Desperate times have caused ING to turn to the Dutch state for financial rescue. NautaDutilh lawyers Michaela Ulrici and Helene Piet explain the innovative structure of the acquisition

NautaDutilh advised Dutch banking giant ING on a Dutch state illiquid assets back-up facility that closed on 31 March, 2009.

The plan allows ING to take a large portion of 'toxic' assets off its balance sheet, so that no further downgrade is needed to calculate the market value of these assets. On the other hand, the Dutch state's acquisition of an 80% interest in ING's Alt-A bond portfolio does not increase the Dutch national debt. NautaDutilh partners Michaela Ulrici, Erik Vermeulen and Walter Schellekens and their team structured this challenging transaction, which is the first of its kind in Europe.

The Alt-A portfolio

The Dutch state's loan guarantee scheme involves ING's portfolio of securities, backed by residential Alt-A mortgages. ING acquired a large portfolio of the Alternative-A paper, or Alt-A notes, due to regulatory demands when expanding its operations in the US.

Alt-A is a type of US mortgage that is considered riskier than prime (A-paper) home loans and less risky than the now-infamous subprime category. Alt-A interest rates tend to be between prime and subprime home loans, and the mortgages are generally offered to buyers with better credit scores, but little or no verification of income, earning them the doubtful epithet 'liar loans'. These loans became prone to default when the credit boom came to an end.

The credit crunch and the general loss of confidence in US mortgages caused the market value of ING's Alt-A portfolio to tumble. In addition, the rising default rates on the related mortgages triggered rating downgrades on a large amount of the Alt-A notes, which in turn imposed substantially higher capital requirements on ING. On a more general note, the uncertainty about future writedowns proved to be detrimental to market confidence in ING's balance sheet.

The Dutch state to the rescue

For banks to recover from the credit crunch, they need to clear their balance sheet of 'toxic' assets such as Alt-A bonds. However, in the current market, it is extremely challenging to find counterparties that have the liquidity and willingness to acquire such assets. Governments and central banks are very much involved, but not keen to further increase the rapidly rising national debt.

Contrary to the current aura of doom and gloom around US mortgages, ING's Alt-A bonds portfolio performs substantially better than is suggested by its market value. Even when using very severe stress tests, the Alt-A bonds will still likely bring up 90% of their par value, according to the valuations made by the Dutch state's adviser. This is substantially higher than the current market value of the same bonds, which is around 65% of the original value. The illiquid assets back-up facility aims to recognise the true value of ING's Alt-A portfolio based on its actual performance.

The terms of the illiquid assets back-up facility

On 26 January, 2009, the Dutch state and ING reached an agreement on the term sheet for the illiquid assets back-up facility. Under the transaction, ING would be able to take 80% of the Alt-A portfolio off its balance sheet. The support provided by the Dutch state is structured as a guarantee rather than a purchase of the assets so that the national debt remains unaffected.

The key to the ING illiquid assets back-up facility is that it separates the legal and economic ownership of the Alt-A portfolio. Firstly, the Alt-A portfolio was transferred through a participation structure under US law to a Dutch group entity of ING. This transfer qualifies as a 'true sale' under US GAAP and leads to de-recognition under the International Financial Reporting Standards (IFRS). Subsequently, the Dutch state acquired 80% of the beneficial interests in this approximately A28bn (£25bn) Alt-A portfolio through the Dutch law governed illiquid assets back-up facility, meaning that it participates in 80% of any fall in the portfolio. This risk transfer is priced at a discount of 10% of the par value. ING remains the legal owner of 100% of the securities and will remain exposed to 20% of any falls in value, however, as 80% of the Alt-A portfolio is replaced by receivables against the Dutch state, ING is able to take this proportion of the portfolio off its balance sheet.

As the Dutch state was not prepared to increase its national debt, it was not willing to accept a proprietary interest in the Alt-A portfolio. It only has contractual rights vis-a-vis ING to receive amounts under the illiquid assets back-up facility. In exchange, the Dutch state will make periodic payments.

Legal challenges

The innovative nature of this transaction poses a number of interesting legal challenges. As US securities are brought into the Dutch legal sphere, a substantial number of conflicts of law need to be resolved. Due to the fact that the portfolio was held by multiple US ING entities, the transaction consists of an internal (US law governed) part and an external (Dutch law governed) part. This accommodates the state's desire to deal directly with only one Dutch counterparty while payments are made through a bankruptcy-remote Dutch law collection foundation so that the state is able to make and receive single periodic payments.

For the assets to be qualified off-balance sheet, the IFRS requires that the cash flows between ING and the Dutch state be independent. However, given that the state's support is structured as a guarantee, it needs to have net exposure (i.e. exposure to actual results) rather than gross exposure on the assets. This also raised several legal issues in order to meet the accounting principles, while protecting the interests of both ING and the state, including a security structure.

Toxic no more

The ING-Dutch state illiquid assets back-up facility is the first government-supported transaction that enables a bank to take 'toxic' assets off its balance sheet under a guarantee. Various challenging legal issues have been resolved by this innovative structure, meeting the interests of both ING and the Dutch state. In other jurisdictions, this may provide a solid solution to banks facing similar issues with their mortgage-backed securities portfolios.