The financial crisis revealed many faults to the securitisation market and there is no question that these needed to be fixed. But it seems likely that the sheer number of initiatives, some of which conflict, will stifle and possibly snuff out the anaemic recovery. William Thornhill reports.
Traditionally, regulators have lacked the teeth to enforce. But in the last two years, they have increasingly found themselves taking centre-stage. Regulators have been instrumental in establishing the new world order. However, though ostensibly laudable, their efforts to devise the safeguards that will ensure a sustainable long-term revival of the securitisation market are in reality politically driven by regional agendas. The resulting uncertainty risked undermining recovery – and even snuffing out securitisation as a funding technique altogether.
“The plethora of different initiatives, some of which are conflicting, may risk some regulatory confusion,” said Krishnan Ramadurai, managing director of the credit policy group at Fitch Ratings.
The flaws in the structured finance market ran deep and were manifold: the perverse incentives of originators that were solely concerned with expanding their market share at any cost; the conflicted business models of rating agencies, who kowtowed to their sell-side paymasters; and the willingness of investors to buy toxic securities they could never realistically hope to understand or value.
Faced with these woeful inadequacies, governments and their regulators moved to insure that such mistakes would never be repeated. Though governments have been mindful to stress that a functioning structured finance market is essential to the effective revival of the global economy, the reality on the ground tells a different story.
“There are a large number of new regulations devised with a view to delivering a more stable structured finance sector longer term,” said Stuart Jennings, managing director in the European structured finance group at Fitch. “However, many of these are due to become effective when the market is still struggling and these will not help recovery in the short term.”
In a report on the role of the ECB in structured finance, Fitch cites various initiatives that may create uncertainty, including proposals to increase capital requirements which will make securitisations less attractive for CRD-reliant bank investors. The increase in regulatory capital requirements ignores the fact that rating agencies have tightened criteria and now demand greater subordination for a given rating. Tighter criteria and higher capital charges were two decisions taken independently but with little thought the combined impact.
Banks wishing to invest in structured finance are also now subject to minimum due diligence requirements under CRD2 (122a). It is difficult to argue that more transparency is anything but a good thing, but there is a risk that the rules will encourage opacity, not transparency. Even in pre-crisis times offering circulars would run to several hundreds of pages, making it relatively easy hide material information within reams of data. Producing a greater volume of information “may result in investors failing to meet their statutory due diligence requirements” if they are found not to have examined this information effectively, Jennings said.
Moves to standardise data fields could genuinely help improve transparency, mitigating concerns over the sheer volume of information. But there is no agreement about what those standards should be.
In a recent structured finance conference in Europe, loan-data disclosure was deemed a good thing. But investors said standardisation of the key definitions was more important. It is more useful to know what an originator calls a self-certified loan than whether a pool contains 5,000 or 6,000 of these loans, they said.
Other very common definitions have yet to be determined. Structured finance professionals met in early May to try to agree a definition for ‘prime borrower’. Unfortunately, after three hours of haggling, no result was yielded.
Standardised loan information is important because it allows investors to perform a bottom-up valuation in a market where there are no bids. Getting hold of this information remains difficult in Europe, and was almost impossible at the height of the crisis for some types of deals. As a result, liquidity seized up altogether across the whole structured finance market.
The consequence of that is that structured finance securities, once deemed the most liquid, will no longer be eligible for proposed liquidity coverage and net stable bank funding ratios under CRD4 amendments. These would make such securities less attractive to bank investors “since they would not be deemed liquid for the purposes of determining these key ratios”, said Jennings.
There were concerns that originators would wash their hands of loans that they had securitised and sold to third parties. IN response, CRD2 regulations require originators to retain a minimum 5% of their transactions, thereby aligning their interest with that of the investors.
Though the aim is worthy, the affect will necessarily mean that one twentieth of every transaction must be kept on balance sheet. This will undermine the cost-effectiveness of issuing deals, particularly for capitally-constrained and securitisatrion-reliant non-bank entities. It will reduce overall lending and make the market less competitive, giving an advantage to large balance sheet lenders.
The European 5% retention rule chimes with US proposals put forward by separately by Congress, the SEC (under Regulation AB) and the FDIC (under its safe-harbour standard). Added to the aforementioned arguments, US industry pros say these proposals could all be applied in slightly different and confusing ways.
The FDIC’s safe harbour rules generally aim to ensure bankruptcy-remoteness of securitised assets by protecting them from being seized by creditors. But among them is another standard, asserting that servicers must be given full authority to mitigate losses on delinquent assets no more than 90 days after they become delinquent.
The rule neither describes what the mitigation steps are, nor gives a precise definition of “full authority”. Such vague language could cause a disagreement after the fact, potentially unravelling a transaction’s safe harbour status.
Accounting rules applied differently
On the accounting front, the securitisation markets face additional uncertainties and conflicts with the way FAS 166/167 accounting rules are applied in the US, compared with IFRS accounting rules in Europe.
“The rules surrounding capital relief for securitisation transactions are more closely linked to accounting in the US, in contrast to Europe where capital relief rules are not tied closely to the accounting rules,” said Ramadurai.
The US FAS rules effectively make some securitisations, such as US credit cards, less viable, forcing banks to hold their funding vehicles on-balance-sheet with no capital advantage. In Europe, IFRS accounting rules are not closely tied to regulatory rules. If a bank consolidates its issuing vehicle on balance sheet, it does not necessarily follow that it won’t get regulatory capital relief.
Jason Kravitt, a senior partner at Mayer Brown, and deputy chairman of the American Securitization Forum, said using control-based accounting rules as a proxy for determining risk-based capital requirements is unreasonable. It throws “securitisation into the pond, and the ripples you see are its last breath,” he said.
In the US there are various other initiatives that sully the outlook and create an uneven playing field compared to Europe. A recent Senate bill, passed on May 20, could have a detrimental affect on synthetic structured finance transactions. If the bill becomes law, US banks would be required to separate their derivatives businesses from their core banking businesses, forcing them to conduct major capital raisings.
Foreign banks, however, would not be subject to these costly provisions. They would be able to draw on their huge balance sheets to help cover the derivative trades that form the backbone of any synthetic structured finance deal.
The demise of European money market funds has also given rise to other regulatory initiatives. The Committee of European Securities Regulators is now trying to implement something similar to US Rule 2a7 that applies to US money market funds. It recently published guidelines on a common definition setting out criteria that will affect the maximum maturities and calls on structured finance deals.
“We view the restrictions as particularly onerous for ABS investments, and believe that few of the currently outstanding ABS bonds are satisfying CESR’s criteria,” said Reto Bachmann at Barclays Capital securitised products research.
The conflicted business models of rating agencies, in which sellers paid rating agency fees, is another area that regulators have pawed over. The SEC’s Rule 17G aims to break the mould by increasing competition among the agencies. The Rule requires issuers to disclose all “material non-public information to nationally recognised statistical rating organisations, regardless of whether they make their ratings publicly available,” the SEC said.
This deal information would then be used by would-be competitors to make unsolicited ratings in a bid to increase market share. But whether the rule actually delivers is another matter. In the first place it introduces considerable rating uncertainty (as one rating is potentially undermined by another). Apart from that, compliance will be very difficult to monitor, especially when if the material information is given orally.
As a result of all these efforts “there is a risk that some investors and issuers may just see the increased burden and expense involved with investing in — or issuing — structured finance securities as too onerous to re-enter the structured finance market,” said Jennings.