Rating action

Scope Ratings UK Limited (Scope) has reviewed the performance of FITZROY 2018-1 CLO DAC and has taken the following actions on the rated instruments, the Class A notes and tranches A through E as defined under the credit protection agreement between Banco Santander and the issuer:

Class A, GBP 697.1m: affirmed at AA-_SF

Tranche A, GBP 697.1m: affirmed at AAA_SF

Tranche B, GBP 46.5m: affirmed at AA_SF

Tranche C, GBP 55.8 m: downgraded to A-_SF from A_SF

Tranche D, GBP 37.2m: downgraded to BBB-_SF from BBB_SF

Tranche E, GBP 46.5m: affirmed at BB_SF

Scope performed the credit analysis using the available historical monitoring data provided by Santander, in the June 2022 reference registry as well as refreshed information on individual exposures, including refreshed debt service coverage ratios.

Transaction overview

The transaction features six credit protection agreement tranches, and six classes of notes, which each reference the credit performance of a corresponding tranche defined in a credit protection agreement that issuer has entered into with Banco Santander London Branch S.A. (Santander). The reference asset of the class A notes is the tranche A of this c. GBP 0.9bn synthetic risk-transfer agreement of project finance loans originated in the UK and other EU countries by Banco Santander SA and its affiliates in the ordinary course of business. The transaction is structured contractually as an executed credit protection deed (CPD) 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 initially had a three year revolving period and has now entered the amortisation phase. The transaction initially comprised 97 (June 2022: 82) 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 (99%) with the remaining portion located in Isle of Jersey and Ireland.

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 pro-rata synthetic transaction with triggers to switch to sequential amortisation, no synthetic excess spread, structured contractually as executed guarantee contracts. The structure features including (amongst others) a cumulative loss trigger (>1.6%) and a concentration-weighted trigger (switch when number of assets fall below 15) which trigger sequential amortisation. 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.

Santander will be holder of the cash collateral account, holding all funds to repay the class A principal. Moreover, the bank is payer of i) the credit protection premium; and ii) the interest on the cash collateral, together the only source of interest payments on the class A notes.

Rating rationale

The ratings reflect the legal and financial structure of the transaction; the quality of the referenced collateral as constrained by eligibility 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, premia payer and collateral account holder.

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 counterparty risk exposure to Santander constrains the class A notes’ rating at the bank’s credit quality as assessed by Scope. The bank is the payer of the risk premia and holder of the collateral cash account. In respect of the guarantee tranches the counterparty risk to Santander as premia payer is limited because the guarantee would be terminated upon the bank’s default.

Key rating drivers

The reference portfolio has entered the amortisation phase in October 2021 and thereby no further replenishments will occur. The portfolio is currently amortising on a pro-rata basis. The reference portfolio has seen a deterioration in the underlying credit quality, with a notable rise seen in the proportion of the portfolio on the early credit watch list. Positively, there have been no defaults to date.

The ratings on the rated CPD tranches reflect the reference portfolio’s lower mapped BB+ weighted average credit quality and the respective tranche’s credit enhancement of 25% for tranche A, 20% for tranche B, 14% for tranche C, 10% for tranche D, and 5% for tranche E. The tranches’ exposure to Santander, as the protection buyer, risk premium payer and collateral account holder is considered as immaterial in Scope’s view.

As with tranche A, the Class A notes benefit from the reference portfolio’s strong credit quality and 25% credit enhancement from subordination. However, the credit quality of Santander itself, as the holder of the Class A note’s cash collateral, constrains the debt instrument’s rating at Santander’s credit rating as assessed by Scope.

No defaults and no credit events have occurred (positive)¹. No triggers have been breached and thus the transaction has amortised on a pro-rata basis since October 2021. As a result, the credit enhancement levels remain unchanged.

Experienced originator (positive)¹. The originator generally targets 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.

Portfolio credit quality (negative)¹. The underlying portfolio’s decreasing credit quality along with the increase in proportion of the portfolio on the credit watch list pressured the levels of support available under pro-rata amortisation going.

Counterparty risk (negative; relevant for Class A)¹. All funds available for payment to the Class A note holders are exposed to the credit quality of the bank. The bank holds the cash collateral paid in by the Class A note investors, which is the only source of Class A principal repayment. The bank is also the payer of the guarantee premium and collateral account interest, which funds the interest on these notes. The bank is of high credit quality, but there is no risk mitigant to limit the excessive counterparty exposure.

Country and sector concentration (negative)². The transaction is only exposed to the UK and Ireland and highly exposed to renewable energy sector. The other sectors include project finance initiatives (PFI), infrastructure and utilities. Concerns about the UK economy in the context of post-Brexit, the Russian Ukrainain war, and the likely recession are offset by the domestic setting of the underlying assets, the strength of the UK’s finances and the dynamic nature of UK markets. The renewable energy sector exposure is somewhat diversified across offshore wind, onshore wind and photo-voltaic solar. The renewable energy sector exposure is also favorably seen in context of the war’s impact on energy markets. The reference portfolio’s underlying assets continue to benefit from higher recovery rates due to their mainly operational status, which helps to mitigate the transaction concentration risk.

