Servicing a credit-linked note for risk transfer, explained

Key figures

• 4 Phases in the life of a securitisation, from origination to termination

• 3 Levels at which servicing operates, namely the transaction, the portfolio and the individual cash flow

• 1 year Horizon of the probability of default supplied for each exposure in the data tape

• 15% Floor risk weight for a securitisation position under the Basel framework

• 10% Maximum remaining Reference Portfolio at which a clean-up call is permitted under the Basel framework

Contents

1. How a funded credit-linked note works

2. True-sale and synthetic transactions compared

3. Conditions for capital recognition

4. The data tape behind recognition and servicing

5. The servicing cycle on each Note Payment Date

6. Credit events and Protection Payment Amounts

7. Calls, termination and redemption

A credit-linked note is a debt instrument whose repayment depends on the credit performance of a pool of exposures that its issuer does not own. Banks use funded credit-linked notes in synthetic securitisations to transfer credit risk to capital markets investors and, where the regulatory conditions are satisfied, to reduce the capital they hold against that risk. Closing such a transaction is the more visible achievement, but the greater operational commitment lies in servicing it accurately on every Note Payment Date until the Notes are redeemed. Terms in capitals in this article follow the defined terms commonly used in transaction documents of this kind.

1. How a funded credit-linked note works

In a funded credit-linked note, investors pay for the Notes in cash at the outset, and that cash is held by the issuing vehicle as security for the protection the bank buys. The bank retains legal and beneficial ownership of the loans throughout, and only their credit risk is transferred.

Figure 1. In a funded credit-linked note the Bank retains the loans in the Reference Portfolio, the CLN Issuer gives a Financial Guarantee over them, and the Note proceeds are held in Highly Rated Securities in the Custody Accounts.

On the Closing Date the CLN Issuer, a special purpose vehicle, issues Notes to investors in tranches that are typically described as senior, mezzanine and first loss. It applies the Note proceeds to purchase Highly Rated Securities of an equal principal amount, which are held in the Custody Accounts, and it does not acquire any of the loans in the Reference Portfolio. At the same time it gives the Bank, as protection buyer, a Financial Guarantee covering the Guaranteed Obligations in the Reference Portfolio, although some transactions use a credit default swap to the same effect.

On each Note Payment Date the Bank pays the CLN Issuer a Guarantee Fee Amount, which the CLN Issuer combines with the income on the Highly Rated Securities to pay interest to the Noteholders. Where the settlement conditions are met for a Guaranteed Obligation, the CLN Issuer pays the Bank a Protection Payment Amount, funded by realising Highly Rated Securities, and the Adjusted Principal Balance of the Notes is reduced by the same amount. At redemption, the proceeds of the remaining Highly Rated Securities repay the outstanding Adjusted Principal Balance to the Noteholders in accordance with the terms of the Notes.

2. True-sale and synthetic transactions compared

The distinction between a true-sale securitisation and a synthetic credit-linked note is a distinction in what the special purpose vehicle owns, and it determines what servicing involves. In a true-sale securitisation the vehicle acquires the loans and is entitled to their collections, whereas in a synthetic credit-linked note the vehicle owns only Highly Rated Securities and its sole exposure to the loans is contractual, through the Financial Guarantee.

The life of either type of transaction can be described in four phases, each of which operates at three levels, the transaction as a whole, the loan portfolio and the cash flows of the individual loans. Origination covers the legal, accounting and structural groundwork, the selection of the portfolio against eligibility criteria and the pricing of the tranches. The portfolio sale in a true-sale transaction, or the fixing of the Reference Portfolio in a synthetic one, settles the pool and its key figures. Servicing then runs for the life of the transaction, and termination unwinds it.

In both structures the bank’s systems identify the relevant loans and maintain a separate record of them, often a subledger, so that defaults, amortisation and any replenishment can be tracked and reported against the transaction for its full term.

3. Conditions for capital recognition

A bank does not obtain capital relief simply by entering into a credit-linked note, because the protection is recognised only if the transaction satisfies the operational requirements of the securitisation framework. The Basel framework sets those requirements, and national regulators implement them with their own variations and supervisory processes.

