Regulatory burdens on banks to meet capital buffers while continuing to lend are providing opportunities for attractive returns for some savvy chief investment officers (CIOs).
Capital relief trades allow banks to meet their burdens for capital buffers without selling off loans or cutting back on lending. Instead, other investors take on the credit risk for some potential loan losses through contracts. As the broader market for so-called synthetic collateralizations booms after a much-needed healing following the financial crisis, some investors see compelling opportunities.
“It’s like selling insurance on bank portfolios,” says Bob Jacksha, CIO of the New Mexico Educational Retirement Board, which manages approximately $12 billion. “They are looking at more than just the economic return of the profile, and they might be willing to take our insurance at better rates than they otherwise would for those considerations.” Maintaining customer relationships and staying in the good graces of regulators are chief among them, he said.
The overall segment is recently experiencing rapid expansion. In Europe, volume for synthetic securitizations expanded to EUR94 billion in 2016 from EUR20 billion in 2013, according to a report by Deutsche Bank earlier this year. Five deals alone accounted for EUR20 billion. Barclays and Lloyds Banking Group expect more deals in 2017 than any year since the financial crisis, according to reports.
Jacksha was early to spot the opportunity. Jacksha first began to invest in funds participating in capital relief trades in 2012, and has invested $350 million to date. Encouraged by the track record of the investments, he is set to allocate another $150 million to his commitments this year based on approvals by his investment committee in December 2016. While Jackha had initially invested in funds that would focus only on capital relief, the mandate for future funds was broadened to include opportunistic co-lending with banks.
That banks have reasons beyond financial considerations is key to the attractive profile of the asset class, Jacksha said in an interview with CIO. Banks stay in the good graces of regulators by lowering their risk profile, and get to continue their relationships to service customers rather than send them elsewhere, he noted.
Low correlation with equities is another benefit of the exposure. “We like how it fits in our portfolio because it adds an element of diversification,” Jacksha said.
Returns to date have been compelling, and Jacksha is looking to invest more and broaden the mandate for the nature of investment.
The New Mexico Educational Retirement Board has gained exposure to capital relief deals by investing in vehicles offered by hedge fund Orchard Global Asset Management.
The New Mexico Educational Retirement Board first invested $150 million in March 2012, and an additional $50 million in the beginning of 2013. The IRR since inception has been approximately 10%, net of fees, Jacksha said.
The New Mexico Educational Retirement Board again invested $150 million with Orchard in August 2014. Returns since inception have been slightly under 9.25%, net of fees, Jacksha said.
Another $150 million has been approved for another Orchard fund, but the contracts have not yet been finalized for the investment.
“We like the return in good times, but we think there is also protection for bad times,” Jacksha said.
Often maligned in the wake of the financial crises by regulators and investors, synthetic securitizations are now regarded as an important mechanism to revitalize the flow of credit to small and medium enterprises (SMEs).
“Securitisation markets have returned to policymakers’ attention recently, only this time as a hoped-for panacea to anemic lending in Europe rather than as a culprit for the financial crisis,” Deutsche Bank wrote in a report earlier this year.
A sharp deterioration in the quality of issuance with increasingly complex issues in the run up to the financial crisis often resulted in unexpected investor losses, Deutsche Bank wrote. But those kind of complex transactions with many market participants no longer happen. “Synthetic securitisation saw mixed trends in recent years. On the one hand, complex arbitrage deals have almost disappeared. On the other hand, balance sheet synthetic deals have surged.”
But issuance quality now has substantially increased and issues are now overwhelmingly bilateral, between two parties, rather than reliant on a third party like a credit ratings agency to evaluate quality and open to a variety of investors.
“While transactions have become mostly private, they are now much less complex and of robust asset quality. Long-term institutional investors are major buyers,” Deutsche Bank wrote, adding, “Since the crisis, synthetic securitisation deals have become bilateral.”
Balance sheet transactions like capital relief deals now comprise the 90% of issuance, according to Deutsche Bank. Investors for balance sheet synthetic deals usually consists of non-bank investors, “mainly hedge funds (47%), pension funds (22%), and sovereign-wealth funds, or public/supranational investors (20%).”
“Industry observers point out that balance sheet synthetic transactions have become much less complex in recent years as well,” Deutsche Bank wrote. “Documentation often comprised around 500 pages in the past, and is now only 20 to 30 pages long.”