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THE VOICE OF THE MARKETS

SECURITIZATION IN THE GLOBAL MARKETPLACEJune 2017

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Securitization in the Global Marketplace | June 2017 | 1

SECURITIZATION IN THE GLOBAL MARKETPLACE

2 THE SUBPRIME CONSUMER Banking on the underbanked: shedding the subprime stigma

4 CONSUMER ABS ROUNDTABLE Turning on the spigot for US consumer ABS

10 Q&A WITH LAUREL DAVIS Inside the World of Connecticut Avenue Securities

13 Q&A WITH WILMINGTON TRUST Auto ABS in Europe and the outlook in a changing market

16 EUROPEAN SECURITIZATION REGULATION The EU’s simple and standard ABS framework is anything but

18 EUROPEAN CLO ROUNDTABLE The old with the new: plotting the course for European CLOs

24 CMBS Millennial bug: US CMBS tackles retail sickness

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2 | June 2017 | Securitization in the Global Marketplace

THE SUBPRIME CONSUMER THE SUBPRIME CONSUMER

THE GLOBAL financial crisis dam-aged more than just the economy — it left an enormous swathe of the US population without access to conventional forms of credit. One lasting legacy of the crisis has been the portrait of the irresponsible subprime borrower, and the image has stuck with banks and regula-tors, which have both made efforts to reign in lending to this segment of consumers.

“There is a stigma now. Many people think that subprime con-sumers take payday loans because they don’t know any better. It’s not because of that,” says Krishna Gopinathan, chief executive of Applied Data Finance, referring to short-term loans with high inter-est rates. “They just don’t have any other opportunities. It’s easy to make assumptions when you don’t meet these consumers and just jump to conclusions that aren’t really accurate.”

According to a report put out at the end of 2016 by the Centre for the New Middle Class, a research group at subprime lender Elevate, a ‘subprime’ status can have financial consequences, with these borrowers being six times more likely to have been denied a job in the prior 12 months because of low credit. They are also nine times more likely to have been turned down for credit in the prior 12 months, and 10 times more likely to say they could not “make financial progress” because of low credit.

In securitization, the pullback in subprime consumer lending — especially for non-auto related sectors — has

also been deeply felt, with subprime consumer ABS issuance slowing to a trickle in the post-crisis years. For the five major credit card issuers, 2008-2016 saw revolving credit available to US borrowers with a FICO score of less than 660 — regarded as the threshold for subprime status — reduced by approximately $142bn, according to data provided by Elevate.

“Subprime borrowers are the only group whose balances haven’t yet caught up with the peak they reached in 2008,” says Joelle Scally, an administrator at the Centre for Microeconomic Data at the New York Federal Reserve. “Everyone else is pretty close to that 2008 peak, but subprime borrowers are 6% below that. Their balances have really shifted in composition — they’re made up of more auto and student loan balances, because it’s very difficult for subprime borrow-ers to get mortgages or credit cards right now.”

The majority of lenders’ efforts are heavily directed at prime and so-called ‘super-prime’ borrowers,

which form a declining percent-age of US consumers. Even online marketplace lending — an industry which emerged in the wake of the recession and which many thought would fill the bank void — mostly targets borrowers in the ‘near-prime’ range of 640-680.

“There’s more subprime consum-ers now — by our calculations, two-thirds of the US either have a credit score below 700, or no credit score at all, yet there is less and less credit available to them than ever before,” says Ken Rees, CEO atElevate.

Don’t judge a book by its numberWith a huge portion of the US underserved by traditional lenders, some observers believe that the solution to widening access to credit hinges on looking beyond credit scores, which follow borrowers like a ball and chain.

“We’ve all gone through things in our lives that have had a finan-cial impact on our credit scores, whether it’s a medical situation or a divorce. It gets recorded at the credit bureaus as a black mark,

and because of that long memory the credit bureaus have, there’s an innate, backward-looking impact,” says Gopinathan. “It makes the assumption that what you were in the past is what you’ll be in the future.”

Rees also highlights that some lenders tend to overlook the nuances between underwriting to secured credit products versus the customer.

“The problem with subprime mortgage and auto paper is that they’re secured credit. Often-times lenders are mak-ing loans predicated on

The number of underbanked borrowers in America has grown since the financial crisis as their access to mainstream forms of credit has narrowed. Sasha Padbidri examines how some companies are working to erase the subprime stigma, experimenting with alternative methods of underwriting

Banking on the underbanked: shedding the subprime stigma

Source: Elevate

46%of American adults say they could not cover an emergency expense costing $400, or would cover it by selling something or borrowing money

Economic realities of the new middle class

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THE SUBPRIME CONSUMER THE SUBPRIME CONSUMER

the collateral and not the cus-tomer. Lenders aren’t really looking at things like ability to repay, or underwriting to an individual and that’s where you get the problems,” Rees says. “If you’re not underwrit-ing correctly, that’s a prob-lem,” he warns.

Meanwhile, some cred-it reporting companies are incorporating the predictive power of machine learning into newer versions of credit models, hoping to improve the ability of lenders to under-write borrowers with little or no credit history.

VantageScore Solutions has announced the incorporation of machine learning into its latest credit score model, which is on track to be rolled out later this year.

“Machine learning techniques — because they’re sort of power platform dynamics — when you process lots of different scenarios hundreds and thousands of times, they’re able to come up with insights and connections in the data that we normally wouldn’t be able to find,” says Sarah Davies, senior vice president of analytics at VantageScore.

“When we look at collections information on the credit file — that’s very predictive of people who’ve historically gone bad or could likely go bad again. What the machine learning techniques did was to link collections information with the enquiries information, which created a variable that was very predictive of people who don’t have that much information,” Davies adds, noting that the new

model gave a 30% improvement in scoring accuracy among consumers with little available credit data.

Securitization’s potentialIn a twist on the subprime mortgage crisis, securitization may be key to opening up more funding for what some people call “credit invisible” borrowers.

While the market for subprime consumer ABS dried up in the years after 2008, the past 18 months have seen a resurgence of deals backed by unsecured consumer debt. Apart from the auto sector, subprime consumer securitizations were not widely seen until the rise of online lenders such as Avant and Lending Club, which both target borrowers beneath the prime threshold. Avant, in particular, has become a regular issuer of unsecured subprime con-sumer loan ABS, and investors have piled into the bonds.

The Chicago-based market-place lender priced its last trans-action in April, having to increase the amount offered and tightening all classes of the capital structure.

Borrowers in that deal had an average FICO score of 655, according to pre-sale infor-mation from Kroll Bond Rat-ing Agency. Investors have been drawn to the bonds for their short duration and rela-tive high yields. Avant’s offer-ing was priced at 115bp over the euro dollar spot forward for its senior single-A rated tranche. The bonds have a duration of 0.5 years.

Regulators take noteConsumer finance observers also point out that the burden

that subprime consumers face is not just aggravated by banks getting out, but also in part by a misreading of the crisis by some regulatory agencies.

“What lenders choose to do is a function of what regulators have said, and how technology has evolved. So technology is moving on one path, regulators on another — lenders sit in the middle of the two and try to serve the customer,” Gopinathan says.

“I don’t think post-crisis legis-lation is harmful as opposed to how the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency reacted to what happened during the reces-sion,” says Rees. “We believe they misread the risk aspects of serving these consumers and overreacted to the real problem, which was essen-tially collateral fraud.”

He adds that banks want to offer products to these customers, but have been told by examiners that they cannot make credit avail-able to anyone with a credit score of less than 700.

Rees says that for lending condi-tions to improve, banking regula-tors need to help banks better serve subprime consumers, rather than cut off their access.

“You can’t always think that the answer to this problem is going to be a 12% installment loan or a credit card — there’s going to have to be a new breed of products and a new level of innovation that regulators should encourage in order to pro-vide more responsible credit prod-ucts for people who are right now stuck with payday loans, or pawn and title loans,” he says. s

Source: Elevate

Non-prime

Credit invisible

Prime

34%

22%

44%

109 MNon-prime

53 MCredit invisibles

Breakdown of US consumers by credit score classification

Source: New York Fed consumer credit panel/ Equifax

% of individuals with a card

100

90

80

70

60

50

40

<620 820-659 880-719 779-720 780+

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Credit card participation by credit score

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4 Securitization in the Global Marketplace

Consumer ABS Roundtable

: How will growth policies under the new US administration affect specific consumer ABS sectors?

Gyan Sinha, Godolphin Capital Management: That question is interesting in a number of different ways. It’s not just growth policies, there are other policies as well that may be relevant to what this administration wants to do that may equally have a bearing. With respect to that, one of the things that you learn about when you study consumer credit is the role of healthcare and medical disasters, with respect to bankruptcy filings. The statistics are that something like half of all bankruptcies are driven by medical related issues. One of the things we have seen in the past four or five years is 20 million more people have insurance today than before, and if some of the policies that are being contemplated on the insurance side go through and lead to a drop in the rolls of the insured then that’s something we would worry about.

On the growth side, we’re not ‘betting the farm’ so to speak that we’re going to get policies that will drive growth up to 3%-4%. Even with the relatively tepid growth that we’ve seen over the last three to four years, consumer credit has done reasonably well. Unemployment rates have come down and hourly wages have gone up but they’re still not

running at the same rate as pre-crisis. So we sort of know how consumer credit and other types of credit behave in a tepid growth environment, but on the other side, if some of the safety nets get knocked out, that’s something that we would worry about. So that’s how we think about the spectrum of political risks right now.

William Black, Moody’s Investors Service: One of the most important credit drivers for consumer assets is the unemployment rate, and that is something that’s been improving year over year for an extended period of time. We’re now in one of the longest economic expansion cycles, and we’re seeing signs of some risk starting to manifest itself in some of the loss numbers, particularly around some of the consumer asset classes.

Moody’s is forecasting the economy to grow faster this year than last year and expects that the unemployment rate will more or less stay where it is today. Most economists define where we are today at pretty much near full employment, so those macro statistics in the context of consumer credit — from a macroeconomic perspective — bode well for performance right now. But we are seeing, particularly in the consumer asset classes that supply collateral for asset backed securities, some signs of credit

Participants in the roundtable were:

William Black, managing director, Moody’s Investors Service

Tracy Chen, portfolio manager, Brandywine Global

Rick D’Emilia, managing director, Wilmington Trust

Joseph Lau, managing director, Lord Capital

Gyan Sinha, CIO, Godolphin Capital Management

Sasha Padbidri, moderator, GlobalCapital

Turning on the spigot for US consumer ABS

The US consumer �nance market has come a long way since the depths of the global �nancial crisis. By most metrics, the market has not just climbed back to the peak but is continuing to rise to new heights. ABS has become a key part of that ascent, as lenders look to extend both secured and unsecured consumer credit.

Subprime credit is also a bigger part of the conversation than it has been since the crisis. Those borrowers deemed to be below prime, underserved by traditional lenders, are obtaining credit from a range of alternative sources. Secured loans on assets such as cars, as well as unsecured debt, are more readily available than they have been at any time since 2008.

In early May, GlobalCapital gathered a group of experts at its headquarters in New York to discuss the state of the auto, student loan, credit card and marketplace loan ABS markets.

004 Consumer ABS RT.indd 4 25/05/2017 17:22


Securitization in the Global Marketplace 5

deterioration, either in the underwriting and/or in the performance.

In terms of growth policies, one of the things that we’re hearing a lot from the marketplace is this tension between those who want to unleash more growth by reversing or adjusting rules that some perceive to be a regulatory burden and others who see them as an important protection to consumers or the financial system. Many proposed changes haven’t been enacted yet, but they’re being talked about as potential sources of further growth. So there may be yet some growth left in this economic cycle.

Joseph Lau, Lord Capital: Yes, that’s a great point, and that was actually what I was going to identify as a wild card — is a change in regulation really going to result in growth in consumer credit, or are we really talking about just changes to regulation for the sake of regulatory change? As we’ve experienced over the last seven or eight years, all of the regulations that have come into place, the costs that have been associated with those and how they’ve flowed through consumer credit. So now, by making wholesale changes to regulations — even if it’s just scaling them back — are we essentially then introducing additional costs into consumer credit and not necessarily being able to pass through benefits to consumers that they’re going to be able to realise?

Black, Moody’s: That’s the tricky thing. What the market is talking about a lot right now are the costs of regulations that have been put in place. What’s being talked about less are the costs of not having those regulations in place, which I think you’re alluding to, and that’s the tension that will take place as the new administration presumably starts to act on some of the things that were part of their platform.

Sinha, Godolphin: It is ironic that a lot of the banking sectors actually don’t want Dodd-Frank to be just tossed out because they have spent the last four to six years retooling their businesses to deal with this, so you can’t have this yo-yo of no regulation, regulation, and no regulation again, which is equally disruptive for everybody concerned.

Lau, Lord: Yes, when we think of the impact of something like the CARD Act on non-prime credit cards and the intended benefits to that consumer, there are massive costs to implementing these changes. Even to make those changes again — whether they’re beneficial or not to those consumers — are going to require a tremendous amount of infrastructure, and that’s going to have to be passed through. So even if it’s looked at as something that reduces regulation, those costs have to be borne somewhere.

