The rating actions are as follows:

Tranche A, GBP 836m: assigned new rating AAA_SF

Tranche B, GBP 56m: assigned new rating AA_SF

Tranche C, GBP 67m: assigned new rating A_SF

Tranche D, GBP 45m: assigned new rating BBB_SF

Tranche E, GBP 56m: assigned new rating BB_SF

Tranche F, GBP 56m: not rated

The ratings assigned by Scope reflect the risk for FITZROY 2018-1 CLO DAC, as the credit protection seller, to make payments with respect to credit events under the terms of the credit protection deed. The ratings do not address potential losses arising from the transaction’s early termination, nor any market risk associated with the transaction. The ratings reflect the expected loss over the expected weighted average life for each respective tranche.

Transaction overview

The transaction features six credit protection agreement tranches, whereby Banco Santander SA, London branch, buys credit protection from FITZROY 2018-1 CLO DAC. The tranches represent a GBP 1.12bn synthetic risk-transfer securitisation of project finance loans originated in the UK and other EU countries by Banco Santander SA (AA-/S-1+/Stable) and its affiliates in the ordinary course of business. The transaction is structured contractually as an executed credit protection deed and is in accord with Basel III (CRR) and EBA guidelines regarding significant risk transfers (SRT). The legal maturity date is 15 June 2045 or earlier if triggered by events.

The reference portfolio will be revolving for three years and initially comprises 97 senior secured, first-lien project finance loans. The projects backing these loans relate to mostly to renewable energy, PPP/PFI, utilities, and infrastructure. They are primarily located in the UK and up to 20% of the balance may be located in Jersey, Republic of Ireland, Sweden, Finland, Norway, Denmark, France or Germany, as per the replenishment criteria.

Credit event definitions for the referenced assets include: failure to pay after the longer of 90 days or the contractual grace period, bankruptcy-like events, and the completion of a restructuring due to credit deterioration which resulted in a loss. Initial and realised losses will be verified by an independent agent.

The tranches are not exposed to foreign exchange risk because non-GBP reference obligations are converted to GBP at a fixed rate. All reference obligations are scheduled to repay three years before the transaction’s maximum legal maturity.

This is a simple pro-rata synthetic transaction with no synthetic excess spread, structured contractually as executed guarantee contracts. The most junior tranche (F) is not rated. Tranches A, B, C, D, and E benefit from credit enhancement of 25%, 20%, 14%, 10% and 5%, respectively, provided by first loss protection.

Premia will be accrued on the effective balance of the tranches (i.e. outstanding balance after writing off losses from the reference portfolio). Losses are strictly allocated to the tranches in reverse sequential order (i.e. from F to A). Defaults, and realised losses after restructurings, increase the loss balance; realised recoveries offset any accrued loss balance.

The structure releases credit enhancement when performance is good due to the pro-rata allocation of reductions in guaranteed exposure (i.e. the reference portfolio’s scheduled and prepaid principal amortisations, and recoveries). Risk at the final stages of the transaction is mitigated by the sequential amortisation triggers. The structure turns sequential after cumulative losses exceed 1.6% of the initial balance, or when the concentration-weighted number of assets is less than 15, among other conditions.

Rating rationale

The ratings reflect the structure’s legal and financial characteristics as defined under the credit protection deed; the quality of the referenced collateral as constrained by eligibility and replenishment criteria considering macroeconomic conditions in the UK and continental Europe; the experience and ability of the originator and servicer, Santander; and the counterparty credit risk exposure to Santander as protection buyer and premia payer.

All guarantee tranches benefit from the credit quality of the assets in the reference portfolio, with low single-asset concentrations compared to most project finance portfolios. Scope expects losses of 1.0% for the portfolio over a weighted average life of 10.0 years.

The ratings also reflect the credit enhancement in the form of first-loss protection of the respective tranches. Tranche A is strongly protected by its senior position. Tranche B is also well protected, but more sensitive than tranche A to unexpected portfolio losses because of its thinness. The conditions to trigger the sequential amortisation of all tranches have a bigger impact the more senior the tranche in question is.

The ratings of tranches C, D, and E also reflect the transaction’s replenishment criteria which could allow a deterioration of the portfolio credit quality. The transaction’s replenishment criteria allow for larger portfolio exposures to construction projects, demand-risk projects, and non-UK projects as each can represent up to 20% of the reference portfolio. However, substitutions remain subject to investors’ consent and credit rating agency confirmation. The expected losses for tranches C, D, and E based on the analysis of the initial portfolio is commensurate with rating levels one notch higher than the ratings assigned to such tranches.

The counterparty risk to Santander (AA-/ S-1+) as premia payer is limited because the guarantee would be terminated upon the bank’s default. The risk is further mitigated by Santander’s alignment of interest with investors’ and by the independent verification of losses.

Key rating drivers

Senior secured exposures (positive). The senior nature of the exposures, together with the fundamental economic value of the underlying projects, generally operating, and the strength of the counterparties involved, result in a portfolio of mostly investment-grade exposures to projects. Scope calculates low expected losses from the revolving portfolio of senior project finance loans (i.e. 1.0% equivalent to a A- quality portfolio over a WAL of 10.0 years), reflecting a high weighted-average expected recovery rate of 88%, typical for senior project finance exposures.

