Navigating the Unknown

Covid Impact on Alternative Credit_Integer Advisors (PDF Version)

Executive Summary

The following is an excerpt of our report (see PDF link for full version)

In this report, we look at the impact of the covid crisis on private and alternative credit markets in Europe, spanning mortgage, consumer and small-/ mid-cap corporate credit.  On our estimates, this non-bank specialty lender-led market has a footprint of roughly €350bn in terms of loan stock, dominated by the UK.

The covid pandemic is of course an unparalleled crisis in its scale and intensity. And the policy-maker response has been equally without precedent, generally comprising a three-prong approach made up of exceptional monetary accommodation, emergency fiscal stimulus measures and loan forbearance initiatives. The response to the covid pandemic hitherto has already far surpassed policy actions taken during the 2008/9 crisis.

In the near-term at least, we feel the fiscal measures in place will provide appreciable support for debt servicing burdens while also cushioning any repayment shocks as some borrowers emerge from payment moratoriums. Household credit stands to benefit most in this respect, in our view.  Rather than loan book credit deterioration, we see lender financing and/or liquidity distress as the main near-term casualty from the covid crisis, given the extent of forbearance on the one hand and the more selective liquidity within securitization and institutional funding markets on the other.  (Non-banks and speciality credit assets generally fall outside central bank liquidity and asset purchase envelopes, with very few exceptions).  This squeeze on many non-bank lender models may provide interesting private market ‘back-book’ opportunities in the coming months.

The longer-term crisis impact on private credit performance depends largely of course on its ultimate toll on employment and business survival.  At this stage we see unsecured credit as being at most risk, save potentially for some higher margin loan books which may be insulated by adequately rich yields.  Mid-cap corporate portfolios may also be vulnerable if default expectations in the larger-cap leveraged finance market is any guide.  (Indeed, this crisis will be the first real test for private debt funds, and also for the likes of marketplace lenders).  Residential mortgages should prove the most credit defensive, in our opinion.

Covid brings the 2010s alternative credit cycle to an abrupt end. In its aftermath, we see a fresh cycle of front-book opportunities re-emerging apace to coincide with renewed demand for specialty credit.  Compelling risk-return economics (typical in any early-cycle lending) against the backdrop of prolonged ultra-low rates should underpin the merits of private loan book investing, once again.

Disclaimer

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients.
The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein.
Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised and regulated by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO).
This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity. Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report.
Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

Steady Momentum Continues

 Update on Capital Relief Trades in Europe (PDF Version)

Executive Summary

This article serves as an update to our original, in-depth report on credit risk transfer / capital relief trades (CRTs) published in the summer of 2018 (see here). Over the past year, primary supply of CRT tranches looks to have remained broadly range-bound, with the greater prominence of supras and development banks as protection buyers emerging as an interesting trend. Demand technicals have also remained stable, with the buyer base concentrated among the (still) few alternative credit funds that have long dominated as protection sellers, despite efforts at bringing in new investor types. CRT pricing has remained sticky, with the range of clearing spreads (8-12% typically) continuing to be enveloped – in our view – by the return thresholds of the buyer base on the one hand, and the implied cost of bank equity on the other. CRT pricing certainly looks dislocated relative to the superior historical credit performance of the asset class, as highlighted very recently in the EBA STS discussion paper which analyses the feasibility of an STS framework for synthetic (balance sheet) transactions. Returns of 8-12% for (historical) reference portfolio loss risks of less than 20bps underscores the compelling value in CRTs (after allowing for tranche leverage and any first-loss retention).

Regulatory developments have been more notable in the past year. CRTs fell under the Securitisation Regulation net from the beginning of 2019, being subject more specifically to the ESMA disclosure framework, compliance with which we feel is unlikely to prove seamless for CRT from a practical perspective. The extension of STS criteria to CRT, as recommended by EBA in the discussion paper (subject to additional criteria) is on the other hand a positive development for the sector. In our view, such endorsement could be (potentially) transformational ultimately, though any STS labelling is unlikely to have any immediate effects considering the current tendency for senior tranche retention and also an investor base that is generally unconstrained by regulatory capital considerations. CRT structures have seen few changes since a year ago, arguably the most noteworthy being the trend for thicker tranches (increasingly split into dual tranches for cost-optimization) as a means to achieving significant/commensurate risk transfer. The treatment of excess spread remains a key structuring consideration for protection buyers, with further regulatory guidance still forthcoming in this regard (the EBA discussion paper suggests exclusion of synthetic excess spread as a criterion for the STS label).

Going forward, we believe there remains a strong impetus for CRT issuance as bank equity remains precious, particularly with the CRR roll-out from next year and the full force of the Basel III capital framework taking effect in 2022. Maturity of the demand side is where we see the greatest potential upside for the CRT market, though we are cautious as to if/ when this might happen. Regulatory inclusion is arguably the most important factor in unlocking mainstream investor liquidity in the asset class, with better transparency also key, in our view. The US CRT market, which benefits from pricing and liquidity not dissimilar to highly commoditized spread products, is clear evidence of the upside that can come with greater liberalisation of the CRT buyside in Europe.

Market Technicals

Stable Primary Market Momentum

Since our last report on CRTs in mid-2018, the market as described by supply / demand technical has largely remained unchanged. Based on data from SCI, placed CRT tranches amounted to EUR 5.26 bn for the 12 months to July 2019, flat versus the EUR 5.48bn seen in the preceding 12-month period. Data released very recently in the EBA discussion paper (citing the IACPM data collection as the source) show broadly similar trends in terms of steady primary volumes measured by placed tranches although year-on-year some variations occur. We estimate reference pool notionals related to such European issuance at around EUR 69 bn versus EUR 80 bn in the preceding year, with the lower portfolio amount (but similar primary volumes) explained by thicker tranche sizes recently, as we outline below. Notably, the CRT deal count increased from 33 to 43 over the two 12-month periods, according to SCI data. Pool notional and deal count data from the recent EBA report (based separately on notifications by domestic regulators in Europe including the ECB) is again broadly consistent as far as we can see although again fluctuating year-on-year relative to IACPM or SCI data.

We repeat the important caveat that these figures are likely to somewhat understate the full extent of CRT activity in Europe. Private deal flow in the European CRT market, to include purely bilateral transactions, will not necessarily be captured by the data, yet make up a relatively significant portion of the market. Based on IACPM data recently published, which covers the entire synthetic securitization universe, only 18.6% of cumulative deal flow since 2008 until end 2018 was placed publicly (the remainder being private trades), with this ratio standing at 32% in 2018.

UK and German ‘SIFI’ banks continue to be the most active CRT issuers overall, but we note that Spain has seen a bigger market representation in the last 12 months, courtesy mostly of Santander. (We would add that the reference assets in this respect have been multi-jurisdictional). Interestingly, EIF/EIB-related transactions have featured more prominently in Italian and Spanish-sponsored deals as well as in some transactions from Central European institutions (namely Poland and Czech Republic).

In terms of underlying portfolios, reference assets in Europe continue to be focussed on corporate and SME loans for the most part. However, this past year has witnessed an uptick in non-corporate reference portfolios, such as auto and consumer loans (via both tranched synthetic and full-stack true sale deals) plus selective residential and commercial real estate loans as well as project finance / infrastructure loan portfolios. As mentioned above, multi-jurisdictional portfolios are increasingly seen in the CRT market, indeed recent IACPM data points to the dominance of multi-jurisdictional risk transfer within the overall universe of synthetic securitizations (60%, to be precise), though our isolation of European bank CRT data suggest a more moderate share. As synthetic technology can efficiently facilitate the securitization of multi-country risk (certainly relative to cash securitizations), we expect to see more by way of such deals by European banks going forward.

Issuer Developments

Notable New Entrants

Large IRB banks continue to dominate the CRT market in Europe. Their market footprint has not materially changed over the last few years on our observations, reflecting the fact that these banks have the inherent advantage of having created efficient structures to fit their portfolio/ capital requirements as well as experience in engaging with their respective regulators. Experience with regulators is a key factor for successful CRT transactions in our opinion, given the absence for now of a prescriptive, rules-based regulatory framework for such deals (see section below). The in-house capabilities and infrastructure needed for CRT transactions can often be barriers-to-entry for new entrant banks in the CRT space.

The chart below shows the (observed) cumulative issuance volumes by bank domicile, highlighting the continued dominance of German and UK domiciled banks. As mentioned above, Santander has also been notable for ramping up their CRT activities in the past 12 months and we understand that French IRB banks have also become more active. But all things considered, the CRT issuer base remains somewhat concentrated relative to other capital market types. Any significant broadening of the issuer base would, in our view, require a conducive (and certain) regulatory framework, more transparency and better pricing ultimately for placed tranches, which in turn will necessitate further maturity and depth in the investor base.

EIF/EIB programmes continue to be important for the smaller and mid-sized banks tapping the CRT market, with such banks typically using the standardised approach. Reference assets in this case continues to be dominated by SME risk.

Arguably the most interesting development in the last 12 months was the embracing of CRT technology by a number of supranational and national promotional institutions. The Room-2-Run transaction from the African Development Bank was the first synthetic securitization by a multilateral development bank as a protection buyer freeing up capital. The deal involved a $1bn portfolio of 40 loans to financial institutions and project finance vehicles across Africa. Separately, the Dutch development agency FMO initiated a new program (‘Nasira’) whereby the agency can act as both protection buyer and protection seller, depending on risk motive. The novel program works with partner banks in developing markets such as Africa and the Middle East, ultimately enabling loan credit provision domestically to underserved SME market segments. We feel more such CRT activity from supras and promotional banks will be forthcoming, but recognise that much will depend on the extent of stakeholder support for, and endorsement of, capital relief trades.

The Investor Base

Evolving, Slowly

While there have been some new buy-side players coming into the CRT market over the past year, we would see the established incumbents – namely alternative credit/ hedge funds and a few pension funds – as continuing to make up the bulk of demand for the asset class. This intelligence is corroborated by the recently published IACPM findings, which also talked to the relative increase in the buy-side share of hedge funds in recent years, at the expense of pension funds.

Our own observations are that these established investors have generally increased AuM wallets dedicated to CRTs, allowing for bigger ticket purchases (EUR 100m+ sizes). This gives many such investors the ability to engage in bilateral deals, although we feel there are some issuers who still prefer syndicated (club) transactions given the potential benefits that come with such price discovery.

We also see ongoing efforts to bring more insurance companies into the market via unfunded formats, essentially as protection seller on the liability side rather than as investors in CRT tranches on the asset side. Such demand may be particularly relevant for upper mezzanine tranches, a relatively embryonic risk type that reflects the recent trend for split tranches in CRT deals (see discussion below). But to our knowledge there has been only one such confirmed transaction in the autumn 2018 referencing residential mortgages, where ING-Diba acted as the protection buyer and Arch Mortgage Insurance as protection seller. On a broader level, the recent IACPM data shows that insurance companies account for less than 1% of cumulative synthetic deal flow since 2008, albeit also pointing to an uptick in participation since 2017.

The potential demand from insurance money aside (both on the asset side as well as the liability side), it is not immediately clear in our view what the natural investor base for upper mezzanine tranches would be ultimately. Whereas we would expect some EIF activity for SME-related reference pools, the buyside for upper mezzanine risk in more traditional CRT types seems as yet uncertain in our opinion, not least considering that most of such tranches are non-rated at this stage.

Comparisons to the US CRT market

More CRT history in Europe, but still less mature

The US CRT market is younger, yet far larger than the European market if measured by deal flow. There are a number of interesting nuances, however.

The US CRT market benefits from a broader and deeper buyer base than for European CRT product, with such investors comprising mainstream money also, in contrast to Europe where alternative credit buyers dominate.  But unlike Europe, the issuer base in the US is overwhelmingly dominated by the two mortgage agencies, Fannie Mae and Freddie Mac. Yet despite this issuer concentration, the US market is still much more liquid/ tradable than its European equivalent given that these two agencies have spearheaded a high level of standardisation and transparency across their CRT programmes, to include deep data on price and credit performance. By contrast, the European CRT market remains largely private and substantially non-traded.

To demonstrate the superior liquidity technicals in the US CRT market, we note that the Fannie Mae CAS program has seen cumulative issuance of $40bn as of July 2019, with secondary trading volumes of around $28bn in the last 12 months, over one times float of $27B. Liquidity, in turn, anchors the deeper buyer base, while also better facilitating repos and leverage-taking.  For this and other reasons, the US CRT programs achieve significantly lower average protection costs relative to the European market.

Domestic investors remain the most important pocket of CRT buyers in the US. Fannie Mae has shifted to REMIC usage (Real Estate Mortgage Investment Conduit) in order further diversify their investor base.  Recent initiatives suggest Fannie Mae is focussed on its programme appeal in Europe, stepping up their disclosure as a non-EU issuer in compliance with the new STS regulations covering EU investors. In doing so, Fannie launched a new website section specifically targeted at EU investors, thereby ‘exporting’ the practices of US CRT market transparency into Europe, where such disclosures are not yet visible with few exceptions.

The US CRT programs highlights clearly the potential long-term benefits to European bank CRT issuers from more programmatic issuance with bond market-style transparency and secondary liquidity support. But, for various (entrenched) reasons, we think more realistically that such maturity in the European CRT market is still some ways off.

Transaction Structures

Testing the product’s versatility

CRT transaction structures continue to be defined by regulatory considerations for the most part. In the absence as yet of any new regulatory framework that could shape (or re-shape) structural norms, there has generally been limited changes to deal structures since our report a year ago, save for a few notable developments as outlined below.

Most CRTs continue to be in synthetic format, however ‘full-stack’ true sale securitizations have become more prominent over the past year in the case of non-corporate reference assets such as auto and consumer portfolios. In such true sale deals, all tranches are normally sold subject to risk retention requirements (typically vertical with 5% retention of all tranches), though in some cases the senior notes are retained. The treatment of excess spread poses particular challenges in cash, full-stack securitizations, specifically because such income can be considered a securitization position from a regulatory perspective. Given the typically high excess spread in the likes of consumer or auto credit, the resulting capital consumption (in normal loss scenarios) can prove potentially prohibitive for the protection buyer, in that any capital relief from buying protection for the entire portfolio can be negated. While deal cash flow mechanics could possibly be tweaked so that any excess spread is extracted higher up the waterfall, we feel that there are no easy structural solutions that would comply with the spirit of the regulatory objectives in this respect. Our own view on this widely debated topic is that using a ‘gain-on-sale’ approach for future risky income that crystallizes such cash flow into a day-one securitized position held by the issuing bank (subject to capital requirements) may in some cases create disproportionate demands on capital relative to the capital position in a like-for-like unsecuritized portfolio.

In our opinion, the most significant structural development in the last 12 months has been the trend of greater tranche thickness among CRTs in order to achieve significant / commensurate risk transfer. Historically, based on our calculations, the average ratio of placed tranches to portfolio notionals in Europe was around 7%. More recently, we see this ratio frequently in the 10-11% area, which is notably different than the IACPM data for the global synthetic market (7.2% in 2018 vs 8.1% in 2017). Analysing what type of asset portfolios have been most impacted is challenging given the many different individual, transaction-specific parameters that also drive tranching. With thicker tranches generally, protection cost efficiency has clearly deteriorated for CRT issuers, mitigated to some extent by more dual tranche deals whereby an upper mezzanine tranche with lower clearing spreads is carved out. The development of thicker tranched CRTs is less noticeable among UK banks, however, reflecting the long-held PRA requirement for CRT tranches to be rated, which often necessitates thicker tranches than otherwise.

A key topical consideration in the CRT market is how to potentially synchronise CRT transactions with IFRS 9 accounting – that is, using capital relief technology to also deliver accounting benefits (release of loan provisions). The idea would be to reconcile credit event definitions more clinically with the IFRS 9 provisioning definitions, which to us amounts to a greater harmonisation of internal accounting and credit management policies. In practice many deals arguably already provide for IFRS Stage 3 loss coverage with the ‘failure to pay’ credit event typically capturing late-stage (90+ days) delinquencies, but efficiently (and economically) replicating coverage of Stage 2 provisioning poses greater challenges. Any release of accounting provisions would also depend of course on the attachment point of the most junior (placed) tranche.

The potential emergence of non-performing CRT transactions is also a topical market discussion. We are not particularly bullish on an NPL CRT market emerging in the foreseeable future, however, given fundamentally the challenges in fitting traditional credit event definition and loss settlement mechanisms into any defaulted asset pools with only recovery-based payoffs. Italian unlikely-to-pay loans (UTPs) would arguably be more compliant with traditional CRT technology, but being capitalised as already defaulted (which we understand is the typical CRR treatment) would kill the economics of buying protection. Above all, we believe that a significant impediment to any NPL CRT market development would be the lack of alternative investor appetite for this asset class, compared certainly to the depth of demand for cash, whole loan NPL portfolios.

Regulatory Considerations

Further notable developments and more to come

The key consideration for CRTs remains the regulatory landscape for such transactions. Regulatory capital relief remains the conditie sine qua non in the use of CRTs, aside from broader risk management objectives. In the absence of a defined and prescriptive regulatory framework for CRT usage, issuers are left to demonstrate significant / commensurate risk transfer to their respective regulators in order to achieve their capital relief aims. In this regard, the EBA 2017 discussion paper continues to be a de facto guide to structuring CRTs in addition to the CRR provisions.

Given that regulators will not ex ante sign off on CRT transactions, there is deal execution risks for potential protection buyers, a challenge that is especially significant for new market entrants without any precedence in engaging with their regulator around CRTs. Anecdotally we understand that there has been some convergence of regulatory application across Joint Supervisory Teams (“JSTs”) over the past year or so which is progress given some inconsistencies of the regulatory applications across EU regulators in the past (we would note that the UK PRA has overall still the most conservative approach).

Among the more notable regulatory-related developments over the past year that we would highlight include:-

• The potential emergence of STS criteria for synthetic transactions, based around the EBA’s consultation paper which was just published. This paper proposes a fit-for-purpose STS framework for synthetic deals that replicates the various criteria inherent in the main STS framework for cash securitizations, while taking into account synthetic-specific features related (mostly) to the protection mechanism, such as counterparty and collateral risks. The EBA paper raises the possibility of a ‘differentiated’ framework with potentially preferential terms for synthetic STS, although also acknowledges that any such preferential treatment would be inconsistent with the current Basel framework for synthetics.   In our view, STS eligibility – while definitely welcome – is from an overall market perspective arguably less relevant for CRTs at this stage, in that transactions are ‘bottom-up’ whereby (largely unrated) junior tranches are sold to investors typically unconstrained by regulatory capital requirements. Moreover, senior CRT tranches are almost always retained in the current market, save for some deals involving banks using the standardised regulatory approach. In the case of the latter deals referencing SME assets, we would note that there is already STS treatment in effect for senior tranches under certain conditions as outlined in CRR Art. 270. All that said however, we recognize that STS eligibility would be a powerful de facto endorsement of the asset type, which should ultimately take the market out of the fringes and into the mainstream by both de-stigmatizing and standardising the product, in addition to more favourable capital treatment most relevant for the retained senior tranche. The STS discussion paper also highlights two important structural aspects: STS labelled transactions would not be allowed to have bankruptcy of the protection buyer (i.e. originator) as a termination event. Moreover, synthetic excess spread could not feature in an STS transaction. On the latter, we continue to believe that synthetic excess spread should be allowable to the extent that it would cover expected losses of the reference portfolio.

• The start of 2019 saw the implementation of the new disclosure regime (under the Securitisation Regulation) based on Art. 7 STS, the scope of which extends to private transactions. Most importantly, CRT deals have to follow the respective ESMA loan-level and (ongoing) investor report templates. This can be challenging in some areas given that the ESMA templates were essentially drafted for true-sale, cash securitizations and, as such, not all data fields can be seamlessly populated in the case of synthetic CRT deals. The ESMA templates do have a specific sub-section in the significant event report template for synthetic transactions (Annex 14), although this is not relevant for private

• The one key structural obstacle for efficient transactions remains the treatment of excess spread, both for true-sale and synthetic CRTs. We sense there is a consensus emerging to have a one-year (rather than cumulative) capital deduction if the synthetic excess spread is at or below the 1-year expected loss of the portfolio, based on an ‘use-or-lose’ approach (the recent EBA STS paper notwithstanding). For true-sale ‘full stack’ deals, any regulatory interpretation of (cumulative) excess spread as a securitization position can be a significant impediment to transaction economics, as discussed above.

Risk/Return Update

Recent data confirms historical credit (out)performance, underscoring value

Large cap corporate and trade finance CRT yields (measured by primary market clearing coupons) have largely remained range-bound since our last report a year ago, albeit with a modest tightening seen in the range. On our observations, such CRT yields have trended between 8-12% in the past year, versus 9-12% in the preceding year. SME CRTs, by contrast, look to have tightened more perceptibly, typically pricing 1-2% inside of equivalent deals from 1-2 years ago.

Overall pricing behaviour continues to depend mainly on macro supply/ demand technicals – more specifically, as we had articulated last year, CRT pricing has remained enveloped by the return thresholds of the specialist investor base on the one hand, and the cost of bank equity on the other. The only meaningful exceptions to this otherwise range-bound pricing dynamic are deals where there is supra involvement (essentially EIF/EIB) as guarantor/ protection seller or investor in the capital structure. Both factors mentioned above – the narrow investor base and bank cost of equity – have remained largely unchanged over the past year, which in turn explains the stickiness of CRT yields. To be sure, liquidity in the CRT market still remains conspicuous for its absence, leaving few directional forces to allow spreads to break through their (long-held) resistance bounds. The lack of liquidity, or mainstream capital market sentiment more generally, has meant that CRTs remain an uncorrelated asset type versus public or tradable risk markets.

By almost any measure, CRT headline yields continue to look compelling versus most other comparable instruments, ignoring any justifiable liquidity premium. We would consider ‘comparable’ products as the likes of securitized residuals (including CLO equity) and bank AT1s or CoCos, which we discussed in some detail in our report a year ago. In the current market, as it was then, CRT yields remain generally superior to such comparables, except arguably for some CLO equity where returns may be indistinguishable from CRTs. We explore the relative value in more detail below.

First, we feel its worth looking into the risk performance of CRTs, which the recent EBA paper is uniquely insightful courtesy of IACPM and rating agency data. (CRT loss performance data was generally unavailable before). Over the period from 2008 to 2018, the data shows that annualized default rates among large cap and SME reference portfolios amounted to only 0.11% and 0.59%, respectively. Write-offs annually stood at 0.03% and 0.18%, respectively.  Such credit performance stands out versus most other comparable spread product. Indeed, the recent EBA report also highlighted rating migration data from S&P that shows the outperformance of synthetic versus cash securitizations since 2008. One key takeaway from the data provided by the EBA report is that the credit performance of synthetic reference pools has been consistently superior versus the same balance sheet (unsecuritized) assets of the institution – this suggests that there is an element of positive asset selection in the case of CRTs referencing core bank assets.

To provide slightly more balance to the bullish credit history described above, we would note that a few CRT deals were vulnerable to high profile UK-based corporate defaults over the past couple of years, to include Carillion, Interserve and selected others in the retail sector. We do not know the end-impact of such credit events at any deal-specific level, but these episodes are a reminder of the inherent portfolio risks among CRTs to idiosyncratic, single-name credit events in what can often be lumpy pools.

The above notwithstanding, richer-than-market CRT yields – in the context of its superior credit performance historically – underscores the compelling value in the asset class in our view, certainly for buy-and-hold money that can withstand illiquidity. Let’s compare with leveraged loan CLO equity, as a case in point. Nominal horizon returns on both CRTs and CLO equity is roughly in the same region, i.e., around 10-12% annually. Leverage, as measured by attach/ detach points, is also generally comparable. Yet CRTs have, historically at least, outperformed CLOs by an appreciable degree – since the 2008 crisis, CRT annualised default rates of 0.11% (large cap corporate reference assets) compares with leveraged loan annual default rates of 3.1% (Source: Fitch). The differences in default rates speak to the typically superior asset credit quality in CRTs versus CLOs, enhanced by likely positive credit selection in the case of CRTs. Moreover, the CRT coupon stream (protection premiums) is not vulnerable to lifetime portfolio cash flow risks, as in the case of CLO equity returns. CLO equity trades in a far deeper institutional market than any CRT product, however.

In our last report we discussed relative value considerations in comparing bank AT1s/ CoCos to CRTs, with the premise being the hybrid-equity parallels of both product types, notwithstanding some fundamental differences. CoCos have posted impressive cumulative total returns since 2015 (see table below), with yields-to-call currently (ca. 3-3.5%) re-approaching the historic tights seen in 2018. Yet CRTs can be shown to have outperformed based purely on coupon carry, at least using similarly discrete cumulative periods. The one exception is 2019YTD, during which reflation drove a sharp rally in high-beta spread products such as CoCos, whereas illiquid CRTs witnessed no similar correlated benefit. Our point here is that any outsized returns in non-traded, non-mainstream paper such as CRTs can only be fully realized over longer holding periods, with high coupon rolls making up for the anchored pricing.

Fundamentally, to recap our arguments from a year ago, CRTs provide for levered but narrow exposures to defined bank-originated asset credit risks (only), whereas AT1s/ CoCos (or bank stock, in the extreme) represent levered exposures to a broader mix of risks to further include operating, financial and event risks. Balance sheet credit deterioration (taken in isolation) has been far rarer a catalyst in triggering sell-offs in bank risk instruments over the recent past, relative to other risk factors. This arguably justifies the return outperformance of CRTs hitherto.

The potential for a better convergence of CRT pricing with its credit fundamentals remains very limited for now, at least in our view. For CRTs to trade like say CoCos, the market will need to be substantially “mainstreamed”, in terms of the buyer depth, dealer market-making, credit and price transparency and, not least, greater regulatory inclusion. Despite moving gradually in this direction, we do not feel that any such transformation will be seen in the short-term.

Disclaimer

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients.
The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein.
Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised and regulated by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO).
This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity. Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report.
Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

Private credit opportunities across consumer, mortgage and SME alternative loan markets

UK Specialist Lending Opptys_Integer Advisors 04 Jun 2019 (PDF Version)

Executive summary

In this report we focus on investable opportunities in the UK specialist lending markets, across the consumer, mortgage and SME sectors. ‘Specialist’ lending can be generally defined as lending related to non-prime borrowers and/or non-conventional loan types, and by definition sits mostly outside of the mainstream banking system. The UK is distinct in being characterised by a relatively deep and diversified alternative loan market, unlike any other European credit economy. We estimate the size of this alternative lending market is around £100bn in terms of outstanding stock, or around 6-7% of the total loan market.

Recent growth of the UK specialist lending market stems equally from the post-crisis bank disintermediation opportunity as well as the sizable captive audience of “underserved” borrowers, which in turn reflects the relatively narrow lending remits of mainstream bank lenders. Looking across the lender, borrower and loan type continuum in this niche credit ecosystem, we would note the following: –

• Lenders are a mix of challenger banks typically with narrower lending styles, non-bank specialist fincos, P2P/ marketplace platforms and even institutional asset management-based direct lenders. Among the non-bank constituency, origination and servicing (including workouts) are sometimes outsourced. Many models – beyond P2P/ marketplace platforms – have also embraced digitization in recent years, in terms of the lending interface, underwriting and borrower relationship management
• Borrowers sourcing credit from specialist lenders are those with non-mainstream credit profiles. For the most part, such borrowers generally have thin/ no credit history, or are credit impaired / adverse given past uncured delinquencies, or are considered non-standard for other reasons (low income, self-employed, inconsistent address history, etc). Alternative borrowers can also include the highly indebted, whether household or small business
• Loans originated within the alternative space would typically be ‘off-the-run’, whether for reasons of complexity, risk-layering and/ or non-mainstream use of proceeds. In the SME market, specialist loans tend to be characterised by small ticket, unsecured credit.