Tracy Chen, Brandywine Global: With regards to Trump’s growth policy, one of the things I want to highlight is his priorities. Trump’s priority is to make America great again, and he is determined to onshore the manufacturing jobs and shrink the trade deficit. So as a result, the biggest risk is a potential trade war with China and other countries. Trade wars can only make imported goods more expensive, which can further squeeze the bottom line of retailers and pockets of consumers. One case in point is we have seen the lumber prices rally 30% year to date, partially due to the new tariffs that US exercises on Canadian lumber, so what’s the ramification of this on future US housing prices?

Right now, housing affordability is already stretched in certain parts of the country. So whether home builders can successfully pass on this higher building cost to home buyers remains to be seen. Mortgages and housing-related expenses are a big part of consumer spending, so I would think this will make the housing prices

potentially even higher in certain places. In addition, there’s Trump’s tax policy — he wants to

have tax reform and to cut taxes. In theory this should have a boost to consumer spending. However, the devil is in the detail, which we are still waiting for. Following a continuous decline in the unemployment rate and a gradually tightening labour market, we already start to see household disposable income growth trending higher than the historical norm. The household debt to income ratio has been at a historical low post the global financial crisis. The household balance sheet is in a relatively good shape right now. We observe a major shift in the composition of households’ balance sheets. On the liability side, households de-levered on their mortgage debt, while levering up on student loans and auto loans. But overall the consumer household balance sheet is in a better shape than before.

: What is the outlook at this mid-to-late stage of the cycle? Are any of you concerned about the growth of unsecured subprime consumer debt, and what are the wider implications for the market here?

Lau, Lord: I am cautious at this point. We have had a good consumer environment over the last few years. There have been a number of tension points in the last 12-18 months, the auto market being one of them, and while we haven’t seen general consumer performance deteriorate, there have been questions about what will happen when we’re no longer in a robust environment. That’s probably most important with unsecured consumer loans. While that product has existed historically, the proliferation of it in the last couple of years has been extremely strong. So while that product has a place, there have been a lot of questions about just ensuring that they will continue to perform, and that in a down cycle the returns will be appropriate and that the consumer will be able to handle the additional debt load that they’ve taken on.

Black, Moody’s: For unsecured consumer loans, when I think about the spectrum of consumer loans out there, that’s the canary in the coal mine — the subprime sector, in particular. So Joe referenced the proliferation of unsecured consumer debt, presumably referring to marketplace lending and some of the unsecured consumer lending that’s been going on by those types of lenders. I want to create a distinction between unsecured consumer loans like revolving credit cards and simple, installment loans. This is another not-much-talked-about distinction with a difference when it comes to order ranking consumer credit risk.

An installment loan has no utility the moment you disburse the loan, which does carry with it an additional layer of risk. When the economy turns, that’s where I’ll be

Tracy Chen, BRANDYWINE GLOBAL




looking for the first areas of consumers under duress. So that will show up in all likelihood in default numbers. We haven’t seen that to date. We’ve seen a little marginal deterioration which again, given the macro-economic content that we’ve talked about, you can argue is somewhat surprising, and that could be a matter of figuring out or fine-tuning the underwriting algorithms. Or it could be an early sign of some pushing the envelope with that cohort of borrowers. It’s too soon to tell exactly what is causing some of that deterioration, but nonetheless that’s the focus. Whether it be unsecured consumer installment loans or you can also point to subprime auto as well. At least for auto that’s another area of focus — that’s where the credit risk is.

Sinha, Godolphin: Just to follow, what’s also important is to keep the concepts separate. Marketplace lending is an organisational form rather than a sector in itself, and while there are marketplace lenders doing near-prime type loans, there are others like Avant that are going deeper down the spectrum. So marketplace loans should not be equated with subprime necessarily. It’s just a different way of organising the business structure.

The second point is that clearly, as you point out, they’re canaries in the coal mine, but the canaries seem to be fairly specific to particular business models like retail store cards. You’ve seen the Capital One reports of increases, but the increases percentage-wise are large, but they’re coming off a relatively low base of delinquencies and charge-offs. So it’s unclear whether it’s a macroeconomic signal or they’re paying for the sins of the past few quarters in terms of pushing the underwriting a little.

The third point is that in many ways secured subprime, especially auto-related, is actually more dangerous in terms of the expansion of the credit cycle. The security in the asset lulls lenders into a false sense of comfort, because they feel like, well, if the person doesn’t pay, I have the asset. So I think it can actually lead to more pro-cyclical lending trends, whereas on the unsecured side you’re kind of not really banking on recoveries. You basically know that if the person goes, they’re gone. So the focus is more laser-like on ability to pay, whereas when you have something where you have a greater sense of security because you’ve got this switch that can turn the asset and make it useless, then at the margin, what does that do to your underwriting framework?

Chen, Brandywine: Yes, I agree. If you look at subprime auto origination as a share of the total number of auto loan origination, it’s actually increased from just 5% to 30%. And if you closely examine the composition of subprime autos, you can find that some new deep subprime lenders have been ramping up their share of the lending market. There are new deep subprime lenders targeting borrowers with FICO

scores below 550. As a result, there are many idiosyncratic risks embedded in different issuers and deals from different issuers perform very differently. I do agree that it’s OK to have subprime auto lending to target borrowers who are not able to get access to credit, but you need to keep the share of that market to below a certain limit in order to avoid systemic risk like what happened in the US subprime crisis.

Rick D’Emilia, Wilmington Trust: I’ll just comment on consumer credit in the first quarter of the year and the deals that priced. As a service provider to the industry, I look at the deals and how they’re executed and how they’re getting done. The deals in this space have been oversubscribed. We’re on more than half of the deals in the marketplace lending space and the deals have gone fantastically well and many have been oversubscribed. So the investor appetite for the deals is there.

There are a lot of concerns on the origination side, but the way the deals have been structured, given the short-term nature of the assets, the appetite is there from investors for the product. All this year the deals we’ve been on have been very well received, so it’s been a good market for marketplace loan securitizations, and as more firms enter the securitization market as well as the whole loan market, they’ll diversify as to what their outlets for the loans are. But the first four months of the year have been very good for the market.

Black, Moody’s: Yes Rick, you bring up a good point, but I think it’s important that we remember that the securitization angle of this brings another layer of analysis to the table. Again, depending on how you define marketplace lending, of course, the visibility that you have for performance is in the very rapid pay-down of those loans and the related ABS. I think that also gives investors some comfort that they’re not going to be exposed for an extended period of time.

Not to mention the other qualitative tests of securitization that are brought to the table when you package securities — the very basic building blocks of securitization, the fundamental aspects of the credit that we’ve been talking about. That is the value add that securitization can bring to the table to fund the real economy.

Lau, Lord: That’s a good point. Compared to the pre-crisis period for these asset classes, and circling back to the unsecured consumer segment, you really had three to five lenders in the unsecured consumer prime and non-prime space — MBNA, Capital One, Household/HSBC. They had heavy concentrations in their balance sheets and did very few securitizations, most of which were private.

So there is certainly greater disintermediation of that risk now. You can debate the robustness of some of the organisations that are involved in originating these assets, but certainly they’ve figured out how to diversify that risk, whether it’s through whole loan sales or the ability to use securitization to be able to transfer that risk to other parties, and using structures that are generally deemed by the investor universe to be pretty robust.

Chen, Brandywine: I agree. Securitization is a very powerful mechanism in terms of protecting investors via credit supports and a de-levering deal structure. As an investor, when we calibrate the excess spreads of certain subprime auto bonds with subprime auto loans charging a rate as high as 25% whereas the bond only carries a 5% coupon, investors are protected by an excess spread of up to 20%. It’s phenomenal protection of any potential default for investors.

: What are the potential impacts, if any, to recent changes in credit reporting? Is leaving certain

William Black, MOODY’S INVESTORS SERVICE




negative data points out of credit reports a credit negative for consumer debt and consumer ABS?

Sinha, Godolphin: There are two specifics I am aware of. One is the public records data, and the other was the medical data. Apparently a lot of the tax lien data is very noisy and just erroneous in many instances. And anyone who’s dealt with their doctors’ bills and the insurance companies are going to understand how much of a disaster the whole medical billing industry is, so I could easily imagine how innocuous late pays or errors are getting into that. To the extent that that is going away, I think it actually probably cleanses the bureau data more than anything else.

And finally, I don’t know of any lender that just blindly takes a FICO score as a single input into an underwriting decision. If things move around and somebody who would have been a 750 now becomes a 760 — and everybody shifts 10 steps here and there — who cares? You just have to live with that. So yes, we personally are not particularly concerned about these things and if anything, to the extent they reduce noise in the bureau data, that’s probably helpful.

Lau, Lord: You make a good point. If you ask someone if you can get more data or less data, they’re always going to say more data. But at the same time what is the value of that data? We know with so many consumer lenders, part of the challenge for them is how to eliminate the noise without moving to a full judgement analysis or judgemental lending? Many have tried to move to automated systems where they can pare down to those risk factors that are truly relevant to their type of lending.

A great example of this is all the proliferation of handset financing. For all the telecommunication companies, where they’ve found certain variables around the performance of their own customer base, these have proven to be far more important than most of the identifiers on a credit report. So when you look and say OK, certain information isn’t pulled out, essentially they’re having to go through that exercise already when they pull down a credit report and try to parse out how they create their score cards.

So it’s not so much what information is on there. When we’re speaking to lenders, they are able to look through their consumers and determine what variables and how do they reweight them, so that they’re almost creating their own custom FICO score, more than they are relying on that FICO number because that number can be completely wrong. Sometimes two 680 or 700 FICO scores can have tremendously different credit performance and it’s not going to be in relation to any one specific variable; it’s a group of variables together.

: Shifting to the student loan market, would anyone like to touch on the trends in private student loans and the Federal Family Education Loan Programme (FFELP) sector?

Lau, Lord: FFELP is going away, but it seems like every year you make that prediction and you’re never quite right about it. Having run student loan financing businesses in the past, on the FFELP side, certain issuers continue to buy in those pockets of FFELP loans. So when we think of FFELP ABS, the number obviously continues to decline year-over-year but that remains a very important asset. Certainly for a lot of asset managers, it is a very important asset class from a portfolio perspective. On the private side, it’s been slow and we work with a number of issuers that have been building what they see as a future for student lending — whether we want to call that a marketplace application — that’s an unfair misnomer in many ways, for the same reason we’ve talked about, which is that marketplace is really an

origination engine more than it is a sector unto itself. But it’s really looking at private entities or finance

companies attempting to determine ways to make student debt available, whether it’s on a refinancing basis or just making education affordable, and understanding the limitations that ultimately exist when a student starts school and is not going to make meaningful payments until they’re out of school. Knowing that that student is not really an understandable credit risk until they reach that point is going to be a very large burden based on the cost of education. All those variables have made it very, very hard for everyone that’s trying to tackle that model.

Black, Moody’s: It’s definitely challenging. It’s a long-term consumer asset class, and there is roughly $1.4tr worth of student loan debt outstanding. The vast majority of that — around $950bn— is direct loans which are not today being securitized. Now that is also being talked about as a potential source of collateral down the road, but I haven’t seen any firm proposals along those lines yet. Then you have roughly, $100bn in private student loan debt and the balance being this diminishing pool of FFELP collateral.

This is always a fascinating sector to talk about because there is — outside of securitization — the government’s role or the philosophical and policy questions that are raised perennially, and they’re all being talked about and brought into the headlines once again as we have this change in administration. During the Obama administration, standards were established effectively targeting for-profit institutions regarding the ability of their graduates to repay their loans. Basically, if the schools didn’t meet the criteria, they could lose an important source of funding and their ability to operate. The new administration has talked about putting a pause on that criteria. So that’s one potential change.

From a securitization perspective, this has very little impact because only a very small percentage of borrowers who are still in-school at for-profit schools are represented in any pools. There are also some discussions around changes to the Grad PLUS and the Parent PLUS programmes. There are some discussions around limiting the amount that the government will lend through those programmes, again, very high level conversations at this point. It’s nothing firm, but that may allow for either less access for borrowers or, at least in those channels clearly where they’ll have to make different decisions, or maybe that’s an opportunity for the private lenders to come in and fill a gap that’s been created as a consequence of scaling back some of those programmes.

The other thing that was talked about and still is talked about, is income-based repayment (IBR). That continues to be promoted by the servicers, and continues to grow as a percentage of the loan balances. What we do see that is interesting, is when you combine IBR with deferment and

Joseph Lau, LORD CAPITAL




forbearance — which are other programmes to help give relief to borrowers — the total deferment and forbearance and IBR ratio has remained relatively steady.

D’Emilia, Wilmington: If you look at the student loan ABS market, we talked about how many loans are being securitized in government programmes, and there really is a handful of people that are doing that. But if you look at all of the names of all the refinancing companies — we’re on deals with some of the largest originators in the market — what I’m seeing from them is that while they’ve started as these refinance companies they’re doing in-school products too. Obviously there is a large amount of the other products, but there’s only a small handful of issuers. You will be seeing two or three new issuers in this space in the months ahead.

