Structured Finance in Brief

Updates and Analysis on current structured finance issues, upcoming events and activities of Reed Smith’s structured finance group

‘Point of no return’ is not the point says Supreme Court

By Andrzej Janiszewski on Posted in Defaults and Restructurings, Lehman, RMBS, Securitisation

So Eurosail-UK 2007-3BL plc (Eurosail) is not ‘balance sheet’ insolvent, no event of default has occurred under the RMBS notes it has issued and a post-enforcement call option (PECO) does not make limited recourse any of the notes it relates to.

Those are the conclusions of the Supreme Court (see here) after it substantially re-affirmed the judgments of both the High Court and the Court of Appeal in the case of BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL and others.

Facts

For those unfamiliar with the facts, the case concerned an attempt by certain A3 noteholders to have an event of default under the notes declared on the basis that Eurosail was balance sheet insolvent due to, amongst other things, losses incurred as a result of the lack of currency swaps originally provided by Lehman Brothers.  The key argument being that the audited balance sheet of Eurosail showed an excess of liabilities over assets and that losses from the loss of the currency swaps could not realistically be recovered.  An event of default in respect of the notes would have meant that the transaction would make payments in accordance with the post-enforcement priority of payments thereby allowing the A3 noteholders to rank pari passu in terms of principal repayments with the existing A2 noteholders (who rank senior in the pre-enforcement waterfall).

Eurosail along with certain A2 noteholders disputed the assertions of the A3 noteholders and argued that Eurosail was not insolvent as, amongst other reasons, it was paying all liabilities as they fell due and Eurosail’s statutory audited balance sheet (i) did not take into account the value of Eurosail’s claim against Lehman Brothers arising from the termination of various swaps with Lehman Brothers; and (ii) it valued all future liabilities of Eurosail denominated in dollars and euros as sterling liabilities using the exchange rates at the time the balance sheet was drawn up which does not reflect the actual exchange rates that will apply until the redemption of the notes (which could be in 2045).

Judgment

Based on the facts, the court agreed with Eurosail and the A2 noteholders and found that Eurosail was not balance sheet insolvent and stated that “Eurosail’s ability or inability to pay all its debts, present or future, may not be finally determined until much closer to 2045, that is more than 30 years from now” and that the “movements of currencies and interest rates in the meantime, if not entirely speculative, are incapable of prediction with any confidence.”

What about the PECO?

As a secondary argument, Eurosail also stated that a balance sheet insolvency could never arise as the existence of a PECO meant that the notes were, for all practical purposes, limited recourse  - i.e. Eurosail’s liabilities would ‘shrink to fit’ the assets it had available in the same way as if traditional limited recourse language had been included.  Eurosail was seeking to overturn the judgments of the High Court and the Court of Appeal on the issue as both had found that the existence of the PECO did not mean that a ‘balance sheet’ insolvency could never arise.  Lord Hope dismissed the appeal as “to limit those liabilities as the Issuer contends would contradict the parties’ clearly expressed commercial intention as found in the contractual documents”.  However, he did go on to say that the PECO “can be expected to achieve bankruptcy remoteness as effectively” as traditional limited recourse.  In other words, economically the PECO mechanism will work but legally speaking the method is separate from the traditional limited recourse provisions.

So what does it all mean?

The case was of interest not only within the securitisation context but also in the wider context of insolvency law as it considered, really for the first time directly, the application of the ‘balance sheet’ insolvency test (as contained in s.123 (2) of the Insolvency Act 1986).  In providing commentary on previous case law, Lord Walker went out of his way to dismiss the ‘point of no return’ test adopted by Lord Neuberger MR in the Court of Appeal insofar as it went “beyond the need for a petitioner to satisfy the court, on the balance of probabilities, that a company has insufficient assets to be able to meet all its liabilities, including prospective and contingent liabilities.”  Lord Walker also stated “whether or not the test of balance-sheet insolvency is satisfied must depend on the available evidence as to the circumstances of the particular case”.  That is not a particularly clear test and will mean that balance sheet insolvency in UK securitisations with a PECO will be difficult to prove, especially if the maturity of any notes issued will not occur until some time in the future.  However, it does mean that a balance sheet event of default can occur, given the right circumstances, in such securitisations.  Whether or not that was originally intended is another question altogether, but issuers, trustees and noteholders will need to consider the balance sheet insolvency event of default during the life of any relevant UK securitisation, particularly as it approaches its legal maturity date.  However, if there is no point of no return test, when does that point come?

