EBA guidance on the EU Securitisation Regulation: positive news for loan portfolio acquisitions but key questions remain unanswered and policy conflict remains

Background 

On 1 January 2019, the new EU Securitisation Regulation (the SR) became applicable across the EU imposing new obligations for originators, sponsors, issuers and investors in securitisation transactions. The introduction of new obligations under Article 9 of the SR (Article 9) looked as if they restricted the continued development of the secondary market in Europe for non-performing loans (NPLs). This is because Article 9 limits the use of securitisation in certain circumstances as a tool by originators and buyers of NPLs to package and transfer the risk of those NPLs to investors. This restriction conflicts with several recent EU policy initiatives focused on a faster resolution to Europe’s NPL back-log.

Following market concern on the negative impact of Article 9, the European Banking Authority (the EBA) has been requested to clarify the intention and effect of Article 9. On 13 September 2019, the EBA responded to a query posed by the Association for Financial Markets in Europe (AFME) in relation to the interpretation of Article 9 - and in particular the problems caused by the verification requirements for an entity which acquires exposures (say, a loan portfolio) for its own account and subsequently securitises it (the EBA Guidance).

In this blog we consider the effect of the EBA Guidance to loan portfolio transactions and in particular NPLs. We also consider what important questions remain outstanding and why Article 9(3) remains unduly restrictive and goes against the EU’s stated policy objective of resolving distressed assets in Europe.

The purpose of Article 9(3) clarified: think “no cherry-picking” 

As set out in our original blog on this topic, NPLs and the new EU Securitisation Regulation: compliance, challenges and conflicts, Article 9(3) requires that a purchaser of exposures (be it loans or other categories of receivables, performing or non-performing) verifies that the original lender under the exposures fulfilled the requirements of Article 9(1). This broadly requires that the original lender[1] applied the same “sound and well-defined criteria for credit-granting” to (a) the exposures to be securitised as to (b) the original lender’s non-securitised exposures (we call this, the Origination Test).

AFME’s question to the EBA requested how an originator can comply with the Origination Test especially when the originator intends to acquire a portfolio of NPLs and securitise them. The challenges specific to NPLs are as follows:

• It is difficult to verify compliance with the Origination Test if the original lender under the portfolio no longer exists (say, because it has been acquired, merged or dissolved) or has gone insolvent. This is not uncommon in the context of the work-out and management of entities that have originated or otherwise created large portfolios of NPLs, and such entities (or the relevant departments) have been already disbanded.
• The original lender may not cooperate with the originator’s attempts to verify whether the Origination Test is met. There may be legitimate reasons for such non-cooperation, such as the cost, fees and expenses as well as time and resources – and potential risk assumed. Why would the original lender cooperate and what is in it for them? A key objective for a seller/original lender under a portfolio disposal is a clean break.
• The portfolio has been bought and sold multiple times. This is not unusual for performing loan portfolios and more recently we are seeing NPL portfolios in the UK and Ireland being subject to secondary sales as the funds backing the transactions seek to crystallise their returns. The problem here is the same as identified in the previous point: there is no desire or incentive to cooperative with the buyer. However, in this scenario the issue is even more challenging in that it is likely to be some years ago since the original lender first sold the relevant portfolio in its original form to the original purchaser. As there will be no relationship whatsoever between the original lender and the buyer (and also possibly between the original lender and the seller), any meaningful verification is likely to be extremely difficult.
• The relevant information required by the originator to verify the Origination Test no longer exists. The original lender’s records may be incomplete, data inaccurate or simply never collected due to different originating standards, objectives or funding arrangements at that time.

The apparent result of the above is that if you cannot establish the Origination Test, you cannot comply with Article 9(3) and therefore cannot securitise the relevant assets. This outcome is in direct conflict with the EU’s policy of tackling NPLs in Europe, specifically by lifting impediments currently in place which prevent the proper functioning of a secondary NPL market.