Chen, Brandywine: Student loan ABS is the number one sector with the biggest policy uncertainty risk. So as an investor, we do require higher risk premiums to allow us to be attracted to this sector. There was considerable rating downgrade and political uncertainty with regards to FFELP for the past one or two years, so we stayed away from it, but since the end of last year FFELPs have created a unique opportunity for investors. But if you compare FFELP with the private student loan sector, the private sector probably is more attractive in terms of the risk/return profile with better loan performance and less political uncertainty. But again, this sector is one with a lot of uncertainty compared to other ABS.

: Do you see student loan refinancing ABS as a more attractive investment compared to FFELP and private student loans?

Black, Moody’s: They’ve carved out a very nice niche for themselves. We’re talking about the ones that have made it to the securitization market. I’m aware so far of SoFi, DRB and CommonBond, which are, by and large, originating to borrowers who have been out of school, who have a track record, a job and verified income that’s quite high. They’ve often graduated from a top tier school as well. As these companies grow their businesses, they’ve expanded their origination platforms, their target markets and their loan types so now many of them are offering other products as well.

But bringing it back to just student loans, their business model is one where they’re identifying people who took out loans when they were in school — therefore a riskier loan and priced as such, presumably — and now 10 years later, they have a job, they’re a known entity, they have a track record, there are less risks and they’re able to price that in

and then offer an attractively financed product to them. And that is working for that cohort of super-prime borrowers that they’ve been focused on.

Again, it’s early, in the sense that none of these companies we’re talking about have been around that long, and they are operating in a very benign credit environment. But certainly, performance is exceptionally good, losses have been extremely low in those pools. But it’s difficult to gauge just how good their underwriting algorithms are given the benign environment that we’re in. So that remains a question unanswered until, quite frankly, we go through a more challenging credit time. That’s the critical question.

: Is the Consumer Financial Protection Bureau (CFPB) still an important buffer between consumers and Wall Street? Or is its role no longer necessary nearly a decade after the crisis?

Sinha, Godolphin: Honestly, I like the fact that it is around. Will alluded to the fact that people talk about regulation, and then they talk about cost, but they don’t talk about the benefits. And one of the biggest benefits really is prevention of things like the recent financial crisis. We’re all ducking underneath the table, thinking about whether the ATMs are going to function next week. So I think if anything, it acts as a stabiliser. And honestly, speaking as a consumer, our interactions with American corporations today are increasingly skewed and driven by the corporations, whether it be through arbitration clauses or whatever it may be. So you need some sort of a stabilising force that levels the playing field. We’re seeing this with respect to the airline industry right now. To the extent that the CFPB has shined some light on what were fairly murky practices, it is really not in anyone’s interest to have financial products that don’t work for the people that take them out.

Over the last five to six years, mortgage lending has been very robust. You can quibble about whether more should have been done with respect to Fannie and Freddie versus the private sector, but do we really want loans coming back where borrowers really don’t have the ability to pay and there are no checks and balances? If that really doesn’t happen, would we all miss it very much?

Lau, Lord: There’s certainly a role for them as a centralised consumer protection body because the comparison I would make to pre-crisis, when you had so many different bank regulatory bodies, and having worked at a bank at the time, one of the challenges was you had so many regulators, depending upon the client you were dealing with and different regulatory standards for every one of those institutions. So having some type of centralised view on what consumer regulation should be is certainly a big plus.

It seems like one of the challenges with the CFPB right now continues to be the politicised nature of its further existence. Every couple of weeks, someone in Congress is raising the idea that it shouldn’t continue to exist which, in some ways, feels like it drives it to continue to justify why it is existing.

Chen, Brandywine: Ideally, the role of the regulatory institutions should effectively synchronise with the ebbs and flows of a credit cycle. At this point in the credit cycle, we’re still in the late expansionary stage where the lenders are just about to loosen their lending standards because of everything going so well. So at this point the role of regulatory institutions like the CFPB is more important than at the earliest part of the cycle where the lenders are very cautious and tight with lending standards.

: What is the outlook for the securitization of

Rick D’Emilia, WILMINGTON TRUST




consumer assets for the remainder of this year?

D’Emilia, Wilmington: We’re inundated with new warehouse facilities by banks willing to lend to issuers, so that’s where I see the large institutions willing to give significant warehouse finance in this space, and that’s increasing. That’s something that’s not quite seen in the securitization market right now, but that’s a precursor. Banks are giving more entities several hundred million dollar lines that are going to be securitized within six to 12 months. So I am seeing an increased activity there, and it bodes well for the issuance of ABS.

Lau, Lord: We’ve seen a tremendous amount of activity in even more non-standard products. We talk about standard consumer, but then there are other applications of consumer lending that are in the early stage — they might be in their first financing, getting a bank involved for the first time, so it might even be further than six to 12 months, but they’re beginning to build a business plan.

So standard consumer ABS certainly feels like it’s going to continue to be very strong so long as the consumers say so. But it also feels like there are a lot of additional applications that people are bringing to market with an expectation that that will move from the lending market to the securitization market because those businesses are developing the tools and the platforms they need to be securitization-ready.

Black, Moody’s: Yes, it goes back to what we were saying when we talked about it in the beginning, that the macroeconomic backdrop for originations and credit performance is pretty good right now. It’s had a better than expected first four months of the year in terms of the issuance volume for the ABS consumer sector. But we still have a long way to go for the year.

So in total, we’re calling for single-digit growth, year-over-year, in terms of issuance volume. But certainly, origination of raw material — if you want to call it that — for potential securitizations is, as I said, where you’re going to have the issuance volume. In student loans, that’s probably from the refi lenders mostly right now, and they’re growing off of a small base but they’re growing quite rapidly.

For autos, we said sales volumes are dropping, but they’re still very, very high from a historical perspective. We expect to see some marginal collateral performance deterioration in some of the more recent vintages, probably as a consequence of several successive years of marginal risk-taking.

And for credit cards — some look at them as a barometer for consumer credit in general — certainly, the securitized collateral is performing exceptionally well. I’ve been calling the bottom of the charge-off rate for many years running now, and been wrong. But in 2017, we’re going to hit an inflection point and losses are going to come off historic lows. But by all measures, credit cards are performing exceptionally well, and will continue to do so for quite some time, particularly the securitized collateral.

Chen, Brandywine: For year 2017, our base case is still a reflationary year with synchronised pick-up in global growth. Led by the US, China and the eurozone, global inflation started peaking slightly but the level is still moderate without urgent need for aggressive rate hiking. With the Federal Reserve’s benign and gradual monetary policy normalisation, it should still be a Goldilocks environment for risk assets. With the French election behind us, the political risk in the near term is declining. However, we are fully cognisant of the other three major risks. One of them is with regards to the normalisation of the Fed’s balance sheet. When and how they are going to taper their MBS and Treasury reinvestment, that’s a big unknown. Another risk is whether China’s

growth will slow down drastically with its current financial market deleveraging and regulatory tightening. The third risk would be involved with political risk surrounding Trump’s administration, i.e., whether they can deliver their promise of fiscal stimulus, especially tax cuts. So, in a rising rate environment combined with a certain degree of uncertainty, I view ABS — based on a nature of short duration and mostly floating rate — would still be investors’ favourite. And also given the fact that we are in the late stage of this credit cycle, consumer ABS has always been a very decisive play for investors. We foresee healthy new ABS issuance volume this year given strong investor demand and the benign macroeconomic environment.

Sinha, Godolphin: The way we look at it is that there’s an overall macro cycle, in which we’re still in a reasonably benign phase. Bond rates are low but we don’t really expect them to tick up. Maybe there might be some regional issues that you have to be careful about. But embedded within this economic cycle you have different industries and sectors that are at different points in their own cycle. For example, subprime auto is very mature and you could start to see some more headlines emerge this year, which is independent of what the macro cycle is doing.

For credit cards, there are pockets, as you said, of stretching. The marketplace lending space is probably the most interesting because that’s where a rationalisation happened last year. It basically was the best thing since sliced bread, and then nobody wanted to touch it, but now people are beginning to see that the models are now consolidating and there’s a bit more stability, so people are starting to re-engage with the space.

A lot of the tools that have been traditionally available to specialty finance companies are beginning to be made available, as you pointed out, to people that are coming in, like ourselves — and are interested in the loans and want to use the ABS market as term financing. s

This commentary is for information purposes only and is not intended as an offer,

recommendation or solicitation for the sale of any financial product or service or

as a determination that any investment strategy is suitable for a specific investor.

Wilmington Trust is a registered service mark. Wilmington Trust Corporation

is a wholly owned subsidiary of M&T Bank Corporation. Wilmington Trust

Company, operating in Delaware only, Wilmington Trust, N.A., M&T Bank and

certain other affiliates, provide various fiduciary and non-fiduciary services,

including trustee, custodial, agency, investment management and other services.

International corporate and institutional services are offered through Wilmington

Trust Corporation’s international affiliates. Loans, credit cards, retail and business

deposits, and other business and personal banking services and products are

offered by M&T Bank, a FDIC member.

Gyan Sinha, GODOLPHIN CAPITAL MANAGEMENT



Q&A WITH LAUREL DAVIS

Why did Fannie Mae begin its credit risk transfer programs? Does CAS fill a hole for investors who would generally participate in the private label RMBS market?

The credit risk transfer program is part of a multi-year drive across all aspects of our company to improve our business model, strengthen the housing finance system, and deliver innovation and certainty to our cus-tomers, which includes our inves-tors. If you think about our business we are one of the largest participants in the secondary mortgage market in the US.

At the end of 2016, U.S. first lien mortgage debt was approximately $9.6 trillion outstanding, and Fannie Mae makes up around one third of that total. We don’t lend directly to consumers. Rather, we acquire loans from lenders in exchange for a guar-antee fee and then place those loans into Fannie Mae MBS. We guaran-tee the timely payment of principal and interest on the MBS to investors. We have approximately $2.9 trillion in single-family MBS outstanding to date. In the past, we always held the credit risk associated with loss-es on the loans that we guarantee. With our CAS program, we created a market that shares some of that risk with investors who want to take U.S.

mortgage credit exposure.Program objectives include

increasing the role of private capital in the U.S. mortgage market. We are also building a stronger and more resilient organization by protecting ourselves against loss scenarios we might experience in a severe eco-nomic downturn. We’re able to do this by leveraging the expertise that we have developed managing credit risk. We manage trillions of dollars’ worth of credit risk for our own book of business and have done so for many years. With this program, we can apply that expertise to manage risk on behalf of our investors. Our goal is to build a robust program that is liquid and sustainable over time and attracts a very broad range of investors, domestically and globally.

What credit risk products are available to investors?

We have developed a suite of pro-grams that are attractive to different pools of capital. Through early June this year we have transferred over $30 billion of single-family mortgage credit risk to the private market. That covers over $1 trillion of mort-gage loan balance, more than any other mortgage finance company. CAS, our largest program, is viewed as the benchmark for U.S. mort-

gage credit. With CAS, Fannie Mae issues credit-linked debt notes that are tied to the performance of a pool of loans. We have issued over $24.8 billion in this product since 2013. We also have a reinsurance program called Credit Insurance Risk Trans-fer™ (CIRT™), which is complemen-tary to CAS. Whereas CAS attracts investors who are in the capital mar-kets like asset managers, insurers, and money managers, CIRT is aimed at the global reinsurance market. In addition, we share risk with our lenders, primarily those who want to retain a portion of the risk on the loans that they sell to us.

Why would investors want to par-ticipate in Fannie Mae’s credit risk transfer programs?

Fannie Mae manages a $2.9 trillion book of single-family credit risk, the largest in the industry. Our footprint allows investors to gain representa-tive exposure to the entire U.S. hous-ing market. We learned a lot from our experience managing that book, especially through the financial cri-sis. Since 2008, we have strength-ened our underwriting and eligibility standards to improve the quality of the loans that are delivered to us.

Fannie Mae acts as an intermedi-ary between approximately 1,200 U.S.

Laurel Davis, Vice President, Credit Risk Transfer, discusses the evolution of the CAS program, Fannie Mae’s investor outreach, and what the market can expect to see from the program in 2017 and beyond.

Inside the World of Connecticut Avenue Securities

M-1 Investor base by type M-2 Investor base by type B Investor base by type

74%

4%

10%

11%

0.4%

42%

2%

49%

0.5%

6%

75%

20%

1%

5%

Asset Manager Depository Institution Hedge Fund/Private Equity Insurance Company REIT

Investor Distribution: 2013-2016

Laurel Davis, Fannie Mae

SPONSORED STATEMENT

Fannie Mae Logo Guidelines 1

© 2017 Fannie Mae. Trademarks of Fannie Mae.

Our logo and symbol

At the heart of our brand identity is our evolved logo. It honors our past while orienting us in the present and pointing us firmly toward the future. It symbolizes a fresh start built on a firm foundation.

The iconic “house-on-the-hill” symbol is immediately recognizable: it tells you what Fannie Mae does and what we represent. The evolved logo retains the concept of the house, but updates it to create an open, contemporary look.

