Lendco’s Adrian Scragg on MFS and Iran conflict

The fallout of MFS entering administration, how Iran war is affecting the market and CLO managers’ software headache

Transcript

SPEAKER_01 0:06

Hello and welcome to the Not Funnet. I'm George Smith, Global Capital Securitization Editor, and I'm joined by our European ABS reporter Topple and a very special guest this week. We have Adrian Scregg with us, who is Director of Treasury, Capital Markets and ESG at LENCO. LENDCO is a well-known name in the UK RBS market by To LED issuer from its Atlas program and also a bridging lender. And this is, of course, the fall into administration of Market Financial Solutions, which is uh another UK bridging lender. Um at this stage, the kind of causes of what's gone wrong there are still a little unclear. And um a spokesperson for the firm gave us a statement last week. Well, I guess we're recording this on Thursday the 5th, so by the time you listen to it, it will be two weeks ago. But saying that the CEO denies fraud categorically, but you know, that the this is a firm that's been backed by a number of the biggest names in in the European securitisation market and and has now entered administration, which is quite a shocking turn of events at the very least. What do you think is the kind of immediate fallout of this, Adrian? Is there something that you expect to kind of dent the demand for specialist mortgage lending among investors in in Europe?

SPEAKER_00 1:42

I think in I think in aggregate, no. Um, but but I think I think where people choose to invest he's probably going to be affected by this. You know, I think I think we've we've seen over the last couple of years an ab an abundance of appetite for people to get into bridging because they've seen it as maybe an easy opportunity to to tap into a higher yielding product. But I think the you know the nature of a lot of uh a lot of fledgling bridging lenders, you know, may in terms of perhaps lack of controls, perhaps perhaps being new entrants to market, and a certain amount of fragility is going to make a lot of the larger institutions maybe think twice. But again, I think I think what we'll probably see in my view, the next six months or so is a reset in what people need to get comfortable to lend to people in this space, and then you know, pr pr pr perhaps we'll see things relax again.

SPEAKER_02 2:36

Yeah, one of the interesting sort of things around this is I mean, do you expect, you know, sort of late fur quality, all the sort of cash will go towards, you know, a lot a lot of the bigger names in the market, and we could kind of see a consolidation of the bridging sector.

SPEAKER_00 2:53

Yeah, I think I think if you'd have said to me three or four months ago, what would you expect to be the biggest change in the bridging market over the next 18 months, I'd have said, I think I'd have probably said consolidation anyway, because I think for a number of landers out there who you sort of felt had smaller balance sheets were feeling compelled to to be more sort of on the higher end of the risk curve to get traction in the market and all of those things. So I think like I I was sort of expecting that anyway. I wasn't expecting it for this reason. But you know, if if if you look at even even in the last week, you know, we've had lots of inquiries around bridging from people who've had you know partially progressed bridging loans from MFS. So I think you are going to see some consolidation. And I think more directly to your question, if a lender has already done their due diligence on an organization and they're comfortable with the way that organization works and they feel like they have transparency in the entity structure and they can see the cash management all working and all of that, then if their dilemma is to do I fund that lender at maybe a more competitive cost of capital versus a more a more risky venture with the new and with somebody new, they're probably going to do the former right in. So I think it could he could present some opportunities for well-established incumbents.

SPEAKER_01 4:25

You mentioned due diligence there, uh kind of asking me. Is that something that kind of you expect to get more rigorous now? And and investors kind of double down on that due diligence and also get on writing and governance elements of that process.