Experienced originator (positive). Santander’s risk appetite is low, generally targeting senior exposures to projects with strong counterparties known to the bank. Santander is an experienced project finance lender in Europe with a longstanding track record and well-tested processes and models.

Limited revenue risk (positive). A significant segment of the initial portfolio balance (69%) is directly or indirectly exposed to the UK government under strong revenue contracts (i.e. production-based, take or pay, availability-based, and/or CFDs).

Credit enhancement (positive). The credit enhancement from subordination provided by the financial structure reduce the expectation of losses for the different synthetic exposures of the tranches.

Long revolving period (negative). The transaction is exposed to portfolio migration over a three-year revolving period. This risk is mitigated by the origination and underwriting experience of Santander and its limited risk appetite. Furthermore, replenishments will require investor and rating agency confirmations.

Country and sector concentration (negative). This transaction is by and large exposed to the UK as single-country (96% of initial balance) and highly exposed to renewables (50% of the initial balance). The concerns about the UK economy in the context of Brexit are offset by the strength of its finances and the dynamic nature of UK markets, supported by excellent property rights and rule of law. Renewables exposure is somewhat diversified among offshore wind, onshore wind and photo-voltaic solar.

Volume risk (negative). The significant exposure to renewables results in exposure to volume risk, despite the general absence of price risk. This risk is mitigated by the long tenor and seniority of the exposures.

Pro-rata structure (negative). The senior classes will remain exposed to risk of losses for a long time because the amortisation of synthetic exposures reduce the tranches pro-rata. Realised losses reduce the effective balance of the tranches sequentially starting with the most junior class F. The transaction will switch to sequential once cumulative losses exceed 1.6% of the initial balance or the weighted number of assets is less than 15.

Rating-change drivers

Positive. Strong portfolio characteristics at the end of the revolving period could support marginal positive rating actions. There is limited rating upside because pro-rata amortisation prevents the accumulation of credit enhancement when the transaction performs well.

Negative. An unexpected deterioration of the macroeconomic environment in the UK could trigger the review of Scope’s default and recovery assumptions for this transaction, which could result in downgrades.

Asset analysis

The initial portfolio comprises 97 senior secured, first-lien project finance loans backed by projects relating to renewable energy (50% of exposure), PPP/PFI (30% of exposure), utilities (13% of exposure), and other infrastructure (8% of exposure). Projects in the UK represent 96% of the initial balance; with the remainder located in Denmark, Ireland and Jersey. The portfolio will have a weighted-average life of 10.0 years or less. Any individual reference obligation will not represent more than 3% of the initial reference portfolio balance.

Reference obligations benefit from solid covenant packages and structural features such as cash sweeps, which will further reduce asset-level leverage if projects underperform. Most projects in the initial portfolio benefit from stable and predictable cash flows, directly or indirectly linked to the UK government for 69% of the initial balance, used to service the reference obligations. Project cash flows are often underpinned by long-term revenue contracts and sound fundamentals. For example, cash flows are protected from demand risks when the project’s output serves an essential necessity. A number of projects rely on payments exposed to significant revenue risks such as wholesale electricity prices or traffic volume fluctuations. However, less than 5% of the initial portfolio balance is exposed to strict demand-based revenue.

The initial reference portfolio’s exposure to construction risks is limited, but it could increase to up to 20% as per the replenishment criteria if such exposure is approved by the protection seller and does not compromise the then outstanding ratings on the tranches. Over 96% of the initial reference notional is linked to fully operational, cash-generative projects.

The reference portfolio is diversified across 18 sub-sectors, with concentration in onshore wind, photovoltaic, education, offshore wind, and smart meters. These five subsectors jointly represent approximately three-quarters of the total initial portfolio balance.
There is sufficient diversification regarding key agents involved in the projects underlying the portfolio, with the exception of the UK government directly or indirectly supporting the revenue of almost 70% of the initial portfolio. The correlation framework applied to the transaction captures the exposure to the UK government as ultimate revenue counterparty in this transaction.

Santander is an experienced originator in the European project finance market. The bank has a prudent origination strategy, a low risk appetite, and strong operational and risk management. Santander’s net economic interests are aligned well with those of investors through a material risk retention in the reference portfolio. Santander has specific internal policies governing communications between front office origination and work out teams, and the CLO structuring and portfolio management teams which mitigate conflicts of interest. This supports independent and consistent loan servicing because the servicing teams do not know what projects had part of their risk covered by this transaction.

Scope’s analysis of the assets in this transaction consisted of: (i) using asset-by-asset fundamental data points to produce a probability-of-default estimate for each reference obligation; (ii) producing rating-conditional recovery rates by incorporating the average leverage employed by Santander in the UK and Scope’s analysis of project finance recovery rates along the lines highlighted in Scope’s General Project Finance Rating Methodology.

Quantitative analysis and assumptions

Scope has analysed the reference portfolio loan by loan and built a mapping to estimate each asset’s probability of default given the portfolio’s good granularity. Scope then simulated portfolio performance using a single-step Monte Carlo simulation implementing a Gaussian-copula dependency framework, extending the risk horizon to account for revolving risk.

