ABS retention tension

paul-sharma

A report by the Committee of European Banking Supervisors last month criticised aspects of a proposal to require securitisation originators to retain 5% of exposures from 2011, while practitioners maintain the move will do little to align incentives between issuers and investors. By Christopher Whittall

Nothing is so defective as those laws that correct defects,” a French philosopher once quipped. This maxim nicely sums up the fears of securitisation originators, as regulators in the US and Europe look to eradicate abuses in the asset-backed securities (ABS) market. Several pieces of legislation have already been proposed that will, among other things, require originators to hold a slice of the risk, raise risk weights for resecuritisation transactions and increase disclosure requirements. However, practitioners worry the string of new regulations may go too far and kill the market.

Regulators and politicians largely recognise securitisation plays an important role in the financial system, and have identified the defrosting of the ABS markets as key to restoring the flow of credit to the economy. Nonetheless, they are equally determined to clamp down on the sector. On May 6, the European Parliament voted in favour of an amendment to the Capital Requirements Directive (CRD) that will require originators of securitisation transactions to retain at least 5% of exposures from 2011 when selling to European credit institutions. The amendment will also impose higher disclosure requirements on originators and require enhanced due diligence from investors. The US quickly followed suit, proposing its own 5% retention requirement on June 17 (Risk July 2009, pages 48–51). More recently, Chris Dodd, chairman of the US Senate Committee on Banking, Housing and Urban Affairs proposed a discussion draft on financial markets regulation on November 10, which calls for a 10% retention obligation to be applied to originators.

“Due to the financial and economic crisis, we have to rebuild trust in the financial markets to bring Europe back on the road of growth and to fight for the balance secured by the social market model – a balance between liberalisation where possible and regulation where needed. The requirement for originators to retain a 5% exposure to securitisations is a crucial element. Europe has to show the political willingness to learn from the crisis and to avoid future ones,” says Othmar Karas, the member of the European Parliament responsible for pushing the CRD through parliament.

Market participants can at least take comfort in the fact the retention requirement is unlikely to be higher in Europe. When passing the amendment in May, the European Commission (EC) called for a review of the retention proposal by the Commission of European Banking Supervisors (Cebs). It published its response to the EC request for comment on November 3, and it is expected to influence the final drafting of the regulation.

The report asserts the 5% retention requirement is “not a panacea for previous issues that arose in securitisation”, noting many concerns may be better addressed by other measures, such as increased disclosure requirements. It recommends the charge should not be increased further, noting there is no evidence “any single number would result in better alignment of (economic) interest between originators and investors”. Moreover, a higher retention obligation could stop originators achieving significant risk transfer and regulatory capital relief.

Cebs does, however, endorse the four retention methods suggested by the EC, noting each has “advantages and disadvantages relative to the others”. As it stands, originators will be able to choose to retain a 5% ‘vertical slice’ of each of the tranches sold, 5% of the nominal value of the pool being securitised (for those transactions backed by securitisations of revolving exposures such as credit cards), 5% of randomly selected exposures that would have been securitised, or 5% of the first loss tranche. The committee also proposes a fifth ‘L-shaped option’, which would combine first loss retention with the holding of a vertical slice. However, it added if such an approach were included, then the absolute and relative numbers of the first loss and vertical slice would have to be quantified more precisely.

New wording

Elsewhere, Cebs recommends new wording for the vertical slice retention option, as it does not currently recognise certain types of schemes that are equivalent to the retention of a vertical slice. For instance, it points to the fact some investors already demand originators retain a given percentage of the assets that are synthetically securitised. It also calls for the wording of the revolving exposures option to be amended, as it currently captures only credit card master trusts. The wording should be changed to include mortgage master trusts too, the committee says.

In addition, Cebs recommends greater clarity on a clause banning originators from hedging their exposures – specifically, it asks for more detail on what would constitute a hedge. More clarity is also required on the duration of the retention requirement, the committee said. For instance, if the originator opts to retain a first loss piece and losses later erode this tranche, the firm will find it difficult to obtain regulatory capital relief if it is required to constantly replenish its interest back up to the 5% level. The report also recommends strict disclosure requirements should be considered a complement – if not an alternative – to retention requirements.

