The Rise of Credit Risk Sharing

 

Credit risk sharing structures have undergone a significant evolution since the Global Financial Crisis, leading us to explore its emergence in financial markets, and its transformative impact on modern risk management strategies. In this Credit Crunch episode of the Bloomberg FICC Focus podcast, Noel Hebert and Sam Geier talk with Matthew Moniot, Managing Director and Co-Head of Credit Risk at Man GPM, about the risk of CRS, the structure of CRS transactions and the due diligence process involved. The episode also covers the potential risks in the market, including counterparty risk, aggressive competition, and the need for further regulation on the liability side of banks' balance sheets.

This episode was first published on 9 February 2024.

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Noel Hebert:

Good tidings, dear listeners, and welcome to the latest edition of Credit Crunch, part of the FICC Focus podcast series where we focus on all things credit. I'm your host Noel Hebert and joining me is colleague Sam Geier. Before diving in a little public service announcement. As we close in on our 250th episode under the FICC Focus umbrella, listener support has been instrumental to our success, and our continued success would benefit greatly if you could take a moment to follow, rate and share. Thank you for your time and consideration.

Today on Credit Crunch, something a little different for you, a conversation that we think we're going to find deeply interesting, credit risk sharing, alternately known as significant risk transfer or SRT. It's a market that's been notable in terms of both financial crisis in terms of growth. As banks look to preserve regulated capital ratios, we explore that product structure, the market, and the market outlook with Matthew Moniot. Matthew is Managing Director and Co-Head of Credit Risk for Man Group. Matt, welcome to Credit Crunch.

Matthew Moniot:

Thanks very much. Thanks for having me on.

Noel Hebert:

So before diving in, I guess maybe a little bit about your background I know my in-laws will be thrilled to learn I believe you're a Longhorn, and pretty much that whole side of my family is all UT folk, so they're going to be thrilled at this one. But maybe a little bit more of your background in terms of what brought you to Man Group, what brought you to this product structure in particular?

Matthew Moniot:

This is hard to say this. About 30 years ago, I started in the capital markets, trading banks and sovereigns on the EM side, and eventually made my way to slightly less volatile climes and started looking at US and then European institutions, and traded essentially everything there was to trade and invested in everything there was to invest in financial capital stack and financial firms, banks, insurance companies, otherwise, equity debt, up and down the capital structure.

And about 12 years ago now, maybe even 13, I started a firm called Alanis Capital Management in New York City, specifically to interact with European banks that were almost certainly going to spend a decade thinking seriously about their capital and their capital structures and their balance sheets and felt like there was a lot of opportunity to trade with them, in particular through a type of structure that many of the folks at Lehman Brothers here in London had worked on in the early 200s and marketed quite widely. And these were essentially synthetic securitizations, dual tranche, with a junior piece of that tranche distributed to investors. And that was very much a Basel II, if you will, modification, which was rolling in in the early 2000s.

And so did that up until 2000 or 2001, I guess, when Man Group came calling, and we had about a year of discussions and kind of agreed that this was a nearly perfect platform for us to come join and so folded ourselves in. And I think I've been really excited and pleased with the decision since taking it two years ago. So I've now been here in London at Man for two years.

Noel Hebert:

Excellent. So let's maybe talk about that structure a little bit, you alluded to a little bit there in your response. So credit risk sharing, and I guess we can just call it CRS from here on out, that'll probably be a little bit easier, it's a corner of the market that maybe not all of our listeners will be familiar with. So what is it, right, I guess is primarily number one, who does it benefit, and why does it exist?

Matthew Moniot:

Yeah, yeah, it's a bunch of excellent questions. So credit risk sharing, at least as we sort of define it, is actually quite broad. We spend quite a bit of time on a relatively large piece of credit risk sharing, but all in all, a relatively niche business, that you've alluded to as well, or noted, which is SRT. SRTs are securitizations, I had mentioned it earlier in talking about when we set up the prior firm, and it's just a really efficient, optimised way to trade portfolios with banks. So it's not a true sale product. The assets are not actually sold off the banks' balance sheet, and it's not a full notional product, like a credit default swap would be. It's also a fully-funded product, meaning 100 cents on the dollar of what we're responsible for or potentially responsible for, or 100 cents of our limit of liability is fully collateralized, fully capitalised at the outset of the transaction. So we present no risk in SRT to the bank counterparty, unlike, for instance, a credit default swap, which is effectively a form of insurance.

So a very, very efficient, very clean way to transfer risk on a defined discreet pool of assets that we can underwrite from a bank to us. What that does is it reduces the risk weightings against those assets, and because it reduces the risk weightings, it increases the bank's capital ratio, i.e., the amount of dollars of capital held against the number of risk-weighted assets. So oftentimes referred to as capital relief or capital release transactions, and you might know that, for instance, Freddy and Fannie have a very large programme of what they refer to as CRTs that are, for all intents and purposes, the functional equivalent.

Noel Hebert:

So I guess what was the ... You sort of alluded to a couple of these things that I just want to maybe dive in. You talked about the structure, and I guess what I'm hearing from there, and I think what we had talked about before, is one of the advantages here is that they can't be bailed in in terms of like you had mentioned CDS as being sort of separate and distinct in so far as you do have that counterparty risk if things go bump in the night. So I guess is that a fair assessment in terms of that feature of it?

Matthew Moniot:

So everything to do with banks is always needlessly complicated. Right? Yeah. We'd be better off if we simplified, but I'd probably be out of a job too, so complexity is fantastic. So the proceeds of any trade that we execute in, there are a few different ways in which the proceeds of the transaction can be treated or where those dollars or euros or Sterling, where they can reside. And in the United States, and one of the big challenges over the past few years in the US market for creating some clarity around the market, was how to treat proceeds.