In scoping the potential private credit opportunities related to UK specialist lending, we use an approach that isolates such whole loan asset portfolios.  Our analysis finds that unlevered loss-adjusted annualised total returns in these specialised lending opportunities can range from the 4-6% area in the most credit defensive end of the lending spectrum, namely specialist first charge mortgages, to ca. 10-15% in the more established consumer and SME lending markets such as autos, credit cards and unsecured loans, to returns in excess of 35% for very specialised, high cost consumer credit such as payday or doorstep loans.  (In the case of the latter, we caveat the variability to such returns given potential loan loss / dilution volatility).  We also find that selected sectors – such as residential bridge financing and guarantor loans – look undervalued versus their immediate peers given lending yields that seem rich relative to impairments experienced over the recent cycle.

Many loan types within the specialist lending space are inherently leverable.  Such readily available gearing can provide enhanced returns for loan book (equity) owners, allowing even the most credit defensive lending types – which are typically the most leverable – to generate above-normal total returns.  Leverage also of course provides the debt investment channel into specialist lending opportunities, whether via public securitized markets or private facilities (direct secured financing, future flow funding agreements, etc).

However, existing investable capital market opportunities related to UK specialist lending – whether listed lender stock, bonds or securitized products – do not seem to fully capture the loan book return economics outlined above, unsurprisingly given the liquidity premium implicit in such instruments, not least.  (Certain risk assets – such as high yield or securitized bonds – look cheap versus traded comparables, however).  Private market alternatives such as whole loans (via marketplace platforms) and managed loan funds appear better yielding in this regard.  Among the latter, which tend to provide the most diversified exposure into specialist lending, we see the unlisted, PE-style fund opportunities as generally more compelling versus the listed fund (closed-end investment trust) equivalents.  In theory at least, unconstrained funds should be the most nimble in being able to exploit these private markets across debt and equity opportunities.

Total returns from investing in specialist loan books (hypothetical as the case may be) look appreciably superior relative to ‘traditional’ forms of private credit, namely direct corporate lending.  Moreover, there is little evidence that there has been any meaningful slippage in underwritten credit quality within the specialist lending markets, in contrast to direct corporate lending in which loan gearing and covenant protections have deteriorated in recent years, as widely documented.  But on the flip side, private corporate debt – particularly in the large cap, sponsored space – is more readily accessible by institutional money, whereas specialist lending is of course harder to reach.  For this reason, we think alpha generation among alternative credit funds invested in specialist lending markets has more to do with being able to originate these opportunities than it is just stock-picking

In our view, the key risks going forward, in terms of loan yield and origination resilience, comes from further regulatory reforms on the one hand, and lending competition on the other.  Legislative changes can forcibly regulate loan margins and narrow the origination bandwidth via tighter lending standards, outcomes that already have precedence in the high-cost lending sectors.  And what feels like the lack of competition in some segments of the industry today looks particularly susceptible to any reintermediation by mainstream banks, which could not only supress lending yields but also force specialist lending incumbents into more niche and/or riskier lending. (There are early signs of just such reintermediation in parts of the first charge mortgage markets, while bank online “flanker brands” are making inroads into other lending sectors).  Credit performance over the longer-term horizon would likely be negatively influenced by any such drift into a riskier product mix, as it would of course under any fundamental deterioration in economic variables such as employment, disposable incomes or house prices.  Notably however, unlike most other risk assets, we do not see specialist lending markets as being materially vulnerable to any normal shifts in interest rate paths going forward.

[All data used in this article – unless stated explicitly otherwise – is sourced variously from different public official sources including the FCA sector-specific reviews, securitization and P2P data, statutory reporting by listed lenders/ loan funds as well as other market research sources.  Please contact us for more details and/ or further market insights derived from our data research]

Profile of the Alternative Lending Markets in the UK

Genesis of this niche lending system

Alternative lending in the UK has no precise or standardised definition that we know of, with the terms specialist lenders, alternative finance and underserved borrowers often used interchangeably in describing the full reach of lending activity within the sector.  For purposes of this report, we look at lending that is characterised by non-prime borrowers and/or non-conventional loan types, outside of the banking system and mainstream loan markets.  While this definition is by no means perfect, we believe it captures the bulk of activity in the alternative lending, and ultimately institutionally investable, space.

We estimate the size of this alternative lending market is around £100bn in terms of loan stock, with mortgages (unregulated buy-to-let products mainly) comprising the bulk of this footprint.  On our estimates, this roughly equates to an alternative, or specialist, lending footprint of around 6-7% of total loan stock across the consumer, mortgage and SME markets.  Various estimates put the likely population of ‘alternative’ borrowers – defined as having non-mainstream debt outstanding – at between 10-12 million people, or some 20% of the UK adult population.

The UK is distinct in being characterised by a relatively diverse range of loan types within the alternative credit space. Whether unregulated BTL or payday/ doorstep credit or alternative finance for small businesses, the UK alternative lending market is arguably the deepest and most mature among any in Europe, dating back some 30 years to the onset of financial sector liberalisation in the 1980s.  Among developed economies, we feel only the US is characterised by a greater degree of specialist, non-bank lending.

Notwithstanding the established, decades-long momentum in the UK alternative lending industry, a number of key factors has served to reshape such markets over the post-crisis era, namely:-

1. More onerous capital requirements and risk governance on established mainstream banks, which led to narrower and more regimented lending remits, in turn fuelling greater disintermediation opportunities for the likes of non-bank, alternative finance providers. Banks effectively pulled out of any ‘stretched’ lending into consumer and small business sectors, with such attrition compounded by the complete withdrawal by many foreign bank lending subsidiaries
2. Reduced role of securitization as a capital market outlet, which not only proved destructive to many originate-to-distribute finco models in this space but also fuelled newer formats of ownership and funding among the private specialist lenders that survived the crisis. This gap was largely filled by alternative institutional investors – PE, for the most part – that have provided fresh equity and debt financing (whether via direct facilities or forward flow agreements, etc) to many specialist lenders
3. Greater regulation across many aspects of this ecosystem, from lending and underwriting standards, borrower protection, capitalisation, securitization etc which has influenced everything from lending styles and target borrower markets to funding and capital considerations, not to mention the very survivability of a number of lending models. We expand on regulatory reforms later in this article.

Lenders in the UK alternative lending space have historically been led by a constituency of finco originators simply called “specialist lenders”.  Over the post-crisis era, such lenders have comprised larger, listed players as well as private fincos, often originate-to-distribute models seeded or funded by alternative/ PE investors, as mentioned above.  Selected challenger banks with narrow, specialist lending styles have also emerged in the post-crisis period, as have online lenders such as P2P/ marketplace platforms, arguably one of the most notable developments in alternative finance in recent years.  Institutional asset management-based direct lenders have also become more noticeable in the SME financing space than at any time in the past, though their lending activities tend still to be weighted more into larger corporate (often sponsored, leveraged) lending.

Save for the larger fincos and online platforms who enjoy direct borrower channels, most other speciality lenders originate loans via the established broker networks in the UK.  (In the case of certain HCSTC markets, intermediaries called “lead generators” are also used to source product).  Loan servicing and workout management are also commonly outsourced to third-parties, leaving many speciality lenders with funding and portfolio management responsibilities largely. Specialist lending has seen increased digitization in recent years, with online lending interfaces becoming very much the norm.

Borrowers in the specialist lending market are characterised typically by non-mainstream credit profiles.  This could span thin or no credit history, credit impaired / adverse given past uncured delinquencies, or non-standard credit status for other reasons (low income, self-employed, inconsistent address history, etc).  Alternative borrowers can also include the highly indebted, whether household or small business, and borrower seeking financing for non-mainstream purposes.

Loans originated within the alternative space are normally ‘off-the-run’ by nature, that is, products that are generally more complex and/ or risk-layered.  We see a trade-off of sorts with borrower credit profiles in this respect, meaning that the more layered such loan products are, the more mainstream the borrower is likely to be.  In other words, a subprime or credit-adverse borrower would likely only be eligible for a standard loan from an alternative lender, whereas a prime/ near-prime borrower could avail more complex products (high gearing, speculative loan purposes, etc).

Recent market growth and the impact of regulatory reforms

The market for alternative lending in the UK has experienced relatively steady growth overall in recent years, following the sharp contraction in the aftermath of the crisis.  But growth has been uneven across the different sectors, indeed the overall observation masks somewhat divergent trends in individual markets.  We would make the following notable observations: –

• Car finance in the alternative space experienced sharp growth up to 2016/17, prompting concern and greater oversight from macro prudential regulators. Growth has moderated more recently
• Unsecured personal loans – and especially point-of-sale retail credit – has also seen above-trend growth recently. By contrast, the likes of payday loans and doorstep credit – and indeed any lending that has come to be defined as ‘High Cost Short-Term Credit’ or HCSTC – have moderated in volumes, with greater regulatory oversight as well as better consumer credit literacy in recent years taking a toll on both lending and borrower demand
• Unregulated buy-to-let mortgages have also witnessed weakness in lending volumes in recent years since the sharp spike in the run-up to the new tax regime in early 2016, with macro factors and the fiscal disincentives weighing on the market more recently
• Alternative mortgage types such as residential bridge loans, second charge mortgages and equity release products have seen relatively strong growth in recent years, fuelled largely by household demand to realise value locked in home equity. Second charge loans have seen particularly strong growth recently, up 20% yoy in February 2019, according to EY

Growth in alternative SME financing looks to have been steady in recent years, however the availability of data (or even estimates) for this market is particularly challenging. From what we can tell, non-bank alternative lenders have noticeable footprints only in specialised markets such as invoice financing.  In more vanilla (unsecured) lending where banks still dominate, the emerging role of P2P/ marketplace platforms in recent years has been notable, with such conduits accounting for nearly 10% of new SME lending flows (but still much lower in terms of the share of lending stock), on our estimates. Post-crisis rules requiring mainstream banks to refer declined SME credit to alternative lenders is a key driver of this emerging non-bank activity, in our view.

Regulatory reforms that have been rolled out in recent years are arguably the most significant factor shaping the market for alternative lending in the UK.  Taken in its entirety, regulatory reforms in the post-crisis era have of course been wide ranging in their scope and aims, affecting lending activity across bank and non-bank/ alternative markets, to include mortgage, corporate and consumer lending.  However, reforms to non-mainstream lending practices in the UK consumer credit market, in particular, have looked the most profound.

Consumer finance came under the regulatory net of the FCA from April 2014, prior to which the Office of Fair Trading was responsible for overseeing the compliance with the Consumer Credit Act, or CCA.  The FCA supervision essentially covers all lenders and intermediaries, with the scope of regulations encompassing credit advertising, lending conduct and adequate transparency of loan terms (to include expressing lending rates as APRs) as well as debt management/ collection, among other practices.  (The FCA rules, which reflect a principles-based regime, are enshrined in its Consumer Credit Sourcebook).  Within the consumer finance space, credit agreements that are regulated are specifically lending to individuals (< £60,260) or sole traders/ micro partnerships (< £25,000).

The most disruptive aspect of consumer finance regulatory reforms has been in the “HCSTC” sector, defined by the FCA as regulated unsecured loans less than one year in duration carrying interest at over 100% APR.  Not all forms of HCSTC have come under greater regulation at this stage, only the likes of payday loans and certain types of RTOs.  (Logbook loans – which falls under legislation governing Bills of Sales – as well as doorstep and catalogue credit are excluded from the rules, for now).   The new regulatory regime for HCSTC, which came into effect at the beginning of 2015, is uniquely prescriptive.  Aside from relatively comprehensive governance around responsible lending (including affordability checks) and product transparency, the new rules also feature economic limits on lending, namely:-

• Cap on interest rates (including fees) of 0.8% per day (nearly 300%+ on simple annualised basis). Further, default fees are limited to £15 per loan
• Overall total borrower costs (interest + fees) capped at 100% of sum borrowed
• Limits to loan rollovers of two times, with similar limits for lenders seeking continuous payment authority
• And in the case of RTO loans, new rules since April 2019 regulate pricing of ‘bundled’ goods sales (where the bundle includes insurance, warranties, etc), in effect capping the cost of the non-goods element at the cost of the goods themselves.  Additionally, firms are required to conduct price benchmarking exercises to mitigate risks of overly inflating goods prices, often for reasons of subsidising credit costs.

The reforms have had far-reaching effects on the industry, not least on the scope of originations and lender profitability.  (According to a CMA report, payday lender returns on capital were as high as 40+% in 2013 on the eve of the new regulations, falling sharply since then). Aside from shrinking the lender industry, the new regulations have also de facto shaped typical loan structures in the marketplace, in terms of rates, tenors and the amounts lent, as lenders have attempted to limit the regulatory impact or bypass the new rules altogether.  However, the flip side of reduced lender profitability has been better default behaviour, according to anecdotal evidence. We see the reforms as also helping to cement the longer-term viability of certain forms of specialist lending, albeit at the likely expense of origination opportunities.

Dissecting Returns in the UK Alternative Lending Market

In this section, we analyse hypothetical total returns that can be derived from such alternative loan types, ahead of discussing current investable opportunities in these markets.  We use an approach that isolates the whole loan asset portfolios.  By this we mean looking at nominal yield and loss estimates related to typical loan books which are hypothetically carved out of the lender, in effect therefore net (or loss adjusted) portfolio income margins, which are of course distinguishable from opco equity returns.  Where possible, we also adjust for any ancillary fee income that supplements loan book yields as well as operational costs related to loan portfolios (servicing and delinquency management mostly), with such cost estimates derived mostly from securitization transactions.

Sizing potential risk-adjusted loan book returns

On a wider observation, we would note that nominal loan book yields in specialist/ alternative lending markets in the UK are generally higher than the equivalent in most of developed Europe (currency unadjusted), and certainly versus the core EU credit economies, which remain heavily banked by comparison.  However, relative to like-for-like alternative loan products in the US, lending yields look much less distinguishable, indeed in certain sectors (subprime consumer finance, for example), nominal loan yields in the US appear richer, unadjusted however for risks or the currency basis.

As we elaborate below, yields in the alternative lending space range from ca. 4-6% among the most defensive loan products (mortgages namely) to upwards of 100+% for very specialised, high cost consumer credit.  Yields on most specialist loans and mortgages have been largely range-bound in the past few years.  Notable exceptions however are the likes of payday loans, in which both lending rates as well as fees have been driven lower by the HCSTC regulatory reforms from 2015, not to mention pressure from consumer groups.  Near-prime credit cards also stand out given portfolio yields that appear very sticky, having been mostly unchanged since the pre-crisis days.  Our take on loss estimates over the past year or two in specialist sectors – sourced variously from FCA reviews, securitization and P2P data as well as statutory reporting by listed lenders/ loan funds – also highlights clear demarcations by lending types, which roughly mirrors loan yields

Coming now to total risk-adjusted returns related to (hypothetical) investments into such loan books. Total unlevered returns after losses tend to cluster into the three bands, in our view, described by their headline yield ranges and estimated loss experiences: –

• Starting with the most credit defensive end of the lending spectrum, investing in specialist mortgages – comprised of unregulated BTLs and other alternative products (adverse credit, high LTV, etc) – looks to generate total returns in the 4-6% range, with higher quality BTLs in the lower end of that range and the likes of second charge products at the upper end. Residential bridge loans are an outlier by most return measures, as we touch upon below. First charge mortgages typically yield between 4.5% and 6% including fees. Second charge mortgages usually yield 6.5% or higher, depending on risk profile.  (All of these observations are corroborated by respective RMBS pool yields).  Total returns are not far off such yields given the superior credit performance of mortgage products, where annual realised losses are typically no more than 0.4%.  There has been little loss variability among mortgages over recent cycles. Residential bridge financing is a notable outlier, however.  Lending rates of between 12-15% typically have little incremental losses, relative to other owner-occupier or BTL mortgage products, to show for it.  Low losses in bridge loans are explained by the typically conservative LTVs among such products, averaging only 55% in 2018, according to MT Finance (and up from 45% a couple of years earlier).  Bridge loans are also an outlier from a tenor perspective, being far shorter dated (< 18 months typically) than other mortgage types, which normally have weighted average lives of anywhere between 2 and 5 years, notwithstanding final maturities that can be up to 25 years.  Second charge mortgages seem also to be somewhat undervalued by this same measure, albeit to a lesser degree

• Total unlevered investment returns in the bulk of established consumer and SME lending – such as autos, credit cards, unsecured loans, more vanilla point-of-sale credit and invoice financing – look to be in the high single digits to say around 15%. Better quality unsecured loans to households and small businesses tend to generate risk-adjusted returns in the high single digits, whereas the likes of near-prime auto and credit card lending fall in the 10-15% range, generally speaking. Durations for such assets range from the ultra-short, revolving types (cards, invoices) to term loans typically up to 2 or 3 years in maturity. The above findings are based on headline lending rates that fall mainly in the 10-20% range, with many such ‘mid-cost’ specialist loans originated by a wide spectrum of lender types, including P2P platforms.  Near-prime credit cards stand out for their appreciably greater portfolio yields in in the 25-40% range, however such portfolios tend to exhibit higher charge-offs as well, typically in the 14-16% area.  The more vanilla forms of unsecured consumer and SME financing can be shown to experience losses in the range of around 1-4%, with auto financing typically in the lower end of this range (subprime loans excepted).

• And finally there are the highly specialised consumer finance markets that are priced at 50+% yields (and often greater than 100% or even 200% annually). Such loan types include payday, RTO, doorstep credit, logbook and guarantor loans, many (not coincidentally) falling under the auspices of HCSTC as defined by the regulator.  For the most part, borrowers in these loan categories are subprime (or ‘deeply’ adverse in some cases) in terms of credit scoring, rather than having non-standard credit statuses for reasons other than payment behaviour, as is sometimes the case of borrowers in other specialist lending markets. Loans in this category tend to be short-dated but can extend up to 3 years in tenor.  Indeed, regulatory reforms put in place since 2015 have, by all accounts, fuelled a lengthening of loan terms as lenders seek to minimise the impact from the rules. In this higher-beta end of the market for specialist consumer loans, losses tend to vary relatively significantly – from around 5% of annual write-offs in the case of certain RTOs to nearer 10% for logbook loans and higher risk PoS financing to 40%+ for the likes of some payday and doorstep credit, in which of course lending rates are typically in the 100%+ area. Volatility around these ranges varies noticeably given what can be highly unpredictable credit exposures. Loss-adjusted total returns in such specialist consumer loans can (hypothetically) be in the 35%+ range, however as remarked above there is noticeable variability to such returns given loss variations as well as servicing costs, which may not be insignificant in such loan markets. Our observations are therefore academic for the most part.  Moreover, the very small market footprints for some of these high cost credit sectors would arguably make them almost uninvestable for all intents and purposes, from the standpoint of institutional money. Yet, there are some interesting observations to make.  Segments such as guarantor loans and certain RTOs, for instance, can be shown to exhibit impairment rates that are appreciably better than the broader sector, yet are based on lending rates that largely mirror the market (40/50%+ annually).  The potential volatility around such losses notwithstanding, there is evidence to suggest that credit performance among such highly specialised lending sectors is much more uneven than otherwise indicated by the very high loan yield ranges.

The linear relationship between loan yields and expected losses is evident to some extent in the specialist lending markets, but as highlighted above, by no means is this correlation universal. Sectors such as residential bridge financing and guarantor loans look ‘undervalued’ against immediate peers, precisely given lending yields that look rich relative to low and predictable impairment risks over cycles.

An important caveat to our discussion above is the potential variability of underwritten credit risk and loan margins within any one specialist lending sector.  While we feel the above analysis captures the bulk of loan profiles (or the ‘bell’ of normally distributed observations), loan credit quality and yields can vary – sometimes significantly – in any given sector, largely reflecting the different lender models and risk appetites.  Take auto finance for instance.  Subprime auto lending is characterised by markedly different risk/ return metrics than near-prime or other alternative auto loans, as highlighted in the recent FCA review of the sector.  Loan rates of up to 40% are not uncommon in auto finance originated to adverse credit borrowers, but this only makes up an estimated 3% of total auto lending, according to the FCA.  Conversely, not all specialist consumer loan markets such as payday lending or catalogue credit are priced at very high rates – there is equally a ‘tail’ of the market that caters to better quality borrowers (often seeking financing convenience instead of rate shopping), which carries yields that are more normalised. We would also highlight that specialist mortgage markets have very thin ‘tails’ in this respect (that is, there is very little outlying lending styles described by meaningfully higher loan risk/ yields), arguably given the widespread rules around underwriting standards based on affordability prescriptions.

The role of leverage in investment returns

The use of gearing in private loan markets is common, with opportunities in UK alternative lending no exception.  Indeed, many asset types within specialist lending are inherently leverable, particularly of course the stable, fixed income-like loans, such as mortgages.

Leverage allows loan book (equity) owners to enhance returns.  Such equity investments are typically represented – to varying extents – in managed loan funds, whether listed trusts or private unlisted PE-styled funds.  Our proceeding discussion looks at hypothetical leveraged equity returns across different loan types, and is conceptual rather than scientific given that we are using a very broad-brush approach with one-size-fits-all assumptions.  All we are doing is demonstrating that returns can be appreciably enhanced through leverage, adjusting the extent of gearing allowable by asset type so as to make the end-findings comparable.

In order to size the potential gearing quantum by asset type, we consider risk-constrained leverage – in this case we define the latter by the typical attachment points for investment-grade financing advances against each loan book type, which we derive from existing securitizations. (By definition therefore, gearing thresholds here are dependent on rating models for the respective asset types, which in turn will be influenced by a host of factors including credit resilience and performance track records, among many others). Our findings show – unsurprisingly – that the more credit defensive (or predictable) and established sectors, such as mortgages and autos, are generally more ‘lever-able’ versus the likes of unsecured SME or consumer credit.  Assets such as BTLs or alternative first-lien mortgages, or indeed granular specialist auto loan pools, can be geared (using investment grade facilities) 10-15x, whereas the equivalent risk-constrained leverage ceiling for bridge loans or unsecured credit or specialist high cost consumer lending seems to be nearer 3-7x.  Near-prime credit cards also fall in the latter category.

With such leverage, established sectors such as specialist auto loans look to generate among the most compelling total returns for equity positions in such loan books, notwithstanding the academic exercise herein.  Even sectors such as BTLs can (hypothetically) generate equity returns into the 30%+ range with conservative extents of gearing. Our point here is that looking at risk-adjusted unlevered returns alone does not capture the full investment case. By exploiting leverage, total return differentials for equity between the more established markets and the high-beta specialised lending sectors (such as say payday or doorstep credit) look much less distinguishable.  Employing leverage is not without risks of course, in effect gearing in this case involves taking incremental financial risk to get closer to high cost, high (credit) risk lending returns.

Leverage financing in itself of course mirrors the channels for debt investing into the specialist loan markets, which can range from public bond and securitization markets to private, often bilateral, facilities ranging from direct asset financing to forward flow loan purchase agreements.  Within the former public markets, asset-backed securities tend to dominate, indeed the widespread use of securitization as a term financing / leverage outlet for owners of such loan books is testament to the leverability of these loan types.

Private financing agreements have become more common in recent years – from what we can tell such facilities are typically priced at appreciable spread pick-ups to public equivalent securitizations, which – judging from recent clearing spreads – typically equate to weighted average yields of 2.5-3.5% (depending on asset type) for the investment grade component of ABS/ RMBS capital structures

Understanding the risks to specialist loan book returns

Based on our simplistic analysis where annual loan book returns are a function of yield (and fee) carry less credit losses, it follows that any risks to such returns comprise factors that could potentially influence yields and/ or loss performance over the longer term.  Among such factors, we would highlight the following:

• We think a key risk to loan yield resiliency – and indeed the sustainability of origination volumes – is the scope for further regulatory reform, which have already had an influential role in moderating lending rates and volumes in certain high cost consumer credit sectors. More regulation is still to come targeted mainly at the niche rather than established specialist lending markets
• Yet another key risk is the potential reintermediation of such markets by mainstream banks, fuelled – not least – by institutions that are generally flushed with capital trapped by contemporary ringfencing rules. This trend looks to be taking hold already in some parts of the first charge specialist mortgage market. Any lending ‘creep’ among specialist lender incumbents into riskier borrower markets, either because of such competition from deposit-takers and/ or other profitability pressures, could also of course shape the loss experienced by such lending in the future
• Unlike more mainstream loan markets, the path of interest rates can be shown to be a relatively insignificant influence on loan yields – which are mostly priced with significant headroom to rates – in all but the most defensive alternative lending segments such as first charge mortgages. For the same reason, we see the credit impact of any adverse interest rate shifts being limited mostly to mortgages (if at all) given both the typically long-term debt burdens and tighter relationship to base rates.  By contrast, the high yield characteristics of most other alternative lending products, not to mention the typically high turnover (or short tenor) nature of such loans, arguably makes credit performance less sensitive to policy rates in any but the most prolonged or severe of tightening cycles
• Losses are of course vulnerable to cyclical downturns or shocks. A full analysis of loss vulnerability is outside the scope of this high-level report, however we would highlight employment and disposable incomes as powerful predictors of loan performance in most alternative consumer finance markets. (Indeed, an analysis by the BoE Financial Stability Report in June 2017 found a meaningful correlation between consumer credit losses and unemployment, lagged 12 months)
• Borrower “willingness-to-pay” is also an important consideration in terms of credit performance, particularly among the high cost consumer credit sectors. Non-economic factors are relevant in this respect, which can range in our view from cases of dissatisfaction with goods purchased via credit (to include examples of say loans secured against used cars or white goods) to other forms of strategic defaulting among high cost borrowers given lender failures and/ or changes in borrower behaviour towards loan rates seen as usurious or predatory.  (As a case in point, complaints related to payday loans rose five-fold in the past year, according to Resolver, an independent complaints website)
• Losses can also be influenced of course by the quality of loan servicing and delinquency workouts at the lender or servicer level. The benign cycle recently has not provided any meaningful test of workout capabilities among the current breed of lenders, many of which only emerged in the post-crisis era.

Mapping Investment Opportunities in Tradable and Unlisted Markets

Institutional investment into UK alternative lending assets prior to the crisis was limited largely to securitization capital markets, whereas today the opportunity presents itself across listed stocks/ loan investment trusts and unlisted “opportunity” funds, whole loans (via marketplace platforms mostly) as well as securitized products and other debt types: –

• Listed equity opportunities are represented via the stocks of selected larger lenders as well as listed loan funds (or closed-end investment trusts, to be exact) managed by institutional investors. Listed loan funds typically invest in a broader array of opportunities via a mix of loans as well as securities, but – with a few exceptions – tend still to be bucketed by type, for example, online/ P2P loans or real estate assets or other single-sector exposures such as SME direct lending
• Securitizations of specialist loan books dominate the debt capital markets, especially of course in established lending markets such as mortgages, autos and credit cards. A few lenders also issue bonds directly, secured via floating charges over substantially all of the unencumbered assets of the lender – such bonds span low investment grade (sold into retail markets often) to high yield (institutional).  Debt issuance in any form, which serve also as a leverage tool, tends to be limited to the more established lenders with sizable loan books and origination flows
• Whole loans feature as a newer investable channel courtesy of P2P/ marketplace platforms, the vast majority of which emerged over the post-crisis era. Such loans tend to be in specific sectors such as SME or consumer or property lending, with platforms having a more diversified product suite being rarer
• Unlisted institutional funds, often structured as locked-up, PE style vehicles. Investments by managers in this regard can include debt (whole loans, asset financing, etc) and equity (loan book residuals and/or stakes in fincos).  For the most part, investments in UK specialist lending among such unlisted funds are part of broader private market strategies, commonly carrying such brands as alternative or tactical opportunities, principal finance, and so on.  We only know of a very few select funds that are dedicated to such specialist lending markets.

Investable capital market opportunities related to UK specialist lending – whether listed lender stock, bonds or securitized products – do not look to fully capture the loan book return economics outlined earlier.  This is unsurprising in the context of liquidity premiums implicit in such traded instruments, that aside such term debt or permanent capital is usually associated with more mature lending models.  With the exception of securitized residuals, asset-backed bonds across senior and mezzanine capital structures, for instance, yield noticeably lower than the whole loan equivalents.  Sub-investment grade lender bonds, commonly priced in the 7-9% area, are similar in that respect.  Stocks in listed lenders have generally underperformed from a total return perspective in recent years, with loan book economics heavily outweighed by lender-specific event risks.  All that said, we would note that certain risk assets related to specialist lending – such as high yield or securitized bonds – look cheap versus their traded peers.

