Securitisation is a sophisticated financial technique that goes well beyond the simple pooling of assets. For such an operation to succeed and inspire investor confidence, it must be accompanied by robust mechanisms for managing risk and securing financial flows. This is where asset/liability management and credit enhancement techniques come into play, essential tools for transforming a portfolio of receivables into an attractive and secure investment product. Understanding the objectives and advantages of securitisation is to look at these instruments, which are the real driving force behind it. The structuring of these complex financial products requires specialised legal expertise, particularly when it comes to navigating the dense regulatory framework. The support of a law firm with expertise in this area is therefore a prerequisite for the success of these operations.
Forward financial instruments and risk transfer
A securitisation undertaking (TO) is not simply a passive holder of receivables. It is authorised by law to actively manage its balance sheet and off-balance sheet items, in particular by using forward financial instruments. These contracts, better known as derivatives, make it possible to transfer or hedge against specific risks without having to sell the underlying assets. The financing and risk coverage within the legal framework of securitisation undertakings are therefore dynamic components of vehicle management.
Credit default swaps
One of the most common instruments for managing credit risk synthetically is the credit default swap, or CDS. credit default swap (CDS). This contract transfers the risk of default by a debtor. The securitisation vehicle can intervene in two ways. As a protection seller, it receives a periodic premium in exchange for its commitment to compensate the buyer if a defined credit event (such as a payment default) occurs on a reference asset. As a protection buyer, it pays a premium to hedge against the risk of default on an asset it holds, thereby transferring that risk to a counterparty.
Contracts transferring insurance risks
Securitisation vehicles are not limited to traditional financial risks. Legislation also allows them to be exposed to insurance risks. Through specific contracts, a TO can acquire risks from insurance or reinsurance companies. These contracts enable insurers to transfer part of their commitments (linked, for example, to natural disasters or longevity risks) to the capital markets, via the securitisation vehicle. The securitisation body will then issue securities, the remuneration and repayment of which will be conditional on the occurrence or non-occurrence of insured claims.
Conditions for conclusion and AMF approval
The use of these sophisticated instruments is not left to the discretion of the management company. Where the fund's articles of association provide for the vehicle to be exposed to risks via financial futures instruments, the management company must draw up a specific programme of operations. This programme must be submitted to the Autorité des marchés financiers (AMF) for approval. This supervision ensures that risk management is carried out in a prudent and controlled manner. The management company may also delegate the implementation of these operations to a specialised portfolio management company, which will itself be subject to these approval requirements.
Credit enhancement mechanisms
Credit enhancement, or credit enhancementThe term "securitisation" refers to all the techniques used to improve the credit quality of the securities issued by a securitisation vehicle. The aim is simple: to reduce the risk of loss for investors and, consequently, to obtain a better rating from specialised agencies. A high rating makes it easier to place the securities and reduces the cost of financing the transaction. These mechanisms constitute a financial "shock absorber", essential for investor confidence. The legal framework for securitisation vehicles provides a number of tools for this purpose.
Issue of shares and subordinated debt securities
The most fundamental credit enhancement technique is internal to the structure of the TO's liabilities. It consists of creating several categories of securities, called "tranches", with different priorities. Lower-ranking securities, known as subordinated or junior securities, absorb the first potential losses on the receivables portfolio. In this way, they protect the senior tranches, which will only suffer losses if the subordinated tranches are completely wiped out. In return for this higher risk, subordinated securities offer a potentially higher return. This hierarchy of risk is at the heart of securitisation.
Overcollateralization
Overcollateralisation is another internal enhancement technique. It involves ensuring that the nominal value of the securitised assets is higher than the nominal amount of the securities issued by the organisation. For example, the TO may acquire a portfolio of receivables worth €110 million, but issue only €100 million in securities to finance it. The difference of €10 million constitutes a margin of safety ("excess collateral") which is used to cover any defaults by debtors. This mechanism guarantees a better securing flows of securitised receivablesThis is because the first losses are absorbed by this surplus before being passed on to securityholders.
External guarantees (stand-alone, first demand)
Unlike internal mechanisms, external guarantees involve the intervention of a third party, usually a financial institution with an excellent credit rating. The most robust form of this protection is the autonomous guarantee, and more specifically the first demand guarantee. Its strength lies in its independence from the basic contract. Unlike a simple surety bond, the guarantor cannot raise exceptions relating to the underlying claims to refuse payment. If the conditions set out in the deed of guarantee are met, the guarantor must pay on simple request by the beneficiary (the TO). This certainty of payment makes it a highly valued protection for investors and rating agencies.