The EU has implemented several policy initiatives aimed at encouraging activity in the NPL market. In particular, the Proposal for a Directive of the European Parliament and of the Council on credit servicers, credit purchasers and the recovery of collateral (the Proposal) has, at its core, initiatives to foster the development of the secondary market for NPLs, in particular removing impediments to the transfer of NPLs by banks to non-banks. The Proposal recognises that high volumes of NPLs on banks’ balance sheets are problematic: they reduce a bank’s profitability as they generate less income; and they tie up a significant amount of a bank’s resources, not only capital but staff. Under the Proposal, credit institutions will be required to put aside enough capital when new loans become non-performing. This creates an even bigger incentive for credit institutions to trade out of their NPL stocks which in turn should drive up the supply of NPLs available to the market. With this potential for increased supply, widening the availability of securitisation techniques to the NPL market through a SR that supports rather than frustrates, can only assist the EU in achieving these wider policy objectives.

The EBA Guidance clarifies that the spirit of Article 9 is on preventing one of the worst characteristics of the pre-credit crisis “originate and distribute” model: so-called “cherry-picking”. This is when an originator creates both strong and weak (or less strong) exposures (e.g., through making loans) and retains the stronger exposures but securitises the comparatively weaker ones. The effect of this is that the securitisation and its investors are exposed to increased default risk under those exposures as compared to the originator. The result is the same if the originator only creates “weak” loans, retaining none itself and subsequently securitises all of them but without being “on-risk” for any subsequent defaults under such exposures. Specifically, the EBA states that Article 9’s purpose is “to prevent that exposures of lower credit quality are created with the sole purpose of being securitised”.

When assessing compliance with Article 9, the key questions for a portfolio purchaser who intends to embark on a securitisation to ask are:

• “Are we satisfied that there was no cherry-picking by the original lender at the point at which it created the loans (now) intended to be securitised?”
• “Does our verification indicate that the original lender did not package weaker assets into the portfolio that we are (now) intending to buy/securitise, whilst keeping the stronger ones itself or otherwise, selling the apparently stronger assets to someone else?”

If a purchaser can conclude that the answer to both questions is “yes”, then it should be comfortable that the Origination Test is satisfied.[2]

Verification: how far do you have to go? 

How far do you need to go to get comfortable that the Origination Test is satisfied? As set out above, buyers of NPLs who intend to use securitisation as part of their transaction face several challenges in complying with Article 9(3) because of the nature of the NPL product. The EBA Guidance states:

“the originator should use adequate resources and make reasonable efforts to obtain as much information as is available and appropriate for such verification in accordance with sound market standards of due diligence for the class of assets and the nature and type of securitisation” (emphasis added).

There are some key practical takeaways from this. Working backwards:

First, the level of verification required will depend on the “class of assets, and nature and type of securitisation”. This is an important and sensible clarification. The EBA has responded positively to the market concern that “one-size does not fit all” and that a transaction-specific approach to verification is appropriate. In practice, the level of verification expected for a prime performing loan portfolio which is expected to be securitised through the issuance of publicly rated listed securities will be different to, say, a single senior investor in a non-rated NPL portfolio securitisation. For the former, there is likely to be more information available (and therefore needing to be tested) to establish compliance with the Origination Test than compared to the situation in the latter. Even if there is a lack of information, the EBA accepts that other factors (considering the nature of the assets) can assist to support the conclusion that the Origination Test is satisfied. For example, in relation to an NPL portfolio, this could be an analysis of historical collateral performance, seasoning, delinquency and restructuring arrangements across securitised and non-securitised portfolios. In addition, any data-driven analysis can be supported by representations and warranties from the seller as to origination standards for both its securitised and non-securitised exposures. We have seen sellers give such representations and warranties which closely track the wording in Article 9. It is important to note though that such representations are supportive to the Origination Test analysis, rather than a replacement to the actual verification which Article 9(3) implies needs to be undertaken. The buyer will need to demonstrate that is has done due diligence to support its conclusion that the Origination Test is satisfied. This clarification by the EBA confirms that the level and intensity of verification expected to be done by a buyer will be objectively higher or lower depending on the type of asset and securitisation – although, in each case, the Origination Test will need to be satisfied.

Second, the EBA has confirmed that a buyer must get as much information as possible to determine whether the Origination Test is satisfied in accordance with “sound market standards” of due diligence.

In practice, the steps that a buyer needs to take to establish the Origination Test will always differ and depend on the standards of due diligence for the market relevant for a particular asset, and the envisaged securitisation. The EBA’s acknowledgement of this and acceptance of a “market-practice-driven” approach is a positive development.

