Rating action

Rating actions are as follows:

Tranche A: GBP 715.7m (58.8%): affirmed at AAA_SF
Tranche B: GBP 104.5m (8.6%): upgraded to AAA_SF from AA+_SF
Tranche C: GBP 118.3m (9.7%): upgraded to AA+_SF from A+_SF
Tranche D: GBP 55.7m (4.6%): upgraded to AA_SF from A_SF
Tranche E: GBP 75.2m (6.2%): upgraded to BBB+_SF from BBB-_SF
Tranche F: GBP 64.1m (5.3%): upgraded to BB+_SF from BB_SF
Tranche G: GBP 83.5m (6.9%): NR

Red 2 Finance CLO 2018-1 (Red 2) is a synthetic securitisation of commercial real estate loans originated by Santander UK plc (Santander). Strong deleveraging offsets macroeconomic uncertainties and data limitations.
Scope’s review was based on high-level transaction reporting through July 2020.

Transaction overview and performance

Red 2 is a synthetic securitisation of a static GBP 1,217.0m portfolio (GBP 2,785.0m at closing) of 384 commercial real estate loans (837 loans at closing), originated by Santander in the United Kingdom (UK). Red 2 sells credit protection on the portfolio through seven strictly sequential, fully funded credit protection agreements – Tranches A to G – entered into with Santander. Red 2 covers up to 95% of the losses from the reference portfolio. Sequential amortisation coupled with no realised portfolio losses have increased credit enhancement since closing as follows: Tranche A (41.2% from 18.0%), Tranche B (32.6% from 14.2%), Tranche C (22.9% from 10.0%), Tranche D (18.3% from 8.0%), Tranche E (12.1% from 5.3%), and Tranche F (6.9% from 3.0%).

There have not been any losses in the reference portfolio. However, as of July 2020 reporting, there are 42 exposures (GBP 207.7m) on Santander’s internal watch list, two of which (GBP 36.5m) the bank considers non-performing.

The portfolio’s average interest coverage ratio is down to 2.66x from 2.96x at inception, while the weighted average loan-to-value (LTV) ratio has improved to 45.4% from 47.6%. Scope expects LTV ratios will increase as the underlying loans near their respective maturities, reflecting the currently adverse economic environment in the UK and the general bullet nature of the portfolio.

The portfolio is diversified across property sectors, with the share mainly comprised of retail (35.0%), residential (27.0%) and office (25.0%) properties, while the remainder qualifies as industrial use.

Under the credit protection agreements, Santander receives cash payments equal to 35% of the outstanding balance of a reference obligation upon its default. The amount is then adjusted for the actual loss during a maximum work-out period of 5.5 years. Additional payments are made to offset any difference between the initial loss claim and the final loss determination after work-out. Losses are allocated to the respective tranches in reverse order of seniority, i.e. from Tranche G to A.

The transaction defines loan default as i) a failure to pay with respect to the reference obligation; ii) a bankruptcy of the obligor or obligor group; or iii) a loss from the restructuring of a reference obligation. The credit protection agreements grant significant supervisory rights to the external verification agent, a reputable global accounting firm. This agent ensures that all loss claims are valid, and the determination of the expected loss and final loss comply with Santander’s internal policies. Santander also must demonstrate to the verification agent that its servicing and work-out processes accord with the bank’s internal business principles and policies.

