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Securitization

SRT market explodes as end of year approaches

UniCredit Tower, headquarters of the Italian bank UniCredit, Milan, Lombardy, Italy

Bankers are working frenetically to get Significant Risk Transfer trades done ahead of next year, when they expect further growth in the market

The last quarter of the year is usually one of the busiest periods for the Significant Risk Transfer market — as banks, keen to improve their capital ratios within the year-end accounting period, work feverishly to complete deals.

The SRT market is typically private, with trades often negotiated bilaterally or as club deals, meaning that the terms rarely make it to the public domain.

Even so, one notable Italian non-performing loan transaction made the headlines this week, when UniCredit announced that it had sold the mezzanine and junior notes of its €2.17bn Olympia NPL securitization.

According to UniCredit, a sale of 95% of the two junior notes had been agreed and the European Central Bank was notified of its intention to recognise it as an SRT deal.

Olympia is expected to be followed by three or four more Italian NPL transactions before the end of the year and it was priced amid a flurry of other SRT deals secured on a much broader range of assets.

“At least 40 deals have been issued so far this year and I would not be surprised if we end up at 55,” said Olivier Renault, a managing director and portfolio manager at Pemberton Capital Advisors.

Renault said that banks often try to close deals before Christmas, but he said they are becoming more organised and realistic in terms of the cost and time it takes to issue.

While the advent of the new coronavirus variant, Omicron, has spooked rates and credit markets, Renault was sanguine about SRT issuance prospects, saying the market was as yet unaffected.

However, he conceded that some investors may “try to flex returns and issuers may adjust portfolios, in terms of concentration risks to vulnerable sectors and countries”.

New banks, assets and countries

SRT issuance peaked in 2019, and although 2020 was busy, banks did not need the capital relief that the product brings as much. “Banks could not distribute dividends and capital ratios went up, so there was less need to free up capital,” said Renault.

After springing back this year Renault and others believe the market is set for strong growth, with issuance likely to increase next year and beyond.

New countries are coming on board, more banks within ones where SRT is established are turning to the market and banks that have a track record are pushing boundaries with new asset types.

Traditional SRT portfolios include corporate loans, loans to small and medium-sized enterprises, as well as retail assets such as auto loans and performing mortgages.

But risk is also being transferred on other more esoteric assets such as infrastructure loans, ships, commercial real estate and much more besides. The key is that the assets should have a long and reliable track record of collateral performance.

Pricing varies from deal to deal, depending on a multitude of factors, including the granularity of the loan portfolio, its credit quality, the replenishment period and the size and location of the tranche.

Tranches are defined by their attachment and detachment points within the capital structure. The lower the attachment point, the greater the risk. For many SRT deals the attachment point is set at 0% — which is the precise location of the first loss, where transfer of risk is most material.

Based on this mix, returns can vary enormously, but generally start from the high single digits (in percentage terms) and go up to the mid-teens area.

All the major UK and European banks have been active in the SRT market — including, for example, Credit Suisse, Deutsche Bank and Santander.

The major Greek banks have also come on board with deals expected before the end of this year and Polish issuers are also in the frame.

In the US, Citi has been issuing SRT deals for many years, but others have been slower to join, with JP Morgan issuing its first deal in 2019. The US market is considered at an early stage of development and therefore has good potential to grow.

Likewise, there are high hopes for Asia, where issuance has so far proved limited. This is particularly the case for the mega banks in Japan. Their large balance sheets and low cost of funding make them ideal candidates for capital risk transfers.

“More banks are likely to use risk transfer as a tool across a more diverse range of portfolios,” said Molly Whitehouse, a managing director and portfolio manager at Newmarket Capital.

Along with increasing confidence from regulators, banks and investors, she expects a lot more growth in the SRT market.

“This is a market that is revving up in terms of supply and demand,” agreed Renault, who noted that, despite credit volatility, “Investors are willing to do more size.”

Regulatory complexity

Notwithstanding the outward appearance of a market that is churning out deals with relative ease, the SRT business is complex, with banks taking much time and effort to put transactions together, especially their first trades.

And from a regulatory standpoint, it is often not clear from the outset whether the local supervisor will recognise that risk has been transferred. This is particularly the case within the Europe Union.

Though banks are all theoretically supervised by the European Central Bank, supervision is delegated at a local level, which in practice means local supervisors can arrive at different interpretations on the recognition of assets for similar trades.

In November 2020 the European Banking Authority proposed some ground rules to level the regulatory playing field, but they are only proposals and have not been implemented.

Apart from the puzzling regulatory maze that needs to be negotiated, a considerable effort is required to get banks’ systems in place. “It takes time to set up the internal infrastructure and approvals for a bank to issue their first SRT deal, but once the road is paved issuance is simpler and therefore also faster,” said Whitehouse.

For this reason, she said, it makes sense to work closely with clients and build strong connections.

The SRT market is “very much a relationship business”, she said. “There are real benefits to nurturing long-standing bilateral partnerships and deal execution within an established documentary framework over time.”

Asset managers, such as Newmarket and Pemberton, also work closely with other buy-side firms. Typically these are large institutional investors such as pension funds, sovereign wealth funds or the investment arms of insurance companies.

“SRT deals are well suited to large institutional investors, as they provide an opportunity to take exposure to a targeted asset class with day one cash flows and day one diversification,” said Whitehouse.

SRT provides investors with an exposure that they would not easily be able to achieve by directly buying debt or equity, she added.

The trades are also well suited to investors that have an environmental, social and governance remit. For example, banks can commit to using all released capital to expand green lending or lending with a social impact.

ESG is increasingly considered mainstream, with sellers and buyers keen to incorporate ESG features into their capital management programmes.

In this respect it is notable that Newmarket has built a strong record in ESG and impact-oriented investing since 2013, when it took exposure to a portfolio of Italian renewable energy facilities.

Since then, Newmarket has built on its specialist expertise to incorporate ESG factors in many of its deals.

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