An Indian summer for LIBOR transition

Read time: 2 minutes 50 seconds

An Indian summer for LIBOR transition - Reed Smith

Over the summer, the Reserve Bank of India (RBI) issued a notice to banks and other RBI-regulated entities, emphasising the need to speed up the transition away from LIBOR. The RBI notice states that banks and financial institutions should not enter into any new LIBOR-related contracts after 31 December 2021, as ICE Benchmark Administration Limited, the administrator responsible for LIBOR, is halting publication of its one-week and two-month U.S. dollar tenors on this date.

The notice also advises banks only to enter into LIBOR-linked contracts prior to the 31 December cut-off date if substantial fallback clauses are provided for in the contracts. This advice similarly applies to the use of contracts referencing the Mumbai Interbank Forward Offer Rate (MIFOR), which is itself linked to U.S. dollar LIBOR. Only in certain instances, for example in hedging transactions or when novating MIFOR contracts, will the use of MIFOR still be advised. The notice suggests that financial institutions comprehensively review all current direct and indirect exposures to LIBOR, informing clients of the existence of transitional arrangements, as well as the alternative rates that may be employed in the move away from LIBOR.

The notice therefore comes as a timely reminder to the markets that increasing focus should be directed at deciding on a suitable alternative reference rate (ARR) to employ in future agreements. This is a significant decision, not least because globally US$260 trillion in contracts is currently linked to LIBOR. In the context of India, the RBI estimated in its November 2020 bulletin that the country’s total exposure to LIBOR sat at $331 billion, as around 90 per cent of India’s current contracts refer to U.S. dollar LIBOR, whether via MIFOR regimes or otherwise.

Despite the RBI’s proposed cut-off date of 31 December 2021, the true deadline for a complete transition to contracts which reference U.S. dollar LIBOR in any capacity is not until 30 June 2023, until which time tenors other than one week and two month, such as one month, three month and six month will continue to be produced. Whilst this avoids an imminent disruption to the market and provides some breathing room for certain transactions, it does raise a question when entering into new facility agreements: should parties elect to put all faith in a designated ARR from the outset of the facility or, alternatively, adopt a wait and see approach by utilising a transitionary mechanism, whereby LIBOR applies for a specified term of the facility before essentially shifting to an ARR following a triggering event?

The messaging from the RBI is significant not only in its timing, but also in how it has been received by the market, with activity levels for LIBOR transition markedly increasing after the announcement. Whilst the first LIBOR replacement transactions at the start of this year showed the market that the issue was being considered, the RBI’s announcement has made banks focus on the need to get their houses in order quickly and develop a firm view on this critical issue. As regulator, the RBI can provide advice and make announcements, but ultimately it is down to the banks to take the next step on this journey to LIBOR transition.

If you are interested in learning more about Reed Smith’s India Business Team and how we can help you navigate the Indian marketplace, please visit our India page or contact Gautam BhattacharyyaSachin Kerur, Niket Rele or Nathan Menon. For further information on IBOR transition and related issues, please visit our IBOR page or contact Claude Brown.

There’s a buzz in the air and it’s CMBS!

Read time: 3 minutes

2021 is so far proving to be a stellar year for European CMBS, and if the current momentum continues 2021 will go down as a truly bumper year for the product.  Like many other financial transactions, despite a promising start to 2020, CMBS certainly ended up having a torrid ride on the primary issuance front. This is a far cry from the first half of this year which has proven to be anything but sluggish! Notable transactions that have so far taken place or are in the process of being marketed include the following:

  • Last Mile Logistics Pan Euro Finance – c.€510m transaction secured by last mile logistics properties located in Germany, the Netherlands, France, Spain, Ireland and Denmark.
  • Agora Securities UK 2021 – c.£211m transaction secured by retail properties located in the United Kingdom.
  • Bruegel 2021 – c. €220m transaction secured by office, hotel and retail properties located in the Netherlands.
  • Berg Finance 2021 – c. €295m transaction secured by office properties located in the Netherlands, France, Austria, Finland and Germany.
  • Last Mile Securities – PE 2021 – c. €373m transaction secured by light industrial properties located in the  Netherlands and Germany.
  • Taurus 2021-3 DEU  – c.€512m transaction secured by the Squaire office and hotel property located in Frankfurt.
  • Taurus 2021-2 SP – c. €132m transaction secured by office properties located in Spain.
  • Taurus 2021-1 UK  – c.£320m transaction secured by last mile logistics properties located in the UK.

Taken together these transactions provide the firmest indicator yet that that the beleaguered CMBS product is firmly back in vogue.

