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Securitization Structured Finance Solutions

Securitization Structured Finance Solutions

Securitization Structured solutions

March 2018 Brochure / report title goes here | Section title goes here

Contents

1. Preface 4 1.1 Introduction 4 1.2 The appeal of 4 1.3 A new European financial landscape 4 1.4 The state of the EU securitization market 6 2. Industry fundamentals 9 2.1 Benefits of securitization 9 2.2 The process 10 2.3 Types of -backed securities 10 2.4 and return profiles of notes 11 2.5 The flow waterfall 12 2.6 True sale securitization 13 2.7 Synthetic securitization 14 2.8 enhancement 16 2.9 Securitization parties 18 2.10 Capital Requirements 24 3. Luxembourg securitization 39 3.1 The Luxembourg securitization framework 39 3.2 Benefits of Luxembourg securitization 40 3.3 The Luxembourg exchange 42 3.4 Securitization vehicles 42 3.5 Authorization and supervision 45 3.6 45 3.7 Reporting obligations 45 4. Structuring scenarios 49 4.1 Structuring scenarios 50 5. Our services and technology 65 5.1 Our services 66 5.2 Our technology 68

02 Securitization | Contents

“It is widely agreed that when used properly, securitization can increase the availability of credit and reduce the cost of . As a funding tool, it can contribute to a well-diversified funding base. As a risk transfer tool, it can also act to improve capital efficiency and allocate risk to match demand.”

Esma, 13 June 2016

03 Securitization | Preface

Ekaterina Volotovskaya Partner Securitization leader

1. Preface

1.1. Introduction held non-performing (NPLs) with to professional and high-net The Law of 22 March 2004, as amended a gross carrying amount of around €1.0 worth clients. Finally, securitization may (“the Securitization Law”), sets out trillion (and with a net carrying amount of serve as a solution to run-off sub or non- a comprehensive and flexible legal, €560 billion) at the end of 2016 (gross NPLs performing private (PE) and illiquid regulatory, and fiscal framework to amounted to 5.1 percent of gross loans in fund . encourage securitization the EU at the end of 20161). The in Luxembourg. The Securitization and restructuring of these legacy 1.3. A new European Law was devised to facilitate capital portfolios through securitization can help landscape market transactions and/or intra-group such restructure their balance The European Commission (EC), the transactions, or a combination of both, sheets and transfer the of European Central (ECB) and the Bank but can also be used in the context of exposure to the wider . of England (BoE) have taken a positive restructuring. view and aim to restart EU securitization From a capital market perspective, notwithstanding that securitization has Aside from the obvious benefits associated securitization can provide additional been stigmatized—sometimes rightly, with freeing up the regulatory capital that opportunities to institutional sometimes not—as one of the major must be set aside by banks, securitization investors with differing asset diversification, contributors to the financial crises of 20082. can act as a catalyst for additional lending risk and returns, and duration profiles. The However, a clear distinction between EU to the real economy. Transferring the risk repackaging of non-liquid or loans and US securitization must be drawn, as of some loans to other banks or - into new financial instruments enables attributes and performance were markedly term investors such as funds conversion from illiquid to liquid securities. different. According to data compiled and generates new Investors can therefore gain exposure to by the EBA, the worst-performing EU lending capacity. This is crucial for the different asset classes such as , securitization products in the “AAA” European economy, since banks are then shipping, consumer finance, aviation or and “BBB” segments defaulted by only free to extend new loans to households vehicle without directly financing 0.1 percent and 0.2 percent, respectively, and —in particular, small and individual assets and violating investment at the height of the financial crisis. medium-sized enterprises. policies or restrictions. This was in stark contrast to rates of 16 percent and 62 percent, respectively, 1.2. The appeal of securitization Securitization can also present untapped for US securitization products rated “AAA” Securitization can also be an effective opportunities for banks in Luxembourg and “BBB”3. mechanism in the deleveraging of seeking to adopt a new or European banks. Europe’s largest banks broaden the appeal of their product range

04 Securitization | Preface

Figure 1: Three-year default rates at AAA These significant differences in default level per asset class (July 2001-January rates between EU and US securitization 2010—S&P, earMoody’s eaut and Fitch) rate can be traced back to the features of US sub-prime residential mortgage securitization pre-2008, which was often characterized by: •• Poor assessment and monitoring of the creditworthiness of the underlying mortgage borrowers •• Inadequately structured incentive structures for sponsors and originators

efa ae (the “originate-to-distribute model”)

•• Complex securitization and re- securitization processes such as collateralized and loan obligations Pre c Pre •• Limited disclosure requirements impairing the ability of investors to understand the associated Source: European Securities and Markets Authority (ESMA) central repository (CEREP) and EBA calculations; adopted from EBA •• An overreliance on credit agencies, which were being paid by sponsors and originators to provide investors with Figure 2: Three-year default rates at BBB independent external assessments4 level per asset class (July 2001-January 2010—S&P, Moody’s and Fitch)

1 Resolving non-performing loans in Europe, European Board, July 2011. 2 The case for a better functioning securitization market in the European Union: A discussion paper, and European Central

efa ae Bank, May 2014.

3 EBA Discussion Paper on simple standard and transparent , European Banking Authority, 14 October 2014.

4 A European framework for simple and transparent securitization, Fact Sheet, Pre c Pre European Commission, 30 September 2015. Nassr, I. K. and Wehinger, G. (2015) Unlocking SME finance through market-based debt: Securitization, private placements and bonds, OECD Journal: Financial Market Trends, Volume Source: ESMA CEREP database and EBA calculations; adopted from EBA 2014/2, p. 89-190.

05 Securitization | Preface

1.4. The state of the EU securitization 25 percent in 2016 compared to pre-2008 market financial crisis levels 5. Aside from the European securitization market remains significant drop in European securitization, subdued and has not yet regained a notable change since 2007 has been traction to recover to levels seen prior to the percentage of securitization vehicles the 2008 financial crisis. While European placed and retained. Prior to 2007, most issuance peaked in 2008 at €818.7 billion, securitization vehicles were placed, but the following years brought a dramatic following the financial crisis, issuers have decline with issuance hovering at around retained the majority of European issuance.

iure uroean itorica iuance in iion Figure 3: European historical issuance 2007—Q1 2017 (in EUR billion)

818,7

593,6

423,8 378,0 376,8 257,8 238,6

e e 217,0 216,6 180,8 109,9

Source: Association for Financial Markets in Europe (AFME); Deloitte calculation

Figure 4: European historical issuance 2007—Q1 2017 (in EUR billion) iure uroean aceretaine iuance in iion

e e e

e eed e ed ee e

Source: AFME; Deloitte calculation

5 This stands in sharp contrast to US issuance, which has recovered more strongly. One factor that has led the US securitization market not to experience such a steep decline in issuance is the role that US government-sponsored enterprises (e.g., and Freddy Mac) play. The EU estimates that around 80 percent of all US securitizations benefit from public and banks investing in such securitization benefit from lower capital charges.

06 Securitization | Preface

This seems to indicate that issuers find it difficult to attract investors to securitization products; this may be attributed to a confluence of factors:

•• Investors’ ongoing lack of trust in securitization despite the very low default rate of AAA and BBB-rated EU securitization vehicles during the financial crisis. To revive securitization, market issuers, originators, and regulators may be required to educate and provide further incentives (e.g., guarantees by national governments, ECB, etc.) to investors

•• Lack of securitization products/ transactions that are tailored to meet the objectives and requirements of the issuer, originator, borrower (in case of loan securitization), and . One example of an instance where the objectives and requirements of the issuer, originator, sponsor, borrower, and investor can diverge is SME true-sale loan securitization

•• On 28 December 2017, the European Union published in its Official Journal the Regulation (EU) 2017/2402 or Securitisation Regulation. While this Regulation does not impact all Luxembourg Securitisation vehicles, the requirements for banks other institutional investors will be increased. The Regulation is applicable as from 1 January 2019

“To ensure that investors perform robust due diligence and to facilitate the assessment of underlying risks, it is important that securitization transactions are backed by pools of exposures that are homogenous in asset type, such as pools of residential loans, or pools of corporate loans, business loans, leases and credit facilities to undertakings of the same category, or pools of car loans and leases, or pools of credit facilities to individuals for personal, family or household consumption purposes.”

European Banking Authority 2018

07 Securitization | Securitization—Industry fundamentals

08 Securitization | Securitization—Industry fundamentals

2.1. Benefits of 2. Industry securitization Securitization is a technique used to convert illiquid assets/claims into tradeable securities. These illiquid assets/claims fundamentals may include bank or car loans, , receivables, and insurance premiums, among others. Securitization Securitization: Why and how does it work? acts not only as a means to raise cash on the capital markets, but also as a credit risk transfer tool. For investors, it provides attractive and diversified investment opportunities without the need to set up a complex and expensive client-facing infrastructure. Instead, they can and benefit from the lending and servicing expertise of originators. Removing loans from the balance sheets of banks can also have macro-economic benefits as banks can create more new lending, which has a positive impact on the economy.

•• Benefits for original lenders/originators: –– Creation of liquidity –– Funding diversification –– Reduction in funding costs –– Risk reduction and transfer –– Regulatory capital relief ––Raise capital without prospectus-type disclosure

•• Benefits for investors: –– Tailored investments –– diversification –– Risk sharing

09 Securitization | Securitization—Industry fundamentals

2.2. The process (CMBS) are secured by commercial real In its most basic form, securitization is the estate such as office buildings, shopping process whereby illiquid assets or rights malls, logistics centers, and industrial are pooled and transformed into tradeable and -bearing financial instruments that are sold to capital market investors. Collateralized debt obligations (CDOs) are The pool of underlying assets or rights, financial instruments that pool a group also known as the “reference portfolio” of assets such as high- debt or ABS, or “ pool”, may be homogenous which are then repackaged into discrete or heterogeneous. Interest and principal that are sold to investors. The payments from the assets or rights are underlying collateral pool of CDOs may be passed on to capital market investors either static or dynamic. In a static CDO through a securitization special purpose structure, the entire reference portfolio is entity (SSPE). Reference portfolios may fixed and the underlying assets cannot be contain assets such as vehicle loans and changed at any point in the entire lifecycle leases, residential mortgages, commercial of the CDO. Dynamic CDO structures are mortgages, receivables, actively managed by the CDO manager, student loans, aircraft leases, or brand and who selects the collateral pool and often franchise royalties that are generated by manages the CDO reference portfolio, a or a (the and can also replace underlying assets to “Originator”). increase performance and decrease credit risk: 2.3. Types of asset- •• Collateralized obligations (CBOs) are CDOs backed by a collection of low-grade backed securities corporate (junk) bonds Asset-backed securities (ABS) can be •• Collateralized loan obligations (CLOs) are broken down into more granular categories CDOs backed by a pool of leveraged bank depending on the collateral type of the loans underlying reference portfolio. Mortgage- backed securities (MBS) are a type of asset- •• Commercial real estate CDOs (CRE CDOs) backed secured by the principal are backed by commercial real estate and interest payments of a single mortgage loans and bonds or a pool of mortgages:

•• Residential mortgage-backed securities (RMBS) are secured by residential property, usually single-family homes

•• -backed securities

Figure 5: Overviewiure of erie ABS by collateral o S coateratype te

onuer eientia S ororate S oercia S oe uine S

• Auto loans and leases • CLO • Aircraft lease • Franchise royalty • Credit card receivables • CBO • Maritime container lease • Brand royalty • Student loans • ABS CDO • Equipment lease • Billboard lease • Residential mortgage • CRE CDO • Commercial mortgage loans loans

10 Securitization | Securitization—Industry fundamentals

2.4. Risk and a distinct level of risk associated with it, investors may only be eligible to invest in return profiles of certain tranches and/or build portfolios with specific risk and return profiles by tranche notes investing in a mixture of senior, mezzanine Notes or bonds issued by an SSPE (the and junior tranche notes. “Issuer”) can be subdivided into graduated slices to attract a diverse range of investors Typical investors in senior tranche notes with different risk and return requirements. include insurance companies, pension These slices, known as “tranche notes”, are funds, and other risk-averse investors. then sold separately to investors. Tranches Junior notes, also referred to as first-loss can pay fixed or floating-rate interest tranches, are generally unrated and offer and the investment returns (interest the highest investment yield, but must and principal repayment) are allocated absorb the first losses on the collateral among the tranches in accordance to their pool. Investors in junior tranches tend . For example, the most senior to be hedge funds and other investors and least risky tranche receives investment seeking higher risk/return profiles. The returns generated by the collateral pool Originator can also retain junior tranche ahead of other tranches and is last to notes if no investors are found or to satisfy incur losses. Due to the lower risk profile the risk retention requirements under the of senior tranches, the EU Capital Requirements Directive (CRD IV) is lower than for higher risk tranches (i.e., and the Capital Requirements Regulation mezzanine or junior). As each tranche has (CRR).

Figure 6: Risk/return profile of note tranches oest eected ote structure atin of trances ast losses oest ris yield

Senior rance a ote

Senior rance a ote ield redit ris

Senior rance oss osition ote

ezzanine a rance ote

ezzanine a rance ote

ezzanine rance ote

unior rance nrated ote

irst losses iest iest ris eected yield 11 Securitization | Securitization—Industry fundamentals

2.5. The cash flow have been fulfilled. The residual cash flow for junior tranche holders after all waterfall scheduled periodic payment obligations Most securitization transactions follow a to securitization servicers/agents, senior, predetermined schedule that prioritizes and mezzanine tranche holders are met the manner in which interest and principal is known as “excess spread”. This excess payments from the collateral portfolio spread serves to enhance the internal must be allocated. This schedule, which credit of the securitization structure and is explained in the documents associated can be deposited in a dedicated “spread with the issuance (i.e., the prospectus), is or reserve account” until some or all of known as the “cash flow waterfall” or simply the notes mature. The excess spread then the “waterfall”. In conventional waterfalls, serves as a first line of defense to absorb senior tranches receive cash flows after losses in the event that the reference payment obligations to securitization portfolio underperforms. If individual servicers (e.g., auditor, , loans or a portfolio of loans experience etc.) and agents (e.g., administrative agent, delinquency or default, the cash from trustee, paying agent, etc.) are met. the excess spread account is used to pay the noteholders. Alternatively, the Investors in mezzanine tranches excess spread can be periodically paid receive the residual cash flow once the out to junior tranche noteholders, thereby obligations to senior tranche holders increasing the yield for those investors.

Figure 7: The cash flow waterfall

nteret sset manaer rinciaa flo ro rustee aetrit atin aency uditor iuidity roider ustodian an ormation eenses ayin aent administratie fees Inestment an Interest rincial a accountin aent Senior rance ote Sericer acu sericer Interest rincial Senior rance otes eal adisors alculation reortin Interest rincial Senior rance ote redit enancements

Interest rincial ezzanine rance ote

Interest rincial ezzanine rance ote

Interest rincial ezzanine rance ote

cess Sread Junior (first loss) Tranche Note

* Note: Please note that the waterfall can also be structured so that Senior Tranche Notes rank parri passu among each other. A possible ranking can also be structured for Junior Tranche Notes

12 Securitization | Securitization—Industry fundamentals

2.6 True sale In step two of the process, the Issuer of the pooled assets or rights securitization the acquisition through the issuance of The true sale securitization process tradeable and interest-bearing financial generally involves two steps. Firstly, the instruments that are sold to investors. As Originator identifies the assets or rights of mentioned above, these bonds or notes which credit risk and/or legal ownership can be sold in tranches with different should be removed from its seniorities in accordance with the cash and pooled. Originators aiming to remove waterfall. both the legal ownership and the credit risk related to the assets or rights from their balance sheet sell and transfer the reference portfolio to an SSPE. In such “true sale” securitization transactions, it is imperative that once the sale and transfer of the assets or rights to the SSPE has been carried out, the transaction cannot be challenged, voided, or otherwise reversed if the Originator is declared insolvent or bankrupt.

