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Article 20(1) of the STS Regulation requires that—in the case of an STS transaction—the title to the underlying exposures be acquired by the securitization special purpose entity (SSPE) by means of a true sale or assignment or transfer with the same legal effect. The draft guidelines suggest that a legal opinion should be provided, confirming the nature of the acquisition by the SSPE, along with an assessment of clawback and re-characterization risks.

We observe that a significant portion of recent European securitization issuance has been backed by assets that were originated by a lender and then traded between market participants as unsecuritized loan portfolios—in some cases several times—before eventually being securitized. In these cases, the ultimate securitization seller is not the original lender and may not have purchased the assets from the original lender. Indeed, in many such cases, the original lender may no longer be a going concern.

It is unclear whether such transactions backed by traded legacy asset portfolios should in principle be excluded from STS eligibility. However, they may in practice struggle to comply with the draft guidelines. In cases where the seller is not the original lender, Article 20(4) of the STS Regulation states that the seller's own acquisition of the underlying exposures should meet the requirements set out in Articles 20(1) to 20(3) and therefore comply with the legal opinion guidelines discussed above.

It may be impractical to provide a lengthy audit trail covering all the underlying exposures' previous ownerships, providing legal opinions for sales at each intermediate step between the original lender and the ultimate SSPE. This would be even more complex where exposures for the securitization have been aggregated from multiple sources over a long period of time. It would be useful if the guidelines could clarify whether this is the intention, or whether only the sale to the eventual securitization seller is within the scope of the requirement.

However, even in the latter case, we consider that the requirement may be difficult to comply with in practice, given that a securitization legal opinion is typically only sought at the time that a securitization is planned. The seller may have initially acquired the portfolio of underlying exposures without a view to eventual securitization, potentially through multiple unrelated transactions from different sources, in which case the legal opinions required for the transaction to be STS-compliant on this criterion may not exist.
Article 20(6) of the STS Regulation requires the seller in an STS transaction to provide representations and warranties that the underlying exposures are not encumbered. However, paragraph 16 of the draft guidelines clarifies that where the seller is not the original lender, these representations and warranties should also be provided to the seller from the original lender.

As mentioned in our answer to question 1, a significant portion of recent European securitization issuance has been backed by assets that were originated by a lender and then traded between market participants as unsecuritized loan portfolios—in some cases several times—before eventually being securitized. In these cases, the ultimate securitization seller is not the original lender and may not have purchased the assets from the original lender. Indeed, in many such cases, the original lender may no longer be a going concern. It may therefore not be practical for the original lender to provide the seller with the representations and warranties required by Article 20(6) of the regulation, as suggested in the draft guidelines.

In our ratings analysis, we would typically review legal opinions to determine that the underlying exposures are not encumbered and to assess the enforceability of the true sale (or other transfer) to the SSPE. We generally apply this approach regardless of whether or not the seller is also the original lender.
Article 20(7) of the STS Regulation requires that exposures transferred to the SSPE after the closing of an STS transaction shall meet the eligibility criteria applied to the initial underlying exposures. Paragraph 21 of the draft guidelines clarifies this requirement by stating that for exposures transferred to the SSPE after closing, eligibility criteria should be no less strict than the eligibility criteria applied to the initial underlying exposures".

In our view, this may be problematic for transactions backed by a collateral pool that revolves over a long period of time, notably in repeat issuance structures such as credit card and residential mortgage master trusts. It could be interpreted as meaning that the standard for assets added to a master trust pool over time can only be higher than when the trust was initially established, which may have been many years earlier in a substantially different market and lending environment.

If the intention is that repeat issuance structures (such as master trusts) should not be excluded from qualifying for STS treatment, it may be helpful if the guidelines clarify that each time there is an issuance from such a repeat issuance structure, the eligibility criteria may be reset. Sponsors of these structures are typically able to increase or decrease credit enhancement levels to reflect any changes in collateral credit quality that may result. Paragraph 21 of the guidelines would then only apply to underlying exposures transferred into the collateral pool between such issuances.

More generally, Article 20(7) of the STS Regulation disallows active portfolio management of the underlying exposures in an STS transaction, as clarified in paragraphs 18 and 19 of the draft guidelines. Paragraph 19a of the guidelines may be too restrictive, in our view, as it would disallow the sale of exposures from the collateral pool for reasons other than seller repurchases related to a breach of representations and warranties. In practice, there may be several other operational and commercial reasons why exposures may be repurchased, including clean-up calls and agreement novations. These would typically not be materially detrimental to the transaction or change the overall credit quality of the pool, in our view, but may make transactions STS-ineligible according to the draft guidelines."
Article 20(10) of the STS Regulation requires that where the underlying exposures of an STS transaction are residential mortgages, the collateral pool shall not include any loans that were marketed and underwritten on the premise that information provided by the loan applicant might not be verified by the lender.