The inflection point for the latest surge in activity can be said to stem from the hugely successful hat trick of Taurus transactions at the height of winter (and in quick succession) which really kick-started the 2021 CMBS party. Not only did these deals breathe fresh life into an otherwise subdued market but the pricing achieved provided market participants with a very stark reminder that with the requisite macro-economic conditions and a healthy dose of investor demand, CMBS can be the golden ticket. The spate of deals that have since followed not only re-affirm and endorse this message, but in fact positively demonstrate that CMBS not only has a role in financing European commercial real estate but that it can be extremely profitable for those market participants (borrowers, arrangers and fixed income investors alike) that wish to embrace this technology.

The great news about this recent surge in activity, is not only the fact that a number of different arrangers are sitting behind these issuances but also the fact that these transactions feature different underlying asset types from a range of jurisdictions. However from our standpoint what is most encouraging about this recent spate of activity, is the fact that European CMBS is making this resurgence notwithstanding the unprecedented pressure that the pandemic has applied to existing CMBS structures. The fact that CMBS 2.0 has managed to weather the worst of the pandemic can be regarded as a ringing endorsement for the asset class.

For the erstwhile industry participant, this is not the first time that we have had the pleasure of riding a CMBS 2.0 wave. 2015 was proving to be an extremely prosperous year until the summer when the threat of Grexit followed by the Chinese financial crisis brought primary issuance to an unexpected crashing halt. Similarly, the same could be said to be true at the beginning of last year until the pandemic struck. Although a sobering thought that the market will only be too aware of, it is nevertheless our hope that arrangers continue to “make hay while the sun is shining”, that CMBS truly prospers and that ultimately we will witness the development of a deep and mature CMBS market.

To discuss European CMBS further, please contact the author, Iain Balkwill.

FCA announces the future loss of representativeness for LIBOR benchmarks

Read time: 2 minutes 40 seconds

The FCA announced on March 5, 2021 the future cessation and loss of representativeness of the LIBOR benchmarks. This news was expected, but its comprehensiveness is very welcome.

As a result, December 31, 2021 will be the last day on which all euro and Swiss franc LIBOR tenor settings are published, and some sterling, yen and U.S. dollar settings will also cease then.

December 31, 2021 will also be the last day the remaining sterling and yen settings are considered representative.

June 30, 2023 will be the last day on which the remaining tenors of U.S. dollar LIBOR settings are considered representative.

The FCA’s announcement went on to describe the start of a consultation in relation to the possible continued publication of one month, three month and six month sterling and yen LIBOR on a non-representative, synthetic basis for a period after the end of 2021. The FCA noted that it will also consider a similar consultation for the continued publication on a synthetic basis of certain U.S. dollar LIBOR settings.

The announcement constitutes an Index Cessation Event under ISDA’s IBOR Fallbacks Supplement and the ISDA 2020 Fallbacks Protocol for all LIBOR settings. This means that the fallback spread adjustments referenced by those documents is fixed as of March 5, 2021 for all euro, sterling, Swiss franc, U.S. dollar and yen LIBOR settings. The ARRC has subsequently confirmed that, in its opinion, a “Benchmark Transition Event” has occurred and its recommended spread adjustments match ISDA’s spread adjustments for U.S. dollar LIBOR (except in relation to loans to consumer borrowers).

The FCA made its announcement of the future loss of representativeness on the understanding that the majority of existing contributors to LIBOR intend to stop providing submissions. ICE Benchmark Administration (IBA, the LIBOR benchmark administrator) provided further clarity in a feedback statement published on March 5, 2021 stating that for all LIBOR settings (other than five U.S. dollar LIBOR settings) a majority of LIBOR panel banks had notified it of their intentions to cease submitting input data after the publication on December 31, 2021 (for the five U.S. dollar settings, the relevant date is instead June 30, 2023).

The FCA’s announcement is in line with its powers under existing legislation, although under the proposed enhancements to the UK BMR set out in the Financial Services Bill, it will be able to determine lack of representativeness in other contexts besides the departure of panel banks (the timing of when the Financial Services Bill will become law is not yet certain).

The FCA could have chosen to compel contributors to continue submitting, but rather it is consulting on compelling the IBA to continue to publish certain tenors of sterling and yen settings for periods after the start of 2022. The FCA made clear that synthetic LIBOR would not be published for new contracts but would be available for tough legacy contracts. So, the market should not see references to synthetic LIBOR as a signal that LIBOR is continuing for the broader market.

While the FCA’s announcement on March 5, 2021 is an important event in the timeline for the end of LIBOR, it will be interesting to see what the enactment of the proposed Financial Services Bill and the production of the synthetic LIBOR means for the market.

