Crisis-proof Russian ABS looks to the future

Russian ABS has done well since the onset of the financial crisis, giving increased comfort to investors and rating agencies alike, who have seen structures successfully tested in courts. The underlying asset performance has also been exemplary with some RMBS deals performing better than transactions from the UK or Netherlands. 

And the decade-old legal framework has gradually evolved and improved. Though it hasn’t been properly tested, there is good evidence from the neighbouring country of Kazakhstan, which has a similar legal environment to Russia, showing the law is robust. But political risk remains a concern where mortgages are concerned.

Though consumer and mortgage lending is growing at a fast pace, it is coming from a low base. House price inflation, though high, has likewise come from a low level. And, since mortgage penetration is low compared to western Europe, Russian originators can exercise a high degree of discrimination and select only the most creditworthy borrowers.

The domestic investor base is vibrant with strong growth in the private sector, but demand is crucially still dependent on state support. International investors could play a key role, but prefer to buy US dollar or euro denominated assets. 

Internationally targeted deals will therefore need to be structured with cross-currency swaps, the provision of which is expensive and difficult to find. But investors are flexible and do not rule out cheaper currency hedging alternatives.

Andrey Suchkov, head of securitization, VTB Capital

Boris Grinberg, portfolio manager, BTG Pactual GEMM 

Francisco Paez, head of CMBS, Metlife 

Lynn Maxwell, managing director, HSBC

Mark Escott, head of securitization, Bank of Tokyo Mitsubishi UFJ

Olga Gekht, vice president, Moody’s Investor Services

Vladimir Dragunov, partner, Baker & McKenzie

EUROWEEK: Andrey, what are the key macro trends in the Russian market?

Andrey Suchkov, VTB Capital: Last year Russian GDP growth was 3.4% driven by domestic consumer demand, which was spurred by real income growth and the historically low rate of unemployment of 5%. Average Russian house prices rose 12% in 2012 but the inflation rate was 6.6% so we saw real growth in house prices. At current levels, house prices exceed the pre-crisis peak of 2008. Most experts anticipate nominal growth in house prices of about 10% this year.

Delinquency rates are declining with mortgage arrears over 30 days down from 4% in the year-end of 2011 to 2.5% in 2012 and the rate is still decreasing. The Russian Agency for Housing Mortgage Lending (AHML) forecast mortgage delinquencies will not exceed 2% this year. Mortgage penetration in Russia is still very low with outstanding mortgage debt at just 3.2% of GDP, which compares to 80% in the UK and 70% in the US.This means there is a huge potential for product growth.

Growth in consumer lending rose 40% last year and was up 44% in residential mortgage lending. We also saw an exceptional boom in unsecured consumer lending, with credit card debt increasing by more than 80% in 2012.This provoked concern at the Central Bank which has since implemented stricter risk controls and higher capital charges for unsecured loans. This year we expect both retail and mortgage lending growth to slow to around 25%. 

Most Russian mortgage loans are long-term, fixed rate, rouble-denominated and are funded with deposits that are short-term in nature. This means local banks are exposed to a high degree of interest rate and liquidity risk. This explains why the development of the securitization market and a secondary mortgage market is considered important. The priority role of capital markets, as a source of wholesale mortgage funding, was confirmed in the latest government strategy document which said that half of all housing mortgage loans should be funded with mortgage securities, such as RMBS and covered bonds, by 2015.

 

EUROWEEK: From a rating agency perspective, how sustainable is the lending growth and what’s your view on the trend in non-performing loans?

Olga Gekht, Moody’s: The non-performing mortgage loan trend has stabilised since the crisis at the end of 2008/2009 due to strong economic conditions and falling rates of unemployment.

There have been no significant RMBS losses, though that needs to be also viewed in the context of the fact that originators repurchase non-performing loans from the RMBS collateral pool. So we take this into account in our analysis.

But repurchases have been between 1%- 2% of original portfolio balance so, even taking that into account, performance has been quite stable and comparable to the better performing regions of Europe such as the UK or the Netherlands. Russian mortgages have performed significantly better than Europe’s peripheral regions in terms of the delinquency rates even if repurchases are taken into account.

Our outlook for Russia is currently stable, which is one of the few stable outlooks that we have for RMBS markets. One reason for that is that underwriting criteria have become tighter compared to before the crisis, as originators have in many cases learned some lessons from the crisis. 

Since the penetration of mortgage lending in Russia is small, underwriters can afford to be selective in who they grant mortgages to. However, lending is growing at a fast pace so we need to remain vigilant on underwriting criteria.

We have seen less experienced lenders enter the market due to the growth in funding opportunities and we are looking at these entities very carefully to make ensure they have the necessary knowledge and resources to perform responsible underwriting. 

This means that for every transaction from a different originator we would perform due diligence by visiting the lender and reviewing their underwriting criteria, as well as taking into account their mortgage servicing capabilities. 

