Transaction Structuring

It influences (i) the composition of the underlying portfolio (also covered here) and (ii) how and under what conditions the credit risk of that portfolio is shared with the investor. Further, transactions have to be structured in such a way that (iii) boundary conditions and requirements of both investors and banks are met, and that it adheres to regulatory requirements.

The structural characteristics of a CRS transaction will be dependent on:

• PGGM’s requirements as an investor, as reflected in PGGM’s mandate and philosophy;
• The reference registry and related pricing assumptions for the CRS transaction. Here, it is important to have structural elements in place ensuring that the risk assumed and priced is in line with the risk the investor will be running;
• Regulatory requirements of the bank: as an important element is to achieve capital relief, regulatory requirements on the conditions for transfer of risk (significant risk transfer) is of influence on the structure of transactions;
• Boundary conditions and requirements, such as regulatory, accounting, fiscal and legal requirements of both the bank and the investor.

Composition of the Underlying Portfolio

First of all, when defining the composition of the underlying loan portfolio, as an investor we need to ensure that loans in the risk sharing transactions will be selected by the bank in a non-discretionary manner, mitigating the risk of adverse selection and cherry picking. Furthermore, the underlying loan portfolio should be a good reflection of the bank’s overall loan book, which will need to be confirmed during due diligence. To this extent, eligibility and portfolio criteria are set in order to control which types of exposures are allowed to enter the portfolio, taking into account risk mitigating features based on our due diligence findings. Another purpose of the eligibility and portfolio criteria is to ensure that the exposures included in the underlying portfolio are in line with the risk profile we have assumed in our expected loss modelling. Generally, we try to ensure sufficient diversification in order to mitigate concentration risk. Each transaction typically references a very granular and diversified portfolio of loans reducing the risk of a large negative impact on the return by a one relatively large loan position defaulting.

Besides initial loan selection, in case the underlying loan portfolio is not static, a replenishment mechanism is included based on pre-agreed individual obligor group and portfolio eligibility criteria for new loans that enter the portfolio. The objective is to ensure that during the life of the transaction the risk sharing portfolio will not significantly deviate from what was the joint commercial understanding at inception. Natural credit migration of the exposures is of course expected, but we generally limit the room a bank has to actively worsen the portfolio through replenishment, as otherwise we must assume the bank will use this room and this comes at a price! Moreover, in some transactions stop-replenishment limits are included to protect against sharp credit deterioration beyond a predetermined threshold.

Credit Risk Sharing on the Portfolio

Credit protection is provided for the first loss tranche of the portfolio, or, in case the bank retains a – typically very small - first loss tranche of the loan portfolio, the second loss tranche. In order to get capital relief, the tranche width is set to cover at least the expected losses on the portfolio as well as a share of unexpected losses. Apart from the tranche thickness, other details need to be worked out. Like the amortization structure whereby either the first loss tranche amortises pro rata, in line with the amortisations in the portfolio, or the first loss tranche amortises sequentially, after senior tranches have fully amortised.

The documentation fine print of the CRS transaction will cover structuring elements such as credit event definitions next to conditions for settlement and loss determination. For each credit event an independent verification agent verifies eligibility of the reference loan, the occurrence of a credit event and the determination of the loss amount.

One of the most important structuring aspects related to credit risk sharing and, core to our philosophy as a first loss investor, is risk alignment. Since we started investing in 2006 we have always required a minimum 20% retention of each loan referenced in the transaction, or of the overall loan book in case of very granular exposure, should ensure that we are aligned with the bank up to the point of, and including, the occurrence of a credit event in the underlying loan portfolio. In our view, a 20% level of retention is necessary to have sufficient skin in the game for the originator, so that the originator remains incentivised to continue to run its loan life cycle process as if no credit risk hedge were in place. Reciprocally, if a bank says it is not willing to share at least 20% of the risk in such core lending exposures, then that is a clear red flag to us. We firmly believe that for first loss positions in CRS transactions this level of risk retention – which is significantly higher than the regulatory minimum of 5% - is not just appropriate; it is also the best way to safeguard against opportunistic behavior or the return of the excesses of originate to distribute business models. We highlight this further here.

These structuring elements are also governed by regulatory requirements regarding the conditions for Significant Risk Transfer (SRT), and need to be met in order for the bank to achieve capital relief on the transaction.

Other Conditions and Requirements

Transactions have to be structured in order to meet boundary conditions and requirements, which includes regulatory, fiscal and legal requirements of both investors and banks. Particularly, changes in rules or the interpretation thereof have often led to changes in legal structures of transactions. For example accounting treatment may differ depending on whether the credit risk is shared via credit default swap or via financial guarantee, even if the economics of the transaction are materially the same. In addition, even in bilateral transactions an SPV is often used in CRS.

In addition, investors or banks may have certain structural requirements that are driven by risk appetite or a mandate. For us, the most important aspect here, and core to our philosophy, is to ensure that the CRS transaction is purely about sharing credit risk and that no ancillary risks are included. The most prominent one is that we have a hard requirement that there should be no counterparty credit risk to the risk sharing bank. This hard requirement is implemented in all our transactions.

We believe this should go both ways: we always fund the transaction fully by transferring an amount equal to the full notional of the investment at inception of the transaction in a separate account. This way the bank is assured that cash is available to settle the claim regardless of the solvability of the investor. This prefunded cash is typically held at a third party custodian and invested in highly rated, short term collateral securities, reinvested every coupon period. This ensures that we as an investor also do not run counterparty risk and that even in case of a default by the bank, the transaction can remain outstanding. In addition, being a large pension fund asset manager, PGGM is also required to manage counterparty limits, just like banks have to.

In our view, this creates a much cleaner, more transparent risk profile. We believe this requirement should be embraced in all CRS transactions, as it protects the interests of investors, banks and supervisors. We elaborate more on this standpoint and which solutions we use to mitigate bank counterparty risk in our transactions here.