Alistair (“Ali”) Lumsden and the investment team at East Lodge Capital have been underwriting and investing in global structured credit markets since the 1990s. Today they are managing over $1.25 billion, and the opportunity set remains compelling. This is in large part because of their global focus, and in particular their expertise in Europe at a time when opportunities in US structured credit markets are far fewer than they were just a few years ago. A decade on from the financial crisis, the spectre of loose monetary policy pushing equities to record levels and spreads ever tighter has meant those with expertise in less travelled markets have an advantage given their ability to seek unique opportunities outside of traditional markets. For East Lodge, it is certain segments of the UK mortgage market that they view as offering the most compelling risk/reward, and these last few years have provided vindication of this view. “Given high valuations for equities and low yields on investment grade fixed income, floating rate ABS is attractive and offers better yields than corporate debt,” argues Lumsden. These instruments have been trading at a discount to par over the last few years, making them “a very defensive investment, with several types of optionality.”
East Lodge essentially invests in UK ‘non-conforming’ mortgages, which have been compared to ‘sub-prime’ bonds in the US, although the borrowers are quite different. A typical UK non-conforming borrower is self-employed, versus being lower income or credit impaired. In fact, Lumsden is very comfortable with the credit quality of these securities. “We own seasoned mortgages that were underwritten ten or more years ago when LIBOR was 5% and total interest rates could be as high as 9-10% for these borrowers. When UK LIBOR dropped to 0.25%, rates on these now floating rate mortgages effectively halved. Prime borrowers in the UK were paying the lowest rates since records began over 400 years ago,” he points out. The significant reduction in rates has put these borrowers in a much better financial position, and this combined with the strength of the collateral package makes these bonds highly attractive. “The weaker borrowers already defaulted years ago (credit burnout),” Lumsden adds, “further improving the securitisation as a whole.”
Another aspect of credit quality is collateral coverage or loan to value (LTV). LTV ratios on these mortgages can be as low as 50-60%, in part due to house price appreciation. “The average indexed loan to value (iLTV) is below 60%, and in some cases below 50%. This is well below the LTV levels these loans were underwritten to originally,” points out Lumsden. In terms of optionality, one of the most interesting aspects of owning these instruments today is the fact that they are 100% floating rate. In a rising rate environment, an instrument that is both floating rate and trading at a discount to par generates a valuable multiplier effect. For example, a bond that trades at 80 cents on the dollar with a coupon of LIBOR +350 might yield 4% at par, but 5% at its current price. If rates rise by 1%, the yield will increase by 1.25%. On balance, Lumsden judges that interest rates in the UK are more likely to rise than fall in the coming years given the European economic recovery and some nascent inflationary pressures. The Bank of England’s February 2018 Monetary Policy Committee meeting raised the prospect of earlier and larger rate hikes. Still, Lumsden would be comfortable if the low rate environment remained for a while as it has helped affordability, one element of credit quality.
There are also at least two additional points of optionality within these securities that could accelerate the pull to par. As Lumsden explains, “these mortgages are both callable and pre-payable, so we can make outsized returns if either of these options is exercised. The market has been poor at evaluating these options and assigning value to them.”
With respect to prepayments, given these securities are sourced at a discount, the faster that borrowers prepay (through refinancing or paying off their mortgage), the quicker par is achieved. Prepayments occur at the level of the individual mortgage rather than the overall deal, and Lumsden expects more prepayments due to the nature of the UK mortgage market. “In the UK, mortgage rates are generally only fixed for a few years and there is no penalty for early repayment after the fix expires. After experiencing a rate increase, borrowers are more likely to switch to another short-term fixed mortgage in order to lock in the prevailing rate for longer, thereby increasing prepayments to the deal.”
Callability is another interesting point of upside optionality for UK non-conforming mortgages. Calls can be a significant risk for much of corporate and other debt that trades above par, as recently demonstrated by the Aviva preference shares that dropped by 34-54 cash points in response to news that they may be cancelled at par. Despite the price recovering after Aviva had a change of heart following political pressure, this is clearly unwanted volatility. However, as these mortgages are sourced at a discount to par, the fact that they can be redeemed at par is a benefit, as it is a source of additional return.
Since 2016, the market has seen 35 UK mortgage deals called (or very close to being called), a key source of returns in 2017 and one that Lumsden believes will continue to drive returns in the coming years.