For more information on IBOR please visit our website.

2021: a critical year for LIBOR transition in India

Read time: 4 minutes 50 seconds

As well as ringing in the start of a hopefully brighter and better 2021, January also saw Indian banks testing the waters of LIBOR transition, with State Bank of India and ICICI Bank involved in their first alternative risk free rate transactions. Utilising the US dollar Secured Overnight Financing Rate (SOFR), these deals signal that the Indian market is at last receptive to the prospect of LIBOR transition, having been initially slower to react than other markets.

The 2021 deadline for the cessation of LIBOR dates back to 2017 when the Financial Conduct Authority commenced the discontinuation process, pledging not to compel panel banks to publish LIBOR beyond the end of 2021. Despite the impact of the COVID-19 pandemic which initially appeared as though it may cause the regulators to extend the status quo, the financial repercussions of the crisis have only served to reinforce the inadequacies of LIBOR, providing momentum to the replacement process globally. That said, the scale of the transition, particularly in the US dollar market is huge and, in recognition of the enormity of the task facing banks, the transition deadline for certain dollar LIBOR rates has been pushed back to mid-2023.

The LIBOR transition process in India has been driven largely by the Reserve Bank of India (RBI) and the impetus and encouragement it has provided to the process. The RBI constituted its Financial Benchmarks Committee in June 2013, in an attempt to review and retain the integrity of the Indian financial benchmark system in the context of the extensive cases of LIBOR manipulation. In June 2019, the RBI introduced a regulatory framework for financial benchmark administrators to create an acceptable and consistent standard of benchmark calculation. Following this, a “Dear CEO” letter was circulated in August 2020, communicating to all commercial banks the need for stakeholders to prepare for LIBOR’s cessation. The pressure on commercial banks increased in November 2020 when the RBI’s bulletin for that month built upon its previous messaging, further increasing market participants awareness of the need for a proactive approach to address LIBOR discontinuation.

Coming around the time of Diwali, the Hindu festival of lights, the November bulletin was an unexpected firework from the RBI, which lit up the financial sky in India in late 2020.  In this bulletin, the RBI laid bare the extent to which progress still had to be made on LIBOR transition and estimated that India’s LIBOR exposure amounted to $331 billion, warning institutions that they only had just over a year to implement their transition plans. In this short timeframe, banks have been tasked with identifying exposures, determining the associated risks, and taking steps to complete the transition process. The link between LIBOR and the Indian economy is profound; the Mumbai Interbank Forward Offer Rate (MIFOR) is calculated using USD LIBOR, as are commercial borrowings, derivatives, government loans and trade contracts. The conversion process will be complex, as evidenced by the challenges currently being faced by other markets which are further forward in their transition journey.

Other economies have established networks of working groups and committees to investigate and recommend alternative risk free rates (RFRs), to replace LIBOR and to advise on managing the transition process. Following this direction, the Indian Banks’ Association (IBA) has formed a LIBOR working group, dedicated to recognising and measuring the impact of LIBOR’s cessation on the Indian markets. Modelled on the approach adopted by the UK and US regulators and trade associations, the working group is raising awareness of the process and issues through a series of webinars and conferences. Its review has revealed that contractual fallback clauses facilitating the continuation of contracts despite the discontinuance of LIBOR are largely absent or, where present, insufficient. This further highlights that the existing fallback language will often be highly bespoke to the Indian market, requiring further development to meet the global standards and practices that have evolved in other economies.

These recent initial SOFR based transactions from Indian banks are an important first step in testing the infrastructure required to support India’s LIBOR transition, signalling that the Indian market has moved on from discussion and consultation to commence the implementation phase. However, despite this promising start, it is clear that developing internal approaches and strategies to replace a fundamentally entrenched benchmark will be a complicated process with far reaching ramifications, and that India still has a way to travel on its journey to adopting replacement RFRs. Guidance has been circulated to assist member banks in the assessment of accounting, tax and IT capabilities necessary for the transition. The Indian economy, like all economies globally, will require a substantial element of re-engineering to prepare IT systems, reporting, risk management and internal governance for LIBOR’s cessation as differing RFR publication timings, and pricing are built into the systems and processes of Indian banks.

At present, not all the future steps on India’s LIBOR transition journey are clear, with the IBA still working towards developing an acceptable MIFOR alternative rate. Having witnessed other economies grapple with settling on an alternative replacement RFR, the proposed replacement needs finalising and publishing imminently to enable stakeholders to act and implement it. In addition, the challenge of amending existing transactions that reference LIBOR and the tough legacy contracts that this process will undoubtedly expose, are largely uncharted territory for Indian markets. Experience of this process in other economies has demonstrated that time is required to identify tough legacy contracts and plan on how to deal with them, work on amendments and devise guidance on how to approach them. However, with the clock ticking, time is a luxury that the Indian market does not have.

