Resurgence of synthetic securitisations: Capital-relief driven transactions scale new peaks
– Vinod Kothari | vinod@vinodkothari.com [Revised March 2022] Balance sheet synthetic securitisations, apparently aimed at capital relief and economic capital management, have scaled new peaks in the European market. In the US market, credit risk transfer transactions have registered substantial traction in the RMBS space. In some of these, the volumes are higher than the pre-Crisis levels, indicating the resurgence of the synthetic securitisation structure. In this article, we discuss this development and note that it is a good time to bury the anathema associated with synthetic transactions during the run-up to the Crisis.
What is synthetic securitisation?
Synthetic securitisation uses credit derivatives or similar devices to transfer the risk of a mezzanine tranche(s) of the credit risk of a pool of assets to capital markets by embedding such risk into credit-linked securities. The word “synthetic” is used in distinction to a traditional securitisation, which may be called “cash securitisation” or “true sale securitisation”. In every traditional or cash securitisation, there is a pooling of credit assets to constitute a reasonably diversified pool. The pool is then tranched into multiple tranches, such that, usually, the first loss tranche is retained by the originator, and mezzanine and senior tranches are moved to capital markets through a special purpose vehicle. The result is funding as well as risk transfer. The first loss piece, retained by the originator, neither leads to funding, nor risk transfer. however, for the mezzanine and senior tranches, there is a movement of money from the investors to the originator through the SPV, and risk transfer in the opposite direction. In synthetic securitisation, the purpose is not funding: the purpose is risk transfer. Therefore, the first loss piece still typically stays with the originator, but the risk in the mezzanine and senior tranches is moved to capital markets through the issue of credit-linked securities. The transfer of risk, without funding, may happen using credit default swaps, or guarantees. The process of synthetic securitisation is illustrated in the graph below (which is based on a diversified pool of 50 borrowers). The credit risk curve shows different loss levels (for example, number of borrowers defaulting) in a pool of credit assets, having a long tail to the right, but joining the X-axis after a certain point, thereby implying that the chances of very severe levels of default in a diversified pool of credit assets continues to come down as the severity level is increased, and becomes almost negligible beyond a point. This is, of course, valid only with some basic correlation assumptions. The first loss tranche is shown in the extreme left segment, which is the risk retained by the originator. The level of risk retention is back-computed by target rating for the immediately following tranche. In the graph, the immediate tranche after the originator-retained piece is the BBB tranche, which means the originator will have so much risk retention as to qualify the next tranche for a BBB rating. We have taken 3 rated tranches above the first loss piece – respectively with the BBB, A and AAA ratings. The AAA rated tranche has a very low probability of default. However, there is still a substantial size of the credit pool, in the Graph, from level 14 and above, where is the probability of default is almost zero. In our example, there is an almost negligible chance of more than 14 borrowers out of the pool of 50 defaulting within the stipulated time. We have called this level “super senior” because, in terms of seniority, this tranche is senior to the senior-most tranche, which is AAA-rated. Since the risk of default at the super-senior level is anyways negligible, there is no point in thinking of transferring that risk – hence the originator retains that risk as well.
While a cash securitisation serves liquidity needs, a synthetic securitisation is aimed at risk transfer. In our example, the originator’s risk is limited to the first loss position. Technically, the originator still has the risk of the super-senior tranche, but the super-senior position is only a theoretical risk, with infinitesimally small probabilities there. Hence, in terms of regulatory capital, the originator will be called upon to keep capital equal to the first loss position, and a very low risk weight for the super-senior position. The originator also gains economic capital relief, as the losses of the originator get capped to the first loss level. The above synthetic securitisation (or synthetic CLO) may be called “balance sheet synthetic securitisation”, as it releases the risk of the assets on the balance sheet. Another synthetic securitisation application, which was quite common during the pre-Crisis period, was arbitrage synthetic CDOs[1], aimed at creating relative value by building up a book of synthetic assets (mostly CDS contracts) and issuing tranches out of the same. However, in this article, we are focusing on balance sheet synthetic transactions.