The clean, linear graphic treatment lends a lightness that evokes openness and transparency, while the circular shape connotes warmth, inclusion, and a focus on what we do: putting people in homes. Placing the house inside of a circle also symbolizes the house as an end goal.

Finally, the circle allows for the house to be used as a stand-alone symbol in certain situations. This modular approach gives us the flexibility to be a contemporary brand, for use across applications from print to digital.

Fannie Q&A.indd 10 25/05/2017 18:27



lenders and a broad array of domestic and international investors, manag-ing the credit risk throughout the life of the deal. We set standards in the U.S. housing industry through trans-parent guides that detail our require-ments for accepting loans from lend-ers and our requirements for those firms that service our loans. When investors participate in our credit risk sharing structures, they get the benefit of an experienced credit risk manager.

We sit at the center of the U.S. housing market. Given our size and scale, we have a vast amount of data available to us that we use to improve loan manufacturing quality and drive innovative quality control solutions. Since the crisis, we have developed cutting-edge data driven tools that support loan underwrit-ing, property valuation, quality con-trol, servicing, and real estate owned management. Not only do we use these tools in our own quality con-trol processes, but we have provided tools to our lenders, so that they can improve the manufacturing process of mortgage loans before even deliv-ering them to Fannie Mae. These tools not only improve the quality of our originations, they help to create a stronger market overall.

In addition to the tools we pro-vide upfront to lenders, we have improved mortgage credit loss man-agement through better servicing protocols, more effective modifica-tion programs, and servicer training. We have the largest program in the industry for managing real estate owned (REO) properties. Despite the size of this REO program, we take a very hands-on approach to property management. We do all of our prop-erty management in-house, includ-ing property valuation and manage-ment of the sales process. This helps us reduce the severity of losses.

What types of investors do you see in the program and how has Fannie Mae tried to grow the investor base?

We have seen an array of investors who are trying to gain exposure to U.S. mortgage credit and are drawn to Fannie Mae’s diverse footprint across the entire U.S. mortgage mar-ket. A broad group of investors par-ticipate in the CAS program, includ-ing asset managers, hedge funds, insurance companies, and real estate investment trusts (REITs). We see U.S. based accounts and con-

tinue to see interest from investors across the globe, including Europe, Canada, Australia, and Asia.

We offer bonds across the capi-tal structure, both investment grade and non-investment grade of dif-ferent weighted average life pro-files and that can attract a different investor base. Some investors look-ing for shorter term higher rated paper are attracted to the higher mezzanine bonds, whereas other investors looking for a little more yield, wanting to take a little more risk further down the capital struc-ture, are interested in the middle and lower tranches. The deals that we bring to market are all uncapped Libor floaters and I think that appeals to a lot of investors. Unlike some residential credit risk secu-rities, this has a twelve-and-a-half year legal maturity, which is appeal-ing as well.

As an issuer, we bring deals at benchmark size regularly into the market. We’re focused on building liquidity for the program, which is why we have a regular issuance calen-dar. We also spend a lot of time focus-ing on developing our investor base, which is strong and continues to grow - we see new investors on every deal. We believe that a robust investor base is critical for ongoing liquidity and the stability of the program.

Do you expect to see the program expand to a more international group of investors in the future?

We spend a lot of time travelling internationally and meeting with

investors. International investors are extremely focused on learn-ing about our credit risk manage-ment and understanding the tools we use to manage the underlying credit risk. We also have structured the CAS securities such that Fannie Mae retains a 5% vertical slice across every tranche that we issue, an important feature for our European investor base as it complies with EU risk retention requirements.

How have the bonds performed in the market and what improve-ments has Fannie Mae seen in the liquidity of CAS securities over the history of the program?

We have seen the market rapidly gain liquidity from the inception of the program in 2013. Arguably, this has become the most liquid mar-ket for residential mortgage credit. Last year, just under $14 billion of CAS securities traded in the second-ary market, just under one times the total amount of outstanding CAS bonds. We think that the liquidity in and of itself has attracted new inves-tors. Larger investors who want to make sure that they can buy and sell without having an outsized impact on market pricing have been able to do this quite easily. We also see multiple dealers making daily sec-ondary markets. These trades are all reported on TRACE, which adds to market transparency. We also have strong dealer support and benefit from their ongoing research about the CAS program. Dealers and third party data vendors offer numerous

Reference Pool● Loans acquired by

Fannie Mae and deposited into MBS

● Meets target selection criteria

Class AFannie Mae retains senior-most risk positionCredit protection provided by M1, M2, B notes

Class B-2Retained by Fannie Mae

Class M-1HFannie Mae

retains minimum 5% vertical slice

Class M-2HFannie Mae


Class B-1HFannie Mae


Class M-1Sold to investors

Class M-2Sold to investors

Class B-1Sold to investors

1

2

3

Credit and prepayment performance of the reference pool loans determines performance of CAS securities

Fannie Mae issues CAS securities: receives cash proceeds

Fannie Mae pays interest to investors

Fannie Mae repays principal less credit losses

If reference pool loans experience losses, CAS notes are written down by a corresponding amount, starting with Class B and continuing in reverse sequential order.

Sample deal structure

Fannie Q&A.indd 11 25/05/2017 18:27



credit models to support the pro-gram, all of which help investors to understand the program and con-tribute to overall liquidity.

How has the structure of Fannie Mae CAS deals evolved since inception of the program?

Although we’ve made some chang-es based on investor feedback, the basic structure of our offering has been fairly consistent by design. The program’s primary focus is to build liquidity for the sector. We think that consistency has been a key factor in helping investors compare bonds. If you think about the legacy RMBS market as a comparison, it is sig-nificantly fractured into thousands of individual bonds and very hard to compare one versus the other. Because of the consistency in the structure throughout the life of the program, an investor can compare a new issue versus more seasoned bonds.

We have made changes, though, mainly based on feedback from investors about what is important to them. Last year we began to get ratings on bonds which were lower down in the capital structure. Inves-tors indicated that this was becoming increasingly important as the pro-gram grew. After implementing rat-ings on the new issue deals, we went back and had some of the earlier bonds retroactively rated. This imme-diately provided value to investors.

Last year, we also began offer-ing all portions of the first loss, or B-piece, although we continue to retain a stake in first loss risk. Our current structure has been favora-bly received by investors looking for a little additional yield, but still maintaining first loss protection by Fannie Mae.

Where do you see the future of CAS?

CAS is now an ongoing programmatic part of our business and we view it as fundamental to our strategy of creat-ing a stronger company and stronger housing finance system. As of March 31, 2017, 26% of our outstanding sin-gle-family book of business is now covered by credit risk transfer.

You can see our commitment to the program through the transpar-

ency that we offer – an objective we continue to focus on to provide value to our investor base. We publish detailed credit performance on over 24 million loans acquired since 2000, which really helps investors to build their own credit models.

We also provide loan-level data at issuance and on a monthly basis for each deal. Investors shared that they loved all the data, but for some it was too much and hard to digest. So we created a really innovative tool called Data Dynamics™, allowing investors to analyze historical per-formance and loan level data avail-able on each deal without having to download all of the loan data. We’re the only issuer in this sector offering a tool like this and it’s available on our website for free.

We also share videos on our web-site that demonstrate some of the tools we use in the underwriting, quality control, and servicing of the loans. These tools are unique to Fan-nie Mae. We have been demonstrat-ing them to investors on the road, but since we can’t get in front of eve-ryone in person, these videos allow investors to see exactly how we use these tools to manage credit risk. We have added commentary and news to our website so we can push out more information about the program. We’ve gotten great reception from investors to these tools and the addi-tional level of transparency.

Looking at the future, we expect to continue to demonstrate transpar-ency and innovation to our investor customers to continue the growth of the program. Last year, we issued just

over $7 billion of securities and we are expecting very similar issuance for 2017. We have issued several deals this year and expect to continue to be in the market on a regular basis, with six or seven transactions throughout the course of 2017. We see this as a market that we plan to issue into for many years to come and are excited to offer the product to our investors.

One area where it is often said that CRT can grow is on making the product more REIT friendly. Is there any discussion underway at Fannie Mae to make CAS a better asset for REITS?

It is definitely something that we are very focused on. To date, REITS have made up just over 4% of the investor base at issuance. The issue is that the current treatment of the product doesn’t meet all of the tax tests that REITs require. However, we do think that REITs are a natural source of funding for mortgage cred-it risk, so their participation in the program could be higher. We have been working really hard looking at ways to make the product more REIT friendly. To this end, we recently announced that we are proposing an innovative new enhancement to our structure that would eliminate these barriers, which we think would be a positive for the overall liquidity of the market. We’ve been working on the enhancement for about a year and are looking forward to market feedback, with the goal to switch to the new structure sometime in the near future. s

Data dynamics

Fannie Q&A.indd 12 25/05/2017 18:27


Q&A WITH WILMINGTON TRUST

I’d like to start off with auto ABS leading up to and after Brexit. How will the event impact the European auto ABS sector and how will issuers and investors respond? Does it affect issuance plans for a company like Mer-cedes, which issues a significant volume of sterling denominated ABS each year?

Marcus Herkle, Wilmington Trust, SP Services: From a German per-spective, at the moment I cannot see a major impact of the Brexit deci-sion for existing auto ABS transac-tions. The whole Brexit subject in our understanding carries a very high level of uncertainty, and it might have an impact at the long end of the investor universe and product spec-trum, but you have to keep in mind that auto ABS paper has a relatively short maturity. In my understanding, that would have a limited impact on issuance volumes.

And from our perspective, this is another reason that Wilmington Trust operates offices not only in the UK but in Dublin and of course in Frankfurt as well. We, as an entity, have a lot of opportunity to share roles between the three offices and follow any need that a client might have at any moment. There is so much uncertainty about the Brexit subject as a whole; it would be dif-ficult to come down to an impact on auto ABS paper specifically.

Eileen Hughes, Wilmington Trust, SP Services: I would agree with that. I think that right now, it’s a pretty stable market. There are low vol-ume costs; consumers have relative-ly strong debt affordability and low

periodic payments which makes it very attractive to investors and for issuers alike because the default rates are staying low. But I would con-cur that as the UK exits from the EU, that there is too much uncertainty for anybody to actually know if it’s going to cause a decrease in demand for luxury cars and perhaps result in people retaining cars for longer or purchasing more affordable cars.

Ulf Kreppel, Jones Day: From my end, speaking as a lawyer, I think with auto loans, you have proba-bly picked on the most “uninterest-ing” asset class to discuss. And by “uninteresting,” I don’t mean that in a negative sense, but to the contra-ry. It’s the only asset class that has been extremely stable, both before and since the crisis. I recently spoke with one of our clients in the auto loan industry and asked them what they think the demand will be in the future. The answer I received was that the UK at the moment is a very attractive jurisdiction in which to invest, as opposed to other jurisdic-tions because you can still pick up

some spread. Having said that, you have to bear in mind that auto ABS is the queen of securitization in Europe in that it’s one of the few asset class-es which is really stable in the mar-ket because of its high diversity and granularity and, as Marcus said, its relatively short tenor.

I do not have a crystal ball to pre-dict the future, but the worst that could happen in relation to Brexit is a downgrade of the rating of the UK. This would certainly also have an impact on spreads and ratings on UK auto ABS deals.

In this context we have to bear in mind that auto ABS is used as ECB collateral, which of course would be impacted by negative rating developments.

What should investors and other market participants be aware of in terms of comparisons between the core and periphery of Europe with regards to auto ABS? It is likely that buyers can get a pickup in spreads by going into a periph-eral market, but is there anything about consumer behaviour or credit quality that people need to be aware of when looking outside of the core of Europe?

Hughes, Wilmington Trust: I would take a look at the unemploy-ment rates. For example, I think Spain has a 21% unemployment rate where-as overall, the EU is about 10%, and Great Britain is approximately 4.7%. I think that this has to be factored in when looking at the periphery.

Right, and then in the UK, there has been a pickup in personal con-tract purchase (PCP) agreements,

The auto ABS sector is among the most stable in the wider securitization market in Europe. In the UK in particular, the auto industry has been an engine of the post-crisis recovery and the sector has drawn securitization investors from far and wide looking for stable, relatively high yielding investments away from more traditional fixed income markets.

But with recent macroeconomic and geopolitical events, including Brexit, new questions have cropped up and market participants have been on the lookout for clues as to how the industry moves forward from here.

Experts from Wilmington Trust, along with a structured finance partner from Jones Day, weigh in on the outlook for European auto ABS, consumer credit in Europe and innovations bringing securitization into a new era.

Auto ABS in Europe and the outlook in a changing market

Eileen Hughes, Wilminton Trust

SPONSORED STATEMENT

Wilmington Q&A.indd 13 25/05/2017 17:24


Q&A WITH WILMINGTON TRUST Q&A WITH WILMINGTON TRUST

in which there is a balloon pay-ment at the end of a lease. What are your feelings on how that’s working out? These sorts of con-tracts work well if prices of used cars are rising, but what happens if used car prices eventually fall? Is there something that you are paying particular close attention to with how contracts are drawn out in the auto market in the UK?

Hughes, Wilmington Trust: I think we’re looking at, especially with Brex-it, residual value volatility. I think everyone is looking at that right now. At the moment, it seems to be stable. But again, if residual values take a dip because premium cars are experi-encing price pressure, then we would likely have an issue in default rates.

