GSE’s Approach to ESG and Other Insights

Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I am the president and chief operating officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy, or investment product. Now, on to our podcast.

Emily Crandall:

Welcome to A Bird’s-Eye View of the Bond Markets podcast. I am Emily Crandall, member of the consultant relations team at Merganser, and today is Tuesday, May 11, 2021. I’m pleased to be joined today by my two colleagues, Jennifer Wynn and Dave Fishman. Jennifer is the PM and head of ESG and DEI, and Dave is our deputy CIO and senior commercial real estate analyst. Hello to you both.

Dave Fishman:

Great to be here with you.

Emily Crandall:

So today, in terms of content, we are going to focus on different aspects of ESG investing at Merganser, and specifically the role of structured products, which our firm has a long history of covering and investing in. With that, I’d like to begin with a question for Jennifer. So Jennifer, you’ve been at the firm for a while and have seen various iterations of ESG integration, both at a company level and within the investment process. Could you discuss that in general, your experience over time?

Jennifer Wynn:

In the last year, Merganser has formalized its ESG committee to spearhead ESG activities at the company. The committee is working to establish a consistent approach to ESG integration across the various fixed income sectors in which Merganser invests. We are also developing marketing material to accurately represent Merganser’s ESG approach to both our clients and the consultant community. The committee is responsible for all reporting to the UN PRI as Merganser has been a signatory to the UN Principles of Responsible Investing since 2018. At the investment level, Merganser views ESG integration as a means of risk mitigation. Factors which would be considered environmental, social, or governance related, are evaluated along with an issuer’s financial factors to develop a complete picture of an issuer’s fundamental credit risk. Each of Merganser’s sector analysts is tasked with developing an assessment of an issuer that incorporates ESG risk factors. This assessment, which includes ESG risk factors, feeds into our relative value decision process.

Emily Crandall:

Great. Thank you, Jennifer. And is this a relatively new development for the firm, or is it something that’s been in place for years?

Jennifer Wynn:

Merganser has historically carried out in depth fundamental credit analysis, which incorporates many risk factors. Some of these factors are now identified as ESG related, for example, corporate governance and the quality of corporate governance. Over time, these risk factors have increased to include not only explicit financial factors, but also the broad array of risks that now fall under the ESG banner.

Emily Crandall:

Thank you, Jennifer. And now switching gears a bit to Dave, I was wondering if you could help us understand how Merganser is incorporating ESG analysis into our structured product research.

Dave Fishman:

Great question. I would say that ESG considerations vary by product type across structured products with a particular focus on governance, which is critical across all sectors. Recall that weak governance was a serious problem that played a role in the last global financial crisis over a decade ago now. Risk retention requirements that went into effect a few years ago were meant to address that shortcoming and we favor vertical retention models and products like CMBS. There are sponsors of certain ABS deals that have done time in prison. That is a red flag for us. And there are sponsors that don’t answer questions. Again, a red flag. My colleague Peter Kaplan has been meeting with issuers for 30 plus years and has strong views that it is sponsor, sponsor, and sponsor that matters most for ABS in general. For a sector like CLOs where many borrowers are non-public, ESG considerations will be hardest to evaluate beyond sponsor risks.

On the environmental side, for many sectors, the impact is indeterminate or not applicable, but for many sectors it is a significant issue and it can be either a risk or an opportunity. Rail cars are often carrying hazardous materials. The shipping industry, which carries containers, is notorious for polluting the air and water. On the other hand, many CMBS, in particular, single asset or single borrower portfolios, have high quality LEED-certified collateral that is making a relatively positive impact on the environment. But these issues are often not black or white; they are gray. What if that LEED Gold certified office building was the corporate headquarters of a gun manufacturer, or what if it sat in a floodplain? So these factors are one input into a larger understanding of a particular asset. PACE loans are another area. On the one hand, the projects they finance are improving the environment, but on the other hand, they are known to have aggressive sales and origination practices and shady contractors, which translates to negative S&G scores.

Agency CMBS issued by the GSEs play a big part in portfolios at Merganser. Stating the obvious here, but GSE is just ESG in reverse. And it should be noted that Fannie Multifamily DUS program, which was founded in the late 80s, represents the original risk retention model for structured products. These issuers have strong track records for lending on projects with positive environmental impacts, and the role they play financing affordable housing, medical care facilities, and nursing homes are supportive of the nation’s social welfare. On the single family side, more recently, the GSEs have started financing green loans for homes meeting certain ENERGY STAR certification criteria and providing loans to borrowers to make their homes more energy efficient. So this hits on all ES&G components.

Lastly, thinking about the SR as it relates to other structured sectors, we think there’s an indeterminate factor for many sectors. Consumer products like credit cards and auto loans do provide a positive benefit of providing consumers with mobility and access to credit that they might not otherwise have. RMBS serving underserved borrowers or lending in distressed areas or reperforming and modified loan portfolios all deserve consideration for positive social impacts. Overall, RMBS though, probably underappreciates the risk of environmental changes and the risk of natural disasters based on the recent research I’ve been reading.

Emily Crandall:

Thank you, Dave. How has issuance changed as a result of sustainable initiatives and demand for ESG strategies? How and to what degree have different issuer types embraced ESG sustainability initiatives?

Dave Fishman:

So the market is very early in adapting ESG. With regards to corporates, the entire corporate market has made some push to claim progress in sustainability and ESG. Consumer staple companies have made the most consistent strides as a sector to signal to investors and consumers that they’re focusing on these areas. Disclosures among the largest corporations have generally improved over the last five years with a couple notable laggards in energy and insurance. The reporting for smaller corporations have improved, but are generally behind those of larger peers, which results in most smaller entities having lower standards as it pertains to ESG ratings, all else equal. There has been notable growth in sustainability issuance linked to specific key performance indicators over the last two years who are skeptical that the incentive to hit those KPIs is material enough to mitigate ESG related risks in sectors where ESG is most relevant.

On the structured side, data collection reporting represents a big challenge for the market to adapt. Issuance has not yet risen to meet the demand. Data standardization is a long way off and changes to data formats for both new issue and ongoing reporting can take years to implement. Of course, in many cases, these changes require changes to loan documents and borrower behavior, which takes time. It’s all happening, but slowly. Some sectors that have gotten off to a faster start are Solar ABS and PACE ABS, which combined have issued about $10 billion, still rather small. Rising electric vehicle sales should make its way into the Auto ABS market, but it has been limited so far.

The most successful program so far in structured, in my view, is the dedicated environmental impact and social impact programs that Freddie and Fannie have created for Agency CMBS. These programs have measurable goals and they’re audited by an independent firm. Fannie has been at it the longest. Their program started in 2016 and is approaching $100 billion in cumulative issuance of green loans. Freddie Mac is behind, but in addition to sprinkling green loans in their generic deals, have also issued about $2 billion of fully green deals in the past two years and another $5 billion in dedicated workforce housing deals that is aimed at tenants earning 80% or less of area median income. Non-agency CMBS, it should be noted, is estimated to have financed nearly $50 billion of LEED-certified office buildings, much of that in the past few years.

Emily Crandall:

Thank you, Dave. Those are some lofty goals for Fannie and Freddie. How would you say that Merganser is measuring the impact in value of our ESG investment decisions?

Dave Fishman:

So we have recently begun to include ESG flags in our monthly review of security level performance. We’re looking for signs that ESG factors had a positive or negative impact and are building out our capabilities around this important issue. I’m really excited to see how this data plays out over time.

Jeffrey Addis:

This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.