SECURITIZATION 10 YEARS ON - GlobalCapital€¦ · SECURITIZATION 10 YEARS ON Rebirth of a market...

SECURITIZATION10 YEARS ONRebirth of a market

December 2018

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82 | Review 2018 Outlook 2019 | www. .com

SECURITIZATION10 year timeline

10 years of post-crisis securitization

2008

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2009 2011 20122010

Lehman falls Driven to the brink by aggressive RMBS and CDS trades, Lehman Brothers, led by CEO Dick Fuld, fi les for bank-ruptcy on September 15. The event sparks the intense phase of the worst fi nancial crisis since the Great Depression. The Dow plunges the most in a single day since the 9/11 terrorist attacks.

Housing horror show Nearly 20% of all US mortgages — 7.5m loans — are in neg-ative equity. Nevada, Florida, Michigan and California are hit worst. Foreclo-sures spike as home equity lines of credit that US borrowers had become accus-tomed to dry up.

CMBS yields spike Yields on the junior triple-A ‘AJ’ classes of US CMBS deals hit 16%.

Raters come under fire A bipartisan Congressional panel pens proposals to reform the credit rating agencies after their role in the RMBS ratings disasters that led to widespread risk in the global fi nancial system. The talks stall.

Tesco re-starts CMBS Tesco issues a £431m CMBS in July, the fi rst commercial mortgage-backed bond since the start of the fi nancial crisis.

SEC probes CDO murk

In December the Securities and Exchange Commission announces probes into how managers valued and traded CDOs, their decisions, compensation schemes and internal controls.

Frank takes aim at GSEs Barney Frank, chair of the House Financial Services Committee, calls for the government to abolish Fannie Mae and Freddie Mac and come up with “a whole new system of housing fi nance”.

Resi MBS return

Redwood Trust, a Californian Reit, markets a $222m private label RMBS in April, the fi rst since the fi nancial crisis. Springleaf Financial soon re-opens subprime.

Massive Dodd-Frank Act passed

President Barack Obama signs the sweeping fi nancial reform package known as the Dodd-Frank Act in July, curbing prop trading.

First solar ABS whispers Lessors including SunRun begin considering securitizing leases on residential solar panels in June. The market goes on to become a booming esoteric ABS sector.

S&P exiled from CMBS S&P receives withering criticism for withdrawing the ratings of a conduit CMBS o� ering in July. The deal is pulled from the market by lead Goldman Sachs, and S&P is e� ectively blacklisted from conduit CMBS ratings for the next three years.

MBS litigation soars Lawsuits involving MBS hit a record 218 cases in January. The settlements will end up raking in billions for the US government, which continues to bring cases against the big banks well into the post-crisis era.

Thar she blows! JP Morgan’s shadowy Chief Investment O¢ ce is restructured after huge losses involving derivatives and CDS trading shock the market. Trader Bruno Iksil is identifi ed as the ‘London Whale’.

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082-83 SEC – Timeline.indd 82 06/12/2018 12:26

www. .com | Review 2018 Outlook 2019 | 83

SECURITIZATION10 year timeline

10 years of post-crisis securitization The securitization market has been to the brink and back. From the depths of the financial crisis,the market faced huge obstacles before it was able to stage its impressive comeback in the last five years. Max Adams charts some of the highs and lows for the market in the decade since Lehman Brothers’ collapse and the financial crisis.

2013 2016 2017 2018

2019

20152014

Risk retention scrappedfor US CLOs The CLO market notches a big win when a US Court of Appeals judge rules that the asset class does not have to comply with risk retention rules meant to align the interests of managers and investors. The market goes on to hit around $120bn of new issuance in 2018.

Revolt at ASF The American Securitization Forum collapses in April after members revolt over transparency and governance. The rival Structured Finance Industry Group becomes the main lobby group for US securitization.

CLOs restartwith Cairn Cairn Capital brings the fi rst post-crisis European CLO to market in May. The €300m o� ering is also the fi rst to comply with new EU skin-in-the game rules.

Freddie gets into CRT Freddie Mac issues the fi rst credit risk transfer RMBS in December to bring in private capital and reduce the burden on taxpayers. Freddie and Fannie’s CRT deals boom.

US CLOs break record The US CLO market hits $124bn of new issuance in 2014. It booms for the next four years, leading to cries of overheating and new corporate credit crises on the horizon.

CMBS is on a roll US CMBS volume for 2014 tops $100bn across deal types. The market is thriving, even as concerns grow about e-commerce killing retail real estate.

EU dreams up STS EU regulators pitch the Simple, Transparent, Standardised rules for European securitizations in October. STS bonds would attract lower capital charges. Negotiations drag on for another four years, as politicians remain sceptical of ABS after its role in the fi nancial crisis.

First UK onlineloan ABS The fi rst ABS deal backed by marketplace loans is sold in the UK. The £129m deal is backed by SME loans originated by Funding Circle and is brought to market by KLS Diversifi ed Asset Management.

MEP Tangshocks ABS Paul Tang (L) shocks delegates at Global ABS when he proposes a whopping 20% risk retention requirement for European securitizations. The centre left MEP is a crusader for reform of securitization and a chief architect of the STS framework.

US risk rules kick in A Christmas Eve gift to the market: issuers must now comply with a 5% risk retention rule for securitized assets. The rule looks di� erent for each asset class and is by no means a one-size-fi ts-all solution for aligning interests.

Global ABS issuance swells After plummeting during the fi nancial crisis, issuance of securitized products climbs to $930bn, up 39% from 2016. Ideal conditions of global growth and low interest rates pave the way for more issuance in the coming years, says S&P.

January 1

New era begins Simple, Transparent, Standardized rules for European securitzation go into e� ect on January 1. Concerns about the new rules are projected to weigh on demand for bonds and some issuers are expected to hold back new deals until at least the second quarter.

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New era beginsSimple, Transparent, Standardized rules for European securitzation go rules for European securitzation go into e� ect on January 1. Concerns about the new rules are projected to weigh on demand for bonds and some issuers are expected to hold

082-83 SEC – Timeline.indd 83 06/12/2018 12:26


SECURITIZATIONFinance in the real world

Goldman — which packaged it up into Elizabeth and placed it in the market this summer, defying gloomy predictions about the future of the UK high street and retail consumer.

A ticket to the CRE gameCMBS has never made up the ma-jority of the commercial real estate market, even before the fi nancial crisis — but it is a crucial way for institutional investors and bond buyers to gain CRE exposure, and a way for investment banks like Gold-man and Morgan Stanley to compete with the fat deposit books of their commercial peers.

Go inside Kingsgate and the impact of securitization might not be obvious. The centre has no banks or other fi nancial institutions inside — and, really, institutions that lend money are where the chain of fi nancing might begin.

But Carphone Warehouse, a mobile phone store, might surprise. After a house and a car, the most valuable possession for many people is their smartphone. Customers receive a phone up front, which might be worth £1,000 — but pay for it over the following 24 months, through a phone contract.

Some of the UK’s mobile provid-ers, like Vodafone, raise investment grade bond fi nance — but others are more leveraged, and seek other, more complex fi nancings.

Virgin Media, for example, owned by US media conglomerate Liber-ty Global, would be high yield in the unsecured market, so leans on securitization to cut its costs. It has issued ‘handset ABS’ in small size in sterling, and uses its trade receiva-bles to raise securitization fi nance.

The market is more common in the US, with Verizon having done seven such deals, but pick up a phone, and you might fi nd it’s securitized.

Crucial roleGreasing the wheels of trade credit is where securitization’s role is perhaps most crucial — and most e� ectively hidden from view. The sweet spot is companies that have high borrow-ing costs in unsecured markets, but supply better-rated fi rms.