So the Fed has been quite clear that now, as of the end of last year, that it vastly prefers a structure, which is to say this is realistically the only thing anybody's going to do, that it prefers a structure where the note proceeds of issuance are held specifically as financial collateral, which means then that they would be invested in commercial paper or something short and safe, US treasuries, and specifically ring-fenced against a given transaction.

So the European structure is a bit different, and I say this, it doesn't mean it's the only structure, but the main structure prevalent in Europe would be what we might refer to colloquially as a direct note issuance, which means that we buy an instrument that, for all intents and purposes, is a senior-preferred instrument, and our proceeds are then balance-sheeted or they are co-mingled as part of the total capital of a bank.

There are protections in the European structure for us, and those can be structural protections. We might be, we would always be, in some sort of bank that had an extra layer of protection for us, often meaning in a UK context, as a for instance, a ring-fenced retail subsidiary. So you can find any big UK bank, and you'll see that there is nowadays a holding company entity, and there'll be a main operating entity, and we would be down at that operating entity with a level of protection.

In the European Union through BRRD, which is the Bank Resolution and Recovery Directive, which essentially sets out how banks, if they fail, will be managed, we are explicitly this senior-preferred layer, which puts us at parity with corporate deposits. So we are largely above, largely meaning we are above, the bright line tests for MRL and TLAC. These are European and financial stability board definitions, MRL, minimum requirements for own funds and eligible liabilities, and TLAC, total loss-absorbing capital. So we are above that line, which means in theory, we wouldn't be bailed in. Now the thing is, regulators, they get lots of flex, which folks who invested in CSAT1 learned, so we pay a lot of attention to our bank counterparties and to our bank collateral. That's a very detailed, probably needlessly detailed, answer of what happens when we execute a trade and where the money goes.

Noel Hebert:

Well, that's the beauty of a podcast is people can always rewind and listen to that part about 42 times and just take it all in. But I guess maybe let's dig in a little bit to the portfolio itself in terms of you're working with the banks, you're taking on the risk component of some of these loan books, et cetera. I guess maybe what does that process look like? Do you guys have discretion over the borrower base, or what's the involvement? Is it just like a BWIC, where they're going out and they're saying, "We've got this book loans. Who wants to take the risk in it?"

Matthew Moniot:

Yeah, I would say there's no uniform, if you will, way that these deals eventually work out. There will be certain banks and certain times when they feel like the portfolios they might bring to market, meaning to one or more potential counterparties, might be relatively static, they might be relatively more open-ended. I would say if we cast our minds back 10 or so years, there was a lot more interaction of, "What do you have? What are you interested in? Et cetera, et cetera." As the market has matured, I think both sides have a better sense of what's available. There are now a lot of fairly regular programmes, so we collectively, the group of us doing this, have a pretty good understanding for any given institution in any given programme what a portfolio is likely to look like.

I have never seen a transaction where if we find a handful of obligations, obligors, that we don't like where the issuer says, "I don't care. I'm planning on keeping them in," which is to say the issuers are uniformly flexible about allowing for some horse-trading. What they typically don't want to see is an attempt to fully recast the portfolio. If they bring a large corp portfolio, they don't want to be told, "Oh, by the way, this should be a TradeFin portfolio." They don't want to be told, "Okay, fine, but I want no consumer discretionary or utilities or technology," that sort of thing. It's typically not feasible and viable, so there needs to be a bit of sensitivity around what you can and can't do. And in particular about if we do make changes, what it means to the portfolio. So if you say to a bank, "Listen, I don't want anything except the 4AA, Moody's and S&P-rated obligors in the portfolio," it's probably not going to serve anybody, right? So a little bit of sensitivity is always helpful.

Sam Geier:

So then getting into just in terms of sizing, what have you guys seen in terms of typical deal size? And I guess I'd be interested, too, historically, have you seen that deal size that you typically do increasing as the market share for the broader asset class has grown?

Matthew Moniot:

Yeah, absolutely. The deal size is clear they have grown over the course of the last decade. I'd say they've always been relatively large. So typically, a bank wouldn't want to execute inside of let's just say a hundred million. Sure there are the odd sort of $75, $80 million transactions, but I think a floor these days at a 100 euro, Sterling, dollars is reasonable. And we have seen transactions get above 500 and sometimes get well above 500, but I would say the distribution is very few deals below 100, very few above 500, and I'd say probably 250, 200 to 225, 250 is probably about where.

Sam Geier:

Gotcha. And then in terms of the leverage, it's a question I think we ask the majority of podcast guests. I'm curious on your guys' end, do you guys implement any leverage in this to boost those returns in any way or do you guys keep it pretty much straightforward with how you get into these structures?

Matthew Moniot:

Yeah, so the SRT version of CRS is implicitly leveraged, because it's a securitization, and we're buying junior tranches. Now, it is on a pure gross leverage basis or this if we don't risk adjust, we're talking sort of 12 times leverage, which will typically feel very high, functionally equivalent, of course, to say CLO equity, so the same sort of multiplier there, an 8% tranche, let's call it, 10% tranche, something along those lines, 10% to 12%, 12.5% leverage. The asset quality, however, is quite different. So from a risk-weighted standpoint, we are often trading portfolios sub-50% risk weight. What that means is from a capital ratio perspective, if we're putting 8 or 10 points down on a subordinated tranche, so if the portfolio has been divided into two, a 10% tranche and a 90% tranche, and we're buying the 10% tranche, but it's a 50% risk weight, that means from a capital ratio perspective, we're putting up 20% capital.

