios. Having a lake (or an ocean) of good quality Italian real estate and corporate restructuring data would have been incredibly valuable in 2015. The world’s biggest alternative asset managers were jockeying for lucrative portfolio purchases and grappled with incomplete information across millions of fields in the data rooms for these deals.

Now, with bank profitability and capital in far better shape, banks are less motivated sellers of NPLs — those that are selling are mostly doing so to make themselves lean, capital-efficient machines rather than out of a desire to stay above water, or because their supervisor told them to.

So how does a servicer reinvent itself for the new era? How best to monetise all the data collected and technology developed?

Most European countries have relatively low penetration of non-bank specialist lending, but it’s manifestly growing in a way that, say, NPL disposals are not.

Plenty of fintech startups tout their data gathering credentials and optimised algorithmic lending, but businesses with sub-€100m loan books that have been around for less than five years realistically don’t have that much to go on.

Contrast this with the riches held in the servicing business. Prelios (out with a bond this week), says it has “54 million data points across credit and real estate, including approximately 125,000 NPE debtors, 6,000 restructuring procedures, 110,000 real estate assets and 610,000 appraisals”.

If the reams of servicing data are becoming less useful for investing in bad, old origination (because there are less portfolios to buy), perhaps the right move is to use it for good, new origination, and sell this information back to banks and to the growing world of non-bank lenders.

Forward flow bank signs forward flow

Somewhere towards the other end of the forward flow spectrum from JP Morgan/MT Finance is Generation Home's deal with SilverRock Bank.

SilverRock is a relatively new institution, granted a banking licence in 2024, self-presented as "the bank for forward flows", and provider of "funding as a service"; the original value proposition was in setting up the guts of the bank, navigating regulation and risk, and not in asset origination, which it is happy to leave to others.

Actually, things have changed a bit since last year. It’s backed by Indiabulls chairman Sameer Gehlaut, who also owns GB Bank. While separate in 2024 (when we last wrote about SilverRock), the two were folded together this year, with GB Bank taking over as a “person of significant control” in April, according to Companies House.

This slightly muddies the original strategy, as GB Bank has a few more traditional lending activities (and a less restrictive licence; SilverRock handed back its banking licence as of March), and has been active in midcap CRE lending, among other things.

But the combined GB / SilverRock is certainly firing up the deposit gathering.

As of Thursday, GB Bank offers were the top of the table on MoneySavingExpert, a popular UK consumer finance website for 120-day notice accounts and six-month fixed term deposits.

As one challenger bank funding head put it: "if you can pay for it, [fixed term deposits] are incredibly easy funding; turn the interest rate dial and you get a couple of yards without breaking a sweat".

Now it has a route to assets too, with its first forward flow announced!

Generation Home lends high LTV mortgages into complex credit situations; the typical use case is a young person early in their career accessing various forms of support from the Bank of Mum and Dad — “Income Booster” and “Deposit Booster” products allow, for example, up to six incomes on an application, or equity participation in a home for any deposit commitment.

This is a strong niche to target — early career borrowers tend to improve their earnings and credit profile as time goes on, and credit performance so far has been excellent. Sometimes labels like “complex prime” or “niche prime” actually just mean “not prime”, but that doesn’t seem to be the case here.

It has several forward flows already — indeed, it only funds through forward flow — none of them with the universe of credit funds and principal desks we discussed above. Nottingham Building Society’s only forward flow is with Gen H, while Perenna, recent turbulence notwithstanding funds its New Build Boost.

High LTV mortgage lending (even if it’s very good quality) is penalised by bank capital rules, and High Street lenders have sought to derisk their first time buyer books where possible. It’s not a good look for the High Street to bin first time buyer offers altogether, but it’s not necessarily desirable business.

GB Bank, being relatively new, remains on the standardised model, but can still make these assets work — yield being the essential ingredient. Prime assets with good performance that pay a decent spread to the High Street means, even at high LTVs, the trade still works nicely.

It is, admittedly, hard to find these desirable qualities in a competitive market, but part of the answer is to avoid competitive processes; the deal came together the old fashioned way, through relationships, rather than mediated by advisors optimising for the last basis point.

