Last week, Deutsche Postbank AG issued an early redemption notice for its synthetic RMBS deal, Provide Domicile 2003-1. This constitutes the first Basel II regulatory call in the synthetic German RMBS market. The Postbank decision is likely to be followed by a wave of early calls for most German synthetic bank securitizations structured with regulatory call language, market sources said.
Regulatory calls generally relate to the implementation of the new Basel Accord. Such calls have been structured into RMBS in order to provide bank lenders with the option to redeem all or some of the outstanding notes (depending on the terms of deal) should the new capital accord affect the economics of securitization, taking into account the cost of funding and capital utilization. In the case of German RMBS, many of the structures are synthetic, and typically the motivation for doing these deals is regulatory capital management.
Under Basel II, the effectiveness of securitization as a capital hedging exercise is diluted substantially, providing a very strong incentive for issuers to exercise their regulatory calls, Deutsche Bank analysts said. All of these deals contain regulatory call options, and given the language used, it is likely that all of these deals may be called, should the issuer choose to do so, said Chris Greener, director and ABS senior credit research analyst at Societe Generale.
Postbank said it exercised its option to redeem the notes early following the occurrence of a "regulatory event" or its implementation of the Basel II capital accord provisions - resulting in a less favorable capital adequacy treatment with respect to the assets securitized compared, at least, with the closing date.
"However, [Postbank's] exercise appears a little disingenuous to us, given that the Basel II rules have changed little when compared to the draft in place when the transactions were launched," Greener said. "Spreads have tightened significantly since most deals were launched, while the risk weight for holding seasoned, performing, low-LTV loans has also declined significantly. Therefore, the call option is likely to prove attractive for sponsors."
Insufficient
collateral
All signs point to Postbank wanting to close this deal as quickly as possible, although there is insufficient collateral to redeem the class D notes (Baa2'/'BBB'/'BBB'), and consequently, redemption of this class will be deferred. Postbank almost managed to call the deal without deferred redemption, but in the latest reporting schedule overdue reference claims stood at 23.6 million ($30.9 million) - including 16.1 million of credit events - and are thereby in excess of the outstanding threshold amount of 15.5 million junior swap in the transaction. "This is why the deferred redemption was exercised for the class D notes (Baa2/BBB/BBB) in the transaction," said Viktor Milev, ratings analyst of structured finance ratings at Standard & Poor's. "However, given the size of the first loss piece, the mortgage collateral, and the characteristics of the portfolio, there is no concern from a rating perspective."
Banks securitizing residential mortgages are currently required to hold capital on a dollar-for-dollar basis against any retained first loss equity, provided there is no interest subparticipation mechanism in place. In such structures, the implementation of Basel II will at, the very worst, be neutral for these banks. In case of interest subparticipation mechanisms in place - which is the case in most German RMBS transactions - the implementation of Basel II will have a negative impact for the originating banks.
In most cases, redeeming the deals will be pretty straightforward. In the event that overdue reference claims are greater than the first loss coverage, only such classes of notes can be redeemed in full which are not affected by the overdue reference claims. Classes which are affected will be subject to deferred redemption. Typically, this affects only the bottom notes in the capital structure and these are the notes that then remain partially outstanding.
According to Milev, in some transactions, the period for which the notes remain outstanding can be limited to two years; if after the two years there are still overdue reference claims outstanding, a loss estimate would need to be conducted. The terms and conditions of the notes remain intact during the period of the deferred redemption.
The German RMBS market has seen some cleanup calls already - Postbank is the first for 2007 and also the first for a pure regulatory reason, Milev said.
"It is likely that we will see more of these as more banks move to Basel II status," he said. "The procedure upon a potential call becomes a mathematical exercise. Given the current enhancement levels in the transactions we anticipate deferred redemptions rather than redemptions in full, if calls were to be exercised.
"From a rating perspective, however, there are no major concerns," Milev said. "In our surveillance of RMBS transaction we constantly update the expected foreclosure frequency and loss severity at the various rating levels and thus determine whether the available enhancement levels are sufficient to warrant the ratings of the notes."
Outside Germany
Outside of the German market, RMBS issuers have included the call option in their deals, including Dutch and U.K. RMBS transactions, now that Basel II is in place, or else these issuers will be applying it at some specified point in the future.
"However, in our dialogue with these issuers when the final Basel II rules appeared, the sponsors implied they had little intention to make use of these call options," SG's Greener said. "Given that the synthetic deals are more likely to be redeemed, it will be difficult for them to trade above par, hence reducing liquidity. However, in the broader market we expect little contagion, as Basel II call options were only present in a small proportion of transactions, and removed from more recent deals."
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