Briefing: The Credit Risk Niche Is Gaining Interest | Characteristics
- Credit risk sharing first appeared around 20 years ago when it was tied to a bank’s internal calculations
- More recently, the EU has promoted securitization as a way to boost lending as part of its Capital Markets Union program
In a world of prolonged low interest rates, institutional investors are scouring different pockets of the investment landscape to generate incremental returns. One area is regulatory capital transactions, which are far from new but are being examined under the microscope for their potential as part of an alternative credit portfolio. However, these transactions can be more complex than other alternative credit asset classes and require specialized expertise, skills and understanding.
For one thing, they have different nicknames. Technically they are referred to as synthetic balance sheet securitisations, but many pension circles refer to them as credit risk sharing (CRS) transactions while some call them credit risk transfers (CRT), credit transfer securitisations. Significant Risk (SRT) or Capital Solution Transactions (CST) to name a few. Essentially, these expressions refer to banks transferring part of the credit risk of a portfolio of loans to investors.
They first appeared about 20 years ago and were tied to a bank’s internal calculations, according to Milan Stupar, portfolio manager at AXA IM Alts, which has operated the field since the same period. However, the asset class gained momentum after the global financial crisis as banks sought to free up regulatory capital due to the stricter Basel III regulatory capital requirements.
The rules require banks to calculate regulatory prudential capital requirements using “throughout the cycle” parameters, which assume that an economic downturn will occur over the life of all credit exposures held by the bank. the banks. Additionally, banks need to have a buffer for other unexpected events such as the COVID-19 crisis, although few would have predicted a pandemic in 2008.
James King, head of ABS portfolio management at M&G Investments, another established player in the field, explains that banks are indeed allowed to share risk with investors and manage their regulatory capital on an ongoing basis. They can do this through the sale of whole loan assets, full capital structure securitization, or synthetic securitization. King says the benefit for banks is the freed-up capital that can be reused, for example, for new loans to customers.
“They can be considered as an alternative investment to equities and they have a better risk profile than, for example, high yield bonds” – Mascha Canio
More recently, the EU has promoted securitization as a way to boost lending as part of its capital markets union agenda. In May 2020, the European Banking Authority (EBA) recommended the creation of a “simple, transparent and standardized” (STS) cross-sector framework for synthetic balance sheet securitisations. The proposed new rules follow the same principles as the 2018 guidelines, which sought to develop a single set of consistent interpretations of existing standards.
“The EBA established the criteria for these transactions because when the market started, the criteria were not clear,” says King. “The key, however, is for the market to grow. People see it differently, but we call them significant risk transfer transactions and they fall under structured credit. They are illiquid, require a lot of upfront work, basic research, due diligence, technical knowledge and monitoring. You also need to have robust systems in place to ensure they comply with securitization regulations.
As a result, barriers to entry have been high and it’s no surprise that there are only a handful of players in the market. This explains why last year Swedish occupational pensions manager Alecta teamed up with Dutch pension fund services provider PGGM to co-invest in what they call CRS. Their first transaction is a multi-year program with JP Morgan that covers approximately $2.5 billion (2.1 billion euros) in corporate loans.
Partnerships of this type between pension funds in different countries are still relatively rare, although PGGM is a leader in the field.
“CRS is a very specialized area and only a small group of people are involved,” says Tony Persson, head of fixed income and strategy at Alecta. “PGGM has been doing this since 2006, but the real trigger for the banks was the global financial crisis and tighter regulations. However, we are a small team and these transactions are too complex for us to carry out profitably, so we decided that we needed some form or cooperation and a much more specialized team to manage them. .
He adds: “It allowed us to take credit risk that was not accessible in the past. This has given us diversification and exposure to many different loan portfolios, from SME loans to project finance, which in turn provide a means of lending to the real economy.
Mascha Canio, head of credit and insurance-related investments at PGGM, also says investors are exposed to illiquid and unique credit risk with different borrowers and loan products. “They can be considered an alternative investment to equities, and they have a better risk profile than, for example, high yield bonds. We’ve generated realized annual returns of around 11% since we started in 2006,” she says.
PGGM began by investing on behalf of its pension fund client PFZW. The mandate takes first and second loss positions in mezzanine or junior tranches of selected loan portfolios in exchange for a fee agreed by the originating bank. It is important, however, that the bank has “the skin in the game” and while the regulations require 5% alignment of interests, PGGM requires that the [risk] sharing bank to retain 20% exposure to uncovered losses on its own balance sheet, according to Canio.
PGGM also undertakes detailed due diligence as well as quantitative and qualitative analysis, looking at the type of loans, contractual terms, how the bank makes loans and manages risk. “We assess each transaction to see how it would perform under normal, mild and very stressed economic conditions,” Canio explains. “We call these base cases headwinds and stress scenarios and although we did not predict the pandemic, the analysis gives us a good indication of whether this is a good investment in time or no.”
Canio also says the term “complicated,” which is often used to describe these transactions, can be misleading. “They are conceptually quite simple, in that an investor takes on credit risk on a selected portfolio of loans from a bank up to a pre-agreed amount and in return receives a proportionate return in the form of coupon payments,” she says.
Stupar echoes these sentiments and adds that investing in a bank’s equity exposes investors to the whole bank as a risk, whereas with these transactions there is only the risk of well-defined portfolio credit.
“These transactions have maturity dates, known coupons and final payments based on realized losses,” he says.
“One of the differences with AXA IM’s approach is that we fully underwrite the portfolio and select loans on a name-by-name basis. It is fully disclosed, compared to others who invest in a blind wallet. We also believe that 5% alignment is usually sufficient,” says Stupar.
Looking ahead, he predicts an increase in demand for these credit risk transfer transactions. “It’s a growing market in terms of size and number of interested banks,” he adds. “2019 was a record year with new issuance above €10 billion and last year was slightly lower, despite the pandemic, although it was the second best year for volumes. On the investor side , most of the real money will be co-invested through funds, but we are seeing greater appetite not only from larger but also smaller insurance and pension funds.