Resurgence of balance sheet synthetic transactions in Europe
There have been various reasons for the resurgence of balance sheet synthetic transactions. The data shown below shows that balance sheet synthetic securitisations in 2018 grew more than double the pool size of 2017, to cross the peak pre-Crisis volume (2006, approx. 97 billion Euros):
The reasons for the surge in use of synthetic securitisations by EU banks are several but primarily focus on increased capital requirements, whether by way of Basel III or the other similar regulatory measures. The interest among investors is explained by the search for higher yields on well-rated securities. Most of the synthetic transactions are bespoke in nature. About half of the issuances have been bought by hedge funds[3]. The reference pools have a variety of asset classes – from vehicle loans[4] to SME loans[5] to commercial real estate loans[6]. Under the EU Securitisation Regulation, synthetic securitisations were excluded from the STS framework and did not enjoy the favourable regulatory capital treatment extended to traditional securitisation. To cater for the synthetic STS framework, section 2a – “Requirements for simple, transparent and standardised on-balance-sheet securitisations” has been inserted into the STS framework.[7] Technical reporting standards for synthetic securitisations have been submitted by ESMA to the European Commission for endorsement. Currently, entities are only voluntarily required to use (interim) STS synthetic notification templates for the purposes of reporting. The framework now affords synthetic securitisations (credit protection agreements) the same favourable regulatory treatment that has been provided to traditional securitisation. The revised framework, however, prescribes additional requirements for synthetic securitisation deals, including risk retention ratios, the appointment of a third-party verification agent to carry out a review of certain aspects of the credit protection when a credit event is triggered, conditions on the use of synthetic excess spread and high-quality credit collateral backing up the transaction. February 2022 saw what is claimed as the first credit risk-sharing transaction based on the new EU STS standard for synthetic securitisation with PGGM and Alecta entering into a Credit Risk Sharing (CRS) agreement with BNP Paribas with an 8-billion-euro loan portfolio as the underlying.[8]
Synthetic RMBS by GSEs in the USA
Fannie Mae and Freddie Mac, under the conservatorship of the Federal Housing Finance Authority, have been doing, since 2012, credit risk transfer transactions on the pools of mortgages acquired by the agencies from mortgage originators. These products have been named STACR® (acronym for Structured Agency Credit Risk) in the case of Freddie Mac and CAS® (acronym for Connecticut Avenue Securities) in the case of Fannie Mae. From the beginning of the Federal Housing Enterprises’ Single-Family CRT programs in 2013 through the end of 2020, Fannie Mae and Freddie Mac have transferred a portion of credit risk on $4.1 trillion of unpaid principal balance (UPB), with a combined Risk in Force (RIF) of about $137 billion, or 3.3 percent of UPB. Also, $2.1 trillion of UPB has been insured by, and $534 billion of RIF has been transferred to, primary mortgage insurers from 2013 through the end of 2020.[9] The amount of unpaid principal balance (UPB) or pool balance of the underlying loans for which the structured debt securities are being issued has gone up substantially over time, with the peak achieved in 2019. The data is captured in the Graph below:
CRT in the US Mortgage Insurance/Reinsurance Space
2021 saw a series of credit risk transfers in the reinsurance space – mostly in the field of mortgage insurance. In February, 2022, Moody’s assigned definitive ratings[1] to mortgage insurance credit risk transfer notes issued by Bellemeade Re 2021-3 Ltd (the issuer), which transfers to the capital markets the credit risk of private mortgage insurance (MI) policies issued by Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (the ceding insurers) on a portfolio of residential mortgage loans. The notes are exposed to the risk of claims payments on the MI policies, and depending on the notes’ priority, may incur principal and interest losses when the ceding insurer makes claims payments on the MI policies. Bellemeade Re 2021-3 Ltd (the issuer) and the ceding insurers will enter into a reinsurance agreement providing excess of loss reinsurance on mortgage insurance policies issued by the ceding insurer on the portfolio of residential mortgage loans. As is the convention in such CRT arrangement, the proceeds from the sale of the notes will be deposited into a reinsurance trust account for the benefit of the ceding insurer and as security for the issuer’s obligations to the ceding insurer under the reinsurance agreement. The funds in the reinsurance trust account will also be available to pay noteholders, following the termination of the trust and payment of amounts due to the ceding insurer.