That’s the situation Smurfi t Kappa, the paper and packing provider, fi nds itself in. It supplies 60% of its products to fast moving consumer goods companies — the likes of Unilever, Nestle, Proctor & Gamble or Reckitt Benckiser. The compa-ny is large, but leveraged, paying an average rate of 4.1% across its fi nancing structure as a whole. But its trade receivables may face investment grade fi rms, and spread risk across a wide variety of its customers.

Earlier this year, it signed a €230m fi ve year facility with Lloyds Bank, using receivables from France, Germany and the UK to back it. Receivables from Austria, Belgium, Italy and the Netherlands back a di� erent securitization facility, with Rabobank and Helaba.

According to its last annual report, it paid 1.375% on its last round of securitization fi nancing — far below its capital markets borrowing costs. Next time you’re handling pack-aging from one of these consumer titans (or if you happen to see the loading bay of a supermarket) con-sider that Smurfi t’s securitizations helped make it happen.

These fi nancings may never make it into the ordinary capital markets for term debt, but they are securiti-zations nonetheless. Lloyds o� ers its Smurfi t Kappa facility directly from its balance sheet, using securitization structuring to ensure its security, but Smurfi t sold its other securitiza-tion transactions into asset-backed

Driving north of Edinburgh and crossing the Firth of Forth on the M90 mo-torway seems an unlikely

place to consider the legacy of the fi nancial crisis — nearly eight hours drive from the skyscrapers of Canary Wharf and the City, where many deals were, and are, structured.

But the Kingsgate Shopping Centre, in the heart of Dunfermline, neatly illustrates how securitization has shifted since then.

The layers of abstraction have been stripped away, the chains of fi nancial intermediation have been shortened. Securitization bonds are no longer packaged into CDOs, and these are no longer bought by structured invest-ment vehicles. Maturities are mostly matched, and sponsors or originators now hang on to 5% of a transaction.

Kingsgate, however, forms part of the security package for Elizabeth Finance, a CMBS issued in August and arranged by Goldman Sachs. US alter-native asset manager Oaktree bought the centre in 2013, and refi nanced the original loan against the centre, which is worth around £40m, with

Securitization markets involve some of the most esoteric, obscure parts of investment banking. Traders and bankers rarely court publicity, while deals are placed to a specialist subset of the fixed income buy-side. Yet, 10 years after the financial crisis, securitization affects almost every part the real economy. Owen Sanderson reports

Securitization, from high finance to the high street

Virgin Media uses trade receivables to raise securitization finance

084,86 SEC - Finance in real world.indd 84 05/12/2018 17:59

SPONSORED STATEMENT


To start, Kevin, could you talk about how Freddie Mac’s STACR program has

evolved since inception in 2013? What did these deals look like then hat is di erent no and what is in store for these deals going forward?

Kevin Palmer, Freddie Mac: When we first started STACR in July 2013, it was a fixed loss transaction that had a 10-year maturity. When I say fixed loss, it means that when loans hit 180 days delinquent, there is a schedule for what that loss severity would be for investors. It was basically a big step for Freddie Mac in moving credit risk away, but there was still some amount of residual risk to the agency.

As we evolved, we shifted to an actual loss transaction and moved the term out to 12.5 years on the STACR product. The next big evolution was moving to a trust structure. The first two phases were debt issuances, but the trust structure is a more traditional structure where the proceeds from the issuance is kept in a bankruptcy remote trust supporting the investors.

Our most recent change in the structure is that we moved to sell first loss, where Freddie Mac retains the first 10bps of the capital structure, which includes expected loss, and sells 95% of all credit tranches to private investors. This is significant from a risk transfer perspective. Early next year we will move the STACR transaction to a REMIC structure, which is beneficial for REIT investors as well as some first loss investors because of the debt accounting treatment it will receive.

What is the appeal for investing in STACR o er other fi ed inco e

products that pro ide e posure to mortgages and the US housing market?

Palmer, Freddie Mac: I think what is unique about what we have created in STACR compared to traditional private label RMBS is the size of the transactions. Given the size of Freddie Mac and the scale of the issuances, STACR reference pools are usually backed by over 100,000 mortgages that provide a significant amount of diversification and stability from a performance profile. You don’t see the idiosyncrasies that you may in private label transactions in STACR.

Liquidity is always on the investor’s mind. The monthly trading volume in STACR has been around $2bn, so that gives investors a lot of confidence when buying the bonds that they don’t have to own them forever and the bid-ask if they need to trade out will be relatively tight.

The other unique aspect of this type of asset class is that there has been transformation in credit risk underwriting as well as credit risk management that the investors are able to take advantage of. From an underwriting standpoint, one of several big changes that have happened since the financial crisis at Freddie Mac is that our credit underwriting has become more robust.

Another benefit to investors is the technology that Freddie Mac leverages to ensure loan manufacturing quality through our proprietary underwriting tool, LAS. The second key focus for Freddie Mac has been the servicing practices and being able to

provide assistance to borrowers earlier on and reduce the losses for any borrowers that do get into trouble. That active risk management is unique in the sector.

With mortgage fundamentals in general, what are you seeing at

the current point in the cycle and hat do you e pect to see in ?

Palmer, Freddie Mac: I think overall mortgage fundamentals remain solid. We’re roughly 10 years past the financial crisis so things have normalized a bit. At the same time, we’re not going to see products we saw before, at least speaking for Freddie Mac, such as the low documentation mortgages and other products like option ARMs and interest only loans. That said, you’ll see a higher percentage of purchase money borrowers that will result in slightly higher credit risk characteristics.

Freddie Mac established the U.S. credit risk transfer market, issuing the first agency CRT transaction through its STACR program in 2013, providing global investors with an innovative way to gain broad exposure to the U.S. housing market. Freddie Mac has set the benchmark for CRT markets and continues to lead the housing finance industry. Kevin Palmer, who oversees portfolio management for Freddie Mac’s single-family business, speaks about the growth and future of the agency’s credit risk transfer program.

Kevin PalmerSVP, Single family

credit risk transfer

Q:

Q:

Q:

Innovations in US housing finance — Freddie Mac talks credit risk transfer

FreddieMac_SS.indd 85 05/12/2018 15:24


EMERGING MARKETSLatin AmericaSECURITIZATIONFinance in the real world

the basis of a rating”.That can also mean securitization

markets, and the fi rm has been an enthusiastic user. It regularly issues from Trafi gura Securitization Fi-nance, a vehicle which, like Smurfi t’s deals, securitizes receivables from its customers — many of them the investment grade-rated oil majors. But late last year, the fi rm took a more unusual step, securitizing its inven-tories of physical crude and metals as well as receivables. The vehicle, Trafi gura Commodities Financing, buys the inventory from Trafi gura and then sells it back, akin to a repo — but a brand-new move in the capital markets, and one with plenty more potential with other fi rms carrying physical inventory.

Home sweet homeReturning back home, and pulling on to the driveway, should also prompt some refl ection on the role of se-curitization in the lives of citizens. Mortgage fi nance is by far the largest chunk of the European market, for the simple reason that this is where most people borrow most money.

If your credit is healthy and your bank is a big one, you may not touch the market. Some fi rms, such as HSBC, have excess liquidity in the UK and strong credit ratings, and do not use mortgage collateral to raise fi nance (though it does in France and in Canada). The prime, owner-occupied parts of big bank mortgage books may be fi nanced through covered bonds, rather than securitization.

But if you’re harder-up, or need something special, be thankful for the market, which comes into its own for the less straightforward customers.

A mortgage to cover refi tting the property? A mortgage for a profes-sional landlord? A second charge mortgage? A mortgage for the self-employed? A mortgage for those with a patchy credit history?

These markets are served by a patchwork of alternative providers, from specialist challenger banks, to non-bank intermediaries, few of which have the credit quality to access unsecured markets at reasonable rates, and use their mortgages to back securitizations.

Home is where the heart is. And one of the many places securitization can be found. GC

commercial paper (ABCP) conduits sponsored by Rabobank and Helaba.

