Regulation 2021/557 (the “Regulation”)¹ recently amended Regulation (EU) 2017/2402 (the ‘’original Securitization Regulation”)² to help recovery from the COVID-19 Crisis.
As the severe economic shock caused by the COVID-19 pandemic and related expectational measures have a far-reaching impact on the world economy, the targeted changes to the original Regulation are intended to ensure the securitization framework provides for an additional tool to foster economic recovery in the aftermath of the COVID-19 crisis.
The main elements of the Regulation impacting the securitization market are as follows:
“Non-performing Exposures” (NPE)
The COVID-19 crisis risks increasing the number of non-performing exposures (NPEs), and increases the need for institutions to manage and deal with their NPEs. New requirements will apply to NPE securitizations:
- Definition of NPE securitization: Securitizations backed by a pool of exposures meeting art. 47a(3) of Regulation (EU) No 575/2013.³ The value of these NPE makes up at least 90% of the pool’s value at the time of origination (art. 2 of the original Securitization Regulation).
- Risk retention: The risks associated with the assets backing NPE securitizations are economically distinct from those of securitizations of performing assets. NPEs are securitized at a discount on their nominal or outstanding value reflecting the market’s assessment of future cash flows and asset recovery. In NPE securitizations originators seek to offload the defaulted assets from their balance sheets. It is important that the risk-retention requirement aligns the interests of originators, sponsors and original lenders of the securitization with those of investors.
- At a minimum originator, sponsor or original lender should retain, on an ongoing basis, at least 5% of the net value of the securitized exposures qualified as NPE as per art 47(3) of the Regulation 575/2013. The discounted value of the exposures transferred to the Securitization entity is to be considered as basis of calculation.
- There is a possibility for the independent servicer to take on the risk retention slice because it has substantive interest in the workout of the assets and value recovery.
- Credit rating: The credit-granting criteria applied on performing exposures are not applicable to NPE at the time the originator purchased them from a 3rd party. Sound standards shall apply in the selection and pricing of the exposures during onboarding in order to make a sensible, well-informed investment decision.
Synthetic securitizations (STS On-balance sheet)
A new set of requirements are introduced specific to Synthetic securitizations which can be used as one way of moving away the risk from systemically important parts of the financial system by means of credit protection agreement:
Synthetic securitizations on-balance sheet should comply with STS criteria (art. 26b to 26 e):
- Transfer of credit risk should relate to exposures originated or purchased by EU regulated institutions within its core lending business activity and held on its balance sheet
- Credit risk should not be hedged more than once by obtaining credit protection in addition to the protection already provided by the synthetic securitization
- Credit protection should only depend of the outstanding size and credit risk of the protected tranche
- Non-contingent premiums or other arrangements as up-front premium payments, rebate mechanism or overly complex premium are prohibited
- Early termination of the credit protection by the originator is limited to well defined circumstances that could not be anticipated at inception and need to involve changes in legislation or taxation events with negative impact on credit risk or economics)
- Ensure full disclosure of the use of synthetic excess spread and the definition of strict criteria to guarantee an effective transfer of risk
- Only high-quality credit protection arrangements should be eligible. For unfunded credit protection, only providers with 0% risk weight recognition are eligible and in case of funded one, eligible collaterals should be high quality collateral which may be assigned as 0% risk weight. Cash collateral should be held at 3rd party credit institutions or on deposit with the protection buyer
- Reference obligations on which credit protection is purchased should be clearly identified at all times via a reference register and kept up to date
- Ensure a transparent and sound documented payment process for the determination of actual losses in the reference portfolio, for that purpose, a third-party verification agent should be appointed to enhance legal certainty in the transaction for all parties involved and the occurrence of disputes and litigations in relation to loss allocation process and ensure the accuracy of certain aspects of the credit protection when a credit event has been triggered
Sustainable securitization framework
The Regulation lays down a stepping-stone towards the development of specific sustainable securitization framework. A report to this shall be published by 1 November 2021, for the purpose of integrating sustainability-related transparency requirements into this Regulation.
The report shall include an assessment of the introduction of sustainability factors, the implementation of proportionate disclosure and due diligence requirements, the content, methodologies and presentation of information in relation to environmental, social and governance-related adverse impacts.
These standards are required to “mirror or draw upon the regulatory technical standards” drawn up for the Sustainability Financial Disclosure Regulation.4
Investments in securitization entities in non-cooperative jurisdictions:
Article 4 of the Regulation provides that securitization special purpose entities (SSPEs) should not be established in (i) third countries that are listed on the EU list of non-cooperative jurisdictions for tax purposes and updates thereto or (ii) in the list of high-risk third countries which have strategic deficiencies in their regimes on anti-money laundering and counter terrorist financing.
The same article provides for a new reporting obligation for EU investors which invest in an SSPE established after 9 April 2021 that is located in a jurisdiction that is engaged in harmful tax practices (as listed in Annex II, which recaps the state of play of the cooperation with the EU with respect to commitments taken by cooperative jurisdictions to implement tax good governance principles). Such EU investor shall notify the investment in securities issued by that SSPE to the competent tax authorities of the Member State in which the investor is resident for tax purposes. This information may be used to assess whether the investor derives a tax benefit.
Annex II currently lists the following jurisdictions as cooperative jurisdictions that have committed to implement tax good governance principles: Australia, Barbados, Botswana, Eswatini, Jamaica, Jordan, Maldives, Thailand and Turkey.
What does it mean for you?
Calibration of the Capital requirements calculation by considering the net value approach instead of the nominal value of NPEs to avoid disproportionate capital charges and higher funding and transaction costs.
Use of the Net value when determining losses allocation approach (attachment point and detachment point) when setting up capital requirements.
Caps for NPE securitizations using the full net basis approach, i.e., the Exposure value and Expected losses should be net of Non-refundable purchase price discount (NRPPD) when calculating the Caps to better capture the characteristics of NPEs.
Ensure that the NRPPD is adequately sized to cover all underlying assets and to address the risk of incorrect valuation of the NPEs.
Reporting to the tax authorities
Luxembourg investors investing in a SPPE established, after 9 April 2021, in a jurisdiction listed in Annex II, e.g., Australia, are required to notify their investments in that SSPE to the Luxembourg tax authorities. No formal process is currently foreseen for such notification.
In the case of a securitization where the underlying exposures are residential loans or auto loans or leases, the originator and sponsor shall publish the available information related to the environmental performance of the assets financed by such residential loans or auto loans or leases as required by art. 22(4) of the original Securitization Regulation.
Originators may, from 1 June 2021, decide to publish the available information related to the principal adverse impacts of the assets financed by the underlying exposures on sustainability factors
Further, by 1 January 2022, based on the report of Commission the above requirements may be extended to securitizations where the underlying exposures are not residential loans or auto loans or leases, with a view to mainstreaming environmental, social and governance disclosure.
How EY can help?
We can offer our services in following areas:
- Portfolio Assets valuation services, ranging from assistance with valuation reviews to full scope valuation opinions. We typically intervene across the lifecycle of the securitization instrument, from acquisition to financial reporting.
- Financial modelling services (e.g., cash flow modelling forecasts)
- Financial due diligence to assist in the portfolio acquisition process
- Analysis and support on the Tax compliance/notification obligations