Synthetic RMBS in the UK:
Reported to be one of the first synthetic risk transfer transactions for UK residential mortgages, Lloyd Securities introduced, in August 2019, a transaction referenced to Bank of Scotland originated residential mortgage loan pool. The reference pool is worth GBP 1.08 billion, consisting of residential loans with LTVs between 90% to 95%. Most of the loans are newly originated – some of them with less than 3 months’ seasoning. The transaction has issued 5 classes of credit-linked notes, adding up to 15% of the reference portfolio, with senior-most rating going to A. The risk of the remaining 85% of the unprotected pool is retained by the originator. As is common with synthetic structures, the funding raised by the issue of credit-linked notes is deposited in a cash deposit bank, with usual covenants pertaining to the rating of the bank, and the ability of the trustees to move the deposit to an alternative bank on certain triggers. Another notable CRT arrangement that occurred, in recent times, in the UK is Fontwell II which is a synthetic securitisation referencing a £1.83bn portfolio of UK agricultural mortgages secured on a first-charge basis over farmland and property originated by the Agricultural Mortgage Corporation plc (AMC), a subsidiary of Lloyds Bank plc. The arrangement structured by Lloyds Bank Corporate Markets as sole arranger and lead manager provides credit protection and is motivated by regulatory capital relief at a beneficial cost of capital as well as prudent risk management within the context of providing support to the UK agricultural industry.[11]
Conclusion
Synthetic transactions, once bête noire immediately after the Crisis, are coming out of the trenches. Synthetic transactions focus specifically on risk transfer, and if one of the avowed purposes of securitisation is to achieve risk transfer, synthetic balance sheet transactions are designed for the same. The resurgence of synthetic transactions is wholesome, and if the regulators lay down an STS framework for these transactions, the market should be able to find comfort with a wider range of investors.
[1] See Vinod Kothari; Securitisation – The Financial Instrument of the Future, 2006 for detailed discussion.
[2] REPORT ON STS FRAMEWORK FOR SYNTHETIC SECURITISATION UNDER ARTICLE 45 OF REGULATION (EU) 2017/2402 – https://www.eba.europa.eu/sites/default/documents/files/document_library/News%20and%20Press/Press%20Room/Press%20Releases/2020/EBA%20proposes%20Framework%20for%20STS%20Synthetic%20Securitisation/883430/Report%20on%20framework%20for%20STS%20syntetic%20securitisation.pdf
[3] Based on https://www.true-sale-international.de/fileadmin/tsi_gmbh/tsi_bilder/Partner_TSI/Material_Textinfo/DBRS-european-synthetic-securitisation-presentation-slides.pdf [4] http://www.aiaf.es/docs/Ficheros/FolletosEmisiones/m_es0305382006_20181220_1.pdf [5] https://www.iflr1000.com/Deal/Profile/20665?SEOtitle=Banca-Popolare-di-Bari-3-billion-SME-loan-portfolio-synthetic-securitisation#undefined [6] https://www.recapitalnews.com/santander-issues-917m-cre-loan-securitisation/ [7] https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32021R0557&from=EN [8] https://www.pggm.nl/en/press/pggm-and-alecta-share-risk-in-8-billion-euro-loan-portfolio-bnp-paribas/ [9] https://www.fhfa.gov/AboutUs/Reports/Pages/Credit-Risk-Transfer-Progress-Report-4Q2020.aspx [10] https://www.moodys.com/research/Moodys-assigns-definitive-ratings-to-mortgage-insurance-credit-risk-transfer–PR_455431
[11] https://www.huntonak.com/images/content/7/9/v2/79128/SCI-CRT-Awards-2021.pdf