Private market, illiquid alternatives such as whole loans (via marketplace platforms) and managed loan funds appear to better capture the return economics inherent in specialist loan books, in our view.  Buying whole loans via marketplace platforms is an entirely new investing format, as is (largely) investing via loan funds. Marketplace whole loans can yield anywhere between 5% to upwards of 10%, depending on both credit risk categories and asset type, with consumer loans in the lower end and SME risk in the higher end, generally. (This simple observation ignores potential loss risks in such loans of course).

Managed funds investing in specialist credit markets comprise unlisted opportunity funds and selected listed investment trusts.  Listed funds afford greater transparency of course in terms of asset profiles and underlying returns, with stock price action also a useful barometer for end-investor appetite for such strategies. In this respect price trends among some closed-end trusts have been stable as have dividend payouts (with above-market yields typically), however total returns in some others have been disappointing in recent years.  Reasons for the out- or under-performance vary, but fundamentally reflects the sentiment of equity income investors who make up the bulk of the buyer base for such listed investment vehicles.

In theory at least, unlisted PE-style funds seem arguably best placed to provide diversified exposure into specialist lending sectors, in our view. Such funds have the benefit of being able to manage a mix of assets and exposures over the longer-term, without the burden of daily liquidity oversight (unlike listed loans funds). Conceptually at least, such vehicles are likely to be more nimble in exploiting debt and/ or equity value (optimizing the use of leverage either way) within the specialist lending markets in the UK, tapping ‘off-radar’ or bespoke opportunities away from the more mature and established types typically represented in the capital markets.  But by the same token, we see alpha generation among such funds coming from the ability to source such ‘hard-to-access’ private opportunities, rather than asset selection per se.  In-house capabilities to manage credit risk over the long-term would also be a key attribute, in our view.

Benchmarking returns to comparable investment types

Total unlevered returns in the 4-6% range for mortgages and certainly the 10-15% range (or higher) for most other established specialist lending markets looks compelling of course versus most other comparable broadly traded markets, whether bonds (where HY benchmarks trade in the ca. 3% range) or corporate loans (par leverage loans ca. 4% currently). This yield basis to public markets has come to be a textbook mantra for private market investing, but of course overlooks the liquidity give-up in the latter opportunities.

Comparing specialist lending opportunities to other established private credit investing is a challenging exercise given the lack of returns data across unlisted funds in these markets.  ‘Private credit’ investing has come to be associated with direct lending into mid-market or large cap corporates, typically via sponsored leveraged facilities.  Based on available data from both Bloomberg and Preqin, we would surmise that funds invested in the vanilla end of such strategies (that is, excluding special situations or distressed, etc) have in the recent past generated total returns of approximately 6-9% annually.  Looking through such fund returns into the underlying asset types, we would note that private senior or unitranche loans to corporates typically yield in the 5-7% area (source: Deloitte).

By the above yardsticks, specialist lending in the UK looks to generate superior yields and returns relative to the more ‘traditional’ form of private credit.  Moreover, unlike direct lending in the corporate sectors where loan gearing and covenant protections have weakened in recent years, there is little evidence that there has been any meaningful slippage in underwritten credit quality within the specialist lending markets (indeed, if anything, certain high cost/ subprime markets have seen regulations limit aggressive lending practices).  Part of the reason why there are better yield opportunities in specialist lending versus direct corporate lending is, in our view, the tighter supply of financing (or equally, lesser institutional penetration) coupled with a captive borrower audience in which demand is arguably more price inelastic.  Private direct corporate lending, by contrast, is better characterised as being a borrower-friendly market currently, reflecting the heavy institutional inflows and lending deployments.

Potentially compelling risk-adjusted return opportunities certainly merits more prominence for UK specialist lending-related investments among institutional private credit strategies, a development that we see taking hold before long.

[Please contact us for more substantive intelligence into risk-return benchmarks in these markets, including insights into the manager universe]

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From Direct Lending Funds to the Capital markets?

Private Credit Middle-Market Opportunities in Europe (PDF version)

Executive Summary

This commentary explores the market for lending to middle-market corporates in Europe, with the ultimate aim of understanding the investment opportunities in this respect.  Middle- market credit has emerged in recent years as a distinct asset class in Europe, but for now is largely manifest in private credit direct lending (unlisted) funds.  We see potential for such opportunities to spill-over into the tradable capital markets before long, as we touch upon below.

Private credit, or direct lending more specifically, is a post-crisis phenomenon that coincided with bank lending retrenchment in Europe given capital/ leverage constraints and more conservative risk appetites. The term ‘private credit’ tends to be a catch-all for lending to companies, covering senior to subordinated /PIK to distressed financing.  Within this, “direct lending” is generally seen as the more vanilla lending strategy, often branded as senior loans to middle market borrowers.  For the purposes of the proceeding discussion, we would broadly define middle-market companies as firms with earnings of between €15mn and €50mn as the upper-most boundary, with debt ranging up to €250mn.

Institutional money inflows into European private credit direct lending funds has looked relentless in recent years, with total AuM among such funds estimated at €100bn+ currently.  Yet the share of institutional funds versus banks in the overall corporate credit economy is still very small in Europe (less than 3% on our estimates), although such funds appear to be capturing an appreciably greater share of new loan flow.  On this observation alone – and considering the extent of institutionalisation in the more mature US corporate credit economy (non-bank penetration estimated up to 60%) – this direct lending ‘revolution’ appears to have a long way to run before being exhausted.

But in our view, the direct lending model faces certain challenges in building a lasting footprint in the European corporate credit economy, key among which include:

• Deploying AuM into more diversified loan markets. Direct lenders have been able to compete based on their ability to underwrite more complex or ‘off-the-run’ credit relative to banks, but evidence points to both origination bottlenecks generally (highlighted by the extent of fund ‘dry power’, not least) and lending concentrations into sponsored and/or larger-ticket syndicated loans. (Indeed, mid-market non-bank lending seems largely an import of leveraged loan market practices). Establishing deployable origination niches away from what seems like a crowded market in lending to such companies, and into more mainstream borrower segments, would better anchor the long-term viability of the direct lending model, at least in our view
• Loan credit management, particularly under any cyclical stresses to come. Notwithstanding the generally superior credit performance of mid-market loans versus large cap equivalents in the recent past, the real test for this young alternative lending sector is of course still to come. Against the backdrop of unparalleled investment inflows and likely origination deployment pressures over recent years, we feel there are legitimate concerns around lending discipline, adverse selection and vulnerabilities to idiosyncratic events, risks which should become more transparent in any credit recession going forward. The workout capabilities of direct lenders have also yet to be fully authenticated, noting the benign credit cycle hitherto.

In building a resilient private credit model that outlives the current ‘bubble’ and any cyclical correction to come, we would surmise that direct lenders will need to replicate to some degree the origination and credit management infrastructure of the bank lending system in Europe.  Doing so is tantamount to becoming ‘owners’ of credit rather than traders/ managers.  Navigating such challenges successfully should create a more permanent, meaningful footprint for such alternative lending models in the European credit economy, where bank disintermediation opportunities generally remain compelling.  (To be sure, direct lending funds in middle-market credit have little by way of non-bank lending competition in Europe currently).  From where we are today, raising fresh capital to drive such institutionalisation seems the least of the challenges ahead.

As the institutionalisation of the middle-market credit system in Europe matures further, we expect capital market opportunities to emerge as alternatives to investing in unlisted direct lending funds.  (Tradable markets are already established in SME credit and leveraged loans, either side of the middle-market lending spectrum).   We see the development of such capital markets being fuelled by demand from direct lending funds for alternative channels of permanent capital (via public equity listings) and/or alternative sources of leverage (via CLOs namely), trends that have driven deep capital markets for middle-market lending in the US.  Absent any credit cycle shocks over the foreseeable future, the tempting risk/ return profiles of middle-market private credit should also lend to this capital market growth.

Scoping the opportunity set in Europe

Notwithstanding the fact that middle-market direct lending is for now by-and-large an import of lending technology that is established in the large cap leveraged loan sector, the capital market or tradable footprint for such opportunities remains distinctly in its infancy, in sharp contrast to the institutionalised large cap market which is visibly represented both directly and indirectly via the established CLO market as well as a relatively deep market for listed loan funds.

Indeed, if we were to isolate middle-market direct lending opportunities, to our knowledge there are no listed funds in Europe at this stage.  Moreover, there are no pure middle-market CLOs in Europe either, as yet, though a few deals have portfolios with not insignificant portions of mid-market loans.  (A recent example of such a transaction is PGIM’s Dryden 63).  And even further afield in the market for capital relief transactions related to bank-originated mid-market loans, we know of just one CRT trade – the Lloyds Cheltenham deal from end-2017 – that is based on credit protection of a mostly middle-market corporate book.  (To our knowledge, four other bank CRT trades have come with a mix of SMEs and mid-market loans).

The largely unlisted nature of mid-market credit opportunities in Europe – certainly in the case of opportunities related to non-bank direct lenders – is somewhat puzzling considering the scale of investor appetite for such opportunities currently, manifest in the rapidly growing footprint of (unlisted) direct lending funds in Europe. The lack of capital market opportunities stands in distinct contrast to other segments of corporate lending in Europe, namely SMEs (represented via ABS and listed equity funds as well as P2P platforms) and large cap lending (syndicated tradable loans, listed equity funds and CLOs).  Europe also differs noticeably to the US in that respect.  Tradable formats of US middle-market lending include the likes of the now-established BDC (Business Development Companies) market as well as other listed vehicles such as retail funds.  Moreover, the middle-market sector is a defined sub-asset class within the US CLO universe, witnessing nearly $30b in primary volumes over 2018.  This capital market opportunity set in the US is poised to grow further with BDCs recently permitted to lever up to 2x (as opposed to a 1x ceiling before) while also being allowed to issue CLOs as a tool for such gearing, following the recent SEC no-action letter on risk retention.  (The risk retention rules were rescinded for “open market”, large cap CLOs early in 2018 but mid-market CLOs, and sponsors such as BDCs, were still deemed to be subject until recently).

As we also reflect in the outlook section below, we think the European middle-market credit opportunity will spill-over into the capital markets before long.  But for now, investor access to such opportunities is limited mostly to unlisted private credit funds.  We would note that the biggest funds still dominate the overall market, with a relatively long ‘tail’ of smaller, often more specialised, funds. Counting among the more dominant mangers of European unlisted direct lending funds are firms such as ICG, Ares, Hayfin, BlueBay and Alcentra, with the likes of Pemberton, Permira and Tikehau also emerging more recently with sizable direct lending strategies.

At this juncture we would make the notable observation that the pre-crisis era offered more capital market opportunities in the mid-market space in Europe, namely via highly esoteric CLOs. Germany, in particular, witnessed a number of originate-to-distribute platforms (a few of which were bank-sponsored) where lending activities were focussed on mid-market corporates.  But in sharp contrast with direct lending funds today, such platforms were engaged in hybrid/ mezzanine or ‘profit-participation’ lending strategies, offering corporates tax-friendly, enhanced leverage versus what was available from the banking system, or indeed to corporates without access to banking credit at all. In the event the asset class did not survive the 2008 crisis, nor did most lending platforms.  Defaults significantly exceeded original expectations, driven by the degree of adverse selection coupled with excessive gearing.  At its peak, such mid-market CLOs totalled more than €5bn.

Exploring the risk/return profiles

Analysing the risk/ return characteristics of the middle-market corporate credit opportunity in Europe at this stage is more art than science, given the lack of transparency in the absence of any authentic capital market activity.  Unlisted funds do not systematically report returns – nor indeed any measure of risk exposures – as part of their normal course of business.  Still, we feel there is sufficient data (observed or anecdotal) available to generally size the risk/ return profile of the European middle-market opportunity.

According to data from Deloitte, European mid-market loans yields range from ca. L+5%-6% for senior secured to ca. 7% for unitranche facilities and up to 10+% for junior, equity-like exposures.  (All observations herein are based on data published prior to the year-end credit market sell-off).  Generally, non-bank originated mid-market loans in Europe appear to yield more generously than larger cap leveraged loans (L+3.5%-4% in normal periods, typically).  And to the extent observable, middle-market loan yields are superior to equivalents in most European private placement markets, certainly in the case of the mature, established sectors like Germany’s Schuldscheine market.  By way of headline comparisons, US mid-market loan sector yields average approx. 6%-7% as at Q3 2018 (Source: Thompson Reuters), have traded in a relatively stable range over the past few years.

The relative value of alternative mid-market loans versus comparable credits in the traded market is therefore plainly visible in headline spread differentials.  (By comparable credits we mean sub-investment grade paper).  Yield premiums to broadly syndicated leveraged loans typically average ca. 200bps (similar to the US), with this differential appreciably greater (ca. 300-350bps) compared to traded high yield BB-rated bonds.  However, we would caution against over-emphasising the yield pick-up in this regard, simply because mid-market loans in Europe are at this stage inherently illiquid compared to syndicated leveraged loans and of course the high yield bond market.  (In other words, the yield premium could arguably be justified as an illiquidity premium).  As a case in point, mid-market loan yields are seemingly no more generous than margins normally observed in the smaller SME segment, where non-bank secured loans can yield up to 6%-7%.

Returns on direct lending funds currently provide the only performance yardstick for middle-market credit opportunities in Europe, in the absence of any observable capital market alternatives.  For the purposes of understanding such fund returns, we refer to data provided by Preqin as well as fund IRRs reported by Bloomberg.  According to data from Preqin covering all direct lending funds globally, net total returns have ranged between 6% and 9% annually since 2014, prior to which returns – in what was a smaller, disparate market for such funds – were noticeably higher (reflecting higher loan yields not least), typically in the 10-20% region.  Our analysis of Bloomberg data, isolating direct lending funds in Europe, show reported IRRs broadly in the same ball-park since 2014 (i.e., 6-9%).  In any case, these anecdotal data clearly evidence that mid-market direct lending opportunities in Europe have, to-date at least, delivered returns that look to be superior to most comparable traded debt markets, arguably also outperforming from a risk/ return perspective noting the more volatile public markets.  While fund returns hitherto have commonly been paraded as being uncorrelated to traded risk assets, we feel the relatively short life of such funds has not provided any meaningful opportunity to demonstrate the true extent of any performance linkages just yet.

Our analysis of Bloomberg fund IRR data highlights a notable dispersion of reported returns.  To make our point, we note that the IRRs among such funds in Europe averaged around 6%-6.5% annually in 2016/17, but with a standard deviation of 7% over the two-year period.  In cases of funds posting above-market returns recently (or alternatively, returns not commensurate with mid-market par loan yield carry), we believe the incremental returns are likely attributable to one or more of the following factors – an overweight of riskier or ‘special situation’ (including potentially distressed) assets, the inclusion of fee income including origination fees which can range up to 2-3% and/ or fund gearing of course.  Leverage is employed by nearly half of all funds (40% in Europe, according to the 2018 survey by the Alternative Credit Council (ACC)), with gearing normally limited to 2x. Based on market feedback, we understand such leverage facilities tends to be longer-term in tenors, limiting any maturity transformation risks at the fund level.

Judging credit performance for such strategies is also a somewhat nuanced process given the lack of transparency.  To be sure, mid-market corporate defaults and losses thus far have been low in Europe, helped by the benign credit cycle in recent years.

Using rating agency data and analysis of leverage finance related to borrowers with total debt <€200mn as a proxy for the ‘mid-market’ corporate economy in Europe, most viewpoints generally underline the better credit quality of this segment of the loan market relative to larger cap borrowers, whether quantified by lower total leverage or greater equity cushions or other more conservative credit metrics.  Moreover, origination practices are widely thought to have been more lender-friendly in the smaller cap loan space, manifesting generally in better covenant protections than seen in the larger cap syndicated market in recent years.  Fewer lenders to each borrower – or bilateral lending in some cases – looks to have also lent to more expedient credit management (amendment agreements and so on), delivering better credit performance relative to the mainstream leveraged loan market.  And given higher loan yields, the spread per turn of total leverage has also therefore been generally superior to the leverage loan market, but we would again caveat this observation by noting that liquidity – as a separate measure of risk – is also significantly less in mid-market loans.

According to data from Fitch, smaller (<€200mn) loan default rates have almost consistently been lower than larger leveraged loans since 2011 in Europe (falling to zero in 2015 and 2016), with seemingly the only outlier being the spike in 2017 on account of just two defaults.  Data on the deeper US market evidences this trend in a more concrete manner. In the ten years to end 2017, the average annual mid-market default rate in US was 1.9% vs 2.8% in large cap high yield loan market (source: Fitch).  Equally, in the more recent five-year period (2012-17), the average default rate was 1.5% in the mid-market segment vs 1.9% in large caps.

The above considerations regardless, we take a more cautious view on trends going forward in the mid-market credit space. Low historical default rates have undoubtedly benefited from the bullish credit tailwinds of recent years, not to mention flattered by the typically longer-term bullet maturities of such loans.  We feel the real test for this young alternative lending sector is still to come, and would highlight the following points as potential sources of credit vulnerabilities in any next cyclical downturn:-

• Better loan credit metrics versus large cap leveraged loan norms overlooks the fact that middle market borrowers are often inherently riskier credit propositions given their relative lack of operating scale and funding resilience. Fitch, for instance, assigns credit estimates consistent with lower sub-investment grade ratings for the majority (>95% in Europe) of smaller borrowers in the leveraged loan universe, precisely for these reasons.  The prevalence of bullet loan maturities adds refinancing liquidity (‘cliff’) risks to the mix
• Retrospective observations of more conservative loan qualities in the mid-market space versus the larger cap market may also not accurately reflect contemporary lending practices. We think it reasonable to assume that there has been some ‘creep’ of looser leveraged loan lending styles into the mid-market direct lending space. (According to LCD, up to 80% of leveraged loans underwritten in H1 2018 were considered covenant-lite). To be sure, the amount of money flowing into this particular debt strategy would normally predicate more borrower-friendly lending
• The dominance of sponsored deals in the asset allocation of some funds should also be considered in this respect. While sponsored loans on the one hand have certain advantages such as the ‘socialisation’ of risk underwriting and more layered due diligence on borrowers, the flip side of this on the other hand is more borrower-friendly loan structures (whether measured by degree of gearing or covenant protections) and potentially weaker alignment of equity interests ultimately.  Moody’s have cited that private equity sponsored companies tend to have higher default risks than their non-sponsored counterparts, all else being equal
• As with any alternative finance model, adverse selection is a key risk consideration in our view, particularly of course given that funds typically target borrowers who are unable to access bank credit. We should caveat that the lack of bank financing for such borrowers may be for reasons other than credit-worthiness (to include duration or other non-credit complexities), yet adverse selection remains a natural concern to us given the backdrop of heavy fund inflows coupled with deployment pressures
• From a portfolio perspective, middle-market credit portfolios are likely to be characterised by greater concentrations – whether by name or sector – than large cap leveraged loan portfolios, reflecting their lack of market depth. Such portfolios may therefore be incrementally vulnerable to idiosyncratic credit events.  (To illustrate this risk, we note that in 2017 – according to Fitch – leveraged loans sized <€200m saw defaults jump to above 3% from zero in the prior two years, on account of just two defaults in the retail sector).  We see this lack of diversification being arguably a reason why mid-market CLOs in Europe have not emerged as yet, that is, such loan pools are likely ‘unsecuritizable’ given credit lumpiness, being better suited to fund rather than securitization structures.  Potential borrower overlap across the direct lender fund universe may further serve to exaggerate any idiosyncratic default shocks
• The sufficiency of restructuring/ workout capabilities within the operating models of direct lending funds is still to be fully explored, considering what has been an untesting credit cycle since this industry emerged in post-crisis Europe. Private credit manager resources look to have been disproportionately focussed on origination efforts thus far. On the premise that the industry experiences a credit cycle correction in due course, and further given that middle-market loans in Europe do not benefit from any meaningful secondary liquidity, we see borrower workout capabilities as one of the key factors distinguishing fund performance ultimately.

At the risk of stating the obvious, we remark finally that private mid-market credit fund total returns will of course be heavily dependent on loan payoffs more than anything else ultimately, not dissimilar to the economics of other par loan trades.  Borrower default behaviour, rather than yield carry, is therefore key to fund performance over the next cycle, which we think will provide the first credible opportunity to judge the asset selection and credit management qualities of direct lenders.  The more mature US mid-market corporate economy has recently witnessed some signs of credit stresses (albeit idiosyncratic rather than systemic at this stage), which has impacted price action in the BDC sector.

The outlook from here

In our view at least, the breakneck pace of growth in the private credit direct lending market in Europe since 2013/14 in an omen for both the potential fortunes as well as challenges for the sector over the foreseeable future.  Whatever anecdotal evidence there is largely suggests that the end-money appetite for such alternative debt strategies remains strong (bordering on insatiable), with direct lending often cited in most institutional surveys as the most favoured opportunity within the overall private credit market. Indeed, measured by the quantum of recent inflows, the private credit/ direct lending market already feels ‘over-bought’ to us, considering what is still a young and untested opportunity.

Whether or not the heavy supply of fresh direct lending funds in recent years outweighed the natural financing demand from the mid-market, translating therefore into easy credit for end borrowers, will become clearer under any credit cycle correction to come.  Any fundamental credit recession – or equally a prolonged credit liquidity dislocation – will also likely test the hypothesis that direct lending strategies provide for uncorrelated, above-market returns.  We expect any such headwinds to temper the rate of fund inflows, or at the very least lead to more selective allocations of such money.  At this point we would add that any rate tightening cycle, if taken in isolation, should not in itself pose material risk to asset valuations given the predominantly floating-rate nature of loans.

All that said, while the defensiveness of direct lender middle-market portfolios will of course be tested in the next downturn, we sense that the industry is sufficiently deep-rooted to survive any such stresses.  In other words, we feel that private non-bank credit is more a structural ‘revolution’ in the corporate credit economy that is premised on lasting financing gaps in bank lending, rather than an opportunistic ‘trade’ that is critically vulnerable to being unwound.  (To this end we would point to the private equity industry, in which the explosive growth during the 2000s was often deemed – wholly inaccurately – by many commentators as unviable.  We would also single out the enduring institutionalisation of the US lending market triggered by disintermediation opportunities in the aftermath of the early 1990s S&L crisis).  In our opinion, the European credit economy will likely witness deeper alternative lending markets going forward, guided not least by continued bank disintermediation opportunities on the one hand and policy maker efforts to cultivate non-bank lending on the other (the CMU is a notable initiative in this respect). Direct lending funds appear well placed over the cycle to continue exploiting this trend.  Unlike in the US, there is for now little non-bank competition for direct lenders within the middle-market credit space in Europe.

But further entrenching the direct lending model in Europe is not without its hurdles, in our view.  We would describe the key challenge going forward as being able to replicate to some degree the infrastructure of the bank lending system in Europe.  By this we mean the ability to deploy institutional inflows into more mainstream borrowers (away from the crowded sponsored/ syndicated capital markets) and to establish workout capabilities akin to being credit owners (rather than credit ‘traders’).  To this end we believe private credit funds will need to invest in both origination and credit management infrastructure in order to demonstrate resilience of the direct lending model over cycles.  Doing so will help secure a more unassailable position for such lenders in the credit system, at least in our view.

As the institutionalisation of the middle-market credit system in Europe matures further, we see capital market opportunities emerging as alternatives to (locked-up) investing in unlisted direct lending funds. Middle-market managed CLOs sponsored by such funds look poised to make their debut in Europe before long, particularly with better depth and diversity to the underlying asset market.  (To be sure, the adequacy of middle-market loan yields already makes this asset class CLO-friendly).  We expect such CLOs to be complemented potentially also by securitisations of investment bank leverage facilities to private credit funds. Away from asset-backed debt, we anticipate more by way of tradable equity opportunities in middle-market loan funds also, shadowing similar public listings seen in related alternative finance sectors such as large cap leveraged loans and SME lending (P2P-sponsored especially).  Any BDC-equivalent legislation in Europe – whether under the auspices of CMU or otherwise – would of course be radically transformative in terms of capital market opportunities, but at this stage we do not foresee any such sweeping regulatory changes to the lending system in Europe.

Appendix

Defining the middle-market institutional lending opportunity in Europe

In Europe, SMEs are defined in official literature while large caps are de facto defined (historically) by its institutional capital market ‘cut-off’ within the corporate lending spectrum.  Middle-market corporates have lacked similar defining characteristics for the most part. For the purposes of this discussion, we would broadly define middle- market companies – by process of elimination more than anything else – as firms with revenue between €50m and up to €250m as the upper-most boundary, and EBITDA between €15m and €50m with debt ranging from say €10m to €200m. Derived from various official sources, we roughly calculate that in the EU4 (UK, Germany, France and Italy), the middle-market corporate economy accounts for around a third of GDP and labour force participation, in this regard broadly comparable to the proportionate footprint of the US mid-market.

We estimate the total market of such mid-market lending in Europe to be in the ca. €3-3.5trn range (this includes real estate and other asset-based lending), which we calculated based again on total corporate lending less the lending stock in the SME and large cap segments of the market. Of this amount, we estimate direct lenders account for ca. €80-90b, based on data on funds raised and deployed thus far in the middle market space.  If our estimates above are ball-park correct, then direct lenders have a ca 3% market share of the total stock of lending to the middle market in Europe, or modestly higher if isolating loans ex real estate.  But on a flow basis, we believe direct lenders enjoy up to a ca. 10% market share currently based on the same calculations.

By way of comparison, the US middle-market economy occupied by direct lending funds is moderately larger at around $120bn (deployed and uninvested combined), according to Preqin.  But taken together with the remaining broad depth of the non-bank lender universe to incl BDCs, CLOs and other institutional lenders including retail funds, the extent of bank disintermediation is far greater than in Europe, with estimates typically ranging from 40% to 60%.  To be sure, banks share of the US large cap leveraged loan market is less than 10% (source: LCD) reflecting the scale of institutionalisation over the past 20 years or so.

We feel it’s worth also making the point that ‘private credit’ tends to encompass all types of specialised/ borrower-specific lending, from vanilla lending to structured to infrastructure/ real estate etc.  In the US at least, such direct lending strategies generally started with mid-market lending but has since expanded to include many other forms of financing and borrower types.  In Europe direct lenders can have various (often overlaying) strategies from direct mid-market/ large cap senior lending to mezzanine to distressed / special situations, aside from sector specialisation such as real estate or trade/ receivable financing – indeed, many of the more established managers in Europe started off as specialists in the loan markets before broadening their product suites to include other forms of direct lending.  As far as we can tell, there seems nothing formulaic connecting direct lending to middle-market credit, with the brand still somewhat loosely defined. For instance, It is still common for direct lending funds to allow buckets for special situation / distressed opportunities.

Private credit AuM as a whole has witnessed annual compound growth of 20%+ in the post-crisis era, with total AuM globally on track to surpass $1 trillion by 2020, according to forecasts by the Alternative Credit Council (ACC).  Direct lending is the most dominant strategy among private credit funds, in terms of capital raised/ deployed. According to Deloitte, direct lending funds raised $82.7b in Europe since 2013.  (Ares alone raised €6.5b in the largest European direct lending fundraise ever in 2018). Preqin data points to $39bn of dry powder currently among direct lender funds targeting Europe, with over $130bn raised in Europe since 2008 (via 160 funds). Many newer direct lending managers have emerged in recent years, with the industry catalysed by the significant money flows into such strategies – less than half of private credit managers have been in the market since the pre-crisis era, with 10% of managers in Europe operating the market for less than 2 years, according to ACC research.

The end money for such strategies comes from global asset owners for the most part.  Pension funds are understood to be the largest source of money for such opportunities, with family offices making up the smallest segment at 5%, according to the ACC.  Regionally, North America institutional money dominates (38%), followed by Europe (31%, mainly insurance money).  All said, direct lenders look to have become established as a favoured alternative investment class for many asset owners.

