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Selling Your Skin In The Game Is Not In The Spirit

22 June 2017 by Douglas Charleston

A popular misconception relating to European ABS was that the banks who created the mortgages and structured the deals didn’t retain any ongoing exposure to the performance of the deal. As such they could move “toxic” assets off their balance sheet.

This was largely untrue – banks voluntarily retained material economic interest in European ABS and this alignment of interest was one of the reasons why the underlying loan quality was good and the structures performed as expected.

This was not the same in the US, with notable differentiation in performance.

Regardless of this key difference, the most important post-crisis reform in the global securitisation market was the establishment of a set of regulations to ensure the alignment of risk and reward through risk retention, a concept widely known as “skin-in the game”. The legal form of this risk retention is now final in the US and continues to be developed in Europe where regulations are close to a final form we expect. It is certainly the case that we as bond investors care that a new transaction is legally compliant with risk retention rules, indeed this can impact the ability of our portfolios to hold a credit, as well as liquidity and relative value.

However, before we dig into legal documents to confirm legal ‘form’, we place more importance on how a sponsor has gone about complying with the ‘spirit’ of risk retention. Ultimately, fixed income investors care about receiving coupons and getting their money back. How a sponsor is likely to behave if things go wrong is crucial to this.

If performance dips or markets widen, will a deal be called and therefore will principal be returned in a timeframe expected during the deal’s marketing period? Will a sponsor suffer a material economic pain or reputational damage? Do they have real economic skin in the game going forward? Will they walk away or can they change ownership?

Take for example an ABS transaction where the portfolio backing it is purchased at a substantial discount e.g. 90% of nominal value (this is probably due to low margin loans rather than poor credit quality). When securitised under current European requirements, the issuer could raise 95% funding, thus keeping the minimum 5% of nominal exposure that meets legal requirements, but they have actually no economic interest anymore and in fact have extracted 5% of excess capital. This can lead to dangerous behavioural economic outcomes if things go wrong. Another example is where an entirely unconnected third party is effectively introduced to take the risk retention obligation and exposure. This again can comply with legal form but not spirit where a decoupling of risk and reward can appear.

It’s an important part of our credit analysis and ongoing due diligence as the market develops in Europe.



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