Rating rationale

The ratings reflect the legal and financial structure of the transaction as defined under the terms of the credit protection deed; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the UK; the ability and incentives of Santander, servicer of the reference loans; and the supervision from the verification agent, a reputable global accounting firm.
The rating actions account for the increased credit enhancement of the rated tranches and the strictly sequential release of risk coverage from reference portfolio amortisation. The ratings also reflect the credit risk of the relatively granular reference portfolio, characterised by material default risk at the loans’ maturity, but substantial recovery upside upon default.
The rating actions account for the limited visibility on the financed properties and underlying tenant base due to data limitations.
The rating actions also incorporate the macroeconomic uncertainty in the UK, spurred by Brexit, Covid-19 and the general economic slow-down for most of the UK’S main trade partners. Scope’s market-value-decline assumptions for commercial real estate properties in the UK reflect uncertainties associated with Brexit, and considers further declines, due to Covid-19. Scope expects heightened uncertainties to have an adverse impact on consumer and investment confidence, which, in turn, may have a knock-on effect on commercial real estate by reducing demand and the willingness to maintain the properties’ condition.
The ratings also account for the flexibility granted to Santander to allocate losses associated with defaulted obligations that are not fully worked out at the termination of the credit protection deed. These losses must reflect Santander’s standard accounting provisions. The risk of inflated losses based on Santander’s accounting provisions is limited to obligations that default within the 5.5 years prior to the legal final termination date.
Premiums and recovery proceeds payments by Santander expose the issuer to limited credit counterparty risk. This is mitigated by i) the high credit quality of Santander; ii) the termination of the credit protection deed upon Santander’s default, which effectively cancels the exposure to the remaining reference portfolio; and iii) the netting of credit protection premiums and collected recoveries with new loss claims. Scope has ratings on Banco Santander SA and Santander UK plc.

Key rating drivers

CREDIT-POSITIVE (+)

Increased credit enhancement¹: Sequential amortisation of the tranches coupled with no realised portfolio losses have increased the available credit enhancement for all rated tranches since closing. Increased credit enhancement helps mitigate the increase in portfolio concentrations and the rising macroeconomic uncertainty in the UK.

Low LTV mortgages¹: The underlying commercial real estate loans have a low average LTV of 45.4% (non-indexed). This LTV level supports high recovery rate expectations, improves the probability of successful refinancing at maturity and mitigates the adverse effect from the generally bullet nature of the loans’ amortisation profiles.

Experienced CRE lender¹: Santander’s real estate lending activities in the UK date back to 1944 (Abbey National plc, bought by Santander Group in 2004).

Static portfolio¹: The portfolio is static and does not allow for loan refinancing or reference loan additions. Extended loans can remain referenced in the reference portfolio under certain circumstances described in the loan portfolio credit protection deed.

CREDIT-NEGATIVE (-)
UK macroeconomic uncertainty^2,3: Brexit, Covid-19 and the economic challenges for the UK’s main trade partners elevate uncertainty regarding property prices, property vacancy levels and the length of reletting periods – three significant drivers for debt servicing, refinancing and recovery expectations. The effects of the pandemic particularly impair the business models underlying many office, hospitality, and retail/shopping commercial real estate properties.

Rating-change drivers

POSITIVE (+)

Increased credit enhancement from further deleveraging accompanied by solid asset performance may result in upgrades.

NEGATIVE (-)

Worse-than-expected default and recovery performance of the assets may result in downgrades. Recovery rates and refinancing probabilities may decline if deterioration of the UK’s economic environment leads to lower than expected demand for UK commercial real estate, reflecting negatively on property values.

Quantitative analysis and assumptions

Scope has analysed the reference portfolio loan by loan and simulated its performance using a single-step Monte Carlo simulation implementing a Gaussian-copula dependency framework. For each loan, Scope has assumed i) a specific default probability, inferred from the credit estimate assigned to the loan over its weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting rating-conditional loss distribution and default timing were then used to project Tranche losses, reflecting the transaction’s collateral release and loss-allocation mechanisms as well as the credit enhancement of the respective Tranche.

Scope’s analysis of commercial real estate loans consists of deriving: i) term default probabilities for all periods over a loan’s life; ii) default probabilities at maturity; iii) and recovery rates upon default. Stressed cash flows over the loan’s life drive the term default probability and the default probability at maturity; while the property valuation implied by these cash-flow drive the severity of default. Refinancing risk is crucial to the analysis as commercial real estate loans typically do not amortise in full.

We have derived most of our modelling assumptions from the initial analysis, which assumes that the general credit profile of the remaining loans is unchanged. Santander’s bank-internal ratings for the remaining loans show that the average credit quality of the remaining loans has not changed significantly; however, the internal rating dispersion is higher.

We consider in our updated analysis the recovery rates derived at closing, to be reasonable, accounting for the 45.4% weighted average LTV for the portfolio with limited dispersion. However, we need to reflect that most of the LTV calculations for this portfolio are based on property valuations that do not account for Covid-19, as the average bank-internal rating update was carried out in February 2020.

