European institutions that invest in securitization transactions, whether in the United States or elsewhere, should be mindful of the risk retention rules that are part of the European capital requirements regulation (the CRR).1 The CRR contemplates that European institutions will invest in a securitization transaction only if the sponsor, originator or original lender in the transaction retains part of the credit risk of the assets that are being securitized. The CRR reflects a belief that risk retention rules will induce the applicable parties "to conduct quality screenings properly, improve underwriting standards and monitor for credit risk" in securitization transactions.2
The CRR applies to securitization transactions in which the investors include European credit institutions3 or investment firms.4 In order for a transaction to comply with the CRR, the sponsor of the transaction (or the originator or original lender) must disclose that it will retain at least 5% of the economic risk with respect to the transaction. The CRR applies to various types of securitization transactions; this article will focus on the application of the CRR to aircraft securitization transactions.
What Type of Transaction Is Covered by the CRR?
In order to be covered by the CRR, a transaction must have the following characteristics: (i) the credit risk associated with one or more "exposures" (such as loans or leases) is tranched; (ii) payments in the transaction depend on the performance of the exposures; and (iii) losses on the underlying exposures are distributed based on the subordination of the tranches. For purposes of the CRR, a "tranche" is defined by reference to the contractual segmentation of credit risk, in which the holder of a position in the transaction takes a risk of credit loss that is greater than or less than the holder of another position in the transaction.
For example, in the context of a typical securitization of aircraft leases, immediately prior to the securitization a leasing company owns and/or manages a group of special purpose entities that are the lessors of the applicable aircraft. In connection with the securitization transaction, the leasing company transfers ownership of the special purpose leasing companies to an issuing entity and the issuing entity may issue a senior class of notes and a subordinated class of notes to third party lenders. That transaction would be subject to the CRR: (i) the portfolio of leases transferred into the transaction constitute the underlying "exposures" in the transaction; (ii) payments on the notes issued by the issuing entity depend on rent payments on the underlying aircraft leases; and (iii) the holders of the subordinated class of notes take more risk of credit loss than do the holders of the senior class of notes.
Who Must Retain the Credit Risk?
The CRR's risk retention requirements can be satisfied if the applicable portion of the economic risk of a securitization transaction is retained by any of the originator, the sponsor or the original lender in respect of the transaction.
For purposes of the CRR, an "originator" is an entity that either (a) by itself, or through related entities, was involved in the original agreements that created the obligations of the debtors that give rise to the exposures being securitized, or (b) buys a third party's exposures for its own account and then securitizes those exposures. In a typical aircraft lease securitization, the originator would be the applicable aircraft leasing company.
Under the CRR, the "sponsor" is an "institution" (other than an originator) that establishes and manages a securitization scheme that acquires exposures from third-party entities.5 In the context of an aircraft lease securitization, a sponsor could include an investment bank that establishes a special purpose entity to purchase aircraft leases from third parties.
For purposes of the CRR, the "original lender" is an entity (other than the originator) "which, either itself or through related entities, directly or indirectly, originally created the obligations or potential obligations" that are being securitized.6 In the context of an aircraft securitization, the original lender could be a bank or an investment fund that made a series of aircraft loans and that is selling the aircraft loans directly or indirectly to a securitization transaction.
The CRR does not require multiple applications of the risk retention requirement for a single securitization transaction. If the originator takes the risk retention for a transaction, the sponsor and the original lender will not be subject to additional risk retention for the same transaction.7 If the securitization transaction involves multiple originators (or multiple original lenders), then the risk retention requirement may be satisfied either (i) by allocating the risk retention among such originators (or such original lenders) on a pro rata basis, or (ii) if certain conditions are satisfied, by allocating all of the risk retention to a single originator (or to a single original lender).8
How Much Risk Must Be Retained, and What Are Permissible Forms for Holding the Required Amount of Risk Retention?
Pursuant to the CRR, a compliant securitization is one in which the originator, the sponsor or the original lender has agreed to retain, during the life of the transaction, "a material net economic interest" of not less than 5%. The CRR specifies various methods for holding the required amount of risk retention.
Retention of Economic Risk in Each Tranche
An originator, sponsor or original lender may elect to satisfy the CRR's 5% risk retention requirement by holding 5% of the nominal value of each of the tranches issued to investors in the securitization transaction.9 For example, in a securitization of aircraft leases, if the issuing entity issued a senior class of notes and a subordinated class of notes, a sponsor using this risk retention approach would retain at least 5% of the face amount of each such class of notes.
As an alternative to holding 5% of the nominal value of each tranche, the originator, sponsor or original lender may satisfy the CRR's risk retention requirement by holding a separate "vertical tranche" that has a nominal value of at least 5% of the total nominal value of all of the other tranches issued in the securitization transaction.10 The vertical tranche could be a separate class of notes (Class V) issued by the issuing entity, and would be required to expose the holder of such class to the credit risk of the other classes of notes on a pro rata basis.11 For example, if $200 million of senior notes and $100 million of subordinated notes were issued in an aircraft lease securitization transaction, the vertical tranche could take the form of a Class V note in the face amount of $15 million ($300 million x 5%).