Irish Stock Exchange announcements – Its all change at the Exchange!

By Simon Hugo on Posted in ABS, CMBS, Defaults and Restructurings, RMBS, Securitisation

Those issuers, corporate services providers, collateral managers, servicers and special servicers that regularly submit debt announcements on the Irish Stock Exchange will know how straightforward and quick it is to submit.  For those that don’t, at present this process involves simply sending a copy of the notice or announcement to the email address announcements@ise.ie and the publication is free of charge if a Word version of the notice is sent.  This quick and easy process enables the issuers (or their agents or lawyers on their behalf) to publish announcements promptly to ensure compliance with the Irish Stock Exchange listing rules and the relevant issuer’s regulatory and transparency obligations under the Market Abuse Directive 2003/6/EC of the European Parliament as implemented by the relevant member states.

However, the process (and the cost) is set to change quite substantially on and from 1 July 2013.

The Irish Stock Exchange proposes to replace the existing process with one that is more formalised but also more time consuming and costly.  The new process will involve each participant registering through an as yet unopened online platform where announcements can be electronically published.  These participants must submit the following information to publish each notice: (a) whether a document is being filed or an announcement published; (b) issuer name; (c) issuer domicile; (d) issuer VAT number; (e) invoicing contact and company details; (f) method of payment; and (g) when the notice should be published (that is, immediately or at a future time and date).

This is a significant departure from the previous process but not one on the face of it that should cause too many problems for corporate debt issuers – in light of the limited information that needs to be submitted.  But how will this affect the corporate services providers, collateral managers, servicers and special servicers that manage and service hundreds and thousands of issuing vehicles, each now to be subject to this new process?

After initially reviewing the update provided by the ISE, I was concerned that service providers would have to separately register each issuing entity they manage or service.  However, having enquired with the ISE, I understand that each service provider need only register themselves and this will allow them to publish announcements in respect of any of the issuing entities that they manage.  In many cases, it is the collateral managers, servicers, special servicers or their lawyers that have customarily submitted the notices for publication on the ISE on behalf of the issuers, provided they have the relevant issuer and trustee approval.   This will not change under the new proposals but it is now these parties that will need to have registered an account with the ISE.  The ISE are still considering how the authorisation process will work and whether specific individuals will need to be named, whether a more general authorisation for each issuer is more appropriate or whether submission of a notice will include a representation that the party submitting is authorised; so at this stage, the outcome on authorisation is uncertain.

However, one thing is certain: there will be a significant increase in the costs of making announcements on the ISE, which will depend on the method of payment selected by the party making the announcement.

There will be three payment options:

  1. Online payment – RealEx or PayPal
  2. Prepaid transfer on account (a minimum of €5,000)
  3. Invoice-based post payment

If the methods (1) or (2) (that is, payment is made at the time of submission or deducted from a pre-funded account) are used the costs will be:

  • €150 excl. VAT per Announcement in Word format
  • €200 excl. VAT per Announcement in PDF format.

If invoice-based post payment (that is, where an invoice is generated and submitted for payment after the publication) is chosen the costs will be:

  • €300 excl. VAT per Announcement in Word format
  • €350 excl. VAT per Announcement in PDF format.

The ISE has said it “intends to provide interested entities with an opportunity to register online a number of weeks prior to July 1st 2013”.  I hope the number of weeks is more than two but in any event, I hope this is enough time for the service providers to complete their registration and set up their authorised persons/organisations (however that ends up being resolved by the ISE).  Whatever the uncertainty at this stage, we should be thankful that we don’t have to register each individual issuer by 1 July….

We expect to receive further information regarding the registration, process and payment procedure in June 2013.  In the meantime, corporate debt issuers, corporate services providers, servicers, special servicers, collateral managers and their lawyers will need to ensure that they are prepared and will be able to complete the registration before the 1 July 2013 deadline.  The consequences of not registering will be important – including the civil and criminal sanctions related to market abuse offences arising as a result of a failure or inability to adequately publish inside information to the public.