Figure 8: Overview of true sale securitization

etorroer etorroer etorroer

as flosoan interest rincial sset manaer rustee atin aency uditor Securitization eice riinator cororate or iuidity roider ustodian an et iaiitie ssetrit ayin aent

ssetrit Senior rance Inestment an ote a accountin aent ssetrit Sericer oo o aet ezzanine ssetrit rit rance ote acu sericer eal adisors unior rance firt o ote alculation reortin redit enancements

ssetsrits netor

rance otes

rance otes

13 Securitization | Securitization—Industry fundamentals

2.7. Synthetic securitization Synthetic securitization is another type of transaction enabling credit risk to be transferred and regulated financial institutions to reduce regulatory capital requirements. The key difference between synthetic securitization and true sale securitization is that the Originator does not sell and transfer legal title of the assets or rights to the Issuer, and subsequently may not obtain any funding or liquidity under the transaction. Instead, the Originator only transfers the credit risk of the reference portfolio to capital market investors through an SSPE by entering into a series of funded and unfunded credit derivatives, usually credit default swaps (CDS) but also total return swaps (TRS) or credit-linked notes (CLNs).

In a simple synthetic securitization transaction, the Originator (the “Protection Buyer”) enters into a single CDS on the underlying reference portfolio as a whole or a series of CDS with the SSPE (the “Protection Seller”). In the event of a default or any other credit event affecting the reference portfolio, the Protection Seller will pay an amount to the Protection Buyer. In return for the transfer of the credit risk, the Protection Buyer will pay a fixed amount upfront—the premium—to the Protection Seller on a quarterly or yearly basis over the life of the CDS.

Unfunded credit derivatives are bilateral, privately negotiated credit derivatives contracts. In such transactions, the Protection seller does not make any upfront payment to the Protection Buyer. The Protection Seller will only make a payment to the Protection Buyer to cover losses when a credit event occurs. This means that the Protection Buyer is exposed to (counterparty) credit risk and relies upon the Protection Seller being able to pay an agreed amount. CDS and TRS are types of unfunded credit derivatives.

14 Securitization | Securitization—Industry fundamentals

nteret rincia aent inetent incoe

Figure 9: Overview of synthetic securitization

S

remium remium riinator Securitization eice Suer Senior oan ericer rotection Seer Sa ounterart et iaiitie

remiums from Senior rance S ote netor eference ool of assetsrits Inestments in ezzanine S iuality rance ote (credit risk-free) securities unior rance ote

s

The SSPE also issues CLNs that are sold to title of the underlying assets or rights of investors, who typically assume the risk of the reference portfolio to the SSPE, such the mezzanine tranche, which is equal to transactions can be brought to the market the remaining notional amount (face value) more quickly without a need for extensive of the CDS. The SSPE deposits the amount legal analysis across multiple legal received from the sale of the CLNs in a jurisdictions. bank account as collateral or invests the proceeds in risk-free financial instruments. Over the life of the transaction, the SSPE Funded credit derivatives entail the issuance of a series passes on the premiums received on the of debt obligations by a bank or SSPE, which are then CDS to the CLN investors. In addition, and depending on the transaction structure, purchased by one or more Protection Sellers. In contrast the returns earned by the SSPE on the to unfunded credit derivatives, there is an upfront financial instruments/amount in the interest-bearing account are then passed payment to the Protection Buyer, who has no exposure backed to the Originator or paid out to the to credit (counterparty) risk. A CLN is a type of a funded CLN investors. credit . CLNs carry an embedded credit The SSPE also enters into a back-to-back derivative, for example a CDS. The amount payable unfunded super senior CDS with a highly rated counterparty (e.g., a bank) and (principal and interest) under the CLN will depend on the therefore passes on a portion or all of the premium payments received on the CDS that are being credit exposure of the reference pool of assets or rights. This super senior CDS can passed on to investors, potential credit events (write sometimes represent up to 80 percent of a downs of losses on the notes), and the returns on the synthetic securitization structure’s notional amount and sit above the CLNs in the risk-free financial instruments. waterfall structure.

Because of the higher degree of flexibility offered by synthetic securitization and in the absence of sale and transfer of legal

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2.8. Credit the desired rating. Having assessed the creditworthiness of the underlying enhancement borrowers, granularity of the exposure Without an investment grade rating, it is pool, expected default rates, correlations very difficult to market a securitization among loans, and other factors, the credit transaction to institutional investors, who rating agency may decide that securities are generally only permitted to invest with a face value of €280 million could be in securities with an investment grade issued. Thus, in circumstances where some rating. To attract investors, a securitization of the underlying borrowers default on transaction therefore typically requires their payment obligations, the issuer would some form of in still be able to honor principal and interest to achieve an investment grade payments to the investors. Assuming all rating for one or several note classes. borrowers meet their payment obligations, Credit enhancement increases the the cash flows from the extra €20 million creditworthiness of the notes to be issued can be used to redeem securities earlier by the SSPE and protects investors from or to redeem securities preserved within bearing all the risk of the collateral pool if the securitization structure and allocated economic conditions deteriorate. to a reserve account. After all notes have been redeemed, the remaining funds in There are two forms of credit the reserve account and any remaining enhancement; external and internal. collateral will be distributed to the Internal credit enhancement refers to originator. mesures taken inside the securitization structure and measures include Reserve/spread funds overcollateralization, , and Reserve accounts come in two forms the use of reserve accounts. External (cash reserve funds and excess spread), credit enhancement involves third-party and are funded at the beginning of a guarantees such as insurance policies and securitization transaction (usually by the letters of credit. It is critical for the issuer to originator). The party that deposits funds examine each form of credit enhancement into the reserve account will normally hold prior to issuance in order to identify the a residual interest in the reserve account. most cost-effective credit enhancement Funds paid into the reserve account may mechanisms. Generally, the issuer will typically only be invested in highly liquid, consider the trade-off between improving investment grade securities. If a borrower the of particular note classes in the exposure pool defaults on a payment in the structure versus the reduction in obligation, the unpaid principal balance of yield required to sell the notes to investors. the exposure is deducted from the reserve account and paid to the investors. If funds 2.8.1. Internal credit enhancement are subsequently recovered through the Over-collateralization /asset enforcement process, One form of internal credit enhancement these amounts are either used to replenish is overcollateralization. This form of the reserve account or paid over to the credit protection is generated by issuing party that holds the residual interest in the securities with a face value that is lower reserve account. than the face value of the underlying collateral pool. For example, if the Excess spread accounts involve the collateral pool consists of exposures with allocation of the excess spread into a a combined face value of €300 million separate reserve account. The excess and the issuer targets a triple-A rating for spread is the amount remaining after all some or all securities to be issued, the periodic administration expenses (e.g., issuer/sponsor would obtain an indication asset servicing fees, etc.) and payments from a as to how to investors have been made. Usually, the many securities it could issue versus excess spread account increases over the collateral pool in order to achieve time up to some pre-defined level and is

16 Securitization | Securitization—Industry fundamentals

used to absorb losses from the exposure 2.8.2. External credit enhancement pool. The terms governing the spread account are normally dictated by the credit Another form of credit enhancement rating agency as the basis for obtaining an is a letter of credit. A letter of credit is investment grade rating. an irrevocable commitment in which a commercial bank or other financial Subordination institution is paid a premium to cover One of the most common forms of internal any losses actually incurred on the credit enhancement is the subordination collateral pool up to the required credit of some tranche notes in order to obtain enhancement amount. a higher investment rating for other, more senior, tranche notes. The subordinated bonds tranche notes are intended to absorb Surety bonds are insurance policies that losses from the collateral pool prior to reimburse the issuer for any losses on the more senior note classes. Based on an collateral pool. Surety bonds—also often analysis of the collateral pool, a credit referred to as performance bonds—are rating agency will specify how many triple issued by third parties, usually triple-A A notes, double A notes, B notes, and so rated insurance companies. Surety bond forth, can be issued. providers generally (often referred to as a wrap) the principal and The following is a simple example of how interest payments for specific note classes. subordination works. Assume the collateral The cost of this guarantee is determined pool contains 100 loans each worth by the insurance company's perceived €1 million and the credit rating agency credit risk in the underlying collateral pool. assesses the cumulative default risk on the The biggest perceived disadvantage of this collateral pool at 10 percent. The objective form of credit enhancement is “event risk”, of the issuer/sponsor is to create tranche meaning that if the credit enhancement notes with an investment grade rating. provider is downgraded, the note classes The easiest way to achieve an investment guaranteed by the credit enhancement grade rating is to create subordinated provider are typically downgraded as well. tranche notes/classes in the amount of €10 million and senior ranking tranche notes/ classes in the amount of €90 million. In the event of a default on a collateral loan, the loan amount would be deducted from the balance of the subordinated tranche notes/ classes. This means that the senior ranking tranche notes/classes would be protected from the risk of loss until the tenth loan default.

Figure 10: Sample subordination structure

Note class Rating Percentage of in € Coupon Credit Max Expected Loss Structure Enhancement

A-1 AAA 63% 176,400,000 + 210bps 38.0% 0.0036%

A-2 AA 11% 30,800,000 LIBOR + 300bps 25.3% 0.0743%

A-3 A 6% 16,800,000 LIBOR + 400bps 18.4% 0.4560%

B-1 BBB 5% 14,000,000 LIBOR + 500bps 13.1% 1.5675%

B-2 BB 5% 14,000,000 LIBOR + 600bps 8.8% 6.4130%

D Unrated 10% 28,000,000 Excess spread N/A 8.6540%

Total 100% 280,000,000

17 Securitization | Securitization—Industry fundamentals

2.9. Securitization parties A securitization transaction involves several parties, of which the most important are the Obligor or Borrower, the Originator, the Sponsor, the Investor, the Trustee, the Credit Rating Agency, the Asset Servicer or Collateral Manager, the Calculation Agent, and the Credit Enhancement Provider.

Figure 11: Securitization parties Luxembourg Securitization Special Purpose Entity (SSPE)

netor Borrower/Obligor riinator rutee itin aent

Calculation and ain aent Credit rating rraner SS reortin aent aenc Underwriter

Legal advisors eitrar Custodian Auditor

et ericer Credit enhancer acu ericer advisors oure oatera anaer 18 Securitization | Securitization—Industry fundamentals

2.9.1. Borrower/Obligor 2.9.3. Investors and it becomes increasingly complex The borrower/obligor is an individual or The investors subscribe to the as a result of the specialist knowledge entity that is legally required through securities issued by the SSPE and are required when dealing with sophisticated a contractual commitment to provide therefore entitled to receive principal asset classes. This is why credit rating one or more payments. The quality repayments, interest and, if foreseen agencies place particular emphasis and performance of the securitization in the constitutional documents, on the capabilities and track record depends on the ability of the borrower/ participations based on the cash flows of the asset servicer. The originator is obligor to honor all contractual obligations. generated by the underlying securitization frequently appointed as asset servicer of If a borrower/obligor does not fulfill its pool. Typical investors in securitized the exposure pool owing to its existing contractual obligations, the obligee (e.g., exposures are institutional investors such relationship with the underlying borrowers. bank, commercial company, SSPE, etc.) as pension funds, insurance companies, The responsibilities of the asset servicer usually has the right to seek recourse alternative asset managers, investment will vary somewhat depending on the in court and, in the case of secured funds, and banks. The appeal of asset- asset class and the local market, but for lending arrangements, the ability to backed securities can be traced back a portfolio of securitized loans they may initiate unilateral collateral enforcement to the higher they offer in include the following important functions: actions. Unless otherwise stipulated in the comparison to other assets with a similar •• Recording loans via a servicing database contractual documents, the obligee is not level of credit risk and the combination required to consent to the sale of the claim of different securitization tranches to •• Accepting and processing loan payments (loan) with the attached payment obligation achieve the desired risk/return profile. from borrowers to another party such as an SSPE. In many Another compelling reason for some •• Transferring payments to the SSPE securitization transactions, the originator institutional investors to invest in asset- or an affiliate of the originator continues backed securities is the regulatory •• Reconciling bank accounts and loan the customer relationship and acts as environment. Institutional investors such balances servicer to the SSPE, collects and passes on as pension funds and insurance companies •• Performing analysis the payment collections, and acts as a loan are often prohibited from engaging in monitoring agent. loan-originating activity. Asset-backed •• Collecting on delinquent accounts securities therefore provide them with the •• Discussing and agreeing new payment 2.9.2. Originator/Sponsor opportunity to gain exposure to certain terms with delinquent borrowers An originator is typically an institution industries (e.g., real estate, shipping, that was involved, either itself or through aviation etc.) and/or indirectly (re)finance •• Initiating and processing foreclosure/ its related entities, directly or indirectly, projects, as they can invest through rated, asset enforcement procedures in in the creation and of the liquid securitization tranches. collaboration with legal advisors obligations involved in the securitization •• Managing accounts of borrowers that transaction. Such obligations arise during 2.9.4. Asset servicer have declared the course of the originators’ ordinary In the context of securitization, asset business activity and are subject to servicing describes the process of •• Maintaining, administering, and various underwriting standards. In some collecting the payments from the underling liquidating asset holding companies instances, the originator purchases assets/ borrowers in the exposure pool and claims (exposures) from third parties transferring the collected funds to the with view to securitizing them at a later SSPE. Perhaps because of the apparent stage. In such transactions, the originator simplicity of this task, the assert servicing is often referred to as the securitization role is often taken for granted by both sponsor. Typical originators include issuers and investors, who often mainly commercial banks, insurance companies, focus on the performance of the exposure captive financial companies, major car pool, the deal structure, and the manufacturers, leasing companies, at which notes will be issued. However, commercial companies, and trade asset servicing is one of the most critical companies. elements in any securitization transaction

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2.9.5. Trustee must also confirm that the When emerging problems are identified The trustee’s primary duty is to in the assets or claims is structured so as that could lead to potential covenant preserve the of the investors to ensure that the assets or claims will not breaches and payment defaults, such as involved in the purchase the securities be vulnerable to the claims of the SSPE’s an underperforming exposure pool, the issued by the SSPE. The nature of the other creditors—a mechanism often trustee will notify investors, mandate and trustee’s duties is specifically set forth in referred to as “bankruptcy remoteness.” liaise with legal advisors, and cooperate the trust agreement. The trustee usually The trustee usually mandates a specialized with investigations and negotiations subcontracts the administration and securitization or law surrounding the matter. The trustee may servicing of the securitized exposure firm and obtains legal opinions to the effect also intervene when other agents or pool back to the originator, an affiliate of that the security interest has been soundly servicers of the SSPE fail to perform their the originator or a third-party provider. structured. duties in accordance with the agency or However, the trustee retains ultimate servicing agreement. The trustee can responsibility for the administration of the The trustee generally plays a passive meet with the agent or servicer concerning SSPE that holds the securitized assets/ role; however, it takes on a much more remedial actions to avoid or resolve claims. active role if any contractual breaches defaults. If the agent or servicer fails to by agents or servicers of the SSPE, or if perform their duties in accordance with The trustee oversees the initial creation obligations or terms and conditions under the agreement, the trustee can terminate of the SSPE that will hold the securitized the transactional documents are breached. the agreement and replace the agent or exposure pool. The trustee must also In such situations, the trustee notifies the servicer. If the asset servicer is replaced, confirm that the SSPE has received clear investors of the breach and awaits their the trustee often serves as a temporary title to the securitized exposures, free of instructions regarding subsequent actions asset servicer until a replacement asset any claims, charges or , it should take on their behalf. The trustee servicer can be identified and contracted. whether actual or implied. When assets of a securitization transaction is usually or claims are transferred to the SSPE entitled to be protected by the security 2.9.6. Asset/collateral manager at the conclusion of the securitization holders against any legal claims, costs, In transactions involving managed (traded) transaction, the assets or claims are and expenses incurred while complying assets, asset managers are responsible for pledged to the holders of securities issued with their instructions, and may ask for assembling and monitoring the underlying by the SSPE. Since the assets or claims will indemnification and upfront compensation collateral and, when contractually foreseen, serve as collateral for the repayment of the prior to proceeding with the requested replacing assets based on pre-defined securities issued by the SSPE, the trustee action. selection criteria.

