German synthetics under threat

The German derivatives market has seen a big increase in the use of synthetic structured products in the past two years. But German regulators could derail the market if they adopt a new proposal relating to synthetics.

A report on the European securitisation market published last year by Deutsche Bank says true-sale securitisations have virtually disappeared from Germany since the introduction synthetics. “The decline in economic activity in Germany has spurred credit-related activity,” says Constantyn Nieuwenhuis, director of swaps and syndicated loans at Hamburgische Landesbank. “Banks are increasingly managing lumps of credit risk through asset-backed securities and collateralised debt obligation structures.”

Deutsche’s CAST 1999–1 E2.9 billion synthetic collateralised loan obligation in 1999 was one of the first major issues undertaken in the country. Kreditanstalt für Wiederaufbau’s (KfW) Provide residential mortgage-backed securities (RMBS) programme and the new Promise collateralised loan obligation programme have already provided many banks that lack securitisation knowledge with a framework to enter the market.

A number of recent innovative deals have seen smaller players enter the market. In February, KfW structured a synthetic collateralised loan obligation (CLO) for the medium-sized German building society BHW Bausparkasse, based in Hameln, involving the collateralisation of a portfolio of mortgages and building society savings. Hamburgische Landesbank is looking to develop synthetic credit products for the German shipping market. KfW also supported the growth of the CLO market in 2001 by helping small and medium-size enterprises to securitise their loan portfolios.

But one thing is threatening to dampen interest in the synthetic market. It is the possibility that the German regulators, the Bundesaufsichtsamt für Kreditwesen, will kill off a crucial component of many current synthetic deals, called the interest subparticipation. This enables specific noteholders, usually of the first-loss tranche, to offset any losses against interest earned from a defined portion of the reference loans over a defined period of time. A holder of the first-loss tranche, the first to be hit in the event of a default, will be compensated for losses in case of a credit event with interest set aside on the underlying portfolio.

Banks issuing the securities also benefit from the interest subparticipation through a kind of legal arbitrage. The interest subparticipation clause enables banks to lower the amount of regulatory capital required against the first-loss piece. The first-loss tranche is normally deducted on a one-to-one basis against a bank’s regulatory capital. However, selling the first-loss piece with an interest subparticipation clause enables the originating banks to reduce the amount of capital that needs to be set aside for the reference portfolio.

Moreover, under German regulations future income receivable is not a capitalised item. Hence any interest that is set aside for future payment against losses is exempt from regulatory capital requirements.

In January, Germany’s regulator issued a paper saying that it may change the current rules, and allow for certain conditions under which the interest subparticipation can be included in synthetic deals. However, since January there has been no more comment on this issue. This indecision is worrying industry practitioners. “Interest subparticipation is the thing that could potentially cause the market to stall temporarily. People are expecting existing deals to get grandfathered – so there is a rush on to complete deals,” says Commerzbank’s Barbour.

Analysts expect the regulators to make a decision on interest subparticipation in the next six months. Investors and issuers wait expectantly.
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