I wrote a comment piece recently on moves towards the novel notion of regulatory high-quality securitisation confirmed by originator self-certification. It’s just one element of the multiple efforts being made by policy makers and regulators to restart the market in Europe and put it on a more solid footing, including as a component of Capital Markets Union. I must say it received good traction and I received some very interesting feedback.
One of the issues I’d commented on was how much of a burden policy makers were putting on investors in expecting them to do so much due diligence ahead of making an investment decision. I said then, and I repeat it now, that I feel the level of due diligence is unreasonable. It takes investors way over that line of reasonableness and potentially pushes up the opportunity cost of investing in securitisation so far that it in fact acts as a deterrent.
I’m not talking here about the small number of specialist investors with the expertise to do the assessments, who know what questions to ask and are familiar with the lenders they work with. I’m really thinking about the relatively large number of new non-specialist investors who presumably need to be tempted into the market to make it a viable source of funding, risk transfer and/or regulatory capital relief for banks and non-bank institutions.
At issue here is the idea that investors have to take responsibility for ensuring the original lenders grant credit on the basis of sound and well-defined criteria with clear processes for approving, amending, renewing and financing them etc. What I didn’t make clear – and which was pointed out to me subsequently – is that this is ALREADY the legal position for investors covered by the Alternative Investment Fund Managers Directive (AIMFD).
Article 52
Read the due diligence checklist around making and monitoring investments and around selecting counterparties and prime brokers. It’s scary. When it comes to securitisation, Article 52 (qualitative requirements concerning sponsors and originators) goes into a lot of specific detail.
The provisions enshrined in Article 52 are mirrored in Article 406 of the Capital Requirements Regulation. They both go too far, in my view, and require investors – legally – to engage in an unreasonable amount of effort. If the returns available in securitisation were so high as to render that effort economically worthwhile, I guess you could say it was worth it. But that’s not the case.
When it comes to originator self-certification, though, it does shift the balance of my conclusions insofar as the rules actually embody the idea that everyone involved in the process has to certify – except regulators who claim moral hazard.
While in theory third-party certification is the way to go and third parties may indeed be tempted by potentially attractive revenue streams, one buy-side participant told me regulators and investors have to accept that no third party reviewer is ever going to be paid enough/have enough skin-in-the-game to take true diligence risk on the assets.
Collision course
That’s one issue. My biggest question, though, is this: have policymakers set CRR on a collision course with AIFMD on the certification and due diligence issue? If a prospectus claims STS compliance, and if arrangers and investors carry out the diligences required by regulators on both sides and all goes to plan, fine.
But what if it doesn’t? If originator or seller rep and warranties turn out for any number of reasons to be false, the investor previously had the right to sue and if upheld could claim all losses and damages. That is no longer the case.
Think about it: the originator can now claim in court – correctly – that investors are now legally mandated to undertake rigorous checks and balances as laid out in black and white in the regulations. Where does that shift the burden of responsibility? If an investor failed to carry out sufficiently rigorous due diligence, it is logically now illegal for them not to have done so. Now that really is an issue of moral hazard.
It’s not just a question of the amount of work investors need to do; it’s the nature of the tasks involved. How do you define sound lending standards vis-à-vis third parties as that pertains to protecting your legal liability? How should you interpret changing lending standards against the constantly moving target of changing economic or business circumstances?
Sub-prime lending doesn’t necessarily, or at all, infer poor lending standards; a lender may be perfectly comfortable with the prospect of returns exceeding risk factors in this segment. But how should an investor view it in a legal context of defining adequate standards?
Policy makers have thrown the cat amongst the pigeons. The obvious sell-side defence in the event of trouble is going to be negligence on the investor side. I foresee drawn-out legal battles with only one realistic end-result: stalemate with no real remedy and lawyers making out like kings.
I write a lot about the laws of unintended consequences; here’s one that could develop into a real headache. Policy makers need to review what they’ve built, taken to its logical conclusions. This certainly is not a solid basis for which any market can reasonably be rehabilitated.