Paragraphs 30 and 31 of the draft guidelines are helpful in clarifying that the marketing—rather than the underwriting—of the loan is the critical consideration in this context. This may be intended to mitigate the risk of adverse borrower selection associated with self-certified" loan products, while allowing loans where the lender has made a process decision not to verify certain information in low-risk cases (e.g., "fast track" loans). We note, however, that "fast track" loan products may still be ruled out according to the draft guidelines if product marketing made loan applicants or intermediaries aware that the process would be fast because borrowers with a sufficiently high credit score might not have their incomes verified.
In our credit analysis of collateral pools underlying residential mortgage-backed securities (RMBS), we treat "fast track" mortgage loans as income-verified if a review of the lender's underwriting processes and historical evidence indicate that the performance of these loans has not differed significantly from that of standard income-verified loans, including through a period of economic stress."
Article 20(11c) of the STS Regulation requires that assets selected for transfer to the SSPE should not include any exposures to a debtor or guarantor with a credit assessment (or score) that indicates a high risk of contractually agreed payments not being made. Paragraph 50 of the guidelines clarifies that this rules out obligors with a credit score that is significantly worse than the average credit score relating to all comparable unsecuritized exposures held by the originator.

It may be impractical for sellers to make the specific calculation of an average credit score across debtors and/or guarantors for all comparable unsecuritized exposures, in order to define the standard for including exposures in the collateral pool. In any case, if such an average credit score were used as a benchmark, then the guidelines would need to include additional information on the definition of significantly higher than average". By definition, the credit scores of many debtors will be lower than (i.e., indicate higher risk than) the average credit score of all debtors in the collateral pool. Given the general principle throughout the draft guidelines that securitized exposures should resemble the originator's unsecuritized exposures, the same is likely to apply when comparing with the average credit score of unsecuritized exposures.

Paragraph 50 of the guidelines refers to the debtor's credit score being significantly higher-than-average. However, the intention may have been to refer to the credit risk indicated by the debtor's credit score being higher than that indicated by the average score, consistent with the wording in Article 20(11)(c) of the STS Regulation."
Article 20(13) of the STS Regulation requires that the repayment of noteholders in an STS securitization does not depend predominantly on the sale of assets securing the underlying exposures. In the consultation paper, the stated background and rationale for this criterion (section 3, paragraph 46) includes the aim to exclude from STS securitization, for example, commercial real estate transactions…" At the same time, the criterion "does not aim to exclude…interest only residential mortgages from STS securitization" (section 3, paragraph 47).

In our view, the guidelines could be clearer regarding this apparent distinction between commercial mortgages and interest-only residential mortgages, which may be characterized by similar bullet principal repayment profiles. In each case, the repayment of loan principal at maturity—and therefore repayment of the holders of a related securitization position—would not depend on the sale of the securing property assets if those assets are refinanced with a new loan or the borrower is able to repay principal with funds from other sources.

If the intended approach to principal repayment is through a refinancing at loan maturity, then repayment would likely depend on borrowing conditions at that time, as well as the market value of the securing assets, but would not depend on an asset sale. This is the case for both the residential and commercial mortgage examples. If refinancing is unsuccessful, the borrower may default on their principal payment, in which case the recoveries used to help repay securitization noteholders will likely depend on the sale of the securing assets, but this is the case for any secured loans that default in a securitization pool.

With an interest-only residential mortgage loan, the borrower may have an offsetting savings plan intended to repay principal at maturity. Although the adequacy of this plan to fully repay loan principal at maturity is not guaranteed, it may not be linked directly to the sale value of the securing assets. However, the means by which borrowers plan to repay principal on the securitization's underlying exposures is not referenced in the draft guidelines.

It may therefore be useful if the guidelines clarify how interest-only residential mortgage loans are not excluded from backing an STS securitization, while commercial mortgage loans generally are, based on this criterion. For example, it is unclear whether the repayment of interest-only residential mortgage loans generally would not be treated as dependent on the sale of the securing property, or only if the borrower has a linked savings plan in place. It is also unclear whether a commercial mortgage loan with a bullet principal structure would always be treated as having its repayment dependent on an asset sale, regardless of how the borrower plans to repay the loan in practice."
Paragraph 53 of the draft guidelines specifies conditions under which repayment of noteholders would not be considered predominantly dependent on the sale of assets securing the transaction's underlying exposures. One such condition is that the value of assets on whose sale the transaction relies should be no more than 30% of the initial pool value.

This may mean that many transactions backed by leases or certain common types of auto financing agreements (e.g., personal contract purchases) are excluded from being STS-eligible, in our view. This is partly because the definition of the ratio used for the proposed 30% materiality threshold may overstate the dependence of note repayments on asset sales. In particular, where the assets are expected to depreciate significantly in value by the time of their eventual sale, calculating the test ratio based on the assets' value at the time of transfer of the exposures" to the SSPE may be misleading. We also note that if noteholders in the transaction benefit from sufficient credit enhancement in the form of overcollateralization, a reserve fund or deferred interest retained by the seller, then their repayment may not be dependent on asset sales at all, even if all the underlying exposures have a residual value component (e.g., leases)."
Article 21(2) of the STS Regulation requires that the interest rate and currency risks arising from an STS securitization should be appropriately mitigated. We understand from the consultation paper that the objective of this criterion is to ensure greater simplicity of STS transactions, since the mitigation of interest rate and currency risks may facilitate investors' modeling of those risks and their impact on the overall credit risk of the securitization investment. Further, the paper states that in cases where interest rate and currency risks are hedged using derivatives, those risks may not need to be modeled at all (section 3, paragraph 52).