Kreppel, Jones Day: Yes, I fully agree. You mentioned the balloon payment at the end of the contract. I think that’s a feature that we increas-ingly notice in securitised portfoli-os, which from a rating point of view can be a concern, because it shifts the performance risk to the end of the transaction. Of course, you have the asset value to cover such risk, so ultimately it may not be purely a con-sumer risk. But obviously, it’s a tail-end risk that needs to be dealt with.

And, as technology moves ahead, we need to watch this space careful-ly. It is not only Brexit, but there are other considerations, such as con-sumer demand following the change of technology and new industry initi-atives, including car sharing models. In my view, the idea of owning a car is becoming less and less important from a status perspective. However, vehicle admission and registration figures still tell a different story.

I’d like to touch on your thoughts on the long-term impact of nega-tive interest rates in Europe. It has been the case that more and more investors are coming into the European auto ABS space, attract-ed by short-dated paper. But what do negative Euribor rates do to auto ABS in the long run? In Germany and France, we’re see-ing deals being priced above par because of negative rates and very low spreads. What are your thoughts on the implications for the asset class and for investor appetite broadly?

Herkle, Wilmington Trust: We are seeing low or negative interest rates. That’s true, of course. But on the

other hand, we have low inflation in Europe as well, together with low or even falling unemployment levels. This is the bigger picture.

And given that the performance and issuance of auto ABS is main-ly related to the registration of new vehicles, we feel that this will both fuel the performance and issuance volume of auto ABS. Because given the stable credit performance which we already talked about, and the high market liquidity of auto ABS paper, we cannot see a real challenge on the demand side.

We know that auto ABS is eligible as ECB collateral and I think the ECB will continue its quantitative easing programme throughout the whole year. That’s clear. And if this should come to an end at some point in time, I think given the credit quality of the asset class there will be enough investors to take over ECB’s role. So we do not see a challenge in either demand or supply at the moment.

Kreppel, Jones Day: Well, you have to do a market comparison to find out what are the markets in which you really earn a return? In my view, applying a risk and return compari-son, the spreads on auto ABS contin-ue to be attractive, both for origina-tors and for investors.

Also, you should not forget insur-ance companies and pension funds – they have huge pressure to invest. For the reason set out above they jump at ABS opportunities, in par-ticular auto ABS.

To bring it back to the general con-sumer market briefly, recent arti-cles have warned about a loom-ing subprime crisis in the UK auto industry. Do you guys agree with the comparison with UK to US with regard to non-prime or sub-prime consumer behaviour? Is there an equivalent in the UK and should investors be worried about the potential for any kind of bub-ble forming in the asset class?

Herkle, Wilmington Trust: I think the UK and US markets are hard to compare because given that, for example, the rating models and the scoring models that are in use, in things like US mortgages or car loans in Europe, they’re completely differ-ent. And I think the good thing is that the scoring models for auto loans take into account very granular data. That should prevent from the devel-opment we saw in the other markets, like US mortgages.

Kreppel, Jones Day: Yes, I think the European market has tradition-ally been a very conservative mar-ket. If you compare it to the US, in particular to the subprime crisis in the residential housing area, there is nothing like that in Europe. One of the reasons is that the lending policy in Europe, to some extent also driven by regulatory con-straints, such as the risk retention rules, is a lot more conservative than in other countries.

In the US, where a person’s con-sumer credit score dictates a lot of what they can do as a borrow-er, how do auto finance com-panies in the UK determine or stratify the borrowers and their ability to repay? What is the doc-umentation that is being used and what are they doing to make sure that there aren’t loans going out to people who are not going to be able to pay them back?

Kreppel, Jones Day: Well, the origination process is very rigorous and sometimes tedious. Following the KYC, banks have to run inter-nal and external credit scoring and quality checks. And it involves a lot of paperwork. When a new custom-er applies for a loan, the process, at least to my recollection, can take up to several weeks before you get the final credit decision. So, you can imagine that it is a quite diligent process.

Is there any movement in the market to get closer to something that is similar to the FICO system in the US? In the US, the credit data bureaus collect and report consumers’ information to deter-mine a personal credit score. Is there anything like that that’s been talked about in Europe, to give people a more concrete score that follows them around?

Marcus Herkle, Wilminton Trust



Q&A WITH WILMINGTON TRUST Q&A WITH WILMINGTON TRUST

Hughes, Wilmington Trust: I think the rating agencies, since they’re rating both US as well as European ABS, are likely applying the standards for the origination. So I think that they’re probably going through as much scrutiny as in the US.

Eileen, is there anything on the product development side that you at Wilmington Trust are working on to enhance your capabilities as a deal administra-tor and trustee? Is there anything that you have been developing for structured finance profes-sionals that is expanding the offering of Wilmington Trust?

Hughes, Wilmington Trust: We are expanding within the struc-tured finance teams broadly. I’ll be moving over to London to align our structured teams in the UK with our US team, and trying to expand the offerings from both offices. It’s a long-range plan, but yes, Wilm-ington Trust is actively involved in increasing its presence in the structured market. Caroline Magee joined our Dublin office, last year to complement the US sales team of Rick D’Emilia and Pat Evans. Caroline’s efforts have been so well received that we are adding Joan-na Taylor to the structured finance team in Dublin. We are confident that our additions will enhance our client base and increase our market share.

Wilmington Trust has been very successful in providing corporate services within the structured mar-ket. But we have not been as promi-nent in the traditional roles of trus-tee, registrar, paying agent, and that’s what we’re going to be focus-ing on – expanding our offerings in the Euro market.

Kreppel, Jones Day: One point that maybe was not mentioned, but is very trendy right now, is the Blockchain technology.

People talk about it a lot and ask the question, what can we do with it and where is the connection between Blockchain and securiti-zation? We have started an initia-tive in Germany to apply Block-chain technology in securitization transactions. Blockchain could help to significantly speed up the cus-tomer screening process, for exam-ple, where you have a multitude of resources that you can pick out to find out what the credit standing of

the customer is. But that is only the starting point in a securitization. Overall, the Blockchain technology can be used in multiple ways and on multiple levels, including the origination process, the asset level and the securities level. In my view, Blockchain will have a significant impact on the securitization area.

That’s interesting. Because it seems as though everyone in securitization agrees that Block-chain is a big deal, but no one knows exactly why. Are you say-ing that its application will be in enhancing the availability and transparency of data?

Herkle, Wilmington Trust: ABS is a very complex product and it’s not only on the sale and the refinancing and the funding in the capital mar-kets; the application of Blockchain can actually start at the origina-tion process. So, at the moment the potential customer negotiates with the dealers for the car and signs the contract, that’s actually when Blockchain can basically begin.

You can essentially represent the customer or the asset and the receivable, as a token, and the token can then be moved. I think it can be used from a ratings perspec-tive, and there are a number of fea-tures that Blockchain can actually improve in this process.

Kreppel, Jones Day: There are a number of angles that you can real-ly apply the Blockchain technolo-gy. We’re still in the concept phase and at the end of the day, we prob-ably need a guinea pig transaction, someone who will say that they are really going to try it. Because the theory can be brilliant, but if it doesn’t work in practice, it won’t be attractive. There have already been some private securitization trans-actions using to some extent the

Blockchain technology, but it will certainly take some time, until mar-ket participants are becoming fully comfortable to rely on Blockchain. However, watch this space.

To bring it back to the auto sec-tor and to conclude, is there any-thing in terms of bigger picture trends you are looking at in the space?

Hughes, Wilmington Trust: I think that, as we said, 2016 was the highest level of car sales since 2007. It was a fantastic year. There’s been a slight dip, but I think, in general, it’s a very stable asset class. Again, I can’t say for sure what will happen with Brexit, but for now, I think that we can expect 2017 to be very sta-ble, very comparable to 2016.

Herkle, Wilmington Trust: Yes, from Frankfurt, we understand auto ABS to be the engine of the whole ABS market in some ways. And this market is dominated by only a handful of originators with their continental funding strategies. And if we talk about, for example, rela-tive value among various jurisdic-tions, our feeling is that relative value can only be found if you look at the originators themselves, the auto manufacturers. Those are the key drivers of the performance of auto ABS and the drivers of relative value. And this is not a question of jurisdictions or structures, but it’s a question of the performance of your car and the auto manufacturers, of the industry itself.

Kreppel, Jones Day: I agree. Even though the regulatory environment can be challenging, we feel that there is light at the end of the tun-nel and the markets will continue to (re)grow. And remember, auto ABS is the queen of securitization and has proved to be a robust, sta-ble and un-destroyable pillar of the securitization market. s

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N.A., M&T Bank and certain other affiliates, provide

various fiduciary and non-fiduciary services, includ-

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M&T Bank, member FDIC.

Ulf Kreppel, Jones Day



EUROPEAN SECURITIZATION REGULATION EUROPEAN SECURITIZATION REGULATION

THE IDEA behind the European Union’s ‘simple, transparent and standardised’ (STS) framework for securitization was simple. With Europe lagging far behind the US in transferring risk to the capi-tal markets, the framework was developed to encourage securiti-zation as a means of funding the economy under a set of guidelines that also promoted stability and predictability in underwriting. It was believed that this would also lead to less stringent capital requirements for investors holding the bonds.

As it turns out, it was never that simple.

Political sparringThe European Commission pro-posed to simplify the origination process and to make securitizations more transparent. The plan passed through the Commission in Decem-ber 2015, but promptly hit a road-block in the European Parliament.

Dutch MEP Paul Tang, rapporteur for the European Parliament’s Committee on Economic and Monetary Affairs (ECON), led calls to more heavily police securitization in Europe, with more regulation, more supervision and more risk retained by issuers, measures he believed would protect against the crisis-era abuses in the US that plunged the world into the recession that followed the global financial crisis.

Looking to block the originate to distribute securitization model, Tang proposed raising the risk retention requirement in the STS proposal to 20%. While that has since been reduced to 10% for verti-cal retention and 5% for horizontal, market participants are annoyed at having to alter their businesses to make up for the excesses seen in US securitization.

Efforts have been made by ABS

market advocates to shed the politi-cal stigma of securitization and to educate legislators on the differenc-es between the US and European markets.

“It’s perfectly reasonable for par-liament to check what is going on and to make sure that we are not going back to the bad old days, it is a legitimate question to ask,” says Richard Hopkin, head of fixed income and managing director in the securitization division at the Association for Financial Markets in Europe (AFME). “Our job at AFME is to answer that question. We clari-fied that is not the case and that in fact most European securitiza-tion performed really well. We have never had the originate to distribute model which caused the subprime problems in the US.”

While risk retention requirements have come down from the proposed 20% level, many in the market feel the European Parliament’s atti-tude towards risk retention contra-dicts the message of making secu-ritization easier.

“The risk retention provisions in these STS proposals are simply not rational and will inhibit market issuance in itself,” says Mark Hale, CIO at Prytania Group in London.

“What should have been done in Brussels is a proper study which looks at all the impact of all these different regulations together and then turns it into a counter-factual

exercise… however, what appears to be the case is that people are react-ing to a problem that essentially happened elsewhere and have polit-ically imposed a solution for a prob-lem that did not exist in this part of the European market.”

Closing up the market Another problematic part of the regulation is that it restricts partici-pation in the market to only EU reg-ulated financial institutions. This is a potentially big problem for US companies and unregulated entities looking to issue into the EU.

“One of the proposals says that originators, sponsors and lenders need to be EU regulated institu-tions,” says David Quirolo, partner in the capital markets group at Cad-walader in London.

“That would only allow EU regu-lated institutions to act as retention holders and the problem is not only that that would exclude US secu-ritization parties from issuing into Europe, it would also stop a Europe-an corporate from securitizing trade receivables as they are not EU regu-lated entities. It really limits any companies which are not EU-reg-ulated financial institutions from accessing securitization as a form of funding.”

According to Hale, the discus-sions about market access and who can participate in securitizations are a huge problem.

“You can understand why they say that you have to be a regulated entity, but the market is much more diverse than that,” Hale says. “The reality is if you want to succeed and fulfil all the ambitions set out in the Capital Markets Union, there should be a paradigm shift away from banks and towards other market participants, especially corporates.”

What does the EU really want?According to data from AFME,

Is there a way to marry European political will with a strong and stable securitization market? Sam Kerr dives into the struggle that has dogged European securitization and looks at the highly politicised debate over the future of ABS under the European Union’s ‘simple, transparent and standardised’ framework

The EU’s simple and standard ABS framework is anything but

“The risk retention provisions in these STS proposals are

simply not rational and will inhibit

market issuance in itself”

Mark Hale, Prytania Group

016 Euro regulation.indd 16 25/05/2017 14:49


EUROPEAN SECURITIZATION REGULATION EUROPEAN SECURITIZATION REGULATION

total issuance of European ABS was €419.2bn in 2007. In 2016, that fig-ure had shrunk to €96.4bn.

Total issuance in Europe, both retained and placed, has always lagged behind the US. However, many in the market feel that the figures should be much closer given the comparative sizes and GDP of the two geographies — a criticism that could be levelled at most sub-sets of the capital market.