If you are interested in learning more about Reed Smith’s India Business Team and how we can help you navigate the Indian marketplace, please visit our India page or contact Gautam Bhattacharyya, Sachin Kerur, Bobby Majumder, Niket Rele and Nathan Menon.  For further information on LIBOR transition and related issues, please visit our IBOR page or contact Claude Brown.

NPL Securitisation – time for this versatile instrument to shift up the gears!

Read time: 3 minutes

The term “NPL Securitisation” has been bandied around a lot recently, and for good reason given the hugely important role it can play in the non-performing loan (NPL) arena.

As banks begin to contemplate life after COVID, they will be acutely aware of the need to neutralise NPLs sooner rather than later. These stockpiles will not only constitute NPLs emanating from the global financial crisis but will also comprise a new crop of NPLs in the form of both COVID loans and those loans that have become impaired as a direct impact of COVID measures on individuals and businesses.

One of the many lessons learnt from the aftermath of the Global Financial Crisis was that the sooner banks off-load NPLs, then the better for not only the bank in question but also the economies in which they serve. It is therefore critical that as world economies begin to unlock there is a concerted effort by banks to address their NPLs on a timely basis rather than kick the can down the road.

All the current hallmarks infer that NPL Securitisation has a critical role in this deleveraging process. On one level this technology can be deployed as a balance sheet management tool, enabling banks  to substitute NPLs with securitised notes. However a much more exciting proposition is that instead of a bank retaining NPL Securitisation notes, these are instead sold to third party investors and thus properly distilling the underlying credit risk from bank balance sheets.

At this point in time, NPL Securitisation is certainly being viewed favourably. In Italy the GACs (Garanzia Cartolarizzazione Sofferenze) framework has successfully run for the past five years, and has enabled Italian banks to shed huge volumes of non-performing loans from their balance sheets. More recently over the past year the Greek equivalent (Hellenic Asset Protection Scheme (HAPS)) has demonstrated that it can play a very important role in enabling the Greek banks to divest large amounts of NPLs in one fell swoop. Both these instances of the deployment of NPL securitisation technology have proven to be highly successful and in many respects have created the perfect blue-print for other countries to follow.

The importance of NPL Securitisation in addressing the NPL problem is also acknowledged by the European legislature. Indeed, so-called “quick fixes” to the Securitisation Regulation and the Capital Requirements Regulation are in the process of making their way through the European legislative mill, which will make the deployment of NPL securitisation technology significantly more appealing.

It would be fair to say that the NPL Securitisation market is certainly in its infancy, but drawing on the success of the utilisation of this technology in Greece and Italy and capitalising on the quick fixes to European legislation, this market is set to grow. Indeed, when you consider the potential volume of NPLs and investors current thirst for yield then this could be a hugely significant market.

The potential of NPL securitisation technology though isn’t simply confined to banks off-loading NPLs. This technology can be more widely used, and in some quarters it has been surmised that it can be used as a funding tool for so-called Asset Management Companies (bad banks). NPL Securitisation can also play an important role for investors through being used as:

  • source of leverage to improve their internal rates of return;
  • a neat tool to either monetise unwanted NPLs or the tail of a portfolio of NPLs that they have largely worked through; and
  • an investment vehicle for one or more funds to acquire interests in NPLs.

Whichever way you look at it, NPL securitisation is a highly versatile piece of technology that has massive latent potential. When you consider all this against the backdrop of huge volumes of NPLs, the need to address these promptly alongside some much encouraging legislative treatment (not to mention it’s much improved reputation….), then NPL Securitisation is certainly primed to shift up the gears!

Lessons learnt from “The Missing Cryptoqueen”: has cryptocurrency regulation caught up?

Read time: 4 minutes

As terms like social distancing and the second wave have permeated our lives throughout the 2020 Covid-19 pandemic, people have been forced to adapt to the new normal. It hasn’t been all bad, and an unanticipated quirk of lockdown has been the huge uptake in hobbies and personal interests as people adopt new methods of entertainment. With podcasts growing in popularity before the pandemic, they have now entered a golden age, as demand soared throughout lockdown for new content.

