Structured finance and COVID-19: Issues you should consider
Measures to combat the spread of COVID-19 have had a severe impact on commercial and consumer demand, and structured finance transactions are not immune to the ongoing economic slowdown. Today, the public market for asset-backed securities (ABS) – including commercial mortgage-backed securities (CMBS) and collateralised loan obligations (CLOs) – has virtually ground to a halt and secondary trading is thin and volatile. Even though we are still in the early stages of the crisis there are important issues to consider in the context of structured finance deals. Within these there are common and overlapping themes relevant to consumer or commercial assets, performing or non-performing assets, classic securitisations or whole-business structures, and structured products generally.
In this briefing, we discuss structured finance points relevant to:
- residential mortgages;
- commercial real estate;
- whole-business transactions;
- non-performing loans; and
- structured products and CLOs.
We also explore the key issues arising under transaction documents (and how to respond to them), before considering the practical steps parties should be taking as the crisis unfolds.
Job losses will reduce aggregate demand and inevitably impact the ability of borrowers to meet their mortgage repayments. Many governments and financial institutions have offered assistance in the form of payment holidays and waivers.Borrowers will no doubt benefit from any statutory regime which eases the burden of reduced income, but by assisting the consumer in this way, the liquidity problem is shifted to any securitisation that is used to finance such mortgage loans. Senior costs and senior debt service will still need to be paid, even though the special purpose vehicle (SPV) will receive less cash as result of the underlying assets temporarily not providing any income. If there is insufficient liquidity in the structure to withstand the reduction in cash available to the SPV, there is a risk of default.
Since payments under the mortgages will not be ‘due and payable’, they will neither be in arrears nor count towards minimum delinquency or default ratio tests. When the payment holiday is over, borrowers may be required to ‘catch-up’ on deferred payments and pay them on the next (or other later) mortgage payment date in addition to the payment that is due on that date. If borrowers are still not able to make such aggregate payments, we may see a corresponding ‘catch-up’ in delinquencies and/or defaults that will hurt the securitisation. Both originators and investors should be aware of (and mitigate against) the potential for such a ‘springing’ delinquency or default spike.
For those transactions that don’t benefit from government-backed forbearance measures (eg in certain jurisdictions, buy-to-let mortgages are not included, although the securitisations are structured along classic residential mortgage-backed securities (RMBS) lines) originators need to be creative. Documents need to be checked to see if loan terms can be temporarily changed without the need for investor consent. Amendments might provide for a payment holiday and/or the rolling of the catch-up payment into the remaining principal balance, or otherwise allow payments to be deferred for a period of months. Changing the payment profile of a loan will assist borrowers and minimise delinquencies. Moreover, it will maintain (and even improve) customer relationships in this climate of stress and avoid any reputational damage being inflicted upon an originator (eg where an originator refuses to grant relief to its customers, particularly those in the SME sector).
Changing the economics of a loan, whether by amending the repayment profile or otherwise making any material amendment, may be prohibited in the funding documents (and potentially, in the hedging documents). There may be a ‘permitted restructuring’ concept or basket that can be utilised. Some deals, however, will require that any loan subject to a restructuring (including any forbearance measure) must be repurchased (and so funded) by the originator. In this instance, what constitutes a ‘restructuring’ will depend on the drafting of the relevant concept and the degree of the change that is contemplated. A three-month principal repayment holiday with a short-term catch-up period is clearly not the same as a permanent change to the amortisation schedule for the life of a loan. The former tackles the issue of liquidity, the latter addresses credit risk. Where there is scope for interpretation, a common-sense view should be taken. For certain businesses, there may be no other option but to approach investors and ask them to consent to the amendment of documentation in a way that enables them to provide temporary respite to their customers, without denying them access to the funding provided by their securitisation.
Commercial real estate
Commercial real estate transactions that are exposed to vulnerable business sectors and assets – such as retail (severe reduction or complete withholding of rent by tenants), hotels (huge falls in occupancy rates) and student loans (academic years being cut short and students returning home) – are suffering (see COVID-19: the European perspective for real estate for further detail). As with the residential mortgage loan sector there is political and reputational pressure on landlords to grant payment holidays, particularly to SMEs. Many landlords across Europe have already come forward and offered payment holidays, and even outright waivers, for vulnerable tenants. Several governments have announced temporary measures preventing tenants from being evicted if they miss rent payments during the next three months. This will undoubtedly help the industry, particularly SMEs, but any material or sustained reduction of asset income will negatively impact any securitisation funding the assets.
