When Paragon announced its return to securitisation, market participants speculated about how it would look. What few people expected was that it would look like a bank deal.
Paragon Mortgages 16 funds the senior, low risk part of the capital structure, protected by 22% credit enhancement. The lender retained the class ‘Z’ — £31.2m of notes — just as banks have held on to the mezzanine and subordinated notes in their structured finance deals since the crisis.
The only exception is Royal Bank of Scotland’s Arran 2010-1. Certain auto ABS originators, notably Volkswagen, have also sold mezzanine notes, while Deutsche Bank sold mezzanine and senior for its Chiswick Park CMBS (supported by a hefty mezzanine loan and equity piece).
It’s not hard to understand why — it comes down to money. Paragon’s mortgages were paying an average yield of 4.7%. The senior notes cost Libor plus 275bp (in the region of 3.75% when the deal was priced). As a fund manager observed at the time: “You’re getting most of the yield of mortgages, plus a wedge of credit enhancement.”
So where does this leave the ‘Z’ notes? EuroWeek is no deal structurer, but that 1% difference between collateral yield and senior notes doesn’t give a lot of wiggle room to pay the sort of high coupon the market would demand.
Subordinated BTL notes aren’t the most liquid asset class and any spread calculations depend on large assumptions about CPR rates, but there have been prime triple-B notes at around 440bp, while Granite triple-Bs have been as high as 1,500bp this month.
Paragon’s warehouse facility (admittedly not term funding) is thought to cost no more than 300bp, meaning the lender had a ceiling on what it would pay for funding... and the cost of selling the ‘Z’ note would be way beyond that.
Anyway, the point of these back-of-fag-packet calculations is that securitisation proper still doesn’t work.
Splitting asset originator from capital provider using securitisation technology isn’t feasible — the best that the market can do is provide senior level debt funding. Banks can transfer risk using the supervisory formula method, but selling a full capital structure of structured finance notes is still uneconomical.
Below the triple-A bargain-hunter level, the investor base for securitisations is painfully thin — hedge funds seeking 15% might take equity pieces (if banks could afford to sell them) but investors looking for 5%-10% yields will only pick up bargains, or shun the asset class entirely.
Yet these same credit investors have portfolios stuffed to the gills with obsolete bank hybrid capital and poorly rated corporate and high yield debt. Bringing them back to securitisation would mean fair value for mezzanine, more opportunities for issuers, and the return of the market below double-A level.
Before the re-emergence of the sovereign crisis, there was an encouraging spread compression down the securitisation capital structure in the first half of 2011. But this was driven by virtually zero supply, and reversed course at the first sign of weaker risk sentiment.
It isn’t all doom and gloom — Investec is in the market right now, aiming to sell mezzanine and subordinated notes in a UK prime RMBS — but the ‘M’ and ‘B’ tranches are tiny, unrated bespoke pieces.
Best of luck to the syndicate teams running the deal, but the market needs more action at this level.
A strength of securitisation, compared with other secured funding, should be its ability to fund any level of risk — this is the whole idea of tranching. Time to unlock the potential of the market.