And of course, you can compare that to where banks are, and TLAC or MRL in most of the banks, most of the big banks around the world nowadays, inclusive of, so this is CET1 equity, AT1, CoCos, if you will, Tier 2 and even maybe senior unsecured are typically getting you to something on the order of 16% to 20% these days. So that's not a mistake, it's not an accident. The transactions themselves are geared to replace the capital that is held before the transaction takes place against that portfolio. So it isn't as if the bank can hold $100 million dollars against a billion-dollar portfolio, come and execute a transaction that's a $10 million transaction with us, and $90 million of capital goes away. That is not what happens.

In fact, after a trade, the combined money that we provide and that the bank holds against the senior exposure is significantly more. Okay, not three times, but it's significantly more than what they were holding before the transaction would take place. That's helpful to us. It de-optimises to some extent, detunes to some extent our transactions, and that leads to this is not a 25% return business, this is a 12-ish percent return business, and that's because of the amount of capital we hope that was.

Sam Geier:

Yeah. Yeah, no, that's great. And I guess I wanted to turn back, too, to something you had mentioned just in terms of the geographic breakdown. You walked us through how the European market differs from the US market, but you also brought up the Fed decision that was in September, which obviously impacts the US market. How do you see that in terms of the overall growth of the asset class? Do you see the US in a way that Fed decision opened up the floodgates for the US, or do you see Europe being the dominant market over the next couple of years years?

Matthew Moniot:

So the US will grow faster, of course, from a smaller base, and the US we expect will become a major part of this market. I think it stands to reason that for the next five or more years, it may well be that this is a market where Europe is still the majority of the issuance. That's maybe also a market structure comment. We have four institutions in the United States that, for all intents and purposes, are 40% of the banking system. And we probably have, okay, they're not nearly as big, but we have maybe 25 or 30 relatively large and, for what it's worth, pretty sophisticated firms.

I know it's a lot of fun to beat on the European banks and talk about how terrible they are, but they've been living under Basel II for a very long time, Basel III since the crisis, and now moving themselves into Basel IV. And the real step change was I to II, and it made banks much more sophisticated.

The US did not ever adopt II, and so you have what would be considered relatively small institutions in the United States in terms of balance sheet size, capital or assets, that here in Europe are actually quite sophisticated. Conversely, you have relatively large institutions in the United States, we could probably point to one that's been on the news lately, as not sufficiently sophisticated.

Sam Geier:

So then I guess turning to broader market backdrops, are there specific backdrops where you see better or worse in terms of origination and performance, whether that's a higher interest rate environment like we've been seeing over the past couple of years, or maybe a higher default cycle? How does the asset class stand up in those specific environments?

Matthew Moniot:

So from my perspective, I think the asset classes performed just extraordinarily well, far better than I would've expected. I certainly expected the first few vintages to be standouts, and they were, but mainly, the business really kept performing. There have been the odd idiosyncratic event, so there have been bankruptcies over the last post-crisis, and by that, what I mean is big corporate bankruptcies and not evidently, obviously distressed, although there's some of those too. And so we've had some that have been totally idiosyncratic, we've had some that have been related maybe to the oil retail shakeout of late 2015, 2016, we've obviously had some COVID-impacted, and yet, it hasn't really meant all that much, mostly because the transactions are fundamentally well-structured. They tend not to take outsized single-name risk, they tend not to take outsized industry risk.

The US and the LevFin business more broadly, which is seen in particular recently a bit more distressed, there's not-great representation of that business in SRT. The vast preponderance of LevFin finds its way into CLOs and/or broadly, excuse me, direct-lending BDCs. It is to a small extent. It is not really resonant on the banking systems' balance sheet. So I think those have been some drivers.

I think we've learned a few lessons from some of the very idiosyncratic events that might've been in a little bit more heavily concentrated portfolios, and those have caused some consternation. Thinking back, we've had a handful of issuers that have been resolved, so, of course, Credit Suisse and Espírito Santo back in the day and Popular in Spain. So those have all worked out fine, but I think they keep us collectively honest about the risks we're taking vis-a-vis bank resolution failure.

Noel Hebert:

So I guess that maybe gives rise to sort of the due diligence question in terms of when you're sort of looking in evaluating a portfolio, is the due diligence at the loan level or is it at the bank level? Where's the focus, and what's the exercise look like there?

Matthew Moniot:

Yeah, it's absolutely at both is the answer. But if we stylize this a little bit, the more we might be looking at a large corporate portfolio, we tend towards underwriting the names in the portfolio as opposed to the bank. So in extremis, it would all be underwriting the names in the portfolio, and we wouldn't even think about the bank. We wouldn't even care. Now, really pushed, I might even be willing to defend that proposition as being tenable. We still underwrite the bank, but whatever. As you move across to smaller and smaller companies, you need to do more and more underwriting of the bank, partly because you can do fundamentally less underwriting of the portfolio, of the individual obligors in the portfolio, A, because there's too many. We can often have in excess of 10,000 line items, so this looks more like resi or auto or various forms of ABS than it does CLO, for instance.

And so then we really want to understand why a bank is doing something, how it's doing it, and whether it's going to continue to do it, who its people are, lots and lots and lots of issues, how it's funded, what its credit worthiness is, what its deposit base looks like, again and again and again, all these sorts of standard things you would think to do if you were doing credit analysis on a bank, and that's just really fundamentally super important to us.

