History repeats itself: the first three-tranche securitization with a Russian rating — LLC “MA Titan 5”

Transactions to issue mortgage-backed securities (hereinafter, MBS) remain the most common type of securitization transactions in the Russian financial market. Despite the clear dominance of agency transactions with quasi-government guarantees (‘MBS Factory’ program of JSC “DOM.RF”), there is still some activity in the classic multi-tranche securitization segment. From the beginning of 2020 to Q1 2023, four market transactions for the issuance of securities were carried out with the assignment of credit ratings to them based on an analysis of the characteristics of collateral portfolios and issue structures. The total issuance volume was RUB 16.3 bln. ACRA has repeatedly noted that the potential of market securitization transactions, both mortgages and other types of loans (primarily provided to the SME sector), remains practically unrealized in Russia. However, a number of factors, including originators’ continued interest in securitization transactions, the need to redistribute risks between the public sector and the private sector, which is urgent in the current economic conditions, and also the emergence of digital financial assets as a new promising form of issuance of debt instruments, give grounds for moderate optimism regarding the industry’s development prospects.

The most recent deal in the classic securitization segment was an MBS transaction secured by a portfolio of mortgage loans of Joint Stock Company “Housing Finance Bank” (hereinafter, JSC “HFB”) and issued by LLC “MA Titan 5”. The Agency assigned the highest credit rating under the national scale for the structured finance sector to the class A bonds. The most interesting distinguishing feature of the transaction is the three-tranche structure of the issue. These structures indeed existed before, however, since the Russian financial market switched to using ratings from national credit rating agencies to ensure independent assessment of credit risk, market participants have preferred standard two-tranche issues.

ASSET ANALYSIS

The analyzed transaction is entirely standard in terms of analysis of the collateral portfolio — as of issuance it included 1,615 mortgage loans to a total of RUB 3.14 bln with an average maturity of about 13 years and an average interest rate of 14.5%. Concentration by size of loan is relatively low — the share of loans provided to the twenty largest borrowers accounts for 4.38% of the portfolio. The portfolio is different due to the considerable percentage of general purpose loans, however, the market has experienced precedents for the securitization of such assets. Loans in the portfolio of LLC “MA Titan 5” are distributed as follows according to the purposes of lending:

• General purpose loans secured by real estate provided to improve living conditions, for refinancing, and others purposes — 54.17% of the total portfolio volume;
• Purpose loans to acquire ready housing in the secondary or primary markets — 45.83% of the total portfolio volume.

Figure 1. Distribution of loans in the portfolio of LLC “MA Titan 5” by lending purposes

General purpose mortgage lending may indicate that it is not possible for borrowers to obtain consumer loans. Consequently, such loans carry a greater credit risk, which is taken into account when quantifying the credit quality of the portfolio.
The loan-to-value ratio (LTV ratio) is, according to ACRA’s rating approach, one of the main drivers of the credit risk of mortgage portfolios, which influences the probability of default and recovery rate for individual loans. First, a low initial LTV ratio may indirectly evidence the stable financial standing of a borrower who was able to make a substantial down payment. Second, such borrowers usually have a more responsible attitude toward servicing loans, since a significant part of their own funds has been invested in the transaction. Third, it is clear that in the event of default, the bank will receive a larger amount of compensation when collecting debt or by agreement of the parties. The collateral portfolio for the transaction of LLC “MA Titan 5” is characterized by a low weighted average LTV ratio, reflecting the ratio of the remaining loan debt to the estimated value of mortgaged real estate — 46.95%. ACRA’s analysis also took into account the relatively high weighted average portfolio maturity (2.9 years), indicating that the peak of defaults has mostly passed, which falls on the first two years of the life of loans in the portfolio.

Figure 2. Initial and current LTV ratios under the LLC “MA Titan 5” securitization transaction

Source: ACRA

Retrospective analysis of mortgage products identified relatively high cumulative default rates in earlier mortgage securitization deals in which JSC “HFB” was an originator bank. Thus, the average level of cumulative defaults, weighted taking into account the volume of transactions of JSC “HFB”, amounted to 17.2% (the minimum and maximum observed values were 6.46% and 19.42%, respectively). However, in the previous securitization deal of LLC “MA Titan 3” in 2019, the specified ratio amounted to 6.49% of the total balance of the principal debt for the portfolio at the time of the start of circulation of the MBS. The fact that over the past three years this indicator has declined even on the back of the challenging economic situation points to an increase in the quality of underwriting and an improvement of work with non-performing pre-default debt. This may have a positive impact on the results of the analysis of future mortgage securitization transactions of JSC “HFB”.

