According to Section 3 of the Guidelines on specification of types of exposures to be associated with high risk (EBA/GL/2019/01 ): “The scope of the exercise of identifying items associated with particularly high risk that are not already covered by Article 128(2) of Regulation (EU) No 575/2013 should cover all exposure classes, with a particular emphasis on the exposure classes referred to in points (g - Corporates), (p - Equity) and (q – Other items) of Article 112 of Regulation (EU) No 575/2013.”

The selected transactions are currently assigned by the bank to the exposure class “exposures to corporates” in accordance with Article 112 CRR.

EBA/GL/2019/01 Section 4: “Institutions should consider as items associated with particularly high risk, from among those referred to in paragraph 3, at a minimum, those exposures that exhibit levels and ranges of risk drivers that are not common to other obligors or transactions of the same exposure class.”

The transaction represents portfolio-based funding to a borrower that purchases US-mortgage loans originated by 3rd parties.

- The underlying assets represent loans granted for the purpose of buying properties (different type of non-owner occupied residential real estate) to be sold after refurbishment. Thus, the repayment of the loans highly depends by the development of the real estate market. By looking through the funded portfolio, the individual loans fulfil the requirements acc. to Article 4 (79) CRR and hence shall be deemed as speculative immovable financing.

- The borrower entity’s Balance Sheet and P&L structure completely differs from that of a plain vanilla corporate customer (i.e. interest income arising from loan origination instead of sales generated from production/provision of goods/services).

- In contrast to plain vanilla corporate risk where the creditworthiness of a single customer (production/provision of goods and services) determines the risk profile of the transaction, this type of transaction (loan-on-loan/lender financing) exhibits aggregated risks arising from multiple sources where risk measurement is only performed on portfolio-level.

- The borrower entity is deemed by the bank as an unregulated financial sector entity in accordance with Article 394(2) CRR.

EBA/GL/2019/01 Section 5: “For the purposes of paragraph 4, institutions should consider, at a minimum, all of the following exposures as exhibiting levels and ranges of risk drivers that are not common to other obligors or transactions of the same exposure class:

EBA/GL/2019/01 Section 5a: any financing of speculative investments in both financial and non-financial assets other than immovable property, in which the obligor has the intention to resell the assets for profit”

The bank’s borrower invests into financial assets representing mortgage loans which are used for speculative investments into immovable property, i.e. properties to be refurbished and sold. Hence, Article 4 (79) CRR can be deemed as fulfilled.

EBA/GL/2019/01 Section 5a i: “there is a particularly high risk of loss in cases of the default of the obligor, in particular in the case of insufficient market liquidity or high price volatility for the financed object that has not yet been sufficiently mitigated by contractual arrangements, including irrevocable pre-sale contracts”

- The bank describes the transaction that is secured by assets representing high-yield, illiquid, speculative investments.

- Non-performing loans are also eligible for the portfolio.

- The cash sweep covenant is only triggered in the event the share of delinquent loans (delinquency defined as >90DPD) exceeds 17.5%.

- The delinquency ratio-based default covenant (delinquency defined as >90DPD) is only triggered in case the delinquency ratio exceeds 25.0%.

- Unlimited eligibility of Mortgage Dependent Promissory Notes (MDPNs) to the funded portfolio which represent unsecured claims (i.e. loans) obligating the issuer to pass on cash received from underlying loans to note holders. MDPNs made up 6% of the funded portfolio as of reference date.

- Loan originators are platforms without sufficiently evidenced track record and the bank has no ability to influence their underwriting standards.

EBA/GL/2019/01 5a ii: “there are insufficient other incomes and assets of the obligor available for mitigating the loss risk for the financing institution, in particular in cases where the loss risk is high in relation to the financial resources of the obligor”

- The borrower has no equity and the guarantee provided by the Sponsor has limited substance (i.e. it must maintain tangible net worth of at least 30% of aggregate loan assets).

The bank’s position:

The structure of the selected transaction provides significant credit enhancements versus a scenario with direct exposure to the underlying pool of loans.

The bank’s argumentation is primarily backed by its high loss absorbance capacity as demonstrated by means of a stress-test (i.e. losses might first occur once US property prices reduce by 40% and the collaterals behind 60% of the loans are foreclosed at a further 20% discount) and by the following terms and conditions as contractually agreed:

- the bank’s facility level advance rate (i.e. the maximum loan amount in relation to the full loan amount originated by the bank’s borrower) amounts to 75%.

- the robust covenant structure with i) cash sweep triggers mainly based on delinquencies and property values which result in timely deleveraging of the portfolio and with ii) default covenants.

- portfolio eligibility requirement in terms of minimum creditworthiness of the ultimate underlying borrower (measured by means of a generally accepted US scoring method).

- the Guarantor has to maintain the borrower’s tangible net worth of at least 30% of aggregate loan assets.