A few preliminary considerations to bear in mind are how this new process impacts on the existing operations of you as a service provider including consideration as to which method of payment is most appropriate.  For example, it might be prudent for a service provider to have an amount on account to take advantage of the 50% discount for submission of the Word version of a notice and recover this from the relevant issuer as a disbursements in its fees costs and expenses indemnities.  Whilst this might be efficient for the issuing vehicle and the ISE (due to the restrictions on payments by the issuer other than on note payment dates) the service providers may well be incurring significant additional costs up front and having to wait 90 days until the next payment date for reimbursement as it’s unlikely these interim payments will be authorised under existing documentation.  If not, the issuing vehicle will just have to bear the higher costs and payments made directly by them under the waterfall on the note interest payment date, which will mean the ISE has to wait those 90 days.  In either case, it will not be welcomed by those transactions that are afflicted by an administrative expenses cap, which in many cases have significant accumulated costs not being paid on each note payment date.

We at Reed Smith will be monitoring the new procedures and remain ready to assist as and when it becomes clear what is required of our clients.

From Finance 101 to CMBS 2.0

By Theano Manolopoulou on Posted in ABS, CMBS, Defaults and Restructurings, Securitisation

It’s been a year since I joined the structured finance team. I can’t believe it went by so fast. A year of learning and moving forward. Downgrades, liquidity drawings and agent replacements in the summer, noteholder meetings in autumn, covered bonds and refinancing of old CMBS deals in the new year. Inevitably, this one year mark makes me think how much I’ve changed, and how much I’ve learned in the process. It also makes me think how much the ABS markets and the types of investors in those markets have changed since the emergence of the subprime mortgage crisis and the credit crunch.

I remember myself at 23, walking into a Columbia classroom to find out more about the roots of the subprime mortgage crisis, curious to understand what types of events and behaviors had lead to the mess the global economy was in back in 2009 (admittedly I did so wearing my NYU jumper which might not have been the wisest decision I’ve ever made). What I remember most from that semester (apart from the countless hours on the 1 and 9 Trains to 116th Street), is being told that it would take many years before the ABS markets could ever recover –  and that there would be very little new issuance for some time.

And yet I now find myself in London, in 2013, dealing with some new CMBS transactions originated in Europe. Indeed, the new issuance is very limited compared to the pre-crisis volumes. However this does not change the fact that there clearly is still investor appetite for new issuance.  Of course, the same way I’ve grown and come to terms with reality in these last few years since I walked into that classroom, the ABS markets have developed too, as have the nature of the underlying asset pools and the requirements of the prospective investors.

The investor base has definitely changed. The special investment vehicles and the banks that heavily invested in the CMBS issuance in the heydays have disappeared from the landscape. The new CMBS issues are driven by investors, who, as the Financial Times put it in a recent article, “are chasing higher yielding assets that have performed well during the crisis”.

The assets pools have also changed. New CMBS issuances mostly feature single loans secured by either prime UK property or German multifamily, given that such loans have demonstrated lower default rates through the crisis.

The rating agencies have really changed. Not only have the pre-existing rating agencies faced criticism and enhanced regulatory supervision by the relevant state and intra-state authorities, but also, as Navigant remarked in a June 2012 report, old CMBS Issuers such as Deutsche Bank, Goldman Sachs, Citigroup and JP Morgan Chase & Co. have turned to newcomers, such as Kroll Bond Ratings Inc. and Morningstar.

Most importantly, what is driving new issuance in most cases is the need to refinance old CMBS transactions. The reality, as Moody’s remarked in their “European CMBS: 2013 Outlook” report is that this year roughly 60 % of the commercial property loans supporting European CMBS will fail to repay on time.

I guess we’ve got a long way to go until the ABS markets are fully transformed and investors and regulatory authorities feel fully confident to support the new ABS products. But I’m certainly interested in finding out what happens next and seeing if CMBS 2.0 is really new and improved enough to get investors to buy more.

LORDS 1 – ON A WING AND A PRAYER

By Iain Balkwill on Posted in ABS, CMBS, Defaults and Restructurings, Securitisation

In December 2012, Reed Smith’s Structured Finance Team completed the consensual restructuring of £362,452,000 of outstanding debt owed by the London & Regional Group (the property company of billionaires Ian and Richard Livingstone).  As the managing associate on the team that advised London & Regional in various capacities (including Issuer and Borrower), I thought it would be worth touching on some of the innovative structural features, the benefits of this CMBS restructuring and the implications that this has for the CMBS restructuring market as a whole.

