- Some issues have emerged from dealing with securitisation vehicles under stress, but generally Australian RMBS and ABS are performing well so far.
It has been an astonishing 16 years since the last time the Australian economy was in a recession. In that time the securitisation industry was established and outstanding securities grew to over $250 billion. We are now over 12 months into the credit crisis and Australia's next recession may be around the corner.
The principal benefits of securitisation are said to be that it creates from receivables (such as mortgage loans, car leases or commercial property) securities:
- which are tradeable
- which are tranched such that different investors may take different levels of risk for different margins; and
- which, in the upper tranches, have an extremely low level of credit risk.
The first of these benefits, tradability, has in practice been illusory in recent times as liquidity in mortgage and asset-backed markets has all but disappeared.
The long-term viability of securitisation will depend upon how the last of these benefits, the creation of securities with very low risk, is seen to hold up over the next year or two as asset prices decline and Australia's economy slows or goes backwards.
There have been a number of credit rating downgrades of publicly issued Australian prime residential mortgage backed securities (RMBS) and asset-backed securities (ABS) in the past 12 months. These can generally be divided into two categories:
- downgrades (mostly of subordinated RMBS) caused by the downgrade of a mortgage insurer or credit wrapper. In these cases the receivables pools continue to perform and to date there seems no real prospect of default; and
- downgrades (of ABS) caused by deteriorating receivables pools and/or insolvent or defaulting servicers and managers. Prominent in this category are notes issued by vehicles associated with Allco, Mobius, Seiza and Elderslie.
To date, however, there have been no defaults in Australia of publicly issued and rated RMBS or ABS.
And, at least so far, the signs to date in the Australian market have been encouraging. With only a very few exceptions, receivables pools backing RMBS and ABS are performing within expected tolerances and the legal structures of securitisations have proven themselves to be robust.
That said, there are clearly lessons that are being learned by investors about some of the risks, and their mitigants, in RMBS and ABS. This article examines the structural issues that have arisen to date in Australian securitisations under stress.
When risk is not diversified
The great strength of securitisation is in its diversification of risk. Investors in RMBS and ABS are generally exposed to a pool of receivables with limits on the maximum exposure to any one debtor and diversification by region and other criteria.
However, diversification of risk at the level of receivables may be undermined by a lack of diversification of risk in other parts of the securitisation structure.
One obvious exception to the diversification of credit risk in Australian RMBS has been the use of mortgage insurers to provide first loss credit enhancement. For some years there have been only two remaining independent mortgage insurers in the Australian market - Genworth and PMI. Both have had their credit ratings downgraded and this has resulted in downgrades of RMBS. The senior tranches on notes in these transactions, however, also benefit from some level of subordination from junior notes and all notes benefit from excess income available to make good losses. Defaults in these transactions still seem a remote prospect.
Another risk that is not mitigated by diversification is that that of originator, servicer and manager risk. Receivables pools backing RMBS and ABS generally share a common originator, servicer and manager of the pool (and more often than not all three are part of the same corporate group).
This is unlikely to change, but investors in RMBS and ABS can require arrangers to take steps to mitigate these risks.
A significant, and perhaps under-appreciated, risk in securitisation transactions is the risk that the originator of the receivables may have acted in a way which impacts upon the enforceability of the receivables.
Legally the receivable may be affected by the debtor setting off that receivable against an obligation owed by the originator/lender to the debtor or by statutory provisions that allow a court to vary or render unenforceable provisions of the receivable contract.
So far as set-off is concerned, most rights of set-off that a debtor might have can be, and are, avoided by provisions in the receivables contract that prevent the debtor exercising set-off rights or by the assignment of the receivable to the securitisation vehicle removing the "mutuality" between the debtor and the lender/originator required for set-off.
However, the risk of certain statutory rights of set-off, and other rights of a court to vary the terms of a receivable contract, cannot be avoided. In particular:
- section 104 of the Consumer Credit Code provides a statutory right of set-off against consumer credit contracts in respect of certain breaches of the Code
- the Australian Securities and Investments Commission Act contains prohibitions on misleading and deceptive conduct and unconscionable conduct in relation to financial services and gives the courts wide remedial powers where such conduct has occurred; and
- section 118 of the Consumer Credit Code and section 73 of the Trade Practices Act can make a lender liable in certain circumstances as a linked credit provider for misrepresentations by a supplier of goods or services that are financed by the lender.
This risk is particularly heightened when the receivables are originated in conjunction with the supply of goods or services which the receivable finances, for example:
- loans originated by use of store credit cards (a credit card for use in a particular department store)
- finance leases used to finance equipment from a single source; or
- investment loans used to finance a single type of investment.
There are two reasons for this. The first is that the entire pool of receivables may be affected by a single issue that relates to such goods or services. The second is that, whether or not the financier is related to the supplier, it may be liable for the supplier's misrepresentations as a linked credit provider under the Consumer Credit Code or Trade Practices Act described above.
The risk of poor origination in relation to a receivable can be reduced (but not eliminated) by:
- clear written disclosure to debtors that their obligations under the receivable contract are separate from any rights that they may have in relation to the supply of goods and services; and
- periodic auditing of the origination process; and diversification of the origination process (for instance, limiting the exposure of the pool to the actions of a single broker).
