S&P Global Ratings has analyzed various nonperforming loan (NPL) transactions in Europe (Spain, Italy, Greece, and Ireland). Some of these transactions in certain jurisdictions were structured with a real-estate owned company (REOCO) in addition to the special-purpose entity (SPE) issuing the securitization notes. The REOCOs were established as limited-purpose entities, whose main activities were to acquire and manage real estate assets either already included in the securitized portfolio or expected to be repossessed. REOCOs are one of the ways in which servicers can diversify the recovery process as they help to maximize recoveries.

This Credit FAQ takes a detailed look at servicers' use of REOCOs in NPL securitizations. In the transactions we reviewed, most of the features we typically see for the SPEs issuing the securitization notes are shared by REOCOs. We answer frequently asked questions on these features.

Frequently Asked Questions

Why do servicers set up REOCOs for NPL transactions?

Setting up a REOCO can help servicers maximize the value of the properties securing the defaulted loans, especially in jurisdictions where lenders cannot directly appropriate the asset as the judicial proceedings require that the property is auctioned. The way auctions work differs depending on the jurisdictions; however, the common issue servicers face is that the price achieved at the auction may be significantly lower than what they could get in the open market. In addition, some jurisdictions may hold multiple auctions if there are no bidders, which can result in drawn-out proceedings.

What is the main purpose of a REOCO in the context of a NPL securitization?

The main purpose of the REOCO, in the transactions we reviewed, is to bid at auctions, and if third-party bids are deemed to be too low, or there are none, to purchase the property and try to sell it in the open market at a higher price. Some of the properties owned by the REOCO may also come from amicable settlements with borrowers. The SPE that issues the notes in a securitization transaction usually cannot engage in similar activities for various reasons, mainly: i) it may not be allowed by the relevant securitization law for the issuer to own assets; or ii) even if it were allowed, owning assets could increase the issuer's insolvency risk.

Which jurisdictions typically have REOCOs in NPL transactions?

REOCOs are a common feature in rated NPL transactions in Greece and Spain. Although we haven't yet seen REOCOs implemented in Italian NPL transactions that we have reviewed, we expect them to become a more established feature, considering the long judicial procedure which is structured with multiple auctions. Furthermore, the Italian securitization law now allows for the setup of supporting SPEs to acquire and manage underlying real estate assets on behalf of SPEs issuing the securitized notes. According to the new provisions, the proceeds from the assets purchased by the REOCO fall within the segregation regime established in the SPE and the noteholders' favor.

In Ireland, REOCOs are not a feature in NPL securitizations, and we do not expect them to be implemented in the future because of the enforcement procedures which normally rely on the appointment of a receiver who takes possession of the asset and sells it.

What do REOCO structures look like?

We saw three different structures in the transactions that we have analyzed so far.

When we review structures where the sponsor owns the REOCO we consider whether this structure increases the risk of the REOCO's insolvency (see question on bankruptcy remoteness considerations).

What do REOCO funding mechanisms look like?

In the transactions we have reviewed, REOCOs can typically access a revolving committed facility. This facility is granted directly or indirectly, depending on the structure, from the issuer either through a specific item in the issuer's waterfall or deducting the amounts needed by the REOCO from the issuer's available collections.

How will the REOCO repay this amount? The transaction documents typically allow a priority of payments at the REOCO level for payments to its creditors, including the repayment of the loan facility. The REOCO typically makes payments on a specific date, which falls before the interest payment date for the securitization notes, and in the following order:

• Senior costs and fees (including taxes and servicer expenses);
• Interest for the use of this facility;
• Principal repayment of the facility; and
• Excess amount.

The "excess amount" is material in our analysis. It is a way to ensure that collections don't sit in the REOCO's collection account, but are instead constantly transferred to the issuer. Additionally, if a REOCO's proceeds exceed the repayment of the principal and interest of the loan, the excess amount is transferred to the issuer. In some transactions we have reviewed we have also seen that extra proceeds can be paid to the issuer (as the REOCO's shareholder) through payment of dividends.

What are the main bankruptcy remoteness considerations when analyzing a NPL securitization with a REOCO?

We make several considerations to understand how likely it is that the REOCO might become insolvent and the potential impact of such insolvency. We base our analysis on our legal criteria (see "Related Criteria") that include some features we typically see that allow us to conclude an SPE is insolvency remote. As we mention in our criteria, the term insolvency-remote is not a legal term, it is an assessment we make based on several considerations and does not mean that an SPE is immune to the risk of insolvency.

1. What are a REOCO's permitted purposes?  The starting point of our review is understanding the scope of activities the REOCO is allowed to perform according to the transaction documents. When applying our criteria, we consider whether the activities are limited to those strictly necessary to purchase and manage the repossessed assets. We believe that unrelated activities increase the risk of insolvency of the REOCO as they increase the likelihood of third-party claims.