This was a highly complex transaction that featured: (i) the consensual restructuring of £234,200,000 of tranched commercial mortgage backed securities issued by London & Regional Debt Securitisation No.1 PLC (Lords 1); (ii) the restructuring of a £128,252,500 contractually subordinated loan; (iii) the compression of a long-dated interest rate swap; (iv) the termination of a liquidity facility; and (v) the implementation of innovative structural enhancements to the London & Regional Group structure that assured the noteholders of the independence of the Issuer whilst maintaining the London & Regional Group ownership of the note issuing vehicle.

Other than the transaction’s undisputed complexity, notable features of the restructuring include the following:

  • the adoption of a flexible and pragmatic approach by both London & Regional and the noteholders to put in place an initial standstill in relation to the enforcement of the debt default to allow the commercial parties to focus on the longer-term restructuring;
  • the incorporation of various property enhancement initiatives, including allowing the refurbishments of one property as well as a lease extension in relation to another thus allowing London & Regional Group to continue to maximise value on the underlying property portfolio;
  • the granting of a step up in the coupon on the notes not only to reflect pricing commensurate with current rates of return but also to permit noteholders to share any potential upside in the value of the property portfolio through the inclusion of a complex PIK element;
  • the employment of a restructuring strategy that allowed the disposal of a property at the beginning of the restructuring with disposal proceeds being trapped in the structure, thus incentivising noteholders to complete the restructuring at the earliest opportunity in order sanction the release of these funds to  pay principal on the notes; and
  • the grant of extensions on its underlying debt obligations to be tied to triggers so as to incentivise London & Regional to de-leverage the structure over the life of the extended debt.

The restructuring can be regarded as hugely successful for both London & Regional and the noteholders as each benefitted from the agreements reached.  The incentives offered and pragmatic approach adopted by the parties ensured that this restructuring was completed in an unprecedented short timeframe, with the consent solicitation being launched within two calendar months of the initial engagement of the adviser appointed by an ad-hoc group of noteholders.  The property enhancement initiatives coupled with provision for an orderly sale of the properties in the portfolio mean that there is every chance that the underlying property portfolio will not only retain its value but also potentially increase in value, the upside in which the noteholders will share through the payment of PIK.  It is for these reasons that this restructuring can be viewed as being highly significant to the CMBS market, as not only is it a template for those single loan CMBS transactions that feature underlying collateral with value ready to be unlocked but it also demonstrates what can be achieved with the inclusion of a considered incentives package.

Hellenic Capital Market Commission – New Emergency Prohibition under the EU Short Selling Regulation

By Theano Manolopoulou on Posted in Capital Markets, European Securities and Markets Authority

On 28 January the competent authority for supervising securities in Greece, the Hellenic Capital Market Commission (HCMC), made use of its powers of intervention in exceptional circumstances and decided to introduce yet another emergency measure under Article 20 of Regulation No 236/2012, also known as the EU Short Selling Regulation. As defined in the Regulation, short selling consists in the sale of securities that the seller does not own, with the intention of buying back an identical security at a later point in time in order to be able to deliver the security.

In a new act of a prolonged saga of short-selling bans originating as early as April 2010, the Commission announced in its press release 1/637/28.1.2013 its decision to temporarily prohibit the short selling in relation to shares of credit institutions admitted to trading on the Athens Stock Exchange and comprising the FTSE/ATHEX-CSE Banking Index, and in specific the shares of the following institutions: ALPHA ΒΑΝΚ,  ATTICA BANK Α.Τ.Ε., CYPRUS POPULAR BANK, ETHNIKI BANK, BANK OF CYPRUS, PEIRAIOS BANK and EUROBANK ERGASIAS.  The temporary short selling prohibition applies to all depository receipts representing shares of the above mentioned credit institutions, and covers both “covered” short selling (i.e. where the seller has borrowed the security before the time of the sale) and “naked” or “uncovered” short selling (i.e. where the seller has not borrowed the security at the time of the sale, or ensured that it can be borrowed).

In its press release, the Commission states that, in reaching this decision, it took into account the on-going process of recapitalization of credit institutions, as well as the recent macroeconomic developments in Greece. 