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2.9.7. Credit enhancement provider diversification, expected default rates, A credit enhancement provider is a recovery rates, and correlation between third-party that agrees to support the the exposures. In addition, credit rating credit quality of another party, individual agencies review the following factors: securities or a pool of assets by making •• Capabilities and financial strengths of the payments, up to a pre-agreed amount, in originator/servicer of the exposure pool; the event that the other party defaults on The “payment report” is submitted to its payment obligations. Such contractual •• Legal risks embedded in the structure, the body of the SSPE; this arrangements protect against the risk that e.g., ensuring that title to the exposure document provides instructions on how to the cash flows generated by the collateral has been transferred and that the allocate the available funds to the holders pool are insufficient to meet all the pledge over the collateral pool has been of the securities. amounts due to the obligor. perfected;

•• Overall soundness of the transaction 2.9.8. Credit rating agencies structure (e.g., asset liability timing of A credit rating agency assigns a credit cash flows, covenants and other default rating that rates a borrower’s/obligor’s mechanisms; ability to pay back debt by making timely interest payments, and the likelihood •• Ability of the asset servicer/collateral of default. A rating agency may rate manager to manage the exposure pool; the creditworthiness of issuers of debt •• Type and quality of credit enhancement, The “investor report” is submitted to obligations, debt instruments, and in some e.g., track record of third-party guarantor. the holders of securities; this document cases, the servicers of the underlying includes information about the notes, the debt. As debt obligations can be issued in Credit rating agencies may be paid by collateral pool (evolution, composition, etc.) several tranches, rating agencies can also the originator/sponsor not only for and the performance of the securitization assign individual credit ratings to tranches assigning ratings to structured securities, transaction as a whole. with different seniority in the cash flow but also for advice on how to structure waterfall of a securitization vehicle. This tranches. This involves back and forth and means that tranches with higher seniority analysis between the originator, sponsor, may have better creditworthiness than structuring and restructuring specialists, a single conventional, unstructured, and where applicable, and the credit rating untranched note with the same overall agency. During this process, the originator/ repayment income stream. Such structural sponsor may submit proposed structures features allow rating agencies to assign to the credit rating agency for analysis, senior tranches high ratings such as triple review and feedback until the originator/ A or other high grades. Notes with a high sponsor is satisfied with the ratings of the rating are then eligible for purchase by various tranches. pension funds and market funds that are required to invest in higher-rated 2.9.9. Registrar debt. The primary responsibility of the registrar is to maintain the records of the registered Three rating agencies currently dominate holders of securities and to process the market: Standard & Poor’s, Moody’s subscriptions and redemptions of the Investor Services, and . securities issued by the SSPE. Smaller rating agencies include DBRS, Kroll Bond Rating Agency, and A.M. Best. These 2.9.10. Calculation and reporting agent credit rating agencies employ varying This party to the securitization transaction methodologies to rate structured finance calculates and reports the distribution products, but generally focus on the type of interest, principal repayments and of pool of assets/claims underlying the profit participation (where applicable) securitization security and the overall due to the investors and other creditors. of the SSPE. This approach The allocation of funds available from often involves a quantitative assessment the exposure pool is governed by in accordance with mathematical the cash flow waterfall. Generally, the models reflecting and issuer following documents are submitted to the management body and investors:

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2.9.11. Paying agent 2.9.14. Custodian 2.9.18. Legal advisors The terms and conditions set out in the The custodian bank is responsible for Considerable legal work is required to securitization documents specify the safeguarding the assets of the SSPE, ensure that a securitization transaction distribution dates on which interest and including liquid assets (e.g., cash, term meets the requirements of the originator principal repayments are to be made deposits, etc.) and transferable securities and the investors while also complying with to the investors. A few days prior to (e.g., shares, bonds, etc.), and for arranging all . Legal advisors will typically the distribution date, the paying agent the settlement of any purchases and sales. assist with: receives a report from the calculation and The custodian bank is also responsible •• Drafting the articles of association reporting agent specifying the payment for the safekeeping of the exposure pool of the SSPE (e.g., in accordance with instructions for the distribution date. On in true sale securitization transactions. In the provisions of the Luxembourg the distribution date, interest and principal Luxembourg, the use of a custodian bank Securitization Law) repayments are made by the paying agent is only mandatory for regulated SSPEs, to holders of securities and payments are such as securitization funds and regulated •• Drafting the prospectus and also made to other creditors. securitization companies. documents

•• Reviewing or drafting the asset sale and 2.9.12. Arranger/underwriter 2.9.15. Liquidity provider purchase agreements The arranger and underwriter is typically Liquidity providers are usually banks that an investment bank that plans, organizes, provide the SSPE with a -term liquidity •• Legal opinions regarding the perfection structures, and markets the securitization facility (e.g., a revolving loan facility) in of the pledge over the exposure pool transaction together with the originator/ the event of non-timely cash flows from •• Loan restructuring (e.g., in non- sponsor. the underlying collateral pool that could performing loan transactions) interrupt payments to investors. Such 2.9.13. Back-up servicer bridge loan facilities cannot be used •• Initiating the foreclosure and asset One of the primary duties of the trustee to cover defaults within the underlying enforcement processes is to assume the role of back-up asset exposure pool. servicer in the event that the original asset servicer is removed or the contractual 2.9.16. Auditor agreement is terminated. To mitigate In Luxembourg, the financial statements/ the risk of issues with servicers and annual accounts of the SSPE have to be agents affecting the performance of audited by one or more independent the securitization vehicle, “back-up auditors (Réviseurs d’entreprises). The servicers” may be appointed as early as auditors of a Luxembourg SSPE are the outset of the transaction. A back-up appointed by the management body of that servicer will ensure that cash collections SSPE. from the underlying exposure pool and subsequent distributions of interest and 2.9.17. Tax and accounting advisor principal repayments to the investors The tax and accounting advisor analyses continue without interruption. A back- and assists with the tax-efficient up servicer may also be authorized to structuring of the proposed transaction. assume responsibility for reviewing and The planned transaction structure is verifying the calculations performed by the designed to mitigate potential tax or calculation and reporting agent. To prevent accounting implications, i.e., to minimize any loss of data and ensure a smooth the corporate income tax liability of the migration if the servicer is removed, the SSPE and/or avoid withholding being back-up servicer may run parallel reporting levied on the cash flows to investors. along with the existing servicer. It is essential that the back-up servicer is always ready to immediately assume the role of servicer should it be required to do so. To that end, the back-up servicer may receive tapes/document copies from the servicer on a periodic basis.

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23 Securitization | Securitization—Industry fundamentals

2.10. Capital Requirements Regulation On 31 December 2013 and 1 January 2014, new EU capital rules for financial institutions set out in the fourth Capital Requirements Directive (2013/36/EU (CRD IV)) and the Capital Requirements Regulation (Regulation (EU) No 575/2013, the CRR) came into effect. According to articles 243 and 244 of the CRR, sponsor or originator institutions may exclude securitized exposure from risk-weighted exposure amount (RWEA) calculations and expected loss amounts if significant credit risk arising from the securitized exposure is deemed to have been transferred to third parties.

2.10.1. Significant Risk Transfer ii. There are no mezzanine securitization To deduct securitized exposure from the positions in a given securitization, and RWEA calculation, originator institutions iii.The originator can demonstrate that must be able to demonstrate to National the exposure value of the securitization Competent Authorities (NCAs) that the positions that would be subject to requirements of a Significant Risk Transfer deduction under CET 1 or a 1,250 (SRT) are satisfied. Based on articles 243 percent risk weight exceeds a reasoned (relating to true sale securitization) and estimate of the expected loss on the 244 (relating to synthetic securitization), securitized exposure by a substantial NCAs also need to consider how the level of capital relief achieved is commensurate with the risk transferred to third parties. It is important to emphasize that originator The mechanistic tests described in institutions and sponsor institutions articles 243 (2) and 244 (2) are passed and should have policies and methodologies in regulated institutions are permitted to take place to ensure ongoing compliance with capital relief when the transfer of credit all significant risk transfer requirements risk to third parties meets the following according to article 243 of the CRR. conditions:

•• Contractual support •• At least 50 percent of the risk-weighted On 3 October 2016, the EBA published exposure amounts of all mezzanine its final guidelines on implicit support securitization positions held by the for securitization as required by article originator institution are transferred, 248 of the CRR. The final EBA guidance where explains that contractual support i. The term “mezzanine securitization includes credit enhancement provided positions” denotes securitization at the inception of a securitization positions to which a risk weight lower transaction. than 1,250 percent applies and that are not the most senior in the Examples of implicit support: securitization structure, and are more •• Overcollateralization junior (a) in the case of a securitization position subject to Credit Quality •• Credit derivatives Step (CQS) 1 within the “Standardized •• Spread accounts Approach” of article 251, or (b) a securitization position rated CQS 1 •• Contractual recourse obligations or CQS 2 under the “Ratings Based •• Subordinated notes Method” of article 261 •• Credit risk mitigants provided to a specific •• At least 80 percent of the risk-weighted tranche exposure amounts that are subject to a 1,250 percent risk weight or subject to •• The subordination of fee or interest a deduction from Common Equity Tier income, or 1 (CET 1) are transferred, subject to the •• Deferral of margin income following stipulations:

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•• Implicit support Examples of implicit support: •• Arm’s length transactions Implicit support refers to support beyond As requested by article 248 of the •• Purchase of deteriorating credit-risk that which originator and sponsor CRR, the EBA also published its final exposures from a securitized pool institutions are already contractually guidelines on what constitutes arm’s obliged to provide. For both traditional •• Addition of higher-quality risk exposures length conditions in the context of true sale and synthetic securitization, to the collateral pool securitization transactions on 3 October implicit support undermines the SRT 2016. According to these guidelines, •• Sale of discounted credit-risk exposures requirement under article 243 and 244. transactions executed at arm’s length are into the pool of securitized exposures at Implicit support acts as a signal to the those where the terms of the transaction above market after the of market that all or part of the contractually are such as they would be in a normal the securitization transferred credit risk is still with the commercial transaction, if: originating institution and has in effect •• The purchase of underlying exposures at A The parties had no relationship to not been transferred. Accordingly, article above market prices each other (including, but not limited 248 sets out restrictions on providing to, any special duty or obligation, and •• Ad hoc credit enhancements provided to implicit support and compels originator any ability to control or influence each one or more tranches, or institutions and sponsor institutions other); and that fail to comply with the requirement •• An increase in the first loss position B Each party: to hold their own funds to hedge all i. Acted independently securitized exposure as if it had not been ii. Entered into the transaction of its securitized. own volition iii. Acted in its own interests; and iv. Did not enter into the transaction on the basis of extraneous factors that are not directly connected

“Securitization markets are a key funding channel for the economy, increasing the availability and reducing the cost of funding for households and companies by opening up investment opportunities to a wider investor base, diversifying risk across the economy and freeing up bank balance sheets to lend.”

Commissioner Jonathan Hill at the Eurofi Financial Forum

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2.10.2. Risk retention requirements Simple securitization means that: •• Legal true sale and transfer of the Article 122a of the existing Capital underlying exposure (no claw-back •• Exposure packaged in securitization Requirements Directive 2006/48/EC provisions in the event of the seller’s vehicles must be homogeneous loans/ will be replaced by articles 404 to 410 ) receivables (e.g., car loans with car loans, of the CRR. The core element of article residential mortgages with residential •• Assets must not be encumbered 122a of the CRD is a “skin in the game” mortgages) requirement intended to ensure that •• Underlying exposure must meet pre- originators of securitization vehicles retain •• No securitization of securitizations is defined eligibility criteria (no active an economic interest in their performance. allowed portfolio management) This requirement is now contained in •• Loans must have a long •• The pool of underlying exposure must be article 405(1) of the CRR, which prohibits enough to allow reliable estimates of homogenous institutions from assuming any exposure to default risk securitization unless a bank has explicitly •• No securitization of securitizations disclosed to the institution that it will •• The ownership of a loan must have been •• Regulatory creditworthiness retain, on an on-going basis, a “material net transferred to the securitization issuer requirements and origination in the economic interest” of at least five percent (i.e., they must be sold by the creator of ordinary course of the lender’s or in the securitization vehicle. the loans to the entity that will issue the originator’s business—material changes securitization) shall be disclosed 2.10.3. Simple, Transparent and Standardized Securitization/ Transparent and standardized securitization •• No underlying exposure can be in default Comparable securitization means that: at the time of transfer in accordance with European standard setters and regulators art. 178 (1) CRR •• Exposure packaged in securitization learned several lessons from the US sub- vehicles must have been created using •• At least one payment must have been prime securitization crisis. One lesson is the same lending standards as any made (exceptions for certain asset types) that opaque and complex securitization other exposure, i.e., no cherry-picking is transactions may pose undesirable •• Repayment shall not depend on the sale allowed risks to investors and accordingly a new of assets Securitisation Regulation was published in •• At least five percent of the loan portfolio the Official Journal of the European Union must be retained by the originator Transparency involves increased disclosure on 12 December 2017, with an effective of information relevant to the transaction •• Documents must provide details of date of 1 January 2019. This regulation which, in turn, will enable investors to make the structure used and the payment enhances the use of Simple, Transparent more decisions and mitigate the contagion waterfall (i.e., the sequence and amount and Standardized Securitization/ effect arising from misinformation. of payments to each tranche) Comparable (STS/STC) securitization6. •• Historical loan-level static and •• Data on packaged loans must be performance data must be provided at published on an ongoing basis the time of pricing; this must cover at 6. “Simple, Transparent and Standardized •• The contractual obligations, duties, least three years for trade receivables securitization (STS)” is the term used by the and responsibilities of all key parties and other short-term receivables and five EC, the BoE and the ECB whereas “Simple, associated with the securitization vehicle years for all other exposure provided by Transparent and Comparable securitization (STC)” is the terminology adopted by the BCBS must be clearly defined the originator, sponsor or SSPE and IOSCO: Criteria for identifying simple, •• Provision of historical default and loss transparent and comparable securitizations, The EU proposal of 30 September 2015 set performance data—at least Basel Committee on Banking Supervision, Bank out specific requirements with regard to for International Settlements and International –– Seven years for non- exposure; simplicity (art. 8), standardization (art. 9), of Securities Commissions, July –– Five years for retail exposure 2015; Proposal for a Regulation of the European and transparency (art. 10): Parliament and the Council laying down •• External verification of data on underlying common rules on securitization and creating Simplicity refers to structuring transactions exposure prior to issuance (pool ) a European framework for simple, transparent and standardise securitization and amending and underlying assets in a less complex with a confidence level of 95 percent Directives 2009/65/EC, 2009/138/EC, 2011/61/EU way to facilitate easier •• Provision of liability-cash flow models to and Regulation (EC) No 1060/2009 and (EU) No and improve investor comprehension. 648/2012, European Commission, 30 September investors Simplicity is governed by the following key 2015; Capital treatment for “simple, transparent and comparable” securitizations, Consultative criteria: •• Originator’s sponsor and SSPEs shall Document, Basel Committee on Banking make all required information available •• The originator, sponsor, and SSPE must Supervision, Bank for International Settlements, for potential investors such as drafts of November 2015. be established in the EU the transaction documents

