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Zach Cooper

Building alpha, brick by brick

James Williams interviews the new wave of managers in the mortgage backed securities (MBS) sector.

Zach Cooper (pictured) is Deputy CIO at Semper Capital Management, a New York-based structured credit specialist that invests almost exclusively in North American RMBS, CMBS and other asset-backed securities. He is fundamentally positive on the mortgage backed securities (MBS) asset class.

“Residential and commercial real estate in the US is by and large doing well, meaning that collateral is increasing in value, which in turn serves to improve the value of the bonds in this universe,” Cooper says.

In operation since 2011, the private hedge fund advised by Semper takes both a bottom-up and top-down approach to the market, looking across sectors to try to optimise allocations in the portfolio to generate risk-adjusted returns. 

“We do that both by spreading trades across asset classes and also by moving across different parts of the capital structure within those asset classes. If I were to differentiate what we do, at least in recent times, we have stayed more in shorter spread durations. We have avoided really deep credit, which offers a higher yield but also higher risk. We strive to find a sweet spot in the risk/reward part of the curve, which shifts depending on what is happening in the market,” explains Cooper. 

Mortgage backed securities consist of diverse pools of mortgages originated by banks, mortgage brokers or specialist investment managers, which get sliced and diced in to different tranches and sold as bonds to institutional investors. Each tranche is rated by Moody’s et al, the most secure AAA-rated layer (known as the senior tranche) representing the lowest risk/return profile. The equity tranche is the most risky layer, in which the underlying mortgages have the highest probability of defaulting. 

As such, identifying which are the best bonds to buy is a deeply complex process given the sheer diversity of each CMBS or RMBS. It is not, for example, possible for investment teams to analyse where the best buying opportunities might be in the New York residential sector, or the San Francisco commercial real estate sector. Each bond that is selected performs based on a slew of mortgages that will often span the entire country.

“However, there are things one can capitalise on. For example, right now a lot of US residential markets are approaching the high-water mark for home prices, the first time since the sub-prime crash. In other words, homes are moving back into positive equity territory. 

“That is very encouraging for the legacy RMBS market where one can still purchase these securities at a discount. 

“Another dynamic that we like are low energy prices. This is disproportionately advantageous to smaller mortgage balances because fuel is one of the biggest expenses of any household. Low gas prices are helping to improve the credit profile of borrowers whose mortgages might otherwise have transitioned from current to default,” explains Cooper. 

The securitisation market became toxic, for good reason, in 2008. But time has passed and institutional investors are once again looking closely at MBS strategies that can offer attractive yield enhancement opportunities. 

Such is the recovery in sentiment that JP Morgan Chase & Co is preparing to securitise USD1.9 billion of residential mortgages. As the Wall Street Journal reported on 14 March 2016, the bank is looking to retain the most secure tranches and sell the rest to investors, and would represent the first house transaction since 2008. 

Discussing current market opportunities, Cooper says that while the overall RMBS market got fully priced in the first quarter of 2015, since that time spreads have gradually widened out. 

“We are optimistic that we will find some good values as a result of that this year. In addition, one of the by-products of regulation is that in a lot of the newer products being offered, as the banks are less involved than they have been historically, the markets have fragmented. As a result we are seeing smaller deals from smaller issuers and these tend to be more conservatively underwritten and generally trade cheaper; although right now the opportunities are more in ABS than RMBS,” says Cooper. 

In the UK, an interesting dynamic is underway. As Cooper alludes to, regulation such as Basel III is restricting the amount of risk capital that banks are able to put to work. As they scale back their lending activities, alternative loan originators are emerging, often in the form of specialist credit/direct lending managers. 

The UK real estate market is still in the dark ages relative to the highly developed institutional debt market in the US. But that is now changing. The direct lending and securitisation markets are converging, creating plentiful opportunities for asset originators; i.e. those that are creating RMBS and CMBS vehicles. 

One such investment company is London-based Venn Partners, an alternative real estate lender who last year was appointed to the UK Government’s GBP3.5 billion private rented sector (PRS) guarantee scheme. The scheme, simply put, is designed to fund new-build private rental housing projects across the UK. 

The first PRS bonds, backed by the UK Government, are expected to be issued later this year, giving rise to an entirely new securitisation asset class. 

“We think securitisation and direct lending is becoming an interesting space in Europe. Non-bank lenders are becoming an ever more significant user and part of the securitised bond market,” comments Richard Green, who heads up the PRS business at Venn Partners. 