Just like their resi-loan, auto-loan, CLO and trade receivables securitisation cousins, these transactions (in the form of public CMBS or privately issued transactions) face asset quality and cash flow testing. Minimum occupancy, rental yield, loan-to-value (LTV) and debt service cover covenants, among others, may be breached. In the short-term, waivers will be needed to avoid defaults. In the longer term, more permanent solutions will be required – for example a wholesale restructuring of the financial covenant package, the underlying assets (we are already seeing a raft of retail store and casual-dining chains closing as revenues crash; see our insights on insolvency related claims for further detail) and/or additional equity. On the flip-side, covenant stress will create buying opportunities for those who have the liquidity and expertise to manage such assets.
Some ‘whole-business’ or secured debt transactions that use securitisation funding techniques have already been downgraded due to the crisis. For obvious reasons, the aviation, pub and leisure sectors are extremely exposed, with aggregate demand in Europe down by up to 90 per cent. in some cases. The financial covenant package on such transactions generally focuses on debt service ratio coverage. Cash generation in some of these businesses has dramatically slowed down, and if they don’t have enough liquidity themselves or cannot access third party funding (which in the current market environment is scarce and expensive), then there will be no option other than to ask for a waiver, amendment and/or even use equity cures (if available) to de-lever the transaction and avoid a default.
Portfolio servicers under securitisations (in whatever form) will not be immune from the economic downturn. Financial and operational stress may negatively impact servicers. In particular, the ongoing ability to collect and manage funds, liaise with underlying debtors to resolve any liquidity issues, or, in the most extreme scenario, to access portfolio data and produce investor reports, may be impaired. Parties to transactions that are particularly servicer intensive, such as non-performing loan (NPL) securitisations and CMBS transactions, need to pay close attention to continued servicer performance.
If performance is seriously impaired, a replacement or termination event may occur. However, replacing a servicer in a dislocated market is potentially very value-destructive and not likely to be an attractive option to any party except in the most severe cases. We expect lenders and investors to be willing to discuss alternatives, such as waivers and amendments, because finding and onboarding a substitute servicer in the current environment will be extremely challenging.
Unsurprisingly, several processes initiated in 2020 by financial institutions to sell their NPL transactions have halted. This includes the proposed sale by UKAR and several Greek banks of their loan portfolios. Secondary sales of NPLs by financial sponsors scheduled for 2020 have also been put on hold (see our thinking on how to manage M&A risk for further detail). Some of these acquisitions were intended to be financed by securitisation. The negative economic outlook will put even more stress on the performance of these portfolios, especially those overweight on commercial real estate and residential loan exposures that will not get the benefit of government support. Depending on the breadth and depth of the projected recession, it is likely that we will see a growth in NPLs. European banks who were looking at 2020 as another opportunity to further clean-up their balance sheet will have to wait longer. This potentially means bad-asset provisioning will continue to cause bank inefficiency and negatively impact earnings. The inability of financial institutions to address non-performing exposures may also lead to ratings downgrades. This will in turn trigger further (and potentially more wide-ranging) liquidity issues for them, even if government support is available.
In response to the wider concerns around the negative impact of the crisis on European NPLs, the ECB announced on 20 March 2020 that, among other things, national supervisors should adopt a flexible approach to classifying borrowers as ‘unlikely-to-pay’ (so-called ‘UTPs’) when banks benefit from any government guarantees offered to borrowers in response to the COVID-19 crisis. The European Banking Authority (EBA) and European Securities and Markets Authority (ESMA) also announced on 25 March 2020 that banks that face delayed borrower payments as a result of government imposed or privately agreed payment moratoria in response to COVID-19 will not need to classify such loans as defaulting loans under International Financial Reporting Standard 9. Both announcements are welcome as it should mean (in the short-term at least) that banks will not need additional loss-provisions which would otherwise put further pressure on them. A temporary payment holiday caused by a systemic liquidity issue does not itself mean that as a general proposition the borrower is unlikely-to-pay or there is increased credit risk. However, any assessment will depend on the circumstances, such as the business sector, its resilience to the economic stress and its ability to bounce back. It is still very early days to assess whether these measures will have a significant impact on helping European banks mitigate against the impact of increasing numbers of NPLs on their books.