Rating-change drivers

Positive. An upgrade may result if Santander’s credit quality improves or if the bank is replaced as collateral account holder with a counterparty with stronger credit quality.

Negative. Deteriorating portfolio characteristics could trigger further downgrades. In regards to portfolio characteristics improving 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.

Quantitative analysis and assumptions

Scope 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 the CPD tranches and the class A notes, which was then benchmarked against Scope’s idealised expected loss curves. Scope’s analysis incorporated the transaction’s capital structure, guarantee reductions, premia payments, and amortisation trigger to test the structure’s mechanisms and their impact on expected loss for the CPD tranches and the class A notes. Scope did not consider the impact of a termination option at the discretion of the protection buyer, upon the reference portfolio balance dropping below 10% of the initial balance.

Scope assumed an 7.2% 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 also assumed a maximum pair-wise correlation of 44.5% (excluding the top exposure correlation stress of +20 pp). The non-parametric default-rate distribution resulting from the simulation exhibits a 98.5% coefficient of variation.

These metrics reflect the reference portfolio’s expected credit quality of BB+, the concentrations in UK assets, and relatively good diversification across 82 reference obligations with no single-name synthetic exposure exceeding 4%.

Scope mapped the bank’s individual internal risk measures in order 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: its operational status; sector; type of revenue risk; weighted-average life; and its debt-service coverage ratio. The mapping was back-tested by conducting complete credit estimates on a targeted selection of 10 projects covering a range of different characteristics.

Scope assumed an average recovery rate for the portfolio of 50% under a AAA scenario for operational projects. The AAA-conditional recovery rate assumed for projects not yet fully operational is 10%. 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. Scope applied rating-conditional tiering to its recovery rate assumptions, which reflect the characteristics of the assets in the initial portfolio. These recovery expectations consider the findings from the recovery study which Scope performed for 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 2.0 pp for all loans; 5.0 pp assigned to asset pairs sharing the same country; 15.0 pp to pairs sharing the same sector; 7.5 pp to pairs sharing the same country and sector; and 15.0 pp to pairs which both have the UK government directly or indirectly supporting the revenues of the project.

Scope also applied stress to the largest exposures, consolidated by project, by applying a 10% haircut to rating-conditional recovery rates, and increasing the pair-wise correlation among the largest exposures by 20 pp.

Sensitivity analysis

Scope tested the resilience of the ratings 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 ratings 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 instrument 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: zero notches, two notches, and zero notches;
   
• Tranche B: two notches, seven notches, and two notches;
   
• Tranche C: one notch, five notches, and one notch;
   
• Tranche D: one notch, six notches, and one notch;
   
• Tranche E: two notches, five notches, and zero notches;
   
• Class A Notes: zero notches, zero notches, and zero notches.

Rating driver references
1. Reference registry June 2022 and transaction documentation (Confidential)
2. Scope’s United Kingdom rating announcement, June 2022  

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 Ratings’ Portfolio Model (Model) Version 1.0.
Scope Ratings performed a cash flow analysis of the transaction with the use of Scope Ratings’ Cash Flow SF EL Model Version 1.1, incorporating default and recovery rate assumptions over the portfolio’s amortisation period, taking into account the transaction’s main structural features, such as the notes’ priorities of payment, the notes’ size and coupons. The outcome of the analysis is an expected loss and an expected weighted average life for the notes.

Methodology
The methodologies applicable for the reviewed ratings (General Structured Finance Rating Methodology, 17 December 2021; Counterparty Risk Methodology, 14 July 2022; and analytical principles of the General Project Finance Rating Methodology, 15 November 2021) are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The models used for these Credit Ratings are Scope Ratings’ Cash Flow SF EL Model Version 1.1 and Scope Portfolio Model (Model) Version 1.0. available in Scope Ratings’ list of models, published under: https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/uk-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.

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 not received a third-party asset due diligence assessment/asset audit. Scope Ratings has performed its own analysis of the data quality, based on information received from the Rated Entity or Related Third Parties, which is not and should be not deemed equivalent to the performance of due diligence or an audit. 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 Scope Ratings UK Limited at 52 Grosvenor Gardens, London, United Kingdom, SW1W 0AU, Tel +44 20 7824 5180. The Credit Ratings are EU-endorsed.
Lead analyst: Mark Vrdoljak, Associate Director.
Person responsible for approval of the Credit Ratings: Benoit Vasseur, Executive Director
The Credit Ratings were first released by Scope Ratings on 28 September 2018 for the CPD tranches and 1 October 2019 for the Class A Notes. The Credit Ratings were last reviewed on 24 September 2021.

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
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