Risk transfer market readies new frontiers
Synthetic risk transfer markets have had another good year, with the core group of banks active in the market returning to issue, smaller firms mulling the market, and investors raising new cash to buy deals. But perhaps most exciting is the development of a whole new issuer base, in the shape of multilateral development banks, following the landmark ‘Room2Run’ deal between the African Development Bank and Mariner Investment Group.
Risk transfer deals enjoyed a productive 2017. A Canadian bank entered the market for the first time, a bank using standardised capital models (Austria’s Hypo Vorarlberg) issued, a rarity, while regular issuers, large universal banks, protected more portfolios than ever before.
High profile credit events like Premier Oil’s restructuring hit multiple deals, while early in 2018, the collapse of Carillion proved the value of portfolio protection. All the big UK banks took a hit on the failure of the construction and facilities management firm — but HSBC had bought $72.5m of protection through its Metrix CLO, when no public market CDS were available.
This year, 2018, has also been a good vintage. Market volatility has whipsawed through the public markets, but the private markets have stayed solid, providing a back door route for troubled and healthy banks alike to raise extra capital, buying protection on a variety of portfolios including SME loans, trade finance, large corporate loans and mortgages.
The biggest issuers in the market tend to be the universal banks with highly sophisticated treasury, ALM and risk teams — and experience printing such deals in the past. Risk transfer shelves like Deutsche Bank’s CRAFT series, Standard Chartered’s START, Commerzbank’s CoSMO or Barclays’ Colonnade regularly place securities in the market, protecting billions of dollars-equivalent a year.
“It’s been a good year, with pretty much every jurisdiction back in the market, mainly the IRB banks with established programmes,” says Francesco Dissera, head of structuring and advisory at StormHarbour Securities. “The big platforms like Standard Chartered or Deutsche Bank get a lot of reverse enquiries for these trades.”
These shelves are the bread and butter of the market, and the hedge funds that regularly sell protection to them — a clutch of specialists including the likes of Christofferson Robb, Cheyne Capital, Magnetar Capital, ArrowMark Partners, and Mariner Investment Group — provide a useful extra tool for their capital management.
But it’s a much more useful market for banks which can’t so easily access public markets.
“It’s been very difficult if not impossible for certain southern European banks to follow the AT1 route to source more capital,
de facto senior to AT1,” says Dissera. “But SRT is a good tool for issuers that want to plan, they know they can execute a well-structured deal, because the investor bases are different and they are delinked from bank credit with a greater certainty of execution.”
Prominent in transferring risk in some of the more challenged institutions is the European Investment Fund (EIF) and European Investment Bank, which offer mezzanine guarantees against SME loan portfolios, under a plethora of EU-funded schemes to ease SME financing conditions. The funds come with strings attached — recycling funds into new SME lending at below-market rates, for example — but the EIF can be available in decent size and at better prices than the usual hedge fund buyers will offer.
Public sector excitement
Perhaps most exciting, though, is the potential presence of public sector institutions as not just sellers.
In 2018 a deal in which the African Development Bank bought protection for a portfolio of infrastructure loans on the continent from Mariner Investment Group, with Mizuho acting as structuring advisor, was justifiably called a “landmark”.
Unlike deals done for banks, the transaction, dubbed “Room2Run”, does not give regulatory capital credit. Multilateral development banks do not have regulators in the same way, nor bank-style equity capital. But the AfDB deal allowed it to protect its rating, and free up credit capacity and lines for certain jurisdictions and assets.
“MDBs don’t have paid-in equity capital of course, but SRTs give private investors a way to participate indirectly and offer capital in those areas,” says Juan-Carlos Martorell, co-head of structured solutions at Mizuho, and the leader of the team working on AfDB’s deal. “We received lots of interest from various private investors at meetings during Room2Run case studies presented at the IMF in Bali, AIF in Johannesburg and IACPM in Connecticut.
“The private investor interest makes a lot of sense because they will achieve to diversify portfolios and exposures. Mariner has an advantage in its involvement with infrastructure assets, but these are not the only portfolios held by the MDBs. Some have lots of trade finance and corporate loans, for example, and other more plain vanilla asset classes, and we could certainly see a broader base buying MDB transactions.”
