21.07.17

Snapshots is wondering if Christopher Nolan’s new movie Dunkirk will win an Oscar. Some critics are already calling it the greatest war movie ever made. As avid movie buffs we can’t wait to find out tonight

Back to the markets and Snapshots is analysing credit opportunities as the markets pause ahead of an August summer lull.  We have been saying for some time that opportunities in liquid credit are sparse away from bank capital.  Structured credit still presents good risk adjusted value and we are excited about a new asset class that is growing very quickly.

Regulatory Capital

There was €60bn of notional portfolio volume of Synthetic Risk Transfer or Regulatory Capital (our preferred moniker) trades by European banks in 2016.  This was from around 25 deals.  This compares with €16.8bn of European CLOs from 41 deals. There are around 10 active buyers of Regulatory Capital.

Recall that prior to the financial crisis these types of deals existed but were different in three major ways: (i) They were rating arbitrage driven under Basel 1, (ii) banks were buying senior protection from non-banks on an unfunded basis, and (iii) they were structured and sold by derivative salespeople.  To name another movie think The Big Short!

The world has changed.  We are now in a capital heavy, loss modelled Basel 3 world.  The deals we are now seeing reflect that: (i) they are structured around losses and Basel 3, (ii) banks are buying mezzanine or equity protection on a fully funded basis, and (iii) they are structured by Loan Portfolio Management teams who are trying to improve the RoE on a divisional banking portfolio.

We think the market will grow exactly for these reasons.  Banks have tried to right-size themselves by selling non-core assets, improving underlying loan data and measurement of their RWAs and cutting costs.  However, they are still struggling to make a decent RoE.  The European Banking Authority estimates that European banks achieved an RoE of 5.4% in the last quarter of 2016.  Of course NPLs and low rates are part of the problem but we think that portfolio optimisation will continue to feature as a core activity of banks in a post Basel 3 world.

These trades allow bank divisional heads to work with their Loan Portfolio Management teams and the regulator to structure trades around their capital heavy assets which include trade finance, large corporate, middle market, SME, CVA, consumer and real estate portfolios. They are like a surgical knife in that they can treat pockets of high capital usage with precision and can be maturity matched for the capital relief required.

The alternative is for banks to raise equity or bank capital at the holding company level.  This doesn’t allow for capital relief benefits to be easily attributed on a divisional basis and they are expensive instruments to issue and buy back/call and are difficult to maturity match.

Of course careful structuring and default analysis are still key for investors.  Another new area that we see significant opportunities in is cross-border trade finance.  And we still see compelling default adjusted opportunities in traditional CLOs.

By Asif Godall
Deputy CIO