The road to preferential STS treatment
On January 17, 2018 two EU Regulations setting out a new framework for European securitisation entered into force. Regulation (EU) 2017/2402 (the Securitisation Regulation) consolidates the patchwork of legislation governing European securitisation s, and introduces a new framework for simple, transparent and standardized (STS) securitisation s. Regulation (EU) 2017/2401 (the securitisation Prudential Regulation, or SPR) replaces certain provisions of the Capital Requirements Regulation (CRR) and sets out the framework under which certain institutional investors (e.g. banks and investment firms) can benefit potentially from more favorable regulatory capital treatment for STS securitisation exposures.
While the legislation will apply to securitisation s completed after January 1, 2019, legacy securitisation s outstanding on that date may be eligible to use the STS designation, provided that the transaction and underlying assets comply with procedural and structural requirements at the time of notification to the European Securities and Markets Authority (ESMA), and provided that other requirements are met at the time of origination (such as risk retention and criteria for credit-granting).
If a securitisation transaction obtains the STS label, it is not guaranteed to receive preferential capital treatment. In addition, not all types of investor will be able to benefit from preferential capital treatment for qualifying transactions. The SPR, which focuses on CRR-regulated credit institutions and investment firms, does not afford the same STS capital relief to other institutional investors such as pension funds, insurance and reinsurance undertakings. While the European Commission has made encouraging noises in respect of extending STS capital relief to insurers, the impact of the new STS framework may be muted if insurers are effectively excluded from benefitting from preferential capital treatment.
Achieving STS capital treatment for securitisation s is therefore a multi-step process - transactions that satisfy the STS eligibility criteria set out the Securitisation Regulation will need to pass additional tests in the SPR. We have set out below some practical steps to be taken in the STS analysis. However, this guide is not meant to replace sound legal advice, as the eligibility criteria need to be applied and processes carried out individually to each transaction.
Step one – check general compliance with the Securitisation Regulation
To obtain an STS designation, a securitisation first needs to comply with the general rules of the Securitisation Regulation that apply to all European securitisation s, such as the risk retention, transparency and due diligence requirements. While these requirements are not new to the market generally, they will apply more widely under the Securitisation Regulation. For example, originators, sponsors and original lenders will be under a new positive obligation to retain a five percent net economic interest in securitisation transactions. This applies to all transactions, including where the investors are not CRR-regulated credit institutions or investment firms (which is not currently the case under the CRR).
Step two – apply the STS label
Are the STS eligibility criteria satisfied?Originators, sponsors and issuers will be jointly responsible under the Securitisation Regulation for assigning the STS designation. The Securitisation Regulation sets out an optional process whereby an authorized third party can attest to the satisfaction of the STS criteria. Third party certification, however, will not absolve originators, sponsors and issuers from liability for making STS assertions that turn out to be false.
In order for a third party to verify compliance with the STS criteria, it must be authorized by ESMA. Authorization will only be granted where the third party is independent, charges non-discriminatory fees on a cost-recovery basis, and has necessary professional qualifications, knowledge, experience and a good reputation. Authorized third parties will not be permitted to provide any form of advisory, audit or equivalent service to the originator, sponsor or special purpose vehicle (SPV) issuer and must have operational safeguards, monitoring and a management structure to ensure no conflicts of interest. Regulated entities such as credit institutions, investment firms, insurance undertakings and credit rating agencies are not eligible to act as third party certification providers.
The below checklist summarizes the required and excluded attributes of ABS and ABCP transactions that form the new criteria:
|Simplicity||All of the originator, sponsor and SPV established in the EU||Any of the originator, sponsor or SPV established outside of the EU|
|True sale, assignment, or transfer with the same legal effect of the underlying assets to the issuer SPV||Synthetic transaction structures|
|Prescribed perfection triggers such as deterioration of asset quality included where assignment is not immediately perfected (common in UK structures)||Commercial mortgage-backed securitisations|
|Originator representations that (to the best of its knowledge) the underlying assets are unencumbered||Re-securitisations (which are banned even for non-STS transactions, subject to limited exceptions)|
|Underlying assets meeting predetermined, unambiguous and clearly documented eligibility criteria||Clawback provisions applied to the underlying assets in the event of an originator’s insolvency|
|ABS with underlying assets that are originated in the ordinary course of an originator’s business||Active portfolio management on a discretionary basis (which will exclude CLOs and some master trusts, but substitution of underlying assets that are in breach of representations is allowed)|
|In respect of underlying residential loans, borrower creditworthiness that meets the standards set out in the Mortgage Credit Directive (or equivalent in third country)||Underlying assets that are in default at the time of selection|
|Underlying assets originated according to underwriting standards that are no less stringent than those applied to an originator’s non-securitised assets||Underlying assets that relate to, at the time of selection, a credit-impaired debtor or guarantor|
|At least one payment having been made on the underlying assets at the time of transfer to the SPV||Repayments structured to depend predominantly on the sale of assets securing underlying exposures|