In its relevant Opinion, the European Securities and Markets Authority (ESMA) considers the adverse developments relating to the Greek banking sector as constituting “a serious threat to financial stability and to market confidence in Greece”.  ESMA deemed the emergency measure as both appropriate and proportionate in relation to this threat, and considered the duration of the measure as justified.

The emergency measure will be introduced for a period of three months starting on February 1.  It remains to be seen whether the Commission will deem it appropriate to lift the ban earlier than that or decide to extend it, as it has done in the case of other short selling bans in the past.

 

CFTC Rules – When is a European SPV a commodity pool?

By Thomas Watterson and Nick Stainthorpe on Posted in ABS, Regulation, RMBS, Securitisation

As part of the Dodd-Frank financial reforms, the U.S. Commodity Futures Trading Commission (“CFTC”) increased its oversight of “swaps”.  One change stemming from Dodd-Frank is that a “swap”, as defined in the Commodity Exchange Act and CFTC regulations, is now a “commodity interest”.  The CFTC regulates collective investment vehicles that invest in commodity interests, which it calls “commodity pools”.  This can include SPVs which are not incorporated in the U.S..

The CFTC regulates the person with managerial or operational control over the commodity pool which is referred to as the commodity pool operator (“CPO”).  Determining precisely which person should serve as the CPO in any given structure requires an analysis beyond the scope of this blog post but where there is a commodity pool, there must be a CPO.  CPOs can be subject to onerous regulatory requirements.  Determining whether or not an entity is a commodity pool and then whether its operator needs to register as a CPO requires some careful analysis and, to make the issue more interesting, the rules have undergone significant changes recently.

Participants in the structured finance markets outside the US have been raising queries as to whether SPVs which are party to swaps could be treated as commodity pools and, as a result, the relevant CPO would be required to register with the CFTC and what the consequences of that would be.  Where possible, the best outcome for the parties structuring a securitisation is for the SPV not to be classed as a commodity pool.

In very high level terms, the CFTC has indicated in no-action letters that it would not consider a securitisation SPV to be a commodity pool and would not require its operator to register as a CPO if:

  • the SPV is limited to passively owning or holding financial assets; and
  • the SPV’s use of swaps is limited to hedging interest rate risk, hedging foreign exchange risk or providing credit enhancement and not using swaps to create investment exposure.

By way of example, an SPV which purchases a pool of residential mortgage loans, issues notes, and enters into interest rate and cross currency swaps would not be a commodity pool because it would passively hold financial assets and would not use swaps to create investment exposure.  This would be true whether or not the SPV held U.S. mortgage loans, issued notes to U.S. persons or entered into swaps with a U.S. bank.

The picture is somewhat different where the structure in question is a synthetic securitisation or credit linked note and the main asset backing the notes is a swap.  If an SPV uses a swap to create investment exposure, then the SPV could be a commodity pool, and unless an exemption exists, the CFTC would require the SPV’s operator to register as a CPO.

The CFTC has jurisdiction over CPOs making use of “any means or instrumentality” of U.S. interstate commerce, such as having a U.S. investor, or entering into swaps with a U.S. counterparty.  Indeed, past CFTC guidance has indicated that the CFTC would not find that CPO registration is required where:

1.  the commodity pool activities of the SPV will be confined to areas outside the U.S.;

2.  no participant in the SPV is a U.S. resident or citizen; and

3.  no funds or other capital may be committed to the SPV from U.S. sources.

CFTC rules also provide exemptions from CPO registration, under certain other circumstances.  Under CFTC Rule 3.10(c)(3), an SPV located outside of the U.S. will be exempt from registering as a CPO if all of it swaps and derivatives in the U.S. are cleared and, when the SPV enters each position, it has no U.S. Person investors.

CFTC Rule 4.13(a)(3) provides an exemption from CPO registration for de minimis swap use.  To qualify for the de minimis exemption:

1.  At all times (but determined when the SPV entered its most recent position), either

a.  the aggregate initial margin or premiums of the SPV’s swaps and other derivatives does not exceed 5% of the liquidation value of the SPV’s portfolio; or

b.  the aggregate net notional value of the SPV’s swaps and other derivatives does not exceed 100% of the liquidation value of the SPV’s portfolio;

2.  at the time of investment, the SPV reasonably believes that each investor fits one of an enumerated list of persons (including “Non U.S. Persons” and “accredited investors”); and

3.  interests in the SPV are exempt from registration under the Securities Act of 1933 and they are not marketed to the public in the U.S.; and

4.  the SPV is not marketed as a vehicle to participate in the commodity futures or options markets.

