Rating action

The transaction comprises the following instruments:

Class A (ISIN IT0005275356), EUR 311.4m: downgraded to B+_SF from BB_SF

Class B (ISIN IT0005275364), EUR 42.5m: downgraded to CCC_SF from B-_SF

Class J (ISIN IT0005275372), EUR 20.0m: not rated

Scope’s review was based on available payment information and investor reports for the January 2020 payment date, as well as servicer reports through June 2020.

Transaction overview

Elrond NPL 2017 S.r.l. is a static cash securitisation of secured and unsecured non-performing loans (NPLs) extended to companies and individuals in Italy. Cerved Credit Management S.p.A. is the special servicer. The loans were originated by Credito Siciliano S.p.A. and Credito Valtellinese S.p.A. The transaction closed on 14 July 2017 and the legal maturity is in July 2040.

As of 31 December 2019, aggregate gross collections were EUR 208.4m, which represents 72.7% of the original business plan expectations of EUR 286.7m. 22.7% of gross collections (EUR 47.3m) have come from closed debtors (i.e. debtors for which the recovery process has fully concluded). Total gross collections are split between judicial proceeds (64.6%), discounted pay-off (‘DPO’) proceeds (23.8%), Confidi guarantees (6.5%) and other sources of collections (5.0%). The present value cumulative profitability ratio is 136.9%, which is based on net collections against the original business plan.

The special servicer has been underperforming since closing. A servicer underperformance event occurs when cumulative gross collections drop below i) 100.0%, ii) 90.0%, or iii) 85.0% of the original business plan; or when the present value cumulative profitability ratio drops below i) 100.0%, ii) 90.0%, or iii) 85.0% of expected collections from the original business plan. Increasing haircuts to servicing fees are applied at each of the three underperformance trigger levels.

Servicing and recovery fees amount to 15.6% of gross collections through December 2019. This is higher than the average for Italian NPL transactions rated by Scope.

32.9% of the class A notional balance has amortised since closing. As a result, the class A notes outstanding balance relative to outstanding GBV has decreased to 27.7% from 33.0% at closing.

Rating rationale

The rating action is driven both by collections underperformance relative to Scope´s initial expectations, as well as by Scope´s updated modelling assumptions, which reflect the agency’s view that the consequences of Covid-19 will weigh negatively on transaction performance going forward. Key updates include an increased average collections delay of at least one year, expected property price declines of about 5% in the short term, and potentially lower unsecured recovery proceeds. Scope expects base case lifetime collections (B rating category) to be 14.9% lower compared to the gross expected collections forecasted at closing.

Unlike most Italian GACS NPL transactions, there is no class B interest subordination feature that’s triggered by either low collections or low profitability on closed positions.

The absence of a class B interest subordination trigger makes class A structurally weaker relative to other senior notes in GACS NPL transactions, where an interest subordination feature is standard. Class A is particularly vulnerable to low collections given its remaining expected weighted-average-life of 6.9 years combined with Class B’s 6.0% annual margin. Conversely, the class B interest component is stronger relative to other peers due its ongoing priority in the payment waterfall.

Cumulative gross collections relative to the original business plan have been consistently below 78.0% since closing, causing underperformance events in each of the first five payment dates. The slow collections are consistent with the relatively high share of proceeds received from judicial resolutions - 64.6% of total collections through December 2019. Scope notes that the share of proceeds from judicial resolutions has been trending upward from December 2018 through June 2020.

Scope calculates a 67.9% cumulative collection ratio when considering monthly servicer collections from January 2020 through June 2020. Collections during this period were 40.1% below the transaction’s semester collections average. Disruptions from COVID-19 clearly had a negative impact; however, Scope notes that collections from January through March were already trending lower.

The cumulative profitability ratio on closed positions is 136.9%. This ratio moves to 108.3% when excluding discounting and time-value benefits that are factored into the cumulative profitability metric. Realised collections on closed positions are 97.1% of Scope’s base case expectations at closing, which also excludes discounting and time-value benefits.
Expected lifetime collections in the most recent business plan are 13.3% lower than the original plan, which is in line with Scope’s revised lifetime base case collection expectations. The reduction in the business plan is fully driven by dampened expectations on secured positions. Delays in expected collections have also been captured in the most recent plan. Adjustments to the servicer’s business plan do not impact Scope’s own recovery assumptions.

Relevant transaction counterparties are: i) Cerved Credit Management S.p.A., the special servicer, ii) Cerved Master Services S.p.A., the master servicer; iii) BNP Paribas Securities Services, Milan Branch, account bank, agent bank, cash manager and principal paying agent; and iv) JP Morgan AG and Banca IMI S.p.A. as interest rate cap providers. All counterparties continue to support the ratings.