EUROWEEK: Does house price inflation of 12% give cause for concern? Is it sustainable?

Gekht, Moody’s: House prices are growing from a very low base. Though it is reasonable to expect a dip in case of an economic downturn, currently we are in a stable economic environment and house prices are expected to continue rising in line with the trend. However, we incorporate a possibility of house price decline during an economic downturn into our analysis by assuming house price stresses based on historical volatility. 

EUROWEEK: Vladimir, how has the legal framework in Russia developed over recent years?

Vladimir Dragunov, Baker & McKenzie: The legal framework in Russia has been constantly developing and improving over the recent years with quite a number of laws being approved in areas dealing with mortgages and securitization. Specifically, we have the mortgage backed securities law which has been in operation for almost 10 years and we have seen quite a few deals issued under this law. Most of the transactions have been driven by the government programme run by AHML and Vnesheconombank. 

EUROWEEK: To what extent has the law been tested? 

Dragunov, Baker & McKenzie: Securitization structures haven’t been properly tested but that’s also true of a lot of other countries where securitization takes place. 

However, there have been a lot of cases in courts dealing with various issues affecting securitization. For example, dealing with the assignment of receivables; disclosing of bank secrecy and data protection in the context of the assignment of the receivables; dealing with insolvency of companies and enforcing security rights. There’s generally been a lot of progress in these areas.

We have seen evidence that enforcement of collateral has really worked. There’s been quite a number of cases where people have not paid their mortgage and have been evicted from their houses. 

The mortgage market has also developed and it is now straightforward for borrowers to apply for a mortgage without having to pay substantial fees or bank commissions. 

EUROWEEK: Mark do you agree with Vladimir that there’s been progress?

Mark Escott, Bank of Tokyo-Mitsubishi UFJ: We don’t really work on the mortgage backed side [of the market] but we have seen some legal developments in the Russian market. There have been some issues with respect to legal assignment that Vladimir mentioned which we investigated as part of our due diligence for investment, and we were satisfied with the way that they were handled in Russia. Russia does require a little bit more work than some other jurisdictions. But as Vladimir says, whilst the law has not been tested this is also the case in some other jurisdictions.

Boris Grinberg, BGTPactual: We’ve read all the laws and see that as an investor we have good protection and our protection exists for all securitization deals. However our main concern is that the laws haven’t been tested. We are concerned that, when it comes to large and systemically important institutions, our ability to come in and enforce, by trying to take possession of mortgage collateral, may be limited. That’s not just the case in Russia but for other emerging markets as well.

EUROWEEK: What is driving these concerns?

Grinberg, BGTPactual: We’ve seen deals across Europe where there have been political challenges and political interventions, such as a moratorium on foreclosures in Ireland and some challenges in Italy and other countries. These actions are designed to protect the consumer as opposed to the debt holder.

But in emerging markets such risks are on a different scale. The political challenge will probably be more complicated than in developed countries. Something may come up or could happen, but we haven’t seen anything yet.

HSBC, Lynn Maxwell: Political risk, or reputational, risk regarding ABS investments seems to come forward more in the context of mortgage securitization than any other asset class. That’s largely because of the social policy behind households owning their homes. 

With other asset classes such as consumer loans and auto loans, there is no hard political element to them. Regarding the development of an international Russian mortgage securitization market, political risk continues to be a concern. It’s a case of gaining confidence that certain events would happen should enforcement have to occur on mortgages.

Dragunov, Baker & McKenzie: Russian mortgage deals performed well during the crisis, unlike some other markets.We’ve seen mortgage enforcements and evictions so Russia is definitely on the right track.

EUROWEEK: Has your view on Russian ABS changed?

Escott, MUFJ: Because we’ve seen some test to the structures my view is more positive post-crisis than it was pre-crisis. As we went through the financial crisis some of the structures that were in place during that period proved to be robust and worked as they should. In one case an auto transaction breached a delinquency trigger, the deal went into early amortisation and the entire transaction was repaid including all the subordinated notes. This is one example of a deal that did ‘what it said on the tin’.

Grinberg, BGTPactual: Russia has definitely been one of the better performing markets and some deals have performed better than Dutch or UK deals. That’s what we like about Russia. And if you look at how deals are expected to perform it is definitely one of the more appealing factors for us when we look at where to invest our capital.

EUROWEEK: Since the performance has been so good, I assume that domestic investors have been keen to get involved? 

Suchkov, VTB Capital: The Russian domestic RMBS market is still at an initial stage of development and the formation of the domestic investor base is a key element to its progress. The government plays a crucial role by providing funding for RMBS purchases via its development corporations, such as Vnesheconombank (VEB) and the AHML.VEB, as the government’s management company, channels state pension fund savings into purchasing RMBS.

