Synthetic securitisation by financial institutions of either pools of bonds or pools of loans has become ever more popular since its inception at the beginning of the 1990’s, and increasingly these transactions are being carried out under programmes. The purpose of these deals is to release expensive regulatory capital that can then be redeployed to other areas of the financial institution’s business. This article discusses the essential elements of synthetic securitisation, and then briefly examines why the Cayman Islands is the jurisdiction of choice for this type of transaction.
What are Credit Derivatives?
A derivative is a financial product the value of which is determined by the value of an underlying asset, whilst a credit derivative is a financial product the value of which is based on the creditworthiness of a third party or group of third parties. A credit derivative allows the owner of debt assets to offset the risk of holding those assets without transferring the ownership. By transferring credit risk and reducing the need to hold associated regulatory capital, synthetic securitisation achieves the same result as more traditional forms of securitisation without many of the complexities.
Types of Credit Derivative
The most common method by which assets are synthetically transferred and capital relief achieved is by way of the credit default swap. In return for regular payments made by the Originator to the counterparty, the counterparty agrees to make a payment to the Originator upon the occurrence of a credit event in relation to the Reference Assets. The "Reference Assets" (being the assets referenced in the Credit Derivative) are correlated to, though are often not the same as the "Underlying Assets" (being the assets held by the Originator, in relation to which it is seeking credit protection). It is preferable that the Reference Assets are publicly issued, and it is for this reason that they often differ from the Underlying Assets, though a high degree of correlation between the two is needed for the Underlying Assets to be removed from the regulatory balance sheet. This avoids the Originator breaching its duty of confidentiality to borrowers, and ensures that the requirement for publicly available information of the occurrence of a credit event is satisfied (see below).
The definition of a Credit Event can range from a potential credit event to an actual failure of the relevant Reference Entity to pay in respect of the Reference Asset, and can include other events of default set out in the ISDA Master Agreement or tailored for the individual transaction. For the event to constitute a Credit Event, it must also exceed a materiality threshold, and there must be Publicly Available Information relating to it. On the occurrence of a Credit Event, the contract may provide for physical settlement of the Reference Assets to the counterparty in return for the counterparty paying to the Originator their par value. Alternatively, the contract may be cash-settled, and the counterparty would either pay to the Originator a fixed amount, or par less the recovery value of the Reference Assets.
Under a Total Return Swap, the Originator will pay to the counterparty the cashflow received on the Reference Assets together with amounts equal to any increase in the market value of the Reference Assets. The counterparty makes regular interest-rate related payments together with amounts equal to any decrease in market value of the Reference Assets. On the occurrence of a Credit Event the swap terminates, and the settlement amount is calculated on the same basis as the pre-credit event payments. The effect of the Total Return Swap is to fully transfer the entire economic interest of holding the assets to the counterparty.
Credit Linked Notes are instruments by which a credit default swap or a total return swap can be packaged into securitised form, and they are accordingly pre-funded by the counterparty/investor. This technique enables investors who are legally prohibited from entering into derivative contracts to achieve the same economic profile as a credit default swap/total return swap without entering into the derivative contract. It enables the contract to be traded by delivery or through book entry in the clearing systems, rather than by novation, and should it be required the Credit Linked Note can be structured in this way to benefit from the Quoted Eurobond Exemption to avoid withholding.
Regulatory Capital Treatment
Economically, the Originator’s exposure to the Underlying Assets is replaced by exposure to the counterparty, and the capital treatment in most jurisdictions reflects this. In broad terms and subject to the detailed rules in the relevant jurisdiction, if the counterparty is a Special Purpose Company (SPC), the risk weighting will prima facie be 100%; if the Counterparty is an OECD Bank, 20%; and if the credit derivative is either funded by the Counterparty/investor, or the Originator is granted a first ranking security interest over cash or OECD Government Bonds, the risk weighting will be 0%.
Collateralised Bond Obligations (CBO’s)
As was first demonstrated by the JP Morgan Bistro transaction, the above techniques can be adopted with an SPC acting as the counterparty to the Credit Derivative, funded by a bond issue in the capital markets, such that any loss that is incurred on the Reference Assets is matched by reduced principal payments to investors.
The credit risk on recent deals has been carved up between different counterparties, and the different techniques (see Regulatory Capital Treatment above) are used to achieve capital relief.
Bank Austria’s Amadeus transactions carved up the credit risk associated with portfolios of bonds comprising subordinated pieces from ABS transactions. The risk of the first 10 per cent of losses on the portfolio was transferred by a credit linked note to a Special Purpose Company incorporated in the Cayman Islands, Amadeus Funding 1 Limited (Amadeus). Amadeus in turn issued two series of Notes, the proceeds of each being held in an account in the name of Amadeus, and charged in favour of Bank Austria. Pursuant to the priority of payments in the Deed of Charge, the Class B Noteholders took risk on the first 3 per cent of losses, and the Class A Noteholders took the risk of the next 7 per cent of losses on the portfolio. The risk of loss on the final 90 per cent of the portfolio was transferred by way of Credit Default Swap to a third party financial institution, and this risk in turn was wrapped by a monoline guarantee given by MBIA.