Green is in no doubt how big an opportunity this could be.

“One way to think about the PRS scheme is one large CMBS, the difference being you are not selling bonds to credit investors but to government bond investors. On one side we are responsible for originating, underwriting and managing a variety of loans and on the other side we are issuing a series of bonds. We have GBP3.5 billion of capital to deploy in the scheme, which is done through an investment vehicle called PRS Finance Plc, a subsidiary of Venn.

“Once all that capital has been deployed, we may look into creating PRS Finance Plc 2.0 and issue bonds that are part of a true CMBS (i.e. no government-backed protection), as is common in the US,” explains Green.

He thinks that more asset managers will inevitably look to lend in this way, which after all has been happening in the US for 30 years or more. Nevertheless, with the PRS up and running, the UK’s RMBS securitisation market looks set to develop in the next five to ten years, according to Green.

“The growth potential is enormous. Knight Frank estimates that the current multi-family rental market size is GBP5-10 billion and that by 2020 as much as GBP50 billion could be invested. This has the potential to become a genuine, standalone real estate asset class. 

“We hope to have our first PRS bond – around GBP200 million – issued in summer 2016 and become a regular issuer of bonds thereafter as the loan pipeline builds out. Our loan sizes range from GBP10 million to GBP100 million for real estate developers across the UK,” explains Green. 

For investors, one of the biggest challenges is coping with the sheer size of the MBS universe. Key to any successful MBS strategy is the ability to capitalise on the lack of transparency on the bonds that are issued. Unlike corporate bonds, where the markets are highly visible on a relatively small number of large issues, with MBS one is talking about tens of thousands of small bond issues that need to be assessed to determine their value. 

“Two deals issued at the same time with similar collateral will have small differences and over the years those differences can become exacerbated. That is where the trading skill comes in to play,” says Cooper, adding that selecting the best bonds for the portfolio always starts with the collateral. 

“The first thing you need to do is have a view on the expected performance of the collateral based on voluntary repayments, defaults and the recovery of those defaults. That and what the market prices are for the various parts of the capital structure will help to determine where we think the best value is. 

“Following that we will then run upside and downside stress scenarios to establish a base case return and to make sure we don’t exceed our maximum risk exposure. When it comes to identifying entry and exit points, everything is traded OTC so to an extent you have to be reactive and opportunity-driven. The entry and exit points will move around based on the opportunities being presented in the market. When the market gets a little overbought we will look to reduce our risk exposure across the portfolio. At other times, when the market gets oversold, we will look to increase our risk exposure,” outlines Cooper. 

On the commercial real estate side of things, Venn Partners is benefiting from the bank deleveraging programme that is underway, not just in Europe, but globally. Venn is able to invite institutional investors to invest in whole loans that they originate, typically in a managed account arrangement. Or, if they prefer more levered, private equity-like investments, investors can choose to provide equity to a CMBS alongside Venn’s own balance sheet, with Venn funding the remainder of the CMBS via the bond markets. 

“We actively look to see where we can create the most efficient liabilities. In some circumstances that might be working with a fund format, it might be with whole loans, it might be with a securitisation product,” says Green. 

Over the past seven years, Venn Partners has worked on approximately GBP1.4 billion of commercial real estate deals, including a GBP97.5 million debt facility to fund the construction of HUB’s 360-home Hoola-London development at Royal Docks and providing the funding for Meyer Bergman’s GBP20 million acquisition of Thames House on London’s Southbank. 

“We have used managed accounts for investors to get access to the loans we originate to commercial real estate. However, this year we successfully launched our first fund – a private equity-like closed ended fund where each investor is a limited partner – and money has been deployed into a number of commercial real estate loans. We have gone through two rounds of asset raising and we have allocated about 85 per cent of the fund’s committed capital. We expect to do a final close later this year,” confirms Beatrice Dupont, a senior member of Venn’s Commercial Real Estate business, adding that the fund’s target AUM is EUR250 million.

The fund will focus on a combination of senior and mezzanine loans, targeting high single digit returns. The investment term is five to six years.

With the US RMBS and CMBS market in resurgence, and asset allocators such as Venn Partners capitalising on the securitisation potential of multi-family private rental schemes in the UK, there are plenty of opportunities for investors to build alpha in their portfolios, brick by brick

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