Like in other alternative or speciality non-bank lending in Europe, the competitive advantage of private credit managers is their ability to underwrite complex, off-the-run risks relative to the more conservatively constrained underwriting style of bank lenders.  This typically manifests in lending features such as higher gearing and more flexible terms (including undrawn commitments, which is particularly capital expensive for banks nowadays).  Aside from sourcing, credit underwriting is generally considered among the more demanding/ intensive aspects of direct lending in Europe, in turn underlining the appeal of sponsored deals where borrower credit intelligence tends to be more readily available.

According to ACC, 40% of direct lender funds globally are targeted at small balance loans/ SMEs, loosely defined as such.  A further 20% comprises lending to large cap borrowers.  Following on, one could crudely assume this data as implying that up to around 40% of direct lender funds are accounted for by mid-market corporate borrowers, again loosely defined. Judging by what data and intelligence there is on loan sizes as well as selected borrower/ loan transactions showcased by managers, it would seem to us that some – or indeed most – direct lenders in Europe tend to crowd into the upper segment of the mid-market, where sponsored deal flow is more dominant.  (Syndicated lending formats via the capital market can also feature in the larger ticket mid-market space, however such lending remains small in Europe relative to the US).  We see this segment as the ‘lowest hanging fruit’ in terms of deployable opportunities for direct lending funds, a segment where origination does not rely upon any proprietary direct marketing channels. For now at least, it seems rarer for funds to have direct origination capabilities that mimics the borrower interface of the banking system.

Rather, fresh asset sourcing is typically via private equity firms, banks and other institutional advisors, with lending to existing borrowers also relatively significant.  As mentioned above, the prevalence of sourcing new assets via sponsored deal flow more than any other non-brokered channel is widely in evidence, though data varies in terms of the extent of such dominance. This origination source is certainly more dominant in US than Europe, yet still some 75%-85% (according to Deloitte) of lending by funds in Europe comprise sponsored activity. (This range is corroborated noting info derived from selected direct lending fund pitch books).  A few funds have lending JVs with banks, whereby the funds complement, or even fully assume, loans underwritten by banks to their own borrowers.  Overall, we think the still-significant amount of dry-powder generally speaks to fund deployment bottlenecks given challenges in sourcing assets.

Loans originated by direct lenders in Europe hitherto tend to be dominated by unitranche formats by most accounts, with senior secured facilities most prevalent otherwise.    Other loan formats such as senior unsecured, mezzanine or junior/ second lien facilities, convertibles, PIK loans and other hybrids (as well as derivatives such as TRS) make up around 15-20% of direct lending types according to Deloitte.  Floaters are most common within the dominant senior secured and unitranche lending, with bullet maturities typically between 3 and 8 years.  Loans are normally embedded with call and LIBOR floor protection features, as is common in the large cap leveraged loan market.

Direct lenders are also known to originate assets in the private placement markets in Europe, particularly in Germany and France via the established Schuldschein and EuroPP markets, respectively.  (Involvement in the French market was catalysed by changes in insurance legislation in 2013 that allowed direct fund participation).  However, the penetration of such alternative funds in these markets is not thought to be significant by any measure. Indeed there is a valid argument in our view that private placement markets are more competition rather than complementary for direct lending funds, being for the most part capital market alternatives to bank lending for mid-to-large cap borrowers and dominated on the buy-side by insurance and other institutional money.  Certainly, in the case of the established and deep Schuldschein (ca. €90bn) market, standardised documentation, listing processes and legal governance better lends to mainstream institutional investor participation rather than to unlisted direct lending funds.

Geographically, most private credit mid-market activity centres on the UK, with France and Germany being the other two dominant jurisdictions. The UK’s historical dominance in such lending reflects the more liberal lending framework for non-banks and creditor-friendly recovery regimes.  European direct lending opportunities were put in motion more recently, led by ELTIF (European Long-Term Investment Fund) regulations since end-2015 across the EU which kick-started alternative investment funds’ (AIFs) ability to originate loans, subject to certain criteria.  Notably in this regard, German and – especially – French rules for non-bank lending were appreciably relaxed, though not fully liberalised noting that non-bank lending take-up thus far appears to be dominated by domestic funds. Many other European countries still explicitly require lenders to have banking licences in order to operate in domestic borrower markets.

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Putting Frontier BTL Markets in Perspective

11 October 2018

Emerging BTL markets – IE and NL (PDF version)

The buy-to-let mortgage capital markets in Europe have hitherto been dominated by opportunities in UK assets for the most part, with such risk dominating BTL RMBS markets and seen also more recently in listed bond and equity (whole loan fund) markets.  To be sure, the 20+ year history of UK buy-to-let lending has fuelled a deep market for institutional lending and investment, led by specialist lenders on the one hand and private equity owners and mainstream capital market investors on the other.  Front-book opportunities have been complemented by sizable legacy asset sales in the post-crisis era, such portfolios being orphaned by failed lenders.

This commentary highlights two emerging buy-to-let markets in Europe that we identify as sharing broadly similar characteristics as the UK BTL market nearer the time of its inception, which in turn underpins their growth potential as investable markets over the foreseeable future.  The two jurisdictions are Ireland and the Netherlands.

Genesis of the ‘buy-to-let’ product in selected mortgage markets

At this juncture we think it worthwhile to recap on what distinguishes a market defined as “buy-to-let” from vanilla investment mortgage lending that is well established in advanced mortgage economies such as the US, Germany and Australia, among others.  We would highlight the following defining characteristics, covering the supply- and demand-side of the product class:

• Foremost is the shift in mortgage lending practices to define buy-to-let as a separate asset type. These shifts have been driven by the desire to more closely align BTLs to owner-occupied mortgages, and away from small ticket CRE loans (this happened in the UK), or conversely, the desire to provide loans that are underwritten to the real estate assets (often outside of the regulatory net) rather than borrower income affordability. In either case the primary driver for such reclassifications seem to have been competitive forces in mortgage lending markets
• On the demand side, BTL markets exists in economies where, fundamentally speaking, housing has come to be seen as an investable asset class, in effect a savings outlet for the wealth-owning segments of the household economy. Stable above-market yields in what has otherwise been a very low-rate environment, the ‘safe-haven’ perception associated with real estate, readily available mortgage leverage and – commonly – tax incentives have been among the key investment motivations in residential property
• On the supply side, BTL volumes have historically been fuelled by lending appetite – among banks and non-bank lenders alike – for higher yielding loans relative to owner-occupied mortgages but typically without the commensurate loss risks associated with other non-prime products with yield premiums. More punitive capital and tighter prudential regulatory frameworks for BTLs over the post-crisis era have led to a lending retreat by banks, with this capacity largely filled by specialist lenders targeting the unregulated BTL segment (that is, “professional” landlords, defined varyingly). Institutional investment appetite across debt (whole loan or securitised) and equity (ownership stakes in fincos) has cemented the viability of non-bank models in the BTL markets

Ireland and Netherlands can be broadly characterised by the market dynamics/ shifts described above.  Both mortgage markets have witnessed a defined BTL product suite emerge in recent years, though the histories of the two housing economies are starkly different.  Ireland has come out of an unprecedented housing recession which took a heavy toll on legacy BTL assets, with the “BTL 2.0” renaissance still near its infancy amid the overhang of the pre-crisis market.  The Dutch BTL market, by contrast, is more of a debutante given no meaningful precedence as a defined mortgage product type.

Compelling residential property investment economics and better financing availability fuel BTL ‘2.0’ market growth

Not coincidentally, both Ireland and the Netherlands stand out for having among the highest residential rental yields in Europe, underpinning the BTL investment rationale.  Both these economies are characterised by a shortage of housing, coupled with recent strengthening in rental demand due to a number of factors that have served ultimately to favour renting over owning, to include tax changes, tighter macroprudential rules for owner-occupied mortgage lending as well as first-time buyer affordability constraints that reflect higher house prices. Favourable tax treatment of residential property investments has also fuelled the BTL appetite in both countries.

Both Ireland and the Netherlands remain at the very early stages of buy-to-let mortgage market growth, driven on the financing side by the emergence of non-bank fincos as alternative lenders to the few banks still lending in this space.  The non-bank lender constituency in both countries remains very young and sparsely populated, in distinct contrast of course to the more established and mature UK specialist lender base.  But like their UK peers, specialist lender models in both Ireland and Netherlands exploit their competitive advantages of operating in ‘alternative’ lending segments, which in both countries are characterised by lending that requires more complex / non-standard underwriting, rather than adverse credit per se.  Banks in Ireland and the Netherlands tend to have narrower lending perimeters and less flexible underwriting criteria, similar in that sense to mainstream banks in the UK, and distinguishable from banking peers in the likes of Germany or France.

Contemporary Irish and Dutch BTL loan profiles typically resemble their respective owner-occupied mortgage products, but with lending generally undertaken outside of the regulatory boundaries. Given the infancy of the BTL 2.0 markets, the investment properties backing such loans are still disproportionately concentrated in cities/ urban areas where supply shortages and demand clustering (or agglomeration, in economic speak) create the most favourable rental economics.

Ownership of post-crisis specialist lenders in both markets is typically anchored by private equity and/or alternative investors. (Such alternative money is arguably a spill-over from the maturing opportunity set in the UK).  Debt financing has been provided by bank facilities or institutional forward purchase agreements in a few cases, with only a couple of front-book lenders tapping the securitisation capital markets thus far.

From unlisted equity stakes to capital market instruments – scoping the investment opportunities to come

Securitisation remains the go-to capital market funding channel for the few BTL lenders in Europe, with a long-established market history carved out by UK banks and non-banks over the past 15 years.  In the case of Irish and Dutch BTLs, the RMBS capital market has played host to a number of post-crisis transactions, but such securitised portfolios have been dominated by legacy or back-book assets, with loans typically aged 10-12 years. The front-book components of securitisations have been fractional in the case of Ireland, and up to ca. 30% in the case of the Netherlands, though we would caution that this ratio overstates the BTL element given the typical mix of securitised assets including small-ticket CRE loans.

We expect front books to dominate RMBS deal flow going forward as BTL lending matures further in both markets. In the particular case of the Netherlands, we anticipate seeing a greater variety of capital market opportunities ultimately – to potentially include whole loan funds and perhaps mortgage bonds (blending covered bonds with pass thru technology, similar to Denmark) – which would mirror the diversified institutionalisation of the owner-occupied mortgage market.

Any opinion on Irish or Dutch BTL RMBS valuations would be premature at this stage given that price discovery is still to come in the case of front-book securitisations.  Clearing spreads on recent legacy (part BTL) RMBS may provide a useful guide in this regard (see table below), however we have yet to see whether the market will demand any premium for unseasoned assets from lenders often without meaningful operating track records. Still, front book ‘2.0’ securitisations from these emerging BTL markets look poised to price inside of UK equivalents, with this disparity explained by differences in current market technicals more than any credit or other fundamental factors, in our view.  Conversely, this relative richness of Euro securitised product likely underscores the appeal of RMBS funding for the owners of emerging BTL front-books in Ireland and the Netherlands.

Owners of specialist BTL lenders in Ireland and the Netherlands comprise alternative investors for the most part.  Their venture capital via unlisted equity stakes in such front-book lenders looks to have been a rewarding trade by most accounts.  For one, yields on the underlying BTL whole loans generally surpass returns on any comparable listed corporate or structured credit, notwithstanding the liquidity give-up.  But taken together with the achievable term leverage costs via RMBS as outlined above, the risk/ return pay-off to equity looks to be very compelling. To make our point, we note that – based on simplistic assumptions using current average book yields adjusted for running (and amortised upfront) costs of say 1% and accounting for the cost of leverage currently available via RMBS – direct investors in Dutch and Irish BTL lenders holding 5% of retained equity would extract roughly 2x and 3x higher returns, respectively, than hypothetical RoEs in a comparable UK BTL lender.  (These observations, which ignore losses, are bordering on being speculative of course, and are only meant to illustrate the early-stage equity investment appeal of new BTL markets like Ireland and the Netherlands relative to the more established UK market). Outsized equity returns, which stem largely from lower securitisation funding costs (currently at least) and, to a lesser extent, the modestly higher loan yields, can of course be expected to normalise as the BTL markets mature further. Concurrent with any such economic maturity, early stage private equity stakes in specialist lenders would also likely then be rotated into other ownership formats. Public listings or conversion to banks may count among them, ultimately.

Credit performance among Irish and Dutch front-book BTL mortgages over recent years is still largely indistinguishable from their respective owner-occupied mortgages, exhibiting low delinquencies and defaults thus far. We expect these benign trends to continue over the foreseeable future, assuming of course the current strong housing market tailwinds and bullish residential property investment economics prolongs.  Looking holistically at the asset class (that is, ignoring the format or structure of capital market instruments to come), we would consider the following points as key investment considerations for BTL 2.0s going forward:

• Loan quality and underwriting discipline, any slippage in the latter being a key consideration as the market matures. In our view, any creep of legacy BTL refis into front-books would also be important to watch in the case of Ireland, particularly given potential re-default risks among loans in earlier forbearance. For now though we would see the current BTL vintage as being superior in quality to anything from the pre-crisis era, whether in terms of loan or borrower profiles
• Residential property market conditions are of course important bellwethers for BTL credit performance. While it is hard to imagine another housing crisis of the scale seen in the last cycle, we note nonetheless that both Ireland and Netherlands have witnessed sharp (almost exponential) upswings in house and rent prices in the recent past, with such momentum naturally expected to be exhausted in due course. The UK market has provided clear testimony that BTL payment behaviour can remain largely immune to housing market ‘soft-landings’, but the 2008/9 Irish experience provides equally compelling evidence that BTL credit sensitivity to house price direction becomes far more manifest in any extreme downside scenarios
• BTL landlords generally have long-term holding horizons when investing in residential property in any of these markets. We believe the historic resilience of UK BTL credit performance over ‘normal’ cycles – or indeed outperformance relative to owner occupied mortgages – can be partly attributable to this staying power. A key investment consideration going forward would therefore be any change to landlord investment mindsets, particularly as continued above-normal returns from property risks drawing in speculative or short-term ‘trading’ behaviour into the BTL loan markets
• Unlike the earlier generation of non-bank lenders, the contemporary specialist lender constituencies in these newer BTL markets are mostly owned by alternative/ private equity investors. We would surmise that such ownership can carry rewards and risks in equal measure. On the one hand, most of such investors have demonstrable finco experience and enough financial firepower to support and further develop the competitive viability of specialist lenders. On the other hand, the long-term commitment of such investors to these platforms in any period of prolonged credit and/or liquidity stress is as yet uncertain. BTL specialist lenders may be considered strategic assets for some investors, but unlikely for all.

The Irish Buy-to-Let Market

Rising from the (crisis) ashes

The Irish buy-to-let market dates back to the pre-crisis era, during which period investment mortgages related to residential property tended to be blended along with small-ticket CRE-like lending.  Most of the country’s banks were lending readily in this space in the run-up to the financial crisis.

The severe housing market recession that followed took an unprecedented (matched only by Iceland among developed economies) toll on the Irish housing market, an event that is of course by now very well-documented. Against the backdrop of the ca. 60% collapse in house prices, the crisis aftermath saw late-stage delinquencies among owner-occupied loans rise to around 16% according to the CBI, with buy-to-let/ investment mortgages experiencing more severe arrears rates (up to 26%).  Actual repossession rates were flattered by the national mortgage resolution measures (or MARP) enacted in 2013 aimed at mitigating the default shock via loan modifications, a programme that also served to moderate mortgage delinquency rates in the subsequent years.  (BTL loan mods were mostly in the form of arrears capitalisations and term extensions).  However, with MARP generally prioritising owner-occupied loans over BTLs, delinquency rates in legacy buy-to-let mortgages have remained stubbornly high, at 22+%.  The overall mortgage stock in Ireland that remains impaired is still noticeably high at 17%.

There are reportedly 175k buy-to-let landlords in Ireland, with 120k BTL loans outstanding.  (We assume this loan stock excludes financing provided to REITs and other institutional landlords, which make up a relatively significant share of owners of rented stock in Ireland).  We understand that a fair share of existing BTL loans were re-classified as such, having been originated as owner-occupied mortgages but where the properties were left unsold when the owner moved.  (In most cases the desired sale price was unachievable, leaving such “accidental landlords”).

Given this legacy BTL overhang, coupled with the substantially greater associated demands on regulatory capital, the resumption of fresh BTL lending by banks since 2014/15 has been tepid by any measure. While most banks have BTL products on offer (to include PermanentTSB, BoI, Ulster, KBC, AIB), buy-to-let ‘2.0’ lending is currently running at only around €280m per year according to the BPFI, or no more than 3-4% of total front-book mortgage originations in Ireland. Indeed, the existing stock of Irish BTL mortgages continues to shrink with back-book repayments significantly outpacing any new lending.

Yet the footprint of newer non-bank specialist mortgage lenders in the BTL front-book re-emergence has been notable in our view, notwithstanding the infancy of the BTL 2.0 market.  We estimate based on both anecdotal and official data that the share of non-bank lending has doubled since 2016 and currently represents up to around 30-40% of all BTL lending in Ireland, or roughly €100-120m annually.  The likes of Dilosk and Pepper Money dominate the non-bank lender base for now, with a few others such as Finance Ireland reportedly considering entry into Irish BTL lending.

New BTL lending in Ireland is typically done at LTVs between 60-70%, in sharp contrast to legacy loans which are mostly still in negative equity (CLTVs>100%).  BTL LTVs reflect macroprudential guidelines that were put in place in 2015, which prescribe 70% limits on BTL lending, with allowances for 10% of lender books to be in excess of this threshold.  (This BTL limit compares to 80% LTV and 90% LTV limits on owner-occupied and first-time buyer loans, respectively). According to recent CBI monitoring information, the bulk of Irish BTL lending done since 2015 is within the regulatory limit, with less than 3% of new loans above this cap.  Aside from LTV considerations, lenders usually underwrite to a minimum 1.2x rental income coverage of loan principal and interest.

Irish BTL lending by non-banks is typically limited to the unregulated sector, which is broadly defined as lending to professional landlords whereby loans are not covered by the same degree of consumer protection as regulated lending.  Like the UK, the definition of what constitutes a professional landlord is not prescribed – most lenders to our understanding normally deem BTL borrowers with three or more investment properties as being ‘professional’.  Loans are also commonly provided to corporate and SPV structures, including pension trusts (where gearing is capped at 50% LTV). What little Irish front-book securitised loans there are suggest that BTL borrower stated incomes are generally 20-30% higher than borrower incomes in the mainstream mortgage market.

Irish BTL loan formats generally mirror product types prevalent in the owner-occupied market.  Most loans are floating rate (with fixed teasers sometimes) and up to 25 years in tenor.  Lending margins range from 4.2% to over 5%, with bank originated product typically in the lower end of this range.  BTL loan margin premiums over owner-occupied product stands at around 150-175bps currently, having proved stickier in recent years relative to the margin compression seen among owner-occupied loans.

Servicing is a mix of in-house and use of third parties, with the latter industry still somewhat shallow, certainly when compared to the UK, or Netherlands for that matter.  Default management of non-regulated buy-to-let loans is appreciably more straight forward relative to owner-occupied loans, which are subject to forbearance under MARP, in effect ensuring that legal proceedings are only initiated for borrowers if no restructuring solution can be found. By contrast, enforcements on non-regulated buy-to-let loans are mostly out-of-court proceedings that allow creditors to expediently take possession in cases of borrower default, in contrast to the lengthy procedure required for mainstream, regulated loans. Similar to the UK, the Irish system provides for “receivership of rent” in cases of borrower default, whereby rental income is diverted from the non-performing owner/ landlord to mortgage lender.

In terms of housing market fundamentals, the recovery since the market depths of 2012/13 has been appreciable, certainly if measured by housing price and rent dynamics.  Evidence indicates that this recovery is driven by the shortage of housing rather than being credit-fuelled, at least thus far.  House prices have posted double-digit growth in recent months, with year-on-year gains having peaked at over 20% (and 28% in Dublin) at the early stages of the post-crisis upswing.  However, despite the significant house price inflation seen in recent years, house prices remain some 20% below the peaks reached during the pre-crisis era.

By contrast, rents (all property types) nationally are just a fraction lower than the peaks seen in 2006/7, with rents in Dublin currently surpassing the previous record high.  Isolating the private rented sector, levels are currently at their highest recorded value, approximately 17 per cent above the pre-crisis peak. Recent rent yoy growth has ranged from 6-12% nationally excluding Dublin, wherein the growth has reached up to 14%. Indeed, these growth rates are lower than what was seen earlier in the cycle, with this moderation arguably explained to some extent by the introduction of Rent Pressure Zoning at the end of 2016, which essentially caps rental increases in designated zones to 4% annually, enforceable for up to three years. (There are currently 21 such designated areas in Ireland). Like sale prices, rental price inflation has been fuelled by the shortage in rental properties.  (According to property website Daft, the nationwide stock of available rentals is near its lowest since data was first collected in 2006). Currently ca. 30% of households in Ireland rent rather than own, with this ratio under 22% ten years ago.  The long-term trend in this respect highlights an interesting pattern – the share of households renting fell perceptibly over the multi-decade post-war period, reaching a low of 18% in 1990 before increasing steadily again.

As highlighted earlier, rental yields in Ireland remain very high compared to other economies, ranging from 5-8% typically. Investment economics have been further bolstered by recent tax changes, namely the re-starting of tax relief on BTL mortgage interest payments from 2017, with such credit having initially been provided for 75% of payments, currently 85% and due to increase steadily to 100%. This recent friendlier tax treatment reverses its abolition in 2009, an outturn that is in distinct contrast to the UK where BTL interest tax offset benefits are scaling steadily lower.

The capital market for Irish buy-to-let risk is, thus far, limited to a few securitisations where the overwhelming component of portfolios comprised legacy BTL loans, typically dating back to 2006/7 vintages.  On our count, the amount of performing BTL loans securitised thus far (isolating such components among RMBS issued) has totalled around €1.5bn, with some of the bonds retained by the issuing banks.  A further ca. €150m of non- and/or re-performing BTL loans have also been securitised, in which the loans are in varying stages of the restructuring or enforcement process. As yet there has been very little by way of front-book BTL assets that have come to the capital markets, though we expect this to change going forward, as discussed in the earlier section.

Flows in Irish whole loan NPL portfolios have been far more prevalent relative to any securitisations over the post-crisis period of course.  We estimate that some €15bn of non-performing residential mortgage portfolios have traded since the crisis, with the buyers being private equity firms for the most part. Of this amount, buy-to-let loans featured relatively prominently.  As recent examples, Ulster sold a €1.4bn NPL mortgage back-book that includes ca.€740m of BTL loans to borrowers in forbearance arrangements, while KBC sold a mixed NPL loan portfolio containing Irish (and UK) BTL loans.  Some of such loans may be potentially refinanced in the RMBS market following satisfactory workouts, but we would expect any such deal flow to remain distinguishable to front-book BTL RMBS.

The Dutch Buy-to-Let Market

Still a novel product type

Unlike the UK and Ireland, mortgages for residential property investments in the Netherlands have not historically been distinguishable in lending practices nor within the mortgage regulatory framework.  Similar in that sense to a number of other core European mortgage markets (Germany and France, among others), Dutch buy-to-let mortgages were largely inseparable from the suite of mortgage products offered by banks.  Data on the legacy stock of such mortgages is not available therefore, though we understand that such bank originations were not altogether uncommon in the pre-crisis era. (We would remark at this point that Irish BTL data is noticeably richer than for the Netherlands).

Largely influenced by more punitive capital costs in the aftermath of the crisis, banks all but ceased investment mortgage offerings from around 2009.  The first bank to reintroduce buy-to-let mortgages in select Dutch cities was NIBC in 2015, with the launch product capping LTVs at 70%. To our knowledge, NIBC remains the only major bank in the Netherlands to offer ‘2.0’ investment mortgage loans.  But the genesis of the Dutch “buy-to-let” label arguably stemmed from the targeted or specialised lending activity from the small segment of non-banks, which were also relatively active by 2015/16.  As discussed further below, the emergence of specialist lenders coincided with noticeable structural shifts in rental demand and landlord investment appetite in the Netherlands.

Yet all things considered the Dutch mortgage market that is defined as “buy-to-let” remains at an embryonic stage, with the product type still barely commoditised.  Anecdotal evidence points to appreciably increased residential investment activity in recent years, with for example Land Registry studies showing that 6% of all residential property transactions were investment-led in 2016, with this ratio climbing to nearer 10% by the end of 2017.  (In urban cities like Amsterdam, this proportion was higher by another ca. 5%).  Considering further that Dutch overall mortgage lending currently totals around €110bn annually (with a stock of €522bn), a simple – yet flawed in our view – interpolation would put BTL lending in the ca. €6-10bn region annually since 2016. We are simply unable to reconcile this figure with our data on origination volumes reported by NIBC and the two active non-bank lenders (namely, RNHB and Domivest), data which collectively suggests annualised BTL lending as closer to €600m.  Even allowing for potential lending activity from other smaller BTL lenders, we would infer that BTL lending in the Netherlands does not exceed €1bn per year currently. This would be more consistent with reported data showing private investors transacting €1.15bn in residential property investments during 2017.  (See chart above).  We assume therefore that a sizable share of current residential investment transactional activity is being financed away from the BTL mortgage markets, likely reflecting institutional purchases using commercial financing.

Still, fresh BTL lending of up to say €1bn annually in the Netherlands is considerable for a young product. And while the size of the BTL market – whether measured in flow or stock – is still overshadowed by the owner-occupied mortgage market (which, in turn, is disproportionately large relative to housing market size or GDP), the penetration of the very few incumbent specialist lenders in overall BTL origination volumes looks noteworthy. We think the non-banks own up to roughly 50% of new BTL lending.  Aside from NIBC, the two other dominant lenders – RNHB and Domivest – are non-banks.  RNHB, which is an established player in the mid-market CRE lending space as well as BTLs, was bought by CarVal and Arrow Global in 2016 from FGH Bank, a long-standing finance subsidiary of Rabobank.  Domivest was organically founded as a dedicated BTL specialist in 2017 by principals formerly active in Dutch direct lending and asset-backed portfolio management.

Like in other BTL markets, these specialist lenders differentiate their product offering through leverage (up to 85% LTV) and the ability to underwrite more complex and/or off-the-run investment loans. Generally, however, lenders mostly underwrite to 80% LTV limits for repayment BTL mortgages or 60% for IOs.  (This is corroborated by WA LTVs of 72.2% for the front-book component of the very recent DPF 2018 securitised portfolio, for instance). Importantly, valuations are normally derived from rented value metrics, typically at haircuts to market values.  Dutch BTL loans are typically also underwritten to 1.25x rental interest coverage limits, with a more lenient cap of 1x or 1.05x normally employed in the case of full (P&I) debt service coverage thresholds. Lender criteria usually also comprise exposure limits in terms of loan amounts, borrower and regional concentrations.

Unlike other BTL markets, as well as the Dutch owner-occupied market, there are no specific macroprudential guidelines for buy-to-let mortgages at this stage.  Therefore, lending appetite and disciplines are formed out of business models for the most part, rather than shaped by industry-wide rules. Principally, BTL loans are underwritten to the assets/ rental cash flow rather than borrower income, which in turn side-steps regulatory requirements and restrictions around mainstream mortgage lending.  Similar to other BTL markets, this necessarily requires BTL borrowers to be deemed as “professional” rather than consumers. BTL lending by banks and non-banks alike in the Netherlands is currently only offered to prime borrowers, in so far as having a clean (or fully discharged) delinquency record with the Dutch credit bureau BKR.

One idiosyncrasy of Dutch BTL origination practices is the lending to syndicates, or “risk groups”, where multiple borrowers assume mortgage debt that is collectively secured over all of the underlying properties of the syndicate. Each BTL borrower in such risk groups is liable on a joint-and-several basis. Risk considerations in this regard can be further complicated given that a borrower can be a constituent in multiple risk groups with cross-default provisions.

