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.

S
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
CLOs

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
Finance

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

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
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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.

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 It’s no wonder, then, that banks have tried to offload these
loans. What’s stopped them? In part, it’s the terms. Covenants
frequently prevent lenders from selling debt or participations.
Even where permitted, banks have frequently avoided doing so
for fear of displeasing regular clients, many of whom remain
unconvinced that allowing banks to sell on their loans to non-
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-
per conduits, particularly to book triple-A-rated debt. Several
banks have successfully established programs to securitize debt
featuring government guarantees. Elsewhere, loans to finance
projects in emerging markets often feature guarantees from
state-backed export credit agencies. These can usually be placed
in conduits as well.
Monoline insurers have also emerged as aggressive insurers
of bank debt, mostly in the busy UK private finance initiative
(PFI) segment, which tends to carry solid investment grade rat-
ings. Providing a regulator signs off on a bank’s sponsorship of
such a conduit ­ — and gives it generous capital treatment —
such conduits can offer a more straightforward type of balance
sheet relief.
CLOs
There have been no cash CLOs since
2001. Lenders just can’t get it past
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their clients.
The CLO deals that have come to market in the last six
years have taken a different tack to Citi and Credit Suisse. All
of them have been structured using derivatives. And none of
Project
them has proceeded without using KfW as an intermediary to
help secure regulatory capital relief — as a government-owned
entity it enjoys a zero risk weighting for capital adequacy pur-
poses.
Depfa’s two deals, Essential Public Infrastructure Capital
—
(Epic and Epic II), have been securitizations of loans to proj-
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ects that meet Depfa’s lending criteria, generally transport and
social infrastructure projects rather than power, oil and gas or
mining projects. Epic, a £391.7 million ($775.4 million) issue,
closed in 2004, and solely securitized debt to UK PFI projects.
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Loans to these projects are repaid with payments from the UK
government for the use of offices, hospitals, schools and roads.
For this deal, Depfa entered into a credit default swap for
each loan with KfW, which in turn wrote a credit default swap
with the special purpose vehicle, which then issued a mixture
of credit-linked notes and a super-senior swap. KfW provides
similar credit default intermediation to banks securitizing loans
to small and medium enterprises (its Promise program) and to
mortgage originators (Provide).
Epic’s £355 million super senior swap was hedged by Am-
bac, while £32 million in triple-A to double-BB tranches was
placed with investors who purchased a floating-rate credit-
linked note issued by the Epic special purpose company. Depfa
retained the first loss tranche. While this still attracts a high
capital treatment, just as the retained portion of any other se-
curitization would, the remainder of the securitized debt is
weighted at 0%, as any regular loan to KfW would be.
Epic was designed to rely upon a readily understood pool
of loans with a high degree of homogeneity. Depfa’s second se-
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
similar in structure to the first Epic issue, also using a synthetic
structure and KfW as an intermediary. But it covers loans to
transport projects and social infrastructure projects outside the
UK.
Basel II Bugaboo
In the period between the two Epic deals, NIB Capital and
Sumitomo Mitsui Banking Corp. completed a £383 million
securitization of PFI debt known as Stichting Profile 1 in No-
vember 2005. That deal demonstrated that all holders of UK
PFI debt, and not just one with a public finance focus like Dep-
fa, could structure a synthetic CLO.
SMBC completed a second securitization of PFI debt in
March 2007. Dubbed the Smart PFI 2007 this was a £388 mil-
lion deal underwritten by Deutsche Bank. Of the issue, 92%
was placed as a credit default swap and 6.3% as credit-linked
notes. SMBC kept a 1.7% first loss tranche as well as the proj-
ect’s inflation swaps.
 The good news for bankers and structurers who would
like to see a more active market is that KfW already expects
to participate in several other deals before the end of the year.
But for the market to really take off, two further structural ad-
vances will be key. First, synthetic securitizations will need to
dispense with KfW as an intermediary, but still achieve a low
risk weighting. Using a bank counterparty for the credit default
swap currently attracts 20% risk weighting, which might not
make a securitization attractive to the issuer. After that, they
will need to comprise a broader range of assets. The two goals