AHML launched its first RMBS purchase programme three years ago. Since then, four similar programmes of Rb20bn each were executed. Within these programmes, AHML has the option to buy RMBS from participating banks at a fixed price. The programmes were quite successful and were always oversubscribed, so now they occur on a regular basis.

There’s also been a shift in AHML’s policy from refinancing individual mortgages to purchasing RMBS with the ultimate purpose of supporting the establishment of a national RMBS market — with private investors. 

EUROWEEK: To what extent can local pension funds invest in mortgage backed securities? 

Suchkov, VTB Capital: VEB is a manager for State Pension Fund savings. VEB can invest up to 20% of pension assets under management in mortgage backed securities. Private pension funds, according to the government regulations, can invest up to 40% in domestic RMBS.

EUROWEEK: How has the private pension industry developed?

Suchkov, VTB Capital: Last year growth of non-government pension fund savings was 70%. But not all of them include RMBS in their investment mandates. The state depositary insurance agency is another source of long-term money. Insurance companies also have a right to invest their resources in RMBS. And banks can provide additional investment opportunity, though they need to consider risk requirements and capital charges set by the central bank. We hope that the central bank will become more flexible in defining the risk weighting of RMBS in the new securitization framework.

EUROWEEK: Can local demand fulfil supply?

Suchkov, VTB Capital: Conservative estimates suggest that existing investment potential is sufficient to cover more than one half of primary mortgage origination which coincides with the government’s target strategy. But further government support is needed because it will take time for Russian private investors to get practical experience and get a better feeling of the risks. But I have no doubt that the share of private investors will grow significantly in the coming years. 

EUROWEEK: How about foreign investors?

Suchkov, VTB Capital: We are definitely interested in advising foreign investors. Historically, Russian RMBS deals were cross-border. The stable performance of the Russian RMBS market provides a strong background for returning to international markets.

EUROWEEK: What do recent euro/rouble placements and tell us about the scope for international placement? 

Suchkov, VTB Capital: More than 90% of Russian bank mortgages and consumer assets are rouble denominated, and rouble funding is a better match for Russian rouble bankers. Rouble denominated Eurobonds can provide a good opportunity for fundraising from international markets as compared with dollar issuance where you need a costly euro/rouble swap. 

EUROWEEK: What deals have been done and how did appetite shape up?

 Suchkov, VTB Capital: Recent experience shows there is a decent scale of investor appetite. From the start of this year there have been several successful euro/rouble transactions, both in Europe and the US. In January we saw the Rb20bn Gazprombank deal with strong demand from offshore US accounts. AHML printed a Rb15bn note in February, pricing tighter than where it was trading domestically. 

We have also seen deals from Novatek gas company and Vimpelcom. Strong demand for these bonds showed investors were ready to hold rouble exposure. But most of these issuers are either state owned, or well-known companies.

EUROWEEK: What about demand for ABS?

Suchkov, VTB Capital: Russian investment grade euro/rouble ABS will provide an attractive combination of yield and credit quality for both European and American investors. Russian rouble ABS should be quite familiar and simple in terms of structure, and viable in terms of risk and with respect to subordination and credit enhancement. What we are actually talking about is a AAA credit quality instrument with BBB sovereign cap. 

EUROWEEK: What is investor appetite like for rouble RMBS and ABS risk?

Escott, MUFJ: Our main focus would be for a prospective dollar or euro denominated ABS transaction as our ability to participate in any RMBS or in rouble ABS is very limited. 

Grinberg, BGTPactual: We don’t have appetite for rouble denominated ABS as we don’t have funds in rouble. We need to buy and hedge currency exposure and it is not simple, so we have not invested in Russian Domestic ABS.

EUROWEEK: Lynn, these two investors don’t have demand for rouble assets but is there demand elsewhere?

HSBC, Maxwell: This camp of investors is typical. We’ve canvassed a large group of European investors and they are pretty comfortable getting familiarised with the story around the performance of assets from Russia. However, the rouble element is a challenge because the majority of their funds, like the investors here, are in international currencies.

Grinberg, BGTPactual: We are investors in ABS and RMBS but for me to get into roubles requires a different level of expertise. It means I need to really understand the currency markets and how the rouble performs, and that introduces a slightly different perspective. It is almost as if we’re no longer investing in RMBS but investing into roubles. 

You can be right on the quality and performance of a particular RMBS bond but if the rouble significantly depreciates we can actually lose money on our investment. As such, our credit committee and management prefers us to invest in ABS/RMBS securities and limit our exposure to currency market fluctuations.

EUROWEEK: Does MetLife have interest in investing in rouble denominated ABS or RMBS? 

MetLife, Francisco Paez: With our insurance business in Russia, we focus on assets than can naturally match our liabilities, so they’re going to be rouble denominated. From that perspective, we have interest in developing new sectors and asset classes to help us achieve our investment targets. 

