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      Scope upgrades to AAA(SF) Tranches C and D of Red 2 Finance CLO 2018-1 – CRE CLO

      Scope Ratings UK Limited (Scope) has reviewed the performance of Red 2 Finance CLO 2018-1 DAC, a synthetic securitisation of a commercial real estate loans from Santander UK.

      Rating action

      Rating actions are as follows:

      Tranche A: GBP 308.0m (38.6%): affirmed at AAASF

      Tranche B: GBP 104.5m (13.1%): affirmed to AAASF

      Tranche C: GBP 118.3m (14.8%): upgraded to AAASF from AA+SF

      Tranche D: GBP 55.7m (7.0%): upgraded to AAASF from AASF

      Tranche E: GBP 75.2m (9.4%): upgraded to ASF from BBB+SF

      Tranche F: GBP 64.1m (8.0%): affirmed at BB+SF

      Tranche G: GBP 71.5m (9.0%): NR

      Red 2 Finance CLO 2018-1 (Red 2) is a synthetic securitisation of commercial real estate loans originated by Santander UK plc (Santander).

      Scope’s review was based on high-level transaction reporting through July 2021.

      Transaction overview and performance

      Red 2 is a synthetic securitisation of a static GBP 776.9m portfolio (GBP 2,785.0m at closing) of 223 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 limited realised portfolio losses have increased credit enhancement since closing as follows: Tranche A (60.4% from 18.0%), Tranche B (46.9% from 14.3%), Tranche C (31.7% from 10.0%), Tranche D (24.5% from 8.0%), Tranche E (14.8% from 5.3%), and Tranche F (6.6% from 3.0%).

      As of July 2021, there were only GBP 33.8m of defaulted assets (4.5% of the total reference pool outstanding balance) and GBP 12.0m (1.5%) of losses in the reference portfolio. Additionally, as of July 2021 reporting, there were 37 exposures (GBP 107.3m) on Santander’s internal monitoring list, six of which (GBP 44.6m) the bank considers non-performing.

      The portfolio’s average interest coverage ratio is down to 2.65x from 2.96x at inception, while the weighted average loan-to-value (LTV) ratio has improved to 43.3% from 47.6% at closing date.

      The portfolio is diversified across property sectors, with the share mainly comprised of retail (31.7%), residential (27.3%), office (30.0%) and industrial (5.8%) properties.

      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 expected macroeconomic improvement during 2021 and 2022 in the UK. Scope expects in the UK a real GDP growth of 6.6% and 5.4% for 2021 and 2022, respectively. This reflects a significant economic recovery from the level of GDP contraction observed in 2020 mostly driven by the pandemic crisis and Brexit uncertainty.

      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 enhancement1,2: Sequential amortisation of the tranches coupled with low 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 portfolio tail risk.

      Low LTV mortgages1: The underlying commercial real estate loans have a low average LTV of 43.3% (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 lender3: 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 (-)

      Portfolio tail risk1,2: Towards the end of the life of the reference pool due its normal repayment the level of granularity in the reference pool will decrease exposing the transaction to a higher level of concentration risk than the one observed at closing date. As previously mentioned this risk is mostly mitigated for the rated notes by the significant build-up of credit support thanks to the notes sequential repayment profile.

      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.

      Scope has 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.

      Scope has considered in its updated analysis the recovery rates derived at closing, to be reasonable, accounting for the 43.3% weighted average LTV for the portfolio with limited dispersion.

      Scope reflected 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. Moreover, Scope increased 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 35.9%. This assumption reflects the probability of default that Scope has assigned to the loans remaining in the portfolio at closing stressed by 25%.

      Scope assumed a portfolio recovery rate of 89.1% for a B rating target and applied rating-conditional haircuts of 17.8% for AAA, 14.3% for AA, 10.7% for A, 7.2% for BBB, and 3.6% for BB. These stressed recovery rates consider the recovery rate haircut applied at closing, plus an additional 5% haircut to account for some possible 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 in the event of: i) an increase in the loan-by-loan probability of default by 50% and capped at 100%; and ii) a reduction in the portfolio’s recovery rate by 10%, respectively:

      • Tranche A: sensitivity to default rate, zero notches; sensitivity to recovery rate, zero notches;
         
      • Tranche B: sensitivity to default rate, zero notches; sensitivity to recovery rate, zero notches;
         
      • Tranche C: sensitivity to default rate, zero notches; sensitivity to recovery rate, zero notches;
         
      • Tranche D: sensitivity to default rate, zero notches; sensitivity to recovery rate, zero notches;
         
      • Tranche E: sensitivity to default rate, zero notches; sensitivity to recovery rate, four notches;
         
      • Tranche F: sensitivity to default rate, one notch; sensitivity to recovery rate, six notches.

      Rating driver references
      1. Transaction reporting including loan-by-loan information (Confidential)
      2. Transaction documentation (Confidential)
      3. Originator’s internal documents and information (Confidential)

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

      Cash flow analysis
      Scope Ratings has primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Rating’s Portfolio Model (Model) Version 1.0. Scope Ratings 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 each instrument.

      Methodology
      The methodologies used for these Credit Ratings, (General Structured Finance Rating Methodology, 14 December 2020; Methodology for Counterparty Risk in Structured Finance, 13 July 2021), are available on https://www.scoperatings.com/#!methodology/list.
      The model used for these Credit Ratings (Scope Portfolio Model (Model) Version 1.0) is available in Scope Rating’s list of models, published under: https://www.scoperatings.com/#!methodology/list.
      Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
      Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions - Credit Ratings, Ancillary and Other 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 Credit Rating performance report at https://www.scoperatings.com/#!governance-and-policies/regulatory-UK. A comprehensive clarification of Scope Ratings’ definitions of default and Credit 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 factors) are incorporated into the Credit 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 Related Third Parties participated in the Credit Rating process.
      The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity, the Rated Entities’ Related Third parties, third parties and Scope Ratings’ internal sources.
      Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
      Scope Ratings 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 Credit Ratings and it has no impact on the Credit ratings.
      Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and the principal grounds on which the Credit Ratings are based. Following that review, the Credit Ratings were not amended before being issued.

      Regulatory disclosures
      These Credit Ratings are issued by issued by Scope Ratings UK Limited at 52 Grosvenor Gardens, London, United Kingdom, SW1W 0AU, Tel +44020-7824-5180. The Credit Ratings are EU-endorsed
      Lead analyst: Miguel Barata, Director
      Person responsible for approval of the Credit Ratings: Benoit Vasseur, Executive Director
      The Credit Ratings were first released by Scope Ratings on 15 October 2018. The Credit Ratings were last updated on 12 October 2020.

      Potential conflicts
      See www.scoperatings.com under Governance & Policies/UK Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

      Conditions of use / exclusion of liability
      © 2021 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis 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.

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