SPEAKER_00 4:41

I I think the interesting thing is maybe the the traditional things that lenders are focused on in due diligence don't don't address this particular challenge and problem that we've seen. And I think if you boil it down to what is the challenge and what do people need to get comfortable with, well, it's do I have an asset that's pledged to me and only me? And at that point, then only at that point that we then get get comfortable that the the advance rate you're giving that borrowers there, and you've got the right amount of security. And I think you know, I I I've I've had quite a number of conversations with third parties in the industry over the last few days about potential solutions and things like that. Um what what is interesting is actually in in our world, and my world of mortgages, it uh and probably autos, it's probably quite a simple thing to address because every car has a VIN, it's unique. Every every property has a land registry idea, it's unique. And as long as you can demonstrate to somebody that on any given day the same lender's not across the same two VINs or the same VIN or the same leg registry idea is fine. I think where you know where where we have things like the stand thing a few months ago is a bit more complicated because that's about something that that you can fabricate, something like a trade received receivable. But I think what what I like to see happen, I think, if it is a number of lenders um start to actually take matters into their own hands, lend lenders being recipients of capital uh in the middle rather than um that can lend us to lenders, and actually start thinking about what what can we do around our assets that gives our funders confidence proactively rather than have, I think, you know, potentially some scatter gun solutions rained upon us because that could be quite expensive and inefficient.

SPEAKER_01 6:38

Yeah. You think some of these, I guess, you know, like people are always talking about different tech solutions and blockchain and and tokenization and that sort of thing. Do you think any of them have promise or potential as like actually being useful in in addressing these kind of concerns?

SPEAKER_00 6:54

I I think I think I think yes. I think tech can always help. And I think you know, wherever you can create a situation where you've automatically coded up uh an asset to its funding and and you've said, you know, the the the these two items, if they're unique, it it can help. I think when you look at things like tokenization in in terms of the more traditional sense, where where they're about anonymizing data to get it um how can I put it, you're putting rigor around data and anonymizing it. I think the anonymous the anonymization piece is probably less relevant here. But I think I think it's more about, yeah, if you can, in an automated way, compar those things that give credibility to the asset to the funding, and then you can host them somewhere where you can compare them to other funders and other lenders in a way that's not compromising security and sort of confidential information, then then that's a win. How you do that and getting that buy in from the from the industry is obviously always the challenge.

SPEAKER_01 7:56

One of the other angles to all of this is that you know, how increasingly like there was a bit of momentum around people trying to fund bridging in the public markets, and you know, there was that deal from Cerberus in the Netherlands at the end of last year, a little bit of bridging in a mostly bite of that kind of popular. Do you think this news sort of ends the prospect of a public deal in the UK for the for the time being?

SPEAKER_00 8:22

It would be a shame if it did for for that reason. You know, I think I think when we sp when we spoke previously, and we talked about bridging and suitability of bridging to public markets. And my view's always been that it's probably not the best fit, but not for any of those reasons, just because it's a very short-dated asset and it doesn't match doesn't really, it's not a good fit for public RMBS from that perspective. But I think one of one of the things that we've been feeding back to funders about, again, why uh there's quite a low risk of double pledging in buy-to-let is because uh buy-to-let portfolios tend to be securitised every eight or nine months. And if you had double-pledged 150 million of assets, when you come to make a 300 million pound deal, you would quickly be in a tight spot. So I think that you know the point being actually people coming to public markets with collateral uh actually demonstrates there's not a problem. So it's probably would would be the opposite, paradoxical.

SPEAKER_01 9:31

Well, that has obviously been one of the bits of unwelcome news for the for the market, but this is also kind of sort of double blow at the same time as a kind of lot of very kind of broad market velocity that that's made a return kind of after what was quite a strong start for the for the public markets, you'd say, so far this year. And that's as a result of the US and Israeli strikes on run and the kind of escalating conflict in the Middle East. I guess at a high level, kind of how do how should issuers sort of view the market at a time where you know there's a lot of volatility around, you don't necessarily know kind of where levels are going to be one week to the next, or or even like I guess whether the market's open, although it does seem like it is um through this through this crisis.