Globally, the majority of MetLife’s liabilities are dollar denominated, so a rouble-denominated transaction would be challenging. Having said that, we have a keen appetite to develop new asset classes within the securitised space.So if we can identify ways to structuring transactions out of Russia that could be efficiently swapped into US dollars, that would be something we would be interested in exploring.

EUROWEEK: So there is definitely interest for euro or dollar denominated assets, but less so for rouble assets. However, does that extend to private sector issuance as opposed to state-backed issuance? Are there systemically important private banks that you would target and how do you view bonds issued by non-agency issuers?

Escott, MUFJ:We wouldn’t exclude private banks but our interest would be very name-specific. Obviously, having some state ownership or state sponsorship does help, but our investment mandate is not completely exclusive to public issuers.

 

EUROWEEK: Francisco how do you view issuance from entities other than the state?

MetLife, Paez: We’re really focused on the quality of the sponsor — one that has a significant participation in the market, a strong financial standing and a good track record and experience in servicing and originating mortgages. We focus more on those factors than whether the sponsor is a public or private bank.

EUROWEEK: Boris, would you consider issuance from the private bank sector?

Grinberg, BGTPactual: Our view is very similar to that of Francisco’s. We would look at all the deals. We would look at the quality of the sponsor and their commitment to the market as well. It is the key for us when we look at investing.

EUROWEEK: What do you look at in a private bank issuer when you’re assessing whether to invest? To what extent do you look at origination standards, their balance sheet and so on? 

Grinberg, BGTPactual: First, we would look at the financial strength of the bank and its presence in the market. We’d look at the ratio of retail to wholesale funding. We take a two layered approach to the analysis. The first step is to ask our corporate/EM team to opine on the financial strength of the originating bank. And then the next layer would be for us to look at the mortgage and/or ABS origination. So we would need to get comfortable with the loan servicing and, if it is a private securitization, we would look at a structure that has a back-up servicer, just in case something goes wrong.

EUROWEEK: How do the funding needs of the second tier private banks compare to the three large state run banks? 

Suchkov, VTB Capital: We work closely with second tier banks which have a greater interest in coming to the market because they need to finance their assets. I think that the quality of paper can be high if the right structure is put in place. Deals would need a high rated back-up servicer, as was mentioned, as well as a cash manager and account bank.

And the subordination for investment grade bonds is not less than 20%, depending on average pool quality. Historically, international rating agencies had been very conservative, and though they have since eased up a little in light of the performance data that has been collected over the years, they remain very strict. 

So with this additional credit enhancement required by the rating agencies that second tier banks could be viewed as quite reliable originators for securitization business.

EUROWEEK: Andrey says that you’re conservative, but have got less so more recently? What sort of things are you looking for when you’re rating a second tier bank? 

Moody’s, Gekht: We are getting more comfortable with performance of the Russian mortgage market because we now have more historical information, including performance data through the crisis. In addition, as Vladimir mentioned, we have seen some cases of enforcement of the mortgage security in Russia. So our level of comfort, with regard to the potential performance of the mortgage market and the RMBS market in Russia, is improving.

As a result we have rated several transactions issued by lower rated banks. However, in transactions where there is a sub-investment grade rated servicer there are operational guidelines that need to be followed to achieve an investment grade rating, such as having a back-up servicer. Otherwise the rating may not reach an investment grade level.

We also pay special attention to the underwriting and servicing standards of the originator itself, as well as to the readiness of the back-up servicer to jump in and perform its role. So we need to assess whether they can accept the portfolio in a sufficiently quick amount time. Then we would check how that timeframe links to the liquidity available in the transaction. So during the transition period there would need to be sufficient liquidity to ensure no payment interruption and a steady performance of the deal.

That said, we have seen a lot of banks exchanging mortgage portfolios and taking responsibility for the mortgage servicing. In Russia, that is something that is done quite commonly and this has helped provide comfort that transitions of portfolios between different originators can be happen without disruption. 

 

EUROWEEK: What sort of entities are typically transferring mortgage portfolios?

Moody’s, Gekht: Whole loan trading in Russia is quite common and banks acquire mortgage portfolios on frequent basis. The transfer could be from a private bank to a state bank or private to private. AHML, for example, is a government agency which purchases mortgage portfolios and they have a network of servicers, which means they can transfer from one servicer to another seamlessly.

EUROWEEK: Are portfolio sales generally from smaller regional banks to the larger ones and then to state banks?

Moody’s, Gekht: Yes, in the majority of cases. However during the crisis there were portfolio sales in circumstances where the banks had encountered financial difficulties and had to be rescued or were forced to divest their mortgage portfolios. Transfers have also been done on a more stressful basis, rather than just regular purchases.