These conduits are vehicles sep-arate from the banks — but often fully backed with bank liquidity facilities — and are one of the most private parts of the market, and one of the sections most changed from pre-crisis. Before 2007, dozens of these vehicles sprang up, many of them “securities arbitrage” conduits, which bought long bonds in the market, and funded them with 30 day commercial paper.

When these bonds had to be marked down, and money market funds stopped buying ABCP, banks had to step in and support their ABCP conduits, prompting a big restructuring of the industry, the clo-sure of many conduit vehicles, and the conversion of most of the rest from partially supported to fully sup-ported. If these cannot issue ABCP, banks will step in and fund them through a liquidity facility instead.

European regulation is now threatening the ABCP market, as new data requirements may force a sudden stop for new issuance. The transactions bought by the conduits will still be there, but they may no longer be able to issue ABCP from January 1, forcing banks to bring them back on balance sheet.

Trade receivables make up 25% of ABCP conduit transactions, or 34% by volume, according to Moody’s, from a global outstanding of $269bn. The Association for Financial Markets in Europe estimates Europe-an banks issued around €90bn.

Securitization journeyHaving browsed the delights of Kingsgate Shopping Centre, head to the car park with your shopping and step into your car. Whatever you’re driving, if you bought it on fi nance or lease it, there’s a good chance the securitization market is involved.

The likes of Volkswagen, Peuge-ot, Renault, Fiat, Ford, BMW or Mercedes have their own banks, lending money against new cars. Financing a large purchase like a car is as much a part of their service as is building a new twin exhaust system. And if you don’t buy new from dealership, you might approach FirstRand’s MotoNovo Finance, Lloyds Banking Group’s Black Horse,

or Santander Consumer Finance, or a raft of other lenders for a separate loan, while if it’s a company car, perhaps it’s leased from LeasePlan of the Netherlands.

But wherever the money comes from, there’s a good chance it tracks back to securitization markets. Car fi -nancings are another huge asset class fi nanced through the ABCP market, making up 20% of the “multiseller” market, according to Moody’s.

Car loans, however, also form a large part of the public, term securitization market. Sometimes conduit transactions are taken out in term markets, while in other cases they themselves o� er fl exible fi nanc-ing periods. If the pool of assets is “revolving”, car manufacturers can rotate new loans into the deals as they write them.

The scale is vast. In 2018, Volkswa-gen alone has issued deals backed by car loans in Spain, Japan, Germany, the UK, Turkey, Australia, Italy, the US and Canada — with more than a few lease deals on the side as well.

If you stop for some petrol on the way back to Edinburgh, perhaps you’ll come into contact with the securitization market again. The vertically integrated supermajors hardly need to touch the market, as blue chip borrowers in the unse-cured markets, with huge internal cashfl ows of their own to manage.

But trading fi rms are a di� erent matter. Trafi gura, one of the largest independent oil traders in the world, has no public rating — and no plans to acquire one, stating that its “strategy has always been to obtain funding from stakeholders who un-derstand its business model, rather than make investment decisions on

Smurfit Kappa paid far below its capital markets borrowing costs for its latest securitization

084,86 SEC - Finance in real world.indd 86 05/12/2018 17:59

COMING SOON

GlobalCapital is pleased to announce its first annual European Securitization Awards. The publication will honor the players and institutions that were most skilled at navigating the market in a time of significant change for European structured finance.

The awards will recognize firms for their participation and support of European securitization, outstanding achievements within specific sectors and innovation in the market in the past year.

In what can be a sometimes chaotic corner of the fixed income market, GlobalCapital’s awards will aim to be a benchmark for achievement and performance for participants across European securitization, with winners chosen through rigorous polling and due diligence conducted by the publication’s experienced team of structured finance journalists.

GlobalCapital will announce and recognize the winners at a cocktail and dinner event in London in March 2019.

PITCH BY JANUARY 22, 2019

VOTE BY JANUARY 28 , 2019

EUROPEAN SECURITIZATION AWARDS

EuropeanSecuritization Awards

For questions about attending or sponsoring the event, contact: Ashley Hofmann

T: +44 20 7779 8740E: [email protected]

Euro Securitization awards 2019 v2.indd 1 06/12/2018 16:16


SECURITIZATIONRisk transfers

Synthetic risk transfer markets have had another good year, with the core group of banks active in the market returning to issue, smaller firms mulling the market, and investors raising new cash to buy deals. But perhaps most exciting is the development of a whole new issuer base, in the shape of multilateral development banks, following the landmark ‘Room2Run’ deal between the African Development Bank and Mariner Investment Group. Owen Sanderson reports.

large corporate loans and mortgages.The biggest issuers in the market

tend to be the universal banks with highly sophisticated treasury, ALM and risk teams — and experience printing such deals in the past. Risk transfer shelves like Deutsche Bank’s CRAFT series, Standard Chartered’s START, Commerzbank’s CoSMO or Barclays’ Colonnade regularly place securities in the market, protecting billions of dollars-equivalent a year.

“It’s been a good year, with pretty much every jurisdiction back in the market, mainly the IRB banks with established programmes,” says Francesco Dissera, head of structuring and advisory at StormHarbour Securities. “The big platforms like Standard Chartered or Deutsche Bank get a lot of reverse enquiries for these trades.”

Market staplesThese shelves are the bread and butter of the market, and the hedge funds that regularly sell protection to them — a clutch of specialists including the likes of Christo� erson

Robb, Cheyne Capital, Magnetar Capital, ArrowMark Partners, and Mariner Investment Group — provide a useful extra tool for their capital management.

But it’s a much more useful market for banks which can’t so easily access public markets.

“It’s been very di� cult if not impossible for certain southern European banks to follow the AT1 route to source more capital, de facto senior to AT1,” says Dissera. “But SRT is a good tool for issuers that want to plan, they know they can execute a well-structured deal, because the investor bases are di� erent and they are delinked from bank credit with a greater certainty of execution.”

Prominent in transferring risk in some of the more challenged institutions is the European Investment Fund (EIF) and European Investment Bank, which o� er mezzanine guarantees against SME loan portfolios, under a plethora of EU-funded schemes to ease SME fi nancing conditions. The funds come with strings attached — recycling funds into new SME lending at below-market rates, for example — but the EIF can be available in decent size and at better prices than the usual hedge fund buyers will o� er.

Public sector excitementPerhaps most exciting, though, is the potential presence of public sector institutions as not just sellers.

In 2018 a deal in which the African Development Bank bought protection for a portfolio of infrastructure loans on the continent from Mariner Investment Group, with Mizuho acting as structuring advisor, was justifi ably called a “landmark”.

Unlike deals done for banks, the transaction, dubbed “Room2Run”, does not give regulatory capital credit. Multilateral development banks do not have regulators in the same way, nor bank-style equity

Risk transfer deals enjoyed a productive 2017. A Canadian bank entered the market for the fi rst time,

a bank using standardised capital models (Austria’s Hypo Vorarlberg) issued, a rarity, while regular issuers, large universal banks, protected more portfolios than ever before.

High profi le credit events like Premier Oil’s restructuring hit multiple deals, while early in 2018, the collapse of Carillion proved the value of portfolio protection. All the big UK banks took a hit on the failure of the construction and facilities management fi rm — but HSBC had bought $72.5m of protection through its Metrix CLO, when no public market CDS were available.

This year, 2018, has also been a good vintage. Market volatility has whipsawed through the public markets, but the private markets have stayed solid, providing a back door route for troubled and healthy banks alike to raise extra capital, buying protection on a variety of portfolios including SME loans, trade fi nance,

Risk transfer market readies new frontiers

Cote d’Ivoire’s Henri Konan Bédié bridge was part financed by the African Development Bank and a portion of the senior loan was included in the portfolio for the Room2Run securitization

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EMERGING MARKETSLatin America

SECURITIZATIONRisk transfers

the upper mezzanine, in unfunded insurance format. It could work as long as the insurance companies are at least A ratings or above.”

