STS Criterion 3. Eligibility criteria no active portfolio management

Description

Eligibility criteria, no active portfolio management

Content

The underlying exposures should at all times be subject to predetermined, clear and well documented criteria determining their eligibility for protection under the credit protection agreement establishing the synthetic securitisation.

After the closing date the securitisation should not be characterised by an active portfolio management on a discretionary basis including the sale of exposures being protected under the credit protection agreement. The following should in principle not be considered an active portfolio management:

• Substitution of exposures that are in breach of representations and warranties
• Where the securitisation includes a replenishment period, the addition of exposures that meet clearly defined replenishment conditions.

In any case, any exposure added to the securitisation after the closing should meet eligibility criteria that are no less strict than those applied in the initial selection of underlying exposures at the closing date.

An underlying exposure may only be removed from the securitisation where it:

* has been repaid or otherwise matured;
* the underlying exposure is subject to a refinancing, restructuring or similar amendment that is not credit driven, and which occurs in the ordinary course of servicing such exposure (such as, for example, maturity extension);
* where due to an error the underlying exposures did not meet the eligibility criteria at the time it was included in the securitisation.

Rationale

Eligibility criteria are essential safeguards in synthetic securitisation transactions as they determine the validity of the credit protection purchased by the protection buyer. Protection buyers and protection sellers should be in a position to identify in a clear and consistent fashion under which criteria exposures are selected to be securitised. The selection should not be an opaque process. Legal clarity over the eligibility for credit protection reduces legal risk.

To enhance legal certainty, additional criteria have been added to limit the conditions under which an underlying exposure may be removed from the securitisation, once it has entered the securitisation under the clearly defined eligibility criteria.

Active portfolio management adds a layer of complexity and increases the likelihood of cherry picking practices occurring, which may undermine the effectiveness of credit protection and hence, increase the risk of the securitisation positions retained by the protection buyer. Active management is deemed to arise whenever the manager of the portfolio sells one or more exposures that were initially included in the securitisation. Replenishment practices and practices of substitution for non-compliant exposures in the transaction due to previous errors in the selection of exposures should not be considered active management of a transaction’s portfolio provided that they do not result in any form of cherry-picking.

Replenishment periods and other structural mechanisms resulting in the inclusion of exposures into the securitisation after the closing of the transaction may introduce the risk that exposures of lesser quality could be added to the pool of exposures protected under the credit protection agreement. For this reason, it is important to ensure that any exposure added to the securitisation after the closing meets eligibility criteria that are similar to, and not weaker than those used to structure the initial pool of the securitisation.