EUROWEEK: Lynn, putting your structuring hat on, when you speak to investors, what do they look for in trying to mitigate risk.

HSBC, Maxwell: The feedback we get from investors is that they want a straightforward, plain vanilla structure. This means having a sequential pay-down; perhaps a static pool to start off with, so no revolving period. If there is a revolving period then the replenishment criteria need to be strict. 

The back-up servicer is key and one that comes up fairly often, and that seems to be the case, notwithstanding whether that might be a private or a state owned bank. That’s just a desire to make sure that continuity is there, in case something were to happen. But those are the key features.

EUROWEEK: Can structure make a difference to pricing?

HSBC, Maxwell: The Russian securitization market is still in the early days of re-opening. There was an active market pre-crisis and there was a lot of knowledge around where Russian RMBS, consumer loans and auto loans used to price. But we’re now re-establishing new pricing levels, so it’s still quite difficult to say where differentiation will happen.

EUROWEEK: Boris do you see any relationships between pricing, structure and the various originators? 

Grinberg, BGTPactual: When it comes to structural features of a deal our demands are for static pools with regular features such as a backup servicer, liquidity provider, independent trustees, etc. However, the biggest challenge for new issue deals in Russia is pricing versus historical performance. Historical performance has been outstanding for most deals and, as such, Russian issuers expect pricing in line or not far from that of the developed markets. 

But then if you look at RMBS deals as part of the bank funding continuum, investors expect deals to price in line with the rest of the financial instruments of the same bank/institution, and that’s where the disconnect is.

When we look at secured versus unsecured funding pricing, Russian RMBS is likely to price wider than the unsecured risk. So when Russian banks look at that outcome, we understand that it is difficult to justify more complicated and expensive ABS funding. 

That is one of the reasons why Russian ABS market is so fragmented and opportunistic and it only makes it more difficult to develop RMBS liquidity. 

EUROWEEK: Has much work gone into exploring and structuring dual recourse instruments, such as covered bonds?

 Dragunov, Baker & McKenzie: We have worked on all the covered bond deals done in Russia so far but there have been a few of them compared to RMBS and ABS deals. We discussed the features that the investors like to see in the RMBS/ABS but I would probably add two things. One is having some form of recourse back to the originator so investors don’t just have recourse on the assets that they are financing, but also some form of recourse back to the originator. Effectively, this would combine securitization and covered bond technologies. We have seen some structures where this recourse is provided.

And the second thing is the level and frequency of information being given to the investors. Lynn made a very good point about having a static pool compared a revolving structure, where you need to make sure that the quality of the assets that are being replenished is high. Then you need to make sure that the structure allows you to monitor these assets to ensure that the quality of the pool continues to be as high as it was from the deal’s inception. 

EUROWEEK: Francisco, what’s your perspective on RMBS?

 MetLife, Paez: We haven’t bought Russian RMBS in the past, but we’re starting to explore the sector. We have bought securitizations from other emerging markets, and there’s no reason why we wouldn’t do the same thing here, subject to the considerations other participants have expressed.

Dragunov, Baker & McKenzie: Yes, but the vast majority of the recent mortgage deals have been domestic rouble denominated and this is one of the main reasons investors aren’t really coming so far. If they were dollar denominated then it would have been a different case.

EUROWEEK: We’ve talked about there being a very low penetration rate; a high employment rate; rising house prices and structures that seem to be relatively strong. There are concerns about the political backdrop. Where do see you the big risks when investing in Russian RMBS?

MetLife, Paez: The legal framework is relatively new and hasn’t been fully tested. So that is something that we would need to spend some time getting comfortable with. To some degree, the low mortgage penetration that we see in the market is not uncommon for emerging markets. The question is how that mortgage penetration evolves. Is lending evolving through customers that are currently banked or is that penetration coming from customers that are new to the banking system? That can make a significant difference.

For example, in Mexico, there has been a very successful RMBS market from participants that were lending to customers that were already banked. That outcome was very different from banks that started lending to customers that hadn’t previously participated in the banking system.

EUROWEEK: We’ve heard from Olga that there’s already quite a vibrant whole loan sales market in Russia. Presumably loans have been made at a regional level by local banks that knew their customers, and then the loan was transferred. Could that present a problem for you? 

MetLife, Paez: Not necessarily, we would have to be comfortable with the ultimate servicer of these loans.

EUROWEEK: How important is it for you to see domestic investors sit alongside international investors? 

HSBC, Maxwell: It’s difficult to mix the two because of the structure of the international issuance versus the structure of the domestic issuance. A domestic buyer will be buying a purely Russian securitization; the international buyer will want the assets to be held in an international SPV based in, say, Luxembourg. And they’ll want the notes to look like typical European bonds. So mixing the two won’t easily fit. 

EUROWEEK: Do you think that having a strong, vibrant domestic investor base helps breed confidence for international investors?