The report has been welcomed by some EC officials, who privately acknowledge it is now unlikely the 5% retention requirement will be increased. “It is safe to say we are quite happy with what came out. I think the report is right in saying there is no uniform right answer in setting the level of retention. I don’t see us raising this regulatory backstop. But you never know with a new commission and what the mood of the parliament is – maybe that demand comes back. But I would say probably 5% is there to stay,” says a senior EC official.

However, many originators, investors and analysts who spoke to Risk continue to express concern about the concept of a formal retention obligation. Practitioners point out many European financial institutions opted to retain some exposure even before the crisis. “I’m not convinced this mandated retention requirement is the panacea the regulators and legislators have held it up to be. We’ve had retention in place and it didn’t stop some problems from arising,” says Gordon Haskins, head of transaction execution at Royal Bank of Scotland (RBS) in London.

This view is echoed in research by Ingo Fender of the Bank for International Settlements and Janet Mitchell from the National Bank of Belgium, published in September. The authors point out retention is nothing new, and originators have traditionally held on to the equity tranche. However, they point out retaining the first loss piece may not provide strong enough incentives for originators to screen borrowers if downturns are imminent and the retained tranche is thin enough to be eroded in a slump. In fact, they argue the success of different retention mechanisms in aligning incentives depends on tranche thickness and the position of the business cycle. As such, mandating an optimal retention amount is likely to be difficult, as it will differ across specific transactions and markets. If the amount is too low, there is less incentive to screen borrowers; if too high, it would increase costs and hamper efforts to reinvigorate the securitisation market.

They instead argue the requirements should be flexible, suggesting regulators should not fix retention amounts or the position in the capital structure, but mandate detailed disclosure of retention amounts at issuance and over time, as well as whether the exposure has been hedged.

However, politicians are unwilling to budge on retention. “I’m convinced there is a necessity for retention due to the crisis and the impact on the European economy. The percentage itself might be higher, but given the situation with an almost dead market in need of rebuilding, the 5% was the only possible political compromise,” says Karas of the European Parliament.

Meanwhile, regulators point out the current size of the proposed retention requirement in Europe is unlikely to increase costs to the extent it will hamper the revival of the ABS market. “The 5% retention is at best a useful bit of risk management and at worst a moderately extra administrative burden. The argument in favour is it focuses the minds of originators; the argument against is there might be better ways of focusing the minds of originators and it is a further piece of bureaucracy. But I don’t see any of that as being determinative of whether, when and how the securitisation market reopens and what its new normal level turns out to be,” argues Paul Sharma, director of wholesale prudential policy at the Financial Services Authority in London.

Perhaps a greater concern for originators is inconsistencies and overlap between other initiatives. These include increases to risk weightings for resecuritisations under Basel II, changes to rating methodologies for structured finance deals, and alterations to accounting rules in the US that will force financial institutions to consolidate special-purpose entities (Risk August 2009, pages 72–74).

“Institutions are going to say ‘why bother? Let’s issue covered bonds instead’. Then five years from now, you’ll have governments scrambling to put incentives in place for banks to securitise more because they would have ruined the real economy,” says one London-based banker.

Even regulators acknowledge there is plenty of uncertainty about how the various regulatory initiatives will affect overall capital levels for ABS transactions. If the cumulative effect is sharply higher capital, it could reduce incentives for securitisation. “The difficult thing for the market at the moment is not so much the new rules that are in place, but the fact that the regulatory community hasn’t made up its mind yet on exactly how the capital treatment is going to fall out. If the treatment is going to be on the harsh side, it may damage the economics of securitisations,” says Til Schuermann, vice-president at the Federal Reserve Bank of New York.

ABS woes

The ABS market is still suffering from the effects of the credit crisis. In the US, issuance volumes increased 200% in the three months to June 30, reaching $48.2 billion. However, 70% of this was intended to be eligible for the Federal Reserve Bank of New York’s Term Asset-Backed Securities Loan Facility. In Europe, issuance volumes reached €81.2 billion in the second quarter, although 99% of this was retained, according to the European Securitisation Forum (ESF).