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Standardization facilitates greater Standardization covers transaction “As a heterogeneous commoditization of securitization through documents, structural features, and easier comparability between transaction definitions of performance: asset class, securitization issues: •• The originator, sponsor or original lender stands to benefit from shall meet the regulatory risk retention • In the same asset class; a framework allowing requirement investors, regulators, and •• Interest and risks arising from the securitization shall be mitigated other participants (such

•• Interest rates shall be based on generally as central banks lending used market interest rates (no complex against securitizations as formulae or derivatives) collateral) to distinguish •• No reverse waterfall structures between deals on an •• The transaction documentation • By the same issuer. shall clearly specify the obligations objective, consistent basis. and responsibilities of the servicer Greater standardization and provisions for the replacement of counterparties and liquidity can also contribute to providers. Policies, procedures, and better liquidity in the controls shall be well documented, as shall definitions, .” remedies, and actions relating to delinquent and defaulting debtors IMF, 2015

•• Voting rights will be clearly defined

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2.10.4. Hierarchy of rating approaches •• Internal Ratings-Based Approach iii.The outstanding balance on all under the securitization framework The SEC-IRBA uses the Simplified underlying assets in the securitization The CRR follows the BSBS framework Supervisory Formula Approach (SSFA) minus the outstanding balance of all closely by ranking the Securitization and the depends tranches that rank senior to the tranche Internal Ratings-Based Approach (SEC- on the level of credit enhancement, that contains the bank’s securitization IRBA) as the primary credit risk calculation KIRB, the tranche thickness and the exposure, to approach, followed by the External supervisory parameter (p) as key inputs. iv.The outstanding balance of all Ratings-Based Approach (SEC-ERBA) Tranche thickness is measured using underlying assets in the securitization and Standardized Approach (SA). To use tranche attachment point (A) and tranche vehicle. SEC-IRBA, a bank needs supervisory detachment point (D). approval of the IRB model for the type of Overcollateralization and funded reserve •• K is the exposure-weighted average exposure in the securitization pool and IRB accounts must be recognized as tranches capital charge of the underlying pool. The sufficient information to estimate KIRB (the and the assets forming these reserve capital charge includes the expected loss exposure-weighted average capital charge accounts must be recognized as underlying portion and, where applicable, dilution of the underlying pool had the exposure assets for the calculation of A and D. risk. The capital charge is calculated not been securitized). An institution that However, only the loss-absorbing part of in accordance with the applicable cannot calculate KIRB for a given vehicle the funded reserve accounts that provide minimum IRB standards under the BCBS will be required to use the External Ratings- credit enhancement can be recognized as framework, assuming that the underlying Based Approach for the calculation of the tranches and underlying assets. Unfunded exposure in the securitization pool is held risk-weighted exposure amounts. Under reserve accounts (e.g., unrealized excess directly by the bank7 . the SEC-ERBA, risk weightings are assigned spread) and assets that do not provide based on credit assessments or inferred •• Tranche attachment point (A) credit enhancement such as pure liquidity ratings, the seniority of the tranche, and represents the threshold at which losses support, currency or interest-rate swaps, the granularity of the securitization pool. A within the underlying pool would first be or cash collateral accounts related to these bank that cannot use SEC-ERBA must apply allocated to the securitization exposure. instruments, must not be included in the the Standardized Approach. If an institution It is expressed in a decimal value calculation of A and D. cannot use SEC-IRBA, SEC-ERBA or SEC-SA between zero and one and is the ratio of: •• Supervisory parameter (p) for a given securitization exposure, it shall i. The outstanding balance of all determines the overall level of capital apply a risk weight of 1,250 percent. underlying assets in the securitization required for the portion of tranches vehicle, minus the balance of all above securitization exposure that tranches that rank senior or pari passu Figureiure 12: ierarc Hierarchy o ratinof rating aroace approaches absorbs losses up to the amount of to the tranche that contains the bank’s capital that would be required if the securitization exposure (including the SInernal atins ased roac SI underlying exposure were held directly exposure itself), to by the bank. If the underlying IRB pool ii. The outstanding balance of all consists of both retail and wholesale Sternal atins ased roac S underlying assets in the securitization exposure, the collateral pool should be vehicle. divided into one retail and one wholesale SStandardized roac SS •• Tranche detachment point (D) sub-pool. A separate p-parameter represents the threshold at which the should be calculated for each sub-pool losses within the underlying pool result in and subsequently a weighted average is eit a total loss of principal for the tranche in p-parameter shall be calculated on which a securitization exposure resides. It the basis of the p-parameters of each is expressed as a decimal value between sub-pool and the nominal size of the zero and one and is the ratio of: exposure in each sub-pool.

7. KIRB must also include the unexpected loss and the expected loss with defaulted exposure in the underlying pool. The scaling factor of 1.06 referenced in paragraph 44 of the Basel II framework is applied to the unexpected loss portion of the KIRB calculation.

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The supervisory parameter p in the context “One of the most appealing of the SEC-IRBA is as follows: features of securitization as

Non-STS/STC securitizations: a technology is its flexibility. It can be used on granular p = max[0.3; (A + B ( ) + C K + D LGD + E M )] 1 assets such as residential ∗ N ∗ IRB ∗ ∗ T mortgages where many STS/STC-compliant securitizations: thousands of individual 1 p = max 0.3; (A + B ( ) + C K + D LGD + E M ) 0.5 mortgages can sit within a N � ∗ ∗ IRB ∗ ∗ T ∗ � deal. It can also be used to where: finance non-granular assets •• 0.3 denotes the p-parameter floor such as commercial real •• N is the effective number of loans in the estate, where deals might underlying pool (as calculated below) only be underpinned by 10 •• KIRB is the capital charge of the underlying pool loans or fewer.”

•• LGD is the exposure-weighted average Financial Times of the underlying pool (as calculated below)

•• MT is the maturity of the tranche, (as calculated below)

•• Parameters A, B, C, D, and E are determined according to the look-up table in Fig. 12.

Figure 13: Look-up values for parameters A, B, C, D, and E

Term Definition A B C D E

Wholesale Senior, granular (N ≥ 25) 0.00 3.56 -1.85 0.55 0.07

Senior, non-granular (N < 25) 0.11 2.61 -2.91 0.68 0.07

Non-senior, granular (N ≥ 25) 0.16 2.87 -1.03 0.21 0.07

Non-senior, non-granular (N < 25) 0.22 2.35 -2.46 0.48 0.07

Retail Senior 0.00 0.00 -7.48 0.71 0.24

Non-senior 0.00 0.00 -5.78 0.55 0.27

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Calculation of tranche maturity (MT) the same obligor must be consolidated (i.e., •• Tranche maturity is the tranche’s remaining treated as a single instrument). effective maturity in years and it can be measured at the bank’s discretion: Calculation of exposure-weighted average LGD 01. On the basis of the weighted average The exposure-weighted average LGD maturity of the contractual cash flows (regular method) is calculated as follows: of the tranche:

LGD = LGD EAD EAD M = t CF CF i i i �i ∗ ⁄ �i T t t �t ∗ � �t where LGDi represents the average LGD where CFt denotes the cash flows associated with all exposure to the ith (principal, interest paymments, and obligor. fees) contractually payable by the borrower in period t. If the portfolio associated with the The contractual payments must be largest exposure is up to 0.03 (or 3 percent unconditional and must not be of the underlying pool), banks can employ a dependent on the actual performance simplified method for calculatingN and of the securitized exposure. The final LGD: legal maturity of the tranche shall be used if contractual payment dates are N = [ C C + ((C C ) / (m – 1)) max{1 - m C , 0}] not available. −1 1 ∗ m m − 1 ∗ ∗ 1 where Cm is the share of the pool 02. On the basis of the final legal maturity corresponding to the sum of the largest m of the tranche as follows: exposure and C1 is the portfolio share of the largest exposure. For the purpose of SEC-IRBA, the level of m is set by each bank M = 1 + M 1 80% and the bank may set LGD as 0.5. If only T L − ∗ C1 is available and this amount is no more where ML is the final legal maturity of than 0.03, then the bank may set the LGD the tranche. as 0.50 and N as 1/C1.

Tranche maturity under (01) and (02) has a Calculation of risk weight floor of one year and a cap of five years. For The formula proposed under SEC-IRBA for credit protection instruments that are only calculating capital requirements per unit of exposed to loss events that occur prior to securitization exposure is as follows: the maturity of the particular instrument, a bank would be allowed to apply the K ( ) = (e e / a(u l) contractual maturity of the instrument a∗u a∗l SSFA KIRB and would not have to look through to the − − protected position. where the constant e is the base of the natural logarithms (which equals 2.71828). Calculation of effective number of The variables a, u and l are defined as sources of exposure (N) follows: The effective number of sources of •• a = -(1 / p * K )) exposure is calculated as follows: IRB •• u = D – KIRB N = ( EAD ) = EAD •• l = max. (A– K ; 0) IRB 2 2 � i ⁄ � i i i Next, the risk weight assigned to a where EAD represents the exposure-at- i particular source of securitization exposure default associated with the ith instrument will be calculated as follows: in the pool. Multiple sources of exposure to

30 Securitization | Securitization—Industry fundamentals

•• When D for a securitization exposure is Figure 14: SEC-ERBA risk weights for Figure 15: SEC-ERBA risk weights for less than or equal to KIRB, the exposure short-term non-STC/STS securitizations short-term STC/STS securitizations must be assigned a risk weight of 1,250 percent. External credit Risk weight External credit Risk weight •• When A for a securitization exposure is assessment assessment greater than or equal to K , the risk IRB A-1/P-1 15% A-1/P-1 15% weight of the exposure, expressed as a percentage, would equal KSSFA (KIRB) A-2/P-2 50% A-2/P-2 50% multiplied by 12.5. A-3/P-3 100% A-3/P-3 100% •• When A is less than KIRB and D is greater All other ratings 1,25% All other ratings 1,25% than KIRB, the applicable risk weight is a weighted average of 1,250 percent and 12.5 multiplied by KSSFA (KIRB) according to the following formula:

K A D K Risk weight = 12.5 + 12.5 K D A D A IRB − − IRB ∗ ∗ ∗ SSFA KIRB The resulting risk weight− is subject to a floor − of 15 percent.

• External Ratings-Based Approach Under SEC-ERBA, risk-weighted assets will be determined by multiplying securitization exposure amounts by the appropriate risk weights. To apply SEC-ERBA, the operational criteria for using external credit assessments or for inferred ratings must be met8. For exposure with short-term ratings, or when an inferred rating based on a short-term rating is available, the prescribed risk weights apply.

The following tables provide the prescribed SEC-ERBA risk weights for short-term ratings for non-STS/STC securitization and STS/STC-compliant securitizations.

8. The operational requirements for SEC-ERBA are set out in paragraphs 71 to 73 of the BCBS securitization framework.

31 Securitization | Securitization—Industry fundamentals

For exposure with a long-term rating, or Figure 16: SEC-ERBA risk weights for long-term non-STC/STS securitizations when an inferred rating based on a long- term rating is available, the risk weights Senior tranche Non-senior (thin) tranche depend on four factors: Rating Maturity: Maturity: Maturity: Maturity: 1 year 5 years 1 year 5 years

AAA 15% 20% 15% 70%

AA+ 15% 30% 15% 90% The external The seniority of rating or inferred the position; AA 25% 40% 30% 120% rating; AA- 30% 45% 40% 140%

A+ 40% 50% 60% 160%

A 50% 65% 80% 180% The tranche The tranche thickness, in A- 60% 70% 120% 210% maturity; the case of non- senior tranches BBB+ 75% 90% 170% 260% BBB 90% 105% 220% 310%

Figure 16 provides the prescribed SEC- BBB- 120% 140% 330% 420% ERBA risk weights for long-term ratings for BB+ 140% 160% 470% 580% non-STS/STC securitization and STS/STC- compliant securitizations. BB 160% 180% 620% 760%

The risk weights assigned to a BB- 200% 225% 750% 860% securitization exposure when SEC-ERBA is B+ 250% 280% 900% 950% applied are calculated as follows: B 310% 340% 1,05% 1,05% •• To account for tranche maturity, banks shall use linear interpolation between the B- 380% 420% 1,13% 1,13% risk weights for one and five years CCC+/CCC/CCC- 460% 505% 1,25% 1,25% •• To account for tranche thickness, banks shall calculate the risk weight for non- Below CCC- 1,25% 1,25% 1,25% 1,25% senior tranches as follows:

Risk weight = risk weight from table after adjusting for maturity [1 mi n( T; 50%]

∗ − where T equals tranche thickness, and is measured as D – A, as defined above.

No granularity adjustments are applied, as the BCBS believes that the external credit rating agencies already account for granularity when assigning a rating to a tranche. The requirement for having at least two eligible ratings is no longer applicable.