This complexity aside however, the BTL product in the Netherlands is – in our opinion – simpler or more vanilla in format relative to the distinctly elaborate owner-occupied mortgage, which historically was originated as ultra-long duration (up to 75 years), 100%+LTV loans, often structured as IOs with savings plans embedded. (The reason of course for such unique product characteristics was because of the full tax deductibility enjoyed by owner-occupied mortgages – as we outline below, tax and other changes since 2013 are leading to a more normalised mainstream mortgage market).  BTL loans are typically fixed rate with linear amortisation schedules, often with residual balloon redemptions. BTL loan terms tend to be shorter than owner occupied product with rate resets at 1, 3,5,7 or 10 years normally, in effect therefore having an implicit refinancing element. (Judging by securitised portfolios outstanding, BTL prepayments appear relatively high with lifetime CPRs around 17%).

Lending yields on buy-to-let loans from the non-bank platforms typically range between 3.5% and up to 5%. (We note from loan-level data, for instance, that BTL loans originated since 2016 in the most recent Dutch securitised portfolio had an original weighted average rate of 3.76%).  By comparison, central bank data show that owner-occupied mortgage rates are currently between 2% and 2.4% for loans with resets under 10 years.  Therefore, the BTL loan yield premium over mainstream mortgages is around 140-150bps, only modestly inside (unadjusted for swaps) lending premiums in markets such as Ireland. However, unlike other BTL markets, lending rates offered by banks (NIBC namely) and the non-bank lenders seem indistinguishable by comparison.

Among the non-banks, BTL loan servicing – to include default management and recoveries – is undertaken by third parties.  This practice is unremarkable considering what is one of the most established and deepest mortgage servicing industries in Europe.

Loan enforcement and mortgage repossession processes in the Netherlands are notable for being among the most seamless and expedient in Europe, with BTL mortgages benefiting equally. But unlike the UK or Ireland, there is no legal concept of “receivership of rent” in cases of prolonged delinquency, though in practice lenders incorporate pledges over the rental cash flow which can be enforced on any uncured arrears.  However, we understand that such contractual provisions are unenforceable if the borrower seeks credit protection under bankruptcy. (This is in contrast to the UK).  A key disincentive to non-payment in the Netherlands is the inclusion of borrowers into the BKR register once 90 days past due – in the case of BTL borrowers therefore, this means that any late-stage delinquency will have direct consequences for their personal credit status.  In the UK or Ireland, such end-impact on personal credit scores is not a given in cases where BTL loans are unguaranteed.

The Dutch property rental market has witnessed extraordinary structural shifts in the past 7 years or so that has fuelled a demand squeeze, as evident more recently. The confluence of different, coinciding factors resulting in the current rental market dynamics include:

• Legislative changes in the aftermath of the 2008 crisis designed to reduce the dominance of social housing associations, which included for example tighter means-testing for tenants, had the effect of forcing higher income dwellers into the private rented market. There are 2.3m rented dwellings in the Netherlands according to official statistics, but some 80% of this stock is (still) owned by social housing associations, the highest such ratio in Europe. All that aside, the Dutch population is growing at its fastest pace in over 15 years
• The policy changes also encouraged the rotation of rented dwelling ownership from social housing (regulated) entities to the (unregulated) private sector, but such liberalisation has been slow, certainly outpaced by the growth in demand for private rental properties. There are 600k dwellings in the unregulated (meaning no rent control) rental sector, but the bulk of this stock is still owned by social housing associations, which have been challenged in optimally managing such properties as de facto private landlords. We understand from lenders that the stock of privately owned non-regulated rented dwellings may be around a mere 113k
• Dutch owner-occupied mortgages came under macroprudential measures in 2013, mirroring similar developments in other ‘high-growth’ mortgage markets in Europe. Such measures included LTI limits and other income affordability tests, LTV caps at 100%, loan term limits and restrictions on mortgage interest tax deductibility to amortizing loans only. Coming from a market that was made up predominantly of ultra-long IOs with foreclosure value-based LTVs typically in the 125%+ range, the new rules took a toll on mortgage demand, in effect increasing the appeal of renting over owning.

Against the backdrop of the above market shifts, rental demand has increased sharply in recent years, outstripping supply.  According to official statistics, the net demand for rental housing rose from -188k (i.e., surplus demand) in 2009 to 47k in 2012, increasing since then to an estimated deficit of 205k in 2017.  Rent inflation has climbed steadily from the end of 2014 to reach double-digit yoy growth by 2017 (currently 7.6%). These overall nationwide figures understate the degree of rent increases seen for private residential properties in the urban areas.

Indeed, the Netherlands has one of the highest property rental yields in Europe, as was highlighted in the earlier section. (We would caution that headline yields have likely dropped more recently with the continued sharp increases in house prices). Coupled with the outperformance of residential property prices over the past four years, the BTL investment proposition has become steadily more compelling as an alternative savings channel in an otherwise low-rate environment.  Following a prolonged post-crisis correction, Dutch house price growth has accelerated since the lows reached at the end of 2013, with monthly yoy growth of between 7% and nearly 10% in the past year alone.  Like Ireland, there is little to point to the recent house price rally being credit-fuelled, rather supply-demand imbalances look to be the main price driver.

In contrast to the UK or Ireland, Dutch BTL borrowers do not benefit from any direct tax relief from the deductibility of mortgage interest as there is none allowed for investment mortgages.  There is, however, some tax-related upside given an unconventional framework that derives the taxable amount for an investment property by applying notional yields (ranging between 2.87% and 5.39%, depending on asset value) to the net worth (i.e., equity value) of the BTL property, and deducting an allowance.  A flat tax rate of 30% is then applied. While the exact formula and notional yields used can vary depending on tax filing status, the net outcome is often an effective tax rate that is relatively attractive compared to the tax-take on other income or investment returns.

The credit performance of Dutch BTL mortgages – to the extent reliably inferable from existing securitisations – looks to be broadly consistent with the owner-occupied mortgage market, which of course boasts one of the strongest credit trends among ‘tradable’ mortgage markets in Europe. Based on available data from the DPF 2017 securitisation, headline delinquencies are moderately higher than the norm seen among owner-occupied portfolios, but defaults and ultimate losses are broadly similar.  In the absence of available loan-level data, we would hazard an educated guess that the bulk of arrears relate to the more seasoned loans pre-dating the housing recession in 2009-13, with delinquencies being far lower (likely negligible) among front-book BTL loans. If this is correct, we would see the extent of legacy loan arrears as being remarkably contained considering the ca. 20% house price fall in the intervening period, which is also captured by the presence of 100%+ CLTV seasoned loans.

To-date, Dutch BTL representation in the capital markets has been via only two securitisations from RNHB, totalling just under €1.3bn. Both deals comprised a significant portion of legacy mortgages (reflecting FGH’s original portfolio), with front-book loans limited to ca. €470mn of the total securitised pools. (And of this amount, BTL loans are roughly half). Going forward, we expect more securitisations of new Dutch BTL lending. But, as touched on in the earlier section, we also see wholesale funding sources for specialist buy-to-let lending coming from other capital market instruments other than RMBS, mirroring similar institutionalisation of the owner-occupied mortgage market in the Netherlands.

Disclaimer:

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients. The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein. Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO). This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity.Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report. Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

Generally adaptable, but CLOs and NPLs face fresh burdens

ESMA recently published its final report on the technical standards on disclosure requirements for securitisations in Europe. Looking through what is a highly technical 339-page document reveals a number of important consequences for the securitisation markets in Europe going forward.

To recap, many existing securitisations in Europe have had reporting and disclosure requirements for more than five years, but these requirements were enforced via the central banks (ECB/ BoE) under their respective repo criteria. Its scope was therefore limited to securitisation types that are eligible for repo in the first place. What has now changed is that disclosure and reporting requirements will become a blanket obligation for all EU securitisations, enforced directly through issuer requirements as well as mirroring investor due diligence obligations. As we discuss below, this EU-based regulatory regime may also ultimately have an extra-territorial impact on cross-border securitisation deal flow sold into Europe. In this commentary, we focus on the changes under the new rules (rather than existing framework), starting with our summarised thoughts.

Assuming that the final report will be adopted into legislation, investors will see a significant increase in information flow in some segments of the market which, in conjunction with the more formalised due diligence requirements, will lead to additional resource needs on the investor side, in our view. There are still some unresolved issues, as outlined in the sections below, particularly with respect to the potential phase-in period which ESMA is referring back to the European Commission.

In summary, given the recent history of loan-level reporting requirements, we do not see the new regulation and data templates as being materially disruptive for most asset classes, operational adjustments notwithstanding. Notable exceptions are CLOs and NPL securitisations, where the changes are by contrast more substantive and will inevitably require significant investment in reporting capabilities. The new regulations will also be also more burdensome for EU investors, reflecting the increased scope of formal disclosures and due diligence requirements. All that said, we see potentially positive effects in the longer-term from the better market transparency and standardisation that should come with these new regulatory requirements, ultimately improving investors’ ability to monitor and predict credit performance. But we are equally cognisant that transparency, while in itself a necessary ingredient for effective markets, is not a cure-all for securitisation performance risks as was clearly evidenced by the previous US subprime mortgage crisis.

While many aspects in the final report are positive and an improvement relative to the consultation paper, we see in particular some challenges for CLOs, CMBS and NPL securitisations. In a nutshell:

Positive outcomes:

• Timing: ESMA has published the report significantly ahead of the deadline, hence allowing the European Commission to adopt this Level-2 regulation before January 1st 2019. This would allow issuers/originators to directly use the new disclosure regime rather than having to use the transition measures, which would mean adjusting securitisation reporting twice. In our view this burden would be a deterrent to new ABS issuance in (early) 2019
• Removal of certain data fields: We had previously argued (see our Pulse from 22 February 2018) that loan-level disclosure of PDs and LGDs would be challenging for a number of reasons. These have now been removed, as have some other more problematic data fields. The templates are now more easily usable, particularly for non-banks
• Many technical points have been pragmatically resolved.

Challenges remaining:

• Leveraged loan CLOs will be required to use the corporate template with some additional data fields as well as a separate section on the CLO manager and transaction details. It remains to be seen how the CLO market will cope with the additional reporting obligations, particularly given that 1) no previous operating or management experience exists given that CLOs were not part of the ECB/BoE collateral reporting requirements, and 2) some of the data fields disclose information on underlying obligors (typically loan borrowers in private markets) which have not been reported in the past
• For CMBS, data templates continue to be among the most extensive, the only let-up being that tenant information is now restricted to the 3 largest tenants
• NPL (or ‘NPE’, as referred by the regulators) securitisations have to report loan-level data using the respective asset class templates plus additional NPE fields based on the EBA NPL template – not unexpected (and in our view, justified). But there is still a high level of data disclosure which will be challenging for some portfolio sellers, whether banks or secondary portfolio owners. The public nature of such disclosure may also prove to be a deterrent to continued bank NPL deleveraging through public securitisations
• One surprising feature is that the NPE data sections also apply for securitisations where the NPE portion has increased above 50% of current pool balance. We see this as a potential challenge for tail periods of “normal” securitisations where more senior notes have been largely redeemed but the clean-up call is not yet exercised, leaving a typically higher portion of NPEs in the pool balance. This requirement could therefore mean a significant increase in reporting obligations for some deals towards the end of their economic life.

The split of the investor reporting into (ongoing) investor reports, “significant event” reports and “inside information” reports makes the reporting, in principle, clearer and more defined, notwithstanding the greater administrative burden on issuers. However, we note that the “significant event” report (which is relevant only for public securitisations) has a number of data fields which patently require ongoing inputs, such as fields relating to master trusts and issued notes – this particular report is thus effectively a separate ongoing reporting obligation, which of course is hardly ideal.

With respect to the jurisdictional scope, it remains unclear if EU regulated investors have to receive the same information also for non-EU securitisations, in line with Article 7 (in cases where originator, sponsor and SSPE are not based in the EU). The due diligence obligation in Article 5 includes a reference that investors must validate that adequate information is provided by in accordance with Article 7, but the wording “where applicable” is unclear in that context and if limits the obligation to EU-securitisations only. In our view, the spirit of the new regulations essentially mirrors issuer reporting requirements and investor due diligence obligations of the same, meaning that any EU regulated investor buying non-EU securitised products would likely need to be provided substantially similar data and information in order to be compliant with the regulations. This would of course be particularly relevant for global, cross-border markets such as leveraged loan CLOs.

Importantly, the reporting obligations on the underlying exposures and investor reports are also applicable for private securitised transactions but will not be published through the securitisation repositories, ultimately confirming our earlier understanding from the Level-1 text (ESMA i.e. considers a potentially different approach as outside of its mandate). In effect therefore, private deals will remain private in terms of information/ data disclosure, but the scope of reporting remains largely the same as public securitisations.

No significant changes for RMBS, SME and consumer related asset classes after all

We argued in the past that the disclosure of PD/LGD metrics on an exposure level would have been disruptive, not least given the possibility to reverse-engineer credit models. In addition– in the case of corporate securitisations – this could have led to the disclosure of bank internal ratings and other information for some obligors, a potentially highly problematic outcome from a legal and regulatory perspective (see our Pulse from 22 February 2018). We hence welcome the removal of these PD/LGD data fields as well as the specific obligor names for larger corporates in the corporate template. PD frequency distributions have to be now provided at pool level, which we think would be more acceptable for (bank) issuers.

These changes are also welcome from the perspective of non-bank originators, an issuer constituency that does not naturally operate around PD/LGD data. There are still some bank-driven data fields such as credit-impaired obligor and default definitions but we think that the remaining challenges are now more limited for non-banks in this regard.

We note that the actual templates have changed in terms of format but the content is very similar to what has been the norm over the last few years based on the ECB/BoE reporting. On balance, these asset classes should have relatively limited remaining challenges although the technical implementation of the new templates will still like be a major administrative task for many originators.

Leveraged loan CLOs will be most affected

We see the CLO market as being most affected by the changes, an important observation considering what is the most dominant securitised sector currently if measured by deal flow. Hitherto, there have been no formalised loan level reporting templates for CLOs given their ineligibility within the collateral framework of the ECB and BoE. The new requirements will hence force many CLO managers into investing in new reporting capabilities for their active CLO programmes in 2019 and beyond. As mentioned above, non-EU CLO issuers (US managers namely) will likely – in our view – need to provide substantially the same data and information in order to tap the regulated EU investor base, which remains subject to due diligence compliance obligations. It will be interesting to see if this ‘back-door’ regulatory capture of non-EU securitisations (via EU investor obligations) will ultimately reach into global CLO market practices in terms of reporting requirements.

ESMA decided against customising the corporate templates just for CLOs, opting instead to maintain the standard corporate template but adding CLO specific data fields such as market value and put options metrics. More importantly, in our view, is the obligation to disclose specific balance sheet data on the underlying obligors, to include revenue, total debt, EBITDA or Enterprise Value, etc. How and whether such name-specific disclosure requirements can be reconciled with what is essentially a private loan market remains to be seen. While technically the names of obligors do not need to be disclosed, in practice it should be relatively easy to identify the underlying loan borrowers (if not otherwise published in the investor report). ESMA explicitly refutes the argument that the information might be only available to the original lender and effectively obliges the CLO manager to provide such information. On top of the underlying exposure disclosure, there are specific CLO transaction and manager sections in the investor “significant event” disclosure template.

CMBS template lighter but still extensive

The revised CMBS template retains tenant specific information but is now limited to the 3 largest tenants. On the CMBS side we do not see any major changes as most transactions already publish tenant information on the largest tenants, that aside tenant rating data fields have now been removed. Nevertheless, there might be confidentiality issues for some CMBS going forward. We note however that the template continues to be substantially similar to the E-IRP template published by CREFC as an industry body. The old ECB CMBS template was also very similar although very few CMBS published loan level data on the European Datawarehouse as the designated ECB data repository.

Suggested phase-in period seems reasonable – but ESMA did not budge on unavailable or confidential data

ESMA outlined a suggested phase-in period of 15-18 months based on the ECB experience with its earlier loan-level initiative. However, in the final report there is no specific mention how this phase-in period will be handled and what thresholds will be used for the unavailability of data in the phase-in period. In this regard, ESMA states that transitional arrangements are outside of its mandate and refers the issue to the European Commission. It is therefore unclear to us if and how such a phase-in period will materialise.

On the so-called “No-data” options, ESMA maintains the view that existing options are sufficient in scope and specifically states that these options cannot be used to avoid reporting obligations. We feel this is a significant position to take in the sense that EMSA is explicit that the confidentiality defence outlined in Article 7(1) cannot be used to avoid reporting on the underlying exposures – in effect, ESMA sees the data fields as providing enough anonymisation. ESMA has now also defined for each data field whether a no-data option can be used. It remains to be seen how this will play out in practice given that it is next to impossible to systematically police the use of no-data options except in obvious cases of avoidance. Moreover, given the absence of thresholds, it is unclear to us what happens if there is an extensive use of no-data options as there is no (detailed) sanctioning mechanism as such envisaged at this stage, at least in our understanding.

Other noteworthy technical points

Without going in too much further detail, we see issues such as unique identifiers, ISO20022 and XML, cut-off dates and some definition issues as mostly positively resolved. Also, the introduction of a ‘default’ template for ‘esoteric’ transactions which do not fit other templates makes a lot of sense, in our view.
One negative however is the use of the currency codes in numeric (monetary) fields – in practice a very user-unfriendly change which requires splitting the data for any calculations. (We hope this decision can still be reversed). We also wonder why ESMA wants to maintain the split into static and dynamic fields but removed the distinction in the actual data templates.

Please contact us for our more detailed thoughts on due diligence obligations for investors under the new regulatory regime.

Disclaimer:

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients. The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein. Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO). This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity.Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report. Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

Capital Relief Trades or Credit Risk Transfer or Complex Regulatory Transactions even – An Executive Summary

5 July 2018

Exploring CRT Opportunities (PDF version)

The market for credit risk transfer / capital relief trades (CRT) in Europe can trace its origins back some twenty years, coinciding with the fusion of CDS and securitisation technology to adapt to bank loan portfolio risks.  But that same synthetic securitisation format used at the outset for hedging/ capital management purposes evolved subsequently to become a directional or arbitrage trading tool (mirroring the evolution of single-name CDS), culminating in the correlation-derived synthetic CDO market which, of course, did not survive in the aftermath of the 2008 crisis. Yet the market for capital relief trades has enjoyed a renaissance in recent years, defying the stigma associated with “synthetic” securitisations.

The market’s post-crisis gentrification has been underpinned by the return of simpler structural formats that resemble the earlier generation of the product type, still aimed at regulatory capital / exposure management but with a dimension also of front-book ‘risk sharing’ between protection seller and buyer.  Banks that buy protection via CRT deals still generally tend to be the larger, IRB-based institutions, with reference portfolios mostly comprising higher RWA asset types. (We use the term RWA in this commentary but note the current convention of ‘RWEA’).  Contemporary CRT structures have evolved to keep pace with the continuous nature of banking/ regulatory capital regimes, with the unfolding SRT framework likely to prove especially pivotal in shaping the CRT market to come.  Indeed, the impact of regulatory direction influences CRT structures and deal flow far more than investor appetite, in our view at least.

CRT deal volumes have been relatively significant in the recent past, totalling on our estimates around €20-25bn in placed volumes over the past five years. This is appreciable both compared to traditional securitisation issuance as well as in the context of public equity raised by European banks over the same period.  Unlike the first generation of synthetic CRTs however, deal flow today is executed mostly privately, with bilaterally negotiated trades not uncommon also.  Our discussion herein is limited to performing loan CRTs.

Mirroring the dominance of privately placed deals is the relatively niche investor base in the post-crisis CRT vintages. Such buyers comprise alternative investors mostly. CRT pricing continues to be largely bound by the return thresholds of this specialist investor base on the one hand, and the cost of bank equity on the other. Certain exceptions to this otherwise range-bound pricing dynamic are deals where there is supra involvement (essentially EIF/EIB) – such trades, where the supra acts as guarantor/ protection seller or investor in the capital structure, have been conspicuous in recent years reflecting the extent of public money earmarked to support SME lending.  The role of supras in this regard has created a better seller’s market in SME CRTs (only), arguably at the expense of crowding out institutional money in that space.

Broadly speaking, investing in CRTs is tantamount to re-underwriting the economic capital justified by a reference portfolio, namely by sizing expected and unexpected losses over the deal’s horizon. CRT investments are inherently risky given where they sit in the securitised capital structure, but the equity-like coupons provide for higher absolute yields relative to bank balance sheet comparables such as AT1s as well as most cash securitisation residuals, save perhaps for leveraged loan CLO equity.  CRT returns have certainly been superior to bank stock returns in the recent past, with this uncorrelated outperformance merited we believe by the fact that CRTs provide isolated exposures to defined loan portfolios within going concern bank lending models, safeguarded from other bank-related risks, whether event, operating or regulatory related.

Going forward, we think the CRT market is poised for further – potentially significant – growth, noting fundamentally the continued capital pressures on banks and the product’s versatility as a capital accretion tool, certainly relative to any public, dilutive equity issue. However, a productive regulatory regime will be a necessary pre-requisite for CRTs to have any lasting economic viability, with regulatory qualification also desirable as a means of broadening institutional buy-side liquidity in the CRT market.  Such regulatory endorsement will also be key in substantially de-stigmatising the synthetic CRT market, which we see as a particularly meaningful milestone for this asset class.

CRT market technicals in Europe

Securitisation technology has long been used to transfer first/second-to-default risks related to bank credit portfolios to third party investors, existing in some format or the other since the very inception of the asset-backed market in Europe.  Such credit risk transfer / capital relief trades have occupied a parallel (albeit much smaller) footprint in the securitisation market alongside more traditional funding trades ever since the first BISTRO transactions in the late 1990s.

For the purposes of this commentary, we define CRT as trades structured for the sole purpose of meaningful credit risk transfer – whether for the reasons of capital or exposure management – without any asset mobilisation and therefore funding utility.  And so it follows that CRTs – in our definition here at least – are distinguishable from true sale, funding-based securitisations even in latter cases when there is an element of credit risk transfer via the sale of the riskiest slices of such deals, for example in ‘full-stack’ ABS or CLOs where the residuals or equity are also placed. By our definition therefore, CRT trades are synthetic in nature in that assets remain on the balance sheets of the bank, with risk transfer accomplished through the use of credit protection mechanisms. The fundamental concept remains alien to many mainstream investors, however in practice we see CRT as not substantially dissimilar, or any more complex, to a portfolio excess of loss insurance or guarantee which is a long-established practice in the credit insurance industry.

The synthetic market has gone through two distinct cycles since its inception, each either side of the 2008 crisis.  The pre-crisis period was initially characterised by the gradual ‘industrialisation’ of synthetic securitisation technology as an effective credit risk transfer tool under the auspices of Basel I, which prescribed simplistic, ‘one-size-fits-all’ capital treatment. CRT deal flow became established among certain programmatic sponsors (eg KfW) and banks as a means of capital/ risk management of balance sheet (and inherently illiquid) loan assets, often via full synthetic capital structures.  But by mid 2000s, the technology evolved in parallel into an arbitrage, delta-hedged trading tool, used in replicating or leveraging corporate credit into tranched formats. (Thus, the product’s use evolved from hedging to directional trading).  Such synthetic CDOs eclipsed the regulatory capital based ‘traditional’ CRT deal type by 2006/7 but did not of course survive the 2008 crisis.

The stigma overhang subsequently associated with “synthetic” securitisations largely shut the market down for a few years in the immediate aftermath of the 2008 crisis. But prolonged pressure on bank capital (and the relatively expensive access to such equity), among other factors, brought deal flow back, with the current profile of transactions resembling the earlier generation of synthetic securitisations, i.e., tools for capital and risk management of non-tradable loan credit portfolios held by banks. CRT market growth has been appreciable in recent years, driven by larger banks across a range of assets in the higher capital consuming categories.

The vast majority of the re-emerged market is now private or in some cases bilaterally negotiated, with very few being public, in distinct contrast to the pre-crisis market.  Given the largely private market, there is little by way of accurate data on synthetic tranche volumes. According to SCI data, observable deal flow in recent years was around €3.5-4bn annually (excluding EIB/EIF transactions) but reported volume data in this respect is incomplete. We estimate that placed CRT tranches totalled around €5bn annually over say the last 3 years, with these estimates based on guidance from available data as well as market feedback. (Some market observers estimate volumes as high as €6-7bn annually). On a cumulative basis, we think around €25bn of CRT tranches have been placed over the post-crisis era, referencing portfolios totalling €250-350bn area, on our estimates.

On most measures, however, synthetic CRT deal flow over the past couple of years have amounted to roughly 5-6% of traditional cash securitisations, which we think is not an insignificant representation.  That aside, on our basic calculations – premised on assumptions around the estimated degree of RWA migration with each trade – the regulatory capital released has ranged (roughly) between €25 and €30bn.  We consider this an appreciable amount in the context of public rights issues from banks (ca. €220bn since 2011, according to Bloomberg), or indeed AT1 issuance (ca. €230bn since inception), Yet we feel that the role of CRT trades in bank capital management in Europe remains generally under-appreciated.

Our data above excludes securitisation deal volumes executed by the EIB/EIF group. Under the EC’s Investment Plan for Europe (the “Juncker plan”), institutions such as the EIB/EIF have played an influential role in providing credit protection to banks with the targeted aim of redeploying freed up capital into new SME lending. Over the past three years, EIB/EIF invested volumes have amounted to over €1.5bn, referencing over €30bn of SME loan portfolios (Source: EIF).

Unlike the earlier generation, current deal flow is limited mostly to the placing of junior or mezzanine risk.  And mirroring this, the investor base has become narrower. According to the 2015 EBA report, the CRT investor base was made up largely of hedge funds (47%), pension funds (22%) and sovereign-wealth funds or public/supranational investors (20%).  We generally concur, save for the observation that the role of supras has likely increased in recent years, as have the prominence of specialist high return investors.  To be sure, regulated capital investors such as banks and some insurers will be disinclined to invest in CRTs given the prohibitive capital charges (normally dollar-for-dollar).

As a final point of comparison, the US CRT market is very active also (more than $40bn in tranche volumes issued last year), but the market is conspicuously – and overwhelmingly – dominated by the two mortgage agencies, Fannie Mae and Freddie Mac.  The buyer base for such CRT trades are broad, with REITs known to be significant investors in the asset class.  In that sense the US market technicals are the mirror of Europe’s, in that there is a noticeable concentration of names on the issuer side, seemingly much less so on the buyer side.

Regulatory capital accretion & exposure management – the key bank CRT motivations

The genesis of the issuer motivation driving CRT trades has always been and continues to be primarily in optimising capital usage against ‘hedge-able’ loan books, overlaid in some cases by the desire for better exposure management. (We use the term ‘hedge-able’ to denote assets that can be adequately analysed by protection sellers, given established traded risk markets and/or comprehensively available data).  Indeed, as an asset class, CRTs have endured as an ‘inter-generational’ de-risking tool, spanning the full evolution of Basel capital accords from I to III.  We expand on the issuer motivations below:-

• CRT’s basic commodity value is in allowing the release of regulatory capital tied to a specified pool of loan assets. This is in many cases complemented by exposure management (both sectors and single-name limit), specifically in the case of larger corporates as reference portfolio
• The use of CRT is often targeted for the purposes of capital release specific to a line (or lines) of business. Factors such as exposure management and divisional risk pricing discipline (for example, the desire to redeploy inefficient capital when held against loans originated as loss-leaders for other ancillary business) are also are key rationales behind such trades
• Asset selection tends to have some commonality across CRT issuers. Most loan types referenced in such trades are RWA-intensive assets, typically corporate exposures from large cap to SMEs, CRE loans and duration-rich credit assets such as project or infrastructure loans.  By contrast, retail asset classes such as residential mortgages or consumer loans are rare in CRT deals given relatively low RWAs.  CRT-referenced loans tend also to be assets core to the bank rather than run-off books, this aspect reflecting both the seller’s going-concern capital management considerations and also investor demands for better alignments of interests. For the same reason, it is rare to see capital relief trades from stressed or distressed institutions
• Banks buying protection via CRT trades are often large institutions (mostly systemically important) using IRB models. The use of CRT by standardised banks by comparison is still relatively rare, though becoming more common. Reasons for the under-representation of standardised banks include the need for external ratings on any retained senior tranches (or, alternatively, the need to place or guarantee such tranches), which of course adds to transaction costs, as well as portfolio data and reporting challenges. That said, there have been few CRT trades from standardised banks, notably including EIF involvement under their European SME initiatives.

