The spreads are too damn tight

Everyone talks the book at a capital markets conference — the buyside generally believes spreads are too tight and they should get paid more, whatever the asset class under discussion. All investors want to do more deals with better economics and less competition. SRT fits the pattern.

But where SRT differs is that winding back one year, it was the hottest ticket in town. The Fed's FAQ allowing it to reserve authority on whether credit-linked notes could be counted as synthetic securitizations would, it was hoped, usher in a massive expansion of the relatively limited US SRT market, both in volumes and in number of issuers. Investors scrambled to raise money for the strategy, whether in SRT sleeves or as part of a broader private credit effort.

There was indeed a wave of issuance, including some enormous deals from, for example, JP Morgan. As of early 2024, it was unclear whether supply or demand would ramp up more quickly, but entering Q4 2024, it's pretty clear that demand moved faster. For a variety of reasons, such as the continued regulatory uncertainty, banks have not dialled up supply as much as investors had hoped, and indeed there's a considerable pent up supply among US majors and regionals alike (Seer Capital, a New York-based hedge fund which has been investing in SRTs for years, had some analysis on this point).

So the new SRT money chased not quite enough deals, and spreads in some of the safer asset classes (subscription lines) raced through the return targets for the opportunistic credit or hedge fund community. Everything credit has tightened a lot in 2024 (consider CLO triple Bs and double Bs) so it's hardly unreasonable that SRT deals have raced tighter too, but funds raising for the strategy might have hoped for an uncorrelated source of credit assets, with enough supply swarming the market.

Regulation really matters

SRTs are (mostly) a creation of regulatory conditions. While the structures can be used to manage concentration limits, price risk, and economically hedge, it’s regulatory capital that drives the bulk of issuance in Europe, and regulatory capital which drives the economics.

The US market has been under considerable regulatory uncertainty, as the Basel III Endgame approaches. US banks are well capitalised (and trade above book value, unlike the Europeans) but that doesn’t mean they’ve got capital to waste; the job of a bank is still about making the best use of its resources, and SRTs can help.

The “Endgame” matters for the SRT market. There’s the big picture situation of absolute bank capital requirements going up, encouraging ever-more sophisticated optimisation, and raising the importance of incremental capital coming through SRT.

Then there’s the details, of which the most important is the securitization “P factor”, a capital penalty applied to securitization risk-weights. Higher P = worse treatment. The US status quo has been a P-factor of 0.5 under standardised risk weighting approaches. The Endgame proposals as of last year included a P-factor of 1, which would not quite double capital charges (the P-factor is an input to a complex formula, not a straight multiplier). Some of the lobbying against those proposals suggested a P-factor of 0.25 for certain kinds of securitisation.

There’s also the effects of the uncertainty, rather than any specific aspect of the proposals. US SRT transactions are generally not allowed to include a “regulatory call”, which lets an issuer redeem a transaction if the regulatory benefits no longer apply. Issuers have therefore looked to shorter-dated deals which will roll off prior to the Basel Endgame (though nobody knows when it will be finalised or implemented, so even that’s not easy), or structures they’re confident will work even under a different rule-set.

The market is now waiting on the reproposal of the reproposal, which, according to a speech from Michael Barr, the Fed’s vice chair of supervision, could take the smaller banks (between $100bn-$250bn in assets) out of the scope of most of the Basel Endgame entirely. Banks with between $250bn and $700bn in assets would partially escape.

The lobbyists and lawyers specialising in reading the regulatory runes have to analyse the political nuances of the speech, as well as the speech itself. To what extent do Barr’s fellow governors share his views? Is the speech a trial balloon, or the summary of a worked-out draft document? How does the upcoming election affect the Fed’s approach? Barr didn’t mention the P-factor at all, but there’s been no shortage of commentary and lobbying on the subject, and it must be on the agenda.

Hanging over much of the US regulatory and administrative state is the Supreme Court’s repudiation of “Chevron deference”, in which federal judges deferred to government administrative agencies in questions of how to interpret the laws governing their work.

In plain terms, this means it’s much easier for financial institutions to sue their regulators, and much harder for regulators to be sure regulations will be implemented in the form they’ve been drafted. As one panellist joked “it’s become socially acceptable to sue the CFPB [consumer protection regulator]… we’re not quite there yet with the banking regulators”.

There’s some reluctance on the part of Congress and the judiciary to stick their oars into the delicate machinery of banking supervision, but this might not last for long post-Chevron. Depending on the political environment of 2025, some financial institution will surely challenge the most onerous aspects of their regulatory regime; collegiate deference to supervisors is not long for this world.

Bring your own SPV

Peculiarities of the US regulatory environment feed through to structures, which feed through to market practice. The standard approach for the largest European bank issuers of SRT is a simple credit-linked note, in which the principal repaid is tied to the credit performance of the underlying pool of obligors. This is by far the simplest and most user-friendly structure, but runs into US specific problems (which were partly addressed by the Fed FAQ last September); the hypothetical derivative baked into the CLN was, under Reg Q, in theory unable to act as "synthetic securitization" and therefore give the capital relief that should be associated.

The fix was to say that certain structures could, on prior approval by regulatory agencies (the "reservation of authority") still count. But this requires said ad-hoc approval, and in any case, there's a hard cap at $20bn of CLN issuance of this kind. $20bn gets you $160bn of portfolio notional protected, on the 12.5% tranche thickness which is standard in the US, but that's a meaningful limit for the big banks; $40bn per year for four years would be among the largest worldwide SRT programmes, but it's a tiny nibble at the corporate portfolios of a JP Morgan or a Citi.