32 Securitization | Securitization—Industry fundamentals

“When operating efficiently, securitization supports economic growth and financial stability by enabling issuers and investors to diversify and manage risk. By transforming a pool of illiquid assets into tradable securities, securitization frees up bank capital, allowing banks to extend new credit to the real economy, and supports the transmission of ”

IMF

33 Securitization | Securitization—Industry fundamentals

• Standardized Approach insolvency proceedings, in the process of To calculate capital requirements for foreclosure, held as , or securitization exposure to a pool using the in default, where default is defined within Standardized Approach, a bank will use the securitization transaction documents a supervisory formula and the following •• The tranche attachment point (A) and bank-supplied inputs: the tranche detachment point (D) as •• The standardized approach capital defined under SEC-IRBA. Where the only charge had the underlying exposure not difference between sources of exposure been securitized (KSA). KSA is defined to a transaction is related to maturity, as the weighted average capital charge A and D will be the same of the entire underlying securitization pool, calculated using the risk-weighted For structures involving an SSPE, all asset amounts in the SA multiplied by 8 of the SSPE’s exposure related to the percent. A provision or non-refundable securitization shall be treated as exposure purchase price discount on exposure to the securitization pool. Exposure related in the securitization pool must be to the securitization that should be treated excluded from the KSA calculation. KSA as exposure to the pool include assets in is expressed as a decimal between zero which the SSPE may have invested such as and one (i.e., a weighted average risk reserve accounts, cash collateral accounts, weight of 100 percent would mean that and claims against counterparties resulting KSA would equal 0.08) from interest swaps or currency swaps. Calculation of risk weight •• The ratio of delinquent underlying The inputs K and W are used as inputs to exposure to total underlying exposure in SA calculate K : the securitization pool (W). Delinquent A underlying exposure is underlying exposure that is 90 days or more K = 1 W K + W 0.5 past due, subject to bankruptcy or A − ∗ SA ∗

34 Securitization | Securitization—Industry fundamentals

If the bank does not know the delinquency status for up to 5 percent of underlying exposure in the pool, SEC-SA may still be used to calculate the capital requirements for each unit of securitization exposure by adjusting the KA calculation as follows:

K = ( ) +

퐸퐴퐷푆푢푏푝표표푙 1 푤ℎ푒푟푒 푊 푘푛표푤푛 푆푢푏푝표표푙 푤ℎ푒푟푒 푊 푘푛표푤푛 퐸퐴퐷푆푢푏푝표표푙 2 푤ℎ푒푟푒 푊 푢푛푘푛표푤푛 A ∗ 퐾퐴 퐸퐴퐷 푇표푡푎푙 퐸퐴퐷 푇표푡푎푙 If a bank does not know the delinquency The risk weight assigned to securitization status for more than 5 percent of exposure under SEC-SA is calculated as the underlying exposure pool, the follows: securitization exposure must be weighted •• When D for a particular source of at 1,250 percent. securitization exposure is less than or equal to K , the exposure mut be The supervisory parameter in the context A assigned a risk weight of 1,250 percent of SEC-SA equal 1 (or 0.5 for STS/ STC-compliant securitization) for •• When A for a particular source of securitization exposure that is not securitization exposure is greater than resecuritization exposure. Capital or equal to KIRB, the risk weight of the requirements are calculated under the exposure, expressed as a percentage, SEC-SA as follows: would equal KSSFA(KA)multiplied by 12.5

•• When A is less than KA and D is greater K ( ) = (e e / a(u l) than KA, the applicable risk weight is a a∗u a∗l SSFA K퐴 − − weighted average of 1,250 percent and •• where KSSFA(KA) is the capital 12.5 multiplied by KSSFA(KA) according to requirement per unit of securitization the following formula: exposure and the constant e is the base K A D K of the natural logarithms (which equals Risk weight = 12.5 + 12.5 K D A D A 2.71828). The variables a, u, and l are A − − A ∗ ∗ ∗ SSFA KA defined as follows: − − The risk weight for hedges such •• a = -(1 / p * K )) A as currency or swaps will be •• u = D – KA inferred from a source of securitization exposure that is pari passu to the swaps •• l = max. (A – K ; 0) A or, if such exposure does not exist, from the next subordinated tranche. The resulting risk weight is subject to a floor of 15 percent. When a bank applies SA to an unrated junior exposure in a transaction where the more senior tranches are rated and therefore no rating can be inferred for the junior exposure, the resulting risk weight under SA for the junior unrated exposure shall not be lower than the risk weight for the next more senior exposure.

35 Securitization | Securitization—Industry fundamentals

2.10.5. Maximum capital requirements 2.10.7. Capital treatment of For a mixed pool, KP equals the exposure- resecuritization exposure weighted capital charge of the underlying For resecuritization exposure, a bank pool using KSA for the proportion of the must apply SEC-SA with the following underlying exposure pool for which the adjustments: bank is unable to calculate K , and K IRB IRB •• The capital requirement associated with for the proportion of the underlying pool the underlying securitization exposure for which the bank can calculate K . IRB is calculated using the securitization framework 2.10.6. Caps for securitization exposure A bank may apply a “look-through” •• Delinquencies (W) are assumed to be approach to senior securitization exposure, zero for any securitization exposure to whereby the senior securitization exposure a tranche in the underlying pool could receive a maximum risk weight •• The supervisory parameter p is set at equal to the exposure-weighted average 1.5, rather than 1 as for securitization risk weight to the underlying exposure. A exposure prerequisite for applying this approach is that the bank must be aware of the Risk weights and capital requirement composition of the underlying exposure at caps defined for securitizations are not all times9. The applicable risk weight under applicable to resecuritization exposure. IRBA would be calculated applying the 1.06 If the underlying pool of a resecuritization scaling factor and would also be inclusive vehicle consists in a pool of exposure to of the expected loss portion multiplied by securitization tranches and their assets, 12.5: securitization tranches are separated •• In the case of securitization pools where from exposure to assets that are not the bank exclusively uses the SA or IRB securitization vehicles. A separate KA approach, the risk weight cap for senior parameter should be calculated for each exposure would equal the exposure subset (including a separate W parameter) weighted-average risk weight that would and the KA for the portfolio is calculated apply to the underlying exposure under as the nominal exposure weighted average the SA or IRB credit risk framework, of the KA for each subset considered. The respectively resulting risk weight is subject to a floor risk of 100 percent. •• In the case of mixed pools, when applying SEC-IRBA, the SA part of the underlying securitization pool will receive the corresponding SA risk weight, while the IRB portion will be attributed the IRB risk weights. The risk weight cap for senior exposure would be based on the SA exposure weight-average risk weight of the underlying assets, whether or not they are originally IRB, when SEC-SA is applied

9. Taking in account the scaling factor of 1.06 under the SEC-IRBA

36 Securitization | Securitization—Industry fundamentals

37 Securitization | Luxembourg securitization

38 Securitization | Luxembourg securitization

3.1. The 3. Luxembourg Luxembourg securitization securitization framework The Securitization Law and the law of 10 August 1915, as amended, (the “Company At the heart of Europe and securitization Law”) allow the use of regulated and non- regulated vehicles for the securitization Luxembourg is a prime venue for securitization in Europe. It hosts of a wide range of assets including trade 25 percent of all European securitization transactions and it is the receivables, loans, tangible and intangibles domicile for more than 900 securitization vehicles . assets, shares, and any other activity with a reasonably ascertainable value or predictable future revenue streams.

Luxembourg securitization vehicles are unregulated entities and not subject to authorization or supervision by the Luxembourg regulator, the Commission de Surveillance du Secteur Financier (“CSSF”), unless shares or bonds are issued: (i) to the public, and (ii) on a continuous basis (more than three times per year)10. These two conditions are cumulative111.

The Securitization Law requires that the assets (e.g., real assets, loans, claims, rights, etc.) are transferred by a third party to the securitization vehicle. A Luxembourg securitization vehicle therefore cannot be used to originate assets (such as new loans). However, a third party (such as a loan-originating debt fund) can continuously generate new assets and subsequently transfer them to the securitization vehicle. The role of the securitization vehicle is limited to the administration (collection and distribution) of financial flows linked to the securitization transaction itself and to the prudent management of the securitized assets.

10 Securitization funds are always subject to authorization and supervision by the CSSF.

11 On 23 October 2013, the Luxembourg supervisory authority ("CSSF") issued Frequently Asked Questions ("FAQs") on securitization.

39 Securitization | Luxembourg securitization

3.2. Benefits of Bankruptcy remoteness In principle, as fully taxable resident The Securitization Law recognizes the companies, securitization companies Luxembourg validity and enforceability of: (i) the have access to double taxation treaties contractual subordination of claims, (ii) the concluded by Luxembourg with other securitization non-petition agreement (whereby investors countries, as well as EU directives. Upon Aside from the well-known benefits of and creditors waive their rights to initiate request, they can obtain a tax residence securitization, such as lower regulatory insolvency or bankruptcy proceedings certificate from the Luxembourg tax capital requirements for banks and against the securitization vehicle), and (iii) authorities. insurance companies, portfolio the noteholders’ limited right of recourse diversification, capital market access, and with respect to the securitization vehicle Securitization funds are assimilated efficient refinancing and restructuring, (the scope of the noteholders’ right of with transparent investment funds for the Luxembourg securitization framework recourse is limited to the assets of the Luxembourg tax purposes. They are not offers a range of additional advantages to relevant compartment/sub-fund only). subject to corporate taxes or net wealth originators, sponsors, and investors. tax and theoretically do not have access Enforcement of pledges to European directives or double taxation 3.2.1. Legal and regulatory framework As with the Securitization Law and the treaties. Investors are taxed according Segregation of assets and liabilities Company Law, the Luxembourg law to the rules applicable in their country of To ensure the appropriate segregation relating to financial collateral arrangements residence. No subscription tax is payable of assets and liabilities, a Luxembourg dated 5 August 2005 as amended on 20 by securitization funds. securitization vehicle can create one or May 2011 (the “Collateral Law”) should more compartments (for securitization be viewed as creditor-friendly legislation As long as they do not have the effect of companies) or sub-funds (for securitization aimed at facilitating and accelerating the transferring rights related to immoveable funds) corresponding to a distinct part of enforcement of collateral arrangements property located in Luxembourg or to the securitization vehicle’s assets. For this (e.g., share and asset pledges) including aircraft, ships or riverboats recorded to occur, the constitutional documents those over credit claims. on a public register in Luxembourg, (articles of association or the management agreements entered into in the context of regulation) of the securitization vehicle 3.2.2. Taxation a securitization transaction and all other must foresee the creation of multiple Securitization companies are fully subject instruments relating to such a transaction compartments/sub-funds. The decision to to Luxembourg corporate income tax should not be subject to registration set up compartments/sub-funds is taken and municipal business tax. Payments formalities, even when referred to in a by the and can be made and commitments made to investors public or produced in court or before at any time throughout the entire life of the and to other creditors are, however, fully any other public authority. securitization vehicle. deductible. The law expressly states that—for tax purposes—payments made Finally, one of the most attractive tax Each compartment or sub-fund can issue by such companies are always treated as aspects is the VAT exemption from which notes against a single asset/claim or a interest, even when made in the form of a a securitization fund may benefit with portfolio of assets/claims. The rights/ , leading to a significant reduction respect to management services. claims of investors/creditors relating to in their taxable basis. No withholding tax a specific compartment or sub-fund will is due on these payments. From 1 January be limited to the assets thereof, which 2016, securitization companies are subject will be exclusively available to cover such to a minimum net worth tax ranging from rights/claims. As with investors, each €535 to €32,100 per year (depending on compartment or sub-fund shall be treated the assets held). They are otherwise not as a separate entity, unless otherwise subject to net worth tax. stipulated in the constitutional documents of the securitization vehicle. Consequently, compartments or sub-funds do not contaminate each other if the assets underperform.

40 Securitization | Luxembourg securitization

3.2.3. Investment policy Figure 17: Benefits of Luxembourg securitization A wide range of assets/rights can be securitized under the Luxembourg Securitization Law. These include:

•• Trade receivables, e.g., credit card receivables, rental income

•• Performing and non-performing loans, e.g., commercial and residential real Eligible investors Legal framework estate, automotive, shipping, aircraft and eed e ee e e infrastructure/ e d e •• Tangible and intangibles assets, e.g., ee , art, royalties de e •• Liquid and illiquid financial instruments, e e.g., shares, bonds, illiquid positions, PE participations

•• Any activity with a reasonably ascertainable value or predictable future revenue streams

Securitized risks may also result from obligations assumed by third parties or utorization netent oic inherent to the activities of third parties. Sueriion d e e ed ee 3.2.4. Authorization and supervision e ee e e Only securitization companies issuing diversification rules. No securities (equity or debt): (i) on a continuous or revolving basis, and (ii) to the e public are subject to the supervision of the CSSF.

“One of the most appealing features of securitization as a technology is its flexibility. It can be used on granular assets such as residential mortgages where many thousands of individual mortgages can sit within a deal. It can also be used to finance non-granular assets such as commercial real estate, where deals might only be underpinned by 10 loans or fewer.”

Financial Times, August 2017

41 Securitization | Luxembourg securitization

3.3. The 3.4. Securitization Luxembourg vehicles Luxembourg securitization vehicles can take two forms: a corporate form or a Securitization vehicles in Luxembourg securitization fund. have access to the Luxembourg stock exchange, which operates two markets: 3.4.1. Creation and legal form the Bourse de Luxembourg and the Euro The constitutional documents (articles of Multilateral Trading Facility (“Euro-MTF”) incorporation, statutes) of a securitization market. The Luxembourg stock exchange vehicle that takes the form of a corporate features more than 40,000 listed and entity (a “securitization company”) must tradeable securities, of which more than specifically refer to the Luxembourg 3,500 Asset-backed Securities (“ABS”) 12 are listed . Other noteworthy statistics Securitization Law to qualify as a about the Luxembourg stock exchange are Luxembourg saucerization vehicle. summarized in Figure 18. A securitization company can take the following corporate forms:

Figure 18: Benefits of Luxembourg •• A public company (société securitization anonyme or “SA”)

•• A limited by shares (société en commandite par actions or “SCA”) •• A private limited liability company (société o a securities iste in à responsabilité limitée or “Sàrl”) ess tan to as •• A organized as a public limited company (société cooperative organisée sous forme de société anonyme or “SCSA”) different issuers of ABS iste urisictions rom ic issuers originate different eiumerm ote rogrammes

12. Listing Asset-Backed Securities at the Luxembourg Stock Exchange, Luxembourg Stock Exchange.

42 Securitization | Luxembourg securitization

Figure 19: Securitization company

Securitization ssets coan rance rigts notes

omartment riinator netor

omartment

omartment

A securitization company only needs to A securitization company can be set up as meet the minimum capital requirement an , e.g., the applicable to its corporate form (i.e., SA/ of the company are Dutch private SCA: €31,000, Sàrl: €12,500, no minimum foundations (Stichtings). In such cases, capital requirement for an SCSA but the securitization company would not be the capital referred to in the articles of regarded as a subsidiary of the originator incorporation must be subscribed upon and may be avoided incorporation). This requirement must (depending on local GAAP). Foundations be met at the company level, not by each are administrated by a management board individual compartment. that is responsible for fulfilling the purpose of the foundation as defined by its articles of association.

Figure 20: Securitization fund

Securitization anagement ssets un reguations anaeent oan rigts

ubun riinator

ubun nitares netor ubun

A securitization fund takes the form of a stand-alone fund, a fonds commun de placement (co-ownership) or a fiduciary trust, managed by a management company whose registered office must be located in Luxembourg. The management regulations must specifically refer to the Securitization Law for the vehicle to qualify as a Luxembourg securitization fund.

43 Securitization | Luxembourg securitization

3.4.2. Compartments and sub-funds Compartmentalization allows for the A securitization company can create segregation of the assets and liabilities several compartments and a securitization across multiple compartments, so fund can create multiple sub-funds within that assets may be ringfenced on a one structure. Compartmentalization compartment-by-compartment basis. allows for the segregation of the assets and liabilities across multiple compartments, To allow for compartmentalization, the so that assets may be ringfenced on articles of association of the securitization a compartment-by-compartment company should simply authorize the basis. Unless otherwise stipulated in board of directors to create segregated the constitutional documents of the compartments. Liquidation of one securitization company, the segregated compartment does not affect the existence compartments do not affect each other if of any other compartment, or that of the assets underperform, as potential losses securitization company itself. are borne by the noteholders and creditors of the various compartments. This means that the noteholders’ and creditors’ right of recourse can be limited on a compartment- by-compartment basis.

Compartmentalization allows for the segregation of the assets and liabilities across multiple compartments, so that assets may be ringfenced on a compartment-by- compartment basis.

