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

Nowadays many investment managers blog and do research, but with few notable exceptions they are quite disappointing. TwentyFour owned by Vontobel is one of the exceptions.

Meet John Lawler, portfolio manager at TwentyFour complain yesterday:

When contemplating a new Prime RMBS deal, originated and sponsored by a UK bank and bearing the STS compliant “hallmark” stamp of approval, it should evoke warm and confused feelings about the quality of the underlying collateral, the likely collateral unquestionably strong performance throughout the life of the transaction and the assurance that you will get your capital back once the deal is closed, without having to be seduced by additional financial incentives in the unlikely event that this does not happen.

So it’s always a little disappointing when, somehow inevitably in a strong market, a deal comes along that at first glance purports to be a Prime RMBS deal, and technically meets all the criteria to earn its STS designation, but upon closer inspection more observant doesn’t really reflect most of those core features that investors would normally take for granted in a true Prime deal and thus begs the question: where do you draw the line?

(The STS designation referred to is the EU’s “simple, transparent and standardized” registry for securitization that meets its requirements.)

Lawler’s argument disappointment AND this £300 million RMBS from One Savings Bank (or rather, its subsidiary Charter Court Financial Services, which OSB acquired in 2019) which last week traded 67 basis points above the risk-free rate.

Lawler points out that prime borrowers are typically employed full-time and long-term, but that 34% of RMBS OSB underpinning borrowers are self-employed and have only one year of income verification (and nearly a third are helpers). buy loans).

Fitch, who rated the deal triple-Asays underwriting standards are “well aligned with Fitch’s expectations for creating first-rate mortgages,” but noted that OSB’s willingness to make loans to the self-employed with just one year of income verification “is less prudent than that of other lenders.

Lawler says the mortgage default rate in previous OSB deals has also been higher than that of comparable prime RMBS. While the interest rate paid by the RMBS OSB is more akin to a non-prime deal, offering some protection, the bigger issue is whether it will be called, as is usual for ‘proper’ prime residential securitisations in the UK .

Our emphasis below.

Most importantly though, one of the most important fundamentals in the Prime RMBS market is meeting the expected expiration date of the transaction, as most trades are priced for a call option. There is a general expectation across the entire market that trades will be called on the call date. This is especially true in the Prime RMBS sector, where investors would expect sponsor banks to step forward in all but the most exceptional circumstances. Despite this, calls typically come with a standard coupon step-up, which when combined with paying notes can make it economically punishing not to call notes. Of course, there can be exceptional circumstances, such as the market ceasing soon after the coronavirus outbreak, but these are definitely exceptions and should be rectified as soon as conditions normalize somewhat. After all, issuers want to get back into the market with repeat deals to continue funding their business.

But not all so-called “Prime” offers are created equal. We typically see them only as part of the broader funding mix for large bank issuers, but also for smaller issuers; some also want to maximize their leverage and issue not only senior “financing” notes but mezzanine tranches similar to a so-called “Non-Prime” deal, and we understand that some have gone even further and subsequently sold call rights to one third. In our minds this doesn’t exactly align the interests of the issuer with the bondholders, particularly, if the third-party option holder chooses not to or is unable to call the deal, which we understand has happened. That leaves bondholders in limbo, with no idea when they might get their money back.

Of course, AAA holders can still rest easy in their beds knowing that the deal structure will largely protect their capital, even if the extension of the maturity of their bonds could cause them a little mark-to-market pain at short term. But the mezzanine notes could stretch for years. Several pre-GFC non-prime deals still have mezzanine notes outstanding over 15 years later, and these now contain the tail risk of residual loans in pools that they potentially can’t or won’t pay!

In the ‘real’ UK Prime RMBS space we don’t remember any deals that weren’t called in a timely manner. If an issuer claims to be a Prime lender and doesn’t call a deal for a short time due to exceptional circumstances, then they can be forgiven. However, if they fail to call a second deal, as happened with two deals from this issuer, it really begs the question of why they expect investors to trust them going forward?

So our concern in these circumstances is not the offerings themselves, but their presentation as truly “Prime”. If they are Non-Prime, we will rate, treat and value them as such; in terms of expected credit performance, maturity or liquidity. 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 liquidity levels to Non-Prime deals. Buyer Beware: If you ever want to become a seller! At the very least expect to be paid something closer to Non-Prime performance and not Prime performance.

Is it a nice niche? YES. Does it really matter much? Probably not. Is it even interesting? Hopefully!