Grinberg, BGTPactual: We would love to see domestic investors invest in their own market. We sit in London, Portugal or in US so what do we really know about what is going on on the ground? We would love to see domestic investors’ participate in dollar denominated deals.

EUROWEEK: In Europe, we see a lot of transactions now which are on the cusp of investment grade. The AAA rating isn’t what it used to be. What’s your view to the rating these days, where do you draw the line?

MetLife, Paez: There are a number of components leading to a rating.I think Andrey was alluding to this — you can see transactions out of Russia that have a structure that’s consistent with an AAA, but because of the sovereign ceiling it is capped. 

We’d first look at the strength of the structure, and we’re going to want to feel comfortable that it can successfully perform at the implicit AAA level.

In terms of the sovereign component, if I’m comfortable with the jurisdiction, I will find a transaction that has an adequate structure for the sovereign rating.From that perspective, we will have to evaluate which portfolio an investment will ultimately go to and what the implications are from a capital standpoint that are related to the rating.

EUROWEEK: So presumably residential mortgages attract a low capital charge but maybe the jurisdiction changes that?

MetLife, Paez: Yes, exactly. For a US asset-backed security, the capital treatment today is based on NAIC guidelines, which means it would be ratings-based.

EUROWEEK: Mark do you need to have an investment grade rating?

Escott, MUFJ: Ratings are important, but we undertake our own analysis of the portfolio and the structure. We would look at the deal on a transactional basis, ignoring the potential sovereign interference, and come up with our own internal rating. If there was a rating in the transaction, then that would help our credit team but they wouldn’t rely on that.

EUROWEEK: Olga can you tell us about the sovereign ceiling and how structure can improve that rating?

Moody’s, Gekht: The local currency ceiling for the transactions in roubles is A1; and for the foreign currency transactions the foreign currency ceiling is A2.In addition, we look at the transaction specifically with regard to operational risk and we assess how linked the transaction is to the rating of the originator.

If the originator is also performing numerous other roles in a deal without operational risk mitigants the transaction may not be rated much above the originator’s rating. However, in the transactions where the originators are sub-investment grade, there is usually a robust operational risk structure with backup servicers, etc. For those transactions, single-B rated originators could potentially reach an investment grade rating in the lower Baa range.

There is also some linkage to the rating of originator due to uncertainties with regard to the legal environment related to the untested nature of true sale and the regional differences in the court judgments with regard to true sale risks. 

EUROWEEK: Vladimir, regarding true sale risk, in your experience is there any test or where confidence can be drawn from the last few years post-crisis? It seems this topic is a recurrent theme.

 Dragunov, Baker & McKenzie: The securitization structure as a whole hasn’t been properly tested because we have not really seen any defaults. But in Kazakhstan where we saw diversified payment rights securitizations, some of banks became insolvent and were restructured. The Kazak DPR transactions were all structured as true sale transactions and investors have not lost money in these deals. Quite a lot of investors lost money in other instruments but the DPR transactions all performed well and haven’t been successfully challenged.

I think we can arrive at the same level of comfort for Russian true sales because Russia and Kazakhstan are very similar in terms of legal environment. We have seen some sales of the portfolios being challenged in Russia on a number of grounds. Borrowers have challenged these transfers by arguing that an assignment of the loan could not be done to a non-banking institution, such as an SPV or a collection agency. They have argued that the sale breached bank secrecy laws or data protection rules, or resulted in some other abuse of rights.

So I would say we have seen portfolio sales being tested quite a number of times in the Russian courts and creditors’ rights have been upheld quite successfully. So I would argue that if you have a properly structured true sale, the risk of a successful challenge is remote.

EUROWEEK: How easy is it to structure a cross-currency swap? They’re quite difficult aren’t they?

HSBC, Maxwell: That’s putting it mildly. Yes, they’re very difficult on a balance guaranteed basis. There’s been talk of using a non-balance guaranteed approach which would be much easier as it is just a plain vanilla cross-currency swap.But what that does unfortunately mean is that the structure is less efficient because the rating agency assess the portfolio as not fully hedged. 

But staying with the more typical ABS style balance guaranteed cross-currency swap, the major amount of risk is around the portfolio prepayment rates changing from what was expected. The challenge is then how to manage the basis risk between rouble fixed/floating rate and dollar Libor, which is something that is actually not hedgeable. 

There’s not an option that you can buy in the market to hedge that risk and that is what creates the biggest difficulty for a balanced guarantee cross-currency hedge. Having said that, you can do them, but…

EUROWEEK: …they’re expensive?

HSBC, Maxwell: Yes, they’re expensive because of the inherent risks. And then there’s also rating agency swap counterparty criteria. In that context there are a number of banks that are uncomfortable with the transition that occurs if they are downgraded as it requires them to post liquidity collateral into the structure.