44 Securitization | Luxembourg securitization

3.5. Authorization 3.6. Accounting 3.7. Reporting Luxembourg securitization companies and supervision must comply with the provision of Section obligations Only securitization companies issuing XII of the Law of 10 August 1915 on Under the Securitization Law, both securities (equity or debt): (i) on a commercial companies, as amended, and regulated and unregulated securitization continuous or revolving basis, and (ii) to the with the provisions of Chapters II and IV vehicles must comply with the following public are subject to the supervision of the of Title II of the Law of 19 December 2002 circulars of the Luxembourg CSSF. In terms of the definition of public on the trade and companies register and (Banque centrale du Luxembourg—“BCL”) issuance, the CSSF has issued the following the accounting and annual accounts of that implement ECB regulations and 13 guidelines : companies (“the Accounting Law”). The guidelines and set out reporting obligations: •• Securities issued to professional clients Accounting Law allows the application within the meaning of Annex II to the of Luxembourg Generally Accepted (i) Guideline ECB/2011/23 of 9 December MiFID Directive (2004/39/EC) are not Accounting Principles (“Lux GAAP”) as 2011, on the statistical reporting considered by the CSSF as issues well as the use of International Financial requirements of the ECB in the field of to the public for the purpose of the Reporting Standards (“IFRS”): external statistics Securitization Law •• Lux GAAP: historical cost/ (ii) Regulation ECB/2012/24 of 17 October 2012 concerning statistics on holdings •• Securities issued with a denomination of securities equal to or exceeding €125,000 each are •• IFRS: fair value deemed not to have been issued to the (iii) Guideline ECB/2013/24 dated 25 July 2013 on the statistical reporting public In the event that a Luxembourg requirements by the ECB in the field of securitization vehicle is set up with •• the listing of securities on a regulated or quarterly financial accounts alternative market does not constitute multiple compartments, a breakdown of (iv) Regulation ECB/2013/40 of 18 October ipso facto as an issue to the public assets and liabilities as well as profit and loss statements per compartment must 2013 concerning statistics on the •• Private placements, irrespective of be prepared in addition to consolidated assets and liabilities of financial vehicle their denominations, are also not financial statements. engaged in securitization considered to be issues to the public; the transactions classification to be attributed to private The accounting and tax regulations (v) BCL circular 2014/236 dated 25 April placements is assessed on a case-by- applicable to a securitization fund 2014 on statistical data collection case basis by the CSSF. The subscription managed by a management company and by securitization vehicles, which of securities by an governed by management regulations is replaces and repeals (i) BCL circular or financial intermediary with a view the Accounting Law. However, this does not 2009/224 dated 8 June 2009, and to a subsequent placement of such apply to: (ii) BCL circular 2013/232 dated 20 securities with the public does constitute June 2013, and sets out the initial •• The content and layout of the annual a placement with the public for the registration requirements applicable report purpose of the Securitization Law to Luxembourg securitization vehicles •• Asset , which will follow the and their continuous periodic reporting Luxembourg securitization vehicles are mark-to-market model set out in the Law obligations generally not subject to the EU directive of 17 December 2010 on Undertakings on alternative managers for Collective Investments, as amended (“AIFMD”). However, the securitization (the “UCI Law”). Thus, the following two vehicles that must comply with the options are available: provisions of AIFMD are 114: (i) Lux GAAP: mark-to-market •• Securitization vehicles acting as first (ii) IFRS lender, i.e., originating new loans

•• Securitization vehicles issuing securities offering synthetic exposure to non- credit related assets and undertaking the transfer of credit risk only as an accessory activity

13. Question no. 4, Frequently Asked 14. Question No. 19, Frequently Asked Questions Questions Securitization, Commission Securitization, Commission de Surveillance du de Surveillance du Secteur Financier, 23 Secteur Financier, 23 October 2013. October 2013. 45 Securitization | Luxembourg securitization

Every securitization vehicle falling within •• Quarterly statistical balance sheet of BCL circular ST.16-0557, dated 24 May 2016, the scope of the reporting population as securitization vehicles: a report must be implemented ECB Decision ECB/2015/50 defined by BCL circular 2009/224 dated 8 provided to the BCL on a quarterly basis of 18 December 2015 (amending Decision June 2009 (implementing ECB Regulation no later than 20 working days after the ECB/2010/10 on non-compliance with ECB/2008/30 dated 19 December 2008) end of the period to which it relates (the statistical reporting requirements. Since must submit the following information “S 2.14 Report”) 1 July 2016, the ECB and the BCL have to the BCL at the time of the initial monitored reporting agents’ compliance •• Transactions and write-offs/write-downs registration: with the minimum standards required to on securitized loans of securitization meet their reporting obligations. All failures •• The nature of the securitization vehicle vehicles: a report must be provided to to meet the minimum requirements will the BCL on a quarterly basis no later •• The International Securities Identification be recorded in a database and sanctions than 20 working days after the end of Numbers (“ISINs”) of financial instruments may be imposed by the BCL. More serious the period to which it relates (the “S 2.15 issued by the securitization vehicle misconduct will also be recorded so that Report”) the ECB may impose sanctions. •• Information about the reporting agent •• Security by security reporting of BCL reporting obligations aside, (i.e., the entity that submits the data) securitization vehicles: a report must securitization vehicles entering into •• Information about the management be provided to the BCL no later than 20 derivatives contracts fall within the scope company, if applicable working days after the month-end to of EU Regulation 648/2012 of 4 July 2012 which it relates (the “SBS Report”) on over-the-counter (“OTC”) derivatives, If a registration is amended or cancelled, central counterparties and trade the securitization vehicle will submit the BCL circular ST.13-0993, dated 9 December repositories, also known as the European following to the BCL15: 2013, lowers the exemption threshold Market Infrastructure Regulation (“EMIR”) 118. below which a securitization vehicle is •• All information regarding the registration exempt from all statistical reporting amendment obligations, apart from the obligation •• The closure/liquidation date if the to produce end-of-quarter reports on securitization vehicle is closed or outstanding amounts in relation to total liquidated assets, from a total of EUR 100 million to EUR 70 million on the balance sheet 217. This must occur as soon as the total assets of a securitization vehicle vary to such an Securitiation o rea aet oan Figure 21: Overview of BCL reporting obligations extent that it could change its situation regarding reporting obligations. er ecuritiation The ongoing reporting obligations that eice omete an fie apply to securitization vehicles are: registration orm

•• Initial notification: any securitization

vehicle whose quarterly total balance uarter nnua ota o assets sheet exceeds €500 million or the nnua accounts xemtion ubise in equivalent in a foreign currency shall treso inform the BCL of this by submitting its most recent annual accounts, if available, within one month of this threshold being 116 passed ie baance seet o obigation to anator o obigation to een in rat as submit statistica uarter submit annua at ate te ast uarter statistica accounts cosure ate reorting reorting

15. Statistical reporting of securitization vehicles— 17. The exemption threshold is determined at the 18. The CSSF confirmed in itspress release no. 13/26 Frequently Asked Questions (FAQ), Banque level of the securitization vehicle as a whole and dated 24 June 2013 that securitization vehicles Centrale du Luxembourg, June 2013. not on a compartment-by-compartment basis are also covered as non-financial counterparties for multi-compartment structures. and may thus be subject to the reporting and 16. The BCL reserves the right to impose specific risk mitigation obligations under EMIR. reporting obligations on securitization vehicles with a balance sheet falling below the threshold. 46 Securitization | Luxembourg securitization

“As a heterogeneous asset class, securitization stands to benefit from a framework allowing investors, regulators, and other participants (such as central banks lending against securitizations as collateral) to distinguish between deals on an objective, consistent basis. Greater standardization can also contribute to better liquidity in the secondary market.”

IMF

47 Securitization | Structuring scenarios

48 Securitization | Structuring scenarios

4. Structuring scenarios

A flexible legal framework and opportunities to create multiple compartments within one legal entity make Luxembourg a highly appealing location for securitized loan portfolios.

49 Securitization | Structuring scenarios

4.1. Structuring Figure 22: Pooling approach 1 scenarios In this section, Deloitte is proud to present Securitization a series of case studies to illustrate the coan advantages of the structural features of Luxembourg securitization vehicles, the oartent Senior rance ote unique securitization scenario of non- performing loans, and the use of double eanine rance taxation treaties to ensure tax-efficient etrit ote structuring.

unior rance ote 4.1.1. Compartmentalization and tranching In the most basic scenario, sponsors, arrangers, and originators of securitization Securitization vehicles can set up a Luxembourg coan securitization vehicle with only one oartent compartment or sub-fund that holds a Senior rance ote portfolio of mostly homogenous assets or rights. Such securitization vehicles are eanine rance typically automotive loans and lease ABS, etrit ote CMBS, RMBS and credit card receivable ABS. The Securitization Law also provides unior rance ote a highly attractive and flexible regulatory framework by allowing a combination of multi-compartment structures Example*: and tranching to tailor securitization transactions to the specific objectives and requirements of originators, arrangers, Siin Securitization sponsors, guarantors, and investors. coan A typical structure is created by pooling assets and rights within the same asset class in compartments. The securitization anersuers ontainer oartent vehicle can then issue series of tranches to essesoans investors (Figure 22).

ea tate Securitization coan

esientia oercia oartent roertiesoans

nratructure Securitization coan

o riges i rigs inars oartent oans

* For reference purposes only 50 Securitization | Structuring scenarios

A second approach is to set up a Figure 23: Pooling approach 2 securitization vehicle with multiple compartments where each asset sub-class is allocated to a dedicated compartment. Securitization Asset sub-classes can be categorized et ca coan Su ca by geographical region (e.g., prime oartent or secondary real estate) or industry Senior rance ote segments (e.g., tanker, dry bulk, and / ass container for shipping) (Figure 23). Senior rance ote / ass

eanine rance ote /

unior rance ote

et ca Su ca oartent Senior rance ote

/ eanine rance ote / unior rance ote

Example*:

Securitization Siin coan

aneroan oartent

ueroan oartent

ontainer oartent esseoan

Securitization ea tate coan

oercia oartent roertoan

esientia oartent roertoan

51 Securitization | Structuring scenarios

Another option is to set up a multi- Figure 24: Single asset/right securitization compartment structure within one legal entity whereby each compartment only acquires a single asset or right (e.g., loan) Securitization within one asset class (e.g., infrastructure, coan real estate, shipping, aviation) and issues oartent tranches of securities against this specific Senior rance ote asset or right to investors (Figure 24). ass

Senior rance ote etrit ass

eanine rance ote

unior rance ote

oartent Senior rance ote

eanine rance etrit ote

unior rance ote

Example*:

Securitization Siin coan

aneroan oartent

ueroan oartent

ontainer oartent esseoan

Securitization ea tate coan

oercia oartent roertoan

esientia oartent roertoan

* For reference purposes only 52 Securitization | Structuring scenarios

Luxembourg securitization structures can Figure 25: also be set up at a more granular level, which can help originators, sponsors, and arrangers to attract investors to Securitization specific industry sub-segments. The Su ca coan Su eent benefit to investors is that they can build oartent portfolios with different risk and return Senior rance ote profiles by investing in tranches with / ass different seniority rankings from several Senior rance ote compartments. / ass

The pooling approach at sub-segment eanine rance ote level can allow for a unique index-based / securitization structure of performing and non-performing exposure (loans). Such unior rance ote index-based securitization structures can provide additional return to investors when Su ca Su eent oartent economic/industry conditions improve Senior rance ote (for a detailed explanation, please see the “Securitization of non-performing loans” / eanine rance section below). ote / unior rance ote

Example*:

Securitization iation aener coan

oartent

oartent

Securitization Siin ontainer coan

oartent ee

oartent ee

oartent ee

* For reference purposes only 53 Securitization | Structuring scenarios

4.1.2. Global note program Securitization through a regulated or non-regulated Luxembourg securitization company allows stakeholders to benefit from a note program. Such a program can be designed to issue bonds/notes on a continuous basis (with varying maturities, interest rates, interest payment frequencies, and currencies) to informed investors or the public, while avoiding the repeated duplication of extensive and costly legal documentation (e.g. offering memorandum, pledge agreement, etc.) for each individual issue.

Figure 26: Example of a global note program*

u S Global note programme

e Senior rances e d otes ass e e Senior rance otes ass

Senior rance otes ass eanine e e rance otes ass A e e eanine rance otes ass

unior rance otes

* For reference purposes only 54 Securitization | Structuring scenarios

4.1.3. Redemption of notes and profit of the offering memorandum not permit participation the replenishment of the reference The reference portfolio of assets or portfolio, then cash proceeds can be: a) rights against which notes are issued retained by the Luxembourg SSPE until does not have to be static provided that the notes mature and/or b) distributed the condition of to noteholders through early partial is fulfilled. Depending on the terms and redemptions of the notes in accordance conditions of the notes and market with the waterfall structure (Figure 27) sentiment, individual or multiple assets or (subject to the terms and conditions of the rights within the reference pool may be offering memorandum or noteholders’ sold on the secondary market. Should: (i) approval). an attractive offer be received by the SSPE and no suitable assets or rights be found to replenish the collateral pool (e.g., for CLO structures), or (ii) the terms and conditions

Figure 27: Sale of assets/rights and early partial redemption of notes* Figure 25: Sale of assets/rights and early partial redemption of notes*

Securitization company

e Senior rance ote e e ezzanine rance a ote / fl unior rance ote

Interest & Principal: €150m

ee e e e fi

ee ee e e fi

e e eee ee ed

* For reference purposes only 55 Securitization | Structuring scenarios

Profit participating notes can provide approval) profit participation upon various and conditions set out in the offering additional returns to investors if economic/ note tranches when the securitization memorandum. In addition, notes can be industry conditions improve, or when transaction is created (Figure 28). redeemed in part or in full in accordance cash flow from the underlying reference Assuming that assets or rights outperform with the waterfall structure. portfolio exceeds expectations. The expected returns or can be disposed of terms and conditions set out in the initial at a profit, Luxembourg SSPEs can make documentation may therefore clearly cash payments to profit participating impose (with or without noteholders’ noteholders in accordance with the terms

iure Figure 28: Set up of the SSPE*

Securitization company Profit participation Senior rance ote e

riinator ezzanine rance netor ote unior rance ote - Excess spread

Figure 28: Sale of assets/rights and profit participation Figure 27: Sale of assets/rights and profit participation

Securitization company e e e urchaser of Senior rance ote Assetrights fl ezzanine rance ote e e urchaser of unior rance ote Assetrights fl

ee fi ee fi ee ee e e e fi ee ee e e fi ee e ed e e eee ee ed

* For reference purposes only 56 Securitization | Structuring scenarios

4.1.4. Securitization of non-performing Because of the AQR and stress test, NPL securitization can be appealing, as loans (NPLs) European banks have improved their improvements in the general economic or Europe’s largest banks hold approximately common equity tier 1 (CET1) ratio, but NPL industry-/asset-specific environment can €950 billion of NPLs (7.1 percent of total levels remain high by historical standards. be shared by originators (if they become loans or the equivalent of 9 percent of the To deal with NPLs, national agencies, bad investors in the securitization tranches, eurozone’s GDP) on their balance sheets banks, and platforms have been set up. e.g., through a partially retained deal) according to the latest financial stability The mandate and roles of such national and prospective investors through profit- review by the ECB19. As NPL levels in Europe agencies include winding up NPLs through participating notes issued by a Luxemburg are higher than in other major developed sales transactions to the capital market. SSPE. Following the sale of an NPL countries such as the US or Japan and While banks are often hesitant to offload portfolio to a Luxembourg SSPE, the new they impair the ability of banks to lend to their NPL portfolios at highly discounted terms and conditions of the consensually the economy, deliberate and sustainable prices to potential buyers, national restructured loans may stipulate that reductions of NPLs has been a major agencies such as the Irish National Asset borrowers must make unscheduled loan concern to the EBA, ECB, and the European Management Agency (NAMA), the Spanish principal repayments to recover some of Parliament20. Sociedad de Gestión de Activos procedentes the potential losses that materialize at the de la Reestructuración Bancaria (Sareb) and level of banks or national agencies upon The ECB carried out a comprehensive the German Erste Abwicklungsanstalt (EAA) sale of the restructured loans to the SSPE assessment in 2014 to ensure that have facilitated a series of sales. (“Performance component 1”). European banks were adequately capitalized and able to withstand possible As an alternative to an outright sale, the The trigger for the unscheduled financial shocks. The first pillar of this securitization of NPL portfolios can help to: repayments of loan principal may be linked comprehensive assessment was an Asset to recognized indices. These indices might •• Restructure balance sheets Quality Review (AQR) and the second be specific to industry sub-segments or pillar was a stress test. The objective of •• Transfer economic and credit even the assets themselves22. As the index the AQR and stress test in 2014 has often (counterparty) risk to the capital market increases, so should the financial strength been mistakenly interpreted as being to and cash flows from the borrowers. •• Potentially avoid significant losses act as catalysts in the NPL deleveraging crystallizing upon sale process21. Instead, the objective of the Notably, and in contrast to a cash sweep AQR was to enhance the transparency of •• Enable banks, national agencies used in restructuring and enforcement bank exposure, including the adequacy (originators), and investors to participate proceedings, the borrowers have additional of asset and collateral valuation and in higher than expected loan recovery headroom and are not required to operate related provisions, whereas the stress test rates and a revived economic/industry at the minimum cash level. Once the evaluated the resilience of banks’ balance environment unscheduled loan principal repayments sheets to economic shocks. have closed the “value gap” (e.g., 30 percent between the sales consideration to the SSPE (e.g., 70 percent) and the nominal value of the loan (100 percent)), scheduled loan principal repayments remain payable by the borrowers.