We really genuinely view what we do, regardless of what the asset class is, we really view what we're doing is providing a form of equity capital to a bank. Even if we think it's amazing that we shed all these other risks, operational risks and agency risks, et cetera, et cetera, that plague the banking system, even though we think it's wonderful that we do all that and we can concentrate our risk down to a defined portfolio that we can underwrite, we still very much want to understand why our bank counterparty is in the business and whether they're good at what they do or not.

Noel Hebert:

It seems like a good question to ask. So I guess maybe one of the things that sort of comes up in that, and some of you alluded to sort of the energy dynamic in 2015, 2016, and obviously, given the nature of your exposures, you would've been through the sovereign European crisis, the PIIGS crisis, whatever acronym you want to throw on it, of 2010, '11, '12, et cetera, when you're seeing things like that that are sort very sectoral or regional, do you pivot the portfolio in terms of where you're trying to do deals into or away from those types of headwinds?

Matthew Moniot:

Yeah, we do, actually. I'd love to tell you we don't. I'd love to. I don't know. It seems the more logical thing to tell you. "No, we just ..." Yeah, we do. We sort of have a belief that we're not trying to actively pick things, but we are trying to look sort of three to five years out, and we're trying to figure out, "What doesn't feel great?" So isn't going to surprise you that it's been a number of years that we have not wanted anything to do with real estate. And listen, don't get me wrong, there's amazing real estate people out there. There are real estate people, if I could be 20 years younger, I would want to be one of these real estate people, because the next decade is going to be extraordinary for them. For people who can go and they know ground level, they know how to refurb buildings, for real God's honest real estate people, this is amazing. I am not a real God's honest real estate person.

Noel Hebert:

I hate to point this out. You're also not 20 years younger, but [inaudible 00:28:03]

Matthew Moniot:

Well, there's that downside, yeah. There's that downside.

Sam Geier:

Yeah, I've got an opportunity for a career change.

Matthew Moniot:

Exactly. So it's important to understand that's not really what this business, this business doesn't allow me, if you will, to be a distressed investor, to be an activist investor, be an active investor, and I have enormous amounts of respect for all of those people and all of those businesses, and I fully appreciate the fact that I'm not in a position to be able to do that. So another one that we worry about is sort of, if you will, macro conditions, and there are certain obvious geographic locations where today they're looked, today, they're looked ... 15 years ago when we started, 14 years ago when we started, you mentioned them, PIIGS, it was quite difficult in '10, '11, '12 to do much in certain countries.

And we think these are largely long-cycle risks. So I know the conventional wisdom is that nobody saw the mortgage crisis coming in the United States in 2008, but that's just fundamentally not true. There were tonnes and tonnes and tonnes of people who did, and many of them sat around for years and years and years ahead of time, screaming and yelling about the insanity of what was going on. The problem is everybody was making money, and when everybody's making money, nobody wants to hear the guys who are like, "This doesn't work long term."

We have this belief, and so yeah, we will shift the portfolio to try to avoid places. Again, I have this great luxury. I used to do long-short credit equity, that sort of thing, I did capital structure arbitrage fund, and there's a truism in liquid markets, your timing has to be good. My timing doesn't have to be good. That's the biggest luxury in the whole wide world. I just have to look out and say, "Okay, fine, that looks a little ugly."

Noel Hebert:

So I guess maybe a couple of questions that sort of arise out of that. I guess number one, when things are happening in real time, and maybe you sort of assess the issue as being maybe problematic but not uninvestible, I guess maybe something like Brexit comes to mind where maybe you have a wholesale sort of pricing impact across the market, does that impact how you, because presumptively you're still going to do stuff in Sterling, but do you look for greater concessions and that sort of thing when there's a lot of noise around a situation?

Matthew Moniot:

Yeah, it's another great question, another great example. The UK really was, post-Brexit, was great. The market was horrified in many ways and recoiled, and for a number of years, transactions that we saw in the UK were arguably incrementally safer and incrementally higher yield. The UK has got its issues, certainly it does. I think all in all, I think the Brexit impact might've been marginally worse than we thought it would be in 2016, but it took much, much, much longer for that pain to play out. And it has been largely offset by a very, very conservative and oligopolistic banking system here in the United Kingdom. Bank competition is great for borrowers and, every once in a while, great for savers even, but it isn't really great for folks who invest in banks.

And so I want to be a little bit careful. The fact of the matter is I love anticompetitive markets, but who doesn't? I think it was Peter Thiel, wasn't he the one who said every company is ultimately trying to be a monopolist, right? Of course, the end-all goal of every company, right? Of course. Yeah. So that's an area that we've looked at. I would point to, I think, Italy's been a strong market, consistently de-leveraging in the non-financial corporate sector in Italy, consistently high spreads. We have not done much in Italy, all in all, a little bit, but not much, and we should have done more. So I think that's an example.

And obviously, the few LevFin deals that have been done, the folks who have done them have been fantastically remunerated. That's an area where people have been consistently too bearish forever, and hats off to everybody in that market. They've built just a fantastic machine, and I genuinely hope that they continue to do super well, both in BSL all the way across to direct lending. I think it serves an important purpose.

Noel Hebert:

Absolutely. So I guess maybe another question in terms of when you get the portfolio outstanding, I guess, or is it just basically done on an average age basis? So the portfolio, you get your money back as the portfolio winds down? And I guess one other question sort of comes to mind when I think about other maybe structured product type deals, sometimes they'll have sort of features where you can swap in loans or exposures if something breaks some sort of covenant or term of lending and that sort of thing. I guess I'm trying to understand those two factors within the nature of a CRS.