We reflect the uncertainty regarding the credit quality and its dispersion as well as the recovery rate expectations in a stress to the default and recovery assumptions that were derived for the remaining loans at closing. Moreover, we increase the correlation assumptions for this modelling update to account for the higher dispersion of credit qualities.

Scope has derived for the outstanding portfolio an average default probability of 31.1%. This assumption reflects the probability of default that Scope has assigned to the loans remaining in the portfolio at closing stressed by 25%. The 25% stress should account for the potentially higher default likelihood in the current macroeconomic environment.

Scope assumed a portfolio recovery rate of 89.9% for a B rating target and applied rating-conditional haircuts of 26.1% for AAA, 20.9% for AA, 15.7% for A, 10.5% for BBB, and 5.2% for BB. These recovery rates consider the recovery rates considered at closing, with an additional 5% haircut to account for the higher uncertainty regarding property prices.

Scope has assumed pairwise asset correlations ranging from 65 to 85%, which reflect additive components including a general correlation factor of 30%, a location factor of 15% and a property type factor of 20%. The general correlation factor considers a 15-percentage point increase to account for the higher credit quality dispersion for the remaining loans at closing.

Additionally, Scope has considered a top-exposure stress, applicable to the largest obligors and to those obligors that contribute more than 2.0% to the portfolio’s expected loss. Scope applied a top-exposure correlation stress of 20 percentage points; stresses the probability of default for these obligors by one notch equivalent; and applies an additional 10% haircut to the recovery rate.

Sensitivity analysis

Scope tested the resilience of the ratings against deviations of the following input parameters: loan-level probability of default and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the ratings to input assumptions and is not indicative of expected or likely scenarios. The following shows how the results for each rated tranche change compared to the assigned ratings when the portfolio’s underlying loans’ probability of default is increase by 50%, or the portfolio’s expected recovery rate reduces by 10%, respectively:

• Tranche A: sensitivity higher default rate, zero notches; sensitivity to recovery rates, zero notches;
• Tranche B: sensitivity higher default rate, zero notches; sensitivity to recovery rates, zero notches;
• Tranche C: sensitivity higher default rate, zero notches; sensitivity to recovery rates, three notches;
• Tranche D: sensitivity higher default rate, one notch; sensitivity to recovery rates, five notches;
• Tranche E: sensitivity higher default rate, zero notches; sensitivity to recovery rates, four notches;
• Tranche F: sensitivity higher default rate, two notches; sensitivity to recovery rates, five notches.

Rating driver references
1 Internal reporting of the originator and issuer
2 Scope research: What will the European CRE sector look like when the dust settles?
3 Scope research: Maroon CRE loan: autopsy of a default UK retail gloomy environment and loan legacy weaknesses

Stress testing
Stress testing was performed by applying rating-adjusted recovery rate assumptions.

Cash flow analysis
Scope has primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Portfolio Model (Model) Version 1.0. Scope implemented the transaction structure and the risk cover release mechanisms for this transaction with a bespoke tool. The outcome of the analysis is an expected loss and an expected weighted average life for the instrument.

Methodology
The methodologies used for these ratings General Structured Finance Rating Methodology (18 December 2019), Methodology for Counterparty Risk in Structured Finance (08 July 2020) are available on https://www.scoperatings.com/#!methodology/list.
The model used for these ratings is Scope Portfolio Model (Model) Version 1.0 is available in Scope’s list of models, published under: https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.

Solicitation, key sources and quality of information
The rated entity and/or 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, the rated entities’ agents, third parties 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 received a third-party asset due diligence assessment/asset audit at closing. The external due diligence assessment/asset audit/internal analysis was considered when preparing the rating and it has no impact on the credit rating. Prior to the issuance of the rating action, the rated entity was given the opportunity to review the ratings and the principal grounds on which the credit ratings are based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
These credit ratings are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst Sebastian Dietzsch, Director
Person responsible for approval of the rating: David Bergman, Managing Director
The ratings were first released by Scope on 15 October 2018.

Potential 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
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin. Scope Ratings GmbH, Lennéstraße 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Director: Guillaume Jolivet.