Jeffrey Warren and Jan Karpinski on the Bristol & West u150m securitisation
The UK mortgage market is becoming ever more competitive and sophisticated. In December 1994 an important milestone was passed when the Bristol & West building society became the first UK building society to undertake a public securitisation of part of its mortgage book.
The society's decision to securitise u150 million of its commercial mortgages secured on investment property continues a tradition of treasury-led innovation at the Bristol & West. It was one of the first societies to launch index-linked investment accounts (or guaranteed equity bonds as they have become known), business expansion schemes for properties in possession and hedged investment and mortgage products.
Securitisation is a process whereby a mortgage lender sells a portfolio of assets for cash funded by secured financing, thereby achieving off-balance sheet treatment. The principal advantage is a reduction in the level of capital required to support the mortgage assets, thereby freeing up capacity for further lending, and in the process generating a significant improvement in return on capital.
Bristol & West saw securitisation as a way of reinforcing its position in, and commitment to the commercial lending market while enhancing the profitability of this area of operation.
The structure adopted by the society was broadly as follows. The society entered into an agreement to sell u150 million of commercial mortgage assets to a specially formed company or 'special purpose vehicle' (SPV), known as Commercial Loans on Investment Properties Securitisation or CLIPS. Simultaneously, CLIPS issued an equivalent value of floating rate 25 year Euronotes secured on the mortgage assets. CLIPS also entered into an administration agreement with the society for the future administration of the mortgages – so borrowers would not, in practice, notice much difference.
Key features of any securitisation will be:
* The bankruptcy break: it is important that the future fortunes of the SPV and the original mortgage lender are entirely insulated from one another. Accordingly, the SPV will not be a subsidiary of the lender and its liabilities will not be guaranteed in any way by the lender;
* Credit enhancement: one of the main attractions for investors in the SPV's notes will be their credit rating. This is enhanced by having a hierarchy of notes enjoying different priorities in the event of a winding up, with the result that the majority of the notes in the securitisation have an AAA rating (although this also reflects the high quality of the society's commercial mortgage book);
* Credit rating: it follows that at least one credit rating agency is going to be closely involved – as a consequence the mortgage lender will have to submit to a process of due diligence in which its systems and procedures are rigorously audited.
Securitisation was used occasionally by central mortgage lenders in the late 1980s. It has been envisaged since about 1986 that building societies might one day wish to securitise and a considerable amount of regulatory thinking went into this possibility. A building society securitisation raises a number of issues which are peculiar to building societies – for example, what becomes of the borrower's membership rights? The significance of our securitisation of a portion of our commercial mortgage assets is that it demonstrates that all the particular technical difficulties in the way of a building society securitisation can be overcome, given adequate legal expertise, and that securitisation is a technique which could become significant in the UK mortgage market in the future.
One thing to be very clear about is that securitisation makes heavy demands on professional skills. An enormous amount of time was put in, not only by senior in-house professionals but also by the lead managers Goldman Sachs, accountants Arthur Andersen and by three firms of solicitors: Allen & Overy (for the society); Freshfields (for the lead managers) in England, and McCann Fitzgerald in Ireland.
On the legal side, the society spoke to several firms before instructing Allen & Overy. We chose Allen & Overy for three principal reasons: the competitive rate quoted; our previous dealings with the firm, particularly in relation to treasury matters (which gave us comfort that the job would be handled well); and the firm's previous experience and therefore expertise in the mortgage backed market.
People often ask how exactly internal and external lawyers work together. Each situation is a little bit different. I know that in other building societies, if a City firm is being instructed in a treasury transaction, the internal lawyers often have nothing whatsoever to do with it. In my view this is a mistake. First of all, it often takes another lawyer to ask the obvious but important questions such as “why are we doing it this way in the first place?” Second, internal legal expertise is vital to assess and take on board the advice which is being given externally. This is particularly important in a building society, where specialised areas of law may be involved and regulatory relationships are often critical. Thirdly, there will always be those little jobs that can only be done efficiently in-house.
For example, in the case of our securitisation one of the problems was working out the Data Protection Act implications. Because this was the first building society transaction of its kind, the Data Protection Registrar was very concerned to establish precedents and lay down guidelines. This was something best dealt with in-house, in view of the regulatory relationship involved.
Jeffrey Warren is finance director and Jan Karpinski senior legal adviser at the Bristol & West building society.