Arch Mortgage Insurance, one of the US’s leading mortgage insurers, struck a deal with ING DiBA, the German subsidiary of ING Groep, to provide capital relief on a €3bn mortgage book, announcing the deal at the end of October, while another US fi rm, Liberty Mutual Insurance, is also now seeking deals in Europe.

Mortgages have traditionally been an unusual asset class for the synthetic risk transfer market, as the relatively low risk density of mortgages, especially in northern Europe, means the deals aren’t e� cient for banks looking to cut risk-weighted assets.

The European Banking Authority’s guidelines on signifi cant risk transfer are the other big change coming. The Authority published its thoughts on the market in autumn last year, followed by a consultation period, and further thoughts early this year.

These proposed limiting time calls and pro-rata amortisation in risk transfer trades, features which make risk transfer more e� cient for the issuer, with a slightly more lenient treatment than the UK’s Prudential Regulatory Authority.

But the market has been waiting for the EBA’s paper to turn into more concrete rules, while trying to comply as much as possible. “All the transactions structured in Europe at the moment are structured with the assumption that the EBA guidelines published in September 2017 will soon come into force,” says Dissera. “It has made deals more standardised, more consistent about their utilisation of excess spread, and how this accounted in levels of support.”

Guidance with the force of law, however, would make structuring more standardised still, and make discussions with regulators, which precede all risk transfer deals, clearer and easier. So despite more regulation, the potential loss in market e� ciency, and some extra work over the break, certainty should help.

“The EBA often brings a document in a kind of ‘Christmas gift’ to the market, so if it happens, clarifi cation on the guidelines is likely to be towards the end of the year,” says Martorell. GC

capital. But the AfDB deal allowed it to protect its rating, and free up credit capacity and lines for certain jurisdictions and assets.

“MDBs don’t have paid-in equity capital of course, but SRTs give private investors a way to participate indirectly and o� er capital in those areas,” says Juan-Carlos Martorell, co-head of structured solutions at Mizuho, and the leader of the team working on AfDB’s deal. “We received lots of interest from various private investors at meetings during Room2Run case studies presented at the IMF in Bali, AIF in Johannesburg and IACPM in Connecticut.

“The private investor interest makes a lot of sense because they will achieve to diversify portfolios and exposures. Mariner has an advantage in its involvement with infrastructure assets, but these are not the only portfolios held by the MDBs. Some have lots of trade fi nance and corporate loans, for example, and other more plain vanilla asset classes, and we could certainly see a broader base buying MDB transactions.”

The AfDB deal took four years, but some of this work won’t need to be repeated — getting the rating agencies over the line, for example, was particularly time-consuming. The deal format also won’t be as useful for some of the larger MDBs, or those with less constraining country limits. But investors are keen to see a wider issuer base, and new sources of other, uncorrelated assets.

“There could be some political reasons why the AfDB transaction was so successful — they demonstrated increased credit capacity, the increase in lines to certain countries, but not so much at the cost of buying the protection,” says Dissera.

But the presence of public sector institutions on both sides of the trade is curiously circular.

“We have seen the EIF/EIB acting as protection seller, and now we see at the same time MDBs acting as protection buyers (potentially EIB for example),” says Martorell. “Some private investors have made criticisms of the EIF’s involvement where there is an existing and functioning private market, saying it’s not as necessary as it was in 2010-2012, but they’re only focused on SMEs and have quite

specifi c requirements, so within reason it isn’t hurting the overall market too much.”

Expanding investor baseAs well as the issuer base, the investor base, too, is growing. Insurers are increasingly looking to sell protection to banks through synthetic risk transfer structures — but with very di� erent

requirements to the usual hedge fund counterparties.

For one thing, the deals insurers want to strike are usually unfunded — meaning they do not collateralise the cover with cash or government bonds, but instead, rely on their high rating. This means deals have to be structured to cope with potential counterparty downgrades, so the banks buying the protection aren’t left high and dry.

“Insurers have always been interested in mortgage transactions, but we know some of them are now looking at SME deals,” says Dissera. “They’re a new type of investor in SMEs, so perhaps it takes a bit more time to get the deal done and sign o� the documentation, but once they’ve done one deal it might speed up.”

Their involvement could be encouraged by some of the regulatory changes hitting banks.

“Basel IV kicks in next year. Although we’d expect the fi rst half of the year to be relatively quiet, we have a good pipeline of fi rst time and repeat issuers,” says Martorell. “Basel IV means you need to widen the tranches, which changes the economics for issuers. We’re seeing increased interest in SRTs from insurance companies with lower risk and lower return targets, looking at wider tranches with higher attachment points.”

He continues: “They’re looking at more like senior mezz tranches such as 8%-11% tranches, also known as

“Basel IV means you need to widen the tranches, which changes the economics for issuers”

Juan-Carlos Martorell, Mizuho

088-89 SEC - Risk Transfers.indd 89 05/12/2018 15:04


SECURITIZATIONEuropean regulation

European regulators have been racing against time to provide detailed rules for compliance in the form of the draft Regulatory Technical Standards (RTS) and Implementation Technical Standards (ITS). These are

awaiting European Commission approval. With small print yet to be clarifi ed, the market is set for a slow start to 2019.

While pre-crisis European securitized bonds performed far better than those in the US, the market was tarred with the same brush, turning EU authorities against complex and opaque products. Securitized paper placed with inves-tors, in excess of €450bn in 2006, has struggled to reach €100bn a year since 2008.

The EU has begun to soften its attitude towards the product, increasingly seeing it as a mechanism to bolster lenders’ capacity to fund household and business needs and an important plank of the Capital Markets Union project.

The new regulations apply to deals issued on or after January 1, 2019, and cover all investors, doing away with separate rules in the Capital Requirements Regulation, Solvency II and the Alternative Investment Fund Managers Directive that apply respectively to banks, insurers and fund managers.

The regulation seeks to foster a better risk framework through enhanced transaction disclosure, transparency and

preventing adverse credit selection — imposing obligations on originators, sponsors and original lenders — while ensuring that investors (now also including pension funds and Ucits) bolster due diligence discipline.

Complex re-securitization deals are banned, as are deals with riskier self-certifi ed mortgages.

In addition, a distinct label is carved out for simple, trans-

parent and standardised (STS) securitizations from issuers established in the European Union, targeted at homogenous pools such as prime residential mortgages, credit card re-ceivables and auto loan pools. These bonds will carry a lower risk weight of 10% compared with 15% for non-STS senior bonds. Managed CLOs and CMBS, however, failed to make the grade for STS eligibility.

Issuers looking to bring an STS eligible deal will need to notify The European Securities and Markets Authority (ESMA), provide a liability cashfl ow model and disclose cer-tain environmental data. This could be a stumbling block for issuers who have not previously captured that information.

Commitment for the label is already evident with some recent deals billed as ‘STS-ready’, a nod to investors that the bulk of requirements are in place.

ESMA has pushed out 16 draft reporting templates, including 10 for specifi c asset classes and two covering in-vestor reports. With some templates requiring 100 or more fi elds to be fi lled, issuers are anxious to avoid potential fi nes and reputational damage and have sought clarity on fi ner details, including options such as leaving some fi elds blank.

But the level of preparedness varies. The European Data-Warehouse, a securitization repository in waiting, notes that larger repeat issuers have started testing their deals against the ESMA templates on their platform, whereas smaller issuers are struggling, lacking in-house expertise.

Meanwhile, ESMA issued further guidance in November, pending approval of its draft technical standards.

“EU securitization regulations will be a major infl uence on the market, particularly in the fi rst half of 2019,” says Kevin Ingram, partner and head of the London structured debt group at Cli¢ ord Chance. “Ultimately the extent to which market participants are prepared to accept questions and ambiguity as the new regulations bed in will impact the number of transactions undertaken. The approach of the regulators during this initial period will be crucial.”

