A different sort of comeback
There had been no new synthetic securitisations of bank assets from Germany for several years. But the situation slowly started to change three to four years ago. This type of securitisation is now appearing more frequently again – but in a different guise however. The trend virtually went unnoticed by the public because it concerned private placements and so details were not published.
In this article about synthetic securitisations, we will however be discussing synthetic securitisation of credit (risks) on a bank’s balance sheet, called portfolio protection transactions or PP-transactions in this article (sometimes also referred to as balance sheet transactions).
These transactions differ from another type of synthetic securitisation where also, instead of assets (which is the case in true sale transactions), credit risks are merely securitised. However, with these transactions, called artificial arbitrage transactions in this article, the credit risks are not real either but artificial, in other words it is not the risk bearer who is relieved of risks incurred in the ordinary banking business, but credit risks are created on paper or simulated and these are ultimately betted on. This actually quite simple principle was often complemented by complex structural elements, options and leverage boosters. These transactions boomed shortly before the financial crisis and will have very likely all but disappeared in the meantime. To be fair, it should be emphasised that even with this type of transaction there were of course differences in the probity of the transactions – but that is another story. What has not gone away is this type of transaction’s poor reputation. Artificial arbitrage transactions were considered to be investments for gamblers or fanning the fires of the financial crisis and in some cases caused catastrophic losses and made the maelstrom of the financial crisis worse. Unfortunately, even up until today not enough distinction is made between artificial arbitrage transactions and PP-transactions: synthetic transactions are often generally thought to be dodgy right across the board. One example is the quality standard of SST (simple, transparent and standardised) securitisations promoted by politicians and legislators. Despite intensive debate, PP-transactions are currently still precluded from this standard for the most part. The result is a severely negative impact on German PP-transactions, although they are verified to have performed well to very well in the past (despite the financial crisis).
Until around 2007, PP-transactions were the main methods of securitisation for bank loans in Germany. This means in particular that in terms of numbers and quantity they outweighed true sale securitisations where the loans really were legally transferred.
This was due on the one hand to German banks’ refinancing options: a large number of German banking groups either had good access to the covered bond market through “Pfandbriefe” and therefore to an internationally prominent, inexpensive refinancing market, or were public banks like the Sparkassen and Landesbanken. Therefore, demand for other types of low-cost refinancing, such as true sale securitisations, was much lower than in some other jurisdictions.
Furthermore, based on the solvability policy “Grundsatz 1” (of the Basel Accord’s capital recommendation in 1988 - Basel I) on minimum capital requirement, relatively few levels of differentiation were allowed for. Therefore, generating RWA capital relief was especially worthwhile so that portfolios were guaranteed and subsequently securitised.
This effect diminished significantly in one fail swoop with the introduction of the “Solvabilitätsverordnung” (Basel II) in 2007/2008. Under Basel II, RWA own funds requirements were now much more sensitive to risk from the outset, so that the easing of the burden achievable through PP-transactions was lower – with the costs staying the same. The crisis on the financial markets, which erupted in the same period, did the rest: investors who paid attractive coupons for bank securitisations were in short supply. Up until 2013/2014 hardly any PP-transactions by a German bank had taken place.
Due to the tightening of regulatory requirements over the past few years, PP-transactions also returned as capital relief options. However, PP-transactions in Germany are completely different to those offered up to 2007/2008:
Usually it is only ever a risk tranche that is placed, normally the second loss/mezzanine tranche. The cost benefit is calculated down to the last cent: how much of the risk needs to be placed in order to generate optimum RWA relief?
Bilateral contractual relationships
In contrast to 2007/2008, private placements primarily take place. In other words, the bank negotiates bilaterally with one or two investors, usually investment/fund companies. They consequently have greater influence over the transaction’s structure and can negotiate an investment geared to their needs. Transactions are designed so that the investment is maintained over the entire term of the transaction. This also means that renegotiation is possible and the rigid nature of transactions can be relaxed. For example, replenishments of the portfolio can be negotiated too if relevant, even if they differ from the original conditions, or were not even provided for in the beginning. However, the proviso for transactions being negotiated bilaterally and tailored to requirements is that the sort of standardisation that prevailed in the case of the old type up until 2007/2008 no longer applies.
No external ratings
External ratings are ordinarily not issued for the new generation of German PP-transactions. This mark of quality is replaced by due diligence processes by the investor concerned.
Due diligence by investors
As a rule, investors perform their own due diligence on loan portfolios. To some extent they refer to the bank’s own internal ratings as a hallmark of quality. Consequently, it is often the case that no eligibility criteria are even defined/pledged in the portfolio’s guarantee.
Simple structures, concise documentation
Due to its bilateral nature, transaction documentation is frequently much more concise and less complex than it was up until 2007/2008. The structures are simple, i.e. there are no convoluted structural elements of the financial engineering type. The bank hardly ever draws up a prospectus.
But despite all the differences, one basic principle has stayed the same:
Trust is good, but control is better.
Even in the case of the new generations of PP-transactions, losses are only borne by the investor(s) if an independent third party (a trustee) checks whether the loans have been managed and used properly by the bank to the benefit of the investors and the loss incurred can therefore be justifiably met by the investors.