are in fact interlinked, since not all project finance debt, such
as that related to extractive industries, may be eligible for KfW
involvement.
Basel II could be another potential stumbling block to
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
ways for different institutions in different jurisdictions. But for
banks able to implement them fully, the new accords will make
it easier to allocate capital more efficiently. That will, generally
speaking, result in better treatment for high-grade loans, espe-
cially triple-A-insured debt, while sub-investment grade loan
treatment will vary.
It is not yet clear whether regulatory relief will be a strong
driver of securitization business in the future, or whether it
will in fact hinder it. The Basel II accords, which offer banks
a menu of capital treatments that are designed to reward those
with more sophisticated risk management systems, may make
it unnecessary, or at least less attractive, for them to securitize
project finance debt.
On The Way Out
The handful of transactions that have happened, then, were put
together under a regulatory framework that is on the way out.
But some of those few institutions that have securitized these
loans anticipated this. The Epic II deal, for instance, includes
CLOs
a provision that Depfa may collapse the transaction if Basel II
does not punish it unduly for the loans that it has laid off syn-
thetically in the capital markets.
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Dexia has a similar call feature on its synthetic CDOs —
the Paris-based specialist public finance lender has been secu-
ritizing its portfolio of triple-A-wrapped infrastructure bonds.
In the future, it will be easier for lenders to gain capital relief on
wrapped bonds and bank loans, since the rating of this debt will
be the main deciding factor in capital treatment.
Project
Dexia has also put together one CLO. The £1.47 bil-
lion Wise 2006-1 CLO exploits additional anomalies in the
wrapped debt market. First, the price of the super senior credit
default swap — which accounted for the majority of the issue,
and was hedged by Assured Guaranty — is lower than the yield
—
on triple-A-wrapped paper.
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Second, it exploits the competition between monoline in-
surers for infrastructure business. This has meant that insur-
ers are capturing even less of the difference between triple-A
debt spreads and the unwrapped debt’s spread than usual. The
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monoline premium for insuring this debt has fallen, according
to several bankers active in the market, from roughly 35-40 ba-
sis points three years ago to levels of 15-20 basis points today.
Thus, the future of project finance-backed securitizations
will depend on the interplay between the changes in capital af-
forded to such debt, which is likely to be more lenient and a
less promising candidate for a CLO, and the spreads that the
underlying debt commands. The first is likely to turn inexorably
against further deals — banks are steadily raising the propor-
tion of assets eligible for Basel II treatment. And higher spreads
will have unpredictable effects on the supply of loans. Project
finance, of course, is not unique in this respect.
Nonetheless, rumors still abound of more deals. Calyon
and SMBC are thought to be close to launching a deal backed
“We think that the CMBS market offers
a useful model for the development of the
market for securities backed by project
finance debt.”
by loans to Middle Eastern projects. That would again involve
KfW as credit default swap counterparty, but also include loans
to power and oil and gas projects. This would, if confirmed, of-
fer some signs of evolution, though many projects in this region
also sell power or oil and gas to government-owned counterpar-
ties.
According to one former banker who now runs a boutique
structuring CLOs, the next big step involves an issuer writing
credit default protection without an intermediary. “We think
that the commercial mortgage-backed securities market offers
a useful model for the development of the market for securities
backed by project finance debt. Like infrastructure assets, com-
mercial real estate is long-lived, the subject of long-term debt
from a small number of specialized institutions, and is financed
on the back of a mixture of short- and long-term contracts.”
Finding reliable counterparties for credit protection on CMBS
has not been difficult, notes this banker, suggesting that this will
not be a problem for CLOs. He adds that under Basel II, CDS
counterparties will need to be just A- rated for a bank to obtain
a 0% risk weighting, and as long as a CLO still makes economic
sense, a bank could dispense with the services of KfW.
That could be some way off, though. Bankers have more
than enough obstacles to contend with just getting the current
deal structures out the door. Until there is more clarity on how
Basel II will affect banks’ capital needs, and more willingness
on the part of borrowers to allow their debt to be sold on or
scrutinized, project finance-backed CLOs are likely to remain a
rarity.
Steve Albert writes about financial markets for a
number of publications. He is based in New York.