CREDIT TRADES DU JOUR: EXOTIC, "NONLINEAR" AND PRIVATE / THE WALL STREET JOURNAL

Credit Trades Du Jour: Exotic, ‘Nonlinear’ and Private

Investor thirst for yield fueling market in private, structured, bondlike deals

By Paul J. Davies


CHANGING BALANCE
Investment Banks and market revenues by source

The hunt for yield is taking Wall Street and investors into exotic territory—and that means an appetite for credit assets that are private, not easily tradable and often complex.

Putting together deals in what some dub “nonlinear finance” is a growth business for investment banks’ big bond-trading arms and is helping clear unwanted assets off some balance sheets. However, such private deals, which aren’t publicly traded and don’t have public credit ratings, are a challenge for regulators keeping track of the growth of shadow banking and to understand whether such activity is driven by regulation—or its avoidance.

“Nonlinear finance” deals aren’t new, but it is heating up as banks, such as Goldman Sachs, hire specialists and commit balance-sheet capacity to feed investor demand. Photo: brendan mcdermid/Reuters 


The business isn’t new, but it is heating up as banks hire specialists and commit balance-sheet capacity to feed investor demand. Goldman Sachs said in September that it could double its financing of “bespoke collateral” by giving its fixed-income trading arm an extra $5 billion worth of balance-sheet capacity. This would bring in at least an extra $100 million of revenue, which likely only counts the net interest income Goldman would earn on debt it keeps and not all the other deal fees involved.

Deutsche Bank is a market leader in this business earning roughly €400 million each quarter from all the financing linked to fixed-income trading including nonlinear trade, while others such as Credit Suisse or BNP Paribas are more focused on certain products or regions.

So what is this business? It starts with lending to private-equity or hedge fund clients who want to buy an assets that are hard to value, hard to sell, or low quality. Such assets can’t be financed in markets by fixed-income trading arms in the traditional way that liquid, high-quality are.

The hot assets right now include pools of European bad loans, other private loans, large property deals especially in the U.S., and things like infrastructure assets in emerging markets. Some come from weaker banks’ balance sheets, but many are being found by investment bankers, or the hedge funds and private-equity firms who anchor the deals. Investor demand for such assets is outstripping investment banks’ ability to find the assets right now, according to one banker in the field.

Banks slice the financing into tranches. The riskiest equity slice is owned by the anchor hedge fund or private-equity firm and gets the biggest payoff if the assets perform well. The safest slice pays steady coupons and gets paid first.


RECOVERY PLAY
Break-down of fixed income and equity financing revenues for investment Banks

Banks make money from both interest and fees. They charge for their structured-credit experts who put the deals together, for selling some or all of the senior debt itself, and for derivatives trades, to hedge currency risk, for example. The banks can choose to keep some slice of the debt they create and earn net interest of typically 2% annually, or sell it all to insurers, pension funds or other banks who want safer senior-secured debt that pays a juicier yield than is available in public markets.

These kinds of deals look a lot like securitizations—the process behind mortgage-backed bonds.

But private structured credit like this business avoids rules drawn up after the last crisis that say banks must retain some exposure in any securitization.

According to one European bank executive, banks can sell almost any kind of private senior-secured debt to investors right now and his bank is giving up interest income because investors are willing to pay more for it.

Industry revenue in this patch rose by nearly a quarter in 2016 and was stronger again in the first half of 2017, according to Coalition, the research firm, which calls the business fixed income nonlinear financing, to distinguish it from traditional market-based, or linear, financing. It isn’t easy to spot, but for some banks this business is supporting revenues in hard-pressed fixed-income divisions.

These hard-to-value assets can cause losses and spread fear when markets turn. Regulators need to be sure they know how much business is being done and where the risks are going.