The revolution doesn’t start here

We’re less than a month from Liberation Day (for European Securitisation) — 17 June, when the European Commission will reveal its thinking on reforming the regulatory regime for EU securitisations.

The trouble with the whole business is that it is about reform, not about revolution.

The process did not begin with questions like “what can securitisation do”, “what harms do we wish to prevent” and “whom should be protected from harm”, but questions like “Is the current calculation for standard formula capital requirements for spread risk on securitisation positions in Solvency II for the senior tranches of STS securitisations proportionate and commensurate with their risk?”

The Commission is unwilling to junk much of what it has arranged already. The sheep will be split from the goats, with the STS regime likely to be maintained and even strengthened. If there is meaningful movement on capital requirements and liquidity treatment, it’s likely to be concentrated in STS. From first principles, this runs counter to the whole securitisation idea. With enough subordination and the right structuring, you can carve a safe bond out of any portfolio! But some safe bonds are safer than others.

Conceptually, much of the problem comes from a desire to avoid relying on the rating agencies.

Credit ratings already provide a rough market-agreed standard for indicating safe bonds, which incorporates not only subordinated, liquidity facilities, cashflow waterfalls, collateral quality, but also data availability, servicer quality, and origination standards.

But after the role of the rating agencies in the GFC, EU regulators do not want to add any further reliance on rating agencies into markets regulation (despite the agencies themselves being drastically reformed to the tune of three separate credit rating agency regulations in the last 15 years).

They therefore sidle up to this problem, by distinguishing between senior and other tranches and by creating the simple transparent and standardised designation, which in theory is an entirely separate concept from credit quality, but still in practice serves to designate the good bonds.

Much of the lobbying around this process (and indeed the original Securitisation Regulation) has been stuck on the difficulties of proving a negative.

The industry says something very plausible, like "look at how little direct insurance demand there is in securitisation in Europe", which everyone around the table agrees is a problem. But finding insurers that say "yes we would invest in securitisation if only it wasn't for the burdensome regulation" is harder.

The firms that respond to 100+ page consultations on securitisation tend to already be involved.

That's a particularly acute problem for the investor due diligence requirements.

For firms already active in the market, these are basically a tickbox annoyance, a small tax on the profitability of investing in securitisation, rather than a blocker. But to get to that point requires setting up a team and systems to actually tick the boxes.

Without this team in place, fixed income investors can't wake up on a Monday morning, decide that European ABS looks cheap to IG corporates, and lift a few offers. If the boxes aren't ticked, the fines are potentially massive. We wonder how much this is linked to the oft-remarked disconnect between ABS and other credit markets; ABS tends to be more resilient, with risk-off periods coming in with a lag and sell-offs shallower, though this year’s Trump-driven turbulence hasn’t quite fit the pattern.

If ABS is a siloed asset class, walled off by the formidable regulatory burden, relative value considerations also come with a lag. ABS-specific investors need to reinvest their carry in ABS, providing technical support, rather than buying whichever piece of the fixed income universe looks juiciest at a given moment in time.

Better STS treatment with respect to bank capital and liquidity buffers should mean more bank-sponsored funding deals, bought by other banks, which is a way to ratchet up the volumes quickly. The EU changes, when they come, may not be enough but even a partial bite out of covered bond volumes would be most welcome.

That doesn’t necessarily help the economics of a securitisation business at an investment bank.

For the more interesting kinds of securitisation, it’s much more important to shift the overall balance of consumer finance in the EU, specifically to encourage more non-bank lending.

Tight bank regulation is helpful here (since it creates more space for non-banks), as are streamlined rules on credit origination.

A good quality securitisation framework helps, but lending is the raw material; if rule changes succeed in bringing in more investors and triple-A spreads tighten 40bps, is that going to fundamentally change the balance of bank and non-bank finance? Maybe not that much, and if it comes with a tightly boxed STS framework that’s very prescriptive on asset types and homogeneity, that could stifle the product innovation that non-banks do best.

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