New regulations in Brazil are steering small and medium-sized bank originators toward building more, and bigger, mezzanine tranches into their securitizations, typically done through the receivable investment-fund (FIDC) vehicle.

Players see little choice outside this route for issuers wanting to grow their portfolios, as alternative sources cannot possibly pick up the slack. But, at the same time, a buy-side bottleneck could be looming as these riskier slices so far appeal only to rarefied tastes in Brazil.

Regulations Favor Mezzanine

The impetus for this comes from new regulations that went into effect Jan. 1. Brazil's Central Bank has determined that if a bank originator retains a percentage of an ABS deal that exceeds the portfolio's historical default rate plus two standard deviations, then the transfer of assets to the FIDC must be booked as a loan and not as an asset sale. That is, it becomes subject to on-balance-sheet treatment. Only financial institutions are subject to this rule, known as Resolution 3533.

A loan would not give the bank any capital relief as spelled out by the Basel accords, according to Patricia Bentes, an executive vice president at Banco Bracce, an investment shop targeting middle-market companies.

In addition, as Moody's Investors Service points out in a recent report, Brazil's Securities and Exchange Commission, the CVM, has passed regulations establishing risk transfer and retention rules for securitizations. "Although it stipulates that sponsor support will trigger reclassification of a securitization as an on-balance-sheet transaction, it does not prescribe any maximum amount for the equity tranches," the agency said.

The upshot of all this is that Brazilian banks looking for off-balance-sheet treatment via ABS now need to craft a retained equity tranche that is a much smaller share of the total transaction than the double-digit figure that has historically been the case, said Pedro Junqueira, a managing partner at securitization data provider Uqbar. But in order to do that and keep senior notes comfortably in the triple-A zone, subordination must come from elsewhere. Hence, the prediction of more and bigger mezzanine tranches earmarked for investors.

The originators most affected are small and midsize banks that over the last several years have been employing securitization as a routine financing source.

"Securitization is a huge part of their funding," said Fred Lima, portfolio manager at Anga Asset Management.

One pressing question is whether this forced shift in the optimal structure of deals will make the economics untenable.

"What's the price for keeping your capital level where it is and still booking profits while issuing portfolios?" Lima asked. "To find the balance is quite difficult, especially with investors being so aggressive."

End of DPGEs

But small and midsize banks looking to grow their portfolios may not have many options outside securitization. Many are bumping up against the mandated limits on a major source of funding in recent years - the issuance of special time deposits known by the acronym DPGEs.

Brazil's Central Bank introduced DPGEs following Lehman Brothers' collapse in order to ensure that the smaller banks would have a source of liquidity through the global financial crisis. "They were virtually triple-A paper with a wonderful rate of return, a huge spread against Treasury," said Bentes. "But the government is now winding down this program, and you can't replace [outstanding deals] with new paper."

As this funding source vanishes, banks will probably have to bite the bullet and keep using securitization. Indeed, players said that a flurry of bank ABS in the second half of last year could have been prompted by the combination of maxed-out DPGE issuance and the anticipation of the new regulations.

More standard corporate issuance is also difficult for the small to midsize banks, as large Brazilian corporates have been crowding them out. In the healthy economy, there is no dearth of companies hungry for capital to grow.

With Risk Comes Yield

While Moody's predicts that the new rules will not impact the quality of senior tranches in bank FIDCs, it expects that the larger mezzanine tranches in these deals will be riskier as well.

Their greater risk will stem from thinner subordination below them in the capital waterfall. Before this rule, an FIDC's mezzanine tranche would normally be relatively lean and hence would have enjoyed ample enhancement from a bulky equity piece, typically making up 20% to 35% of the total capital structure. Now equity pieces are unlikely to be larger than a single-digit percentage of the transaction. Moody's does not see other forms of enhancement offsetting this.

The agency similarly cautioned mid-last year that another regulation going into effect at the time would likely push up the risk of mezzanine tranches. That rule discourages issuers from supporting their FIDCs through asset buybacks and substitutions, something they had been doing and that had helped out the performance of mezzanine tranches.

As a result, investors will demand higher returns on this slice of the structure. In the words of Bentes from Banco Bracce: "They'd have to leave a lot of spread on the table."

But it remains an open question whether even fatter spreads will draw enough buy-siders to keep this market segment going.

There are Brazilian mezzanine investors out there, but they have been a minority within a minority. The volumes they've swallowed so far have been a tiny share of the total structured finance market.

"Banks have to find investors interested in buying the mezzanine - we don't have a market to do that in Brazil," said Jean-PierreCote Gil, a portfolio investor at Western Asset Management Co.

Western Asset holds senior and mezzanine risk in the form of shares issued off BMG FIDC IX. Originated by the prolific ABS issuer Banco BMG, the mezzanine tranche was initially an unusual 12% of the total transaction, with the equity tranche equal to 5%. What backs the deal are personal loans to retirees and pensioners of the National Institute of Social Security. Payments are automatically deducted from the social security disbursements, adding a level of security to the deal. The transaction amounts to R$602.4 million, with the mezzanine tranche worth up to R$72.3 million. Standard & Poor's rates the mezz 'brAA (sf)' on Brazil's national scale. Its yield is 676 basis points over the interbank deposit DI rate.