SPEAKER_00 10:18

Yeah, I was I was lucky enough to to to to catch up on the syndicate desk over there because of the stay also and um sort of had had that similar conversation with them. And I think what we've we've seen increasingly is this this sort of um robustness around these these socio-political events, and you know, that this it it almost seems like the physical pause to to to any of these actions is becoming briefer and briefer. You know, I think you know the markets were closed uh sort of Monday for a day, and then things started to open up. And yeah, I mean I th I think that the the binary aspect of with can you or can't you sell paper is sort of seem seeming to to to not be the challenge. I think where investors and issue is about having a challenge around these events is the as you mentioned, it's the levels. So, you know, I think I think we'd see uh scarce supply in Jan and Fab. And I think we'd seen uh a bit of a certainly in my you know in my world of fight to left, which we'd seen what low 70s, probably expecting deals to all to probably come inside that 70 area on senior, which it's again would have would have would have been inside where we got to last year. And then today I'm I'm I'm hearing talk of you know 75 to 80 sort of areas for the seniors in that space. So yeah, I don't think it's whether people can bring papers to market or bring bring bring deals to market, it's whether it's where they price them. And I think there that there's there's the challenge. But you know, I I was I was unfortunately out in the market who during the uh liberation date uh last like last year, and I was I was out in the market trying to price a deal on the Fridays, and it was uh it was a tough, lonely place. But but I'd I'd say you know, maybe maybe a year or 18 months prior to that, I I maybe wouldn't have I wouldn't have got there. So it definitely feels like there was there was a resilience to it.

SPEAKER_01 12:18

Do you think it would kind of I guess it does seem like the market is showing a bit more resilience and and do you think that's something that's changed in the mentality of issuers, or do you think it's something to do with the investigation? Like, what do you put that down to?

SPEAKER_00 12:32

I th I think both both move in parallel and uh can sort of support each other, don't they? I think because because it it feels like maybe there's a slightly more of a shortage on the on the issuance side. It's not being flooded as much, but it does seem like there's just more and more and more cash to deploy. And I think you know, if you're an issuer, you have this dilemma, don't you? Shall I come to market at a point where I might not sell my bonds? People are not going to do that because they don't want the, you know, it it it's it's slightly embarrassing for a program if you'll if you're the deal that's out there that doesn't get done. But also, you know, there's the risk, there's the cost, there's the expense. I think because people are feeling the issue is a feeling like is this resilience there and they feel like investors will still participate, they're more willing to take the chance.

SPEAKER_01 13:25

I guess finally, from a from the perspective, what when you know it's the human kind of geopolitical risk and and the kind of exposure to like things that are just completely out of control of like anyone at a UK mortgage lender uh has gone up again with this uh this escalation. Do you think it's time to kind of take a more cautious approach and maybe like add warehouse capacity or or other options to I guess kind of give yourself a bit more headroom and a bit more flexibility in approaching the market?

SPEAKER_00 13:58

Yes, to an extent. I think as a as a as a as a lender, you've got you've always got to to strike a delicate, delicate balance between taking lots of capacity and then being cost inefficient by running that capacity. And you've got to temper that with, well, if I'm in a world where I think I've got systemic stress in the market and I might not be able to get there within six to eight months, you know, it it's always seen as a thing you should never say. But should you not just dial down production a little bit on the basis that you're you're creating stock that you may not be able to deploy out into the markets anyway? So it it's a tie rope. But I think you know, all things being equal, yeah, if you today you might want to take an extra 20-25% aheadroom to to where you might have been a year ago just to shore things up and especially this time of year, because you always have that, you know, that dynamic. If I can't go to market in June, I probably don't really want to go in July and August. So I need an extra three months to to take me through the summer cycle.

SPEAKER_02 15:09

You know, what one kind of interesting thing I think for the sector has been, you know, a a lot of kind of banks are kind of getting into buy-to-let lending, whether that be through like, you know, obviously Elmon getting the banking license and becoming Vita Bank, or whether it's, you know, like Barclays uh acquiring Kensington. I mean, do you do you think there's you know, is is that sort of I mean not like a not like a threat to the sector, but I mean d is it kind of an interesting thing where you know it seems like banks are some, I guess, you know, I mean I guess that maybe that's part of the reason why you know bridging is is gaining popularity because you have you know specialists who are are able to offer these high high-yielding you know products. But I mean, yeah, what what are your kind of thoughts on that?

