By Nidhi Bothra, (finserv@vinodkothari.com)

As a securitization market matures, one of the surest things that should emerge is the market for mezzanine tranches. This article tries to articulate on the relevance of mezzanine tranche in the securitization market that is on an upswing currently.

What is a mezzanine tranche?

A mezzanine tranche is a small layer positioned between the senior tranche (mostly AAA) and a junior tranche (unrated, typically called equity tranche). The mezzanine tranche, is normally defined as the piece above an investment grade rating – that is, if the transaction was putatively to be rated BBB, what would have been the support required.

Ideally the role of a mezzanine tranche is to be able to reduce the weighted average cost of the asset-backed securities issued. To explain further, consider a transaction with only 2 tranches – a senior tranche and a junior tranche, as it currently is the practice in India. As there is no mezzanine tranche, and the senior tranche still expects a AAA or similar rating, the total level of support required for the senior tranche is the total of the (first loss piece + second loss piece). In a 2 tranche transaction both the first loss and the second loss support is provided by the equity tranche which is held by the originator.

Assume a case, where the support required for an AAA rating is 11%, which is provided by the equity tranche. In absence of a mezzanine tranche, the weighted average cost would be high. On the other hand, if for BBB rating, the support required is 8% and at AAA, the support required is 11%, then 3% is the second loss piece. In absence of the second loss piece, the unrated lower tranche or the equity tranche has to be 11%. The difference in the weighted average costs with and without the mezzanine tranche is illustrated below:

The cost of the unrated or equity tranche for regulatory purposes is deduction from equity. For economic purposes, it is nothing but originator’s equity. Hence, the cost should be the same as the cost of originator’s equity. Assume the cost to be 18%. The weighted average cost, therefore, in case of a two tranche transaction, as also illustrated in the table above is (18%*11%) + (9% *89%), which comes to 9.990%.

Now if the unrated tranche is split into two pieces – the mezzanine tranche and the equity tranche, as in case of three tranche illustration in table above, as long as the cost of the mezzanine tranche is lower than 18%, the weighted average cost of the transaction comes down. The weighted average cost of the three tranche transaction is (8%*18%)+(89%*9%)+(3%*12%), which comes to 9.810%.

There is every reason for the cost of the mezzanine tranche to be significantly lower than 18% as this class itself has the support of the equity tranche.

Relevance of mezzanine tranche:

Adding a mezzanine tranche to a securitization structure has several benefits. One of the benefits as illustrated above is reducing the weighted average costs of the transaction. This would mean that the equity required for the transaction would also come down. (As illustrated in the transaction, the requirement for equity tranche falls, therefore the regulatory requirement for the equity tranche would also be lower than a two tranche securitization structure). Since the equity infusion comes down, the leverage of the transaction goes up.

Adding a mezzanine tranche from accounting perspective also is beneficial, as it facilitates the off balance sheet treatment for the receivables in case of securitization transaction. IFRS 9 is relevant for securitization accounting and provides for principles and conditions of de-recognition. IFRS 10 and 12 are also relevant for securitization accounting, as they deal with the issue of consolidation and disclosure requirements as applicable to unconsolidated structured entity respectively.

The conditions of de-recognition are stated in para 3.2.6 of IFRS 9. There may be essentially 3 situations:

• Transfer of substantially all risks and returns – de-recognition
• Retention of substantially all risks and returns – no de-recognition
• Retention of some risks and returns – however, surrender of control – partial de-recognition.

In order to qualify even for a partial de-recognition, there has to be a significant (that is, more than nominal) transfer of risks and returns. We need to understand two key elements:

• Risks
• Returns

Risks is exposure to credit risk and returns is compensation for such risks. Prior to securitization transaction, the risks are that of the originator. Post securitization, the test of de-recognition is the significant transfer of risks and rewards. In a two tranche transaction, the significant amount of risks are retained by the originator and the originator also retains the excess spread or residual profits in the transaction and therefore, is a key constraint to the assets going off the books. Slicing of the equity tranche to create a mezzanine tranche results in transfer the risks of default. The transaction should facilitate the assets going off the books (except for the equity/ residuary piece retained by the originator)[1].

Issues in mezzanine tranching

While there is relevance to illustrate on slicing of a mezzanine tranche, considering the Indian securitization market, it is pertinent to mention some demerits as well.

Typically a mezzanine tranche is a thin slice and therefore could be too small an investment for institutional investors. To explain the point, if receivables worth Rs. 100 crores are securitized, the mezzanine tranche may be on Rs. 3-4 crores which may not be too lucrative for institutional investors to consider investing in.

Also, while the probability of default of a mezzanine tranche is a function of the subordination below it (the fatness of the equity tranche), its expected loss will be quite high given its thin nature. To explain the point further, in a transaction the equity tranche is of Rs 8 crores, and mezzanine tranche of Rs 4 crores (out of a total issuance of Rs 100 croes), if the loss reaches Rs 9 crores, it takes away 25% of the principal of the mezzanine tranche.

If an investor were to invest in the mezzanine tranche as well as the senior tranche, his total return will be worse than how much he will make by investing in a senior tranche of the transaction which does not have the mezzanine tranche. This is but natural, as the laying of the mezzanine tranche between the senior and the equity tranche goes to the benefit of the issuer – hence, to the disadvantage of the investor.

Possible investors in mezzanine tranche in India

Considering the Indian securitization market, the possible investors for mezzanine tranche could be institutional investors (despite the concerns on the thin slice) or HNIs.

One of the ways to deal with the thin size of the mezzanine tranche is to create collateralized debt obligations or CDOs. The idea would be to pool several of such mezzanine investments and thereby, a virtual CDO that invests in mezzanine tranches.

One of the pausible hurdles to creating a CDO is that it may be viewed as a case of re-securitisation which is not permitted under the securitization guidelines. While re-securitisation is not permitted, but a fund (without structured liabilities) investing in mezzanine tranches could be an alternate and legally feasible solution. This may create diversification as well as allow high rate of return in securitsation transactions.

Conclusion

Globally securitisaiton structures have three or more tranches. The growth and development of securitization market led to innovations to make the securitization transactions cost effective. It is time for the securitization market in India to evolve and grow beyond its inefficiencies.

Globally, as well, slicing and dicing of tranches is a common phenomenon and so is the case of creation of CDOs and CDO squares and cubes. It is time that the Indian securitization market also encashes upon the inherent benefits of securitization which remain largely untapped in the existing structures prevalent in the Indian market.