The relevant regulatory rules were complied with: accordingly a zero per cent risk weighting was given to the tranche cash collateralised by Amadeus, while the tranche protected by the OECD Bank received a 20 per cent risk weighting.
The Benefits of Synthetic Securitisation
The most obvious way of offsetting credit risk is by trading the particular debt asset. Whilst not so much the case for retail customers, corporate banking is very much a relationship business, and accordingly the assignment of corporate loans is generally considered not to be acceptable by the banking fraternity, even if the Originator maintains the servicing function in relation to the loans. The transfer of loan assets by assignment can also give rise to withholding tax in the event that the assignee does not qualify as a s.840A Bank. A bank’s common law duty of confidentiality to its customers makes the securitisation of loan assets, whether by assignment or using the Rose subparticipation structure, somewhat troublesome.
By contrast, Credit Derivatives enable the corporate relationship between the bank and its corporate borrowers to remain in tact, and by ensuring that the Reference Assets differ from the Underlying Assets, the bank’s duty of confidentiality to its Borrowers should not be breached.
"True Sale" securitisation gives rise to further problems associated with the transfer of ownership of the assets. Prima facie, the transfer of debts gives rise to the document of transfer being a stampable instrument. Whilst there are a number of techniques of avoiding the payment of stamp duty at the outset of a transaction, the Rating Agencies require a reserve to be held or a facility to be put in place in respect of such liability, in the event that stamp duty would become payable on the insolvency of the Originator.
Some assets have non-assignability clauses embedded into them, which the House of Lords held in Linesta Sludge (1994) to be binding. The assignment of assets have a number of formalities that need to be complied with: in particular, a legal assignment requires notice to be given to the borrowers, and the requirement for the transfer to be in writing mitigates against the well used "Offer and Acceptance" route for postponing stamp duty liability on the transfer.
The use of a synthetic transfer, by contrast, avoids these issues that arise on the transfer of ownership, and generally the documentation is less complex and therefore more economical to put in place.
The Cayman Islands as Jurisdiction of Choice
The reasons why the Cayman Islands is the jurisdiction of choice for carrying out CBO’s and CLO’s are well understood. They hinge on the common law nature of the legal system, being based on English law, with more flexible legislation having been introduced reacting to the requirements of both the international financial markets and the regulators.
In particular, the jurisdiction is creditor-friendly, at the top of Philip Wood’s spectrum of creditor-friendly jurisdictions. In the Cayman Islands, there is no equivalent of Chapter 11 in the U.S., or Administration or the new Voluntary Arrangement regime (that is in the process of being enacted pursuant to the Insolvency Bill) in the U.K. Whilst deals issued through SPC’s incorporated in the United Kingdom will shortly see the Rating Agencies impose additional liquidity requirements arising out of the new insolvency legislation, the Cayman Islands offers the international community a more robust insolvency law from the creditors perspective.
The trust, again deriving from English law, is another area in which Cayman Islands law lends itself to the structured finance community. By separating the beneficial interest in the shares of a special purpose company from their legal title, a share trustee can hold the legal title of the shares, without the accounts of such special purpose company being consolidated in the accounts of the share trustee or of the Arranger. As an alternative to the share trust being in the form of a charitable trust, the innovative trust legislation of the Cayman Islands permits non-charitable purpose trusts. These trusts (known as STAR trusts, being established pursuant to the Special Trusts (Alternative Regime) Law 1997) enable the Noteholders to be the beneficiaries under the share trust, which avoids residual profit at the maturity of the Notes being paid away from the transaction.
The fiscal regime with no corporation tax (or withholding) in the Cayman Islands and the status of the Cayman Islands as a UK Overseas Territory ensuring that there is no "Sovereign Ceiling" that limits the rating of debt issued by a Cayman Islands’ company, are further essential ingredients. The professional infrastructure, and in particular the responsiveness and expertise of the corporate administrators in the Cayman Islands, serves to ensure that Cayman Islands’ companies are centrally managed and controlled outside the United Kingdom and are therefore not subject to U.K. Corporation Tax.
Credit derivatives and their application in synthetic securitisation, is only the latest of an ever expanding range of derivative products which are changing the global financial landscape. The capital adequacy rules are under constant review by the Bank of International Settlements, and further changes in this area will be forthcoming, which will give rise to further developments in transaction structures. This, combined with the continued focus on return on equity, would suggest continuing development of synthetic securitisation.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.