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European Secured notes: what is compatible with risk transfer?

05 June 2015
Richard Kemmish

Covered bond lookalikes, the first branch of the ECBC’s European Secured Note proposal, could be quite easy to structure. But to the extent that the real problem preventing banks from funding SMEs is capital, not funding, it will only ever have a limited benefit.

The real problem is capital. As we know capital is more of a problem than funding, in particular in the southern European countries that most need SME financing to be unlocked. So the second branch of the ECBC’s proposal is, like test cricket or Wagner operas both much more difficult and ultimately much more rewarding.

When you look at the differences between covered bonds and securitisations, some of the covered bond features are clearly incompatible with risk transfer. Some are clearly compatible. Some – the interesting ones - seem to fall in-between and warrant further debate.

Taking the easy ones first. Obviously a risk transfer product must do away with recourse to the issuer, cross default clauses to other debt products and asset cover tests replacing underperforming with performing assets. None of these can be made compatible with risk transfer. 

On the other hand, a clear legal definition of eligible assets and a special supervisory regime to protect bond-holders interests are pretty easy to cut and paste from the covered bond to the securitisation market. Why did it take a crisis for this to happen?

Then there is the legal structuring: boxes and arrows, asset transfer agreements, asset ring-fencing rules and intra group regulatory treatment have all been developed to a very high degree in almost every country in Europe in the context of their covered bond law. In almost every case it would be very easy to simply copy this technology into a risk transfer product (you’re welcome).

The fun bits are going to be around revolving pools and the creation of bullet maturity structures.

Revolving pools are not incompatible with risk transfer. Credit card securitisations have always adopted technology to ensure that the replacement of old receivables with new ones doesn’t contain a hidden credit support. Master trust securitisation structures adapted the technology to residential mortgages but you only have to feel the weight of the prospectus to know that it was a ridiculously complicated exercise legally. People who know these structures well tell me that only the most sophisticated investors ever really understood them and that it was never really clear whether they would actually work in practice.

Then there is the related pre-maturity test/extension provisions/conditional pass through debate. In the covered bond world credit risk and refinancing risk are close relatives, whereas the securitisation market with its pass-through-as-standard structures has only ever worried about the former. How does collateral posted to address refinancing risks get treated?

The simple solution to these two in-between problems is not to bother. Risk transfer seems to be much more easily compatible with floating rate amortising structures. Is that the right structure? Or do we need to do some very clever structuring?

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