One podcast that has kept us engrossed in recent months, produced by Jamie Bartlett through BBC Sounds, is “The Missing Cryptoqueen” which documents the creation of OneCoin. Marketed as a Bitcoin-style cryptocurrency with an almost cult-like devotion, its creator Dr Ruja Ignatova seemingly successfully executed a multi-billion dollar scam, marketing her fictional OneCoin as a legitimate cryptocurrency, all before disappearing from view and leaving a trail of chaos in her wake. “The Missing Cryptoqueen” highlights the borderless nature of cryptoassets, and the decentralised system upon which they are built. Which prompts an important question, how are cryptocurrencies regulated?

The risk of cryptoassets are well established, with the volatility of cryptocurrencies often their biggest draw to investors. The decentralised digital foundations of cryptocurrencies makes them vulnerable to crypto crime, with often insufficient recourse in the law for victims of offences. This risk has generated a gradual, yet somewhat reactive response from governments when approaching regulation. To regulate is, after all to lend legitimacy and integrity to an asset class, signalling to the market that this investment is safe, and protected by law. Until recently, this argument has dictated a cautious approach from the UK government, generating reluctance to regulate and legitimise these financial instruments.

Despite this, cryptoassets have increasingly entered mainstream markets, no longer reserved for individuals with an interest in finance and technology, and are increasingly seen as the future of finance. Large organisations have lent legitimacy in this process; Facebook announced their own cryptocurrency, Libra, last year, and in October 2020 online payment giant PayPal joined the cryptocurrency market, permitting cryptocurrency buying, selling and shopping on the network renowned the world over as one of the safest ways to pay online. These market movements have eroded government resistance generating a surge of cryptoassets regulation.

2018 saw the UK government pledge support for cryptoassets in the form of the FCA’s cryptoassets task force, and a consultation of cryptoassets soon followed. The resulting legal statement has formed the foundation for regulation, classifying cryptoassets as property under English law despite their decentralised, intangible nature.

This classification imposes English common law and regulation upon cryptoassets and their activity. Fraud, insolvency and company legislation now monitor and control the marketing, trading and holding of cryptoassets for the first time. This process was seen in practice in the case of AA v Persons Unknown in February 2020 where the court made a direct ruling on the status of cryptocurrencies as property, granting an interim injunction over Bitcoin. Demonstrating the importance of this classification for the future of cryptoassets, as their new property status means cryptocurrencies can now form the basis of claims relating to fraud, theft, insolvency and vesting of property.

In early 2020, the UK government built upon these foundations mandating companies who conduct crypto-related activities to register with the FCA. This requirement followed a recent amendment to the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs), which appointed the FCA as cryptoassets’ official regulatory body. This development is designed to reduce money-laundering relating to cryptoassets through registration and ongoing reporting obligations.

In addition to this ongoing monitoring, more definitive action has been taken in relation to derivative instruments that reference cryptoassets. Regulated by virtue of the derivative to which they relate, effective from 6 January 2020 the FCA is imposing a ban, prohibiting the marketing and trade to retail clients, of derivatives, which reference cryptoassets within the UK. This action reflects the risks associated with cryptoassets, demonstrating that regulatory bodies are not entirely comfortable with the wide scale adoption of cryptocurrencies within the UK market. In the accompanying FCA policy statement, lack of understanding and transparency of cryptoassets were cited as justification behind this prohibition.

Ideas surrounding cryptocurrency regulation have been mooted for many years, however it seems that regulation of these innovative, fast moving instruments is finally materialising but not at the pace most would hope. ‘’The Missing Cryptoqueen’’ showed us the extent to which cryptoassets can be used as a front for Ponzi schemes, exploiting financially vulnerable people in the UK, and abroad. Regulators have found themselves having to catch up with sophisticated and marketing savvy cryptocurrency efforts – and making rogue market participants harder to task. Clearly, regulations introduced have gone a significant way to help prevent another financial crime being perpetrated without sufficient recourse in the UK.  It is now up to regulators to continue their vigilance against such schemes, all whilst allowing the legitimate cryptocurrency market to thrive.

Navigating the NPL Securitisation maze

Read time: 4 minutes 25 seconds

NPL Securitisation is a term that is very much en-vogue at the present time. Although its rise to prominence can be attributed to a number of factors, in recent weeks the chief contributor has been the European legislature steps towards amending the Securitisation Regulation and the Capital Requirements Regulation. These steps are being taken to ensure that securitisation is better placed to facilitate banks offloading NPL’s in the aftermath of the COVID-19 pandemic. In the months and years ahead, the term NPL securitisation will no doubt be bandied around a lot, but what exactly is NPL securitisation? As an attempt to de-mystify this, I thought it would be helpful to give an overview of the different types of structure.