But SPV structures, in which the bank faces a note-issuing SPV via credit default swap or financial guarantee, are also fairly painful in the US, requiring regulatory gymnastics to avoid the SPV being a Volcker Rule "covered fund", or to undertake the analysis considering whether the bank is a sponsor of said fund. Consumer asset pools in an SPV then bring in another regulator, the CFTC, which considers them commodity pools and the bank a commodity pool operator, and if that weren't enough, the withholding tax analysis for a US SPV entity isn't easy either.

So the emerging standard is for investors wanting deals to provide their own structure.

The bank faces an investor-sponsored SPV via a simple CDS contract, making the issuer’s experience much more straightforward.

That can be particularly differentiating in the case of smaller regional banks without experience in the market. The first SRT deal a bank does is generally the most painful, and the difficult part is organizational coordination. Loan documentation, legals, treasury, credit risk, C-suite, board; every part of a bank needs to buy in. If that also involves threading the needle around a bank-sponsored SPV, or waiting for case-by-case regulatory sign-off, that adds an extra obstacle for market debutants to clear.

But what begins as a solution to a regulatory regime described by one panellist as "whackadoodle" could end up affecting the balance of market power.

Once an investor-sponsored SPV has done the deal, it can resyndicate or lever the risk without much control from the issuer side. Lawyers working on SRTs are spending a lot of time on which controls and consents sit with issuer, investor and leverage provider; as one put it “you want to make sure that there isn’t someone else in the background moving the arms and legs”.

Bayview Asset Management, to take one example, has already redistributed risk on a portfolio of Huntingdon auto loans, issuing CLNs from its own SPV structure.

It may be that having a series of SPVs sponsored by the same investor helps create liquidity and tradeability in the asset class; while SPV documentation is different and details matter, once you have a relatively standard "Bayview doc" or "Blackstone doc" to work with, the market can start to look more like CLOs. Documentation still matters there, but tranche investors have a good idea how different CLO managers set up their deals, and can price and differentiate accordingly.

Redistributing the risk also creates a two tier market. Investors with the expertise and pain tolerance to create said SPVs and originate deals can expect better economics than those who buy redistributed risk or relever SRT tranches; end accounts (just as in CLOs) will be helping create an arbitrage.

What to hedge?

Figures for the whole market are hard to come by, but the asset classes coming out in SRT format are not necessarily the problem children of the banking system.

Regional banks are under pressure to derisk their CRE books, but getting a CRE SRT away is particularly complicated and difficult, and relies on finding investors with particular CRE underwriting expertise (it’s typically a line-by-line approach, rather than the more statistical underwrite on a granular book).

The beauty of the US regional banking system, though, is the wide variety of business models available, and the extent to which SRT transactions can target particular balance sheet concentrations. Local CRE exposures, energy lending, agricultural equipment leasing; the lending concentrations of local banks are driven by the economic activities in their home markets. SRT deals can help them escape this concentration and recycle capital, while giving potential investors a diverse menu of asset classes to choose from.

That, at least, is the theory. In practice, it takes time to pull an SRT deal together, and the acute capital pressures on the regional banks are easing; rates are coming down, and last year’s wobbles are in the rear-view mirror. The main driver for regional banks doing SRT deals this year, according to a couple of panellists, is simply to have done a deal. As we heard at least 10 times through the day, SRT is a tool to have in the capital management toolkit, and it’s better to get the tool ready so it’s there when you do need it. Open the market and go through the process and the second deal will be much easier.

From the large banks, subscription lines have been the favoured asset class, likely reflecting the mismatch between the economic risk and capital treatment. Spreads on sub line SRTs are super-tight (one estimate put them roughly 300bps inside a corporate deal) because the risk exposure is fund LPs who often have plenty of money. The subscription lines are supposed to manage the drawdown of this investor capital, but large LPs do generally stand behind their commitments to funds.

Complexities with sub lines are more about confidentiality and client lists; to what extent do PE funds want the credit arms of their competitors (who are buying the SRT) to have transparency into their arrangements. Blind pools with a GP whitelist can be one way around it, but probably come with a premium reflecting the limited information on offer.

Big banks are also considering SRT, broadly defined. JP Morgan executed a cash risk transfer deal with Chase-originated mortgages over the summer, retaining the senior note in loan format. One might consider this ordinary run-of-mill securitization, or even a portfolio sale, but as one panellist noted “if it was called the whole loan sale conference, the room would be half empty”.

Insurance money

Coming from Europe, where pleas for insurers to invest more than a de minimis asset percentage in securitization have been going on for a decade, the extent to which the US market is turning to insurance capital was surprising and impressive. In Europe, insurers have been ramping up their participation in SRT, but through the liability side of the balance sheet, with large reinsurers (often Bermuda-based) writing unfunded insurance contract protection on portfolios.

But the US market sees meaningful participation from insurance asset pools as a growth area. The fat 12.5% tranches required for US SRT deals mean that, in good quality pools, there's a meaningful slice of investment grade risk at the mezzanine level, with an attractive spread to equivalently-rated corporate debt.

Regular-way insurers are happy to buy private instruments, but appreciate having a rating that plugs into the NAIC (insurance regulator) rating scale and allows them to hold these exposures in capital efficient format. These ratings can themselves be private, so it doesn’t necessarily imply opening the kimono and revealing any much about the underlying portfolio.

It does, however, point the way to further capital coming into the sector, and further industrialisation of the SRT market. Lots of the alternative asset managers which are active in SRT have captive insurers already in place, providing much of the IG-oriented capital which they invest; there’s a natural partnership to be put in place between the risky credit fund capital in the first loss and an insurance ticket in the mezz, and the US is the best place to ramp this up.

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