The European system has never operated in the same way as the US, with central bank funding and the covered bond market playing a larger role since the crisis.

This has led to speculation that some MEPs see no need for securitization, and would advocate instead for shrinking the industry given its association with the financial crisis.

Still, the compromise around risk retention levels shows that there is at least some willingness in parliament to adapt their thinking on the market.

“The view that Europe doesn’t need securitization is very much a minority view, even in the parliament,” says Hopkin.

“The Commission is completely supportive of the need for securitization because of the big picture requirement to make Europe less dependent on banks and to have more access to capital markets funding. There is a big difference between Europe and the US on that point and securitization

is the perfect tool for building a bridge between bank balance sheets and capital markets.”

However, Brexit has thrown another wrench in the wheels. Negotiations to remove the UK from the EU will see the most capital markets-friendly country in Europe taken out of the equation.

This could dampen support for STS in the Commission, and the fact that the UK is Europe’s largest securitization market means an important voice will be absent from future discussions.

“One of the unfortunate consequences of Brexit was to remove one of these most powerful advocates for more sensible regulation from the policy equation in Europe, especially Lord Hill and the Capital Markets Union initiative,” adds Hale.

“The momentum for that has been reduced and, you can argue, has been permanently impaired.”

Examples of compromiseFortunately, the European Par-liament has shown an ability to compromise already on STS, and according to AFME has come to a more sensible conclusion on the issue of capital requirements regu-lation (CRR).

Many banks have struggled with some of the modelling require-ments originally laid out in the pro-visions, but the European Parlia-ment has moved to pass measures to make the rules less onerous. This

development bodes well for STS.“The CRR is the more technical

part of this package. Less political discussions were ongoing and therefore the process was slightly faster,” says Anna Bak, manager in the securitization division at AFME. “There were fewer things to cause so much of an issue. You hear from a number of people in the industry that the capital charges are still quite conservative and definitely higher than anything for similar products. But to be a little bit more optimistic, we have seen an intention to include provisions in the text for banks to be able to use proxy data in their internal model calculations, which is very important.”

Headaches to comeCompromise on CRR and some pieces of STS point to EU legislators being able to put aside politics in order to achieve desired results.

There are still concerns in the market about the proposals, but the regulatory discussions will likely be concluded by the end of June, at which time the market must adapt to the new regime. At that point, the market then faces another chal-lenge in the months following implementation.

Cadwalader’s Quirolo says that while the current rules do provide for grandfathering, following the effective date of the new regulation, the market will need to wait at least six months following the effective date for regulatory technical stand-ards to be published by regulators.

This will potentially lead to a period of uncertainty where markets are operating in a state of limbo.

“During those six plus months, we can continue to use the old regu-latory technical standards (RTS), but once the new ones come into effect, they will apply retroactive-ly to any transaction that closed since the new regulation came into effect,” Quirolo says.

“A lot of the provisions relied upon by the market, such as the ability to enter into risk retention financing, are laid out in the RTS, so it’s going to be very difficult to do a deal where those standards may change and then apply retro-spectively.” sSource: AFME

0

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Total US versus European securitization issuance

016 Euro regulation.indd 17 25/05/2017 14:49


European CLO Roundtable

: Risk retention is still the biggest ques-tion mark for Europe’s CLO market. How are managers approaching issues such as Brexit and potential increas-es to risk retention levels? How does the market move forward from here?

David Nochimowski, BNP Paribas: Risk retention is still a big question both in Europe and in the US. I don’t think there is one single solution that is the most optimal one. If you look at the deals that were done this year so far in Europe, I think it’s probably 50/50 between the sponsor route and the originator route.

In 2015, the sponsor route was popular as the originator route was being tested by regulators. And then in 2016, after the Brexit vote, the originator route became the more favoured one because the MiFID authorisation of UK-based sponsor managers became a question mark.

But what was interesting is that the pricing, at least in the secondary market, hasn’t really differentiated between the sponsor route and the originator route. It did differentiate in the first two weeks after the vote on Brexit, but since then we haven’t seen a real pricing differentiation. It seems that every manager has its own strategy, so there’s no optimal solution.

The vertical approach is now becoming more popular. This year I think around 60% of managers have used a vertical slice approach versus horizontal slice. One of the reasons is

probably easier access to funding. This could be positive for investors that want to participate in the equity, as it leaves more share of equity to invest in.

The vertical slice could also be an optimal way to achieve dual compliance, as its definition is pretty much similar between US rules and European rules.

Rob Reynolds, Spire Partners: Risk retention is a concept borrowed from the insurance industry and dates back to the 1970s when it wasn’t possible to get product liability insur-ance. The idea broadened out to what we know today as the insurance excess where the insured party retains some of the risk and gets a lower premium. Retaining some risk meant that people were also more protective of their assets.

Risk retention for securitization was introduced after the subprime crisis. One of the issues was the agency model in which the originator of the mortgages passed on all the risk to third parties.

Thus the idea was to align the interests of the investors and the originators and managers. In fact, CLOs worked well before and through the crisis, so I don’t think risk retention was necessary for the CLO model to work, but it did give the regulators comfort that the agency model had been addressed.

In our experience, investors are not seeking an increase in the risk retention amount. It’s not an investor requirement so the optimal level is really a question of the balance

Participants in the roundtable were:

David Nochimowski, global CLO strategist, BNP Paribas

Ian Perrin, associate managing director, Moody’s Investors Service

Robert Reynolds, CIO, Spire Partners

David Bell, moderator, GlobalCapital

The old with the new: plotting the course for European CLOs

The European CLO market has reached a juncture. The asset class has performed well over the past two years, with spreads ratcheting to post-crisis tights while a broader range of investors from across the globe have been drawn to the sector.

The market has also been �uid in the way it has dealt with new regulation, an approach that will be crucial in coming months as it faces potential changes to risk retention rules, as well as new questions over the market’s future in light of Britain’s vote to leave the European Union.

CLO managers have been able to navigate an extended benign credit environment with skill, and the industry is humming along well. But with a hot leveraged loan market causing some concern, lingering questions must be addressed if European CLOs are to continue their bull run. GlobalCapital assembled a panel of experts in London to discuss the state of the market and the questions that

need answering to ensure its continued success in 2017 and beyond.

018 European CLO RT.indd 18 25/05/2017 18:29



between what managers can fund, what investors require and what regulators consider appropriate.

Ian Perrin, Moody’s: What I found interesting with the risk retention is just how the CLO managers’ community has been nimble about it since its inception. As David has pointed out, you started by having the horizontal slice then there was a switch to vertical as funding solutions came along. It’s a topic that’s been constantly moving with the approach taken by the regulator.

With Brexit, there are people already going to the originator route. Whatever happens, the CLO managers’ community seem to adapt to what’s put on the table, and hopefully the market will continue. A potential increase of the 5% retention level is going to be punitive to the market, but you would expect that the market will find a solution.

Reynolds, Spire: I would add that CLO structures changed post crisis. Initially, the deals were less levered, for example, but also there was more control put on the eligibility criteria and the percentage buckets, et cetera. So there was an evolu-tion, as well, within the CLO market separate from the intro-duction of risk retention.

: David, you mentioned appetite from inves-tors on financing risk retention. Are you seeing a lot more appetite from investors who want to finance that?

Nochimowski, BNPP: Yes, I think it’s a new development. With risk retention rules being effective both in the US and Europe, it creates new market opportunities. But in order to be able to finance risk retention, you need to be able to provide long-term financing. In Europe, you have to keep the retention for the entire life of the deal. In the US, it could be a shorter period, but it’s still a relatively long period.

So you might see some more long-term investors, such as insurance companies coming into this market, and some banks could also be able to provide funding solutions. Given the tenor and given the requirements, it offers new opportunities for funding providers. In Europe, there are not as many deals as in the US, so we have to see still how this develops, but we should expect these opportunities to be mostly focused on vertical slice options.

I think retention financing will become critical, and this is probably where the future growth of this market lies. If some institutions have the ability to provide this long term financing, it opens doors to further business expansion.

: Bringing insurance companies back into the market, this is something that the market’s been crying out for, hasn’t it — the return of long-term insurance capital?

Nochimowski, BNPP: True. I think the European market has suffered, over the last few years, from the lack of insurance money investing in CLOs. I’m referring to European insur-ance companies not investing in the CLO capital structure due to the relatively expensive cost of Solvency II capital.

That has created some weakness in the mezzanine part of the capital structure, which other investors have filled. It is regrettable as you have a stable investor base in Europe, which is not being fully exploited. So we have to see the extent of their participation to this market by providing retention financing. I think that could help solve an important part of the equation.

: From a regulatory perspective, do the

same disincentives not apply to insurance companies financing risk retention?

Nochimowski, BNPP: Well, that’s the question, whether investing or providing financing and whether it’s treated the same way. I don’t think we have that answer yet. Probably the insurance companies have done the work on that, but anything that helps the insurance companies to come in this market is very positive, for the stability and development of the CLO market, which is needed for the European economy.

: Do you see that appetite coming back, as well, Robert?

Reynolds, Spire: There is constant debate about risk reten-tion financing, that’s for sure. Could we cope with an increase in risk retention requirements as a market? Yes, I think we could. But then it’s a question of choice. Is there a better use for that capital, are there different structures avail-able? As I said before, we’re not seeing requests from inves-tors for an increase in the risk retention amount. It’s not high on the agenda, it’s actually not a topic we discuss with them, so it’s not coming from the investor side.

: It seems as though, over the last year, that the investor base for CLOs has broadened and we’ve got a bigger range geographically and institutionally of investors buying into CLO debt. Do you get the sense that CLOs are becoming less niche, less of a specialist investment and they’re becoming a more broadly appreciated asset class?

Nochimowski, BNPP: I think it’s still a niche product. To be clear, from a regulatory standpoint it’s still considered a structured product and it’s not changing. Just looking at the spread levels, it’s wider than many comparable products in the market, so that’s evidence that it’s still not completely viewed as a flow product.

But you’re right, there’s been some development over the last year in the European CLO market. I think the major development has been the interest of Japanese investors on the triple-A part of the capital structure. If you just look at the spread on triple-As, it has moved in by more than 50bp over last year, and this is really the evidence of the participation of Japanese investors. This is important, because they represent a stable investor base which is looking more at a buy-and-hold to maturity approach, in the same way they invested in US CLOs. At the top of the capital structure, there is very good demand and this Japanese bid is helping. If you look at the bottom of the capital structure, equity and junior debt, then you see more the presence of hedge funds investors.

This base is less stable, because of course, by nature, these investors are looking at the secondary market to benchmark performance. So I think we have to differentiate really

David Nochimowski BNP PARIBAS




between these two parts of the capital structure: senior versus subordinate.

Perrin, Moody’s: One thing that has helped is the perfor-mance of the CLO product. I think the CLO 1.0 product, having gone through the crisis, has come out of the crisis pretty strong. The CLO has been a really great example of a securitization and how it actually works. You have OC trig-gers that have been breached, diversions of interest flows that have helped redeem the senior notes. You have manag-ers that have been able to purchase assets at a discount and rebuild par, and I think you’ve seen a lot of transactions going through difficult times in 2009, 2010, 2011 and really coming out of that pretty strongly.

I think we see the flow of transactions being redeemed on that side, and the losses really have been limited at the most junior part of the capital structure — less than five or six transactions have suffered losses on junior tranches, with probably another handful on the remaining stock of 1.0. I think investors have seen this strong performance and that’s helping them return to the market.

Reynolds, Spire: I like to see new investors, I like to see new managers, and I like to see the market grow as a whole. To pick up Ian’s point, CLOs now have a 20-year track record through the cycle, and actually, as David mentioned, it’s back on a growth path. There’s been a total of just over €54bn issued across European CLOs since 2013. There are 36 man-agers in Europe and 133 transactions, so I think it’s no longer a niche product. After all, €54bn is not immaterial. But I would say that it’s still a specialised product. Investors under-stand the structures, as Ian said, and they see that there is real value in the notes through the capital structure in CLOs.

: Compared to other credit products, do you think the spread premium in CLO debt is an accurate reflection of the complexity of the product?

Nochimowski, BNPP: It’s never really accurate, because there is an opportunity, I think. As we have been saying, it has proven to be a strong product from a credit standpoint. But I think if you look, for example, at what’s happening recently, CLO spreads have been relatively stable over the last two weeks, when the other indices have come in signifi-cantly. So it does create some relative value, and I think it’s still, at the spread levels, a very interesting opportunity to get access to European loan market, and managed by strong managers.

: Is that spread stability more a reflection of the fact that CLOs are less liquid than other credit prod-ucts?

Nochimowski, BNP: There are lots of components to this, of course. It’s a more specialised product, so you may have less liquidity, or banks and insurance companies may have regula-tory costs also to hold the notes. But if you think on an abso-lute basis, it is a relatively good opportunity when you com-pare spread levels from a few years ago and what the levels are today. I don’t think you have a lot of competing products.

: Let’s move on to the leveraged loan market. Levels are very tight at the moment, but what do you think could cause loans to widen in the medium term?