In general, we note that transactions with interest rate and/or currency mismatches between their underlying collateral pool and liability structures have historically often used derivatives-based hedging arrangements with specific language regarding counterparty collateral posting and replacement provisions. However, in our experience, it is becoming increasingly common for transactions to use a wider variety of techniques in dealing with such interest rate and currency risks. This requires third parties to adopt alternative approaches to analyzing the resulting credit risk. We therefore support the overall sentiment expressed in the draft guidelines—and the clarification in paragraph 56—that there are potentially many ways to appropriately mitigate interest rate and currency risks in a securitization, that hedging through derivatives instruments is only one of these possible ways, and that other mitigating measures may also qualify as appropriate for a transaction to qualify as STS on this criterion.

However, the detailed elements of the draft guidelines seem quite prescriptive and may not be in line with acknowledgement in paragraph 56 that there are many approaches to effectively mitigating interest rate and currency risks.

For derivatives-based mitigation approaches, paragraph 57d requires collateral posting and replacement language, using some form of credit-based triggers. Credit rating agencies have traditionally analyzed such elements of the derivative documentation—including details of the trigger rating levels employed and levels of collateralization commitment—in order to quantify the credit effect of the hedging arrangement and factor it into the securitization's ratings. In the context of the STS eligibility criteria, however, we understand that the aim is merely to simplify investors' risk assessment process, by transforming what would otherwise be an analysis of interest rate and currency risks into largely an analysis of counterparty credit risk. This could be achieved without prescribing details of the derivatives agreements, such as the inclusion of trigger-based collateralization and replacement language. Paragraph 57e acknowledges that interest rate and currency risks may in any case not be perfectly hedged, even when derivatives are used, e.g., due to only partial coverage of the at-risk notional amount or using an interest rate cap rather than a swap. This is another reason why it seems overly-prescriptive to require a collateral and replacement framework.

In the context of quantifying creditworthiness, our own criteria for analyzing derivatives-based hedging arrangements are somewhat flexible, allowing for the same tranche rating to be achieved through different combinations of collateral posting and replacement trigger commitments, including the option of a relatively higher replacement trigger with no collateral posting at all, for example.

In addition, although credit ratings are not mentioned explicitly in paragraph 57d, their use is potentially implied through the term creditworthiness of the counterparty". In our view, it may be useful to clarify that the measure of "creditworthiness" in question does not need to be tied to a credit rating, in line with initiatives to ensure that there is no mechanistic reliance on ratings in regulation.

Finally, paragraph 57e requires a demonstration of the effectiveness of any derivatives-based hedging through quantitative analysis, to include a "sensitivity analysis that illustrates the effectiveness of the hedge under extreme but plausible scenarios". Again, this requirement could be considered onerous and suggests a requirement for the seller of an STS transaction to demonstrate its creditworthiness, rather than merely ensuring the transaction is relatively simple for investors to analyze.

Turning to the envisaged cases of risk mitigation without the use of derivatives, the draft guidelines in paragraph 58 appear to be very prescriptive, in our view, and inconsistent with the more general sentiment expressed in the consultation paper that there are many ways to mitigate interest rate and currency risks. Leaving derivatives-based mitigation measures aside, paragraph 58 as drafted appears to rule out any approaches other than the provision of dedicated, fully-funded reserves. For example, the guidance that risk mitigation measures should be "specifically created and used for the purpose of hedging only the interest rate or currency risks" appears to rule out the simple use of higher subordination or a larger (regular) reserve fund in order to mitigate these risks. In some transactions, minor interest rate mismatches (e.g., basis risk) may also be covered by excess spread, for example. In our view, transactions that use these alternative approaches should not be disqualified from being STS-eligible on the basis of not having a separate credit enhancement mechanism that is dedicated to covering identified interest rate or currency risk."
Article 21(3) of the STS Regulation requires that any referenced payments under the securitization assets and liabilities shall be based on generally used market interest rates or generally used sectoral rates reflective of the cost of funds. In our view, the draft guidelines in paragraph 62b do not entirely clarify whether securitizations backed by mortgage loans paying a standard variable rate (SVR) would meet these criteria.

The draft guidelines in paragraph 62a clarify that loans with rates linked to a widely-used market benchmark are eligible. However, many mortgage loans pay interest at a rate that is determined by the lender on a more discretionary basis, without any direct link to an observable benchmark rate that is used in the market more widely.

The draft guidelines may intend to include SVRs in the term: internal interest rates that are directly reflecting the market costs of funding". If this is the case, it may be helpful if the guidelines stated more explicitly that lenders' SVRs are included and/or provided a standard to determine when an internal interest rate is deemed to directly reflect a lender's funding costs in this context."
Andrew South
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