The type of borrower income confirmation is another important indicator that characterizes solvency. 2-NDFL and 3-NDFL personal income tax statements serve as official proof of income. Unofficial income confirmation (statements in no particular format or from a bank, account statements, etc.) or the absence of confirmation make it impossible to reliably assess a borrower’s ability to pay, even in the event of compensatory factors, which makes it irrelevant to analyze the ratio of a borrower’s payments on a mortgage loan to their income. The share of borrowers who do not have an officially confirmed income is 70% in the securitized portfolio of LLC “MA Titan 5”, which influenced the results of the Agency’s analysis of the portfolio.

Figure 3. Breakdown of the portfolio of LLC “MA Titan 5” by form of borrower income confirmation

Source: ACRA

When making lending decisions, many banks categorize a borrower’s level of education as an optional parameter. However, ACRA’s statistical database for the Russian mortgage lending market, which underlies the Agency’s rating approach, allows us to judge the importance of this criterion. Loans provided to borrowers with secondary, secondary specialized or incomplete higher educations have a higher possibility of default than loans issued to borrowers with one or more higher educations or borrowers with academic titles. In the analyzed portfolio of LLC “MA Titan 5”, 27.3% of borrowers do not have a higher education, which was taken into account by ACRA in the assessment results.

Figure 4. Breakdown of the portfolio of LLC “MA Titan 5” by borrower education

Source: ACRA

Based on the results of a comprehensive analysis of quantitative and qualitative factors, ACRA estimated the median expected losses for the portfolio of LLC “MA Titan 5” at 3.44%, and the extreme expected losses (GRASP AAA indicator) at 22.65%. The next step was the analysis of the structure of the transaction, which allowed the Agency to determine the percentage of issue tranches and assign a target credit rating to the senior bond class.

ANALYSIS OF TRANSACTION STRUCTURE AND SPECIFICS

The classic structure of an MBS issue involves a number of investor protection mechanisms, the main of which is the subordination or division of the issue into tranches with different priorities. According to common practice, market securitization transactions in the Russian market have a two-tranche issue structure, in which the senior class of bonds, which is assigned a credit rating, is offered to a wide range of investors, while the junior debt, which can be issued either in the form of bonds or a loan, is held by the originator. The economic essence of tranching is to distribute the portfolio credit risk among bond classes. The size of the junior tranche reflects the expected losses on the securitized portfolio, while the senior (higher priority) tranche is a reduced-risk portion of the portfolio. Therefore, market investors are protected, which is confirmed by a high credit rating, while the holders of the junior tranche accept the risk of the first losses. At the same time, portfolio credit risk is forecast for the entire duration of the rated securities, subject to cyclical fluctuations in the economy. Various loss scenarios are taken into account, including the so-called AAA scenario that includes a recession and a significant economic slowdown in the country.

The transaction of LLC “MA Titan 5” is distinct because of its three-tranche structure: in addition to the standard senior and junior tranches, there are mezzanine class bonds (Fig. 5). From an economic point of view, the mezzanine class bears part of the risk that, in a standard two-tranche transaction, is inherent in the junior tranche, but at the same time has a greater degree of protection. In practice, this means that the priority of the mezzanine class bonds is higher than that of the junior class bonds, but lower than that of the senior class bonds. This applies to both the repayment of the bonds’ par value and the coupon payments. In other words, until the class A bonds are repaid in full, payments on the mezzanine class are made only to the extent that the cash flow generated by the securitized mortgage portfolio allows, after the mandatory payments on the senior class of bonds are made. The standard and most probable forecast scenarios that are characterized by moderate risk assume that there will be sufficient funds to repay the two tranches in full. However, in a stress scenario, with sharp fluctuations in the default level in the portfolio for several consecutive payment periods, senior investors will be more protected.

Figure 5. securitization transaction structure of LLC “MA Titan 5”

Source: ACRA

• The volume of defaulted loans in the payment period does not exceed 3% of the current volume of the collateral portfolio;

• The balance of outstanding defaults does not exceed 1% of the current volume of the collateral portfolio;

• The weighted average interest rate on the portfolio does not decrease relative to the rate actual the time of bond issue by more than 1.2 p.p.;

• The share of cumulative defaults does not exceed 16% of the initial portfolio.