In essence, an NPL Securitisation describes a financial structure whereby an owner of NPLs sell these to a special purpose orphan vehicle that funds such an acquisition by issuing debt securities into the capital markets. The vehicle will in turn appoint a servicing entity that will manage the NPLs on a daily basis with a fee structure that incentivises them to maximise recoveries on the underlying loans. On a broad level such a securitisation falls into two categories:

  • Primary Securitisation – which involves the seller (typically a bank) using this technology to remove NPLs from their balance sheet.
  • Secondary Securitisation – which involves an acquirer in NPLs using securitisation as a form of leverage to maximise their internal rates of return.

We will now delve into a little more detail with respect to each of these categories of NPL Securitisation.

Primary NPL Securitisation

Primary NPL structures are rightfully receiving a significant amount of attention from the regulators as this technology has been identified as having the potential to play a hugely significant role in enabling the banks to clean up their balance sheets. There are three divisions of this type of structure.

Third Party NPL Securitisation – here a securitisation structure is used to offload loans from a balance sheet with the resultant issuance being solely subscribed for by third party investors. This is of course the ideal mechanism to transfer problematic credit risk from the banking sector to the capital markets and these transactions will be of increasing importance in the coming years. More information around these types of structure are detailed in articles I recently had published in The World Financial Review (Time for securitisation to be a friend and not a foe of the NPL hit banks) and World Finance (Securitisation – the antidote for non-performing loans).

Retained NPL Securitisation – in this instance, all of the issued notes are retained by the NPL Seller on the basis that they will command a more favourable capital treatment for holding securities in lieu of the non-performing loans themselves. In other words, NPL securitisation is being used as a balance sheet management tool which may also involve a repo.

Government Backed Securitisations – these types of structure constitute the most prevalent type of NPL Securitisation in recent years although only confined to Italy (“GACS” (“Garanzia Cartolarizzazione Sofferenze”)) and Greece (“HAPS” (“Hellenic Asset Protection Scheme”)). In both jurisdictions, governments have enacted a scheme whereby they provide a guarantee for the most senior class of notes whilst at the same time the junior class of notes are sold to third party investors.

Although these are the broad categories, there are often hybrids of these structures in place in situations where issued securities are both retained by the seller as well as issued to third party investors.

Secondary NPL Securitisation

As has become customary in the NPL market, leverage has been a key ingredient for investors to boost their internal rates of return on NPLs. The predominant form of leverage to date has taken the form of loan-on-loan financing which has been provided by the seller or a third party bank either on the acquisition date itself or at a later point time. In the context of NPL securitisation what is envisaged is that in lieu of loan-on-loan financing, a securitisation takes place in order to provide a form of leverage. Indeed, if it can be demonstrated that this form of leverage is cheaper and is capable of providing greater flexibility for the investor than otherwise would be the case for a loan-on-loan financing (which I understand is the case), then these are fertile conditions for growth of activity in this space. Similarly, it is worth noting that although not strictly an NPL securitisation, there have been a number of instances in the market where investors have transformed NPLs into re-performing loans and have securitised these.

Based on this canter through the NPL securitisation maze, there are clearly many different types of NPL securitisation which have their own unique characteristics and this is before we factor in the nuances of individual structures such as whether the issuance is listed, rated, public or otherwise. To make matters even more convoluted, given that for the purposes of the Securitisation Regulation loan-on-loan financings are technically classified as a securitisation, market participants frequently refer to these types of financing as securitisations despite the fact that there is no capital markets element.

In conclusion, the NPL securitisation label is extremely broad and although the rise to prominence of this technology can be considered hugely welcome, given the amount of attention these structures are rightfully receiving as well as the infancy of the market, a concerted effort to be properly prescriptive on what NPL securitisation actually means would pay dividends for the greater good of the NPL securitisation market as a whole.

The tide has changed! Don’t wait – embrace NPL securitisation now!

Looking at the most recent data in the European Banking Authority quarterly Risk Dashboard (published on 5 October 2020), it becomes abundantly clear that COVID-19 is beginning to manifest itself in the NPL market with the cessation of the multi-year declining trend in NPL levels.  The NPL tide has clearly changed, and if you consider the new crop of NPL’s when coupled with those legacy impaired assets stemming from the global financial crisis, it becomes apparent that there will be a heightened volume of NPLs that will need to be distilled from the banks in the coming years.

It is our view that securitisation can play an instrumental role in efficiently off-loading NPLs from the balance sheets of banks (which was not really an option following the GFC), and in this vein, we explore the feasibility of this in two recently published articles:

  • The World Financial Review – “Time for securitisation to be a friend and not a foe of the NPL hit banks” –  as available to view in full here (25 September 2020)
  • World Finance – “Securitisation – the antidote for non-performing loans”  available to view in full here (5 October 2020)

Ultimately, the sooner that securitisation technology is embraced, the better this will be for not only the banks but also the economies in which they serve.

