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by Steve Albert

Neglected stepchild or future class leader? Project finance loans look like perfect candidates to be put into
CLOs, and their obvious potential continues to attract interest. But looming regulatory changes — and
alternative ways to lay off some of the risk— keep lenders from pursuing the product further.

tructured finance experts have excelled at creating new
products out of all manner of assets. But there is one
type that has largely eluded them — the project finance
loan. As hard as they have tried, it’s rare to see a CLO which
is backed by infrastructure finance debt hit the market. In fact,
there have been just eight known deals raising little more than
$6 billion in the nine years since Credit Suisse launched its

groundbreaking $617 million securitization of its own loan

book. But that isn’t stopping investment bankers from thinking
up new ways to push the product. The question is, will they

have much success?

That they haven’t so far doesn’t appear to make much sense
at first. The technology clearly exists. And there’s no issue with
the ratings agencies, which have become increasingly comfort- The path to project finance CLOs is attractive, but rarely used
able with pooling project finance debt. Standard & Poor’s, in particular, has been building up a solid body of performance data since
working on a 2002 study commissioned by major lenders when first drafts of Basel II suggested an onerous capital treatment for

project finance debt.

In fact, project finance loans seem like ideal fodder for CLOs. It’s a booming market market that grew more than a fifth last
year — about $220 billion was lent to fund infrastructure projects around the world, according to Dealogic ProjectWare.
A booming market it may be, but banks complain that it is difficult to make sufficient returns to justify the personnel needed
to structure this debt, even with ancillary income from interest-rate swaps, and more lucrative advisory work later on. In part, it’s

because the fees and interest coupons are so low, even though the loans are rarely rated better than low investment grade and have

much longer maturities than the average seven-year corporate leveraged loan.
Regulatory capital costs hit returns as well. Currently banks have to assign a risk weighting of 100% to loans to special purpose
companies, as most project finance borrowers are structured, when calculating their capital adequacy ratios. This means banks have
to assign a relatively high level of capital to such debt.

It’s no wonder, then, that banks have tried to offload these Loans to these projects are repaid with payments from the UK
loans. What’s stopped them? In part, it’s the terms. Covenants government for the use of offices, hospitals, schools and roads.
frequently prevent lenders from selling debt or participations. For this deal, Depfa entered into a credit default swap for
Even where permitted, banks have frequently avoided doing so each loan with KfW, which in turn wrote a credit default swap
for fear of displeasing regular clients, many of whom remain with the special purpose vehicle, which then issued a mixture
unconvinced that allowing banks to sell on their loans to non- of credit-linked notes and a super-senior swap. KfW provides
bank investors can benefit their capital raising goals.
Even if clients consent to a bank selling its participation,
they have frequently balked at allowing ratings agencies suffi-
cient access to monitor the credit quality of underlying loans.
Banks familiar with the process of assembling CLOs say that
while this isn’t so much of a problem with loans to public proj-
ects, other projects have caused stumbling blocks.
That any deals have been completed stands for something.
Credit Suisse’s 1998 debut, as well as its follow-up $500 mil-
lion deal two years later, involved the sale of participations in
loans, though, not true sales or a synthetic securitization. So
did Citigroup’s $350 million CLO in 2001.
Since then there have be no more cash CLOs. Lenders
just can’t get it past the clients — nor could they obtain suf-
ficiently attractive regulatory relief on the first loss piece. Banks
do have other options. They can use or create commercial pa- similar credit default intermediation to banks securitizing loans
per conduits, particularly to book triple-A-rated debt. Several to small and medium enterprises (its Promise program) and to
banks have successfully established programs to securitize debt mortgage originators (Provide).
featuring government guarantees. Elsewhere, loans to finance Epic’s £355 million super senior swap was hedged by Am-
projects in emerging markets often feature guarantees from bac, while £32 million in triple-A to double-BB tranches was
state-backed export credit agencies. These can usually be placed placed with investors who purchased a floating-rate credit-
in conduits as well. linked note issued by the Epic special purpose company. Depfa
Monoline insurers have also emerged as aggressive insurers retained the first loss tranche. While this still attracts a high
of bank debt, mostly in the busy UK private finance initiative capital treatment, just as the retained portion of any other se-
(PFI) segment, which tends to carry solid investment grade rat- curitization would, the remainder of the securitized debt is
ings. Providing a regulator signs off on a bank’s sponsorship of weighted at 0%, as any regular loan to KfW would be.
such a conduit ­ — and gives it generous capital treatment — Epic was designed to rely upon a readily understood pool
such conduits can offer a more straightforward type of balance of loans with a high degree of homogeneity. Depfa’s second se-
sheet relief. curitization was more ambitious. Epic II, which closed in June
last year, was a €900 million ($1.22 billion) issue backed by

loans in a number of jurisdictions in Europe and the U.S. It is

There have been no cash CLOs since similar in structure to the first Epic issue, also using a synthetic
2001. Lenders just can’t get it past structure and KfW as an intermediary. But it covers loans to

transport projects and social infrastructure projects outside the

their clients. UK.