The CFTC indicated that operators of SPVs formed prior to 12 October 2012 will not be required to register as CPOs.  For SPVs formed after 12 October 2012, the CFTC will not take action against SPV operators for failure to register as a CPO until 31 March 2013.

For more information on U.S. derivatives regulation, please visit our sister blog The Swap Report.

 

This article has been published for information purposes only and should not be relied upon as legal advice under any circumstances.

RMBS can form part of the Basel III liquidity buffer. Some good news for the structured finance industry.

By Nick Stainthorpe and Theano Manolopoulou on Posted in Basel Committee on Banking Supervision, Regulation, RMBS

The Basel Committee on Banking Supervision announced yesterday that it had finalised the rules for the Liquidity Coverage Ratio or LCR i.e. the main mechanic for regulating liquidity in the Basel III package of reforms.

The LCR requires that a bank hold a sufficient stock of “High Quality Liquid Assets” to meet its net cash outflows in a hypothetical stress scenario. The rules set out the parameters for the stress scenario, the calculation of the net cash outflow and the type of assets which can constitute High Quality Liquid Assets.

Lobbying has achieved a notable success as certain “residential mortgage-backed securities rated AA or higher” can now be included in a bank’s stock of high quality liquid assets (subject to a 25% haircut, which is lower than the haircut applied to some corporate debt securities and to the limitation that this component can form no more than 15% of the buffer as a whole). This proposal is watered down in relation to the original formulation of the LCR announced in 2010, under which Level 1 assets (i.e. the most valuable components of the liquidity buffer which are uncapped and not subject to haircuts) were limited to cash, central bank reserves and bonds issued or guaranteed by sovereigns or certain supranational organisations and Level 2 assets (which are subject to a cap of 40% of the total buffer and subject to haircuts) were limited to lower rated sovereign bonds and certain corporate bonds and covered bonds. The importance of this amendment should not be underestimated as banks will now have a major incentive to hold such RMBS. It also shows that the message has got through that securitisation is an important asset class which can contribute positively to financial stability.

The Committee also pushed back the final implementation of the proposals by four years: The LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60% of the planned total, and will only reach 100% in January 2019.  Basel III will of course require implementation through local laws (such as the Capital Requirements Regulation in Europe) in order to take effect.

This follows the consultation paper published last December by the Basel Committee on the revision of the securitisation framework (see our blog) which some feel will have a very negative impact on the ability of banks to hold securitisation positions. It remains to be seen whether the committee’s new found goodwill to securitisation will extend to making these revisions more palatable.

What the Fitch??!

By Andrzej Janiszewski and Simon Hugo on Posted in CMBS, Defaults and Restructurings, Rating Agencies

As some of you may have seen, Fitch helpfully issued a press release last week clarifying its position on providing rating agency confirmations (RACs) during the replacement of special servicers on EMEA CMBS transactions. Rather unhelpfully, however, the release stated they would not be providing any such RACs in the future. This policy, of course, applies to the very transactions that Fitch rated (in the majority of cases) at inception which contained (presumably, either at Fitch’s request or at the very least with their knowledge) the requirement that such RACs be obtained from the relevant rating agencies before any transfer of the special servicer function could occur.

The right to replace the special servicer of a particular loan in a CMBS transaction typically lies with party that is exposed to the first loss position in relation to that loan i.e. either the B-piece lender or the lowest ranked class of noteholders (usually labelled the ‘controlling party’ or ‘controlling class’). Such controlling party or controlling class therefore has a strong economic incentive to ensure that the maximum recovery from the loan is achieved by the special servicer.