The inclusion of these triggers in the terms of the transaction makes it possible to increase the protection of mezzanine investors since in standard economic conditions, payments to them will be made faster than in the sequential amortization of tranches. In addition, this makes it possible to strengthen the protection of senior investors in stress scenarios, since in case of deterioration of the current indicators of the portfolio, the entire cash flow within the transaction will be applied to repay the senior bonds and pay the coupon.

The junior tranche, which is amortized after the full repayment of the senior and mezzanine tranches, is characterized by a floating yield depending on the current difference between the mandatory payments under the transaction, including coupon payments on the senior tranches, and the average interest rate on the collateral portfolio. Floating yield is usually higher than the yield on senior debt, which partially compensates for the increased risk.

Thus, the general credit enhancement for class A bonds is ensured at the expense of class B and C tranches; additional credit enhancement for bonds is provided by the special purpose reserve fund (SPRF) created at the time of issue. During the life of the transaction, the SPRF is one of the main sources of liquidity to compensate for the short-term insufficiency of interest income required to make payments on bonds and pay for the services of the issuer’s counterparties. Additionally, the reserve can serve as a source of funds to repay the par value of the bonds and compensate for losses on the collateral portfolio at the bonds’ maturity. If there is no need to use the SPRF, it can be amortized in proportion to the repayment of bonds, thereby providing replenishment of the interest flow of payments and generating additional yield on the junior tranche of bonds.

An important role in the assessment of the transaction was played by a relatively high level of excess yield resulting from the significant difference between the weighted average interest rate on the asset portfolio and the coupon rate on the rated bonds. In addition to the yield on the junior class bonds, the excess yield acts as a buffer to compensate for current defaults in the portfolio, providing additional protection for senior and mezzanine investors.

The final structure of the issue, which made it possible to assign the highest credit rating to the senior class bonds in the transaction, is shown in Table 1.

Table 1. MBS issue structure

* Reserve of short-term liquidity support that is also used to cover losses on the principal debt on the bond due date.
** % of the par value of class A bonds.
*** Total credit enhancement offered by the structuring party may exceed the support sufficient to achieve AAA(ru.sf) assigned by ACRA.
(а) Floating coupon rate paid out of excess spread (if any).

The three-tranche structure can potentially contribute to unloading the originator’s capital. The sale of the mezzanine tranche in full or partial sale of bonds of the mezzanine and junior tranches to qualified investors, on the one hand, leads to a reduction in the positions held by the originator. On the other hand, theoretically, this makes it possible to deconsolidate the issuer’s balance sheet, as well as the balance of the banking group, since the originator ceases to be the sole holder of the risk of the securitized portfolio. In addition, it is possible to assign a rating to subordinated tranches, which in turn will create additional issuance opportunities.

BENEFITS OF THREE-TRANCHE STRUCTURE FOR ORIGINATORS

Summarizing the outlined specifics of the transaction, we note the following reasons why the three-tranche structure of securitization transactions may be of interest to many originators of mortgage and other retail loans, as well as banks specializing in lending to SMEs and leasing:

• Reduction of the percentage of junior debt held by the originator, which means reducing the main risk position in the transaction. For example, in the structure of the issue of LLC “MA Titan 5”, an almost twofold reduction in the size of class B bonds was achieved¹;

• More efficient distribution of the credit risk of the collateral portfolio among lenders;

• Greater flexibility in determining the structure of tranches depending on the interests and risk appetite of anchor investors;

• The possibility of reducing the pressure on the originator’s capital by deconsolidating the issuer's balance sheet from the balance sheet of the originator’s banking group.

ACRA believes that the above advantages can contribute to the popularity of the three-tranche structure as such, as well as classic securitization in general.

¹ As part of the analyzed transaction, the originator bank represented by JSC HFB, during the placement, redeemed the class B bonds to its balance sheet, accounting for 9.5% of the total issue volume. In a two-tranche structure, the bank would have to hold a junior bond class of about 19% of the portfolio. Thus, the three-tranche structure makes it possible to achieve significant savings for the originator, increasing the economic efficiency of the transaction.