|Underlying asset pools that are homogeneous in asset type||ABS and ABCP transactions backed by bonds, shares or other transferable securities listed on a trading venue|
|Underlying exposures containing contractually binding and enforceable obligations with full recourse to borrowers and, where applicable, guarantors||Transactions backed by residential loans that were marketed or underwritten on the premise that the loan applicant's income might not be verified by the lender|
|Underlying exposures with defined periodic payment streams||ABCP transactions backed by underlying assets (other than auto loans, leases or equipment leases) with a weighted average life (WAL) exceeding one year or with a residual maturity of more than three years|
|Originators or lenders with expertise in originating exposures of a similar nature to those securitised||ABCP transactions backed by auto loans, auto leases or equipment leases with WALs exceeding three and a half years or a residual maturity of more than six years|
|ABCP programmes with sponsors that are EU-supervised credit institutions||ABCP transactions backed by residential or commercial mortgages|
|ABCP programmes that are supported by sponsors in respect of liquidity and credit risks for all transactions||ABCP programmes with call options, extension clauses or other clauses affecting the final maturity|
|Material dilution risks of the underlying assets and transaction and programme-wide costs supported by the ABCP programme sponsor||Certain non-sequential or reverse order priorities of payment on enforcement|
|Standardisation||Risk retention requirements satisfied||Failure by the originator, sponsor or original lender (as applicable) to retain the 5 percent net economic interest|
|For ABCP, the sponsor retains risk at the programme level or seller retains risk at the transaction level||Referenced interest payments based on “complex formulae or derivatives”|
|Currency and interest rate risk hedged||Inclusion of non-hedging derivatives|
|Either non-revolving ABS, or, if a revolving ABS, with early amortisation events for termination of revolving periods based on prescribed triggers||Any trapping of cash following enforcement in a term ABS or revolving ABS where the revolving period has ended, beyond what is necessary to ensure an SPV’s functioning or repayment of investors, or to prevent the deterioration of credit quality of the underlying assets|
|Standard asset servicing, trustee and other ancillary service provisions included in transaction documentation||Any trapping of cash in ABCP transactions following a seller or originator’s default or an acceleration event, beyond what is necessary to ensure an SPV’s functioning or repayment of investors, or to prevent the deterioration of credit quality of the underlying assets|
|Servicers with experience in servicing exposures of a similar nature to those underlying the transaction, and well documented policies, procedures and risk management controls related to servicing the exposures||Servicers with no demonstrable track record in servicing a given asset class or documented servicing policies and procedures|
|Clear counterparty replacement provisions included in transaction documentation||Sub-standard or insufficient asset servicing, trustee and other ancillary service provisions or servicers that fail to meet minimum standards|
|Transaction documentation with clear provisions for resolution of conflicts between classes of investors, bondholder voting provisions and trustee responsibilities||Provisions requiring automatic liquidation of underlying assets at market value|
|Historical loan-level static and dynamic performance data provided at pricing, covering at least three years for trade receivables and other short term receivables, and five years for all other exposures provided by the originator, sponsor or SPV|
|Transparency||Originator and sponsor providing environmental performance of assets financed in a residential mortgage or auto loan/lease ABS transaction||Failure by originator, sponsor and SPV to be jointly responsible for compliance with transparency requirements|
|Originator, sponsor or SPV providing investors with asset performance data at pricing and quarterly investor reports for ABS or on a monthly basis for ABCP||Failure by originator, sponsor and SPV to jointly provide investors with asset performance data at pricing and quarterly investor reports for ABS or monthly investor reports for ABCP|
|Originator or sponsor providing a liability cash flow model to ABS investors at pricing and on an ongoing basis||Lack of external, independent verification of underlying exposure data|
|External verification of underlying exposure data by an appropriate, independent party|
|Compliance by the originator and sponsor of general transparency requirements (e.g. transaction documentation, asset performance), with related information being made available to potential investors before pricing (on request)|
Why are certain types of securitisation s excluded?Commercial mortgage-backed securitisation s (CMBS) have been excluded from the STS eligibility criteria, due to perceived vulnerabilities arising from a strong reliance on the sale of the underlying loans in order to repay the CMBS obligations. While better capital treatment for some products is certainly welcome, it is discouraging that a large number of securitisation s that have performed historically well (such as some synthetic or more actively managed structures) will continue to be disadvantaged relative to more traditional ABS and ABCP.
At the end of 2015, the European Banking Authority (EBA) submitted to the Commission a report on synthetic securitisation . In its report, the EBA recognized that synthetic transactions that are used by credit institutions to transfer the credit risk of their lending activity off-balance sheet (i.e. balance sheet synthetics) have performed relatively well. The EBA advised the Commission to extend preferred regulatory capital treatment to senior retained tranches of synthetic transactions provided that specific criteria are satisfied. Among other things, the transactions would need to be comprised of fully cash-funded credit protection provided by private investors in the form of cash deposited with the originator institution. While the Securitisation Regulation contemplates the possibility of including synthetic products in the future, it is unlikely to include them when it takes effect in January 2019.
How are underlying assets “homogeneous”?