Fundamentally, of course, the re-emerging CRT market is being fuelled by greater regulatory capital demands on banks, particularly universal models, over the post-crisis era. Managing compliance to such capital demands has led to newer funding markets in equity, equity-linked and/or TLAC instruments on the one hand, and asset de-risking via RWA reductions on the other.  Aside generally from non-core/ NPL asset divestments by banks in recent years, CRTs have played an important role in the latter RWA mitigation strategies, with one of its key benefits being that it is non-dilutive to the capital structure.

With the direction of regulatory capital requirements generally continuing to drift higher, the impetus for CRT deal flow should remain strong. The imposition of leverage ratios on the banking system should add a further dimension to such trade types, in that complying with these rules requires a reduction in total (unweighted) assets, in effect an accounting deconsolidation.  This should fuel more ‘full-stack’ cash securitisations with first loss (CRT-like) tranches distributed also, allowing for both regulatory capital and balance sheet asset relief. We see the key difference in such full-stack deal flow, relative to current CRT trades, being the assets used, with the former likely biased to lower RWA (nominally asset heavy) loan types.

The recent adoption of IFRS9 will also potentially add a new dimension of issuer incentive behind CRT trades to come.  IFRS9, which came into force earlier this year, forces lenders to recognise upfront expected losses over one-year or the lifetime, depending on the prescribed ‘three-stages’ of the loan.  CRT structures could potentially be employed to mitigate such costs as part of the credit risk transfer mechanism inherent in such trades.  The precise structural format and accounting/ regulatory treatment is still evolving in our understanding.

It should be noted that, like cash securitisations, CRT trades demand operational capabilities across front-mid-back offices to appropriately book, account and manage loans that have been hedged.  This necessary requirement means that banks without adequate functionalities (like more extensive data capture) may be challenged in doing SRT trades. Bank CRT issuers need also to manage their capital positions going forward given call features and amortisation although we would argue that the ‘flowback’ risk is not substantially different to AT1 issuance, all things considered.

Synthetic CRT structures – shaped mainly by regulatory regimes

The current generation of CRT deals is largely similar in structural style and format to the first generation from the early 2000s, with only few exceptions. (One key difference being the predominantly private nature of CRT trades today). In its most fundamental form, a CRT structure is designed to simply transfer a pre-determined portion of credit loss risk related to a specific loan portfolio to the protection seller(s).  While there are different structural permutations, especially in the case of bilaterally-negotiated deals, the basic transaction steps can be outlined as such:-

• The bank enters into a credit protection agreement (normally CDS) with the protection seller, typically via an intermediary SPV. (It should be noted that some trades provide loss protection or guarantees directly, without any SPVs). The SPV issues CLNs or equivalents to the investor to mirror the CDS or guarantee economics
• In return for the protection premiums paid, the CRT investor agrees to cover losses based on pre-determined events, with settlements calculated in an interim format with so-called ‘true-up’ mechanisms which mirror the actual recovery performance of a loan
• Investor proceeds are deposited into an account – commonly held at the issuing bank – which is used to collateralise the portfolio insurance inherent within the CRT structure
• From a cash flow perspective, the deposit is reduced by the amount of crystallised lifetime losses, while the carry is used to supplement the protection payment stream to investors.

Beyond the basic structural elements as outlined above, CRT deals are further layered with features that detail aspects of portfolio replenishment, tenor of credit protection, scope and profile of payouts/ events, economic skin-in-the-game, among other considerations.  This can, depending on the precise structure, introduce an element of complexity as far as traditional investors may be concerned.  We summarise key CRT structural features in the table below, but before elaborating on such features we first touch on the regulatory aspects of CRTs. CRT structural designs are borne mostly out of regulatory considerations.

The raison d’etre of any CRT trade – the freeing up of capital – depends crucially on compliance with regulator’s requirements in this respect, namely by demonstrating that commensurate or significant risk transfer (SRT) has been achieved under the CRT deal.  The overriding concern of regulators is to avoid regulatory capital arbitrage, or capital leakage risks, ensuring therefore that capital relief is fully commensurate with the transfer of economic (credit) risks.

Such SRT ‘guidance’ in itself is, at this stage, not all that straightforward. The Basel II/III rules, which are encapsulated within the CRR in Europe, sets the basic framework for SRT compliance, with this complemented by guidance provided by jurisdiction-specific authorities. More recently, the ECB’s SSM coverage of systemically important banks in Europe has given it a voice over such rules also. Overlaying all of this is the EBA’s ongoing efforts at harmonising the EU’s rule-book for SRT, which may not be formulated into legislation before 2019/20 – nonetheless, the EBA’s current discussion paper (issued in September 2017 with an ensuing consultation phase) appears to set guiding principles for CRT trades currently, at least for some banks and their respective regulators.  There are notable variations, however, for example the UK’s traditionally conservative or ‘gold-plated’ approach, as recently evidenced in the PRA’s consultation paper

Looked at holistically, SRT regulatory literature remains somewhat complex reflecting various prescriptive tests and criteria determining best practice. Discussing SRT details is beyond the scope of this commentary focussed on CRT capital market (investor) opportunities. But suffice to say that SRT guidance in various regulatory rule-books, including proposals in the pipeline, is what shapes both CRT structures as well as the protection cost-benefit balance that underpins issuer incentives and deal flow ultimately. Indeed, the impact of regulatory direction in this regard influences CRT structures and deal flow far more than investor appetite, in our view at least.

Among the key broader structural features of CRTs that come out of compliance with SRT frameworks or guidance include:-

• Tranching. CRT typically involves the placement of mezzanine (second-loss) tranches above first-loss exposure retained by the bank – the thickness of this retained first loss tranche in an important determinant of both investor protection as well as bank capital efficiency. Senior tranches are retained in the case of IRB banks. Mandatory securitisation skin-in-the-game requirements (minimum 5%) is normally achieved via vertical or alternative balance sheet retention mechanisms
• Sequential vs pro-rata amortisation. Sequential structures generate increasing costs to the issuer over time which can make CRTs uneconomical over the deal’s life.  Pro-rata structures (with performance-based switch triggers) are more cost-effective and can also be more investor-friendly but are generally unwelcome by regulators given the erosion of credit-protection, specifically in back-loaded stress scenarios. Replenishment periods for a number of years are common
• Call optionality. CRT structures typically have embedded issuer calls options in the form of clean-up, time and regulatory calls. Time calls represent early protection redemption options for the issuer, which would usually be exercised when the cost of the trade outweighs any benefit from capital relief or loss coverage, but normally not before the portfolio WAL for regulatory reasons. (Time calls also have to fulfil other regulatory conditions).  Regulatory calls are more specific to regulatory events that negate any capital benefit to having the CRT outstanding, allowing the issuer to collapse the trade.  Regulatory calls can therefore potentially be ‘in-the-money’, as it were, given the continuously evolving regulatory environment
• Protection premium payments. Premiums paid to CRT investors can be structured as fixed coupons vs contingent payments, with the latter payments reduced proportionately in line with portfolio losses assumed by the protection buyers during the life of the transaction
• Excess spread and other ‘soft’ credit enhancement. Synthetic excess spread – essentially a ‘top-up’ in payments made by the protection buyer – forms an additional layer of defence against expected losses beyond the first loss retained by the issuer.  There are many variations to excess spread provision, both in terms of calculations as well as the availability over time.  Excess spread can be trapped to form a loss cushion or structured as a use-or-lose facility available only for certain periods. The regulatory treatment of excess spread) is among the key CRT issuer considerations
• Scope of credit events definitions and loss settlement mechanisms, including verification styles. Failure to pay and bankruptcy are the two standard events of course. Restructuring as a credit event – which is a mandatory requirement in certain jurisdictions – can add a somewhat more complex dimension to analysing underlying portfolio risks.  Once a credit event has occurred, loss settlement mechanisms kick-in. The process varies but typically mirror the actual recovery and/or ultimate loss related to a loan default, with internally-derived bank LGD estimates used as a first proxy
• Termination clauses. CRT deals would typically be terminated if the bank as protection buyer fails to pay the premium. In the past, termination clauses in some structures would also be triggered in the event of the bank going into resolution/bankruptcy, however regulators (rightly, we think) question the value of capital relief if the deal cannot outlive any resolution/bankruptcy of the protection buyer.

Scoping CRT investment opportunities – a largely hidden market, still

Our intent in this section is not to provide a substantive investment thesis for the asset class, however for the sake of discussion we would summarise the key investment considerations into the following segments:-

• Reference portfolio. Loans referenced in CRT trades tend of course to be higher RWA assets, which means that lifetime losses are likely to have a non-zero outcome.  Given that most banks executing such trades are IRB institutions, the depth (and predictive quality) of credit data to be analysed should normally be more comprehensive than otherwise available – however on this point we would note that blind reference pools (by obligor line item) are very common, especially in the SME segment, with analysis therefore limited to portfolio-level metrics. As the CRT market matures, the risk of asset ‘creep’ into more exotic/ riskier loan types should be noted. Portfolio losses – and therefore protection payouts – are often back loaded, with this risk offset somewhat by time-value benefits
• Duration. Unlike traditional asset-backed bonds, CRT trades are layered with call options that allows the issuer to redeem the outstanding protection early, typically on a timed or regulatory event trigger as described earlier. Deal termination clauses can also of course affect CRT durations.  Such early redemption manifest in investor prepayments. Conversely, there may also be certain extension risks to expected maturity to consider, related to loss settlements that may spillover beyond the redemption date
• Structural. Most of the key structural elements of European CRTs were covered in the earlier section. Aside from considerations related to these features, we would also highlight the importance of credit enhancement adequacy. While mandatory skin-in-the-game requirements in CRTs are typically satisfied via vertical retention, there is still normally a thin first loss exposure assumed by the bank.  That aside, there can be provision of synthetic excess spread, which – depending on the trapping mechanism and ceiling limits – can form a useful first loss cushion before any losses assumed by CRT investors, subject to the timing of any credit losses as well as potential single obligor risks
• Alignment of interests. Vertical retention (or alternative mechnisms) provide for a lesser quantum of skin-in-the-game than retaining the full 5% horizontally often used in traditional securitisations. But the fundamental characteristics of CRT deals (that is, the selling of protection associated with portfolio equity or near-first loss risks) validates the need for alignment of interests to be demonstrated elsewhere. A key aspect of current CRT deals is that the credit protection relates to core assets/ businesses, where released capital is normally recycled back into fresh lending – this effectively mimics risk-sharing in a going-concern lending business, aligning both protection seller/ investor and the issuing bank as protection buyer/ lender. Some deals involve the random selection of assets, with the servicing and workout units unable to distinguish loans that have been hedged through CRTs – these are further factors that should be considered in the context of alignment of interests
• Deposit structure. The deposit created out of investor proceeds, which is normally held at the issuing bank, may be vulnerable to bail-in haircuts under a resolution/ bankruptcy, notwithstanding its hierarchal seniority. Ultimate CRT defeasance may therefore be impacted under such scenarios, though we would argue that the risk in this respect is remote relative to the primary reference portfolio risks. Bank downgrade and other credit-related tests that trigger segregation of the deposit funds or its replacement by, for example, government securities are potential risk mitigants in this respect.

CRT trades come mostly in unrated form.  Yields on such paper are normally in the 9-12% range currently (before losses) for scheduled tenors of up to seven years, where observable.  On the face of it, such returns are of course attractive relative to more mainstream capital market opportunities. But noting more specifically the resemblance of CRTs to both asset/ securitised finance residuals as well as bank equity-like instruments, we make the following observations: –

• Bank securitisation equity is rare, whereas such residual-like positions are more common in non-bank securitisations, where yields normally range from 7-9% for alternative mortgage risks to 11-13% for leveraged loan CLO equity. Such yields are of course based on asset finance-derived residual income, whereas CRT payouts depend on the cost of regulatory capital/ equity to the bank, which may be entirely decoupled from portfolio yields.  Both cash ABS/CLO residuals and CRTs are, fundamentally, highly levered exposures to loan portfolio risks, however – unlike cash securitisations – synthetic structures do not assume any non-credit cash flow risks, whether related to asset liquidity and/or other disruptive issuer events.  Ownership of assets is normally of no relevance while deal termination is not in any way dependent on portfolio liquidation
• The most established bank quasi-equity product is of course the AT1 or CoCo market. AT1s tend to trade in the 4-8% range, depending largely on individual bank quality. CRTs are therefore appreciably higher yielding for now following the significant yield compression of CoCos in the last few years. On the one hand, CRTs are entirely illiquid relative to AT1s.  But on the other hand, the risk of forced equitization/ writedowns or coupon deferral/ cancellation is a bank-wide consideration in the case of CoCos, in contrast to a defined portfolio consideration in the case of CRTs.   Aside from the broader exposure to non-portfolio and/or event risks related to the issuing bank, AT1s may also be vulnerable to coupon dilution risks given regulatory reform (eg changes to MDA terms) which are otherwise unrelated to capital threshold tests
• There may arguably be some merit in comparing CRTs to public bank equity. Both instruments are, principally speaking, at the bottom of bank-related capital structures and share some degree of pricing relationship since CRT coupons are struck as a function of the cost of equity. But equally there are many reasons why bank equity and bank CRTs cannot justifiably be regarded as comparables. In any case, a cross-asset analysis in this respect would be complex and beyond the scope of this commentary, however we think it still worth noting the following return profiles: Over the past five years, European bank equity – as measured by the STOXX 600 Banks index – delivered total returns of 20%, which was made up entirely of dividends (price return near zero). In the same period, bank CRTs would have returned closer to 60%, excluding the effects of any protection loss-related write-downs.  On this backward-looking standpoint, it can be argued that the isolated equity exposure to a bank’s loan book via CRTs has proved, in retrospect, an uncorrelated yet compelling alternative to bank stock.  We caveat of course that this somewhat primitive comparison ignores factors such as tradable liquidity and says nothing about potential future returns from here.

Notwithstanding the higher-than-market headline yields, we think it worth noting that CRTs – unlike its traded capital market comparables (public equity aside) – have not repriced meaningfully tighter in recent years, with coupons remaining generally range-bound despite the more bullish appetite for bank debt-like risk generally. In our view, CRT pricing has remained enveloped by the return thresholds of its specialist investor base on the one hand, and the cost of bank equity on the other. Going forward, these same factors would of course remain key influential price drivers, with any normalisation in the cost of bank equity and/or investor demand technicals shaping lower and upper resistance levels in CRT pricing, respectively.

To our knowledge, alternative investable opportunities in CRTs are limited to just the one listed equity fund managed by Chenavari (CCSL) – the fund, which trades at a ca. 10% discount to NAV, has been in effective run-off since the beginning of 2017.

CRT market outlook – poised for growth, but vulnerable to regulatory outcomes

We believe the current drivers of the synthetic CRT market will continue to fuel primary volume growth going forward.  Such drivers on the supply side are the more stringent capital demands on banks (overlaid also by IFRS9 considerations, potentially) and pressures to optimally manage capital/ risk exposure within many business lines. On most measures CRTs still represent a compelling tool to accrete regulatory capital, certainly relative to any public, dilutive equity issue. That said, we see compliance to leverage ratio caps driving more deconsolidated, ‘full-stack’ cash securitisations, which might cannibalise some synthetic CRT issuance over the foreseeable future, although we note that the underlying assets will most likely differ between the two forms.

On the demand side, we expect most current established CRT buyers to increase allocations into the asset class, not least as mandates have delivered superior returns relative to other alternative products. Newer CRT investors are also likely as deal flow remains strong, however we see such entrants made up mostly of alternative asset investors, mimicking the profile of the existing investor base.  Therefore, with CRT investments typically made from alternative credit/ equity money with high return thresholds, we see limited scope for CRT coupons to tighten much further at this stage.  For such product to break through into lower yield ranges, greater institutional liquidity – namely from more mainstream investor types – would be a necessary pre-requisite, in our opinion.

Whether such institutionalisation unfolds going forward depends largely on regulatory endorsement.  Indeed, the regulatory regimes relevant for CRTs – stretching from the coming SRT framework to CRR to STS designations, among others – will be key in cementing the long-term viability of the asset class, not to mention also shaping deal structures to come. We would welcome the EBA-crafted new rules as it will allow for a harmonised (some potential jurisdiction gold-plating notwithstanding) and standardised CRT regime, which would of course level the playing field across Europe.

As the CRT market matures, we anticipate more innovations to deal and structure types.  Without going into too much detail, we would see a key theme in this respect centred around aspirations for more permanent capital benefits from these instruments, whether manifesting in programmatic CRT shelves or other innovations.  We expect the highly involved role of supras to remain a feature of the CRT market, potentially spearheading such innovation.

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22 May 2018

   P2P Marketplace opportunities (PDF version)

In this commentary we highlight the growing footprint of marketplace loans in the capital markets in Europe, and discuss the key considerations in investing in these instruments. Our discussion of such opportunities precedes a review of growth trends and business fundamentals of this contemporary industry.  We begin with a synopsis of our observations and views in the section below.

The UK can lay claim to the origins of the P2P/ marketplace (‘MPL’) industry as it’s generally known today, courtesy of Zopa which launched in 2005. This was followed by the likes of Prosper and Lending Club in the US over the next couple of years and Ppdai in China in 2007, in turn inaugurating three of the most established global jurisdictions for marketplace lending today.

We see the contemporary P2P/MPL platforms as the most clinical manifestation of the originate-to-distribute non-bank model, which has of course existed in various guises over the past thirty years or so. MPLs are distinguishable for acting solely as conduits for borrowers to tap directly into non-bank lenders/ investors, without assuming any transitory asset or financing risks. (MPLs therefore do not employ maturity or risk transformation).  The funding model has evolved significantly since the early days, with retail money being largely overtaken by institutional capital in recent years.

Looking through the headline trends, we find that much of the growth in lending volumes is driven by just a few platforms that have cemented their dominance in the market. Such platforms, and the more prominent institutional funds that buy their loans, make up the sponsors of MPL capital market instruments such as listed equities, securitised products and – more rarely – secured bonds. We find that yields across this equity – ABS – bond continuum seem to exhibit little absolute or directional correlation with underlying loan rates.

Going forward, we see the key considerations for capital market investors as centred on loan deterioration risks as well as operating/ funding vulnerabilities of the MPL model under any credit cycle downturn, with changes in regulatory regimes also important to watch:

• • The susceptibility of MPL borrowers – across all credit bands – to a weakening in the credit cycle, whether economic or rates-led.  We see this vulnerability as being greater in the case of MPLs (relative to mainstream lending by banks) given the targeted lending at underserved and/or alternative borrowers, aside from any inherent adverse selection risks. Yield sufficiency to cover losses is of course also a key related consideration
  • Unusually for a non-bank credit intermediary, MPLs typically take ownership of the ‘full-suite’ of origination, underwriting, servicing and workout processes. We think platforms may face scalability challenges in managing this concentration of functions in a credit recession, potentially jeopardising the cost leadership enjoyed by the MPL model currently
  • The question of origination/ underwriting discipline over a full cycle is also important noting that the MPL revenue model is heavily dependent on sustaining lending volumes, with platforms having seemingly little incentive to moderate origination growth for reasons of prudent credit management. Relatively thin skin-in-the-game may exaggerate these risks in more extreme cyclical conditions
  • Vulnerability to institutional investment flows under any number of scenarios, to include rates/ yield curve normalisation
  • Much is still yet to come by way of the regulatory regime for P2P/ marketplace lenders. Any regulatory ‘shock’ can bear significant effects on the very viability of the MPL industry, as the recent example of China shows.

Equally core to the investment thesis for P2P/ marketplace opportunities, in our opinion at least, is transparency, i.e., the quality of the lens into platform assets and their operating models, which based on our analysis does not seem generally sufficient in the case of most platforms to make a fully informed risk/return decision.

In terms of the outlook for the P2P/ MPL industry, we think it reasonable to assume that some well-managed platforms will navigate any headwinds to come and establish meaningful footprints in the credit system, likely at the expense of a number of competitor failures. But, by the same token, we see incumbent banks using their inherent dominance and balance sheet advantages to defend their lending territories, perhaps even re-intermediate some segments of the lending economy. Therefore, we believe that MPL models will establish themselves in alternative, niche pockets of the lending system, with banks remaining dominant in mainstream loan markets.

We expect established MPL platforms to better diversify their funding going forward, both in terms of broadening sources of current retail/ institutional capital while also tapping new channels of funding. To this end we see greater capital market opportunities to come in the MPL space.

Sizing the Capital Market Opportunities

The unique aspect of the investable opportunities related to P2P/ marketplace loans is that the whole loans themselves are of course directly investable for the most part, in contrast to traditional lender intermediated loan markets.  MPL platforms are designed specifically to appeal to direct whole loan investments, which make up the biggest share of this investable universe.

MPL loans are also represented in listed equity markets, namely via funds (and, more rarely, platforms themselves) that have invested in either multi- or single-platform loans.  Such permanent capital vehicles are similar to loan REITs or BDCs, but without any investment perimeters or tax incentivised distribution requirements. MPL equity funds that invest in UK and/or European loans are mostly listed in London (and denominated in sterling) and structured as closed-end funds. Leverage is normally employed to enhance returns, with such gearing typically limited to 1.5-2x NAV, though such funds are often managed at a lower gearing level than the prescribed ceilings.  Currently, investor-managed MPL funds listed in London are generally trading at discounts to NAV for various reasons, to include dividend disappointment and in a few cases high-profile platform failures among the underlying investments. (IFRS 9 adjustments have also shaved NAV in recent months).  It should be noted that such funds may not limit asset allocation to MPL loans only – normally underlying investments can include platform equity, securitisation residuals, co-lending portions and other related asset financing exposures.  Funding Circle’s SME Income Fund is the only listed UK fund that is sponsored by an MPL platform, with raised capital channelled into loans originated by the platform.  There is a naturally greater universe of listed funds investing in MPL, or speciality finance asset more broadly, in the US.

Securitisations of MPL loans are a growing asset class on both sides of the Atlantic.  The very first MPL asset-backed transaction came to the US market in October 2013, with the first rated and broadly syndicated deal seen in January 2015.  The UK’s MPL ABS debut came a year later. Since then, there have been four securitisations of MPL loans totalling just over £660mn, excluding the retention tranches. (By comparison, the US MPL asset-backed market has witnessed over $60bn of issuance volumes since its inception. $2.6bn of such bonds came to market in Q1 2018 alone).  UK MPL ABS thus far has been issued under two programmes, each linked to established platforms in the consumer (Zopa) and SME loan markets (Funding Circle), respectively.  Unlike the US where MPL platforms have been direct sponsors of securitisations, MPL ABS deal flow in the UK thus far has only seen investment fund sponsors, including managers with listed MPL funds.  Such managers are normally motivated to tap the asset-backed market in order to term out leverage facilities in a cost effective manner.

Vanilla bonds secured on platform loan assets is another capital market format that has been seen within the MPL space, but such opportunities remain rare for now.  In the UK, LendInvest and Wellesley are the only platforms – to our knowledge – to have issued such debt, with for instance the two Lendinvest issues totalling just £90mn targeted largely at retail investors.

Yields across the equity – ABS – bond MPL continuum seem to display little absolute or directional correlation with underlying loan rates, in our opinion.  Starting with MPL loan yields, these range anywhere from 3% from the secured (often resi mortgage), prime borrower loan to over 20% for unsecured, essentially deep-in-alternative credit. We see the bulk of gross loan yields – excluding outliers – as ranging from 6% to 12% across the consumer (ex-mortgage) and small business borrower segments. Net yields adjust according to servicing fees charged of course. Servicing fees are typically in the 1% region where such charges are explicitly disclosed, though in some cases the servicing fee is neither clear nor transparent. In case of any defaults, recoveries flowing back to the investor will be netted of fees but, again, such fees are not made transparent in many cases. Funding Circle is a notable exception for being one of the rare few platforms to disclose recovery-related fees.

As against those asset yields, the liability side of MPL loan markets is relatively dispersed in terms of yields and returns.  Listed equity and debt typically yield in the region of 6% (isolating dividend/ coupon returns only).  Current yields on the former listed funds, which as mentioned normally use some degree of gearing to extract greater returns, can look inflated in cases where the equity trades at discounts to NAV without a commensurate compression in distributions. As a very cursory comparison, similar US funds as well as BDCs typically yield more generous dividends, reflecting a combination of greater gearing, higher asset yields and, in some cases, deeper discounts to reported NAVs.

Securitised MPL capital structures have rallied significantly since the debut MPL ABS. Senior (AA-rated) bonds have recently priced at L+75bps vs over L+200bp two years ago, while the most deeply subordinated tranches have recently cleared the market at ~5% floating-rate yields vs over 7% in early 2016.  Current subordinated ABS yields are inside that of listed equity referencing largely the same assets, despite having greater structural leverage on account of being the second-loss, thinly sliced tranches of ABS capital structures. Such deeply subordinated ABS yields are also inside underlying loan yields, making MPL asset-backed liabilities look rich currently relative to the assets, yields in which have remained largely unchanged over the last couple of years. Given this tighter execution of ABS relative to MPL loan markets, it is of no surprise that term leverage provided securitisation capital markets have been attractive to asset owners and platforms alike on both sides of the Atlantic.

Exploring the Key Investment Considerations

We summarise below some of the key considerations in investing in MPL loans, whether directly or via capital market instruments such as equity and asset-backed securities.  Our list is not meant to be exhaustive or substantive, rather a high-level assessment of pertinent investment consideration for this contemporary asset class.

Looking through the capital market instruments into the underlying MPL proposition, we think investment considerations should take into account two key inter-related factors – the first being asset quality and the second being vulnerabilities of the model itself.  Assets originated by MPLs are for the most part established loan types, albeit largely alternative to mainstream bank product.  But such alternative loan products typically have relatively demonstrable track records in the non-bank credit economy, at least in the UK. By contrast, the P2P/ marketplace business/ operating model in its current form is of course novel and substantially untested through different credit and economic cycles (only one platform, Zopa, experienced the 2008/9 crisis).  Against the backdrop of the recent explosive growth of investment inflows and therefore lending capacity relative to their peers, we see merit in fully understanding the P2P/ marketplace platform model, not least given the apparent genesis parallels with the 2008 crisis.

Equally core to the investment thesis for P2P/ marketplace opportunities, in our opinion at least, is transparency, i.e., the quality of the lens into platform assets and their operating models, which we feel is crucial in being able to analyse outcomes that will influence returns.

Among what we see as the key investment considerations are:

1) Loan asset quality, loss predictability and the sufficiency of yields

The default/ loss experience of most UK MPLs has been broadly consistent with expectations derived (and published) by the respective platforms, however such anticipated and actual credit outcomes have generally deteriorated moderately among the more recent vintages.  As it stands, and as a very broad-brush observation, lifetime expected defaults for current loan production range between 4% and 6% generally among the lower-risk bands of consumer and SME loans.  (We would caveat at this juncture that credit performance among MPL loans can vary significantly by loan and/or borrower type).  Actual defaults among the 2015 cohort (i.e., loans aged roughly three years) have ranged around 3-4% for consumer assets and 2-3% for SMEs, with losses modestly lower given some recoveries, again ignoring the outlying weaker credit risk categories.  For comparison, bank loan defaults are typically around 100bps lower than MPLs (unadjusted for duration or other loan variables), based on anecdotal evidence and selected bank reporting. But that one-dimensional view clearly does not take into account the perceptibly higher yields on MPL loans relative to bank loans, which hitherto has arguably generated better loss-adjusted returns relative to comparable bank loans.  US MPL loan yields are typically higher than the UK, but largely justified by the higher default/ loss experience – for example, defaults among the weakest grade of small business loans can reach as high as 30% in the US.