Even in a worst case or last resort scenario for these loans, where a lender is forced to repossess a property, Lumsden is confident these securities are unlikely to experience losses. “The UK has a judicial process for repossession, and loss severity upon default has recently been around 20-30%.” That loss would be absorbed by the margin of safety (or ‘excess spread’) within the deal. In contrast, loss severity on US sub-prime is still as high as 70-80%, after as long as eight years without interest payments being made on the delinquent loans, according to Lumsden.
We are more focused on lower cost properties where the UK has seen endemic undersupply for a decade or more.
East Lodge maintains little mortgage exposure, and no direct lending exposure, to high value London property, which is perceived as potentially vulnerable to Brexit as companies consider relocating staff to mainland Europe. “We are more focused on lower cost properties where the UK has seen endemic undersupply for a decade or more, and which are benefiting from the UK government’s reduction of stamp duty – first in December 2014 and later enhanced in the November 2017 UK budget,” says Lumsden. These properties are typically further shielded from risk due to their low LTVs, one of the best indicators of default risk in a mortgage loan.
Outside of the UK, East Lodge believes it has identified some of the best opportunities in broader Europe, and Lumsden believes this is partly because fewer participants follow the market. East Lodge’s largest exposures have included France, Germany and Italy, with smaller exposure to the Netherlands, Ireland, Sweden and Finland. In these markets, certain securities, such as European Commercial Mortgage Backed Securities (CMBS), are both high cash-flowing and short duration, two very valuable characteristics in a fixed income strategy. These assets are backed by quality office, retail and industrial or manufacturing property. European CLOs are another area of focus for the firm, offering high cash on cash returns and protection within the capital structure of the deal. European CLOs also allow investors to harness the protection of diversity to take exposure to corporate Europe.
The ECB’s Asset Purchase Programmes have had a limited impact on East Lodge’s opportunity set. In the case of the initial QE programme, the ABS Purchase Programme (ABSPP), the focus has been on the most senior paper, a part of the capital stack that is less the purview of hedge funds given the lower return profile. East Lodge typically invests in equity or mezzanine tranches, but can invest in senior paper that offers enough return potential, such as certain Spanish senior bonds that have compelling characteristics and structural nuances that can cause the securities to be mispriced. The ABSPP has also been much slower than initially expected, thus the overall amount of purchases has been small and the effect of eventual tapering on ABS markets is likely to be minimal. The same cannot be said for the effect of tapering on markets subject to larger QE programs, such as the Public-Sector Purchase Programme (PSPP) which focuses on sovereign bonds, or the Corporate Sector Purchase Programme (CSPP) which focuses on corporate purchases.
Additionally, if eventual ECB tapering paves the way for rate rises, this will increase the yields on East Lodge’s floating rate assets.
A key reason why UK non-conforming and other European mortgages may be mis-priced is that they often have low credit ratings (and some may not be rated at all). The credit rating agencies were clearly behind the curve in downgrading mortgage debt during the crisis, and to a similar degree they have been rather slow to factor in subsequent improvements. This is not only a constraint, but an outright obstacle for investors such as insurance companies who are subject to Solvency II rules on capital usage. But Lumsden is starting to observe more ‘real money’ accounts (perhaps crowded out of investment grade by ECB asset purchases) moving into ABS.
The hallmark of East Lodge’s investment process is bottom up, fundamental loan-by-loan analysis. This involves a full underwrite of every bond they buy. Lumsden has been active in Europe’s mortgage markets since their inception (with the exception of Denmark’s much older market). At the age of 28, he was given responsibility by his then employer, Abbey National, for a broad array of mortgage markets including the US, France, Spain, Italy and the Netherlands as well as markets further afield such as Asia and Australia.
Most of the East Lodge team also have extensive experience at the coalface of the mortgage market, in underwriting and retail banking. “Full underwriting is in our DNA,” says Lumsden. The team are close knit, most having been former colleagues at different points in time, including at CQS. Critically, they have lived through multiple business cycles including, of course, the global financial crisis.
As a graduate trainee in the early 1990s, Lumsden was asked to research the US sub-prime market which, like high yield corporate debt, was seen as a source of higher returns. “In the early 1990s, the product made sense. Borrowers had had some history of being unable or unwilling to repay past consumer debt, but loan to value ratios were much lower and there was full documentation to demonstrate the borrower’s debt serviceability had improved.” Lumsden, who was raised on a farm, learned the value of discipline and hard work at a very early age. He loved the aspect of rolling up his sleeves and digging into the underwriting process that he felt these markets required. “We would do our own complete due diligence when investigating a deal. This involved meeting with underwriters to understand operational aspects, corporate structures and incentives of lending entities. For interest-only loans, we would ensure the underwriting process included verification of sources of income.”