The AfDB deal took four years, but some of this work won’t need to be repeated — getting the rating agencies over the line, for example, was particularly time-consuming. The deal format also won’t be as useful for some of the larger MDBs, or those with less constraining country limits. But investors are keen to see a wider issuer base, and new sources of other, uncorrelated assets.
“There could be some political reasons why the AfDB transaction was so successful — they demonstrated increased credit capacity, the increase in lines to certain countries, but not so much at the cost of buying the protection,” says Dissera.
But the presence of public sector institutions on both sides of the trade is curiously circular.
“We have seen the EIF/EIB acting as protection seller, and now we see at the same time MDBs acting as protection buyers (potentially EIB for example),” says Martorell. “Some private investors have made criticisms of the EIF’s involvement where there is an existing and functioning private market, saying it’s not as necessary as it was in 2010-2012, but they’re only focused on SMEs and have quite specific requirements, so within reason it isn’t hurting the overall market too much.”
Expanding investor base
As well as the issuer base, the investor base, too, is growing. Insurers are increasingly looking to sell protection to banks through synthetic risk transfer structures — but with very different requirements to the usual hedge fund counterparties.
For one thing, the deals insurers want to strike are usually unfunded — meaning they do not collateralise the cover with cash or government bonds, but instead, rely on their high rating. This means deals have to be structured to cope with potential counterparty downgrades, so the banks buying the protection aren’t left high and dry.
“Insurers have always been interested in mortgage transactions, but we know some of them are now looking at SME deals,” says Dissera. “They’re a new type of investor in SMEs, so perhaps it takes a bit more time to get the deal done and sign off the documentation, but once they’ve done one deal it might speed up.”
Their involvement could be encouraged by some of the regulatory changes hitting banks.
“Basel IV kicks in next year. Although we’d expect the first half of the year to be relatively quiet, we have a good pipeline of first time and repeat issuers,” says Martorell. “Basel IV means you need to widen the tranches, which changes the economics for issuers. We’re seeing increased interest in SRTs from insurance companies with lower risk and lower return targets, looking at wider tranches with higher attachment points.”
He continues: “They’re looking at more like senior mezz tranches such as 8%-11% tranches, also known as the upper mezzanine, in unfunded insurance format. It could work as long as the insurance companies are at least A ratings or above.”
Arch Mortgage Insurance, one of the US’s leading mortgage insurers, struck a deal with ING DiBA, the German subsidiary of ING Groep, to provide capital relief on a €3bn mortgage book, announcing the deal at the end of October, while another US firm, Liberty Mutual Insurance, is also now seeking deals in Europe.
Mortgages have traditionally been an unusual asset class for the synthetic risk transfer market, as the relatively low risk density of mortgages, especially in northern Europe, means the deals aren’t efficient for banks looking to cut risk-weighted assets.
The European Banking Authority’s guidelines on significant risk transfer are the other big change coming. The Authority published its thoughts on the market in autumn last year, followed by a consultation period, and further thoughts early this year.
These proposed limiting time calls and pro-rata amortisation in risk transfer trades, features which make risk transfer more efficient for the issuer, with a slightly more lenient treatment than the UK’s Prudential Regulatory Authority.
But the market has been waiting for the EBA’s paper to turn into more concrete rules, while trying to comply as much as possible. “All the transactions structured in Europe at the moment are structured with the assumption that the EBA guidelines published in September 2017 will soon come into force,” says Dissera. “It has made deals more standardised, more consistent about their utilisation of excess spread, and how this accounted in levels of support.”
Guidance with the force of law, however, would make structuring more standardised still, and make discussions with regulators, which precede all risk transfer deals, clearer and easier. So despite more regulation, the potential loss in market efficiency, and some extra work over the break, certainty should help.
“The EBA often brings a document in a kind of ‘Christmas gift’ to the market, so if it happens, clarification on the guidelines is likely to be towards the end of the year,” says Martorell.