Retention of Economic Interest in Randomly Selected Exposures
The CRR's risk retention requirement may be satisfied through the holding of "randomly selected exposures" in an amount equal to at least 5% of the nominal value of the securitized exposures.12 This option is available only for larger pools of loans or leases, since there must be at least one hundred loans or leases for this option to apply. If there are at least one hundred loans or leases, then the originator or sponsor could satisfy the CRR's risk retention requirement by retaining an economic interest in at least 5% of those loans or leases selected at random from the total pool of loans or leases.13
Retention of First-Loss Tranche
Another option for satisfying the CRR's risk retention requirement is the retention of a first-loss tranche equal at least 5% of the nominal value of the entire pool of securitized exposures.14The CRR permits this option to be satisfied by a combination of a first-loss tranche and other tranches that (i) have a risk profile that is the same (or more severe) than the risk profiles of the tranches issued to investors and (ii) do not mature earlier than the tranches issued to investors.
First-loss tranches are not unusual in aircraft securitization transactions. For example, securitizations of aircraft loans, aircraft leases and aircraft engine leases have featured the issuance of equity tranches in the form of E certificates that will be the first to bear losses arising from the pool of securitized assets.
The first-loss form of risk retention may also be satisfied by overcollateralization, if the overcollateralization is sized to be at least 5% of the nominal value of the tranches issued in the securitization transaction.15 For example, in connection with a securitization of a portfolio of $420 million of aircraft loans, the issuing entity might issue $250 million of senior notes and $150 million of subordinated notes. The overcollateralization in this example would be $20 million (which is the difference between the size of the loan portfolio and the face amount of the notes), and would equal 5% of the $400 million of notes issued in the transaction.
Retention of First-Loss Exposure to Every Securitized Exposure
Another way to comply with the CRR is through the retention of a first-loss exposure equal to 5% of every securitized exposure in the transaction.16 In a securitization of aircraft leases, this would require that the losses on each lease be tracked separately, and that any loss on a lease would be allocated first to the applicable holder of the risk retention until the total loss borne by the holder of the risk retention equaled 5% of the amount due on such lease at origination. This method of risk retention may be accomplished by selling assets (such as leases) to the securitization issuer at a discount of at least 5% of the nominal value of the applicable asset.17
Synthetic and Contingent Forms of Risk Retention
The CRR's risk retention requirements may be fulfilled through a synthetic form of retention or a contingent form of retention.18 A "synthetic form of retention" is defined as retention of an economic interest by means of a derivative instrument. This would appear to include a total return swap or similar arrangement. A "contingent form of retention" is defined as retention of an economic interest by means of a guarantee, a letter of credit or "other similar forms of credit support ensuring an immediate enforcement of the retention." If the party providing the synthetic or contingent form of retention is not a "credit institution" as defined in the CRR, then the synthetic or contingent risk retention must be 100% cash collateralized.
Other Types of Risk Retention
Certain types of risk retention may satisfy the CRR even though such types of risk retention are not expressly mentioned in the CRR. The Committee of European Banking Supervisors published guidelines (the CEBS Guidelines) relating to various types of risk retention in connection with the European risk retention rules that existed prior to the adoption of the CRR.19 The European Banking Authority has indicated that all methods of risk retention included in the CEBS Guidelines will remain available for purposes of satisfying the risk retention requirements of the CRR.20 For example, the CEBS Guidelines allowed a first loss tranche to consist of, among other things, the funded portion of a reserve account.21 Thus, a cash reserve of 5% should satisfy the CRR's risk retention requirements.
Transfer of Risk Retention
The CRR provides that the risk retention in a securitization "shall not be subject to any credit risk mitigation or any short positions or any other hedge and shall not be sold."22 This is designed to ensure that the originator, sponsor or original lender, as applicable, continues to have "skin in the game" after the closing of the securitization transaction. Certain hedges are permitted under the CRR so long as they do not have the effect of hedging against the retained credit risk.23 A hedge against foreign currency risk could be a permitted hedge, since that hedge would protect against fluctuations in the value of a particular currency rather than protecting against the failure of a lessee to pay rent.
What Is the Consequence of Failing to Comply with the CRR?
If a European institution becomes exposed to a securitization transaction (other than as the originator, original lender or sponsor), and the securitization transaction fails to conform to one of the permitted risk retention models under the CRR, the European institution will face an additional capital charge on its exposure to the securitization transaction.24 By penalizing the investment of funds in non-compliant securitizations, the CRR incentivizes European institutions to require that the securitizations in which they invest comply with the risk retention requirements of the CRR.
Due Diligence Requirements
The CRR imposes due diligence requirements on European institutions that invest in a securitization. Both before and after investing in a securitization, an investor subject to the CRR must “have a comprehensive and thorough understanding” of various types of information relating to the securitization, including: (i) the net economic interest retained by the applicable sponsor, originator or original lender; (ii) the risk characteristics of the applicable class of securities in which the investor is investing; (iii) the risk characteristics of the loans or leases that are being securitized; (iv) the reputation and loss experience of previous securitizations completed by the applicable sponsor or originator; and (v) the structural features of the securitization that could have a material impact on the performance of the securities in which the investor is investing, such as the payment waterfalls, the liquidity and credit enhancements applicable to the transaction, and the events of default applicable to the transaction.25 An investor subject to the CRR must review its compliance with the CRR at least annually (and more frequently upon becoming aware of certain developments that could adversely affect the investor, including a material change in the structural features of the transaction).26
In transactions involving the securitization of aircraft loans and leases, it is not unusual for the party establishing the securitization to retain some economic risk in the transaction. This economic risk has taken various forms in the past, including the retention of subordinated securities, overcollateralization and the funding of reserve accounts. The CRR imposes a 5% threshold for the retention of risk in securitizations that qualify for the CRR. That 5% test should not prevent the successful completion of securitizations of aircraft assets.