EUROWEEK: Boris, would you buy a deal with a non-balance guaranteed swap in it? 

Grinberg, BGTPactual: We have seen deals in the past where issuers come to us and say ‘would you look at a deal where the swap is not based on balance guarantee, but it would be based on some boundaries, sort of a minimum and a maximum?’.

That idea could work for us. We can look at the deal, study historical performance of that particular originator versus historical performance of the entire mortgage market, and can potentially get comfortable. But we expect to be compensated for assuming additional prepayment risk.

EUROWEEK: Francisco, what’s important for you when you look at a swap?

MetLife, Paez: There are two options. One is to buy a transaction that has a swap inside the transaction, i.e. the bond is already denominated in US dollars and we just buy that US dollar bond. This is certainly the simplest way of getting that asset on to our books. But once you go down that route, some of the issues that are raised by the other participants come into play, particularly the rating implications and the effect that can have on the transaction cost.

The second option is to structure a tranche that is more efficiently swappable into other currencies. As long as you have that type of structure in place, the cost of the swap shouldn’t be overly prohibitive. 

So long as it’s something that can be efficiently swapped into US dollars — and provided that after swapping into US dollars it provides reasonable relative value — that’s something we could consider.

EUROWEEK: Andrey, swap provision is quite a challenge. But on the investor side, there seems to be some acknowledgement of this and a degree of flexibility to look at different approaches. What is your approach to the provision of swaps?

Suchkov, VTB Capital: When arranging our post-crisis cross-border deals, we have to act on a reverse enquiry basis. In principle VTB Group is ready to provide the swap arrangement. But there are some peculiarities as usually investors want to have a higher rated international bank as the swap hedge counterparty for balance guaranteed swaps.

EUROWEEK: On the rating side, can you tell me about your approach to assessing the cross-currency swap? How important is the rating of the swap provider and how does that impact the transaction? 

Moody’s, Gekht: If there is no swap in the transaction, we would need to incorporate the foreign currency risk into the subordination, which would increase the size of credit enhancement and could be prohibitive for the efficiency of the transaction or might even affect the maximum achievable rating.

We recently published a request for comment with regard to the linkage framework between the rating of the swap counterparty and the ratings of the notes. This framework is particularly helpful in cases where the senior notes of a transaction are rated below Aaa, such as in Russia.

This request for comment outlines the framework for assessing the linkage between the ratings of the swap counterparty and the ratings of the notes depending on the type of the swap, the size of the swap, the size of the exposure, the collateral posting, as well as on the rating of the actual counterparty.

EUROWEEK: Andrey, what are your thoughts about covered bonds? 

Suchkov, VTB Capital: The Russian law on mortgage securities provides for two types of mortgage obligation. We have an obligation issued by an SPV for RMBS, and but there is also an obligation issued by the bank itself which is a covered bond. Russian housing mortgage covered bonds, in most characteristics, comply with the European standards in terms of bondholders’ rights, LTV requirements and in terms of monitoring the collateral.

The Russian covered bond law, which was modelled on the German Pfandbrief law, was put in place in 2007. However, there have been only eight Russian mortgage covered bond deals. One of the problems is down to the rating. 

For lower rated banks RMBS provides an opportunity to get a rating several notches higher than their corporate rating, but and for covered bonds the rating uplift is more questionable. And, by issuing a true sale RMBS, Russian banks benefit from capital relief under Russian accounting laws. 

But for top ranked banks with an investment grade rating, such as VTB24 and DeltaCredit, this instrument could be preferable.

EUROWEEK: And do you think there’s a possibility that in time these covered bonds might even be denominated in euros?

Suchkov, VTB Capital: In principle it’s possible, but we also face the problem of cross-currency swap provision.

EUROWEEK: Moving on to other forms of ABS and securitization, Mark, apart from auto ABS, would you consider other types of Russian securitizations. 

Escott, MUFJ: Yes, subject to doing due diligence on those assets and on the actual issuer, we would look at consumer loan ABS and trade receivables. We would probably need to do a lot of homework, but certainly we’re open to participating in those assets, rather than RMBS.

EUROWEEK: Boris, would you look at different asset classes? 

Grinberg, BGTPactual If we step back and look at the influx of the liquidity over the last couple of years, we’ve seen that yields across the world have tightened significantly. Then you look at the emerging markets and specifically Russian one, it is not as liquid as some other markets, but performance has been very good, despite some very volatile market conditions. We can view this market as an opportunity to find yield pick-up without sacrificing collateral quality versus other jurisdiction.

So from an investor’s perspective, Russia looks appealing. We’re willing to do the work, and we will look at various sectors of Russian ABS markets.

Dragunov, Baker & McKenzie: We see quite a lot of interest from the Russian originators to issue consumer loan deals, credit cards and auto loans. If you look at some of the consumer loan deals, the portfolios are generating yields over 50%, so there’s a lot Russian banks can offer to investors, in terms of the yield on their notes.