Much of the overall higher default outcomes and expectations recently among established MPL platforms stems, we believe, from the inclusion of weaker credit bands/ borrowers in their lending remits over the past three years or so.  Going forward, the key concern is the vulnerability of MPL borrowers – across all credit bands – to a weakening in the credit cycle, whether economic or rates-led. We see this vulnerability as being greater in the case of MPLs (relative to mainstream lending by banks) given the targeted lending at underserved and/or alternative borrowers, aside from any inherent adverse selection risks.  That said, absent a credit or economic shock, we take some comfort in the fact that MPL internal risk models should benefit further as the market matures, with the greater depth of data allowing for better credit underwriting and default forecasting accuracy.

Should the current generally benign economic tailwinds reverse course and the MPL loan default drift worsens (this trend being visible already in unsecured consumer loan markets), loan yield sufficiency will be key in mitigating ultimate losses.  With MPL internal risk-tiering models/ algos mostly undisclosed, it is unclear whether front book loan yields are adjusted as loss expectations or actual loss outcomes change, particularly if in an environment of lending competition and yield compression. (In other words, are MPLs price-makers or price-takers?)  Investors in platforms with buffer funds should benefit from such yield management given the socialised first loss protection (i.e., the excess spread buffer funds are used on a first-come, first-served basis).  We would note finally that static MPL portfolios – such as securitised pools – will not benefit from such loss-mitigating strategies.

2) Underwriting/ origination integrity in a volume-driven model

Adverse selection risks are valid considerations with MPL platforms given their competitive lending edge is primarily in alternative borrower markets not generally served by mainstream banks.  MPL origination channels vary – aside from direct online applications, loans are also known to be sourced via broker intermediaries, pricing comparison websites as well as bank referrals of declined credit.  There is generally very limited data available on the breakdown of different loan origination sources, nor indeed on the credit performance disparities (if any) between loans originated via the different sources.  (We note however a recent press report stating that only a very small fraction of declined credit referred from banks are accepted for MPL loans).

The question of origination/ underwriting discipline over a full cycle is particularly important with MPLs given there is seemingly little incentive to moderate lending volume growth for credit management reasons, on account of the model’s revenue-dependency on originations given borrower upfront fees, which range from 1.5% to 6% depending on loan type and tenor.  Regulated banks are subject to counter-cyclical measures where lending volumes become outsized relative to norms (as was the case with UK bank consumer lending late last year), whereas MPLs face no such prudency brakes. As far as we can see, the only counter-cyclical control on MPL lending volumes is through (potentially) reduced investment inflows as investor appetite becomes more credit and/or rates-sensitive over the cycle.

Lapses in underwriting/ origination discipline in the case of ‘new’ online lending models have plenty of precedence going back to the early 2000s (Belgium mortgage lender EuropeLoan and US credit card firm NextCard, to name but a few). Notwithstanding how the digital lending model has matured since then, there have been a number of P2P/ marketplace platform failures much more recently in the UK and Europe, the highest profile case being Sweden’s TrustBuddy.  In the US, LendingClub – one of the largest MPL players – has faced significant issues related to origination misconduct in recent years.

3) Skin-in-the-game, or lack thereof

MPL lenders have far less skin-in-the-game compared to traditional asset risk takers, which we see as a very relevant consideration following on from the underwriting slippage risks described above.  The counter-argument here is that MPLs can afford to be thinly capitalised as they do not warehouse asset risks in their role as conduits between loan investors and borrowers. To be sure, other intermediation-only platforms such as brokers and exchanges do not have to provide skin-in-the-game either.  But we think the key difference in the case of MPLs is their sole ownership of the entire origination, underwriting, servicing and workout management of credit as part of the lender/ investment proposition, which arguably demands some alignment of interest. Realistically, of course, skin-in-the-game is no replacement for prudent management aimed at long-term business viability, which would only be demonstrable in a credit recession. It remains to be seen which platforms will successfully manage the challenge between volume growth (which drives revenue) and credit discipline needed in the long run.

As it stands, MPLs benefit from a capital-light regulatory model, with for instance a £1bn MPL loan book requiring just 0.1% capitalisation.  (Presumably such regulatory capital requirements have been sized to reflect operating risks only, given no asset risks).  Precedence in the non-bank credit economy suggests that trailing loan book income and reputational risk concerns are insufficient in themselves as skin-in-the-game surrogates in any credit cycle fallout. It should be noted that ‘buffer’ or first loss funds provided by some platforms are funded normally out of loan excess spread rather than own capital.

Were an MPL platform to issue ABS in order to fund loan investments, the platform would require to hold a minimum 5% of the capital structure under securitisation regulations. (This is the case for platform-sponsored ABS in the US). MPL loan owners such as funds who securitise are subject to this retention rule of course.

4) Scalability challenges over the cycle

Most MPL platforms are young and still generally thinly resourced, yet (unusually for a non-bank model) tend to retain all loan origination, servicing and arrears management inhouse.  A key investment consideration in our view would be the ability of platforms to manage this concentration of functions and deliver incremental resources in order to cope with a credit cycle downturn, particularly if loan performance stress coincides with reduced funding/ origination volumes. (Revenues are squeezed by both lower servicing and origination fees in this scenario)

In short, we see scalability challenges to deal with any credit recession without impacting the cost leadership currently enjoyed by MPL platforms. And not being able to fully invest in loan recovery processes when needed most may exaggerate loss outcomes ultimately.

5) Vulnerability to institutional investment demand

MPL funding has seen a noticeable rotation to institutional money over recent years, mirroring the generally reduced reliance on retail funding. This shift has undoubtedly had a powerful impact in cementing the lending footprint of a few MPLs.  Investment rationales for institutional investors include the generous yields, low correlation to listed assets and the diversification benefits of otherwise inaccessible credit sectors such as consumer or SME loans.

But the shift to institutional money arguably means that funding is less ‘sticky’ that would have been with retail money. Such money is susceptible to flight under any number of scenarios, to include (potentially) rate normalisation, other macro or credit events and indeed any negative headlines in the MPL space.

By contrast, retail money is likely to be stickier, particularly if invested under ISA allowances in the case of the UK.  In the US, a number of the larger and more established platforms have developed hybrid funding strategies that span retail, institutional as well as own balance sheet funding, the latter mostly via asset-backed debt programmes.

6) Transparency considerations in the context of visualising risks over the horizon

MPL platforms are certainly more transparent than any other non-bank finco model, in that credit underwriting outputs and loan terms/ features are made readily available at the point of origination.  That aside, platforms also provide historical data on credit performance of their originated loan stock, to varying degrees of depth.

But given the non-recourse nature of P2P/ marketplace lending and taking into account some of the other risk factors outlined above (potential drifts in underwriting discipline, lack of skin-in-the-game, other operating challenges and credit vulnerabilities as cycles turn), the issue of sufficient data transparency in order to clearly identify current credit trends as well as visualise borrower payment behaviour patterns is a key investor consideration, in our opinion.  By ‘sufficient’ we mean the depth of loan book information such as borrower and loan profiles, default and loss statistics, etc, produced in a line-by-line format.

Our high-level review of selected MPL platforms, as summarised in the table below, highlights disparities in the quality of loan book data transparency. (We looked at the more established platforms that draw funding from both institutional and retail money, thus excluding the likes of Market Invoice, Lendable, Lendinvest Creditshelf, etc. given their non-retail focus.  We also excluded aggregator platforms).

Foremost, we have observed a noticeable difference in disclosure standards between UK and European platforms, with transparency provisions among the latter platforms remaining relatively basic, if not minimal.  The one notable exception is Lendix in France. And even within the UK, where most (but not all) platforms provide good aggregated data on yields and defaults/l losses by cohorts as well as fee structures, there appears to be noticeable differences in the depth of this information provided between different platforms, with MPLs adhering to the P2PFA standards generally providing better transparency as well as data standardisation. There is, however, typically very limited information provided on other important trends such as origination channels, loan rejection rates, underwriting scoring models, collection and workout resources, etc.. It is also unclear if and how ratings are updated, hence rating migration tables are not available. Moreover, internal rating methodologies are updated taking into account new data which makes comparisons with historical rating performance potentially difficult.

Mandatory data requirements for securitisations, in the context of complying with central bank (BoE/ ECB) criteria, provides a useful yardstick to measure the depth of loan-level data provided by MPL platforms. For the most part, we note that platforms publishing loan books provide fewer loan-level data fields than that required of central bank-eligible securitised products.  To make our case, we would note that the ECB consumer, SME and residential mortgage data templates have 46, 48 and 55 (mandatory) data fields, respectively, that needs to be filled. (See table below for MPL comparisons

7) Regulatory outcomes

Regulatory changes to come also poses risks to the MPL model, but perhaps also competitive benefits to platforms that are able to adopt to such demands and build businesses around any new regulatory regimes.  Thus far, the UK has implemented a broad-based rule book for MPLs, following on from the requirement for such platforms to be authorised by the FCA. European platforms remain largely unregulated for now.

In the UK, the FCA’s full review of the industry and further regulatory initiatives are still pending.  Both the UK and the EU launched regulatory action plans in Q1 this year, namely the EU Fintech Action Plan and UK Fintech Strategy, respectively, intended to cover the full gamut of technology-based industries – including marketplace platforms – within financial services.  What comes out of these initiatives is of course still unclear, but we sense from the tone of these plans that the intent is to design regulatory frameworks without diminishing the growth and/or innovative capacity of this sector.

Much is still yet to come by way of regulating P2P/ marketplace lenders. In the case of MPL platforms, we see the direction of regulation being guided by the fundamental perspective regulators will ultimately have of MPL models – that is, are these platforms ‘shadow banks’ or ‘shadow asset managers’?  Lending directly into the real economy and borrowing using a combination of institutional money and deposit-like retail facilities gives some credence to the view that MPLs resemble banks. Or conversely, MPLs can be seen simply as asset allocators of institutional and retail capital that have specific appetite for exposure to the assets in question, without employing any maturity or risk transformation.  Our overall view is that any treatment of MPLs as shadow banks will ultimately mean a more comprehensive and stringent regulatory regime versus thinking about these platforms as anything else.  We are also of the opinion that some further regulatory oversight – in terms of borrower/ investor protection, lending conduct and overall operating governance – is likely inevitable any which way, to potentially include greater capital requirements.

Any regulatory, or indeed legal-related, ‘shock’ can bear significant effects on the very viability of the MPL industry. In the UK, a number of platforms are known to have shut down rather than embrace the FCA’s (relatively light, for now) requirements. The US has also witnessed certain regulatory and legal disruptions, notably including the Madden vs Midland case which threatened the fundamental viability of nation-wide MPL models. But for the most instructive example to understanding the potential impact of unfriendly regulations, one only has to look to China.  Over the course of 2017 and into this year, there has been a significant tightening in the regulatory framework for P2P lenders in response to both misconduct cases and, more generally, demands to rein in the shadow financial system.  The new regime includes usury rate ceilings, borrowing caps and other restrictions in lending practices, limits on asset-backed bond issuance and funding from financial institutions, aside from requiring all lenders to file for authorisation. Most commentators have argued that the scale of the regulatory clampdown will trigger a material shrinkage in the P2P industry, with only a few platforms being able to survive going forward.

There is one, investor-friendly aspect of the regulatory regime in the UK that we think is deserves mention, that is, the requirement for platforms to have “living wills” in place.  Similar in some sense to how securitisations work, the rules are designed to allow for an asset run-off in cases where a platform fails. This is untested of course, but we still like wind-down frameworks over any unorderly outcome in the event of MPL dissolutions.

Brief Thoughts on the Outlook for the P2P/MPL Model

There has been no shortage of commentary talking to the outlook for the P2P/ marketplace industry since this model became better entrenched in different lending economies. Opinions are generally bifurcated into the “bubble and unsurvivable” or the “revolutionary, here to stay” camps.

In this commentary we do not profess to have undertaken any substantive analysis to be able to fully discuss the long-term outcomes for the MPL industry.  That said however, in the section below we articulate our thinking in this respect.

Our simplified view is that there are two key outcomes to consider:

• Taken in isolation, can the contemporary marketplace operating and funding model survive any ‘shocks’ to come, whether via credit recessions, investment outflows or regulatory tightening, to name but a few? Even in the absence of any such shocks, it would be reasonable to assume that the current explosive growth trend will be exhausted before long, putting pressure on the weaker platforms. In the US, MPL lending actually peaked in 2015, with growth rates gradually moderating since then.
• Will incumbent banks re-intermediate lending markets currently occupied by MPLs, namely by cloning the technology-led infrastructure or, indeed, by acquiring established players? Most commentators agree that the MPL model will not have an enduring advantage over the bank model, simply given the ease of replication of any innovation, whether in terms of borrower origination interface or underwriting risk models or otherwise. But equally, we see the banks’ current competitive advantage from asymmetric information being eroded with PSD2 and the UK Open Banking Standard forcing greater sharing of such data.

Reflecting on the points above, our sense is that – like any young, fast-growing industry – there will be well-managed platforms that navigate any headwinds to come and establish meaningful footprints in the lending economy.  Such survival could well be underpinned by sector consolidation, and potentially also at the expense of some competitor failures. But, by the same token, incumbent banks are likely to use their inherent dominance and balance sheet advantages to defend their lending territories. Therefore, we think that MPL models that outlive the ‘bubble’ will establish themselves in alternative, niche pockets of the lending system, with banks remaining dominant in mainstream loan markets. Where there is overlap in targeted lending segments, we see bank-MPL lending JVs becoming more prominent, a trend that is already visible in the US.

There certainly is precedence for such complementary lending ecosystems, not least in the US where the non-bank credit economy has proven resilient time and again to cyclical fortunes. On this side of the Atlantic, we see the UK as more naturally suited to this parallel bank/ non-bank credit system, given both the regimented nature of bank lending on the one hand and the deeper institutional (and capital market) appetite for loan credit assets on the other. And the fact that certain MPL investments can now count towards household ISA allowances is a powerful de facto endorsement of the model by policy-makers, in our view.  Still, we do not see such ISA inflows cannibalising deposit-taking by the incumbent UK banks.

By contrast we see the MPL model facing greater challenges in core Europe over the foreseeable future. Not only are there generally wider boundaries to bank lending appetite, but there is also (concurrently) more limited ‘alternative’ lending opportunities.  Or put differently, any alternative borrower segments tend to be further out the non-conforming spectrum, whether measured by credit quality or otherwise.  (We note, for example, that there is little precedence for alternative non-bank credit models successfully surviving in a highly-banked economy like Germany).  There will likely be exceptions of course in terms of countries and/or lending pockets for MPLs to operate viably.  In this regard we see it as encouraging that European policy makers have explicitly recognised the role non-bank lenders can play as alternative sources of financing (subject to oversight, however), as spelt out for instance in the EU’s Capital Markets Union blueprint.

There can be no certainty as to how MPL models will ultimately look like as the sector matures.  But we see two key potential developments to come, aside from the focus on alternative loan markets as outlined above.  The first is based on our earlier articulated view that the concentration of underwriting, origination, servicing and credit management of loans is likely to be tested in any downturn, leading potentially to more autonomised functions provided by third-parties, perhaps leaving MPL platforms as origination conduits only. (This will resemble more traditional finco models in some respects).  The second is that the more established MPL platforms will likely seek to fully diversify their funding sources. We see this featuring both in terms of broadening sources of current capital (that is, tapping institutional and retail money through more diversified formats) as well as funding strategies that reach into new channels of funding.

Capital market MPL opportunities to expand further

Following on from our point made immediately above, we see greater capital market opportunities related to MPL assets going forward in Europe.

Such opportunities should manifest via listed equity, securitised debt and potentially other bond formats. Asset-backed bonds, in particular, are likely to be more fully embraced given the compelling financing costs for what are normally highly ‘securitisable’ assets.  We also see a shift to platform-sponsored opportunities, potentially at the expense of the current model of investment fund-sponsored capital market instruments. Listed equity markets, for instance, remain largely untapped by the established MPL platforms – by contrast, investor-managed multi-platform equity funds have faced challenges recently, as reflected in typical NAV discounts.  (In one high profile case currently, the deep NAV discount has attracted an activist investor who is using their stake to attempt forcing for a wind-down of the MPL fund).

P2P/Marketplace Explained

Genesis of the Industry

The UK can lay claim to the origins of the P2P/ marketplace (‘MPL’) industry as it’s generally known today, courtesy of Zopa which launched in 2005. This was followed by the likes of Prosper and Lending Club in the US over the next couple of years and Ppdai in China in 2007, in turn inaugurating three of the most established global jurisdictions for marketplace lending today.

We think it’s worth defining this “P2P/ marketplace” industry in the first instance, in particular distinguishing this model from the broader online or digital lending universe, which in itself has also grown rapidly in recent years.  Such online lending platforms share similar ‘front-end’ (i.e., borrower-facing) lending infrastructure with marketplace platforms, but with the key difference that the latter’s funding or liability side is sourced from a broad marketplace of retail and institutional investors.  It is this democratized funding profile that we use to define MPL platforms.

Notwithstanding the platform debuts in the mid-2000s, it was not really until the post-crisis era when the P2P/marketplace phenomena took hold, led by breakneck expansion in the US and Chinese markets, followed soon after by the UK and, most recently, Europe.  Factors underpinning the success of the P2P/ marketplace model are now well-documented, to include the digitally-enabled, streamlined and cost-effective underwriting and origination process which affords quick lending decisions, bringing a radical change to the typical customer journey relative to practices of the incumbent bank lenders.  Funding appetite from yield-starved retail and institutional investors, along with seeding by supras aiming at fostering the alternative lender industry, also helped to propel the model in the post-crisis era.

Growth of the UK MPL market accelerated noticeably from 2014.  Despite the proliferation of the number of marketplace platforms, much of the growth in lending volumes was driven by just a few platforms that cemented their dominance in the market. The industry in Europe still remains at an early stage, and – like the UK – concentrated among a select few platforms and lending aggregators.  What’s notable about the European MPL market is the preponderance of bank and/or insurance JVs with MPL platforms (compared to the UK, at least), though we would note that some such platforms are more online lenders than MPLs, strictly speaking. At this time Germany and France remain the largest MPL markets in Europe.

There are around 50 MPL platforms in operation in the UK today, following compound growth of some 30%+over the post-crisis period, with business lending (SME loans and invoice financing mainly) growing the most sharply.  On any measure, the growth of the P2P/MPL market in the UK has significantly eclipsed the growth of any other lender type, to include the loan books of challenger banks that came into being at roughly the same time as marketplace lenders.

Yet total cumulative MPL lending in the UK stands at almost £9bn, according to the P2PFA, representing (approximately) just 2-3% of total gross lending, isolating the consumer (non-mortgage) and SME loan markets. The stock of MPL loans outstanding stands at around £4.5bn, which is less than 1% versus loans outstanding in the broader credit system. In Europe, the MPL footprint in loan markets is at a fraction, still a rounding error as it were.  So while the growth of this contemporary lending model has been nothing short of staggering, its penetration into the broader (bank-dominated) credit economy remains minimal thus far.  For this and other reasons, we are cautious in talking up the “disintermediation” accomplishments of such lenders – rather, we see MPLs as arguably more complementary to incumbent bank lending, as we outline further below.

For now, there seems to be no let-up in MPL lending growth in the UK and Europe, with 2017 breaking new records again with the UK seeing total originations of just over £5bn and Europe just over €1.5bn, according to AltFi. On the funding side, most of such platforms have long since evolved from retail or “P2P” models, with institutional money largely fuelling growth in recent years.  A few of such institutional managers have tapped the capital markets for leverage or capital, as have selected MPL platforms directly. (See discussion above)

By contrast, the US MPL market witnessed around $25bn of originations in 2017, but notably lending volumes have gradually declined from the peaks reached in 2015.  Yet, despite not having any head start on the UK, the P2P/MPL industry in the US (and China, for that matter) is noticeably larger at this stage, measured both in absolute terms of course (given the sheer size of the credit economy) and also in proportion to the overall lending markets.  The US, which is of course the closest comparable to the UK in terms of the credit industry backdrop and lending (or disintermediation) opportunities, is also more matured in terms of MPL model visibility, funding reach as well as the depth of the overall MPL/ online lending ecosystem, aside from lending penetration. Bank – MPL JVs are becoming increasingly common in the US loan market

Profiling the P2P/ Marketplace Model

We see the contemporary P2P/MPL platforms as the most clinical manifestation of the originate-to-distribute non-bank model, which has of course existed in various guises over the past thirty years or so. But unlike non-bank (often securitisation-based) lenders of the recent past, MPLs stand apart for acting solely as conduits for borrowers to tap directly into non-bank lenders/ investors, in effect playing a similar intermediation role as exchanges rather than that of outright lender. MPLs do not generally assume transitory asset or financing risks, and do not therefore employ maturity or risk transformation.

Disclaimer:

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients. The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein. Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO). This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity.Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report. Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

27 April 2018

In this the second part of our series on investable loan markets in Europe, we look at corporate-related opportunities. Unlike mortgage or other inherently illiquid asset finance markets, corporate loan credit-related opportunities manifest directly to a large extent in the capital markets via tradable loan markets, whether in syndicated investment grade or high yield/ leverage loan sectors. Our proceeding discussion focusses more on the scope of indirect investment opportunities, that is, investing in isolated portfolios (whether managed or static) of corporate loans via debt, equity or fund instruments, as opposed to directly buying singe-name corporate loan credit.

The opportunity suite is certainly broad when it comes to corporate loans, not to mention diverse from an asset/ credit perspective.  Investable instruments that reference corporate loans range from securitised products (CLOs, mostly) to listed equity and unlisted direct lending funds to the more contemporary whole loan opportunities presented by marketplace platforms. To better conceptualise this product suite, we will need to distinguish the European corporate loan market by borrower type.

Taken in its entirely, corporate loans in Europe continue to be dominated by banks, to a much greater degree than say in the US. Bank loans outstanding as at end 2017 stood at €5.2trn (source: ECB/EBF). Non-bank ownership of corporate loans – from which of course most investable opportunities stem – has certainly increased with post-crisis bank disintermediation, but remains comparatively low, estimated at less than 10% of the stock of loans outstanding. (By contrast, such institutional lending accounts for 70-80% of the US loan market).  Non-banks in the corporate loan markets comprise CLOs and direct lending/ marketplace funds for the most part. Other speciality finance lender models substantially did not survive the 2008/9 crisis.

The large-cap segment of the corporate loan markets – namely syndicated high grade and leveraged loan markets – is by far the most institutionalised, certainly in the case of the high yield leveraged loan market where the extent of bank participation in new deal flow is typically no more than 25% currently.  At the other end of the continuum, SME loans continue to be owned overwhelmingly by the banking system despite disintermediation efforts in the post-crisis era, with a fraction (albeit growing) of such borrowers currently sourcing credit from non-bank entities such as direct or marketplace lenders. The corporate economy that falls in between – loosely defined as the mid-market loan space – is also largely bank-dependent for borrowing, however there is a deeper footprint of non-bank lenders. But as we discuss further below, little of this institutional activity in the mid-cap market translates into capital market investable opportunities.

Mirroring both loans sizes and the degree of non-bank institutionalisation, large loan and highly institutionalised markets such as leveraged loans are of course the most liquid (by tradable depth), while – at the other extreme – SME loans are entirely illiquid for the most part.  What we see is that the yield continuum from large to small corporate borrower loan markets looks linearly correlated to liquidity, with loan yields the richest in the larger loan / more liquid segments and cheapest in illiquid small balance markets otherwise dominated by banks. The same generally extends to the capital market instruments referencing the different loan types, save for when returns are enriched by instrument gearing. We caveat of course that these simplistic observations provide just one half of the risk/ return picture, with no account taken of the risks, which can vary materially by loan/ borrower types.

Across all sectors without much exception, bank loan margins are tighter (often noticeably) than non-bank lending margins. This disparity is explained by a number of historical as well as more topical factors, in our view. Banks have been direct beneficiaries of generous central bank funding accommodation and specific programmes designed to incentivise corporate lending (to SMEs particularly), while enjoying a powerful head start over the newer generation of non-bank lenders in terms of borrower relationships and credit intelligence. Similar to other asset finance markets therefore, non-banks have been squeezed mainly into ‘alternative’ sectors, which in the case of corporate lending is mostly special situation lending like leveraged loans as well as other pockets of the loan markets that are underserved by banks, whether for reasons of capital-intensity, complexity or other risk-related factors.

Large cap markets: The greatest degree of institutionalisation, the biggest investable footprint

Large loan markets stretch from syndicated investment-grade loan markets to high yield, leveraged loan sectors.  There is a greater balance of lending volumes in the IG market of course. The outstanding leveraged loan market stands at ca. €280bn (including bank lines), of which more than half are institutional facilities.

Syndicated high grade loan markets have faced relatively little lender/ investor disruption over the last (post-crisis) cycle.  Certain countries have developed their own unique loan capital markets with direct investment incentives, the Schuldscheine in (mostly) Germany (€27bn issued globally in 2017) being an example.  The capital market footprint away from direct investing is limited from what we understand, for this reason we do not focus on this particular segment in this commentary.

Leveraged loans, CLOs and loan funds

By some contrast the leveraged loan market has evolved somewhat. Institutional participation increased steadily since the late 1990s, fuelled not least by the first generation of CLOs. The securitisation implosion post-crisis saw part of this institutional buying power replaced by loan funds, some of which were listed. The CLO market comeback since 2014, and its solid growth in the past year especially (totalling €27bn since the beginning of 2017), has re-asserted securitisation as an important funding/ investment channel in the leveraged loan market.  Currently CLOs account for around a third of the stock of leveraged loans outstanding, but that understates the degree of participation in new issues which stood at 38% in Q1 (compared to just 21% five years ago), according to LCD. Loan funds, whether listed or unlisted, are roughly equally dominant in their loan buying. Banks currently make up only 20-25% of high yield lending, with this disintermediation fuelled by a number of factors to include the more restrictive, US-like leveraged loan lending guidelines imposed recently by the ECB.

This degree of institutionalisation means that the capital market footprint of leveraged loans is sizable, not only as direct investments of course (not dissimilar to syndicated high grade loans) but also indirectly via CLOs and listed loan funds. CLOs dominate this footprint, with listed (equity or unit) funds being less ubiquitous relative to unlisted loan mandates.

Notwithstanding the recent sell-off, leveraged loans and its constituent products such as CLOs have rallied significantly since the end of 2016, outperforming most other comparable traded credit. Currently, the yield universe ranges from very defensive senior CLOs to highly geared CLO equity, with loan funds somewhere in between in terms of yields/ returns. Senior AAAs currently have spreads around 70bp, while deeply subordinated BB/B yield in the range of 6-8%, with equity often returning in the low-teens. Listed senior loan funds yield in the range of 3-5% (not dissimilar to direct leveraged loan yields of course), with total returns enhanced over the past year by stock/ unit price or NAV appreciation.  Unlike the US, such funds are generally unlevered, reflecting the capital incentives for the dominant end-investors, that is, insurance and pension money.

On the face of it – without analysing any structural and asset nuances – yields on highly geared CLO equity and/or retention tranches continue to be outliers in the context of overall loan capital market opportunities, much as can be expected.  We would finally add that a number of ‘second order’ listed funds exists that invest in CLOs across the capital structure, including funds dedicated to deeply subordinated/ equity CLO tranches.

The direct lending revolution in mid-market loans

The mid-market loan space lacks the definition seen in large-cap and SME sectors, being almost by default neither of the latter two sectors. Like other loan markets, the mid-market sector has traditionally been dominated by banks, with institutional money crowding into the more liquid large-cap, leveraged loan market instead.  However, the post-crisis era witnessed a notable shift in the balance of participants within the mid-market lending economy. Recent policy maker-led initiatives in various countries have also allowed better direct access to capital markets for mid-caps via private placement-like bonds, though borrower usage has been generally uninspiring. Examples include mini-bonds in Italy, Mittelstandsanleihen in Germany, MARF in Spain and the EuroPP programme in France.