CMBS 2.0: Treatment of prepayment fees and the icing on the cake

Read time: 3 minutes 50 seconds

Fourteen years ago this September, I distinctly recall attending a conference hosted by the European CMSA that was focussed on the advent of CRE CDO’s. At the time, the emergence of these structures was seen as an extremely exciting development as it marked a natural progression for the maturing CRE finance market (following the success of the product in the US). Additionally, it showed there was an overriding need for the asset class as a means of absorbing the ever increasing numbers of B-Notes, CRE mezzanine loans, CMBS bonds and other forms of structured CRE debt that was beginning to flood the market.

Despite there being a general acceptance that this was a natural and welcome step in the evolution of European CRE finance, a number of issues were raised such as the lack of standardisation and the availability of suitable underlying collateral. The chief concern though was around prepayment risk, which was a very  real issue at that point in time on account of escalating interest rates coupled with the exponential growth of CMBS issuance that provided increasingly favourable pricing for borrowers.

Although the heightened level of prepayment risk was not cataclysmic for CMBS, this issue was construed as a fly in the ointment. From an investors perspective prepayments were certainly not welcome, especially if redemptions happened relatively soon after issuance. From the structurers point of view, given this was an issue that was very much under the spotlight, it created a structural nightmare in terms of devising how principal should be applied. This was especially true in those transactions that featured multiple loans of varying quality, a difference in interest rates and a wide geographical spread of underlying properties. The modified pro-rata application of principal repayments really went through the structuring mill, which manifested itself with some hugely complex CMBS structures as the structurer sought to ensure that principal was applied in such a way to ensure that credit enhancement erosion for the senior notes was limited, that the weighted average rate on the notes was kept in check whilst at the same time ensuring that the class X would not be adversely impacted.

In essence, prepayments were a necessary evil and were a natural by-product of the economic forces at the time. For the greater good of the product, measures were taken to mitigate prepayment risk through a combination of lock-out periods and prepayment fees. Although a useful deterrent, there are two important points to be mindful of. Firstly, there was no absolute prohibition on prepayment after the lock-out period had burned away. Secondly, prepayment fees were invariably for the sole benefit of the Class X or the loan seller as deferred consideration and thus not shared with those noteholders who suffered from the pain and inconvenience of the early redemption.

If we turn to CMBS 2.0, this in-equitable distribution of prepayment fees has sought to be addressed through noteholders now being entitled to a quantum of the prepayment fees and therefore a vast improvement from the previous status quo. Although credit should be given to CMBS 2.0 for this more equitable division of the spoils, one thing that has become clear is that how these prepayment fees are allocated varies widely:

  • Some transactions allocate a percentage (say 50 per cent.) of prepayment fees to the noteholders, where other transactions just stipulate that all amounts should be paid to the noteholders.
  • Other transactions include a detailed formula which ensures that the prepayment fees are split between the Class X and the noteholders in the same ratio as interest on the underlying collateral is applied between the two classes of investment. An enhancement to this (from the Class X perspective) has been to exclude administrative costs from the formulation, thus increasing the amount that benefits the Class X.
  • Another structural nuance (which benefits the noteholders) is that following the occurrence of a Note Acceleration Event, 100 per cent of the prepayment fees are directed to the noteholders at the detriment of the Class X.
  • A further modification has been the application of a cap to the amount of prepayment fees that a certain class of notes is entitled to receive, the quantum of which ratchets down over time.

The treatment and application of prepayment fees can therefore be said to be one of the bedrocks of innovation for CMBS 2.0. Indeed, like other aspects of CMBS which I have written about (CMBS 2.0 – Standardisation the fuel for exponential growth; CMBS 2.0 – Class X – variety is not always the spice of life; CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0), this is yet another area of the structure that would certainly benefit from greater standardisation. Although for now CRE CDO’s have been confined to the history books of European structured CRE debt prepayment risk certainly has not, and although the equitable distribution of prepayment fees has been a huge leap in the right direction, the standardisation of this would be the icing on the cake.

CMBS 2.0 – Standardisation the fuel for exponential growth

Whether you are a supporter of using CMBS to finance commercial real estate or not, the simple fact is that it provides an efficient mechanism to transfer commercial real estate loan risk away from the banking sector, whilst at the same time providing much needed transparency to the commercial real estate lending market. In light of these hugely positive attributes, not only will CMBS continue to have a role in financing commercial real estate, but if market participants play their cards right, then we could once again witness the return of exponential growth of issuance.