2. What is a typical REOCO ownership structure?  Another consideration we make relates to the REOCO's ownership. In fact, in cases where a REOCO shareholder has the power to voluntarily petition the REOCO into bankruptcy proceedings, we may consider how the structure mitigates this risk. For example, we believe that the use of independent shareholding entities--the votes of which would be required along with the vote of a parent shareholder in order to commence voluntary insolvency proceedings--may help to mitigate this risk.

We may look to a non-consolidation opinion to derive comfort as to substantive consolidation or similar risks in the relevant jurisdiction and consider the existence of separateness covenants designed to provide comfort that the REOCO will hold itself out as an independent entity.

3. Do REOCOs create security over the assets?  In structured finance transactions, we typically see that the issuer of securitized notes creates security over its assets in favor of the noteholders. This feature is relevant for our insolvency remoteness analysis because we see it as reducing the incentives for equity holders or unsecured third-party creditors to file the SPE into insolvency proceedings to potentially gain access to the SPE's cash flows and assets.

In the transactions we reviewed, the REOCOs did not create security over the properties in favor of the issuer or any other party. We understand the reason is the high costs and operational hurdles that creating security would determine. As a result, we could not conclude that the REOCOs were insolvency remote in line with our legal criteria. However, we were still able to derive comfort from several other features which helped to mitigate the insolvency risk. We discuss them in the last question.

4. What specific considerations apply when analyzing REOCOs in Spanish transactions?  According to Spanish law, if the REOCO's net equity falls below 50% of the share capital and it is not remedied within six months, a liquidation process of the REOCO would automatically begin. In the transactions we have analyzed we have seen this risk mitigated in different ways: (i) via the possibility of the REOCO to convert part of its loan facility into equity subject to certain debt-to-equity ratios, or (ii) through a profit participation loan injection directly or indirectly from the issuer. In the latter, this loan can be repaid at maturity, increasing the risk of delay of payment from the REOCO to the issuer. This specific risk is generally mitigated through the "excess amount" we mentioned in the question relating to the funding mechanisms above, which allows a constant flow of funds from the REOCO to the issuer.

5. Are REOCOs exposed to additional value-added tax (VAT) liabilities if part of a VAT group?  In some structures we analyzed, the REOCO was part of the servicer and sponsor VAT group. This increases the risk of insolvency as the REOCO could become jointly and severally liable for other group companies' unpaid VAT obligations, if, for example, one of the VAT group companies becomes insolvent. If the REOCO cannot pay these potential claims unrelated to the securitized assets and rated securities, this can increase the risk of an insolvency proceeding initiated by the local tax authority. In this type of situation, we would typically try to determine the maximum amount of VAT liabilities the REOCO could be exposed to. To this end, we would analyze relevant information about the group's historical VAT liabilities and potential future business activities. This set of data would guide us in setting a stress to be applied to the historical exposure to address the risk of an increase of the VAT liabilities in the future. We would then apply the resulting amount as a loss in our cash flow analysis.

How likely are REOCOs to be subject to insolvency proceedings?

Although we were not able to conclude that the REOCOs reviewed so far can be considered insolvency remote entities in line with our legal criteria, we see it as unlikely that they will become subject to insolvency proceedings. In fact, all the REOCOs we have analyzed so far have covenants in place very similar to those of the SPE issuing the notes, i.e., they cannot have employees and their activities are limited to purchasing the assets securing the NPLs, managing them and eventually selling them in the open market. All the costs, fees, and expenses needed to operate the REOCO, including taxes, are always paid senior in the REOCO priority of payments.

Additionally, all the properties owned by the REOCO have insurance in place, the size of the properties are on average small and well diversified geographically, with most of the properties being residential assets, therefore significantly reducing the environmental risk in the transaction. Finally, in the transactions we reviewed, security is created over the accounts where the proceeds from the sale of the properties are paid, and over the REOCO's shares.

Consequently, we do not expect REOCOs to have material exposure to third-party creditors who might have an incentive to enforce the assets and start an insolvency proceeding against the REOCO. Moreover, the creditors of the REOCO under the transaction documents, such as the issuer and servicer, are typically bound by non-petition and limited recourse language. Since the REOCO repossesses the assets at the end of the foreclosure process or through an amicable solution, we do not expect the original borrower to try to challenge the ownership of the asset.

Finally, REOCOs are only one of the strategies available to servicers. In the transactions we have worked on, on average, they represented less than half of the expected recovery proceeds. In addition, in those transactions, the REOCO's insolvency does not trigger an event of default at the issuer level. We consider a REOCO's insolvency to be unlikely, but even if it does occur, we would not expect it to materially disrupt the cash flows available to repay the securitized notes.

Editor: Claire Ellis.