Matthew Moniot:

Yeah, so we would refer to those two things in reverse order as replenishment, which is this idea of for some defined period of time, there may, or may not, but there may be rights that the collateral manager, in our case, collateral manager means the bank, that they may have to manage the portfolio. Those are very, very tightly managed in the documentation, so very proscriptive about what they can and cannot do as you move through time. And deals are anywhere from static, meaning no replenishment, to potentially replenishing for as long as two or three years. In particular, shorter, faster amortisation portfolios, which if you just did them static, they would go away so quickly that it almost wouldn't even justify doing the transaction or, in some cases, wouldn't justify it. A TradeFin transaction will run off in six months, so obviously you want to replenish for a year or two.

So replenishment is that key feature. Then this next piece, I alluded to it is runoff and how quickly that takes place. This is a function of CPR and inherent amortisation, i.e., a structured amortisation of a given loan, like a US residential real estate loan. 30 or south AM has a amortisation pattern that you can immediately see for yourself, plot out, and many loans do, in particular on the SME side. Large corporate, standard, like a revolving facility typically is issued for five years. Typically, CFOs don't like them to get inside of a year, so they have an effective life of about four. But then, of course, companies are always doing things, they're making acquisitions, all sorts of stuff, and those can often lead a CFO or his or her team to come to market and say, "I want to change my documentation." That would be an amendment. They'll often use that as a moment to extend the maturity back out. And so those are often events which will kick an exposure out of the portfolio. So there's a fair degree of activity, I should say, going on inside the portfolio at any given time.

And then as the portfolio amortises, there are two different structures, one in which, as it amortises, we amortise, our note that we own amortises on a pro-rata basis with the portfolio. The portfolio shrinks by 10%, our note shrinks by 10%. Another form, much less loved by the issuers, is one where our transaction is static, which means if we have a 10% of a total, and the portfolio goes from 100 to 50, we're still at 10. That means that we go from 10% of the total to 20% of the portfolio, and that continues essentially until we are 100% of the total portfolio. Obviously, banks don't like that because they pass a lot of money, and as the portfolio gets really small, okay, fine, they're paying it on a relatively smaller base, but they're paying us a huge amount. The protection becomes super uneconomic. So everybody likes a pro-rata amortisation.

Sam Geier:

So I'm shifting gears a little bit here. I'm curious just in terms of how you all hold these actual structures. Are they held in funds? Are they held in SMAs? Where do they live in the broader Man Group ecosystem?

Matthew Moniot:

Yeah, super good question. The market is roughly 50% private and 50% illiquid. Okay, it's club. Our version of a syndicates is five buyers, six buyers, seven buyers, okay. That's what we would call a syndicated deal. Otherwise, club is two or three, and of course, bilaterals, just private bilateral. So this is not a market that you trade. This is a market that you enter into in the primary, and they mature on you some date out in the future. And as a result, we can't offer, and I don't know of any of my competitors that offer, liquidity in funds that hold these. There will be some small allocations maybe in multi-strategy, liquid multi-strategy funds out there, but anything that's remotely pure play is going to be closed-end or is going to be non-redemption.

So we run an open-end but non-redemption, and that works well for us, and it just means that traditional private credit structure, so you have a harvest period, and your assets amortised away. It's a super-safe model, and that's where the vast preponderance of these assets reside. And then we have both funds, and to your point, we have what I believe you said with separate accounts, it's kind of an imprecise term, effectively a fund of one for institutions that are of sufficient scale that they want some level of non-commingling for all intents and purposes.

Sam Geier:

So then turning to, I guess, the broader competitive landscape, how do you think about the current market size versus the broader addressable market? Do you see a lot of room for growth for the industry, or do you see certain ceilings just depending on how big in terms of the assets for banks are looking, more broadly?

Matthew Moniot:

Yeah, so the market's been growing at a supranormal pace now for a long while, since the crisis. Now, for all intents and purposes, securitization was dead for 12 months, 2009, early '10, and then began to get back on its feet. So small base effecture, but it's been growing really consistently and really fast, and it will continue to grow really consistently and really fast. And that growth, I suspect, will continue long after I'm doing something else.

Sam Geier:

Hopefully on a beach, sipping some margaritas or something.

Matthew Moniot:

That'd be nice, yes. Changes in latitudes, changes in attitude. That's exactly right.

Noel Hebert:

Are we quoting Jimmy Buffett? Is that what we just did?

Matthew Moniot:

I was just going to say we're all going to be singing Jimmy Buffet by the end of the podcast. Yeah, in particular, there is both deepening in core issuing Western European markets with banks issuing more programmes, referencing more diversity of collateral. There is expansion into markets like Poland, Greece, Canada, and, of course, the 800-pound gorilla, which is the US banking system, which is beginning to come online. So that combination, and there's no reason that the Japanese aren't eventually issuing more significantly. There are large, there are very large flares in the global corporate markets. Potentially some other areas, potentially a bit of expansion in EM, but the market's growing and going to continue to grow.

Noel Hebert:

Is the skill setting ... Oh, go ahead, Sam.

Sam Geier:

Oh, I was going to say just in terms of the actual number of competitors, do you see the broader asset class has quite a few competitors to you all, or is it pretty tight-knit in terms of who you're competing against?

Matthew Moniot:

It's pretty tight-knit, and this is a very difficult business for a lot of asset managers. It's a business that takes a lot of handholding, it takes a lot of upfront. The market leader, PGGM, has 30-odd people doing this. That's a lot of time and effort, and it's not the DNA to most liquid managers to take that time and that effort. And I think it's unique enough, I don't think there's an unlimited resource of people who have credit skills, structured credit skills, bank credit skills, bank reg skills, on and on and on, so it's difficult to assemble all that.

