Capital relief trades make slow comeback from Covid slump

European synthetic credit risk transfer market now more expensive for banks

Synthetic securitisation deals transferring credit risk from banks’ loan books to buy-side firms are making a slow comeback from a coronavirus-induced slump, and dealers are finding the market has become more expensive for issuers.

“The market for synthetics has almost completely stopped,” says Robert Bradbury, a managing director at advisory firm StormHarbour Securities. “Almost everything that would normally have been done was put on hold.”

Lenders use balance sheet synthetic securitisations to transfer the credit risk on a portfolio of loans to investors. The deals have become increasingly popular among banks because of their potential to reduce capital requirements. Under the EU’s bank capital laws, if local supervisors deem a deal facilitates a significant risk transfer, the bank can then deduct the transferred risk away from its total risk-weighted assets.

Three sources say the market has suffered a slump in issuance due to the coronavirus pandemic raising the prospects of companies defaulting on their loans. Higher default rates than expected would result in investors facing loses on the bonds or notes of synthetic deals they hold.

“I would say the vast majority of transactions have been put on ice, though we now see signs of a thaw,” says Giuliano Giovannetti, a managing director at advisory firm Granular Investments. “One of the reasons for the freezing is that it may still be difficult to take a position with respect to what is going to be the default rate on a transaction, especially if exposed to certain sensitive sectors.”

Companies that make their money through hospitality, travel, retail and oil are seen as the most at risk of defaulting due to the government-imposed lockdowns to combat the coronavirus pandemic. The uncertainty has led investors to either shun the product or charge banks higher coupons for taking the risk.

“The initial slowdown in late Q1 and Q2 was the result of various factors,” says Kaikobad Kakalia, chief investment officer at private debt manager Chorus Capital Management. “Banks and investors were getting used to working from home and were focused on understanding the impact of the economic slowdown on portfolio risk. Uncertainty in relation to where the impacts would be felt was another factor driving cautious behaviour.”

Sources also say the earlier stages of the crisis in Europe saw some distressed bond and noteholders selling their inventory to generate cash with which to cover incoming margin calls. This led investors – who were willing to stay in the market despite the heightened risk – to buy discounted bonds on the secondary market rather than investing in primary issuances.

Restart

Banks are starting to issue deals again, but Granular Investments’ Giovannetti says there will be lower volumes compared with the same period last year. He expects to see more issuance than usual next year, as lenders issue deals they had put on hold. At the moment, he says just “a handful” of banks are still issuing deals, mostly focused on renewing existing transactions that are coming to the end of their life.

“For the most part, I don’t think there have been a lot of transactions for Q2 and won’t be in Q3, although we are seeing enquiries right now,” says Giovennetti. Hopefully we will see a post-summer catch-up, but I don’t think it is going to make up for the year that it should have been, and perhaps we’ll see quite a bit more issuance in 2021.”

Chorus Capital Management’s Kakalia expects issuance to pick up in the second half of this year, as the impact of loan losses incentivises banks to reduce the amount of provisioning held against their loan books by issuing more synthetic deals.

“As markets have stabilised and Europe is gradually emerging from lockdown, we expect activity to pick up strongly,” says Kakalia. “The impact on bank capital ratios will certainly incentivise new issuance in the second half of 2020, and beyond.”

The market for synthetics has almost completely stopped. Almost everything that would normally have been done was put on hold

Robert Bradbury, StormHarbour Securities

StormHarbour Securities’ Bradbury, however, doubts a slew of new transactions will come to the market in the short-term due to the extra breathing room regulators have given banks on their minimum capital requirements.

Supervisors in Europe have relaxed capital buffers to encourage banks to make new loans and expand their balance sheets. As a result, the bank’s capital ratios can fall below their typical regulatory minimums without intrusive responses from supervisors.

Banks are now assessing how best to use the extra room, although some supervisors have doubts lenders will reduce their capital ratios to levels below their previous regulatory minimums.

“Issuing these deals is less of a priority at the moment for banks and their capital management teams,” says Bradbury. “Regulators have in many ways waived or adjusted capital requirements, so at the moment banks are looking at how they are going to address immediate issues rather than looking at how they can get still more room by using synthetic transactions.”

The new normal

In synthetic securitisations, buy-side firms typically invest in mezzanine or junior tranches, meaning they shoulder more losses before the senior tranche – retained by the originating bank – takes a hit.

StormHarbour’s Bradbury says coupon levels for mezzanine or junior tranches would normally be 5% to 9%: “We are starting to see some signs of life as we head into the second half of this year, [but] the appetite for something like this at previous pricing levels… is very limited.”

Concerns surrounding the solvency of companies within banks’ loan portfolios will continue, as physical restrictions to stop the spread of coronavirus are still in place in some countries in Europe. Even as those restrictions are lifted, there is no clear timeline on when or if customer behaviour will return to normal and businesses can go back to the way they were operating in the past.

“Everyone is pretty focused on how many corporates are going to default because of the pandemic,” says Bradbury. “There has been clear central bank support across the board, but at the same time it is a big unknown what will happen to many companies – there is limited additional clarity available compared to March. It doesn’t mean there is no price, but it points to it being more expensive.”

In addition to central bank liquidity injections, there have also been sweeping programmes of government support provided to companies either directly, or through the banking sector in the form of loan guarantees or mandatory deferrals of existing loans.

Everyone is pretty focused on how many corporates are going to default because of the pandemic

Robert Bradbury, StormHarbour Securities

“This has led to relatively stable performance in portfolios, which unfortunately masks the issues that will arise once these measures are withdrawn. There is limited data which gives one any sort of meaningful indication as to what the next 12 months will look like,” says Kakalia.

He expects coupons for equivalent transactions to be on average two percentage points higher than they would have been before the crisis, reflecting the higher economic risks. But in practice, banks are no longer issuing the same kind of deals they would have done before March. Instead, they are looking at ways they can alter the structure of the deal to lower the coupon they have to pay out to investors.

Kakalia says one way banks have been bringing down the coupon is by improving the quality of loans they securitise. This could include only securitising loans where the bank has tighter eligibility criteria for applicants, or the portfolio consists of loans to companies that have higher credit ratings.

Banks are also more likely to increase the amount of protection they give to investors within deals. One example is by increasing the spread collected by banks between the coupon payable to noteholders and the yield on the underlying assets, which is earmarked to cover losses the bank expects the portfolio to suffer.

This so-called excess spread is informed by two factors: the amount of losses banks expect the portfolio to incur annually, and the margin of error in the bank’s estimates. The higher the amount of the so-called excess spread, the higher the losses need to be before investors must shoulder them.

“The volatility around a portfolio’s projected expected loss is greater now because it is uncertain which borrowers are likely to default,” says Kakalia. “Due to the uncertainty generated by the coronavirus, banks are more willing to introduce excess spread into transactions, because it helps to mitigate potential volatility in the performance of a transaction.”