Suboptimus Prime

We don’t cover the securitised markets as much as we used to around here, but TwentyFour Asset Management has highlighted an interesting deal that caught FT Alphaville’s eye.

Plenty of investment managers run blogs and pump out research these days, but with a few notable exceptions they’re pretty underwhelming. Vontobel-owned TwentyFour is one of the exceptions.

Here’s TwentyFour portfolio manager John Lawler lamenting yesterday:

When one contemplates a new Prime RMBS deal, originated and sponsored by a UK bank and carrying the STS-compliant ‘hall mark’ stamp of approval, it should conjure up warm fuzzy feelings around the quality of the underlying collateral, the likely unquestionably strong collateral performance over the life of the transaction and the certainty that you’ll get your principal back once the deal is called, without having to be seduced by the additional financial incentives in the unlikely event that it doesn’t.

So it’s always a little bit disappointing when, somewhat inevitably in a strong market, a deal comes along which on the face of it purports to be a Prime RMBS deal, and technically meets all the criteria to attain its STS designation, but after closer inspection doesn’t really reflect most of those fundamental characteristics that investors would normally take for granted in a true Prime deal and therefore begs the question — where does one draw the line?

(The STS designation he references is the EU’s “simple, transparent and standardised” registry for securitisations that meet its requirements.)

The subject of Lawler’s disappointment is this £300mn RMBS from One Savings Bank (or rather, its subsidiary Charter Court Financial Services, which OSB acquired in 2019) which priced last week at 67 basis points above the risk-free rate.

Lawler points out that prime borrowers are usually in full and long-term employment, but that 34 per cent of the borrowers underlying the OSB RMBS are self employed, and have just one year’s income verification (and almost a third are help-to-buy loans).

Fitch, which rated the deal triple-A, says underwriting standards are “well-aligned to Fitch’s expectations for prime mortgage origination”, but noted that the OSB’s willingness to make loans to self-employed individuals with only one year’s income verification “is less conservative than that of other prime, high street lenders”.

Lawler says that the delinquency rate of mortgages in previous OSB deals have also been higher than in comparable prime RMBS. While the interest rate the OSB RMBS pays is more akin to a non-prime deal, which offers some protection, the biggest issue is whether it will be called, as is normal for “proper” prime residential securitisations in the UK.

Our emphasis below.

Above all though, one of the most important fundamentals in the Prime RMBS market is meeting the expected maturity date of the transaction as most deals are priced to a call option. There is a general expectation in the whole market that deals will get called on their call date. This is particularly the case in the Prime RMBS sector where investors would expect sponsor banks to step up to the plate in all but the most exceptional circumstances. Notwithstanding this, calls typically come with a standard coupon step-up, which when combined with the paydown of the notes can make it economically punitive not to call the notes. Of course, there can be exceptional circumstances, such as the market cessation in the early aftermath of the coronavirus outbreak, but these are very much the exception and expected to be rectified as soon as conditions normalise somewhat. After all, issuers want to come back to the market with repeat deals in order to continue to finance their business.

But, not all so-called ‘Prime’ deals are the same. We generally just consider them as part of the broader funding mix for the big bank issuers, but for the smaller issuers; some also want to maximise their leverage, and issue not just senior ‘funding’ notes but also mezzanine tranches similar to a so called ‘Non-Prime’ deal, and we understand that some have gone even further and subsequently sold the call rights to a third party. In our minds this doesn’t exactly align the interests of the issuer with bondholders, especially, should the third party option holder decide not to or be unable to call the deal, which we understand has happened. This leaves bondholders in limbo, with no idea when they might receive their money back.

Of course, the AAA holders can still sleep soundly in their beds knowing that the deal structure will amply protect their capital, albeit the extension of their bond maturity may cause them a modicum of short-term mark-to-market pain. But mezzanine notes could extend for years. Several Non-Prime deals from before the GFC still have mezzanine notes outstanding 15+ years later, and these now contain the tail-risk of the residual loans in the pools that potentially can’t or won’t pay!

In the ‘true’ UK Prime RMBS space we don’t recall any deals which haven’t been called in a timely fashion. If an issuer purports to be a Prime lender and doesn’t call a deal for a short period due to exceptional circumstances then that can be forgiven. However, if they fail to call a second deal — as has happened with two deals from this issuer, it really begs the question of why do they expect investors to trust them going forward?

So our concern in these circumstances is not the deals themselves, but the presentation of them as truly ‘Prime’. If they are Non-Prime we will assess, treat and price them as such; whether from an expected credit performance, maturity or liquidity point of view. It is also worth noting that with an STS label these deals qualify for preferential Liquidity Capital Ratio (LCR) treatment for bank investors and yet trade with similar levels of liquidity to Non-Prime deals. Buyer beware — if you ever want to become a seller! At the very least expect to get paid something closer to the Non-Prime yield and not the Prime yield.

Is this pretty niche? Yes. Does it actually matter much? Probably not. Is it even interesting? Hopefully!