What are “sound market standards” of due diligence? This must be the level of verification that a reasonable and professional buyer would undertake for the relevant assets in question. Some examples of the steps professional buyers take to establish the quality of the asset that they are intending to bid for typically include:

• performing a loan underwriting and valuation process either in-house or through mandating a third party;
• engaging in detailed vendor Q&A processes as well as on-site seller (and loan servicer) due diligence;
• accessing (and often relying on) vendor due diligence reports;
• engaging legal counsel and tax advisors to test any vendor due diligence, as well as investigating new issues the buyer may raise; and
• requesting representations from the seller in relation to the loan portfolio which include the quality of the loan underwriting process.

Such processes often require the buyer to spend a fair amount of time and money, including engaging third-party advisors such as corporate finance, legal and tax advisors. This is particularly the case if the vendor conducts an auction sales process, often used for large or strategically important loan portfolios. The standard and steps will differ and depend upon the type of asset, jurisdiction and transaction specifics, such as its size and whether the securitisation will be publicly rated or not. Given the high degree of professionalism and sophistication shown by top buyers of loan portfolios across Europe in the current market, it will be relatively easy for such buyers to demonstrate that they have scrutinised the portfolio to establish compliance with the Origination Test – and to a standard that is (and often in excess of) the accepted sound market practice for the relevant asset and proposed securitisation.

Third, and building upon all of the above, the EBA will expect a buyer to use “adequate resources” and “reasonable efforts” to establish compliance with the Origination Test. This is another good signal to the market and, again, reflective of the practice the market has already developed. The EBA Guidance means that a buyer will not be required to spend a disproportionate amount of time, money and other resources on the verification to comply with Article 9(3); there is a limit to what is required. Clearly, an informal or superficial verification will not work. In practice, based on our experience, we doubt that this is an issue. As mentioned above, the high degree of professionalism and sophistication shown by buyers and securitisers of loan portfolios in Europe, including the steps typically taken by them set out above, means that it should not be hard for them to demonstrate that “adequate resources” were used and “reasonable efforts” were made to get the required information and do the verification.

Create a record

Although rather obvious, buyers should have an accurate and complete record of the verification they have done to establish compliance with the Origination Test. This should include:

• the reasons why the buyer has reached their conclusions;
• details of any issues raised and how those issues have been resolved; and
• any gaps in information.

Based on our experience, creating records on the scale, content and outcome of any portfolio due diligence is nothing new for sophisticated buyers. In fact, we have seen loan underwriting and the supporting due diligence standards undertaken by buyers increase, especially as portfolio sales become more complex and the competition for assets means that pricing accuracy is key. There is undoubtedly a big overlap between what a buyer would ordinarily due diligence to establish the quality of a portfolio and the broader activities of the seller, and the additional requirements imposed by Article 9(3).

What if you can’t satisfy the Origination Test?

The biggest difficulty with Article 9(3) is that if a buyer cannot satisfy the Origination Test, the effect of the SR is that the buyer cannot undertake a securitisation. There are four obvious scenarios where a buyer might not be able to satisfy the Origination Test:

• where there is evidence of the seller having engaged in cherry-picking;
• where a seller did not engage in any securitisation activity prior to the sale of the assets;
• where a seller only engaged in securitisation activity; and
• where there is not enough evidence available to verify either way whether the Origination Test can be satisfied.

In such cases, the effect of the SR (absence guidance to the contrary) is to prohibit a buyer from using securitisation to refinance the acquisition. In our view this is not the right outcome for the following reasons.

Firstly, if the buyer is fully aware that the seller intends to sell assets which are comparatively weaker than assets which the seller retains, but these risks are fully and accurately disclosed in good faith to (and accepted by) all the parties to a proposed securitisation of such assets, the SR should not prevent the use of securitisation as part of the transaction. The key assumption is full and accurate disclosure. Only then can all the apparent risks of any cherry-picking or poor origination standards be analysed and appropriately priced or otherwise addressed. As mentioned above, the loan portfolio trading industry is highly sophisticated and professional. In this highly competitive environment (driven by a search for yield), participants are willing to assume risk for a certain price and transaction structure. If after such disclosure, assuming such risks by a buyer is viewed as acceptable, the SR should not prevent parties using securitisation as a tool to support such transactions.