Lumsden was amongst the first investors to notice lending criteria was being eased pre-crisis. “Once the investment banks got involved, mass securitisation created the CDO monster, distancing loan due diligence from those making the investment decision at the end of the chain. CDOs or even CDO-squareds were sold to distant investors who had no connection to the process. Our on-site due diligence identified that the underwriting had deteriorated. The rush to originate as much as possible seemed to lead banks to ignore all the predictive data they had on borrower performance.”
Having spent the first half of his career running long only portfolios, Lumsden’s first-hand view of this ‘abandonment’ of underwriting compelled him to join a hedge fund, Michael Hintze’s CQS, where he could express his negative view through a short strategy. From the start, Lumsden put on some short CDO positions as well as overlaying some capital structure arbitrage trades. Anomalies in the relative pricing of CDO and sub-prime tranches allowed Lumsden to construct a portfolio that offered both positive carry and a high degree of protection.
The ABS fund that Lumsden ran from 2006 to 2012 generated average annualised returns of 27.8% including a 72.8% return in 2008*.
Today, East Lodge continues to employ an active short strategy, however the environment is quite different, with high quality underlying borrowers and generally strong credit markets. Thus, the current approach is more focused on identifying appropriate tail-risk hedges, such as CDS on specific countries or indices (to hedge certain macro or credit risks). Still, Lumsden’s laser focus on the fundamentals means he is ever attuned to the possibility of credit deterioration which would lead him to shift more of the short exposure into idiosyncratic, single name CDS or even equity.
Post-crisis, Lumsden reckons lenders have come around to the idea of full underwriting, whilst risk retention also represents a return to what was standard practice in the 1970s and 1980s when lenders retained the first loss or even the entire loss. He advocates ‘risk retention’ as ‘skin in the game’, because the split between origination and risk taking was what led to issues that culminated in the global financial crisis.
Currently, Lumsden is concerned that some marketplace (or ‘peer to peer’) lenders bypass ‘skin in the game’ as these entities are deemed to be technology firms thus allowing regulatory arbitrage. These very young firms may also have limited experience of servicing loans and perhaps no experience in doing so when defaults and delinquencies cause servicing costs to spike up.
“We devote a great deal of due diligence to the servicers we interact with. Securitisation effectively outsources the servicing function however we look to forge relationships with many of these servicers,” says Lumsden, who has been digging into mortgage servicers since the 1990s. He likes to investigate legal structures, resolution scenarios upon bankruptcy, as well as ownership and incentive structures. All of these can influence how a mortgage servicer might behave when dealing with delinquencies. East Lodge could also contemplate investing in the equity of mortgage servicers at the right point in the cycle, but has also shorted these entities when they have identified issues.
In addition to investing in more liquid structured credit markets, East Lodge employs a direct lending strategy focused on smaller sized European commercial real estate opportunities in market segments such as office redevelopment and purpose-built student accommodation. This is another area of growth for the business in a segment of the market that has seen growing investor demand.
Structured credit has been described as ‘the original big data strategy’ by one allocator, Kempen Capital Management. East Lodge is a good example of why data expertise matters just as much for a discretionary and fundamental manager, as it does for a systematic and quantitative manager.
The East Lodge team have a broad experience and skillset, including technology and modelling, computer programming, origination, loan underwriting, commercial property valuation, on site due diligence and risk management. “This leads to a multi-faceted approach to modelling that draws on a skill set covering a wide range of asset classes and geographies,” says Lumsden, who has been refining his approach to modelling through several cycles since the 1990s.
Whereas US data on securitisations is standardised, European data is disparate and heterogeneous, even after the advent of the European Data Warehouse (EDW) in 2012. This data jungle places a premium on knowing where to find the data and how to manipulate it, which some East Lodge team members have been doing for multiple decades. “We have been designing models since 1993. Our Chief Risk Officer worked on creating financial models for several early mortgage deals during his time at Abbey National,” recalls Lumsden. East Lodge’s technology team utilised their technical loan modelling capability to begin building a proprietary infrastructure from day one. Lumsden believes this expertise, along with being on the ground and having built up the right relationships, are all sources of competitive edge for the firm.
East Lodge is wholly owned by its partners, and all staff members share in the ethos and success of the firm. Staff also invest their personal capital into the firm’s strategies, something that is important to Lumsden as he believes that managers should be willing to ‘eat their own cooking’ if they are going to ask investors to do the same.
*Past performance is not indicative of future results.