As the market for first loss in mortgage equity transactions heats up on the public front via some recent U.K. deals, so has the interest among buyers and sellers on private offerings.

Behind this growth are banks that are turning to securitization for regulatory capital relief, or risk being penalized for keeping the first loss piece on balance sheet, said Giuliano Giovanetti, head of sales and market development at PMI Europe.

Although the IAS 39 scenario (ASR, 10/24/05) is still unclear, lenders could find themselves obliged by the regulator in certain jurisdictions to reconsolidate the entire portfolio on their balance sheet if the first loss is retained, and sometimes penalty charges can exceed the size of the first loss piece held by these banks. But growth in this segment of the market also coincides with more banks looking for a return on equity. "Banks used to focus on having larger balance sheets which meant they kept all loans in the portfolio but that thinking has changed," Giovanetti said.

Investor opportunities

On the buyside, Giovanetti said that while there has been increased competition in the market, the numbers still remain limited. He estimated that, currently, only less than 10 market players would buy a first loss piece. From a lender's perspective, it is actually better to have a concentrated number of buyers because the amount of due diligence work required in a first loss piece transaction is much more than on senior tranches. Also, some sellers are unwilling to disclose all the information needed to invest in first loss risk, which includes performance data and detailed process descriptions.

PMI has been particularly active in this segment of the market since its inception. Giovanetti said that in Germany, where PMI has been one of the more active buyers, it's been largely synthetic deals that the insurer has worked on. Synthetic deals work well for covered bond issuers, a prevalent and well-established market segment in Germany. In other markets where securitization is the more common funding option, there are more cash deals of first loss packages.

From a buyer's perspective, there are completely different risk profiles that must be considered in both structures. "In synthetic structures, all you really have to look at is the credit risk but on cash deals you also have to consider excess spread, prepayment risk and liquidity risk," Giovanetti said. In cash deals, the protection seller buys a bond that traps the residual income from the loan portfolio, after paying expenses and other senior noteholders. For synthetic deals, the originator transfers only the risk to the protection seller. This structure is typically executed as a guaranty/credit default swap where the protection seller gets a fee and pays losses when due. It can also be structured as credit linked notes, where the protection seller buys a note and losses decrease the value of that note, which is then bought back by the originator at the transaction's maturity.

There is a need for both solutions. Over the years, Giovanetti said that the market has grown pretty wide with a number of deals coming from different sources. But most of the deals are still done privately and very rarely is there any public disclosure.

However, in the U.K., mortgage lenders are warming up to the idea of executing these deals publicly. Last year, Northern Rock issued its first publicly placed securitization of a first loss piece via its Whinstone vehicle (ASR, 10/17/05). The U.K. bank is back in action again this month, marketing an additional GBP168.5 million pound ($316.5 million) bond to reduce balance-sheet risks via another synthetic securitization. Guidance for the three-tranche transaction was offered at 275 basis points over the three-month Euribor; pricing is expected by the end of last week. Barclays Capital and Lehman Brothers are lead managers for the deal.

And last week, Britannia Building Society announced its debut transaction referencing the residual cashflows from the Leek series 10 to 17 transactions. The synthetic transaction, Dovedale Finance 1 offers GBP103 million of notes in euro and sterling denominations, including GBP13.3 million of single-A notes, GBP36.7 million of triple-B notes and GBP53.3 million of double-B rated notes with 2.2-year, 3.3-year and 4.6-year average lives, respectively. The transaction is structured with an initial threshold amount of GBP30.0 million, providing credit enhancement for noteholders. It is the first deal of this kind for the U.K. non-conforming sector.

Standard & Poor's said last week that it placed on CreditWatch with positive implications its ratings on the subordinate classes issued by Leek Finance Number 10 PLC, Leek Finance Number 11 PLC, Leek Finance Number 12 PLC, and Leek Finance Number 14 PLC. But Kate Livesey, a senior analyst on the Dovetail transaction at S&P, said that a possible upgrade of these notes would have no effect on the first loss piece transaction.

Interest in the sector

Giovanetti said that there is definitely a growing interest from banks and investors. At a recent European Securitization Forum gathering in London, a panel discussion of first loss securitization was well attended. Furthermore, at the ESF's Venice industry conference held earlier this year, a panel on the subject was added to the conference agenda at the last minute. Close to 100 people attended even though it was held on the last day. "I think that with the current environment where spreads are tight, many players are looking down the credit curve for wider spreads," he said. "These transactions are becoming more mature."

Despite this growing interest, Giovanetti does not foresee a secondary market for this paper. "There is a lot of analytics that go into pricing a first loss piece - it's still very much artisan work," he said. "And all of these non disclosure agreements might not allow for secondary trading. Also, maturities are short and, depending on the structures, most of the reward can be concentrated in the early periods."

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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