SPEAKER_00 15:54

I I I I remember sitting with investors in in 2016, which yeah, is it's good because it's uh well, 10 years ago, and and being asked similar questions of what what do you see is the biggest threat? And I remember uh how how can consistent uh response was a major high street bank actually getting into the buy-to-elect sector and and and doing wealth. And sort of 10 years on, it's not really happened. And I think I think part of the reason is that the well of capital they're willing to lend is deep, but but it's it's not a wide well in terms of the the the criteria piece. So, you know, they they they're often limited on on their exposure to individuals. And what what what's happening there is they're not able to fully serve the segment. And some of that is because of the capital rules and the capital treatments around the loans, some of that's in terms of policy. And what what's happening with a lot of those same institutions, actually, they that they can now lend let lend to lenders via warehouses and it starts to make sense for them. So I I think until until they can get parity with the specialist lender market in terms of what they can offer the brokers and offer the borrowers, that they're always going to have this disadvantage. But again, I stand by what we said 10 years ago. The minute somebody does crack that nut and they manage to make it happen, it will be a challenge for my sector because they should have you would think they would have cost of funds advantages.

SPEAKER_01 17:25

Well, thank you so much for joining us, Adrian. It's been a a super interesting and I think very timely interview.

SPEAKER_02 17:35

We are back uh because no episode of Another Fine Meds would be complete without a little a little word on CLOs. And luckily I'm joined by our CLO reporter, uh Thomas Hopkins. How are you doing, Thomas?

SPEAKER_03 17:50

I'm doing very well, Tom. And yeah, I'm I'm very pleased not to have been there, sort of left out of this this episode. You know, it's uh it's always good to sort of uh champion the the the CLO cause. Um and uh I am going to be away all of next week as well, so there will be nothing from CLOs uh next week. So yeah, pleased to be here.

SPEAKER_02 18:08

Yes, excellent. Uh it'll be like uh the the old days when it was just just me and George going going through the struggle of just two people on the podcast. But uh we we'll do our best to try and keep the the CLO coverage uh up while you're gone. And uh yeah, obviously wishing you well on your holiday. Uh but this week, I mean, you know, mo most people have been talking about you know the Iran conflict, and it is what uh George, Adrian, and I were speaking a little bit about earlier in uh the episode. But you've really been writing a little bit more about sort of software. And you know, I I guess my first question on your story this week is you know, why are CLO managers so concerned about you know software loans in their portfolios?

SPEAKER_03 18:50

Well, yeah, thanks, Tom. Yeah, I think certainly while we have kind of covered the Middle East conflict in relation to CLOs this week, you know, and there there was kind of I think a bit of a slowdown in in to new CLO issuance and maybe some sort of wider pricing on the junior mezzanine tranches as a result of the Iran conflict. CLO managers are actually a bit more concerned about software leveraged loans right now than they are about, you know, the conflict in the Middle East. It's not that the conflict is irrelevant to CLOs, it could have an impact on their portfolios. But what's been a bit more of an sort of an enduring um kind of crisis for CLOs uh over the last month or so, you know, is software. And the reason for this is sort of following Anthropics release of kind of a new plug-in for its clawed co-work kind of AI tool, I think basically the whole sort of CLO market and other sort of leverage loan investors as well kind of recalibrated how they kind of think about the risk posed by AI to sort of software companies. You know, you tend to think of software companies and AI as being part of the same sort of universe, and they can be. But what's interesting is that what the view that the market is increasingly taking is that AI could potentially just easily replicate some of what these software companies, you know, sort of just do, uh, you know, the services they provide. And what this translates into is a slightly less viable business model. If you have a less viable business model, you're more likely to default on your loans. And so this has now become a bit of a problem, you know, and it what it prompted is kind of a mass sell-off of any software, you know, basically any software leverage loans, any any names kind of linked to software in any way. This started in early February, but the reason we're still writing about it really is that I think initially the market maybe thought this was just a kind of overreaction, you know, a new AI model got released, and you know, maybe the market overcorrected. But actually, what market sources are saying to me now is that the way in which the market is thinking about this is as both a kind of a long-term issue, an enduring problem for CLOs and other leveraged loan investors. And secondly, that there's more nuance developing as to kind of the different types of companies and how they're basically affected. And so uh, yeah, that that's kind of how market participants' understanding of AI's impact on software has sort of evolved over the last few weeks.