Subordinated loans
A securitisation vehicle can also strengthen its financial structure by taking out one or more subordinated loans. The mechanism is simple: a third party, often the seller itself or a financial institution, grants a loan to the SPV. The special feature of this loan is that repayment is subject to full payment of all sums due to the holders of securities issued by the organisation. In the event of difficulties, this loan acts as an additional cushion, absorbing losses after the subordinated tranches but before the senior tranches, thereby strengthening the protection of the latter.
Cash deposit (reserve fund)
A direct and effective method of credit enhancement is to set up a reserve fund. At the start of the transaction, a sum of money is deposited in a specific account with the securitisation vehicle. This deposit, which is often financed by part of the proceeds of the securities issue or by the seller, is intended to cover initial portfolio losses or temporary cash shortfalls. It provides immediate liquidity to meet payments due to investors, even in the event of late payment by the debtors of the underlying receivables. The amount of this reserve fund is calibrated according to the historical risk of the asset portfolio.
Temporary acquisitions and sales of securities
To optimise its cash and asset management, a securitisation vehicle is not limited to simply holding receivables. Legislation authorises it to carry out transactions involving the temporary acquisition and sale of securities. These techniques enable more dynamic management of cash and risk, by offering the possibility of investing surplus cash or obtaining short-term liquidity in a secure manner.
Repos, securities lending, repurchase agreements
Authorised transactions include several mechanisms that are well known to the financial markets. A repurchase agreement (pension) is a contract under which the TO transfers full ownership of securities to a counterparty, while committing itself and the counterparty to a retrocession on an agreed date and for an agreed price. Securities lending enables a TO to lend securities from its portfolio to a borrower in exchange for a fee, with the borrower undertaking to return equivalent securities at maturity. Sale with right of repurchase, or vente à réméré, allows the sale of securities while reserving the right to repurchase them within a specified period, in return for the return of the price.
Counterparties and eligible securities
These dynamic management operations cannot be carried out without a strict framework. The regulations impose precise conditions on the counterparties with which the TPO may enter into contracts. These are generally credit institutions or insurance companies of proven financial strength, located in the European Economic Area or in an OECD member country. There is also an exhaustive list of securities that may be traded. These are mainly liquid debt securities traded on a regulated market, such as Treasury bills or negotiable debt securities, to ensure the security and liquidity of these transactions.
Limits and application of the rules
In order to avoid excessive leverage and to preserve the financial stability of the securitisation undertaking, the law strictly limits the volume of these transactions. The securitisation vehicle may only engage in temporary purchases or sales of securities up to the value of its assets. This constraint ensures that the vehicle does not take on excessive risks and that its financial structure remains balanced. The use of these techniques must be expressly provided for in the fund's rules or articles of association, which must define the objectives and procedures.
Assignment of unmatured or past due receivables
Although the main purpose of a TO is to acquire receivables, it may also sell them in certain circumstances. This gives it flexibility in managing its assets, particularly to meet liquidity needs, comply with its commitments or wind up its business. This active asset management is a key component of its financial strategy.
Conditions and specific approval
The transfer of receivables by a securitisation vehicle is not a routine management transaction and is subject to strict conditions. The rules or articles of association of the vehicle must provide for this possibility and define the terms and conditions. In addition, when these sales form part of an active and regular management strategy, the management company must obtain specific approval from the AMF for its programme of operations. However, this approval is not required in certain exceptional situations, such as when the fund is liquidated, or when the amount of remaining receivables is very small.
Terms and conditions of sale
To ensure that the transactions are symmetrical and straightforward, the law stipulates that the securitisation vehicle must use the same simplified procedures for the transfer of receivables as for their acquisition. The transaction is therefore carried out simply by handing over a slip, in accordance with the provisions of the French Monetary and Financial Code. This method ensures that the transfer of ownership is carried out quickly and securely, and is enforceable against third parties from the date on the slip.
Mastery of financial instruments, credit enhancement mechanisms and asset management techniques is fundamental to the success of any securitisation transaction. Although complex, these tools are essential for structuring solid, credible financial products. The complexity of these arrangements and their dense regulatory framework make expert legal advice essential. For an in-depth analysis of your project and the implementation of appropriate financing solutions, our law firm is at your disposal.
Sources
- French Monetary and Financial Code, articles L. 211-1 et seq (Financial instruments).
- French Monetary and Financial Code, articles L. 211-27 et seq (Repurchase agreements).
- French Monetary and Financial Code, articles L. 214-168 et seq (Securitisation vehicles).
- French Monetary and Financial Code, articles R. 214-217 et seq (Operating rules for financing institutions).
- Civil Code, article 2321 (Independent guarantee).
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