The key to unlocking the latent potential of CMBS as a financing tool lies with continuing to build the trust and confidence of investors, regulators and market participants as a whole. Indeed, giant steps forward have been achieved on this front through arrangers taking heed of the structural reforms proposed by CREFC (Market Principles for Issuing European CMBS 2.0) and the investor principles of March 2013. The Securitisation Regulation has also acted as a beacon of best practice through encouraging and incentivising securitisation structures to be simple, transparent and standardised.

Although the European legislature’s decree that CMBS is not capable of qualifying as a simple, transparent and standardised securitisation and therefore able to reap the reward of some favourable regulatory capital treatment, the structuring of deals as simple, transparent and standardised should still be considered best practice. This is essential for harnessing the trust and confidence of the market that is ultimately required to fuel exponential growth.

If we turn to the recent crop of CMBS deals, it is apparent that there is a lot more standardisation than was the case prior to the Global Financial Crisis of 2007. However, if a more forensic review of these structures is undertaken and comparisons made across deals, then it becomes clear that structures are not as standardised as they could be. This is something that we have already identified with regard to Class X (CMBS 2.0 – Class X – variety is not always the spice of life), but the same could be said to be true with regard to payment waterfalls. High level observations of these variances include:

  • Although all deals have a revenue waterfall, a principal waterfall and a post enforcement waterfall, some transactions also have an intermediate waterfall which kicks in once there has been a material default on a loan. To add to the complexity, if there is a risk retention loan in place (which is not always the case), then there will also be a corresponding loan waterfall for each note waterfall, meaning some deals could have eight waterfalls where as others just three.
  • With regard to the revenue waterfalls, these do vary from one transaction to another. For example, some deals provide a separate bucket for prepayment fees where others do not. Also, in situations where there is no intermediate waterfall, there is likely to be separate buckets for the sequential application of principal and excess floating rate amounts.
  • Principal in some structures is applied pursuant to a waterfall which makes provision for work-out and liquidation fees as well as caters for surplus proceeds. Other transactions are a lot simpler and only specify what amounts of principal are due to certain classes of notes and their relevant order.
  • The application of principal varies widely, with some deals at one end of the spectrum having a straightforward modified pro-rata waterfall with cash trap proceeds being applied sequentially and the remainder amounts pro rata. At the other end of the spectrum,  sequential proceeds are actually based on the amount of principal received on a loan based on the relevant loan’s principal amount outstanding. In addition, some transactions (but definitely not the majority) provide for the reverse sequential application of certain amounts of principal.
  • With regard to liquidity support, we have seen this take a variety of forms whether by way of a reserve or a facility provided by an affiliate of the arranger or a third party (see further CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0). Given these variances in liquidity support, this also manifests itself with different types of payment buckets across deals.
  • Finally, although all deals have the essential payment components (various administrative fees, interest, principal, pre-payment fees, excess floating rate amounts, default interest) there are also a number of additional payment buckets that differ across deals. Similarly, there are also variations to the treatment of the payment of Class X amounts, especially after these have been subordinated.

When looking at the above list, it is clear that each of the points is independent and separate. If one or more of these is adjusted (even slightly), the consequence is that when you compare one transaction against another, the payment structure can look substantially different. This is especially true if you also factor in some of the nuances that we have identified with regard to the structuring of the Class X. Although on a case by case basis taking into account the underlying collateral and the benefit of a structure, then the rationale for a particular variance does becomes apparent. The issue lies with the fact that as far as payment waterfalls go there is a lack of standardisation in European CMBS.

Given that CMBS by its very nature features underlying collateral that is not hugely granular, and that to date we have not witnessed (unlike in the US) the volume of issuances that actively encourages a more standardised and commoditised approach to structuring a deal, it is inevitable that there is a level of variance as transactions are finessed, improved and structured to cater for the unique attributes of the underlying collateral whilst at the same time maximising returns. Until we reach the point in time that there is a steady flow of issuance, structures have been tried and tested and ultimately CMBS becomes more commoditised, variance in CMBS will continue to be endemic to the asset class, albeit the magnitude of variance will likely diminish as the market continues to mature.

Market participants and structurers in particular should therefore be hugely cognizant of this lack of standardisation, and although it is correct that they should be modifying and finessing transactions to improve the overall product, such changes should not be at the detriment of investor confidence. Accordingly it is imperative that where possible, material changes should be incremental and standardisation should be actively promoted not only within CMBS programmes but also across programmes. If this can be achieved, it will improve CMBS consumer confidence and with it provide the vital fuel to spur the exponential growth that the product rightfully deserves.