Secondly, it is not uncommon for a seller not to engage in any securitisation activity at all prior to the sale of the assets to the buyer (who in turn intends to securitise them). Many assets have been originated by financial institutions and financed through means other than securitisation. In this case, by definition, the Origination Test cannot be satisfied as there cannot have been any cherry-picking. The same applies if the seller only engaged in securitisation activity, i.e., all assets that it originated were sold under securitisation transactions. Again, in this case, there is no cherry-picking by the seller as it cannot have preferred itself over the securitisation investors. The EBA have not clarified this but the sensible conclusion must be that in such circumstances, Article 9(3) would not apply to the transaction.

Finally, the very nature of NPLs has the potential to directly conflict with Article 9 and specifically, the requirement for exposures to be created based on “sound and well-defined criteria for credit granting”. One obvious reason why NPLs may be “non-performing” is because the underlying credit granting criteria was not “sound and well-defined”. In this case, based on the wording of Article 9 and the absence of any official guidance to the contrary, the SR prevents the use of securitisation of such NPLs. If this interpretation is correct, this would be the wrong outcome for the NPL secondary market. As mentioned above, with full and accurate disclosure, we don’t see why Article 9(3) should be a barrier to using securitisations to finance NPL acquisitions - and ultimately provide investors exposure to such investment risks. This is even in the case where the original lender engaged in credit granting criteria that were not, by any measure, “sound and well-defined”. Such additional risks caused by sub-standard origination practices can be priced into the investment proposition. This is consistent with several EU initiatives aimed at enhancing the secondary market for NPLs in Europe and assisting in alleviating problems (frequently acknowledged by the EU)[5] still facing several European financial institutions (as well as countries) who still have high NPL ratios.

Unfortunately, the EBA Guidance does not expressly address the issues raised above.

Conclusion

The EBA Guidance is good news for the loan portfolio market. It confirms that the obligations under Article 9 are not absolute; they are subject to what is reasonable and proportionate – and the specific circumstances of a transaction. The response should give buyers comfort that so long as they use reasonable efforts and adequate resources to establish compliance with the Origination Test – based on what is sound market practice for the type of asset and securitisation in question – they should not be in breach of Article 9(3). We think that this is broadly reflective of the approach the market already takes and so this market-driven approach taken by the EBA will be very welcome. The EBA Guidance, however, has not gone far enough and important questions remain outstanding. In particular, the applicability of Article 9(3), where cherry picking is not relevant to the transaction and further, where the loans are a result of bad credit origination practices. With full and accurate disclosure to investors, the SR should not prevent securitisation being used by participants to transfer risk to those members of the investment community willing and sophisticated enough to do so.

The EU has, at the heart of its policy on NPLs, a focus on developing an efficient, functioning secondary market for distressed assets. Securitisation is an important tool in transferring European NPL risk to the private sector. It makes sense then that the European regulators would want to provide guidance on the SR in relation to Article 9 so as to assist the further development of the secondary market and ensure that it does not frustrate the use of securitisation. The EBA Guidance assists in ensuring that the SR does just that – and although some important questions remain unanswered, it reinforces the central message that, so long as the required standards of due diligence and asset quality are satisfied, securitisation can be used as a tool to buy and sell loan portfolio risk.

Further reading

Freshfields blog: Market insights from AFME & IMN Global ABS 2019: Introduction to NPLs dated 27 August 2019

Freshfields blog: NPLs and the new EU Securitisation Regulation: compliance, challenges and conflicts dated 20 February 2019

EBA response: “What are the obligations of an originator who purchases third party's exposures and subsequently securitises them, in order to meet the requirements set out in Article 9 of the Securitisation Regulation?” dated 13 September 2019

Fourth progress report on the reduction of non-performing loans (NPLs) and further risk reduction in the Banking Union dated 12 June 2019

Proposal for a Directive of the European Parliament and of the Council on credit servicers, credit purchasers and the recovery of collateral dated 14 March 2018

Council conclusions on Action plan to tackle non-performing loans in Europe dated 11 July 2017

Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation

[1] Specifically, “Originator, sponsors and original lenders” but for the purposes of this blog, reference will be to the “original lender” which is practically the most important in the context of portfolio sales.

[2] Clearly in the context of NPL portfolios, the fact that the loans are non-performing should put the purchaser on high alert.