Wins, disappointments and hopesKey wins for the industry include a risk retention require-ment kept at 5% and lower capital charges for insurers in-vesting in senior STS bonds. However, revised capital charg-es for non-senior STS are too high, say advocacy groups, discouraging insurers from buying tranches with higher yields that would be a better match for their business.

For bank investors, only STS deals will count as level 2B high quality liquid assets (HQLA) for bank liquidity cover-age ratios, leaving investors with legacy investments worse o¢ once the 18 month grace period expires.

The industry hopes that, once teething problems are resolved, securitization will be more attractive for issuers and investors alike, but reduced 2019 fi rst quarter supply is likely to pull spreads tighter. GC

European securitization poised for new year regsThe European Union’s new securitization regulations come into e� ect on January 1, a year after publication. Market participants hope they will help spark an industry revival, 10 years on from the global financial crisis. But lingering concerns could stall issuance of European ABS as 2019 gets under way. Asad Ali reports.

“EU securitization regulations will be a major influence on the market, particularly in the first half of 2019”

Kevin Ingram, Cli� ord Chance

090 SEC - Euro regs.indd 90 04/12/2018 19:42

SPONSORED STATEMENT


To start, what did 2018 look like for the Greek non-performing loan sector?

ere any ban s o oading these pools? What were the underlying assets and what kinds of buyers were in the market?

Having peaked in 2016 at 50.5%, or €106.9 billion, NPL coverage ratios in Greece remain among the highest in the EU. Thus, NPL reduction is the core of banks’ strategy in Greece.

At the end of June 2018, the stock of non-performing exposures (NPEs) decreased by 4.1% compared to end of March 2018 and by 6.1% compared to the end of December 2017, reaching €88.6 billion or 47.6% of total exposures. Compared to March 2016, when the stock of NPEs reached its peak, the total has declined by 17.3%, or €18.6 billion.

The reduction of NPEs is mainly driven by sales. Apart from sales, write-offs, collections and liquidations, as e-auctions appear to have produced some early results and have also contributed to the reduction of NPEs.

Alternative asset managers including private equity and hedge funds have emerged as the biggest enthusiasts for European NPEs, seeing these instruments as an excellent opportunity to augment returns and diversify away from traditional revenue streams. Investors believe they will generate strong, double digit internal rate of returns from European NPEs which is leading to firms building up their portfolio exposures.

Typically there are two ways of getting involved. Pension funds can invest in distressed or opportunistic credit funds run by firms such as Apollo and Blackstone, which buy in the equity tranche of NPL portfolios. The other way is to buy the senior component of securitizations

: What is behind recent movement in Greek NPLs?

The European bank bail-in regime, introduced in 2015, was instrumental in the market’s development. The banks have to take losses

on NPLs before they can access public money to avoid bankruptcy. Indeed, a bank’s decision to write down or write off the value of a portfolio of loans is the starting point of any NPL transactions.

Recent changes in the legal framework to accelerate repossessions, improve the legal process and enforce the collateral through auctions, should help banks to reduce the stock of NPEs. The changes should provide banks with a credible tool to negotiate with those customers who could pay but opted not to do so (strategic defaulters), which according to different market participants range from 15%-25% of the total NPE obligors. Moreover, the changes should drive an increase in appetite from institutional investors in the market as they see repossession as key for a secondary market for NPEs.

o ill be di erent? Will we see more Greek NPL securitizations in 2019?

Banks have pointed to plans for bringing their NPE ratios down to 15%-25% by 2021. These would be supported by strong economic momentum, including the incipient recovery of the housing market, an increasingly dynamic secondary wholesale NPE and mortgage securitization market, and a lower strategic default rate over time as recent structural reforms help improve the country’s payment culture.

Furthermore, Greek banks will increase their focus on property auctions with the purpose of increasing their numbers and variety, as according to lenders’ calculations, some 20,000 properties will be up for liquidation in the next three years.

All the Greek banks have launched portfolio sales, either for second half 2018 or first half 2019. The effort for a more front-heavy reduction of NPEs through the sale of loan portfolios tops of the agenda of objectives.

What services does il ington rust o er its

clients working in Greek NPLs?

Wilmington Trust is well placed and poised to assist in providing the full range of Trust and Agency services for the wave of NPL securitizations anticipated in 2019. With offices in London, Dublin, Frankfurt, Paris (opening in the first quarter of 2019) and the United States, we can accommodate warehousing, securitizations, and restructuring transactions in numerous jurisdictions. In addition, we have an active Italian team already actively participating in the Italian NPL market. Wilmington offers a full range of Trust and Agency services, including note and security trustee, SPV services/entity management, calculation agent, cash management, accounting and common representative.

The Greek NPL market is set to provide vast opportunities for yield-hungry investors in 2019. Banks are accelerating their disposals of these assets, from business loans to residential mortgages, and the volume of portfolios sales and securitizations is expected to surge this year. Wilmington Trust has tapped Yannis Kyriakopoulos, who brings 20 years of experience in financial markets, to serve new and existing clients working in the Greek NPL space.

Q:

Q:

Q:

The Greek NPL opportunity in 2019 – Q&A with Yannis Kyriakopoulos

Q:

Yannis Kyriakopoulos

Vice PresidentWilmington Trust

SPV Limited(London)

Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Wilmington Trust Company, operating in Delaware only, Wilmington Trust, N.A., M&T Bank and certain other affiliates, provide various fiduciary and non-fiduciary services, including trustee, custodial, agency, investment management and other services. International corporate and institutional services are offered through Wilmington Trust Corporation’s international affiliates. Loans, retail and business deposits, and other business and personal banking services and products are offered by M&T Bank, member FDIC.

wilmington.indd 91 05/12/2018 15:25


SECURITIZATIONFinancing the US economy

As the engines of the US credit machine have slowed, the securitization model is no longer delivering the volume it once did. As the cur-rent economic cycle perhaps enters its last years,

outstanding volumes of both residential mortgage backed securities (RMBS) and commercial mortgage backed secu-rities (CMBS) are only just north of 50% of what they were in 2007. However, where real estate backed securiti-zations are declining, there are some bright spots in the burgeoning market for consumer ABS deals.

Since the financial crisis, homeownership among those aged 25-34 has declined to 37%, versus 45.4% for Gen Xers and 45% for Baby Boomers when they were the same age, according to the Urban Institute’s Housing Finance Policy Center in its Millennial Homeownership report.

A simple explanation for this decline is that younger Americans do not want to buy a home. Fewer people aged 21-37 are married and this group are also delaying having children — historically milestones on the way to home-ownership. They are also relocating often to gateway cities and require flexibility for changing jobs andlocations.

However, there are also significant structural economic headwinds possibly throttling rates of millennial home-ownership. Lenders have tried to learn the right lessons from the financial crisis and prudentially extend mortgage credit. Likewise, speculative homebuilding is less common than it was in the 2000s.

“Supply constraints are a major reason why millennials cannot afford a house. Even if preferences have changed, some would have become homeowners at this stage of their lives,” says Jung Hyun Choi, fellow at the Urban Institute’s Housing Finance Policy Center.

As these trends apply to the mortgage-backed securi-ties market, a constrained market for residential credit has unsurprisingly meant fewer mortgage-backed securities to issue. Annual mortgage originations have declined overall, and private label issuance has taken a substantial hit. That

sector soaked up as much as 40% of all first lien mortgag-es in the years before the financial crisis. Today, that pro-portion hovers closer to 1%.

While the government-sponsored enterprises have picked up the slack, the mortgages they are allowed to finance are generally aimed at high-quality borrowers, given that Fannie Mae and Freddie Mac end up guarantee-ing that investors in their securities will be repaid in full. Federal Housing Authority loans can target lower quality borrowers, but only if they are first-time purchasers.