The Securitisation Regulation has been criticized for the vague nature of its eligibility criteria relating to the homogeneity of underlying asset pools. One common question has been how granular the homogeneity requirement will be, i.e. will asset pools need to be grouped by class, or according to sub-sets exhibiting common characteristics.
The EBA is consulting on an approach that would specify a list of asset categories as well as list of “risk factors” to be considered when determining whether an asset pool is sufficiently homogeneous. Risk factors include type of obligor, type of credit facility and collateral, repayment mechanics and industrial sector. Under this approach, not all risk factors would be relevant to each category. For example, it makes no sense to describe the type of immovable property relating to an auto loan securitisation (for which there is none), or type of obligor for owner-occupied residential loans (who are obviously individuals). In an effort to tick off each relevant risk factor, originators may struggle to pool together enough sufficiently similar assets to benefit from economies of scale.
Step three – notify the regulators
Will third-party certification be worth it?
The final step in the labeling process is to notify regulators of the STS designation. The STS labeling process requires originators, sponsors and the SPVs to notify their regulator and ESMA in accordance with a prescribed template, following which ESMA will publish the STS notification on a register on its website. There is an optional process whereby authorized third parties can attest that the eligibility criteria are satisfied. If this option is exercised, the notification must include a statement that the STS criteria was checked by that third party. Third party certification, however, will not absolve originators, sponsors and SPVs from liability for making STS assertions that turn out to be false. In addition, the attestation provided by the third party is a “point in time assessment”; therefore, they will not provide ongoing monitoring. Originators, sponsors and SPVs will shoulder responsibility of notifying their regulator and ESMA if a transaction ceases to be STS-eligible.
ESMA is currently consulting on draft technical standards that will set out the procedural, form and content requirements for making an STS notification. The STS notification will need to include a concise explanation or justification as to why the transaction satisfies the STS criteria. This obligation is proportionate, as some criteria will require greater explanation than others. The notification process is also likely to include a cross-referencing exercise to the prospectus (if there is one). The intention behind this is to remove duplication in the notification form vis a vis the prospectus. However, in practice it will be an extra administrative step in the notification process.
Step four – apply for STS preferential treatment
Are the STS prudential eligibility criteria satisfied?
Investing institutions calculate capital requirements for their securitisation positions in accordance with a single hierarchy of approaches, which is applied in the Commission’s order of preference:
- Securitisation Internal Ratings Based Approach (SEC-IRBA): uses an institution’s own internal rating models that must be pre-approved by the institution’s regulator. SEC-IRBA looks at the capital treatment of the underlying exposures as if they were not being securitized, then applies certain pre-defined inputs.
- Securitisation Standardized Approach (SEC-SA): this method relies on a supervisory-provided formula using as an input the capital requirements that would be calculated under the existing standardized approach under the CRR, subject to a risk-weight floor of 10 percent for senior STS securitisation positions. This approach assesses the capital charges of the underlying assets (based on type) and then applies the ratio of delinquent underlying exposures to the total amount of underlying exposures.
- Securitisation External Ratings Based Approach (SEC-ERBA): this method of last resort is based on credit ratings assigned by external rating agencies (or inferred) to the securitisation tranches.
While investing institutions will have a certain degree of flexibility with respect to what risk weighting method they use for determining their overall regulatory capital requirements, only the SEC-SA method is available when determining whether a securitisation position is eligible for more favorable STS treatment. For example, positions in an ABCP programme or ABCP transaction will only be eligible for STS treatment if the underlying exposures meet, at the time of the inclusion in the ABCP programme (taking into account credit risk mitigation), an SEC-SA risk weight of 75 percent or less.
For other qualifying securitisation s, the underlying assets must not, on their own, receive a risk weighting above a set of prescribed thresholds (based on the SEC-SA method). The risk weight caps vary depending on the class of asset being securitized, and are subject to credit risk mitigation. Specifically, the underlying exposures must have, at the time of inclusion in the securitisation , a risk weight equal to or smaller than:
- 40 percent on an exposure value-weighted average basis for loans backed by residential mortgages or fully guaranteed residential loans
- 50 percent on an individual exposure basis where the exposure is a loan secured by a commercial mortgage
- 75 percent on an individual exposure basis where the exposure is a retail exposure
- 100 percent on an individual exposure basis for any other exposures.
For residential and commercial mortgage loan backed securitisations, loans backed by second and third mortgages can only be included in the securitisation where all loans secured by the first mortgages on that asset are also included in the securitisation.
Step five – apply borrower concentration limits
Finally, once all other requirements are satisfied, the SPR requires that the aggregate value of all underlying exposures to a single obligor must not, at the time of inclusion, exceed two percent of the aggregate value of all exposures in the underlying pool. For these purposes, loans and leases to a group of connected obligors are considered to be a single obligor.
For ABCP programmes, the same borrower concentration limit applies at the programme level, at the time the underlying assets are added to the programme. However, the concentration limit does not apply in respect of trade receivables in an ABCP programme where the credit risk is covered by eligible credit protection.