Scope produced a measure of the expected loss and the expected weighted average life for each rated tranche, which were benchmarked against Scope’s idealised expected loss curves. Scope has incorporated in the analysis the transaction’s capital structure, guarantee reductions, premia payments, and amortisation trigger to test the structure’s mechanisms and their impact on expected loss to the protection seller for each rated tranche under the guarantee. Scope has not considered the impact of discretionary termination option of the protection buyer, upon the reference portfolio balance dropping below 10% of the initial balance.

Scope has assumed an 8.0% mean lifetime portfolio default rate and an 88% weighted-average portfolio recovery rate, based on its analysis of the portfolio using mapped loan-by-loan input assumptions. Scope has also assumed a maximum pair-wise correlation of 44.5% (excluding the top exposure correlation stress of +20pp). The non-parametric default-rate distribution resulting from the simulation exhibits an 90% coefficient of variation.

These metrics reflect the reference portfolio’s expected credit quality of A-, the concentrations in UK assets, and relatively good diversification across 97 reference obligations with no single-name synthetic exposure exceeding 3%.

Scope mapped the bank’s individual internal risk measures to assess the default risk of each reference obligation for the transaction. The mapping is based on a loan score that Scope assigned to each reference obligation. The loan score incorporates i) fundamental data points that provide key information on the reference obligation’s credit risk including country, sector, revenue type, project stage, and key credit metrics; and ii) Santander’s internal assessments. Scope then created a regression model that considers the most significant characteristics of each project: the operational status; the sector; the type of revenue risk; the weighted-average life; and the debt-service coverage ratio. The mapping was back-tested by conducting complete credit estimates on a targeted selection of ten projects covering a range of diverse characteristics.

Scope has assumed average recovery rates for the portfolio of 50%, 60%, 70%, 75%, 85%, and 90%, under rating conditional scenarios AAA through B, respectively, for operational projects. The recovery rates assumed for projects not yet fully operational under the same rating conditional scenarios are 10%, 15%, 30%, 45%, 55% and 70%. These recovery rate assumptions reflect the seniority and leverage of the underlying assets, as well as the general characteristics of the projects in the portfolio. The tiering of recovery rates results from sampling the implicit recovery rate distribution at constant probability steps. The recovery rate assumptions reflect the characteristics of the assets in the initial portfolio considering the recovery study Scope has performed in its project finance methodology.

Scope applied an asset correlation framework that it deems appropriate for the analysis of multi-sector project finance assets in different countries within the same region. The maximum correlation can be split into: a minimum 2.0pp for all loans; 5.0pp assigned to asset pairs sharing the same country; 15.0pp to pairs sharing the same sector; 7.5pp to pairs sharing the same country and sector; and 15.0pp to pairs both having the UK government directly or indirectly supporting the revenues of the project.

Additionally, Scope applied stress to the largest exposures, consolidated by project, applying a 10% haircut to rating-conditional recovery rates, and increasing the pair-wise correlation among the largest exposures by 20pp. Five reference obligations exposed to four projects (11.4% of the initial portfolio balance) were selected based on their relative size and contribution to portfolio expected loss.

Rating sensitivity

Scope tested the resilience of the rating against deviations of main input parameters: portfolio mean default rate and its coefficient of variation, and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the rating to input assumptions and is not indicative of expected or likely scenarios.
The following list shows how the number of notches that the results for each rated tranche moves when: 1) the portfolio’s expected default rate increases by 50%; 2) the portfolio’s expected recovery rate reduces by 50%; and 3) and the portfolio default rate’s coefficient of variation increases by 50% (respectively):

• Tranche A: one notch, one notch, and one notch;
• Tranche B: one notch, four notches, and one notch;
• Tranche C: three notches, six notches, and three notches;
• Tranche D: three notches, six notches, and three notches;
• Tranche E: one notch, five notches, and zero notches.

Methodology

The methodology used for these ratings, General Structured Finance Rating Methodology (to analyse the transaction),  Methodology for Counterparty Risk in Structured Finance (to analyse counterparty risks) and General Project Finance Rating Methodology (to analyse elements related to project finance) are available on www.scoperatings.com.

Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.Europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.

Solicitation, key sources and quality of information

The rated entity and its agents participated in the rating process.

The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity and Scope internal sources.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Scope Ratings GmbH has not relied on a third-party asset due diligence/asset audit. Scope has performed its own analysis of the assets, based on information received from the rated entity or related third parties, which is not and should be not deemed equivalent to a due diligence or an audit. The internal analysis has no negative impact on the credit rating. ¹

Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and the principal grounds on which it is based. Following that review, the rating was not amended before being issued.

¹ This paragraph regarding the absence of third-party asset due diligence/asset audit was added on 6 December 2018.

Regulatory and legal disclosures

This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Carlos Terré, Managing Director
Person responsible for approval of the ratings: Guillaume Jolivet, Managing Director
The ratings were first released by Scope on 28.09.2018

Potencial conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings. 

Conditions of use / exclusion of liability
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