19. Financial Stability Review, European Central 22. Indices from the shipping industry provide Bank, May 2016. illustrative examples. Multiple indices for different shipping industry sub-segments 20. EBA Report on the Dynamics and Drivers of (e.g., tanker, dry bulk, tanker) are available and Non-Performing Exposures in the EU Banking vessel owners already use indices for hedging Sector, European Banking Authority, 22 purposes (e.g., forward-freight agreements July 2016. Draft guidance to banks on non- (FFA)). Shipping indices are also available at performing loans, European Central Bank, a more granular and asset-specific level. For September 2016. Non-performing loans in the example, the Baltic Dry Index (BDI) breaks Banking Union: stocktaking and challenges; down into the Baltic Capesize, Panamax, European Parliament, 18 March 2016. Supramax, and Handysize Index. Similarly, the Howe Robinson Container Index and the Container Ship Time Charter Assessment Index 21. Challenges for the European banking authority, (New Contexts) by the Hamburg Shipbrokers’ Lecture by Vítor Constâncio at the Conference Association (VHSS) provide charter rates for on “European Banking Industry: what’s next?” different sizes of container vessels. Madrid, 7 July 2016.

57 Securitization | Structuring scenarios

iure Securitization o Figure 29: Securitization of NPLs*

orrower orrower orrower

ee sset anager de rustee ating agenc uitor e ee riinator an e iuiit roier ustoian an aing agent Senior rance nestent an ote a accounting agent oo o Sericer ezzanine retructured rance ote acu sericer oan ega aisors unior rance firt o ote acuation reorting reit enanceents eed netor

fi e e

Figureiure 30: Securitization Securitization of o NPLs—performance erorance components* coonent

erorance coonent

s erorance ne it coonent floor an ca

d ee e ee d

e e e e e e e e e

eded ee d ee eded ee e de fl

* For reference purposes only

58 Securitization | Structuring scenarios

The future cash flow related to Another incentive for banks and borrowers •• Cash flows linked to performance performance component 1 may also be to consider such NPL securitization components 1 and 2 are classified as structured as a deferred purchase price structuring is that (long-standing) interest payments and not as option (e.g., over a period of between relationships are not broken. The bank can under the Luxembourg securitization three and five years), so that the originator become a third-party loan monitoring and framework. Consequently, no withholding (bank) is eligible to receive additional servicing agent of the Luxembourg SSPE tax is payable at the level of the purchase price consideration from the through a service level agreement (SLA). Luxembourg securitization company SSPE when the relevant index attached This SLA could generate fee income for the •• The payoff profiles of the indexation to the loan(s) increases. Depending on bank as servicer of the loan and avoid staff performance components are similar to local GAAP and subject to discussions redundancies. Other benefits of index- those of a and create value for with the auditor of the bank, the deferred linked NPL securitization are: investors. Such call options can be traded purchase price option could be valued •• Borrowers are incentivized to separately on the OTC market and capitalized (based on a projected outperform the reference index through index by a recognized third party, e.g., •• Investors can hedge/swap out LIBOR improvements in their operating model MSI for shipping). The bank and its and only keep returns from the indexed (e.g., higher revenue, opex reduction, auditor would need to have an annual performance components etc.). Borrowers outperforming the index discussion regarding the likelihood of the can build up a cash reserve whereas •• Loan can be stress tested via LIBOR and bank receiving part or all of the additional borrowers underperforming the index indexation for the IFRS 9 “Expected loan purchase price consideration and write- are incentivized to review their business losses model” calculation downs on the receivable might be needed. model and improve operational efficiency One possible benefit of such securitization structuring is therefore that the bank may not be required to recognize the full losses FigureFigure 31: 30: Securitization Securitization of NPLs—operational of NPLs—operational efficiency efficiencyfor borrowers for borrowers on the date of the sale of the NPL portfolio to the Luxembourg SSPE. ncome orroer A

In addition to performance component e de 1, investors may also benefit from e upturns in the general economic/industry effie environment by linking loan interest ndex payments on the restructured loans to relevant indices (e.g., the same index as for fl de performance component 1). Consequently, e as the index increases, borrowers are effie required to make higher interest payments deee on the loan (performance component 2). To protect investors against a falling index and ncome orroer borrowers against onerous loan interest payments, an interest floor and cap can be set (e.g., floor: LIBOR + bps = min. 4 e percent; cap: LIBOR + bps x index = max. 15 percent). Investors therefore have return profile that cannot fall below a certain threshold and borrowers know in advance the maximum interest payment amounts.

59 Securitization | Structuring scenarios

4.1.5. Run-off structure for illiquid Besides the pricing conundrum, the assets illiquidity of such hedge fund positions The nature of illiquid assets such as sub- or can be amplified by restrictions on non-performing investments transferability. In the worst cases, and shares in gated hedge funds can pose transferability restrictions lead to lengthy significant realization challenges to banks, liquidation periods or to those illiquid investment funds, asset managers, and assets being “parked” indefinitely in liquidators. investment fund “side pockets”. The resulting situation can then be similar to For the wider PE market, “zombie” the effects of zombie funds, with potential private equity funds have become a recoveries (cash distributions) swamped genuine concern, not only in terms of by the running costs of the run-off holding underperformance but also due to the structures. to the industry 123. These “living dead” funds retain their investments for longer than their scheduled holding periods and trap “Zombie” private equity investors seeking to exit24. This can result in disagreements and conflicts between funds have become a GPs and LPs, with the former having little power to direct or intervene in the affairs of the investment vehicle or to genuine concern, not only in wind-down structures through orderly and timely liquidation. Investors in zombie terms of underperformance PE structures also face the risk of low recoveries if GPs realize investments to generate cash for management fees and but also due to the not with returns to investors as their primary motive. reputational damage to

Another illiquid asset class warranting 1 particular attention is gated hedge funds the industry. that are closed to redemption requests by investors. Although an active secondary market for illiquid hedge fund positions One possible solution to transform illiquid has emerged over recent years, pricing private equity investments and shares in such assets remains notoriously difficult gated hedge funds into liquid securities with sellers and buyers relying on a and minimize the operating costs of mixture of publicly available information run-off structures is through the use of a (e.g., net assets per share statements, Luxembourg SSPE. The following five steps annual financial statements, etc.), private provide a high-level overview how such an information (i.e., communication with illiquid securities run-off structure can be the investment manager) and their implemented: own estimates regarding future cash distributions.

23. A recent study provides a comprehensive 24. As of end of July 2015, Preqin estimated that and excellent overview on the zombie fund there were 1,180 PE zombie funds globally, subject: Eidensen, M. and Erla, B. (2015), originally set up between 2003 and 2008, sat Private Equity Zombie Funds: Performance and on unrealized assets of US$127 billion. Fund Characteristics, Master Thesis, , Norwegian School of Economics.

60 Securitization | Structuring scenarios

Step 1: Preparation phase Step 2: Set up of run-off Step 3: Sale of assets to Given that transferability restrictions may structure the run-off structure apply and the statutes or regulations of A dedicated Luxembourg SSPE is created The OIHSs (e.g., fund, banks) sell illiquid hedge funds may establish a “right of first to act as a holding structure for illiquid portfolio securities (e.g., hedge fund refusal” before a portfolio security can be portfolio securities. The articles of securities (HFS)) to compartments of the sold to a third party, discussions with the association or the management regulations Luxembourg SSPE via an SPA. It is also underlying hedge fund managers should be of the SSPE may require the creation of possible for all known and unknown assets held at an early stage of the securitization multiple compartments. The decision and liabilities of the initial investment process. A clear understanding of the to set up compartments is taken by the structure to be contributed in kind to the purpose of the transaction (e.g., closure board of directors and can be made at Luxembourg run-off vehicle, but such of liquidation proceedings, reducing any time throughout the entire life of the transfers will probably require the advance investment-holding costs, etc.) and the securitization vehicle. Such compartments approval of creditors. structure of the run-off securitization can be used to segregate assets and vehicle is likely to be crucial in order to liabilities at the level of the Luxembourg mitigate concerns by the underlying hedge securitization vehicle for various fund managers. Timely discussions with investments funds of the same group to the underlying hedge fund administrator transfer their illiquid portfolio securities. regarding how the portfolio securities will Multi-compartment SSPEs can also be be transferred/sold and the collection of attractive when several asset managers or the necessary documentation to perform stand-alone investment funds collaborate the transaction (e.g., statement of holdings, to set up a joint run-off structure for illiquid net asset statements) can also increase portfolio securities. Such run-off structures execution speed during the securitization can lead to accelerated liquidations of the preparation phase. original investment holding structures (OIHSs) (e.g., investment funds, commercial companies, etc.), whilst the general fees and expenses of the securitization vehicle can be shared. To ensure cost transparency and avoid conflicts, the articles of association of the securitization vehicle can set out how general fees and expenses that are not related to a specific compartment are allocated (e.g., pro rata based on the of the compartments).

61 Securitization | Structuring scenarios

Step 4: Issuance of tranche In summary, the key benefits to notes original investors of using Luxembourg securitization vehicles as run-off structures In return for the assets sold, the are: OIHSs receives note tranches from the Luxembourg SSPE. The tranching of the •• Illiquid assets are held in a dedicated notes issued by the various compartments run-off structure that is scalable can mirror the OIHS’s register •• The compartments of Luxembourg on the liquidation opening date or on the securitization vehicles allow different date of the sale to the Luxembourg SSPE. banks, asset managers, and run-off/ For liquidating OIHSs, the note tranches liquidating funds to pool illiquid assets in issued by the securitization vehicle can a single legal structure, while remaining be distributed to investors through an segregated from each other advance on or final liquidation bonus in kind. It should be noted that such advances •• General operating costs of the on or final liquidation bonuses in cash or in securitization vehicle (e.g., accounting, kind are not subject to withholding tax at , tax services, etc.) can be shared out the level of the liquidating Luxembourg among several banks, asset managers, and run-off/liquidating funds

•• Illiquid assets can be transformed into transferable and tradeable securities that can be distributed in kind to original investors or sold to new investors Step 5: Investor reporting and run-off •• The run-off and/or liquidation of the original investment holding structure can In terms of investor reporting, the be closed in a timely manner creation of a multi-compartment run-off securitization structure is also appealing. •• A Luxembourg securitization company If a Luxembourg securitization vehicle can be set up as an orphan structure, is set up with multiple compartments, e.g., the shareholders of the company are a breakdown of assets and liabilities as Dutch private foundations (Stichtings). well as profit and loss statements per The securitization company may compartment must be prepared in addition therefore not be regarded as a subsidiary to consolidated financial statements. These of the originator and consolidation may ensure that investors in such securitization be avoided (depending on the local vehicles have a clear overview of the GAAP) performance of each compartment and the auditor can certify compliance with the true and fair principle for both the securitization structure as a whole and the individual compartments.

62 Securitization | Structuring scenarios

FigureFigure 32: 31: Run-off Run-off structure structure for forilliquid illiquid assets assets

uebour SS

e und e e S ede d ee e e as rigina nestors rance otes

e e e und rance S otes e e e ee e e nestors as rigina nestors rance otes

63 Securitization | Our services and technology

64 Securitization | Our services and technology

5. Our services and technology

Deloitte Luxembourg—Integrated solutions for securitization services

Securitization has proved to be the refinancing and restructuring vehicle of choice in recent years. Deloitte can guide you on the journey ahead.

65 Securitization | Our services and technology

5.1. Our services Deloitte is proud to offer a centralized securitization team and state-of-the- art technology to assist with the initial structuring and regulatory, tax, and accounting set-up, as well as the daily administration of securitization structures, their investment portfolios, and issued financial instruments. Our services encompass:

1 2 Pre-securitization Securitization assistance implementation assistance

Deloitte’s pre-securitization advisory During the second stage, Deloitte can Asset and collateral valuation services help to prepare portfolios for the assist with: Listing and implementation assistance securitization process by: •• Review of commenting on the Deal structuring •• Focusing on the objectives, needs, and prospectus and resubmission to the requirements of originators, sponsors, •• Formulating a consensual and Luxembourg Stock Exchange and investors comprehensive asset (e.g. loan) •• Submission to house of restructuring plan •• Providing modeling and scenario the prospectus approved by the analysis and coordination with rating •• Assisting and coordinating Luxembourg Stock Exchange agencies legal advisors in drafting legal •• Submission of listing application documentation •• Ensuring completeness of the loan files packages to the Luxembourg Stock and documents •• Preparing financial forecasts Exchange

•• Pre-listing services Set up of the securitization vehicle

•• Confirmation of the tax treatment applicable to the Luxembourg vehicle (e.g. access to double tax treaties)

•• Coordination with external service providers

66 Securitization | Our services and technology

3 Post securitization services

Following the securitization process, •• Modeling and assisting with the •• VAT analysis and reporting Deloitte can assist you with the daily monitoring of currency and interest •• Statutory annual audit operations of the securitization vehicle: hedging

Risk management and modeling Loan servicing and monitoring Accounting, financial, and tax reporting •• Basel III, CRR/CRD IV, Solvency II •• Assisting with evaluation and •• Accounting services for entities in monitoring of collateral maintenance multiple locations •• IFRS 9 covenants in loan agreements •• Multi-GAAP (Lux GAAP, IFRS, US GAAP •• Measurement and management of •• Solvas|Portfolio™ and customized risk etc.) accounting, (market, operational, management tools (including meeting compilation, and consolidation credit, liquidity, etc.) the requirements of IFRS 9) •• Support in the external financial •• Quantitative evaluation and •• Enforcement option analysis and step- reporting process management of portfolio risk by-step plans for share/asset pledges •• Identification and analysis of proposed •• ICAAP and Calculation •• Assisting in the monitoring of and or newly implemented accounting •• Capital adequacy, regulatory reporting investment criteria and restrictions principles and compliance for financial institutions (e.g., for CLOs) •• Continuous tax-efficient planning and •• Development of Value-at-Risk models •• Modeling and assisting in the structuring; identification and selection and back testing. Assistance in the monitoring of interest cash flows as of appropriate Luxembourg and foreign validation of risk models and their well as scheduled and unscheduled investment structures technical capabilities and functionalities distributions/redemptions related to •• Cross-border tax compilation and the issued financial instruments reporting

67 Securitization | Our services and technology

5.2. Our Maximum flexibility and user access updates with both user ABS Suite provides a customizable data and timestamp information. Role-based technology architecture that is easily adjusted to security allows customized application Deloitte Advisory offers a range of financial accommodate an unlimited number of access rights for users across the technology software solutions and services asset classes, interfaces, and transactions. organization. to meet the administration, accounting, Our unique Allocation Rules Technology compliance, and surveillance demands of (ART™) is a visual tool that is used to define Enhance today’s market—and your firm’s unique the waterfall and related calculations Through a combination of a single data needs. Whether your company is a start-up for even the most complex structures, repository and robust reporting tools, fund or a large global financial institution, such as delinked master trusts, with no ABS Suite provides advanced investor and in more than a dozen countries programming changes. In addition, custom and management reporting. The user is across five continents, we keep pace with calculations can be defined via a powerful able to easily view the performance of a innovations in technology and changes on business rules engine. single transaction or the entire platform the global financial markets to help you in standardized or ad hoc reports. User- improve efficiency, increase transparency, Increase scalability and operational friendly report writing tools put your and build value. efficiency organization in control of producing the The ABS Suite architecture provides reporting needed to analyze, monitor, and scalability, allowing your program to administer your programs. grow without an incremental increase in resource requirements.