Structured products and CLOs
Transactions with derivative or margin lending components are facing significant challenges. The economic turmoil has depressed both equity and fixed income asset valuations and impacted credit ratings, leading to margin and collateral calls against counterparties and/or mandatory prepayments. If such calls are not met, a close-out process will follow. Considering the volatility of asset valuations, disputes over the conduct of any close-out process and/or associated asset values may become more frequent. Where a dispute arises, the dispute resolution mechanisms (if any) provided for in transaction documents should be consulted. If the underlying assets involve publicly traded securities, the related regulatory issues (such as insider trading) will need to be considered.
For CLOs, assets in the form of corporate loans (leveraged or otherwise) may themselves face negative ratings actions. Speculative grade credits in sectors such as aviation, leisure, corporate events, hotels and energy are especially vulnerable. If the CLO assets don’t have enough sector and issuer diversity and/or there are insufficient buffers in the CLO to absorb collateral downgrades, the CLOs themselves will come under downgrade pressure. This may lead to a breach of over-collateralisation and/or portfolio quality covenants (eg weighted average rating, weighted average spread and/or diversity score) and trigger early amortisation of senior tranches – and even the sale of collateral into a market which is already fragile. Lastly, similar issues will impact CLO warehouse funding lines provided by banks and other financiers to managers. Asset downgrades and falling prices may trigger draw-stops under those lines. If they do not, banks will be stuck with continuing finance exposures until the relevant warehouse line is required to be refinanced, which will typically be for up to 18 months.
For any structured finance product, collateral appropriation will be impacted by depressed asset valuations and the presence of a limited number of buyers in the current market. Widespread liquidations will likely further depress valuations by flooding markets with similar types of securities. However, on the flip-side, defaulting transactions and depressed asset valuations will also create opportunities for acquisitive and expert fixed income buyers who identify price dislocations.
Issues in documents and how to respond
The financial, operational and social stress caused by the crisis will likely lead to a rise in delinquencies and eventually defaults of assets backing structured finance transactions. Whether you are dealing with residential or commercial real estate backed assets or a securitisation of trade receivables, from a documentary perspective, certain financial conditions (typically those relating to asset quality and cash flow generation) may be breached. Depending on the nature of your assets and/or the structure of your transaction, this may cause one of more of the following:
- A stop-purchase event. No further sales of new assets (including, potentially further advances under assets that are already securitised) will be allowed until the transaction re-performs. The inability to sell assets will mean those assets cannot be financed. This will cut off working capital to the originator at a time when it needs it most and credit is expensive and in short supply.
- Trapped cash. Residual cash payable to an originator, in the form of deferred purchase price (DPP) or variable interest under subordinated debt issued by the SPV, will be trapped. Cashflows are automatically applied by the SPV to prepay senior debt causing the transaction to de-lever (so called ‘early’ or ‘turbo amortisation’) and/or replenish any credit reserves. The originator will not be able to use DPP to originate new assets, or for general working capital purposes. On sponsor-backed transactions, such residual cash will no longer be available to the sponsor.
- Depleted credit reserves. Severity and frequency of default will eat up credit reserves. If DPP is not enough to replenish these reserves and additional equity is not made available, this will often cause a stop-purchase event. Transactions will need to be checked to see how much headroom there currently is to absorb losses.
- Credit reserve funding requirements. Transactions with credit reserves that require funding if certain asset performance tests are failed, will need to be capitalised. Such commitments may be guaranteed by an entity in the originator group or a sponsor which, due to current market conditions, may itself be subject to liquidity constraints and default as a result. This may trigger a chain of wide-reaching and very damaging cross-defaults.
- Defaults. If asset quality or cash generation tests fail to reach certain levels, they may cause a straight event of default. This will give the senior investors the option to accelerate and/or enforce all or part of the debt and supporting security.
- Enforcement. If transaction performance deteriorates so much that the SPV cannot service interest on the securitised debt, such that the transaction defaults, investors may bring acceleration and/or security enforcement action.