Without private issuers willing to take on more risk, mortgage originators simply cannot distribute the same volume of mortgages they once did. And, according to the few originators left in the affordable housing market, it is leaving a broad chunk of Americans out of the capital markets infrastructure that has once encompassed a broad-er swathe of the economy.

“The level of support on capital markets for non-luxury, higher-end housing is minimal. Absent some support from [Fannie and Freddie] for affordable housing pro-grammes, it’s seen as too risky. But that’s where we see opportunity. Somebody has to step in,” says Pat Jackson, chief executive at Sabal Capital Partners and former executive of IndyMac, a major real estate lender in the lead-up to the financial crisis.

Shop dropIf more Americans are not taking out mortgages, they are also skipping out on another venerated American insti-tution: the great American shopping mall. But while housing may be a story of supply constraints, the shifting

Securitization runs hard to keep up with the US consumer

Consumer spending habits have changed beyond recognition since the financial crisis 10 years ago. US households are more wary of debt and are turning away from many of the traditional avenues of spending that have driven ABS markets for decades. While the market has come back since the depths of the crisis, securitization in 2019 is a di� erent beast. Alex Saeedy reports.

0

10

20

30

40

50

60

70

80

90

100Auto

Card

Student Loan

Personal Loan

2017 2018 YTD 2019 forecast

Consumer ABS New Issue Forecast 2019

$ bn

Source: Wells Fargo Securities

Consumer ABS new issue forecasat 2019

092-93 SEC - US financing.indd 92 05/12/2018 15:07


EMERGING MARKETSLatin America

SECURITIZATIONFinancing the US economy

landscape for retail and its impact on CMBS appears to represent an evolution in consumer preferences.

“It’s all about changing customer behaviour,” says Manus Clancy, director of research at CMBS and commercial real estate data provider Trepp. “An older generation did all their shopping at malls, including for Christmas and back-to-school [seasons]. But now, nobody is doing this, par-ents included. Going to a mall needs to have a reason to bring you in.”

While retailers come and go, the continued shrinking of major department stores is pressuring mall owners, who struggle to meet mortgage payments when anchor ten-ants go dark. That has especially played out for the smaller, B-class malls in highly concentrated markets.

Declining occupancy has in turn put pressure on a number of CMBS deals, which have historically been a stable source of financing to smaller, regional malls that would otherwise struggle to strike a deal with balance sheet lenders.

Delinquency in declineYet defaults in CMBS are low. According to data from Trepp, delinquency rates for retail CMBS loans have declined over the past 12 months to 5.55% from 6.63%. Likewise, retail CMBS issuance has ticked up in some mar-kets as investors take bets on re-purposed retail space that include tenants focused on ‘experiences’ rather than shop-ping alone, and renovating space to make room for cine-mas and restaurants.

But elsewhere, securitization has found room to run in the field of consumer ABS deals, which received a great deal of investor attention this year as their short duration and ties to the rebounding consumption economy made it an attractive form of exposure. Wells Fargo forecasts ABS issuance to total $218bn in 2019 — a mild increase from last year’s $205bn of issuance, nearly 75% of which is inside three years average life.

“We expect borrower demand for credit to continue, which should imply additional funding needs for lenders in ABS,” wrote Wells Fargo analysts in a 2019 outlook for structured finance. “Consumer ABS credit trends are likely to remain well behaved, and auto ABS from prime and subprime loans and auto leases should maintain its place as the largest ABS sector.”

Post-crisis, non-mortgage consumer credit outstanding has been led mainly by growth in student loans, which some economists have worried is crowding out other kinds of consumer debt, such as credit cards. But personal loan debt outstanding grew to $273bn as of Q2 2018 according to Wells Fargo, making it the fastest growing consumer debt sector in 2018.

While many personal lenders, such as SoFi and Marlette, have turned to the ABS market, there are lingering con-cerns about underwriting and borrower performance in an economy with rising rates.

“The introduction of personal loan ABS, especially from those lenders using the internet channel, up to $28bn

from zero in 2012, presents a challenge for many inves-tors. Pricing spreads have been at attractive levels, but short business histories make credit analysis and com-parisons over time more difficult,” says John McElravey, analyst for consumer ABS at Wells Fargo.

Moving onWithout question, securitization in 2018 is not financ-ing the same percentage of the real economy that it did in a year like 2006, a year when former SEC Chairman Christopher Cox addressed the American Securitization Forum, telling the audience they played a crucial role in the lives of ordinary Americans.

“Any American with a home, a car, or a child in college — that is to say, millions of Americans — depend on what you do,” Cox said. “Homes, cars, and college tuitions, like so many other things we need, are more often than not financed with loans. And the chances are good that when we finance these necessities, our loans are securitized. It’s also very likely that if they had not been securitized, many of these loans could never have been extended in the first place.”

But today’s pared back market does not exactly repre-sent a foundational shift in US capital markets. Instead, the market has undergone a reconfiguration in how the securitization industry finances consumer activities. And as a new generation comes of age and makes new choices about how to live and invest their time and money, it will accordingly respond to these changes.

Housing credit may be tighter, but there is still a deep and liquid market for investing in MBS, which remain an attractive asset for investors looking for exposure to a mainstay of the US economy.

There may be fewer malls in the US in 15 years’ time, but that will hardly grind the retail segment of the CMBS market to a total stop. Meanwhile, burgeoning forms of consumer credit collateral have found their way into ABS deals in the last few years, with deals backed by market-place loans, residential solar loans and leases and residen-tial mortgages made to borrowers.

Despite the widespread shifts in how people live and work, securitization has adapted, and while lenders are not as keen to up their exposure to consumer credit risk, especially when it comes to real estate finance, there is ample evidence that they are still willing to participate in funding the real economy. GC

“The level of support on capital markets for non-luxury, higher-end housing is minimal… But that’s where we see opportunity. Somebody has to step in.”

Pat Jackson, Sabal Capital Partners

092-93 SEC - US financing.indd 93 05/12/2018 15:07


SECURITIZATIONNon-agency RMBS

Given its legacy as one of the primary culprits of the financial crisis, and a large pullback from mortgage finance by the bank community in the last decade, non-agency securitization issuance is unlikely to

rebound to its 2007 peak, when it totaled more than $1tr.However, the market in 2019 is looking up, according to the

dedicated investors and asset managers who have stuck around to trade on what they see as one of the best, most robust underlying assets in the world: the US mortgage.

While total annual non-agency issuance rose slightly in 2018 from $64bn in 2017 to roughly $75bn, that figure is more reflective of a decline in re-performing and non-perform-ing loans, which slipped from $26bn in issuance to $14bn. Rising rates are seen as the main cause of the drop, increasing the duration of these non-conventional mortgage bonds as the refinancing window closes.

“This market has hit some headwinds as of this year,” says Neil Aggarwal, head of trading at Semper Capital Management. “The NPL trade is largely over, as supply dissipates and is now dominated by re-performing borrowers. Further, it is within the RPL mortgage trade that duration very much matters, and six to eight year bonds are soon becoming 10 plus year bonds as mortgage rates continue to rise.”

Issuance in other classes has picked up, however, as the non-agency market diversifies and takes on new complexity.

Perhaps the most obvious trailblazer for non-agency credit is the credit risk transfer (CRT). Derivatives based off the per-formance of underlying collateral, the deals have helped both Fannie Mae and Freddie Mac to transfer the risk from their mortgage portfolios while creating a further secondary market based on US residential mortgage credit.

A tweak to the legal structure of Fannie Mae’s CRT, which saw the agency issue debt through a real estate mortgage investment conduit (REMIC), was a big step forward in bring-

ing more investors — most notably, Reit and international investors — into the asset class.

Laurel Davis, head of CRT at Fannie Mae, says Reit participa-tion in the bottom tranches of the deals jumped from rough-ly 7% to 22% with the new legal structure. The agency now intends to issue all its CRT deals via the REMIC structure.