Another risk faced by investors in RMBS and ABS transactions is the risk of poor servicing or management or of an insolvent servicer or manager. This is an unavoidable instance of lack of diversification which needs to be managed.
Poor servicing (and poor origination) has been seen as a factor in the bad performance of some pools of receivables. In addition investors have seen servicers and managers enter into insolvency administration (notably the Allco, Mobius, Seiza and Elderslie groups of companies). In many cases the transaction documents, and the parties, have not been well placed to deal with this contingency. Problems have included:
- The lack of a standby servicer. In same cases there have been no documented standby servicing arrangements. In other cases the trustee has agreed to act as standby servicer but has not been in a position to quickly and effectively take over the servicing role.
Obviously the need for a standby servicer varies depending upon the nature of the receivables. Non-conforming loans, for example, can deteriorate rapidly if not serviced consistently and well. Margin loans are another example of an asset that cannot be left unserviced for any period. Prime mortgage loans, on the other hand, can likely withstand inadequate or non-existent servicing for a period without significant impairment.
On the positive side, there has clearly been a market for companies willing to take over the servicing role and these replacement servicers (such as Pepper) are seemingly able to provide a high standard of servicing.
- The lack of the materials necessary to take over management and servicing. For example, we have seen a replacement servicer being unable to obtain the right to use the software necessary to service the receivables. In another case, a lack of any provision or updating of data on the borrowers, combined with a now suspicious and non-co-operative servicer/manager, has meant that the proposed replacement servicer could not effectively prepare to take over the servicing prior to enforcement proceedings (which would likely trigger the collapse of the manager/servicer group).
These problems should not be overstated. To date, in our experience, they have been able to be resolved in a satisfactory manner. Their resolution is made more difficult, however, by two other problems discussed below:
- the use of in-house trustees; and
- a lack of control for senior creditors in restructuring and (to a lesser extent) enforcement of securitisation transactions.
All of the above risks are exacerbated by the use of in-house trustees. This has been a feature of some transactions, such as those of RAMS (now RHG) and Allco. The disadvantages are:
- there is less independent oversight of the originator/servicer/manager; and
- in the event that the servicer or manager needs to be replaced, it is far more difficult to arrange as creditors need to act through a trustee that is a related entity.
These transactions of course have independent security trustees - but generally the security trustees have a limited ability to act absent enforcement of the security - and enforcement of the security should not be necessary.
It is, again, an instance of lack of diversification - but in this case avoidable. With the in-house trustee model all the risks associated with the operation of the special purpose vehicle, of poor management or servicing, of fraud or inadequate controls, are concentrated in one entity (or group). When, for instance, the trustee, the manager and the servicer of a securitisation vehicle all go into receivership on the same day (as has happened recently) the delays associated with restructuring a vehicle (whose assets may still be performing) are likely to be significant.
For this reason in-house trustees are not likely to be a feature of future Australian securitisation transactions.
Enforcement and restructuring
Recent events have also highlighted another group of issues in relation to the structure of securitisation transactions - those related to the ability of creditors, and in particular senior creditors, to restructure or enforce securitisation transactions that have experienced difficulties.
Who controls enforcement/restructuring
While it is usually (but not universally) clear that senior creditors will control enforcement of a securitisation transaction following an event of default, difficulties have often arisen in restructuring transactions in order to prevent defaults.
- provisions in transaction documents that allow subordinated noteholders to approve changes to the trustee, the manager or the servicer of a vehicle, or to the terms of the documents unrelated to their notes, make taking action difficult. Where the subordinated noteholder is related to the manager and the servicer (who have caused the problems) such provisions can be particularly frustrating;
- provisions for meetings of secured creditors of securitisation vehicles have sometimes proved less than satisfactory in operation (with overly long notice periods or impractical quorum requirements).
The main lesson from such difficulties has been the importance of senior creditors having the ability to take action early to remedy problems in a securitisation vehicle without being required to push, or threaten to push, the vehicle into enforcement.
Getting control of collections
Another significant issue has been in gaining control of collections.
Partly this has been a technical problem. For the sake of practicality direct debits on receivables cannot be made into the appropriate trust account in a multi-trust program as a debtor cannot be expected to re-execute a direct debit form each time the receivables moves to another trust. Collections on receivables therefore are often paid into a multi-trust account and swept into the appropriate trust on a regularly (usually daily) basis.
Difficulties have arisen in:
- gaining control of the relevant collections in that multi-trust account; and
- managers having control of such accounts without adequate supervision.
The above are some common issues that have been encountered in dealing with securitisation vehicles under stress although they are by no means the only issues.
For the most part, the risks discussed above were not risks that were unknown and nor were they entirely unaddressed. As you would expect, however, at this stage of the cycle there will be a tightening in the standards.
To date Australian RMBS and ABS are, with only a few exceptions, performing well. In most of the relatively few cases where servicers and managers have been replaced, the underlying receivables pool still appears able to support payments on rated notes.
In addition, structurally the transactions have performed robustly. Perhaps the best example of this is with the RHG (RAMS) program which, with all its problems, never showed any sign of being likely to default on notes (including its extendible commercial paper).
If the relatively good performance of Australian RMBS and ABS continues, particularly when compared to other sections of the credit markets, it will be a compelling story for investors when credit markets finally recover.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.