The replacement (or indeed the threat of such replacement) of the special servicer is one of the, if not the, most important right of such controlling creditor. However, it is also usual for such right to be subject to certain conditions before it can be exercised or the replacement can be effected. For example, the requirements sometimes include: (a) the replacement special servicer will be required to accede to the servicing agreement and in many cases, the issuer deed of charge and cash management agreement; (b) the replacement special servicer will need to be approved by a number of the transaction parties (most commonly, the trustee and/or the issuer); (c) the replacement special servicer must have sufficient experience and capabilities to perform the function; (d) the replacement special servicer’s fees must not exceed those of the outgoing special servicer; (e) rating agencies must be notified or, more applicable to the recent announcement, rating agencies must confirm that the replacement will not lead to a downgrade or withdrawal of the ratings of the notes. Fitch’s announcement therefore makes the exercise of such right in transactions which have a requirement for RACs more difficult than it otherwise should be and may, depending on the wording of the underlying documents and the stance of the existing special servicer, take it away altogether.

Fitch’s concerns include potential conflicts of interest including “a connection between the controlling class (or its representative) and the prospective special servicer” and “conflicting preferences between the controlling class (or its representative) and other (in particular senior) noteholders”.  First, these concerns presume no such connection exists between the existing special servicer and a particular noteholder or class of noteholder and, secondly, they also presume that the replacement special servicer would disregard the ‘servicing standard’ (in accordance with which such special servicer has to act).  We would hope that Fitch in coming to this conclusion isn’t assuming that a replacement special servicer will breach the terms of the servicing agreement and if so, what of the transactions where multiple parties or affiliates act in different capacities, which might have different preferences?  The protection provided is that parties are contractually bound to perform their obligations and in most cases the issue of conflicts is specifically provided for in the realm of servicing obligations.

So what are the practical consequences of the Fitch announcement? Well, certainly a headache for lawyers advising issuers, trustees, servicers, controlling parties and noteholders or at the very least some delays in the replacement process, which will prove frustrating for controlling creditors attempting to exercise their rights. In reality, as with most securitisations, the devil will be in the detail of the documents, as the transaction parties will want to know, for example, if the RACs have to be in written form, whether the documents specify which party has to be satisfied that a RAC has been obtained, whether there is a fallback provision allowing a noteholder vote in the absence of a RAC or if Fitch are willing to provide a press release stating that the change of servicer will not impact the ratings of the notes once the change has occurred. Surely an outgoing special servicer wouldn’t object to the waiver of this rating confirmation requirement and the replacement if it is sanctioned by the noteholders or directed by its principal, the issuer or the trustee? 2013 looks like it’s going to be a fun year in CMBS for all sorts of reasons and Fitch have just given us another one.

Merry Christmas to all.

Basel Committee proposes changes to the Basel II securitisation framework – what does this mean for new issuance?

By Nick Stainthorpe and Theano Manolopoulou on Posted in ABS, Basel Committee on Banking Supervision

A new consultation paper  published earlier this week by the Basel Committee on Banking Supervision will inevitably cause uncertainty and is likely to affect investment decisions long before the new rules take effect.

The paper sets out the Committee’s proposal to revise the treatment of securitisation exposures and is largely inspired by the belief that highly-rated securitisations currently attract too little regulatory capital and low-rated senior securitisations are subject to regulatory capital charges which are too high. The proposals are relatively high level. The Committee has invited the submission of comments by 15 March  2013. Responses to the public consultation, together with the results of a quantitative impact study, will be considered as the Committee moves forward to suggest detailed amendments to the securitisation framework.

The consultation paper includes some eye-catching suggestions, such as the extension of the minimum 20% risk weight currently applied under the standardised approach to the (generally more sophisticated) banks which apply the internal ratings based approach and new sensitivity to the remaining term and thickness of tranches.  This is a fundamental review with all of the secondary rule making, adjustment and uncertainty which that implies.

The Committee is also considering whether certain early amortisation provisions should prevent an originator benefiting from significant risk transfer as, in their view, such provisions often result in regulatory arbitrage.

The development of these changes is occurring in the broader context of changes to prudential regulation such as Basel III and the implementation of Basel III and wider changes through CRD IV in Europe.

It is difficult to predict the long term consequences that these changes will have on the ABS market.  In the short term, institutions will take time to adjust and other investment and funding options may seem relatively more attractive. To the extent that the changes reduce the capacity of banks to originate and invest in securitised products, they may provide further impetus for non-securitised capital markets products and the non-bank  lending sector.  Could this provide more opportunities for the “shadow banks” which policy makers find so dangerous and yet so hard to define?