•• With ABS Suite's copy functionality, issuing a new transaction can be as easy The solution of choice for asset-backed as copying an existing deal structure issuers, servicers, and trustees around the world, ABS Suite™ is a powerful structured •• Our workflow automation allows finance and program processing to run unattended and administration system. This solution is minimizes precious work hours required backed by the global Deloitte Touche to perform multiple tasks Tohmatsu Limited network of member •• ABS Suite’s relational database provides a firms and Deloitte, both recognized as centralized data repository that can hold experienced leading service providers to data across multiple issuance programs the structured finance industry for more and asset classes than three decades. ABS Suite is asset-class independent and The automated processing allows your has been implemented in the Americas, team to focus on analyzing results instead Europe, Africa, and Asia Pacific for various of compiling and reconciling information. asset classes, including credit cards, mortgages, vehicle loans and leases, and Mitigate risk equipment finance. The system’s unique ABS Suite automates the data exchange flexibility supports an array of structures, between upstream systems, such as including: loan servicing, origination, and loss •• Discrete trusts management systems and downstream systems such as the general ledger. •• Master trusts Standard and customized data validations •• Delinked platforms are performed on both inbound and outbound interfaces. •• Covered bond programs

A “four-eyes” approval process is designed In today’s challenging times, it is more such that changes to any business rule, important than ever to have a flexible, deal structure, or report are reviewed scalable, and efficient solution that and approved. Robust audit controls mitigates risk and provides rich data permanently log the results of all analytics. calculations, configuration changes,

68 Securitization | Our services and technology

ABS Suite’s modular architecture includes •• Accounting—defines journal entries and ABS Suite utilizes state of the art the following capabilities: facilitates interfacing with the general technology, including: ledger •• —custom •• A Service Oriented Architecture (SOA) definition of inbound servicing system •• Collateral forecasting—projects future based on .NET platform interfaces, user defined calculations, data collateral performance based on the •• An advanced user interface based on transformations, data verifications, and characteristics of your underlying user-defined metadata, utilizing our edit checks collateral or hypothetical collateral and proprietary application framework user-defined performance assumptions •• Collateral servicing—an account-level •• A single relational database, using either calculation engine to supplement the •• Transaction forecasting—forecasts the SQL Server or DBMS information that your servicing systems future performance of your transaction may not be able to provide using collateral forecasting results paired •• Robust security features, including native with your existing or proposed deal support for various user authentication •• Pool selection—a robust engine to define structures schemes like Active Directory, Windows criteria and concentration limits for asset Integrated and Basic/Digest pooling and analytics •• Reporting—an easy-to-use interface to generate a full-range of reports, ad hoc •• Support for load-balanced and failover- •• Transaction structuring deal component queries, and data extracts required to standby server configurations for quick pricing and issuance definition along with administer your program disaster recovery visual waterfall and calculation definition (using ART™) •• Configurable archiving to support large data volumes

69 Securitization | Our services and technology

Soa uort te u rane o olvas|ortolio ainitratie is a roust ortolio ta anatica and asset olvas|gent nee an adinistration cash generates agent reortin activity tracing and reorts and notices reuireent o reorting syste individually or in te et aret designed to suort atch or oth the adinistrative orroers and rocesses o the lenders ro asset iddle and adinistration back-office. activity traced in olvas|ortolio

olvas|ccounting is a dynaic and flexible financial accounting and reorting sotare acage that olvas|oliance olvas|erorance suorts unliited allos users to rovides interactive reorting entity odel and calculate asset ortolio and configurations, credit agreeent crossortolio rovides covenants erorance reorting ulticurrency ortoliolevel caailities to suort and allos eligiility criteria coleent or various and concentration olvas|ortolio accounting liitations ithout ethodologies rograing he syste also suorts hyothetical scenario analysis

olvas|o rovides the olvas|redit sealessly caaility to design integrates ultile data riority o ayent sources to allo or a calculations as a corehensive vie o coleent to current investentsand olvas|ortolio and provides the flexibility to olvas|oliance aid in credit and trading analysis

70 Securitization | Our services and technology

In a market where flexibility is key, Solvas|Portfolio™ is a multi-asset class •• Global, cross-portfolio processing of spreadsheet-based operations produce portfolio administration and reporting principal and interest transactions, and unwanted risk, and expensive legacy or solution for asset managers, alternative cash receipts generalist systems fall short, a complete, investment funds, trustees, fund •• -level interest calculations and flexible, and reasonably priced software administrators, and agent banks. Having accruals package is essential. Deloitte Advisory’s already been a leading collateralized loan/ ™ team offers a debt obligation (CLO/CDO) administration •• Multi-currency support leading suite of software solutions for the solution for the •• Support for portfolio and asset level debt market. The Solvas software solutions and trustee market for over a decade, swaps encompass credit analysis, portfolio Solvas|Portfolio™ (together, with administration, compliance and covenant Solvas|Compliance™, formerly known •• Expected vs. actual transaction reporting monitoring, performance reporting, and as CDO Suite™) has evolved into a •• Unlimited user-defined fields accounting. comprehensive software package for the Our comprehensive set of solutions are: asset management and financial institution •• Robust library of standard reports community. •• Built on state-of-the-art, standardized •• Full historical reporting, as of any date technology platforms Designed as a diverse portfolio •• Data import/export and comparison •• Ready-to-use without unknown administration, collateral tracking, and tools implementation costs reporting tool, Solvas|Portfolio™ is •• User activity logging used by a wide array of leading financial •• Business user-friendly institutions including hedge fund and asset •• User access control available at multiple •• Modular and flexible to allow you to managers, hedge fund administrators, levels choose only the functionality you need syndicated, corporate, or real estate loan •• A Web-native user interface administrative agents, and agent or trustee •• Capable of stand-alone implementation banks. Features include: •• Centralized, relational database design or integration with existing infrastructure •• Support for industry-standard •• Available for on-premises or hosted •• Global asset master with portfolio-level reconciliation files and interfaces installation overrides •• Competitively priced Whether the client is a start-up fund •• Detailed support for a broad array of manager or one of the world’s largest collateral, including bonds, factor-based trustees, Solvas|Portfolio™ was designed securities, asset-backed securities, to meet the asset management industry’s syndicated, corporate, or real estate needs. The result: an easy-to-use, loans, credit default swaps, and equities transparent, and comprehensive portfolio •• Multiple payment-in-kind (PIK) calculation administration system. methodologies

•• Pro rata and non-pro rata trading with purchase lot tracking and global or portfolio trading wizards

•• Loan Syndications and Trading Association (LSTA) and Loan Market Association (LMA) trading conventions for par/near-par and distressed , including detailed delayed compensation calculations

71 Securitization | Our services and technology

Solvas|Accounting™ is a dynamic and •• The system generates various financial flexible financial accounting and reporting reports including: software package designed for investment ––Statement of Assets and Liabilities/ managers and fund administrators. Balance Sheet Solvas|Accounting™ can generate ––Statement of Operations/Income financial reports for portfolios of financial Statement instruments. The system supports ––Statement of Changes in Net Assets unlimited reporting entity configurations, •• Solvas|Accounting™ is designed to provides multicurrency support, and allows accommodate complex financial for various accounting methodologies. instruments, such as syndicated bank debt or mezzanine loans Accounting functionality •• The system allows the presentation of •• Solvas|Accounting™ allows various financial reports in different currencies accounting methodologies, including fair with an automatic, separate calculation of value and amortized cost the foreign currency translation gain/loss •• Multiple accounting methodologies •• The information in the system is may be applied to the same portfolio to preserved at the most granular level, support reporting on different accounting allowing drill down from aggregate bases, such as International Financial account balances to the underlying Reporting Standards and US Generally individual journal entries Accepted Accounting Principles

•• The system provides robust handling Built-in workflow manager of back-dated activity related to closed •• The workflow manager includes periods predefined workflows for setup, on- •• Solvas|Accounting™ has the flexibility demand processes, and recurring to accommodate different accounting activities period durations, including support for •• Business users can modify predefined quarterly, monthly, weekly, and daily workflows or create new workflows to closing support various procedural or approval •• Level yield, straight-line, and other needs custom amortization methods are •• The system supports task assignment to supported individual users

Presentation capabilities Implementation •• The reporting entities in the system have •• Solvas|Accounting™ can be implemented their own customizable chart of accounts as a stand-alone accounting system, and can include one or more portfolios hosted, or integrated with an existing •• Each reporting entity provides general ledger independent sequential processing •• While Solvas|Accounting™ can import based on its own reporting calendar transactional data from any portfolio •• Solvas|Accounting™ offers a configurable system, Solvas|Accounting™ is designed dashboard to be integrated with Deloitte’s Solvas|Portfolio™

72 Securitization | Our services and technology

Solvas|Agent™ is an administration and desktop email application. All notices •• Transactions reporting system designed to support distributed are logged in the system for a •• Accrual history the activities of loan administrative full record of past correspondence on loan agents. Solvas|Agent™ provides the transactions. •• Cash activity ability to create agent reports and notices from loan administrative activity Centralized information Solvas|Agent™ brings the latest and most tracked in Solvas|Portfolio™. The Advanced information management for accurate administration technology in the extensive loan administration support contacts and wiring/payment instructions loan industry to loan administrative agents. of Solvas|Portfolio™ coupled with supports the complex network of parties Solvas|Agent™ brings modern technology and details necessary for accurate portfolio to the operations of loan administrative servicing. agents. Agent-specific reporting Efficient, modern distribution In addition to facilitating the agent’s The platform supports individual or batch administration needs, the system has a notice generation in various file formats. library of agent-specific reports, including The automatically customized notices reports addressing: can be sent directly by the system’s •• Outgoing wires email distribution capabilities from your corporate email server or from your team’s •• Lender allocations

Solvas|Compliance™ is a rules-based complex collateral tracking capabilities •• Ability to create custom variables compliance engine that provides of Solvas|Portfolio™ and Solvas|PoP™, •• User-controlled calculation sequences flexible, user-configurable calculations Solvas|Compliance™ allows advanced allowing for iterative calculation testing for CLOs, collateral managers/trustees, monitoring of CLOs and covenants. managers, and •• Dynamic, user-defined rules to fund administrators. The system provides Designed for the CLO and loan market, determine: collateral managers and trustees with Solvas|Compliance™ offers industry- ––Notched ratings the ability to model deals without leading flexibility and control. Features ––Recovery rates programming and robust compliance test include: ––Principal balances and hypothetical trade scenario analysis ––Calculations •• The ability for business users to model capabilities. Alternative investment and maintain deals without programming •• Multiscenario hypothetical trade analysis managers and fund administrators can knowledge also use this compliance engine for •• Data comparison tools calculating credit agreement covenants. •• Comprehensive library of CLO Combined with the multicurrency and compliance test templates

73 Securitization | Our services and technology

Solvas|Performance™ provides •• Supports multicurrency portfolios as well •• Includes interactive drill-down performance reporting capabilities as as various PIK methodologies functionality for calculated and a complement to the Solvas|Portfolio™ dependent values to enhance •• Generates results for a single user- collateral administration system. transparency, usability, and auditability selected portfolio or multiple user- Constructed to seamlessly integrate with selected portfolios over a specified •• Is complemented by a series of portfolio Solvas|Portfolio™, Solvas|Performance™ period of time reports for incremental information offers interactive, cross-portfolio, and related to performance calculations multicurrency performance reporting •• Uses the Modified Dietz investment including: for collateral managers, trustees, and method and composite return –– Earned income alternative investment managers. calculations based on Global Investment –– Realized gain/loss Solvas|Performance™: Performance Standards (GIPS) guidelines –– Interest activity •• Provides asset returns across multiple •• Produces a unified, dynamic performance –– Principal activity asset classes directly from activity in report that summarizes performance of –– Market value Solvas|Portfolio™ portfolio(s)

Solvas|PoP™ is a rules-based priority of calculation blocks, and entity level user- •• Executes applicable priorities of payments module that provides flexible, defined fields payments as part of the calculation user-configurable priority of payments sequence, either on demand or •• Provides the ability to apply separate calculations for collateralized loan automatically logical and timing conditions to obligation (CLO) collateral managers/ any payment to customize the •• Provides summary and detailed waterfall trustees, alternative asset managers, payment sequence as required by results with the ability to drill into the and fund administrators. Solvas|PoP™ the , loan agreement, or calculation details of any payment provides the capability to design priority portfolio documentation (including date of payments as a complement to the •• Facilitates the comparison of waterfall applicability and criteria applicability) Solvas|Portfolio™ and Solvas|Compliance™ results to any current, historical, or collateral administration and compliance •• Has the ability to define and reuse hypothetical portfolio created with a functionality. Constructed to seamlessly payment groups to model complex trading scenario in Solvas|Compliance™ integrate with these systems, Solvas|PoP™: payment sequences and distribution scenarios easily Solvas|PoP™ offers a flexible and user- •• Allows the typical business user to model friendly priority of payments and waterfall all priority of payment calculations •• Includes specialized overcollateralization calculation solution to CLO managers/ (including interest, principal, liquidation, and interest coverage test calculators trustees, alternative asset managers, and and acceleration) using a set of that have the ability to calculate and fund administrators. specialized calculation templates apply cures for failed tests

•• Uses calculation capabilities and other •• Allows accrual and tracking of various features of the Solvas|Compliance™ fees and expenses necessary to model calculation engine, including variables, payments and payment caps

74 Securitization | Our services and technology

75 Contacts

Ekaterina Volotovskaya Eric Collard Partner - Audit Partner - Restructuring Securitization leader +352 451 454 985 +352 451 452 387 [email protected] [email protected]

Michael JJ Martin Partner - Restructuring +352 451 452 449 [email protected]

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