But one of the issues is that legislation in Russia is really only tailored towards the issuance of domestic RMBS and covered bonds. There’s no specific law to deal with securitization of other asset classes like consumer loans, credit cards and auto loans. 

We are currently working on a pioneering structure which combines international ABS and domestic RMBS features into a single structure. The aim is to bring the securitization of other asset classes in the form of a domestic bond, so this can be offered to domestic investors in roubles. 

I think we’ll be seeing more deals of this type over the next year or so.

And there’s also a push to pass the securitization law in Russia to deal with domestic securitization of assets other than mortgages, although the current environment actually allows you to structure such a deal with the use of an offshore SPV. 

But sometimes having a law is not always helpful, as we have seen in the past. For example, if you look at the Luxembourg securitization law, it’s a good law, but it’s only good for plain vanilla deals. If you’d like to do something more structured and more tailored, the law may not work. So it really limits you to the specific structures.

The Russian MBS law was passed in 2003 but the first deal issued under this law was only three years later. That shows you that the law wasn’t perfect and required some secondary legislation to be implemented. So sometimes I would argue it is better not to have detailed regulations in place because you could have greater flexibility.

Suchkov, VTB Capital: We see definite interest towards Russian auto ABS, and we’re absolutely ready to structure a Russian deal if there is such interest, especially for second tier banks. The auto ABS asset class is quite reliable, the risk weight is low and the origination is quite active. 

EUROWEEK: Francisco do you look at any other asset classes apart from RMBS?

MetLife, Paez: Yes. Very similar to what Boris was saying, to the extent that the fundamentals are solid and the relative value is compelling, we would welcome and be open to investing in other asset classes.

EUROWEEK: And finally Andrey can you tell me a little about the history of the Euroclear system?

Suchkov, VTB Capital: Earlier this year Euroclear and Clearstream established direct links with Russian central settlement depository (National Settlement Depository, NSD) and started direct settlement of Russian rouble denominated government debt.

Access to the corporate bond market, including RMBS, was supposed to be granted to the international clearing system in the first half of this year, but due to unresolved taxation and information disclosure issues, it was postponed. The Ministry of Finance of Russia is now working on an alternative option to resolve the taxation issues, and we hope a final decision will be made by the end of this year.

To my mind, Euroclear and Clearstream for the corporate debt market is an important technical issue. To the extent there is foreign investor appetite for Russian RMBS, Euroclear and Clearstream should facilitate demand.

EUROWEEK: How important is Euroclear for investors?

Grinberg, BGTPactual: Euroclear would probably provide an extra comfort. 

MetLife, Paez: Euroclear should help as the effort in opening the asset class internally would be made simpler. Otherwise, there would be an infrastructure effort that we would have to undertake and that would make the investment a little bit more complicated.

EUROWEEK: Vladimir what would be the tax position? 

 Dragunov, Baker & McKenzie: One of the things that Euroclear and the National Settlement Depository are now discussing is how exactly tax will be levied.But generally Russia has a large number of international double tax treaties providing with zero withholding tax. 

It’s possible some changes to the tax code could be made to allow some specific exemptions.

So I think we will be seeing developments over the next few months. I definitely think having the Russian RMBS and ABS instruments being Euroclearable would be helpful for international investors. Euroclear would facilitate interest, but then obviously you need to get comfort with the level of disclosure.

Just to give you an idea, the Russian RMBS prospectus can be 1,500 pages with disclosure on a loan-by-loan basis. So if you have 1,500 of mortgages in your pool this is attached to your prospectus. The level of disclosure is very different from what you would expect in an international RMBS prospectus. But I think there’s a move in Russia towards unifying and making the disclosure similar to what you see internationally. 

HSBC, Maxwell: I think that an international rating would be necessary as well. Based on the typical European ABS investor base, which is generally somewhere around 50%-70% banks, they need to have an international rating for the purposes of their capital calculations.

Dragunov, Baker & McKenzie: That should be fine. For the purposes of Russian Lombard List and the Basel regulations, which are been slowly implemented in Russia these days, only ratings from international agencies are so far recognised.

Moody’s, Gekht: The programmes which purchase RMBS in the domestic market refer specifically to the international rating, and the ratings that we assign usually in Russia are the global scale international ratings, rather than the national scale ratings.

Dragunov, Baker & McKenzie: Over the last year there was a big push to educate domestic investors about domestic RMBS and covered bonds and I think we had some success. The next step is to try and educate international investors, and obviously things like Euroclearable RMBS would help to gain acceptance.

We’ve actually produced a brochure on the domestic MBS law including a translation to English which was a first for Russia. So hopefully that will facilitate the educational process and understanding of the Russian MBS law and regulations.