- Notifications. In addition to notifying counterparties and third parties (such as ratings agencies) of the occurrence of any of the events described above, if a transaction is a ‘securitisation’ under the EU Securitisation Regulation, any ‘significant event’ (eg a default) must be notified by the relevant party to the relevant investors and regulators.
- General contractual implications. Further to the structured finance specific points mentioned above, don’t overlook the relevance of more generic contractual rights, such as being able to rely on: force majeure, economic impossibility or change in law clauses; the use of dispute resolution provisions; and any material adverse effect/change qualifiers. There are also rights available under general law that are potentially relevant, such as frustration under common law systems and economic impossibility under certain civil law systems (see our insights on managing contractual risk for further detail).
We are already seeing classic documentary responses to the circumstances listed above, such as amendments and/or waiver processes (see our thinking on financing issues for further detail). Originators, servicers and/or asset managers should examine their documents quickly and carefully. If issues such as insufficient liquidity, asset deterioration and weakening servicer performance are on the horizon, approach your banks, counterparties or investors, or your originator and sponsor, as applicable. In the market, many businesses and sponsors are busy reviewing documents, formulating detailed plans (including any required changes to covenants and baskets) and contacting their investors. Aside from actual or potential covenant breaches, investors are also proactively reaching out to their clients to see how businesses are coping and whether they need support. Investors (and particularly banks who have government support!) will be under political pressure to be constructive and offer respite in these unprecedented times.
In return for amendments and waivers, lenders and investors may: charge consent fees; re-price the economics of the transaction, including the credit support/effective borrowing base; and ask for additional covenant protection, security, or credit support in the form of performance guarantees and additional reserves.
Sponsors or corporates may exercise any option they have to inject additional capital (in the form of subordinated debt or equity) to cure covenant breaches. This can be in the form of a permanent deleveraging or cash deposited in a secured account of the securitisation issuer. If the latter, such cash should be available to be released back to the corporate or sponsor if the covenant breach is cured.
For privately issued transactions, the process of approaching investors (often banks) with a plan, including cash flow models, and seeking consent to waive and/or amend contracts, will be much easier and quicker than for, say, publicly issued ABS. The latter will often require a formal noteholder consent process as the requested changes will directly or indirectly impact cashflows. In these situations, security trustees will have no choice but to take a conservative view. Any changes will also be subject to ratings agency affirmation.
Care should always be taken to ensure any payment deferrals are implemented in accordance with applicable law and regulation, including, in the context of consumer loans, treating all customers fairly (see our thinking on how to manage consumer risk for further detail).
In the future, we will no doubt see additional risk factors appearing in disclosure documents, which disclose issuers’ existing and future exposure to the effects of the current and any future global communicable disease (including measures of mitigation, such as social distancing) in addition to any specific or long-term impact of COVID-19 on their business and/or assets (see Debt capital markets and COVID-19 and our insights on securities issues for further detail). Such risk factors will likely mention the material adverse effect of disruption to supply chains, the closure of facilities or a decrease in demand for goods. In addition, we expect originators (at some stage, although not perhaps now) to push for ‘corona-clauses’; namely, the ability for transactions to suspend all or part of debt service or effect asset-level restructurings on a temporary basis if and to the extent that there is any business disruption on an economy-wide scale due to factors beyond the parties’ control.
It is too early to predict the long-term impact of the crisis on the structured finance market. However, if you are a party or otherwise exposed to structured finance transactions of any kind, you should be thinking about, or at least be aware of, the issues explored in this briefing – we are already encountering them in practice. You should invest time now to understand the overall and specific risk position in your transactions. The choices participants make today may, as they were in the financial crisis, be challenged in the long run. A reactive approach will not be enough. The situation is complex, serious and fast-moving, as governments, supranational entities and markets continue to grapple with the scale of the crisis. Parties will need to be creative and nimble, and not compromise on expert transaction structuring. Seeking trusted advice and leaning on long-term relationships will help sponsors, businesses, banks, investors and other participants in the structured finance market to weather the crisis and emerge from it ready to capitalise on new opportunities.
We will continue to monitor developments and update this briefing from time to time. For more detail and practical tips on managing the impacts of COVID-19, please visit our coronavirus alert hub.