Noel Hebert:

So I guess I was kind of curious as you were answering, you talked about some of them with the geographic opportunity there. Is the skillset largely fungible, you're just doing sort of the same thing in different markets, or if you go into a market like a Poland or sort of any of the CE markets or Japan, you have to bring on a new skill to really tackle those?

Matthew Moniot:

So candidly, part of the attraction to Man Group was that, which is to say leveraging resources that they might already have in-house. So sitting right there is a native Polish speaker, as a for instance. I have native Spanish speakers, French speakers, Italian. I have colleagues in Japan who we work with, I have colleagues in Korea that we work with. We have pretty strong insights into these local markets, and there are fundamental distinctions. These various asset markets, at a distance, might look very similar, but they can often be quite distinct.

Everybody is talking about multi-family New York City these days, or at least for the last week or week or so, and that's a very unique market and kind of ironic, because otherwise in the United States, multifamily resi is doing okay, but it's doing, at least the rent regulated part of it, is doing profoundly poorly in New York City right now. Manhattan prices are down some 35%, 40% from the highs, and that's a function of New York state legislation passed in 2019 and, of course, over-exuberance leading up to that. You have to get pretty granular to start to pull stuff like that out.

We attempt to do that, and we're super-conservative about moving into new geographies. We have fund law firms that we like and believe in, and we have to find analytic talent, and we have to find, principally, as you asked, local analytic talent, i.e., folks who can speak the language and can go and talk to people and find the right information.

Noel Hebert:

So I guess one other thing I am kind curious about in terms of just thinking about how you go to market, are you benchmarking against cash, or are you benchmarking ... What are you measuring yourself against in terms of saying, "Here's how we're outperforming or not outperforming?"

Matthew Moniot:

Yeah, another good question. I don't know. [inaudible 00:45:37]

Noel Hebert:

"Here's your double-digit return. Don't worry about it."

Matthew Moniot:

Yeah, I'm going to be careful on this. We largely think that there are investments that should generate a similar kind of return. So I think that subordinated CLO tranches, i.e., sort of equity BB are a reasonable proxy, and by default, or maybe not by default, excuse me, by comparison, BDC equity, for instance, is a reasonable comparison. I think AT1, or some combination of AT1 and common equity, but of course, that becomes a laughably low hurdle because, one or two banks aside, the last decade in bank equity has been laughable.

But those are all sorts of ways I think that you could say, "Okay, we're more or less taking credit risk, and we're more or less putting some form of leverage into it to create an output," which is kind of low double digits, high single, low double, and then I think people can sort of take it from there. I've never done long only, so I've never had this transparent, "I have to beat the S&P 500." I wouldn't even know where to begin. So yeah, I sort of laughed, because I'm asked the question on almost a daily basis, and I still don't have a good answer.

Noel Hebert:

Well, now they have the podcast just reference them to.

Matthew Moniot:

Exactly.

Sam Geier:

You all published a white paper in May just talking about CLOs versus CRTs. One thing that you highlighted in there was just recovery rates for SRTs relative to leveraged loans. I'm just curious, it looked like it was around 80% on the SRT side, 66% on the leveraged loan side. Where do you see the big difference then there in terms of those recovery rates?

Matthew Moniot:

Yeah, what's driving the differences?

Sam Geier:

Yeah.

Matthew Moniot:

Yeah, okay. Right, and funnily enough, I was with some people a couple of weeks ago, and they said, "Oh, that white paper you guys wrote, that's being used as literally a blueprint by people to get into your market these days." I was like, "Oh, my god. I'm going to go yell at some of the people who said I should write that thing." Let's simplify bank lending into pre-crisis and post-crisis. Okay? This is a pretty big sea change for them, and for the most part, the craziness of the naughties has been replaced by this conservatism since. Banks want to lend at the top of the capital structure, they want to take security, if they can, and they want to have lots of capital subordinated to them, so if something happens, they're protected.

We still believe that banks are operating fundamentally in that mindset, but I think that is a super-important piece of why bank-issued, managed, underwritten, financed credit has performed so well over the last decade. I also think that this restructuring of the credit markets with CLOs and BDCs, this has been really positive, because it's reducing the volatility and the procyclicality of lending. It's reducing the leverage broadly in the credit markets, and it's extending permanent capital more deeply into the credit markets. What do I mean by that?

When banks lend, banks always know in the back of their mind that they're subject to their funding, and their funding, there's both a retail element of that with retail deposits, and they sometimes get scared, and there's an institutional element. A hundred years ago, it was always the retail element that killed banks over. Today, it's more the institutional, but nonetheless, banks have to always keep an eye on that. So they tend to recoil very quickly. The capital markets themselves, the bond markets, tend to recoil, but these committed capital facilities, like you will see in private credit funds, they don't, because they have gobs and gobs and gobs and [inaudible 00:50:41]

So the last 18 months, this has been an extraordinary story, has been the story of direct lenders gobbling up huge market share into BSL. Direct lenders are now routinely, okay, sometimes it's club, but they're routinely making multi-billion dollar loan commitments. That's extraordinary. It's really an amazing, amazing fact. Super-good for everybody involved, and all of this is driving better behaviour from the credit markets.