SPEAKER_02 21:19

Yeah. So I mean, you're obviously talking about, you know, it's it's getting a little bit more nuanced. I mean, are there you know any specific types of software companies that are you know getting particularly affected by the development of AI?

SPEAKER_03 21:33

So yes, uh, and particularly software as a service or sort of SaaS companies, you know, are are sort of most affected. Uh or that the you know, CLO managers are kind of scrutinizing those companies in particular. And the reason for this, you know, software as a service businesses sort of basically offer kind of like cloud based um services to consumers and companies, and essentially the A concern that AI can just sort of replicate the service that kind of these SaaS companies provide at a kind of fraction of the cost. Because often, you know, if you have a kind of cloud-based system that you use as a consumer or company, you kind of often like pay a regular subscription fee to access that that you know that cloud-based software. Now, if you can just access an AI model that can develop a similar system for you very, very quickly, and you know, things like Anthropics Claude co-work tool are demonstrating that this is increasingly possible, well then you know these existing SARS companies' business models are just like you know completely redundant. BNP Parabah has sort of identified a bit more of a threat to what they call kind of vertical SARS company companies versus horizontal ones. Now, the threat sort of applies slightly less to the vertical companies than to the horizontal ones. And the reason for this is that the vertical model is sort of sector-specific, whereas the horizontal is kind of cross-sectoral. Now, it it's slightly harder for an AI tool, there's a sort of greater barriers to entry to replicating a kind of vertical SARS business model. And this is because, you know, if you've really tailored your software as a service, you know, the software as a service system that you provide to one very specific industry, that's going to be harder for AI just to replicate or reproduce because there's a whole lot of sort of deep sector industry knowledge tied up in that, you know, is just more difficult. Whereas if it's something that's designed to be broad-based, used by a whole lot of different industries and things, that is something AI probably would have less sort of difficulty with uh with sort of reproducing. Um additionally, that there are some other areas where market participants are sort of thinking that you know some particular software businesses will be sort of more affected and some less affected. So, for example, anything where businesses sort of software businesses have proprietary data, they're proving to be a little bit more resilient because sort of businesses with exclusive data that sort of can't just be scraped by AI bots are definitely more insulated from the sort of threat posed by AI. Whereas, you know, companies, things like sort of travel websites, the sort of financial administration, you know, kind of back office services, research analysis, these are all kind of under threat from AI because they are all sort of you know tools that an AI could simply develop quite quickly. And uh yeah, sort of anything involved with cybersecurity and data protection is a little bit less likely to be affected. And so you're seeing this sort of with the leveraged loans, you know, they can be trading down between you know, sort of two or 15 points, depending on how investors, you know, how CLO managers leverage loan investors are thinking about you know the impact of AI on the underlying borrower. So there's a sort of differentiation in the market at the moment about you know the different types of software companies and the impact AI has on them.

SPEAKER_02 25:01

How's the weakness in software credits uh impacted CLO so far?