The CLO deals that have come to market in the last six Basel II Bugaboo
years have taken a different tack to Citi and Credit Suisse. All In the period between the two Epic deals, NIB Capital and
of them have been structured using derivatives. And none of Sumitomo Mitsui Banking Corp. completed a £383 million

them has proceeded without using KfW as an intermediary to securitization of PFI debt known as Stichting Profile 1 in No-
help secure regulatory capital relief — as a government-owned vember 2005. That deal demonstrated that all holders of UK
entity it enjoys a zero risk weighting for capital adequacy pur- PFI debt, and not just one with a public finance focus like Dep-
poses. fa, could structure a synthetic CLO.
Depfa’s two deals, Essential Public Infrastructure Capital SMBC completed a second securitization of PFI debt in

(Epic and Epic II), have been securitizations of loans to proj- March 2007. Dubbed the Smart PFI 2007 this was a £388 mil-

ects that meet Depfa’s lending criteria, generally transport and lion deal underwritten by Deutsche Bank. Of the issue, 92%
social infrastructure projects rather than power, oil and gas or was placed as a credit default swap and 6.3% as credit-linked
mining projects. Epic, a £391.7 million ($775.4 million) issue, notes. SMBC kept a 1.7% first loss tranche as well as the proj-
closed in 2004, and solely securitized debt to UK PFI projects. ect’s inflation swaps.

The good news for bankers and structurers who would monoline premium for insuring this debt has fallen, according
like to see a more active market is that KfW already expects to several bankers active in the market, from roughly 35-40 ba-
to participate in several other deals before the end of the year. sis points three years ago to levels of 15-20 basis points today.
But for the market to really take off, two further structural ad- Thus, the future of project finance-backed securitizations
vances will be key. First, synthetic securitizations will need to will depend on the interplay between the changes in capital af-
dispense with KfW as an intermediary, but still achieve a low forded to such debt, which is likely to be more lenient and a
risk weighting. Using a bank counterparty for the credit default less promising candidate for a CLO, and the spreads that the
swap currently attracts 20% risk weighting, which might not underlying debt commands. The first is likely to turn inexorably
make a securitization attractive to the issuer. After that, they against further deals — banks are steadily raising the propor-
will need to comprise a broader range of assets. The two goals tion of assets eligible for Basel II treatment. And higher spreads
are in fact interlinked, since not all project finance debt, such will have unpredictable effects on the supply of loans. Project
as that related to extractive industries, may be eligible for KfW finance, of course, is not unique in this respect.
involvement. Nonetheless, rumors still abound of more deals. Calyon
Basel II could be another potential stumbling block to and SMBC are thought to be close to launching a deal backed
the growth in project finance CLOs. It is difficult to generalize
about the treatment accorded to project finance loans under the
impending new regime since it will be implemented in different
“We think that the CMBS market offers
ways for different institutions in different jurisdictions. But for a useful model for the development of the
banks able to implement them fully, the new accords will make
it easier to allocate capital more efficiently. That will, generally market for securities backed by project
speaking, result in better treatment for high-grade loans, espe- finance debt.”
cially triple-A-insured debt, while sub-investment grade loan
treatment will vary. by loans to Middle Eastern projects. That would again involve
It is not yet clear whether regulatory relief will be a strong KfW as credit default swap counterparty, but also include loans
driver of securitization business in the future, or whether it to power and oil and gas projects. This would, if confirmed, of-
will in fact hinder it. The Basel II accords, which offer banks fer some signs of evolution, though many projects in this region
a menu of capital treatments that are designed to reward those also sell power or oil and gas to government-owned counterpar-
with more sophisticated risk management systems, may make ties.
it unnecessary, or at least less attractive, for them to securitize According to one former banker who now runs a boutique
project finance debt. structuring CLOs, the next big step involves an issuer writing
credit default protection without an intermediary. “We think
On The Way Out that the commercial mortgage-backed securities market offers
The handful of transactions that have happened, then, were put a useful model for the development of the market for securities
together under a regulatory framework that is on the way out. backed by project finance debt. Like infrastructure assets, com-
But some of those few institutions that have securitized these mercial real estate is long-lived, the subject of long-term debt
loans anticipated this. The Epic II deal, for instance, includes from a small number of specialized institutions, and is financed

a provision that Depfa may collapse the transaction if Basel II on the back of a mixture of short- and long-term contracts.”
does not punish it unduly for the loans that it has laid off syn- Finding reliable counterparties for credit protection on CMBS
thetically in the capital markets. has not been difficult, notes this banker, suggesting that this will

Dexia has a similar call feature on its synthetic CDOs — not be a problem for CLOs. He adds that under Basel II, CDS
the Paris-based specialist public finance lender has been secu- counterparties will need to be just A- rated for a bank to obtain
ritizing its portfolio of triple-A-wrapped infrastructure bonds. a 0% risk weighting, and as long as a CLO still makes economic
In the future, it will be easier for lenders to gain capital relief on sense, a bank could dispense with the services of KfW.
wrapped bonds and bank loans, since the rating of this debt will That could be some way off, though. Bankers have more
be the main deciding factor in capital treatment. than enough obstacles to contend with just getting the current

Dexia has also put together one CLO. The £1.47 bil- deal structures out the door. Until there is more clarity on how
lion Wise 2006-1 CLO exploits additional anomalies in the Basel II will affect banks’ capital needs, and more willingness
wrapped debt market. First, the price of the super senior credit on the part of borrowers to allow their debt to be sold on or
default swap — which accounted for the majority of the issue, scrutinized, project finance-backed CLOs are likely to remain a
and was hedged by Assured Guaranty — is lower than the yield rarity.

on triple-A-wrapped paper.

Second, it exploits the competition between monoline in-

Steve Albert writes about financial markets for a
surers for infrastructure business. This has meant that insur-
number of publications. He is based in New York.
ers are capturing even less of the difference between triple-A
debt spreads and the unwrapped debt’s spread than usual. The