So these recoveries, they're not a function of something I do. I'd love to take credit for it. And it isn't as if on January 1st, 2009, every commercial banker woke up and was like, "Wait a second. You know what I've been doing wrong my whole life? I'm never going to do that again. I'm going to change." No. It is the fact that structurally, when you lend with lots of subordination, when you take a lot of security, when you don't lend 90 cents on the dollar, whether there is security, instead you say, "I don't lend a dime more than 60%," think about the situation that the US banking system would be in if we were still lending against commercial real estate like we did in 2006. We'd have four banks left in two years. We will have more than four banks left in two years, because banks became more conservative, and now they have 40 points at worst of subordination, often 50, 60, 70 points of subordination. That's going to literally save the US banking system over the next couple of years. These are the drivers.

Conversely, our colleagues in the private credit markets, obviously, there's a lot of competition, and there's a lot of drive towards unitranche and that kind of origination efficiency, and of course, over time, that is going to lead to deteriorating recoveries. And we have seen, that's clearly evident already, we will continue to see that play out. I don't think it's going to be catastrophic. I think, all in all, there's fairly good underwriting going on. There's particularly good underwriting, I think, in the direct space. They take their underwriting super-seriously.

But there will always be this thing, always, for a long while here, there'll be this big distinction between recoveries, in particular for large corporate revolvers versus funded term loans and certainly bonds, which bonds are the kids left out in the cold. Which is okay, because they get scooped up by distress guys, who are then the smartest guys in the room, and they beat the tar out of everybody else. And so the ecosystem is healthy, right?

Noel Hebert:

Just revives your love of humanity.

Sam Geier:

That was a compliment in a way for Noel in his old distressed days, huh?

Noel Hebert:

Exactly, exactly.

Sam Geier:

But I guess just another question from my end, just in terms of risk, if you had to narrow it down to one or two risks, the primary risks that you see for the asset class, what would those be? Just thinking about it, I would assume banks pulling back on lending or obviously something like Credit Suisse that was pretty significant in its overall impact to the market, for you, what are you kind of worried about and thinking about?

Matthew Moniot:

Yeah, excellent questions. So there is an ever present in this business, or there should be an ever present, fear, worry, concern that your counterparty might've woken up and decided, "Yeah, I know this is about capital, but maybe I should make this about stuffing folks with losses." So that's something we pay an enormous amount of attention to. We spend genuinely an enormous amount of time and effort and, candidly, money in monitoring and surveilling our portfolios. Everything we get from everyone goes into a database.

That sounds maybe in this day and age easy, but it isn't. We get totally different form of information from different folks, sometimes different languages, so it all has to be translated to something that's similar, made uniform, cleaned, and dropped down and then surveilled to time, and this is honestly one of the few places in the world. So that's my step one.

Step two would be do banks just start expanding into assets that maybe just don't fit quite as well? Do banks that maybe don't have as strong an underwriting culture or are in just weaker positions, do they bring deals to market that blow up? So these are things I worry about, because I worry about how we're perceived. I worry about fundamental misunderstandings from the reg community about what we're doing and the risk involved in what we're doing, in particular that we might bring to the banks if we do a trade, to what extent are the banks at risk to us? They are not. We fully collateralize everything we do, US dollars, treasuries, but you wouldn't necessarily know that listening to some of the folks on the fringes of the regulatory debate.

And then finally, I worry about, not too much competition, but I worry about too sort of aggressive competition. I worry about people who might have slightly different business models that think they can underwrite for a couple of hundred basis points lower than everyone else to win business because they have a different model.

You asked about leverage earlier. These are not assets that fit with traditional leverage, and non-traditional leverage, i.e., leverage that doesn't mark to market and doesn't subject you to margin, is very, very expensive. So there's a question, of course, as to whether it's worth it to utilise very expensive debt capital. And yet, some folks might have different structures where they have enough liquid assets, so multi-strategy credit funds for instance, who might feel like, "Yeah, okay, fine." Implicitly, because my book sort of three-times leveraged on repo or PBE or whatever, that I'm happy to underwrite this well inside of where the rest of the market is. So I worry a bit about that.

Noel Hebert:

Interesting. So I guess I want to stay mindful of time here, but I do have a couple of final ones for you. I guess the first one is we think about the low default experience, and we think of, I guess, the nature of the stress that the asset classes has sort of navigated since the financial crisis. And I guess, given obviously, the great financial crisis was predominantly non-corporate, we mentioned the energy one, post-pandemic was met with a tidal wave of liquidity very shortly after the damage started to get done. So I guess when you think about the asset class, do you feel like you've been through the test, that it's really sort of navigated that period that sort of flushes out strategies?

Matthew Moniot:

Just if I don't answer the question in a coherent way, just come back to me. Look, honestly, I'm concerned, preoccupied maybe, with the reality that most of the post-crisis period has been at or near zero. Europe, even sort of more aggressively than the United States, where we've had lots of negative interest rates, and the transition to positive interest rates, which I'm assuming, subject to my constant proclivity to change my mind, but is a thing now. I worry about what that looks like.

I've been caught over the course of the last year sort of between two worlds of one, wanting the market, the economy to slow down simply because let's face it, overnights at somewhere between half of zero and where they're today, that'd be great. So US at 250, 300, and Europe at 150, 200, that'd make me feel incrementally a little bit better for, in particular, some of the smaller ticket SME type exposures, which I just worry got addicted to deserve.

I will say, though, okay, and this really just is super-important, again, because of the crisis and because of how brutal the fallout from the crisis was, in particular in the European banking sector, and how sort of quasi-capital-impaired these institutions have been for so long, they've really stuck to their knitting. So had we experienced ZERP in the 2000s, we'd all be living in caves now, because the banks, they would've gone completely haywire. But you could certainly have justified much more aggressive lending in Europe, in resi, in commercial, in CRE, in everything if you were just looking at things like coverage ratios.