Yields on mezzanine pieces in Brazilian FIDCs typically run between 400 and 700 basis points over DI, depending on credit risk, asset class and originator.

Cote Gil said that when Western Asset snapped up the mezzanine shares in BMG FIDC IX, it already held senior tranches from other transactions backed by personal loans with automatically deducted payments, apart from being a seasoned investor of securitizations more generally. While the expected push toward bigger mezzanine pieces would be a new phenomenon, the structures that will carry them are a known quantity and can provide more yield than comparables, Cote Gil added.

"Some of the structures we're looking at have a better risk profile than whole corporate loans, and they provide a better return," he said.

Lima from Anga Asset Management has likewise invested at the mezzanine level. He sees the market as one of a select group of domestic asset managers who've already specialized in securitization, "the investors who are capable and educated enough to analyze the mezzanine tranche of different asset classes." Apart from payroll-deductible loans, small and midsize banks in Brazil originate such securitizable assets as auto loans and factoring receivables.

"In the short-term, you're getting better paid to hold incremental risk for an asymmetric yield," said Henrique Ferreira, who recently left his managing director position at boutique structurer Horus Finance to start his own firm. "What you'll be doing, from the institutional investor standpoint, is [saying], 'I'll take this risk I've been keeping track of for eight years, and I'll get more yield for it.'"

But this works only for those with deep experience in the sector.

The enormous pension funds that make up the bulk of Brazil's investment industry are unlikely to pay much attention to this new development in bank FIDCs, as, so far, they haven't been significant buyers of even senior tranches.

"I don't see pension funds as ready to do this," Lima added. He said they might show interest only once this new iteration of the mezzanine piece has a longer track record.

Tapping Foreigners

Players might have a better chance with foreign investors, though no one expected them to make much of a difference to the market.

For some time, issuers will have to rely on those local investors who have particular knowledge of ABS, Ferreira said. "It's just another share tranche of the same asset class they already know."

Yet it isn't unheard of for foreign investors to buy mezzanine risk in Brazilian FIDCs.

An apparent case in point is Eco-Multi Commodities FIDC Financeiros Agropecuarios, formerly known as Union National Agro + FIDC Financeiros Agropecuarios. Eco-Multi was issued in late 2007. The collateral basically consisted of CDCAs, which are certificates of agribusiness credits issued by corporates in this field, and other sorts of credit rights. Backing these, in turn, were rural products certificates, known as CPRs, and contracts, both of which pledge assets to the repayment of the CDCA and other obligations in the FIDC's collateral package.

Fitch Ratings and Standard & Poor's gave initial, national-scale ratings to the mezzanine piece of 'CCC(bra)' and 'brB (sf)', respectively. Foreign investors were said to have bought into this tranche, which had a volume of R$133 million at issuance, according to a few sources. The deal's collateral started to deteriorate in mid-2009. A number of lenders in the structure were having trouble exercising their claim over a borrower's assets whenever one became delinquent on its obligations. Essentially, the CPRs and other contracts did not provide the insurance that investors had thought they would, said a source close to the deal. He added that court proceedings to recover agricultural assets can be capricious and depend on each state's jurisprudence.

The upshot is that loss provisioning shrank the mezzanine piece, along with an equity tranche, to nothing by late November 2010. Fitch no longer rates the deal, while S&P now has the mezzanine at 'brCCp (sf) NRi', meaning that the rating applies only to the principal component and not the interest. The reason it is not rated 'D' is because there could be recoveries that would trickle down to payments for the mezzanine holders before the legal final maturity of December 2013. Chances are that this would be negligible at best.

If Eco-Multi is indeed foreign investors' only experience with mezzanine tranches in Brazil, then those some buysiders may be loath to come back. Some players, however, noted that the agribusiness asset class is very different from others and that this transaction in particular had an idiosyncratic structure.

Players point to the fact that there are mezzanine pieces that have performed well, arguing that the experience with Eco-Multi has not left a stain on this segment, which will be, after all, dominated by banks.

There is a risk particular to bank deals in Brazil that investors may want to watch out for, however.

Ferreira noted that the well-worn asset classes of payroll-deductible loans and auto loans - the two forms of collateral most tapped in securitizations by small to midsize banks - may face operational issues as some banks continue to grow their portfolios briskly, albeit at a slower pace than in recent years.

To be sure, over the past couple of years, rating agencies have warned that Brazilian banks looking to grow fast may have relaxed their underwriting standards. Ferreira added that this will not necessarily show up in transactions when the current loans are not part of the initial pool.

At the same time, however, there have been signs of less aggressive origination. This is the result of banks having a harder time obtaining financing as well as some consolidation in the industry.

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