The framework requires that significant credit risk on the underlying exposures be transferred to third parties and that the protection meet the general credit risk mitigation rules. It does not permit a bank to treat a special purpose vehicle as an eligible guarantor, but collateral pledged by such a vehicle may be recognised, which is why the Note proceeds are held in Highly Rated Securities rather than relying on an unfunded promise from the CLN Issuer. The bank is also expected to obtain a legal opinion confirming that the protection is enforceable.

The terms of the protection must not limit the credit risk that is transferred. The framework excludes, among other provisions, clauses that materially limit the protection, oblige the bank to improve the quality of the pool, increase the bank’s cost of protection or the yield paid to investors as the pool deteriorates, or increase the bank’s retained first loss after closing.

Once the protection is recognised, the bank calculates the capital charge on any positions it retains under one of the securitisation approaches. A bank on the standardised approach for credit risk will generally apply SEC-SA, which takes as its starting point the capital that would apply to the underlying exposures under the standardised approach and is subject to a floor risk weight of 15%. Each jurisdiction also operates its own process for confirming significant risk transfer, so the applicable local rules should be confirmed at the structuring stage.

Note

No vehicle guarantee

Under the Basel framework a special purpose vehicle is not an eligible guarantor, so its protection is recognised through the collateral it pledges.

4. The data tape behind recognition and servicing

Each step described so far depends on loan-level data supplied by the bank. The capital calculation requires the risk parameters of every exposure, investors require the same parameters to price the Guarantee Fee and the tranches, and the servicing agent requires a stable baseline against which each later Protection Payment Amount can be verified. For that reason investors and their advisers expect a complete and internally consistent data tape before the Notes are priced.

Loan-level fields are complemented by portfolio-level documentation. Investors will typically request a description of the bank’s internal credit portfolio model and rating methodology, rating migration matrices together with any external agency matrices on which they rely, and the market data used internally, such as yield curves and credit spreads, with supporting documentation.

The same tape becomes the baseline for servicing once the transaction closes. Exposure identifiers must remain stable for the life of the Notes, because every subsequent report, eligibility test and Protection Payment Amount is traced back to the exposure as it stood at closing, and an institutional-grade tape at the outset is what allows that tracing to be performed reliably.

5. The servicing cycle on each Note Payment Date

Servicing a synthetic credit-linked note is a recurring calculation cycle, typically performed quarterly by a calculation and administration agent appointed by the CLN Issuer under the transaction documents. Because the CLN Issuer holds no loans, the cycle involves no collection of borrower principal or interest, and the only cash flows it administers are the Guarantee Fee Amounts, the income on the Highly Rated Securities, any Protection Payment Amounts and the payments to Noteholders.

Each cycle begins with the Reference Portfolio, for which the agent receives updated loan-level data from the Bank, reconciles it against the previous period, records amortisation, prepayments and maturities, and tests any proposed replenishment against the eligibility criteria and portfolio limits. On that basis it calculates the Guarantee Fee Amount due on the outstanding protected amount and reconciles it against the payment received from the Bank.

The agent then applies the waterfall in the order the documents prescribe. Guarantee Fee Amounts and income on the Highly Rated Securities fund the interest on each tranche, calculated on its Adjusted Principal Balance. Where a Guaranteed Obligation has met the settlement conditions in the period, the agent determines the Protection Payment Amount, allocates the loss to the tranches in reverse order of seniority beginning with the first loss tranche, and reduces their Adjusted Principal Balances accordingly.

Each cycle concludes with reporting, in which Noteholders receive investor reports on the Reference Portfolio, credit events, losses and tranche balances, securitisation disclosure rules in many jurisdictions require loan-level information in prescribed templates, and the Bank reports the transaction to its own regulator on the basis of the same figures.

Note

Stable identifiers

If an exposure identifier changes during the life of the Notes, each later calculation for that exposure has to be reconciled manually against the closing tape.

6. Credit events and Protection Payment Amounts

A Protection Payment Amount is the mechanism through which investors bear a loss on the Reference Portfolio, and the documents strictly govern when it becomes due, how it is measured and which tranche absorbs it. The agent’s role is to apply those provisions mechanically to the facts reported by the Bank.