Reynolds, Spire: We see this as a technical market, so there’s an imbalance between supply and demand which has been driving the pricing. Supply has increased because investors have seen the attractions of the asset class.

The obvious answer is once the equilibrium is restored,

you’ll see some spread widening. The question is, when will that happen? It could be that some large transactions currently being discussed come to the market and take away some of the excess supply. Also we need real new product in the leverage loan space.

Or maybe it comes from tightening going too far so the arbitrage doesn’t work anymore and supply is constrained. Another factor could be some event or a general increase in default levels which affects the performance of the CLOs. We don’t see increasing default levels anytime soon, looking at the performance of the underlying collateral. Ian, maybe you’ve got a view on default levels.

Perrin, Moody’s: I think we still are in a benign economic environment. Interest rates in Europe are very low so compa-nies have very little to pay on a periodic basis. That supports very low default rates. Our expectation of the default rate is around 2% for the year, which means that you don’t expect really the pressure to come from that angle.

But there’s potential in Europe, I would say. The leverage market is still very small compared to the US, if you compare the diversity score of European portfolios to the ones of US portfolios, there’s a lot of room there. There’s hope in the market that it could grow. Some industries here are not really using the leverage technique, so this could potentially help the imbalance between supply and demand. But it’s taking a lot of time for the market to get to that level.

Nochimowski, BNPP: I can see two different technical fac-tors that can help widen spreads in the end. So it can come from equity investors that do not accept going beyond a cer-tain yield. This could actually translate into wider spreads, if CLO demand is not there because CLOs represent a big part of leveraged loan demand.

But it could also come from the supply side, if we have more volume on the loan side. I think we’re starting to see more volumes over this year compared to last year. Of course there is a lot of refinancing and repricing, but we also hope there will be more volume driven by M&A activity.

: I’ve seen notes from investors talking about the leveraged loan market and saying that, given how aggressive documentation and pricing has become, they’re concerned about credit skeletons creeping into leveraged loan market. Do you have any such concerns?

Reynolds, Spire: Well, you mustn’t forget that this is actually a sub-investment grade credit.

As such, lenders have a higher degree of control than investment grade. For example, we have security over the assets and there are certain covenants built into the documentation, although maintenance covenants are probably a thing of the past. So there are restraints on borrowers and protections for lenders. Lenders are also getting paid a premium for the sub-investment grade risk.

The best way to mitigate idiosyncratic risk is by building a broadly diversified portfolio, as Ian said. That’s what CLOs are designed to do.

In terms of skeletons, I don’t think there is a big problem. There are some sectors that are more challenged than others. I would just list the old perennial, the retail sector, which suffered a lot during the crisis. Some of the media companies, cyclical businesses, chemicals, autos, construction, they may be vulnerable in a future crisis.

We look at what is appropriate leverage for the sector and for the particular company within that sector. It’s not a one-size-fits-all. We try to gauge differences between risks and relative return.

Perrin, Moody’s: From our point of view, we see how man-




agers have learned the lessons from the crisis. There was a lot of talk about zombie companies a couple of years ago. As Rob was saying, in the CLO 1.0 space, retailer, direc-tory businesses, these were very popular names. Managers have traded out of those names in the CLO 1.0 space, and clearly stayed away from those in the CLO 2.0 space. Retail, which used to be in the top three industry in the CLO 1.0 space is now number eight or number nine in the CLO 2.0s. Managers are doing a great job at selecting the names and therefore avoiding some of those multi-defaulters.

Nochimowski, BNPP: The performance in the 2.0 market is pretty strong, almost no defaults, which is very rare to see. Even the triple-C bucket is extremely low, a picture already different to the 1.0 space, which is now in amortisation mode and so there’s a natural trend of retaining quality among what’s left in the pools.

It’s also important to say that manager rules have also changed between 1.0 and 2.0. Now, there is less ability to amend and extend beyond maturity of the CLO, so investors have better predictability of cash flows. Also, all the language of reinvestment, post-reinvestment period, is more common and more standard across CLO documentation. Generally, the market has learned the lessons of the 1.0 world, both in terms of sector diversification, but also in terms of CLO documentation. The picture is relatively strong right now.

Perrin, Moody’s: I would say from the trading point of view, it must have been very difficult to trade CLO 1.0 in the sec-ondary market, because literally every single transaction had different documentation. Every bank or every manager was trying to have their own little thing that would differentiate them from the rest of the market. I think the CLO 2.0 really has become a global product. I think the managers on both sides of the Atlantic, the arranging banks on both sides of the Atlantic, the investors on both sides of the Atlantic, all want the product to be as common as possible. It helps trad-ing if everybody has the same criteria, the same rules. It’s not strictly perfect yet, but we’ve moved towards getting a product which is much more standardised across the docu-mentation. As you’ve said, David, the documentation is more flexible. I think in terms of reinvestment, post-reinvestment criteria, for example, managers have much more flexibility to trade in and out of names, which has helped mitigate the impact of defaults.

: How has the rise of managed accounts and other competitors in the leveraged loan investor base changed the picture for the CLO managers?

Reynolds, Spire: The picture has changed but we welcome competition, anything that increases the scale of this market

is welcome. I would add, or rather reiterate, what I said earlier that CLOs have a 20-year track record.

CLOs have developed appropriate structures, managers have established platforms and have proven ability to manage the asset class, they also have trading expertise and a proven model. Managed accounts and direct lenders are buying leveraged loans and the percentage has increased in the last year or so as new funds have been raised.

Time will tell whether or not that model works; it’s lower leveraged, it’s looking for lower yield, and it lacks the standardisation that the CLO model now has that we’ve talked about. It has the benefit of a lower capital weighting for some investors. So we welcome the arrival of new investors — it improves liquidity and it should increase the market’s size so everybody benefits.

: But if it’s driving down yields on the underlying assets, is that making it more challenging for managers?

Reynolds, Spire: It’s part of the supply side of the equation.

Nochimowski, BNPP: We’re seeing the same trend in the US. Retail loan funds are becoming an increasing part of the leveraged loan market which does introduce some volatility, but as you know for CLOs, volatility could also be a good thing. Equity investors want to optimise the yield of the portfolio so there are two sides to this issue. Yes, we’ve seen more funds being raised from direct lending, I think many of them do focus on more middle market type names because they still have more yield than broadly syndicated loans, but they don’t seem like a real game-changer for CLOs. CLOs still represent a big share of the buyer base for loans.

And what’s important about this is that the CLO buyer base is a stable one. CLOs are a buy-and-hold vehicle so they’re a very important part in keeping stability in the loan market and in the economy. I don’t see that retail funds and direct lending will be a game-changer from that perspective.

: There was a recent Moody’s report talking about the amount of cov-lite loans in CLO portfolios, and whether this was undervalued — what drove that research, Ian?

Perrin, Moody’s: When you look at the evolution of CLO 2.0s, the size of the cov-lite bucket has been increasing. And we are asked regularly by investors whether this is a concern. It’s interesting because you have different opinions when you’re discussing this with collateral managers and investors.

We see that the percentage which is reported in interest reports is generally low compared to the proportion of cov-lite loans in the market these days. So we spent some time looking at it and I think the real difference comes from the fact that ultimately there’s no clear definition of what cov-lite is.

Basically in the CLO you’re either cov-lite or you’re not cov-lite. It’s pretty binary. In reality, you have various shades of cov-lite so the numbers are slightly different because of that. Ultimately what we found was that the managers were not necessarily buying more cov-lites than what the market had.

There are a lot of new buyers in the leveraged loan space who may be interested in buying a loan that suddenly a CLO doesn’t want to hold anymore. That’s why from a manager’s standpoint, the cov-lite hasn’t been really much of an issue.

Investors are focused on it mostly because, from a recovery rate standpoint, there’s a view that if you delay the recognition of the default your recovery rate expectation is going to be low. Studies that were done in the pre-crisis era showed no big difference between recovery rates. But I

Robert Reynolds SPIRE PARTNERS




think it was a small segment at the time and it was mostly US-based, so we will have to see what the next cycle brings to this in Europe.

Reynolds, Spire: If there’s a maintenance covenant in the RCF and the RCF is parri passu, then it’s not cov-lite according to the definition in the CLO.

Cov-lite is appropriate for larger borrowers who can access capital markets as well. From our perspective these larger borrowers are often lower risk. When you do have a covenanted loan, these days it tends to be to a smaller borrower with a higher risk profile.

It’s difficult to determine with the smaller covenanted loans whether the premium pricing relates to risk or whether it relates to liquidity. As this market evolves, as Ian said, we’ll see how the various different products develop but we’re now seeing cov-lite as an established feature of the marketplace.

Nochimowski, BNPP: Yes it’s also an established feature of the market, as it is in the US. Unsurprisingly 70% of the assets in a CLO now could be cov-lite. But you haven’t tested the credit quality of this in terms of the covenant, and the definitions are still very broad. Sometimes, as Robert was saying, the good quality issuers are the ones able to issue the cov-lite loans. So in terms of expected loss — which is a combination of default and recovery — we don’t have a full picture today if it performs worse or not than a non-cov-lite loan.

: How are you finding the tightening in leveraged loans — is it making it difficult for managers to hit their weighted average spread tests in new deals?

Reynolds, Spire: The weighted average spread is not the whole story. There is a matrix of other measures. Yes, spreads have come down, but the answer will depend on where spreads are in the medium term. Really, the question is how does it affect returns? This is a slightly broader perspective. Returns have actually held up well and they’re beating the model. The reason is because the model includes certain assumptions about default rates and recoveries and we’re in a low default environment.

So most CLO managers have been able to hit their targets despite the fact that spreads have come in, and most of the models have a conservative perspective on spreads over the longer term. I see spread tightening as an element of the whole picture and CLO structures have a broader perspective than just spreads.

Nochimowski, BNPP: With a CLO you can’t just look at the picture today — it’s constantly evolving. With a four year reinvestment period, the market can turn so the spreads that we’re seeing today may not be the ones we’re going to see tomorrow. That is why, for equity investors, a big element of their investment assessment is the reinvestment spread.

Also, the ability to refinance any single tranche after the non-call period is a relatively new phenomenon which was not really seen in the 1.0 era. That gives some relief to the portfolio spread compression. Just looking at the recent wave of refis and resets, it can help the deal save about 50bp in its average cost of liabilities, which is a benefit to the equity investors. So I think the answer is that yes the spread is tight today relatively speaking, but it may not be the same story one year from now. On top of that, you have the structural element in CLOs (refinancing of tranches) that allows the equity investor to maintain a certain level of excess spread in the deal.

Perrin, Moody’s: The ability to refinance is very powerful.

The entire 2013-2014 and now 2015 vintages are being refinanced and that really mirrors what’s happening on the leveraged loan side. The ability to save up to 50bp on the triple-A tranche, reducing the weighted average costs of the capital structure, helps maintain the arbitrage for the CLO.

Nochimowski, BNPP: The most important part is the collateral sourcing, rather than the spreads. On that part I can see the opportunity in seeing deals from 1.0 being called to provide collateral to new deals to offset the lack of loans. Also what we’ve been seeing is deals being priced with a lower percentage of identified or ramped assets in the pool or an extension of the price to close timing. So I think there’re still some options in the market to source collateral although it’s a bit more difficult but I think here lies more the issue than the spread.

: How has the equity investor base reacted to loan tightening?

Reynolds, Spire: They’re obviously interested in the tightening of the assets. If you look at the equity investment thesis last year compared to this year, last year loan prices were below par so equity investors had the opportunity to benefit from discounts on loan purchasing and higher spreads. And they’ve also had some good early distributions which is attractive. This year equity investors are seeing a slightly different investment case, where they’ve got locked-in, lower costs on the liability side and the prospect of spread widening on the asset side.

If you’re looking at last year’s equity thesis and this year’s equity thesis both are viable. The optionality of the repricing within the liability structure gives a very interesting horizon for equity investors.

Nochimowski, BNPP: CLO equity in its design has an interesting profile which you can’t compare to other fixed income instruments. As loan spreads widen, it benefits equity holders because the excess spread is magnified in the deal. But also if spreads do tighten, it could be temporary, but also now equity investors may have the ability to control what’s happening with the CLO debt tranches as well.

If you see the cash on cash distribution of equity I think it’s probably in the high teens, close to 20%, so it hasn’t really reduced yet by much because of loan tightening.

But this ability to benefit to a certain extent from both sides can help maintain that level of cash on cash.

: With increasing numbers of capitalised risk-retention vehicles coming into the market do you think that equity investors are going to struggle to get allocations in deals? What alternative opportunities are

Ian Perrin MOODY’S INVESTORS SERVICE




there to get similar kinds of returns?

Reynolds, Spire: The first part of your question is fairly straightforward. If you look at the volume of CLO issuance in Europe of about €16bn-€17bn a year, equity demand is about €1.6bn-€1.7bn a year.

I don’t think that the scale of the new vehicles is yet sufficient to match that demand. There is still direct equity available. And equity investors can also look to invest in these new vehicles as well and get a more diversified equity investment than hitherto.