Private label progressWhile the US agencies dominate CRT issuance, some private label issuers are making inroads. Sponsors including Radian, Arch Capital Group and Essent Guaranty all tapped securitiza-tion markets in 2018 to transfer portions of the risk contained in their mortgage insurance portfolios. Their comparable bonds trade at sharply different spreads, however, with bonds rated BBB- priced at 100bp wider in several 2018 deals.

Most CRT deals allow investors to take exposure to different parts of agency RMBS deals, although the first loss bonds are retained by the GSEs.

Investors have taken to the product, as shown by tighten-ing spreads since the programme began in 2013. There is also more movement from the non-qualified mortgage sector, where private label issuers have bundled together high quality loans that do not meet GSE purchasing standards into securiti-zations. Non-qualified mortgage origination volume in 2018 was close to $9bn, spurred by new entrants — more than double that of 2017’s $4bn across six issuers.

“We’re seeing a more programmatic kind of issuance, which is a net positive as there’s more supply and a better under-standing in the market,” says Lauren Hedvat, managing direc-tor of capital markets at Angel Oak.

However, investors have been critical of how non-qualified mortgage deals are idiosyncratic and potentially expose them to different risks, deal to deal. “This sector is very intrigu-ing, but it’s not standardised,” says Tracy Chen of Brandywine Global in Philadelphia. “You have to look into each issuers’ underwriting. The collateral is a little worse than prime jumbo.”

But, even as non-agency seems poised for a rebound, rising rates and market volatility buffeting fixed income also means that pricing questions could weigh on demand and supply.

There is some solace in the arrival of a new FHFA direc-tor, who is expected to encourage further private capital into non-agency RMBS through setting higher agency guarantee fees and potentially modifying loan limits.

But that is still only likely to cause an incremental change, as market forces potentially weigh on issuance and each individ-ual sector within the non-agency market takes time to grow.

“For 2019, we expect the strong primary market to continue and project gross issuance volume to be around $76bn, flat versus 2018,” says Vipul Jain, head of RMBS research at Wells Fargo. “But we continue to be defensive. With the yield curve and credit curves generally flat, we believe investors are not being compensated enough for taking too much risk.” GC

Private label set for comeback in 2019

Once a big portion of global structured finance, non-agency RMBS has been a small part of the MBS market since 2008, in spite of a housing recovery in the US. Alexander Saeedy examines the outlook for a comeback of private label bonds in 2019.

“This market has hit some headwinds”

Niel Aggarwal, Semper Capital Management

094 SEC - RMBS.indd 94 05/12/2018 15:01


SECURITIZATIONUS CLOs

Against a backdrop of rising Libor rates, deteriorating loan covenants and strong corporate earnings, CLO participants in 2018 had to digest a host of mixed signals from the market. Investors and managers are cautiously eyeing a continued bull run as the sector comes to a late-cycle crossroads in 2019. Max Adams reports.

A host of competing factors in 2018 drove CLO activity, in terms of both issuance

volume and movement in triple-A debt spreads. A “pig in a python” scenario gave investors a huge wave of CLO reset paper to sort through in the April and July payment date windows, with about $23bn of CLOs reset in each of those periods, according to Gretchen Lam, senior portfolio manager at Octagon Credit Investors. That number dwindled as the year wore on, but the heavy supply helped push triple-A spreads out from near post-crisis tight levels of 92bp over Libor in February to around 117bp toward the end of the year. Octagon tapped the market 14 times in 2018 between true new issue deals and refi nancing and reset transactions.

“As we look to 2019, the big question for us is where do triple-A spreads go. That will drive the pace of supply,” says Lam. “CLO issuance is only a function of where triple-As price and do the [equity investors] care at that level. Everything else in between is just a pricing exercise.”

Meanwhile, Japanese investors, who have often anchored the order books for new CLOs at the tri-ple-A level, pulled back as hedging between yen and dollars became more costly in 2018. Many Japanese institutions moved on to European CLOs or US CMBS where net returns were stronger over the course of the year.

Another change in the investor base saw short duration bond funds, which piled into the market in 2017, pull back as deals they were invested in were reset into new

fi ve year structures throughout 2018. According to Tom Majewski, managing partner at CLO equity investment fi rm Eagle Point Credit Management, the fi ve year ten-or was not a natural fi t for these funds, and this technical change in the buyer base also weighed on CLO spread levels.

“We actually got out of sync over the course of the year, where the loan market was stronger than the CLO market simply because we were paying back a lot of these short term buyers,” Majewski says. “Our outlook is certainly to see triple-As tighter in 2019.”

Macroeconomic factors, such as the pace of interest rate hikes by the Federal Reserve will also have a hand in shaping supply and de-mand for CLOs. The market is pric-ing in three increases in 2019. To the extent that changes, that will have an e� ect on investor appetite, Majewski adds.

Given some of the uncertainty around key issues such as the size and shape of the buyer base next year, the pace of leveraged loan issuance and movement by the Fed, issuance predictions for 2019 are varied. 2018 activity was brisk, with outstanding paper increasing

by 11% by the end of November, but the market could have trouble reaching 2018’s volume if macro and market specifi c factors do not line up.

No covenants, no problem? But while triple-A debt spreads and overall issuance levels are certainly on everyone’s mind as 2019 kicks o� , there is equal attention being paid to the state of leveraged loans, from the standpoint of both pric-ing and loan covenants.

The proliferation of cov-lite loan documents seen over the past two years intensifi ed in 2018, leading to a deluge of negative press cov-erage about the state of what some have identifi ed as the trigger point for the next fi nancial crisis. Inves-tors meanwhile have bemoaned the state of loan documentation but have also accelerated the spread of cov-lite loans with their near insatiable appetite for fl oating rate debt.

One particular ‘bad boy’ loan cov-enant that received a lot of atten-tion over the past 12-18 months, and which observers say they ex-pect to see more of in 2019, allows borrowers to move assets out of the reach of fi rst lien creditors and pledge them as collateral for new debt. Clothing retailer J Crew has been a high profi le example of this practice. However, instead of reck-lessly overleveraging and spiraling into insolvency, J Crew used the ability to take on new debt judi-ciously, keeping up with payments and inspiring enough investor con-fi dence to push the price of its fi rst lien debt in the secondary market from 50 cents to over 90 through-out the course of 2018.

“We’re pretty optimistic that cov-enant-lite will actually delay the on-set of the next default cycle… While actual loan prices may be volatile, the actual instance of defaults will be low in 2019,” says Majewski.

Peak CLO market prepares for rate cycle gyrations

“We are actually more concerned about cov-lite than most of the market and have been for years”

Rob Kinderman, Ellington

095-96 SEC - US CLOs.indd 95 04/12/2018 19:41


EMERGING MARKETSLatin AmericaSECURITIZATIONUS CLOs

needed for new CLO formation. High profi le LBOs, such as Black-stone’s deal to buy the fi nancial and risk unit of Thomson Reuters for $20bn and Carlyle Group’s buy-out of the specialty chemical unit of Akzo Nobel for $12.5bn, were high-lights of the leveraged loan market in 2018.However, rising costs for fl oating rate borrowers and a more uncer-tain corporate earnings backdrop generally could eat into new loan volumes.

Angelo Gordon’s D’Alleva says the refi nancing and reset opportunity for managers will be much smaller in 2019, therefore CLO issuance will be lower. Additionally, CLOs will be more dependent on LBO activity, as she also expects loan refi nancings to be lower over the course of the year.

Still, for private equity fi rms with a CLO strategy, the sector will remain attractive, particularly at the CLO equity level where returns on those investments since the fi nancial crisis have outpaced other asset classes.

“We think it is a well structured asset category,” says Bharath Srikr-ishnan, managing director at private equity fi rm Pine Brook Partners, which invests in energy and fi nan-cial services related companies.