There were signs of life in the third quarter in Europe, however. On September 24, Volkswagen Leasing successfully placed €500 million of AAA-rated senior paper and a €19.1 million A+ rated tranche. Hot on its heels, Lloyds Banking Group issued a £4 billion residential mortgage-backed security (RMBS) via its Permanent programme. The three tranches were all rated AAA. Then, in late October, Nationwide Building Society issued an RMBS from its Silverstone Master Trust. The issue contained three tranches totalling £3.6 billion, all rated AAA.

Both the Lloyds and Nationwide transactions contained put options, designed to shield investors from extension risk. Traditionally, master trusts have included an issuer call option after five or seven years, allowing issuers to buy back the notes at par, less any incurred losses. Typically, the inclusion of a coupon step-up encourages issuers to call the deal at this time. However, with spreads widening dramatically since the crisis, many issuers decided not to call their transactions. The put option is designed to give investors comfort around this point, and analysts believe this is likely to be a feature of master trust securitisations in the future.

“Over the course of the next 12 months, I would assume an issuer will offer investors a tranche with a put and a tranche with a non-put, naturally with a degree of differential. It will be very interesting to see how much value is assigned to the put option by investors at this point, and more broadly where risk appetite truly stands. For now, however, I expect to see it as a relatively common feature for UK master trusts,” says Gareth Davies, head of European ABS research at JP Morgan in London.

This recent activity has given investors a chance to gauge the level of disclosure provided by originators. Stéphane Caron, head of ABS investment at Natixis Asset Management in Paris, says the amount of information provided by originators has not materially changed. “I went to the Volkswagen road-show and I don’t think we had more information than for previous transactions – the level of information was already very good with historical performances for the loans within their balance sheet,” he says.

But further, formal requirements on disclosure are likely. Aside from the CRD, the ESF published a set of principles to enhance transparency of RMBS transactions in February, which attempt to standardise information around the security, collateral and aggregate loan information. Meanwhile, the European Financial Services Roundtable, an organisation focused on financial services policy, comprising chairmen or chief executives of leading European banks and insurance companies, is working on an initiative to develop a labelling system for ABS transactions. The project is still in its early stages, but would allow an ABS to be certified as reaching a certain benchmark if it meets standards in terms of structure, liquidity and disclosure.

Also, the European Central Bank (ECB) has launched an initiative to encourage loan-level disclosure for ABS deals via its repo window. “Currently, we are working with rating agencies… with a view to introducing loan-by-loan level information in the ongoing surveillance process for eligible ABS,” said Francesco Papadia, director general at the ECB, at a securitisation forum in London on June 2.

This scheme is believed to be merely a trial at the moment, but observers point out the ECB is in a strong position should it wish to extend the programme. “The ECB has recently been signalling that it is considering requiring loan-level data to be provided for securitised transactions, maybe not as a requirement for access to the repo window but potentially as a haircut differentiator. From a broad perspective, we would view this development as extremely positive for the industry. If provided to the ECB or rating agencies, it would be harder to refute requests from investors for data, becoming the new market standard,” says Davies at JP Morgan.

However, participants point out all this additional disclosure will come at a cost for originators. “Originators may need to consider whether their reporting systems capture the information required, as well as how they disseminate that information and keep it updated. If there is to be loan-by-loan disclosure, this might result in further costs that may be prohibitive,” says Haskins at RBS.

Others believe the main problem facing the securitisation market is not the level of disclosure, but the damage done to the reputation of the asset class. Many investors have fled the sector and many are unlikely to return in the near term, even with the proposed changes to the regulation.

“We still face a liquidity crisis in ABS in Europe simply because there is a lack of investors for the product. We need to have a public initiative to explain to the financial community that securitisation will be different, even if it is not very different from the rules used in 2006. Right now, most investors we meet want to avoid ABS completely because there has been such a negative news flow,” says Caron.

 

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