Non-bank institutions, made up mostly of asset or loan managers, entered the mid-market post-crisis as bank lending retrenched and disintermediation opportunities proved compelling. This evolution has been largely captured by the “direct lending” phenomena, led by the activities of private debt funds.  Many of such funds are managed by traditional leveraged loan investors, with funds re-branded to target opportunities away from the capital markets, focusing instead on bank-facing borrowers.  Such private debt funds have established a meaningful footprint in selected direct lending markets in Europe, particularly in the larger end of the mid-market loan segment, where deal flow channels share similarities with the leveraged loan market. According to Preqin, direct lending funds outstanding stand at €83bn (out of total private debt funds capital of €188bn) as at end 2017.  In 2017 alone institutional direct lending mandates accounted for €22bn or two-thirds of all fresh capital raised by debt funds.

Proliferation of direct lenders has not translated into capital market opportunities

Direct lending styles, while varied, have generally tended to be imported from the large-cap, leveraged loan market i.e., where historically many such asset managers operate.  For example, private debt funds are typically separated by sponsored and sponsorless lending, with the former resembling credit provided to private equity sponsors in a buyout or recapitalisation but in mid-market borrower situations. Such funds are also branded by loan types, with senior or unitranche loan funds distinguishable from mezzanine, special situations and/or venture debt, among other examples. Indeed, in many respects the asset profile of private debt funds within the mid-market space can not be perfectly defined, with lending practices generally fluid.

The commonly heralded theme with such funds is of course the disintermediation of traditional bank lending incumbents. But our take on institutional non-bank mid-market lending activity is that the theme has been less about outright disintermediation and more about complementing bank lending, that is, providing credit to corporates underserved by the banking system. Indeed, co-lending ventures between banks and institutional investors have arguably been most prevalent in the mid-cap space, typically via unitranche formats.

Securitised products have played little, if any, role in funding mid-market non-bank lending thus far.  And with most direct lending funds being unlisted, there are therefore few capital market opportunities related to the mid-market loan space in Europe, certainly compared to the large-cap and SME markets. Unlike the US where the likes of BDCs have become established capital market conduits to mid-market loan investing, public listings of direct loan funds are still very rare in Europe for various reasons, among which we think are the challenges in deploying funds in this particular lending segment.  (Case in point being that uninvested funds, or dry powder, among direct lenders amounted to just under €30bn – or more than a third of AuM – as at end 2017, according to Preqin). Similar to SMEs, the barriers-to-entry for non-banks are not insignificant.

From what we can tell the few listed direct lending funds that overweight mid-market opportunities typically have cash yields in the 4-7% region, though we would caveat that such returns may not be neatly attributable to the mid-market corporate loan market given the tendency to blend in other lending strategies.  Among the large universe of unlisted direct lending funds, IRRs reported by selected investors in these funds (source: Bloomberg) indicate that returns range from ca. 4% for the more vanilla lending styles to as high as low double-digits for special situation lending where equity upside and deal fees typically enhance returns.

Marketplace lenders stand out as the disruptive non-bank entrants in SME loan markets

Banks still overwhelmingly dominate small balance or SME lending in Europe.  According to the EBA, SMEs reliance on bank finance in Europe is up to 80% when including all credit formats (trade credit, leasing, overdrafts etc, aside from more vanilla lending), compared to just 25% in the US.

In our opinion, the continued dominance of banks in SME lending reflects the significant barriers-to-entry for non-banks, given both the extent of post-crisis central bank accommodation and even regulatory capital subsidies for SME lending as well as the legacy of inherently deeper borrower relationships and better credit intelligence within the banking system. But notwithstanding this asymmetric advantage, the post-crisis era has seen an appreciable degree of lending disintermediation under the circumstances, led mainly by direct lending funds and marketplace lenders. Early-phase capital for these funds have in some cases been provided by public bodies, in turn reflecting the highly politicised issue of SME credit availability, or lack thereof. (Examples include the Business Finance Partnership in the UK).  Speciality non-bank lenders have also recently re-emerged (such fincos were far more visible pre-crisis), but for now remain too young to make capital market debuts.

Direct lending SME funds – less of a bang than headlines would suggest

Direct lending funds dedicated to the SME space remain few and far in between. Following a number of high profile launches in the immediate aftermath of the 2008/9 crisis, the growth of such SME funds stuttered over the ensuing years, all things considered.  We think the challenges in deploying capital within the SME borrower markets was a key hurdle to the proliferation of such funds, moreover before long the incumbent banks were re-motivated to lend by central bank funding and other government/ supra-led incentives. A number of private debt funds formed co-lending partnerships with incumbent bank lenders as a means to source assets and provide alternative, yet complementary, financing to bank funding.  Nearly all such SME direct lending funds are unlisted vehicles. There is little data to reliably highlight the extent of direct lending penetration of the SME markets, but data from the British Business Bank suggests that, in the UK, direct SME lenders accounted for less than 1% of total gross lending in 2017.

Marketplace lenders broaden the investable product suite in SME loan markets

In somewhat of a contrast to the measured pace of growth of direct lending funds dedicated to the SME markets, marketplace lenders look to have made a greater impact if measured by the recent growth of origination volumes.  Such lenders have long evolved from the retail P2P model, with the more established platforms currently serving as conduits for institutional whole loan investments, similar to trends in the US market. Selected marketplace institutional investors have listed equity funds. Such funds normally employ leverage to enhance returns, including in few cases tapping the public ABS capital markets. That aside, the marketplace platforms themselves of course provide channels to directly access SME credit in whole loan formats.  Taken as a whole therefore, the growth of marketplace lending has broadened the suite of SME-related investment opportunities decisively, whether via whole loan or capital market instruments.

The marketplace lending phenomena has hitherto been limited mostly to the UK, although their growing presence – albeit still embryonic – in Europe is notable. Within the UK SME market, such lenders have originated £4.8bn of loans cumulatively since inception (source: AltFi), impressive in itself but still only a fractional penetration (3.3% of gross lending in 2017) of what remains an overwhelmingly bank dominated market.  We would note that in the case of SME marketplace activity, the constituent base remains heavily concentrated for now, with the largest platform in the UK – Funding Circle – accounting for 70% market share of fresh lending since inception.  Outside of the UK, total marketplace SME origination volume in Europe stands at €588m, but similarly one lender (Lendix) commands a market share of around 30%. (Source: AltFi). These concentrations highlight that marketplace disintermediation in SME loan markets is barely an industry theme and more a case of the dominance of one or two platforms.

Lending channelled via such technology-based platforms have tended to be in unsecured format for a number of reasons that have, conversely, underpinned their origination achievements, in our view.  Unsecured lending lowers transaction costs relative to taking security and allows for a speedier loan underwriting/ approval process while also enabling lenders to tap borrower demand from SMEs without financeable collateral, which is precisely the pocket of the market where the banks have largely retreated from. (Secured SME lending is still a bank staple lending product). Higher yields on unsecured lending is in turn more appealing to the alternative whole loan investor base that dominates funding via such platforms.

Aside from the unsecured aspect, higher yields are also (arguably) justified by the premium for speedy loan approvals and smaller ticket sizes.  But, marketplace loan yields remain significantly outside bank lending equivalents. Taken in combination with the explosive growth of such lending, there are naturally certain concerns around this model, as outlined below:

• The potential for adverse selection (particularly in cases of bank or broker referrals) in combination with a different skin-in-the-game model
• Credit scoring methodology which is not fully disclosed given IP issues, although there certainly is transparency and depth to the default and loss statistics
• Risks related to the concentration of the full origination-underwriting-servicing-workout chain under one roof, based on a (mostly) flat annual fee structure, particularly in the event of an economic downturn
• Other potential vulnerabilities of this still novel model as the industry matures. (The older US market has been witnessing such platform-specific challenges in the recent past).

Any such deeper analysis on the marketplace model is outside the scope of this commentary but we will address these concerns in a forthcoming report. However, suffice to say for now that P2P/ marketplace platforms look to us to be a near-perfect version of the originate-to-distribute model, and we would make the further important observation that these models are not lenders but conduits matching whole loan investors with borrowers. (Skin-in-the-game is therefore not as straightforward a consideration as it would be for other speciality finco lenders).  Suffice to say also that the marketplace industry has thus far been unique in establishing a meaningful non-bank lending footprint in UK SME markets, much more so than any other post-crisis disintermediator model.

Asset-backed bonds dominate the SME capital market, but deal flow remains lacklustre

Securitised products make up a significant part of the investable footprint within SME capital markets, though such opportunities are noticeably smaller today relative to the pre-crisis market.  Headline outstanding SME ABS volumes from banks of nearly €80bn (and €12.7bn in 2017 alone) vastly overstate the extent of investable opportunities given that most deal flow is retained for central bank repo funding purposes. Much of the outstanding market comprises legacy securitisations, with post-crisis new issue flow being relatively limited. (Only € 500m of SME ABS was placed in 2017). What little primary deal flow there is has been generally limited to senior (AAA/AA) bonds only, with very few securitisations placing mezzanine or subordinated paper.

Not that SME securitisation incentives have otherwise been lacking – there have been a number of initiatives both at national and EU-wide levels (ESIF/ EIF-led programmes for example) aimed at incentivising SME securitisations as a means to revive credit supply, while the ECB’s ABSPP has a well-publicised mandate as a ready buyer of such securitisations.  But unlike similar programmes during the pre-crisis period that had their intended impact of generating deal flow, such as the ICO-sponsored initiative in Spain and the Promise programme in Germany (both since fallen by the wayside), these post-crisis initiatives have largely failed in resurrecting SME securitisations.  Fact is, securitising SME loans for funding purposes is less cost effective for banks compared to other assets such as residential mortgages, on account of higher clearing spreads and less levered capital structures (i.e., more expensive credit support) – that aside, central bank special facilities (such as the TFS in the UK, repo window at the ECB) have acted as compelling alternatives to capital market funding by banks. Non-banks, to include marketplace platform investors for the most part, have brought a few SME securitisations to market, but such deal flow is limited at this stage.  In contrast to asset-backed funding activity, SME loans have tended to be the asset of choice in regulatory capital relief deals, as we touch upon below.

Except for reg cap trades, yield opportunities look most convincing in non-ABS formats

Counter-intuitively almost, the SME loan market enjoys a greater investable footprint than the mid-market loan space, thanks largely to bank-issued asset-backed bonds as well as the suite of opportunities presented by marketplace platforms, complemented by a few SME direct lending funds.

In terms of returns, senior bank SME ABS would typically be around the L+30-40bps range, with newer alternative portfolios (to include marketplace loans) priced appreciably wider. To the extent observable, listed direct lending funds yield in the range of 4-5%, mirroring margins in the underlying alternative SME loan markets.  Funds invested in marketplace loans generally offer higher yields, reflecting fund-level gearing in some cases aside from typically higher loan-level spreads.  Indeed, marketplace SME whole loans come in a wide range of yields from 4% in the case of defensive lending to as much as 15% for riskier assets, with the bulk being in the 6-12% range. As we mentioned earlier we are not taking into account yield risks in this commentary, but the consideration is important in the case of marketplace unsecured loans given the naturally higher losses-given-default, compared certainly to large or mid-market secured lending.

We remark finally on regulatory capital trades, many of which reference bank SME loan collateral. According to SCI, placed reg cap tranches totalled around €14b across 36 trades in 2017, highlighting that this esoteric market has a far greater footprint compared to vanilla, senior-stack SME ABS. Most reg cap trades are privately placed but the very few public deals – and data on returns from listed reg cap funds – suggest that yields on such highly levered, first/second loss tranches can range from the low double-digits and upwards.  But we would caveat that these instruments are not priced to asset finance yields but rather to the economics of regulatory capital relief provided to the hedging banks.

More non-banks in the credit economy = deeper alternative lending markets = greater scope of investable opportunities

We see the investable, capital market universe related to European loan opportunities growing in the coming years, based on the following arguments:-

• Policy makers, whether under the guise of CMU or otherwise, seem committed in some ways to lowering the barriers of entry for non-banks in the credit lending system. (In the UK, for instance, banks are obliged to refer declined borrowers to alternative lenders). That aside, a number of funding-side initiatives – to include fund capitalisation and debt buying programmes – have yet to fully take effect, and could ultimately better anchor the non-bank credit economy in Europe
• One particular barrier related to proprietary borrower intelligence enjoyed by the banks is likely to be undermined by the PSD2 directive (plus the Open Banking Standard in the UK) – in effect, non-banks should gain some of the asymmetric information advantage of incumbent banks as SMEs can more easily share their bank data, which is of course more timely and potentially more credit instructive than statutory accounting data
• Absent a macro shock, better technicals in the securitisation market should create deeper economic funding outlets for non-banks, whether CLO managers, marketplace investors or newer speciality fincos. (The latter being distinguishable from CLOs by their originate-to-distribute rather than asset management model). In the case of SME asset-backed markets especially, securitisation regulation – STS in particular – could potentially fuel stronger demand for SME ABS
• Still, central bank accommodation of corporate (SME especially) loan funding to banks remains exceptionally generous, though potentially there will be tapering in the foreseeable future (or already being withdrawn, in the case of UK). We would expect banks to continue re-intermediating mainstream lending to corporates but still see a meaningful role for non-banks in selected pockets of the lending market.  Such alternative lending should deepen as the economic recovery matures.

Overall, we expect securitised bonds to continue dominating the investable landscape, but with listed fund opportunities (including geared vehicles) increasing in scope. To be sure, Europe would see a transformational impact on non-bank lending and investable opportunities if it were to introduce US BDC or REIT-like legislation that institutionalises the non-bank credit system.

Disclaimer:

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients. The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein. Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO). This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity.Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report. Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com

22 March 2018

In this first of a two-part commentary, we take a cursory look at the broader yield opportunities in the investable mortgage market in Europe. (The second part will look at similar yield opportunities across the investable corporate loan markets in Europe, dominated by CLOs). By ‘investable’ we specifically mean capital market instruments that provide near-enough an isolated exposure to mortgage loan pools, rather than bank funding-related instruments with mortgage loans as collateral. (We therefore exclude from our considerations covered bonds as well as agency-like markets such as Denmark). Historically, such capital market exposures have manifested mainly, or indeed entirely in some cases, via bonds, namely RMBS, although most deals only sell the higher rated tranches rather than the “full stack”. But in selected countries a somewhat broader suite of mortgage instrument types has emerged in the capital markets, to include whole loans and listed equities.

Our findings, as further discussed below, are that such mortgage capital market opportunities are the broadest in only the UK and Netherlands. The ten-year long pre-crisis securitisation bull market acted a as key catalyst to the growth in non-bank lending as well as autonomous origination and servicing industries in these countries. And more notably, this institutionalisation of mortgage markets survived the securitisation implosion from 2008, with the post-crisis era seeing bank asset divestments (both performing and NPL portfolios) into institutional investors initially, complemented subsequently by a newer generation of non-bank lending models. Loan assets acquired from or originated outside the otherwise dominant banking sector now forms a key part of the mortgage capital market footprint in the Netherlands and UK. Ireland also looks relatively promising with respect to mortgage capital market opportunities, though still in the early stages of lending (front-book) disintermediation.

Mortgage markets like the UK, Netherlands and Ireland continue to be among the higher yielding in Europe, despite the significant yield and margin compression seen in recent years. On the mortgage instrument side, yields are particularly high in the UK (relatively speaking), which mirrors the deeper market for alternative mortgages as well as the greater use of leverage among listed products. By contrast, the Dutch mortgage market trades more defensively reflecting – in equal measure – the more conservative investor appetites and collateral types, notwithstanding continued high LTVs.

The schematic below provides a snapshot comparison of underlying mortgage portfolio yields versus liability instrument yields, expressed as multiples of the former. What is immediately observable is that the more senior or de-levered tranches of securitised mortgages trade at spreads that look entirely decoupled from underlying mortgage portfolio yields, with such spreads influenced instead by RMBS bond market technicals. By contrast, underlying asset yields are more fully realised via whole loan exposures (whether in loan or equity formats), while the more junior parts of RMBS capital structures employ leverage to extract similar or superior yields to the underlying assets.

We would caveat of course that the cross-instrument yield snapshot above paints an overly simplistic picture of relative returns. To accurately compare the risk/ return profiles across such instruments, we will need to look more forensically at the asset credit and embedded financial risks. More such analysis will follow in our future commentaries.

De-Banking: The genesis of mortgage capital markets

Going forward, we see greater institutionalisation of mortgage markets like the UK, Netherlands and Ireland as an almost inevitable evolution, underpinned by a number of factors. Key among such factors is the de-risked lending style of incumbent banks on the one hand (whether for the reason of regulatory capital constraints or otherwise), and on the other the growing appetite among institutional investors for rates or spread product surrogates that better meet their risk/ return profiles. Low capital charges and portfolio diversification benefits of residential whole loans afforded to long-dated liability managers under Solvency II will be a key catalyst in this respect, in our view.

We expect such institutionalisation to be fuelled by the continued rotation of whole loan books (both performing and NPLs) out of incumbent banks and into non-bank ownership over the foreseeable future. Irish banks remain under pressure to correct impairment ratios while in the Netherlands policy makers continue to incentivise mortgage ownership by insurers and pension funds. The recent announcement by the UK government of its plan to sell further mortgage assets including a Help-to-Buy portfolio is yet more evidence of the potential depth of the institutional investor base in residential mortgage markets. Back-book acquisitions aside, non-banks also look poised to maintain active footholds in fresh mortgage lending in countries like the UK, Netherlands and even Ireland. And as incumbent banks gradually re-intermediate some vanilla lending markets, we would expect non-bank lending to naturally creep into alternative mortgage products, which should in turn deepen the market for higher-yielding mortgages.

The degree to which the greater institutionalisation of mortgage markets seeds a greater diversity of capital market opportunities going forward depends to some extent on RMBS market technicals, in our opinion. RMBS continues to be the most economically efficient way for non-banks to fund securitisable mortgages, its limitation dictated only by the depth (or lack thereof) of the investor base. Indeed, we see the non-bank constituency continuing to dominate RMBS issuance going forward, with such issuers ranging from specialist lenders to fund manager sponsors to private equity owners of back-books, some of which will feature re-performing loans. But assuming there is no return to the pre-crisis bull market for RMBS, we would expect the scope of alternative liabilities to continue broadening as mortgage funding matures, spanning listed, ‘REIT-like’ funds and other whole loan opportunities. We would also anticipate mortgage capital markets becoming more cross-border over time in terms of investment flows, in contrast to European mortgage lending markets which are likely to remain distinctly domestic over the foreseeable future.

Looking beyond the UK, Netherlands and Ireland, we do not currently see any meaningful opportunities in other developed EU mortgage markets to take direct, uncomplicated exposures to (performing) residential loans, both from a yield or secondary liquidity perspective. Neither non-banks nor alternative lending plays any appreciable role in other countries and therefore – reflecting what are mostly bank dominated, vanilla product markets – mortgage yields remain comparably low. (As cases in point, German and French mortgage lending spreads are inside that seen in the Netherlands, adjusting for product and LTV characteristics). Mortgage capital market opportunities in these countries remain largely limited to the likes of senior-only RMBS. We do not see this market dynamic changing significantly in the foreseeable future given the very entrenched nature of banking systems and, conversely, the high barriers-to-entry for challenger or non-banks or indeed alternative lending products in the residential mortgage markets. Portfolio whole loan sales and/or ‘full-stack’ securitisations may moderately increase in frequency as the banking system complies with regulatory pressures such as leverage ratio rules, but such opportunities are likely to be limited.

Some market background

UK: The most diverse mortgage capital market in Europe, bar none

Securitisation was the key catalyst to the growth of the non-bank, specialist lender market in the UK since the 1990s (then called ‘centralised lenders’), which in tandem fuelled the growth of alternative mortgage products. Indeed, the UK stands out in Europe for having deepest market for alternative loan types, spanning self-employed, lo-doc, credit impaired, second-charge, lifetime or reverse equity mortgages and other non-mainstream product, including a uniquely defined investment, or ‘buy-to-let’, lending segment. Alternative products accounted for around 20% of all mortgage lending in recent years, with the bulk of this comprising unregulated buy-to-let loans, according to IMLA. Mortgage yields on alternative products remain appreciably higher than for standard, bank-originated loans.

While the 2008 crisis put enormous pressure on the specialist lender model, non-bank institutions found roles in the ‘secondary’ market for mortgages as buyers of legacy whole loan books, to include run-off portfolios inherited by the government. Non-bank lending disintermediation opportunities re-emerged before long, given the prolonged mortgage lending attrition and regimented risk/ underwriting appetite among the established UK banks in the post-crisis era. The newer breed of disintermediation lenders comprised not only specialist platforms, many of which are owned by private equity, but also direct lending funds and marketplace lenders, with RMBS again featuring as the funding channel for some of these asset owners/ originators. With the exception of direct lending by UK insurers which primarily target lifetime (reverse equity) mortgages, buy-to-let loans have generally dominated the asset profile of these non-bank lenders. Non-banks make up around 7% of all mortgage lending currently, up sharply from the lows reached in the immediate aftermath of the crisis, but down from the peak of 18% reached in 2007. (Source: IMLA)

Reflecting what is both the most diverse mortgage owner/ lender constituency and the deepest lending market for alternative mortgage product in Europe, the UK remains distinguishable today for its broad suite of investable mortgage instruments. These comprise not only RMBS but also listed funds from UK asset managers investing in mortgages (or, more precisely, funding intermediary specialist origination platforms), marketplace loan opportunities and even vanilla bonds/ equity issued by ‘narrow’ or monoline mortgage challengers. The table below captures the yield continuum by instrument/ lender-type across the mortgage credit spectrum in the UK, with the alternative segment dominated by buy-to-let product mostly.

As is clearly observable, mortgages continue to offer compelling yield opportunities as a credit asset class on a relative basis. We would caveat again that there is of course a trade-off between enhanced mortgage yields and risks, which in the UK is inherent in loan credit quality and/ or financial leverage, employed in RMBS as well as listed whole loan funds. Balance sheet liabilities of monoline mortgage lenders should also be analysed in the context of potential structural subordination and corporate event (non-asset) risks.

Netherlands: Champion of the whole loan model, but yield opportunities for the few only

The Dutch story is slightly different. Non-bank lending is an established practice in the Netherlands, with insurers and pension funds in particular long being a relatively dominant lender constituency, alongside the banks. Securitisation funding has historically been used by banks and non-banks alike. The Dutch RMBS market was arguably the most resilient coming out of the 2008 crisis (measured by the recovery in primary RMBS volumes, not least), with the crisis disruption limited by the relatively small component of alternative product and/or ‘originate-to-distribute’ specialist lenders.

However, the prolonged housing recession coupled with high profile bank lender failures during the post-crisis era, led to a distinct shift in the wholesale sources of mortgage lending. Insurers and pension funds became noticeably more active in the lending market, with the full endorsement of policy makers championing a better balance of lender types and asset-liability matching in addressing the funding gap within the system. Such long-dated liability managers were also buyers of whole loan pools divested by incumbent banks. This shift in mortgage market ownership was complemented by new non-bank specialist lender platforms. On most measures, the mortgage market in the Netherlands is the most institutionalised in Europe currently, with banks and non-banks sharing almost equal shares in new mortgage originations. (According to consultancy IG&H, approximately 40-45% of all front-book lending in the Netherlands currently is from non-banks such as insurers, pension funds and specialist lenders; the equivalent share was around 20% in 2008). Notably also, non-bank lenders in the Netherlands are much more dominant in the mainstream mortgage market, unlike say the UK or Ireland where non-banks tend to operate in more niche or underserved lending segments.

We infer from the relatively narrow asset yield range that the dispersion of credit quality is equally narrow (unlike the UK), meaning that the Dutch mortgage loan market is comparably homogenous. Non-prime lending did have some presence in the pre-crisis period (Lehman’s ESAIL and GMAC-RFC’s E-MAC platforms being the most well-known in this respect), but to our understanding such lending has all but ceased since the financial crisis. Where there are outlying high asset yields among Dutch mortgages, these are typically explained by longer-than-normal fixed rate reset periods of up to 30 years (see chart above). High LTV loans also incrementally influence yields, but the ‘delta’ in this regard is fractional compared to other markets in which high LTV loans are normally labelled as ‘alternative’ (see chart below). High LTV loans have always been and still are very mainstream in the Dutch mortgage market, a legacy of generous interest tax deductibility.

The capital market footprint of Dutch mortgages continues to be dominated by RMBS (private whole loan sales aside), however as mentioned above there has been a notable growth in institutional asset managers primarily (or exclusively) originating mortgages for pension funds, with a select number of these funds being listed. Dutch mortgage capital market instruments currently trade in a relatively tight yield range (save for deeply subordinated RMBS), commensurate with asset yield behaviour. As a case in point, listed mortgage funds in the Netherlands – albeit still rare as an opportunity type – offer yields that mimic the underlying asset market minus servicing (25-30bp) and fund administration (20-25bp) costs, in contrast to the UK where leverage tends to be more readily employed to enhance offered yields. We think the predominance of unlevered mortgage funds in the Netherlands reflects the capital constraints of investing in geared mortgage instruments under Solvency II, the relevant rule-book for the largest segment of domestic institutional investors.

Dutch mortgage yields have also compressed significantly in the past few years which makes the current market look rich on a historical context. No doubt the relatively low, range-bound yields are arguably justified by the credit homogeneity of mortgage assets, however to us the Dutch mortgage capital market seems better catered currently to defensive investors, most of which comprise the domestic insurers and pension funds. Duration-rich mortgages in the Netherlands are naturally suited to such long-dated liability managers.

Ireland: Compelling (hypothetical) returns but capital market remains in its infancy

Mortgage yields in Ireland are among the highest in Eurozone, meriting a mention in our view. Headline benchmark rates are some 1.5% higher than in core Europe, while recent securitised portfolio data indicate that performing non-bank front-book yields are in the range of ca.4%.

We would first remark that the non- and sub-performing component of the broader Irish property finance market is substantially owned by institutional investors (mostly private equity firms), following the exceptional scale of de-leveraging undertaken by Irish banks and NAMA in the crisis aftermath. However institutional ownership of large swathes of non- and sub-performing legacy financing assets has yet to meaningfully translate into institutional non-bank residential mortgage lending. Save for some buy-to-let refinancing activity, lending disintermediation by non-banks in the mortgage market has been tepid thus far, defying the yield opportunities on offer. (Non-banks accounted for less than 2% of new lending in 2016, according to the CCPC report). Likely reasons for this include, we believe, the combination of tighter post-crisis lending regulations and still relatively weak demand for financing, not to mention the limitations of scale in a country like Ireland. New mortgage lending in Ireland is currently running at around 10-15% of volumes seen in 2007, the sharpest correction of any market in Europe, according to the EMF.

Ireland has for now a very small mortgage capital market, limited to the few RMBS opportunities. Such opportunities have notably included deals from non-bank issuers as well as NPL/ re-performing portfolio securitisations. As non-banks increase their dominance in alternative mortgage markets (buy-to-let or otherwise), we expect to see a deeper market for RMBS emerge as a precedent, potentially, to other liability types in the mortgage capital market. This development does not appear imminent, however.

Disclaimer:

The information in this report is directed only at, and made available only to, persons who are deemed eligible counterparties, and/or professional or qualified institutional investors as defined by financial regulators including the Financial Conduct Authority. The material herein is not intended or suitable for retail clients. The information and opinions contained in this report is to be used solely for informational purposes only, and should not be regarded as an offer, or a solicitation of an offer to buy or sell a security, financial instrument or service discussed herein. Integer Advisors LLP provides regulated investment advice and arranges or brings about deals in investments and makes arrangements with a view to transactions in investments and as such is authorised by the Financial Conduct Authority (the FCA) to carry out regulated activity under the Financial Services and Markets Act 2000 (FSMA) as set out in in the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO). This report is not intended to be nor should the contents be construed as a financial promotion giving rise to an inducement to engage in investment activity.Integer Advisors are not acting as a fiduciary or an adviser and neither we nor any of our data providers or affiliates make any warranties, expressed or implied, as to the accuracy, adequacy, quality or fitness of the information or data for a particular purpose or use. Past performance is not a guide to future performance or returns and no representation or warranty, express or implied, is made regarding future performance or the value of any investments. All recipients of this report agree to never hold Integer Advisors responsible or liable for damages or otherwise arising from any decisions made whatsoever based on information or views available, inferred or expressed in this report. Please see also our Legal Notice, Terms of Use and Privacy Policy on www.integer-advisors.com