Excess Spread — Borrowing long, kind of Blue

Borrow long and lend short

The biggest trend in the past few years of credit markets has to be insurance capital, whether its fuelling CLO creation, private investment grade, private placements, related party capital for credit managers or just bidding up most of the bond market. American retirement is a booming business, and, as one credit manager told us this week, “if every other annuity provider could have a balance sheet like Athene, they would”.

Because insurance capital is a big deal, structuring deals to be insurance-friendly is also big business, and nowhere more so than Apollo, which has been pioneering new structures such as the long-duration APADS and the shorter, more CLO-esque AMAPS.

They’re new enough structures that the acronyms haven’t exactly settled. For Moody’s they’re MCFVs (Multi-Credit Fund Vehicles). For the NAIC, they’re “multi-collateral structured credit investments”. If and when Apollo’s competitors bring out a copycat, they won’t want the PADS and MAPS brands, for doubtless their own structurers will want to signal clear space between the Apollo structures and others. BMAPS and KMAPS are surely being contemplated, but under different nomenclature.

The NAIC, the US insurance regulator, has been looking at these structures, and trying to figure out the risks that might be posed — specifically the duration mismatch inherent in building a 40-year bond collateralised by much shorter assets. It’s a consultation that’s attracted significant attention in the CLO market, which also constructs longer bonds out of shorter assets, relies on insurance capital, and rests on the ability of managers to actively reinvest.

In CLOs, there are structural guardrails against relying purely on the manager — coverage tests and post-reinvestment amortisation for example — so any final rule which targets APADS-style vehicles but not CLOs will have to get deep into the weeds.

The Structured Finance Association also flagged possible impacts on other asset classes, such as credit card ABS, floorplan facilities, CRE structures, and rated feeders, and outlines how a Ginnie Mae MBS would fail the NAIC’s proposed self-liquidating test.

While the NAIC’s concern for insurance balance sheets is kind of its job, usually the thing that blows up financial institutions is the other kind of maturity transformation — unstable, short-term funding against long-term assets which can’t be called in. Much of banking regulation is dedicated to putting guard-rails around banks’ ability to do maturity transformation.

For society, banks provide a vital service in this respect; the preference of individuals and corporations, the users of the financial system, is almost always to be able to withdraw their money at will and borrow for a long time on stable terms. Sight deposits fund 30-year mortgages.

Apollo is on both sides of the business of maturity transformation. The firm, as with most of its competitors, has been raising retail money to invest in private credit and asset-based finance — and, as seen earlier this year, some of that cash has a short time horizon. Redemption rules mean that it can’t run like bank deposits, but it can be awkward when it tries.

APADS runs the opposite way around, funding a collection of credit assets with liabilities whose tenor massively exceeds that of the assets involved. In finance generally this is a counter-intuitive move — long liabilities generally cost more, so that should reduce excess spread — but in this case, there’s still a lot of space between the earnings on the credit assets and the cost of the IG liabilities — and duration (the “duration solution” of the deal designation) is more important than this potential reduction.

While it’s reasonable to want guardrails to ensure the collateral pool remains topped up, this shouldn’t be beyond the wit of structurers. Even with a 40-year bond and eight year collateral, a combo of overcollateralisation, amortisation triggers, and servicer-step in features should be able to do the trick.

But the really big picture for APADS is that perhaps there doesn’t need to be as much maturity transformation in the world.

Right now, sponsor-backed private credit and bank loans are seven-ish years long, but that’s just down to historical contingency. It’s not a law of nature, but a product of fund lives often being seven-ish years and accumulated market convention. Lots of credit assets are already appreciably longer, but maybe there is an underserved category of borrower that would actually love to raise 20 year money, but ends up in a circle of refinancings driven by market convention. Create a “duration solution”, and you might end up with a more stable financial system in the aggregate.

Kind of Blue

It’s a rare thing to have a servicer insolvency in a public ABS transaction. While bankruptcy remoteness is kind of the whole point of the market, it’s not usually given a proper test, and comes bundled with so much other complexity that it can be hard to unpick. Bankruptcy is never simple!

We do, however, have an example in Blue Motor Finance — though one which raises its own complex questions.

Blue is the first and so far only casualty of the FCA’s Motor Finance Redress scheme — its assessed £55m redress liability was enough to prevent directors giving a clean solvency opinion, which meant in turn that it couldn’t find a new funding partner after Shawbrook closed its facility in January, and was in technical default on its Hodge Bank forward flow. Hodge waived the default to allow a potential sale process for the business, though this ended up in Hodge itself winning the bidding.

This illustrates the problems of the whole redress concept — although the scheme itself was paused, and is subject to legal challenge (it might not even happen!) the non-cash, uncertain possibility of the redress was enough to take an otherwise healthy and successful specialist lending business into insolvency.

The Hodge outcome doesn’t seem to have been bad exactly — the employees are still employed, origination is still running, the business is functioning — but it’s definitely bad for any possible redress claimants!

According to the administrators report, the sale price was £15m, which, along with a pool of NPLs, is the main source of funds to cover potentially £55m or more of redress claimants, the main liability left with the company.

But what happens to the roles of the Blue Motor shell in its remaining public transaction, Azure No. 3? There’s not much left of the deal, which was done in 2023 — the senior classes have all amortised down, and there’s only £16m of bonds left.

Blue Motor is still technically the risk retention holder, according to investor reports. My inexpert read of the UK risk retention rules doesn’t seem to actively prohibit an insolvent entity from holding a risk retention.

Doesn’t look to me like you can structure a new deal with an insolvent risk retainer — the sole purpose test includes a line about “capacity to meet payment obligations” which would seem to preclude this, and honestly it would be a very weird thing to do.

The only mention of insolvency in the FCA handbook concerns the ability to transfer risk retention in insolvency (you can, but it does not specify that you must). That seems logical enough; investors in ABS should be minimally exposed to servicer insolvency, that’s the point of investing in bankruptcy-remote products, so making them forced sellers of bonds in this scenario would be a bad outcome.

According to the administrators’ report on Blue, though, it only actually holds £95k of Azure notes — meaning its presumably still a counterparty to a repo provider financing the rest of its risk retention bonds.

The administrators mention a charge in favour of Morgan Stanley, the arranger of Azure 3, noting that “There may be sufficient coverage (i.e., value) in the underlying collateral such that the charge on the Company is not enforced”. It’s not clear, though, from the notice, whether this relates to a risk retention repo.

The insolvency of Blue technically allows bondholders to perfect title, though a notice this week recommends against it — aside from the administrative cost, this would make the SPV the lender of record for the loans, with at-best uncharted implications for motor finance redress.

Instead, the plan to collapse the deal rests on the clean-up call, which Blue still holds the right to execute. The administrators are seeking a funding partner who can back Blue’s exercise of this option, fund the loan purchases and redeem the deal.

It’s likely to be a bit of a niche interest — a subscale package of loans from an originator that’s not going to be back in the market — but at the same time, the portfolio will likely pay down quick. The most logical counterparty, as with the opco, is surely Hodge, which has lots of other Blue-originated collateral.

But it’s an interesting journey. Azure investors will likely be made whole, not via the collateral mechanisms built into the deal itself, but by the actions of a company-level administration team, and by a hopefully buoyant market for a whole loan package. It’s bankruptcy-remote, but not at all remote from the bankruptcy process.