SPEAKER_03 25:05

Well, there was a certain lag time initially when this sort of crisis started. In fact, you know, in early February, we were still talking about how CLO liability pricing was kind of tightening versus the end of last year. And that's because, you know, obviously it does take a while for something like the software crisis to sort of trickle down through kind of you know asset spreads, asset prices into CLO liability pricing. But we have now seen spreads widen. So um, you know, and and right across the capital stack. I mean, sort of data from Acunio Credit Management sort of shows average spreads rising month on month in February, sort of between February and uh and January. And this is right across the capital stack. I mean, as you might expect, the junior MES tranches widened the most because, you know, the junior mes tranches have the sort of first loss position of the CLO debt tranches. So, you know, we saw single B tranches widening um by 110 basis points, double B's by 45 basis points. But, you know, even on the AAA's, you saw sort of you know eight basis points of widening. And this is all I should say in secondary market trading. That we have seen, you know, sort of some slightly wider trades in primary, but you know, the market's been a bit slower this week, certainly because of the Middle East conflict. So it's slightly more difficult to tell with primary, but certainly in secondary market data, we are seeing wider spreads. Um, we've also seen sort of investors actually sort of struggle to sell uh their liabilities in the in the secondary market. You know, some of the B Wicks that have been put forward just simply weren't uh traded in the end. And um certainly what's also happening is that investors are, according to a lot of market sources, just kind of telling CLO managers to sort of steer clear of software names. And what this is doing is sort of reducing uh the kind of pool of loans that CLO managers have to sort of choose from. And, you know, this has been a kind of enduring problem actually for European CLOs is that, you know, what with a lot of the leverage loan market pricing at par, there are kind of fewer leveraged loans that are good quality that they can sort of buy at a lower price and then sort of build par in their portfolios by sort of seeing these good quality loans appreciate in value. So it's sort of made it even harder for them to make the arbitrage work in their portfolios and the sort of wider pricing. Because the thing is software is a pretty major sector in CLOs. You can't just avoid it very easily. So you've got the wider spreads and the and you know, a further compressing arbitrage, which is certainly something we've talked about on this podcast before.

SPEAKER_02 27:36

And so, you know, how are CLO investors, you know, responding to the threat of AI in software companies?

SPEAKER_03 27:42

So investors, I think, are responding in a couple of ways. I mean, in simple terms, they're just sort of they're trying to sell positions in CLOs that have got more exposure to software. They're also, I think, sort of rewarding managers that exercise a bit more discernment in sorting the stronger software names from the weaker names. Um, I think they're preferring sort of to invest in charges with higher levels of credit enhancement to sort of insulate themselves from portfolio losses. And then sort of European CLOs are likely to be a bit more attractive to investors than sort of US CLOs at the moment because the US is sort of so dominant in software development globally that US CLOs tend to have more software exposure than European CLOs. So that could, you know, eventually kind of end up benefiting European CLOs, actually. I mean, look, European CLOs are certainly very affected by the software crisis, but investors that invest in both US and European CLOs might eventually kind of exercise a preference for European CLOs. And then I suppose the sort of the final thing to note here is that, of course, some software companies do actually stand to benefit from AI if they can sort of integrate it profitably into their products. You know, canny CLO managers that can pick up those stronger software credits sort of cheaply now will improve their long-term returns. But that's not a strategy that I think is going to impress investors very much until we sort of see a kind of pricing floor for these software loans. And that I don't think has happened yet. This this the AI is developing so fast that it's proved quite difficult for investors to price and calibrate the risk. Yeah.

SPEAKER_02 29:14

Okay, well, excellent. Well, if anyone wants to read that, it's called Software Headache Worsens for European CLOs as AI threat grows. And that's available to read on the global capital website. So uh, well, I I guess uh you know it's been a pretty jam-packed episode. We've had Adrian giving his thoughts on the full of market financial solutions and you know the situation with Iran. We we've had you know a word from Thomas on CLOs, so uh I guess uh all all that's left to say really is uh if you need to get in touch with us, the email format is firstname.lastname at global capital.com. And uh we'll we'll see you next week. Goodbye. Goodbye.