But folks were fairly prudent, all in all, and nowhere more so than in household and SME, i.e., retail exposures in Europe. Is that now becoming evident, which is to say, "Sure, we've had some credit migration in portfolios. Sure, we've had some defaults, but they have been a small fraction." If you had told me three years ago, "Guess where we're going on overnights? Put the crash helmet on, right?" It hasn't happened. There's no sign evident that it is happening. The longer we stay here, the more it's going to continue to drive stress, and slowly, this will leak out. I'm not saying it's not going to, but clearly the only reason is because, for the last 10 years, these institutions have been fairly to extremely conservative.

Noel Hebert:

Yeah, I think the point is well taken there in terms of I think a lot of people, to your point, if you fast-forwarded it from three years ago, a lot of people would see a lot more damage out there than has maybe sort of been realised. But last question for you here, and we always save the best for last because we know people love to talk about regulation, they wake up dreaming, "Can I answer a question about regulation today?" I guess what's on your radar in terms of the regulatory climate in terms of what maybe impacts you? We talked about the Fed a little bit, we talked about Basel II and III. I guess when you kind of step back, it seems like maybe you guys are, and maybe I'm misunderstanding, but maybe on sort of the other side of the ledger where to some degree the regulation actually helps you, because a lot of it is targeted at sort of driving banks to improve their capitalization ratios. But is that a correct assessment, or is it maybe more neutral or hurtful?

Matthew Moniot:

No, I think regulation has been, all in all, I think it's been somewhat helpful to us. What was Basil III about? It was about increasing the quantum and the quality, importantly the quality, of regulatory capital. It was possible to get away with running a bank with no tangible equity in 2008. I shouldn't say 2008, because I'm trying to market to losses. Let's go back, 2006, okay. What we found out in 2008 was, in fact, it wasn't possible, but the models and the way the regulation had worked, the regulation didn't care much about tangible. It allowed you to use substantial amounts of non-common equity, tier one, and it just wasn't asking for all that much either, right? So unsurprisingly, we developed towering amounts of leverage in the banking system, and now we have banks that are holding really very, very substantial amounts of tangible common equity, which is the expensive stuff.

There's not a giant arbitrage between market-based capital, what we do, and bank capital, which should say in the favour of bank capital. Everybody just assumes, "Oh, the arbitrage is these sharpies in the capital markets are carting all the stuff away and doing some backroom deal that it's not going to hold up." It's really not the case. We can trade with banks, and we can generate relatively high returns, and we can have relatively thick tranches, which protect us from volatility, still generate decent returns, and that is, at least to a great extent, a function of the changes that were introduced in Basel III. There are ongoing changes with Basel IV, Basel III endgame.

There are some super-arcane, for a general audience, even candidly for a securitization audience, discussions that are finally effectively resolved around things like floors for advanced internal rating space, internal models, and how much improvement you can take from standardised models, and a lot of that is being rung out. So we're pushing the most sort of aggressive models, the most optimised models. We're detuning them, so they look more like standardised. And then we're adding increasing amounts of incremental capital, capital non-neutrality is the idea, between a portfolio of loans versus a securitized portfolio of loans.

So I think a lot of the most sort of frightening elements of this were managed over the last couple of years with European authorities, and the US seems to have picked up on this. So we feel pretty good about that, and we feel largely like we're at the end-ish of a very long, very intense period of re-regulation of the banking system. I will note, I'll toss it back to you, lest we wind up seeing the sun come up back out behind me, but I will note that we haven't solved all of the risks. We have rather myopically focused on asset risk, credit risk, some other market risk to an extent, and capitalising against that.

But the obvious thing that we have failed to fully address is the other side of the balance sheet. There are two sides, believe it or not, and we haven't fully addressed liabilities, and in particular, what is assumed to be the highest quality liabilities, which, of course, is deposits. So there's no giant shock that First Republic, Silicon Valley, Credit Suisse are all about a similar thing, and that similar thing is deposits, liabilities, deposit flight, in particular low quality deposit bases dressed up as high quality deposit bases, discussed in terms of core deposits, retail deposits, et cetera, et cetera, but in reality, not. And I think that's too bad to a great extent. I think there needs to be further work probably done. I don't think it really means much to us.

And then lastly, I guess I would point and I would say, I think if you look at the multifamily resi portfolio at New York Community Bank over the last 20, 30, 40, 50, 60 years, up until this last year, you could easily have argued that the risk weights on those assets should have been very, very, very low. And in a pre-crisis world, low risk-weight assets and low amounts of capital means that would be a dead institution today. Maybe round one, but it's not a dead institution. It's got plenty of capital, and that's partly a function of tighter regulation, and no giant coincidence that it was that institution moving into a category four that precipitated the write-down, and so something probably to keep an eye on.

Noel Hebert:

All right. So a lot to digest there. I think the good thing is, I think, listeners are probably going to have to listen to this one a couple of times over, but I love it. I'll probably listen to it a couple of times over. But Matt, thanks so much.

Matthew Moniot:

All the nerds are going to send you fan mail, and all the normal people are going to be like, "I'm never listening to your podcast again."

Noel Hebert:

Yeah, I think my in-laws tuned out after Longhorns and probably said, "Okay, that's good enough." Matt, thanks so much for joining us. We really appreciate you making the time, helping sort of illuminate all the issues around this. To our listeners, on behalf of Sam and myself, thanks so much once again for sharing your time with us. This has been Credit Crunch.