Key rating drivers

CREDIT-POSITIVE (+)

Profitable closed positions: Reported profitability on closed positions stands at 136.9% and has consistently been above 128.0% since closing¹. This ratio moves to 108.3% when excluding discounting and time-value benefits that are factored into the cumulative profitability metric. Profitability on the same closed positions is 97.1% against Scope’s base case expectation at closing, which also excludes discounting and time-value benefits.

Senior notes’ liquidity protection: A 4.0% cash reserve protects the liquidity of senior noteholders, covering roughly 18 months of senior fees and interest on the class A notes².

CREDIT-NEGATIVE (-)

Cumulative collections: Realised cumulative gross collections are 72.7% of the original business plan’s expectation through 31 December 2019, and 67.9% through 30 June 2020. Accounting for the latter, this represents six payment dates since closing with consistent underperformance in each collection period¹. Cumulative gross collections relative to Scope’s base case expectations at closing are 60.9% as of 31 December 2019, and 61.1% as of 30 June 2020.

Italian economy: The Italian economy faces a deep recession in 2020 fuelled by the Covid-19 pandemic³. Despite government support measures, increased collateral liquidity risk and weakened borrower liquidity positions negatively affect recovery prospects.

No subordination trigger: Principal repayment for class A noteholders is fully subordinated to class B interest, even in cases of severe underperformance. The absence of a class B interest subordination trigger is not standard for Italian NPL transactions and is detrimental for the class A noteholders².

Rating-change drivers

POSITIVE (+)

An unlikely scenario of rapid economic recovery resulting in servicer outperformance compared to Scope’s updated assumptions in terms of recovery timing and the total amount of collections could positively affect the ratings.

An increased focus on DPO resolution strategies would potentially improve collection delays while decreasing recovery expenses that are typically higher in judicial resolution cases.

NEGATIVE (-)

Servicer performance which falls short of Scope’s updated collection amounts and timing assumptions could negatively impact the ratings.

If the Covid-19 pandemic lasts longer than expected, the supportive measures taken by the Italian government may prove insufficient. This could lead to lower collection amounts and delayed recovery timings, both negatively impacting the rating.

Quantitative analysis and assumptions

Scope analysed cash flows, reflecting the transaction’s structural features, to calculate each tranche’s expected loss and weighted average life. Scope analysed the assets to produce a rating-conditional cash flow projection of gross recoveries for the portfolio of defaulted loans.

Scope has updated its modelling assumptions to reflect the current performance of the transaction. The class A rating scenario incorporated a gross recovery rate of 38.3% over a weighted average life of 5.6 years. The class B rating scenario incorporated a recovery rate of 41.0% over a weighted average life of 6.9 years.

By portfolio segment, Scope assumed a class A gross recovery rate of 53.2% and 6.3% for the secured and unsecured portfolios, respectively. Scope assumed a class B recovery rate of 55.4% and 6.8% for the secured and unsecured segments, respectively. Scope captured idiosyncratic risk by applying rating-conditional recovery rate haircuts to the 10 largest borrowers of 1.7% and 0.0%, for the class A and class B recovery rate scenarios, respectively.

Sensitivity analysis

Scope tested the resilience of the rating to deviations in expected recovery rates and recovery timing. 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 shows how the results for class A notes change compared to the assigned rating in the event of:

• 10% haircut to recoveries, two notch decrease;
• a one-year recovery lag increase, one notch decrease.

The following shows how the results for class B notes change compared to the assigned rating in the event of:

• 10% haircut to recoveries, zero notches;
• a one-year recovery lag increase, zero notches.

Rating driver references
1 Confidential servicer reports
2 Confidential documents of the issuer, arranger and originators
3 Scope’s economic research

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

Cash flow analysis
Scope performed a cash flow analysis of the transaction using the Scope Cash Flow SF/EL Model Version 1.1. The analysis incorporated recovery rate and timing assumptions. It also took into account the transaction’s main structural features, such as the notes’ priorities of payment, the notes’ size and coupons. The analysis provided an expected loss and an expected weighted average life for the notes.

Methodology
The methodologies used for this rating were Scope’s ‘Non-Performing Loan ABS Rating Methodology’ published on 3 September 2019 and its ‘Methodology for Counterparty Risk in Structured Finance’ published on 8 July 2020. All documents are available on https://www.scoperatings.com/#!methodology/list.
The model used for this rating(s) Scope Cash Flow SF/EL Model Version 1.1 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 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 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 rating 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 at closing. The external due diligence assessment 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 rating and the principal grounds on which the credit rating is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst: Thomas Miller-Jones, Associate Director
Person responsible for approval of the rating: Antonio Casado, Executive Director
The ratings were first released by Scope on 14 July 2017. The ratings were last updated on 19 July 2019.

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.

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