The settlement conditions typically refer to a credit event on a Guaranteed Obligation, such as a failure to pay or the insolvency of the borrower, evidenced by a notice from the Bank. Depending on the documents, the loss may be fixed at a final amount once recoveries are known, or paid as an initial estimate that is adjusted after the work-out, and in either case the collateral data and loss given default recorded in the tape inform the estimate. Venture debt terms in Asia, explained discusses the borrower-side default and cross-default provisions that often give rise to such events.

Case in point

A borrower default

In an illustrative transaction, a Reference Portfolio of US$200 million supports Notes of US$20 million, of which the first loss tranche is US$8 million. A borrower with a Guaranteed Obligation of US$4 million fails to pay and the settlement conditions are met, and after the work-out the loss is fixed at US$2.4 million. The CLN Issuer realises Highly Rated Securities and pays the Bank a Protection Payment Amount of US$2.4 million, with the result that the Adjusted Principal Balance of the first loss tranche falls from US$8 million to US$5.6 million and interest on subsequent Note Payment Dates is calculated on the reduced balance, while the mezzanine and senior tranches are unaffected.

7. Calls, termination and redemption

A synthetic transaction ends when the Notes are redeemed, either at their scheduled maturity or earlier under a call right, and the protection and any associated capital relief end at the same time.

Transaction documents commonly give the Bank a time call exercisable after a set date, a regulatory call exercisable if the capital treatment changes, and a clean-up call exercisable when the Reference Portfolio has amortised to a small remainder. Under the Basel framework a clean-up call does not attract a capital charge if it is exercisable only at the Bank’s discretion, is not structured to avoid allocating losses to investors and is exercisable only when 10% or less of the original Reference Portfolio remains, and a call that does not meet those conditions can affect the capital treatment of the transaction.

On redemption the CLN Issuer realises the remaining Highly Rated Securities and repays the outstanding Adjusted Principal Balance of each tranche after any final Protection Payment Amounts. The termination of a true-sale securitisation follows a different course, because the vehicle there holds loans that are typically sold back to the bank before its notes are repaid.

Common questions

What is a credit-linked note?

A credit-linked note is a debt instrument whose repayment depends on the credit performance of a reference portfolio of loans or other exposures. If a reference exposure defaults and the settlement conditions are met, the principal repaid to Noteholders is reduced by the loss allocated to their tranche.

How does a credit-linked note transfer risk from a bank?

The bank retains the loans and buys protection on them from the CLN Issuer under a Financial Guarantee or credit default swap. Investors fund that protection by paying for the Notes at the outset, and the proceeds are held in Highly Rated Securities, from which losses on the Reference Portfolio are paid to the bank as Protection Payment Amounts.

What is the difference between a true-sale and a synthetic securitisation?

In a true-sale securitisation the loans are sold to a special purpose vehicle and their collections pass to it. In a synthetic securitisation the loans remain with the bank, the vehicle holds only collateral such as Highly Rated Securities, and the credit risk is transferred through a guarantee or credit derivative.

Why does a credit-linked note need to be funded?

Under the Basel framework a special purpose vehicle is not an eligible guarantor, although collateral that it pledges may be recognised. Funding the protection with Note proceeds held in Highly Rated Securities therefore allows the bank to recognise protection from the CLN Issuer, subject to the other conditions and to local rules.

What data does a bank provide for a credit-linked note?

The bank provides loan-level reference, exposure, maturity, credit quality and collateral data for each exposure in the Reference Portfolio, including probability of default, loss given default, default flags and stable identifiers. Investors also expect the bank’s rating methodology, its migration matrices and the market data it uses internally.

What does a calculation agent do in a credit-linked note?

The calculation agent runs the servicing cycle on each Note Payment Date. It updates the Reference Portfolio, calculates the Guarantee Fee Amount and the interest on each tranche, applies the waterfall, determines any Protection Payment Amounts, reduces the Adjusted Principal Balance of the affected tranches and prepares the investor reports.

About the author

Gavin McDaid is a practising solicitor (England and Wales) and former venture capitalist, with an LLM in Law and Technology from Queen’s University Belfast. He writes on company law, fundraising and governance in Singapore.