Pine Brook owns the Dallas, Texas-based CLO manager Trinitas Capital Management, which issued two new CLOs and one reset trans-action in 2018.

For Srikrishnan, concerns as 2019 gets underway are similar to those voiced by other participants. He says that the scrapping of the risk retention requirement for CLOs was a negative. From a macro standpoint, the cycle is getting long in the tooth.

“We’re in the eighth inning but we don’t know how long the ball game will be and to what extent external shocks like trade wars and rising rates play into credit performance.” GC

The agonizing over deteriorating loan covenants, observers say, has to be taken in hand with the fact that corporate earnings are strong. As long as the economy keeps humming along in 2019, these loans will continue to perform.

Maureen D’Alleva, managing director and head of performing credit at Angelo Gordon, also says that the market is holding the line against the most aggressive practices.

“Credit selection is really the key [for CLO managers] as we navigate through the last innings of the credit cycle. We have infl ationary pressures and tari� s that will add another element of costs for com-panies,” D’Alleva says. “What you see in the press is a change in the credit protections that we’ve had. Documentation has become pretty aggressive but we’ve been disci-plined in pushing back.”

Still, cov-lite is problematic enough that most of the market agrees that loan recoveries will be lower when the cycle does turn. This possibility is front and centre for hedge fund Ellington Management, which both invests in and manages CLOs. The fi rm’s CLO management unit takes a much harsher view of the cov-lite environment that the market now operates in.

Greg Borenstein, portfolio man-ager in Ellington’s CLO manage-ment group, says that while the fi rm buys lower rated credit to pool in its CLOs, 70%-80% of the loans it buys have stronger covenants and documentation and Ellington is

positioning for a turn in the cycle when a wave of triple-C down-grades pressures the market.

“When these downgrades do hit, it will be a slow motion train wreck. We also think there is a some false sense of security in these deals given how short lived the distress was in the loan space during the crisis and given how much room there is to benefi t from fl oating rate product,” Borenstein says. “The lesson learned about how resilient these deals are is the wrong lesson to take away in our opinion.”

Rob Kinderman, partner and head of credit strategies at Ellington, echoes his colleague’s sentiment.

“We are actually more concerned about cov-lite than most of the market and have been for years. The reason we stay in more structurally strong mezzanine paper is that we see the data and the leverage is moving up and documentation continues to get worse. As we see it playing out, we expect recoveries to be a lot lower,” says Kinderman.

Ellington’s strategy is to buy loans in the secondary market that are more seasoned, focusing on paper with maybe three or four years left to maturity.

“Buying these loans in second-ary is like taking a time machine back several years to what docu-mentation used to look like,” says Kinderman.

The PE perspectivePrivate equity fi rms’ leveraged buy-out activity will continue to drive issuance of the leveraged loans

0

20

40

60

80

100

120

140

160

180

2012 2013 2014 2015 2016 2017 2018*

New Refi/reset/re-issue$bn

* 2018 totals as of November 16

Source: JP Morgan

US CLO issuance

“Credit selection is really the key as we navigate through the last innings of the cycle”

Maureen D’Alleva, Angelo Gordon

095-96 SEC - US CLOs.indd 96 04/12/2018 19:41


SECURITIZATIONUS housing GSEs

While there have been few substantive initiatives to privatise the US housing government spon-sored entities (GSEs), guidance from the US Treasury and the appointment of a new regu-

lator in 2019 suggest that change is looming for the agencies that have assets roughly equal to 20% of US GDP.

“The consensus in Washington is that the current status of the GSEs is not sustainable. Even if legislative reform proves difficult, the US Treasury has made clear that it will pursue administrative reforms that will significantly scale back GSE market share,” says Raghu Kakumanu, senior vice president of public policy at Wells Fargo in Washington DC.

Much attention has been paid to the appointment of a new director this year at the Federal Housing Finance Agen-cy (FHFA), the regulator that looks after the activities of the GSEs. Mel Watt, a Barack Obama appointee, is expected to leave the post when his term expires in February. Fannie Mae and Freddie Mac have, or will have, new CEOs, which could finally bring transformation a decade after the financial crisis.

Once vetted by the US Senate, the new Donald Trump-ap-pointed director is widely expected to promote policies that would see the GSEs step back from the secondary markets and better allow for private capital to re-enter mortgage finance.

That is especially true in the multifamily market, where reg-

ulatory caps on GSE multifamily financing have been largely evaded through exemptions. Those caps were put in place by Ed DeMarco, acting director of the FHFA from 2009-2014.

“The utility of the multifamily caps has been eroded thanks to so many exemptions,” says Isaac Boltansky, director of poli-cy research at Compass Point in Washington, DC. “Each GSE is doing almost double what its cap mandates. You’ll almost cer-

tainly see a narrowing of these exemptions.” Edward Pinto, head of housing policy at the American

Enterprise Institute, a Washington think-tank with ties to the Republican Party, says: “There should be certainly be a rollback in the multifamily sector. The GSEs claim that they’re active in making this market more affordable. But there’s no proof that they actually help to lower rents, full stop. That’s because their multifamily programmes are mainly cash-out refis. To me, it’s unclear why taxpayers should be guaranteeing this line of business business.”

Loan limit reform?The new director may also ramp up limits on the size of mortgages eligible for purchase by the GSEs and the price of guarantee fees that ensure investors will be repaid even if the mortgage holder defaults. “Encouraging private capital to come into US real estate will include reforms to loan limits and fees at the GSEs, says Boltansky. “There’s a fear of loan limits being reduced, although what we’re more likely to see is a higher loan-level price adjustment grid. That’s a less blunt instrument than adjusting loan limits themselves.”

But even if the GSEs’ footprint is reduced under new lead-ership, there is broad recognition that the business of Fannie and Freddie has expanded remarkably over the past five years even while the GSEs have remained under direct state control.

By pioneering programmes like credit-risk transfer, the GSEs have helped the private label RMBS market grow while trans-ferring risk away from taxpayers. Issuance for credit risk trans-fer deals has ticked up by roughly $1bn to $7bn this year.

“Losses are still minor on CRT deals and the bonds are still trading at a premium, especially as they’re all floaters in a ris-ing-rate environment,” says Tracy Chen, an asset manager and CRT investor at Brandywine Capita in Philadelphia.

In 2018 there was a big development in the credit-risk transfer market as Reits were allowed to participate in a new form of CRT deal that marketed the debt as REMIC-eligible, as opposed to corporate debt issued through Fannie Mae.

Likewise, the FHFA-driven Uniform Mortgage Backed Secu-rity (UMBS) initiative has helped to engineer a big change in housing policy. The UMBS involves the creation of a com-mon securitization platform through which both Fannie and Freddie will deliver securities to investors on the TBA (to be announced) market. The FHFA has established guidelines on prepayment speeds and underwriting that will ensure the uni-formity of all securities with the title of UMBS, regardless of which agency issues the bond.

The common platform is a possible framework for re-pri-vatising the GSEs and opening up the RMBS market to private capital. If Fannie and Freddie could still be privatised and deliver UMBS by conforming to the FHFA’s standards, others might sign up and issue on the same platform.

The first UMBS will be issued on June 3 2019. GC

GSEs finally face up to change, 10 years on from crisis

It has been more than a decade since the US government nationalized Fannie Mae and Freddie Mac, the government-sponsored enterprises at the heart of US housing finance. Private sector advocates have hotly contested their conservatorship — without results — but 2019 be the year that that changes, writes Alexander Saeedy.

“There’s a fear of loan limits being reduced, although we’re more likely to see a higher loan level price adjustment grid. That’s a less blunt instrument than adjusting loan limits”

Isaac Boltansky, Compass Point

097 SEC - US housing GSEs.indd 97 04/12/2018 19:43

SECURITIZATION 10 YEARS ON - GlobalCapital€¦ · SECURITIZATION 10 YEARS ON Rebirth of a market...

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