Nochimowski, BNPP: I don’t think this a big problem for equity investors. Even if a risk-retention vehicle buys, let’s say, half of the equity there is still quite a lot of equity to sell. And it’s not new — since 2013, European deals have had to be risk retention compliant. The vertical slice is a new development so you always had the presence of a manager or originator in the equity of a deal in Europe. So there’s still equity available for sale in deals.

: Where do you think best value for debt investors currently is?

Nochimowski, BNPP: If you look at the debt today I think you have two types, you have the debt that it’s issued at par, which is all the investment grade tranches and you have debt and it is issued at a discount price. What we see is once a deal prices it moves to the secondary market and many bonds are trading above par, which is a natural barrier to further tightening. Why? Because investors don’t want to take a big risk of refinancing them. So I think that bonds that still show discount to par could have some potential because you are less limited by this natural barrier to further spread tightening. So I think that’s the differentiation that we’ll see more of.

: And what part of the capital stack are we likely to see this in?

Nochimowski, BNPP: Investment grade tranches issued at par are now usually trading above par in the secondary market. Double-Bs, single-Bs are issued at a discount. They have this kind of convexity but they also have longer duration and volatility in the returns. I just wanted to mention the fact that there is a natural barrier to spread tightening when you already are in the zone above par. So it really depends on investors and where their yield target is. The fact that so many bonds trade above par from triple-A to triple-B is a new element that has to be taken into account in valuing CLOs.

: How does it look from the other side of the equation, when you’re selling CLO debt, Rob?

Reynolds, Spire: Investors differ according the size of their investment, their rating targets, the duration, the returns they require, etc. So my answer is that all debt tranches represent good value, in particular vis-à-vis other asset classes of similar ratings and duration. I also think that investment in the debt tranches of new CLOs represents good value as well. As David mentioned, in a lot of the older CLOs, certain notes are trading above par.

We’re seeing increased demand from a variety of different sectors and countries and generally increased interest in credit. This is a reflection of the continuing search for yield. Investors are looking at where they can deploy their money to meet their own investment objectives and their underlying obligations to their policyholders or pensioners. So there’s a demand for an established product that gives a predictable

yield at the top of the capital structure. There’s also a demand for debt tranches that give good

returns relative to the underlying collateral. For example, the single-Bs in the CLO structure are paying better than single-B loans, which is remarkable because they benefit from enhancement and diversity.

Nochimowski, BNPP: Given that the performance is very good across the history of the product and it shows particularly good value to other segments of the credit markets, I agree that all tranches have value. My point is that the market is evolving and there’s no complexity now in analysing a different part of the capital structure but it’s hard to find a competing product that is actually providing these types of returns in the fixed income space.

: Are investors more interested in floating rate debt compared with fixed rate?

Nochimowski, BNPP: We do have some fixed rate tranches that are issued also to fixed rate investors. And I guess the risk is being assessed because the asset side invest in some fixed rate loans so that’s a natural hedge. If it’s not then you put a hedge on this.

Perrin, Moody’s: Generally you have a natural hedge between the managers committing to buy a certain percentage of fixed rate assets to offset the fixed rate liabilities that are being issued. Putting a hedge is something that is not really done anymore. It was mostly seen in the CBO days where the collateral was by nature fixed rate instruments while the liabilities were floating rate. We see that less and less now although the ability to put a hedge in place is in all documentation generally.

Where hedges were very common was on the multicurrency side but this is also something which seems to have more or less disappeared from the market. I guess it will be interesting to have Rob’s point of view on that. Pre-crisis, the European CLO market was a multicurrency market with triple-A tranches being issued in several different currencies. We’ve heard of clear interest from the managers but not that much interest from investors to have FX risk introduced into transactions. So far in the CLO 2.0 space, there has been one deal per year done with a multicurrency element to it except in 2016 where all deals were euro-denominated only.

Reynolds, Spire: It’s a dynamic portfolio so it changes week to week, month to month. There’s an obligation on the managers to hedge non-euro exposures. We’ve taken the line that we prefer to just have euro assets and the reasons are that, first of all the hedging can be quite expensive so you reduce the spread. Swaps also introduce a degree of illiquidity into the underlying asset because you need to close out the swap at the time you sell the asset.

So our approach has been to keep it simple: euro assets, euro liabilities.

: To round up the conversation, are there any other topics you would highlight?

Nochimowski, BNPP: I would highlight that we are seeing more and more alignment between US deals and European deals. As I said, the euro CLO market is becoming global, risk-retention rules are effective in both jurisdictions, investors have become global and I think we will see more of this. Investments will just flow from one to the other. I think we’ll see more deals that are dual compliant to satisfy this global investment base. This is an opportunity for CLOs to grow and to be more standardised which I think benefits everybody in this market. s



CMBS CMBS

WITH US retailers announcing plans to shutter 4,942 stores across the country during the first quarter of 2017, retail space is being vacated at the fastest rate seen since 2008. That’s got mall owners, and the CMBS lenders that finance them, seriously worried.

Those figures, from recent research notes from real estate ser-vices firm JLL, underpin the revo-lution in US buying habits that is finally catching up with one of the most densely retailed nations on the planet.

With the rise of online and mobile retailing, a generation of consumers are steering away from traditional bricks-and-mortar shopping.

How this plays out in the com-mercial mortgage backed securities market, which since 2013 has seen an average annual volume of $82bn bonds issued, is contentious.

According to data from Kroll rat-ing agency’s Credit Profile product, retail exposures account for roughly 24% of the $510.5bn CMBS universe that the agency surveys — that’s 7,038 loans totalling $124bn.

Of those loans, the agency has identified 1,327 totalling $26.5bn as

loans of concern, meaning they are either in default or at heightened risk of default in the near term. While some of those loans may still be repaid, 555 of them totalling $8.7bn are already being worked out with a special debt servicer.

The next Big Short?These growing pressures have con-vinced many CMBS players to start shorting the market, via two indices tracking the movement in the price of conduit CMBS bonds issued in 2012 and 2013, which had a higher than average concentration of retail exposure.

The value of the trade is hotly debated. There seems little doubt that weaker malls will struggle in the near term. But analysts disagree on how quickly and how hard this will hit bonds relying on loan repay-ments from those mall owners.

What is clear however, is that the shake-up in the retail sector will cause a divergence in performance, depending on the underlying cir-cumstances facing each proper-ty, stepping up the credit work for CMBS investors.

“It’s fair to say that a good num-

ber of CMBS investors are con-cerned about retail,” says Eric Thompson, senior managing direc-tor in structured finance at Kroll in New York. “But some we speak to think it could be overblown to some degree.”

“Undoubtedly there will be some retail credit performance issues, with store closures, but it’s going to be a case-by-case basis. There will be some properties with strong per-forming retailers that will do just fine,” he says.

Investors are keeping a keen eye on the plans of anchor department store tenants such as Macy’s, Sears and JC Penney. A big concern is that if those anchor tenants pull out of malls, other tenants will follow, leading to a catastrophic domino effect.

Jeffrey Gennette, CEO of Macy’s, warned in the company’s first quar-ter earnings call in May that the changes facing the retail sector are “secular and not cyclical”. The company announced plans to close around 100 stores out of a total of 730 in August last year.

He said that the US’s saturated retail market was due a correction. “As for the retail industry overall, we’ve known for some time that the United States is over-retailed com-pared to other markets, so it’s not surprising to see the contraction in retail square footage. And it will take some time to tell how the con-solidation and the closure of stores, and in some cases, entire brands will impact us.”

In its 2017 outlook, Green Street Advisors said that malls at the bot-tom end of the spectrum would cer-tainly struggle, pointing out that 300 ‘C’ class malls are at most risk over the next several years.

But managing director DJ Busch pointed out: “Fortunately, these malls only account for roughly 5%

Generational changes affecting the way consumers in the US shop, work and live, could be set to transform the nation’s commercial real estate market. The plight of shopping malls, and the wider retail sector, is the topic that has caused most immediate concern in the CMBS market. But that’s not the only factor that market participants should be concerned about, writes David Bell

Millennial bug: US CMBS tackles retail sickness

Source: DBRS

-

50

100

150

200

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Total Delinquent Balance

Outstanding Balance Not Delinquent

Paid o� No Loss Loss

$bn

US conduit CMBS delinquency rates

024 CMBS.indd 24 25/05/2017 14:50


CMBS CMBS

of mall value in the US and most won't be missed.”

Discerning shoppersThe challenge for CMBS investors is to make sure they are exposed to the better quality malls that are still expected to do well. This is largely dependent on key retailers improv-ing their “multichannel” offerings to draw shoppers instore, as well as malls bringing in more food and entertainment offerings to increase the appeal of the shopping destina-tion.

“Retailers are clearly responding to the changing environment, and some have been doing so for sev-eral years,” says Larry Kay, director at Kroll in New York, who adds that there has been a “bifurcation” in terms of mall performance.

JLL’s retail outlook for 2017 said that the function of stores would be “redefined” as they react to the challenge of e-commerce.

“Rather than being limited to transactional locations, stores are increasingly serving in a greater capacity as cross-channel fulfil-ment centres, pick-up stations for online orders, convenient locations for returns, product showrooms and vehicles to boost branding and cre-ate buzz. This is clearly illustrated in the number of online retailers opening up physical space, not just to transact sales but to interact with their customers in ways that cannot be replicated online,” the analysts wrote.

Certain segments of the retail sec-tor are also more immune to the challenge posed by e-commerce.

“We’ve seen off-price stores and outlet centres doing fairly well, because they may be less price-sen-sitive to competition from e-com-merce,” says Kay.

But across the board, the sec-tor is underperforming compared

to other types of real estate debt. According to a recent default and loss study, the number of annual defaults over the past three years in all commercial property types has been declining, except for retail, where they have been at a fairly constant level.

Focus on office, industrialThe community of conduit CMBS issuers, which bundle a range of different types of commercial real estate assets including retail, office, industrial and hospitality assets into bonds, have taken note.

The proportion of retail loans in conduit deals launched in 2017 is down to around 21%, according to the Kroll analysts. Last year the fig-ure was around 28%, and from 2010 to 2015 it ranged from 25%-50%. “That is indicative of originators being more selective when it comes to the retail sector,” says Thompson.

Investor and originator concerns over retail exposure in conduit CMBS is driving demand for other types of real estate assets.

Industrial assets, such as ware-houses, are booming as online retailers hunt for more space to house inventory. And with e-com-merce shoppers wanting instant gratification, many are investing in developing fulfilment centres close to major cities in order to facilitate same day delivery.

In their sector outlook, JLL ana-lysts wrote that industrial rents were at record highs, while vacancy rates are at a 17 year low.

Finding pools of those assets is tricky, however.

“Most existing spaces are leased out and new deliveries are hitting the market at steady pre-lease rates. Nationwide, there’s simply little to no industrial product available,” the firm said.

CMBS conduit lenders have

increased the proportion of indus-trial properties in new deals in 2017, up to 6% from the 4% average last year. But the lenders face stiff com-petition from industrial real estate investment trusts (REITs) that can tap cheaper sources of funding.

Office related debt is taking up the bulk of the slack caused by dwindling retail appetite.

In the first quarter of 2017, office properties accounted for on aver-age nearly half of all collateral pools — the 46% proportion is up signifi-cantly from the full year average of 29% in 2016, according to a report from Standard & Poor’s.

This should come with some con-cern. The rating agency also recent-ly pointed out that maturing office loans have been experiencing the lowest payoff rates in the CMBS market of late, and a large volume of loans coming up for maturity have debt yields below 8%, making them a trickier proposition when it comes to refinancing. Almost half of struggling loans in the CMBS universe that are with special debt servicers — $2.3bn out of $4.3bn — relate to office properties.

“We caution investors to keep their eye on this sector amid the flurry of stories focusing on retail,” wrote S&P analysts in May.

Both sectors are shifting under similar generational pressures, with office spaces evolving according to the differing needs of younger workers. If office building managers don’t stay on trend, credit quality could suffer, say analysts.

“Baby boomers may have wanted a corner office, but millennials can plug in anywhere,” says Kay. “Individual work areas are becoming less about corporate rank and more about functional use. Office properties that aren’t able to adapt to new technology are probably where we’ll see more issues,” he says.

The struggles facing the US retail market may not have the Doomsday effect that hedge fund investors playing the short game would like. Retailers, mall owners and CMBS lenders will adapt. But these long term shifts, as new generations of consumers and workers constitute a bigger proportion of the US economy, will no doubt cause some short term turbulence as markets adjust. sSource: Kroll Bond Rating Agency’s Credit Profile

Sizing up retail exposures in the US CMBS market

Total volume of outstanding commercial real estate loans: 27,498 loans totalling $510.5bn

Retail exposures account for: 7,038 loans, totalling $124bn

Identified “loans of concern” within those retail exposures: 1,327 loans totalling $26.5bn

Of those loans of concern, number with special debt servicers 555 loans totalling $8.7bn

024 CMBS.indd 25 25/05/2017 14:50

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CS15341 WISD_GCM GlobalTrusteeAd_GLOBAL CAP Final 5.1.17.indd 1 5/1/2017 1:54:09 PM

the voice of the markets securitization in the global … · 2017-05-30 · short-term loans with...

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