Piecemeal approach to regulatory reform threatens to stall recovery of securitisation market

Early on in the financial crisis, the US authorities viewed fixing the securitisation market as critical to getting credit flowing through the economy again. But a plethora of regulatory changes could endanger the longer-term prospects of the industry.

Deeply shaken by the financial crisis, the US securitisation industry this year faces fundamental changes as a result of reform measures proposed or already taken by accounting standard-setters, regulators and legislators. The collective decisions made by politicians on Capitol Hill, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation and others will in turn have profound consequences for the availability of consumer and business credit in the United States and beyond.

There is little debate over whether reform is needed. Securitisation played a significant role in the crisis and few investors or issuers believe that markets can simply return to business as usual. However, there are growing concerns that restrictive new rules could hamstring a market that accounted for an estimated 30% of business and consumer credit provision at the end of 2008.

The challenge is to ensure the revival of securitisation markets while also guarding against the kinds of abuses that fuelled the crisis, such as creating incentives for lax underwriting of underlying assets, opaque and complex asset pools, credit rating failures, inadequate risk capture in both accounting standards and regulatory capital, and breakdowns in disclosure.

One major sticking point, according to some observers, is the lack of a harmonised approach to the market’s problems among the various regulatory and legislative bodies. The fear is that without co-ordination, new rules from a variety of sources could suffocate the market rather than revive it.

Speaking at the ASF 2010 securitisation industry conference in February, John Dugan, the US Comptroller of the Currency, acknowledged the danger. “If we do not appropriately calibrate and co-ordinate our actions, rather than reviving a healthy securitisation market, we risk perpetuating its decline, with significant and long-lasting effects on credit availability,” he said.

Chris Killian, vice-president in the securitisation group at the Securities Industry Financial Markets Association (Sifma) in New York, likens the problem to so-called ‘risk-layering’ in mortgage securities, a practice that helped fuel some of the highest default rates in the housing bust. In isolation, low documentation loans, high loan-to-value loans, or loans with low introductory teaser rates may not have run aground, but when all these factors were combined, the rates of default and loss were unprecedented.

Killian adds: “Any individual regulation may not be harmful by itself, but taken together, a series of more restrictive rules could make the additional costs of securitisation uneconomic.”

Many of the nuts and bolts of financial reforms for the post-crisis world are yet to be fully agreed upon, adding weight to industry efforts to help steer the process as the year progresses. In December, the House of Representatives passed the Wall Street Reform and Consumer Protection Act, an expansive 1,300-page bill covering issues ranging from greater oversight of depository institutions to the creation of a new consumer financial protection agency. Fewer than a dozen pages of the House bill were dedicated to securitisation reform, but the document contained a handful of provisions that have industry experts worried.

The Senate issued its own proposals in November containing similar provisions, but has yet to put forward its own bill for consideration. Further clarity from the Senate could take some time, as Senate Banking Committee talks on financial reform had all but broken down at the end of February. Bipartisan consensus on issues such as defining systemic risk and a new consumer financial protection agency has proved elusive, stalling the legislative process.

This has made it hard for industry participants to gauge whether new rules for securitisation will ultimately be more flexible or more restrictive when the Senate’s yet-to-be finalised proposals are reconciled with the House bill, and even harder to guess when the process will be complete.

Edward Gainor, a partner at Bingham McCutchen in Washington, says: “The timing of reform is uncertain because securitisation will be the tail that does not wag the dog. There will be more focus on issues such as ‘too big to fail’ and consumer protection.”

One issue of particular concern for issuers and investors is the focus on a bright-line standard for risk retention in securitisation deals, to be applied across all asset classes so that issuers have ‘skin in the game’. The House bill calls for issuers to retain 5% of the risk in securitisations, while the early Senate proposals call for 10% of retained risk.

It is hard to argue with the ultimate goal of skin-in-the-game proposals, which is to improve the underwriting quality of the loans being securitised. If the issuer of a securitisation retains a material risk in the deal, it stands to reason the issuer will have a stronger incentive to ensure the loans are soundly underwritten at origination.

However, both buy-side and sell-side experts argue a mandatory risk retention standard is too blunt an instrument to achieve these aims and is by no means guaranteed to work. Still unaddressed are questions of how much retained risk is really enough, and what type of retained risk is appropriate: should it be the first-loss piece, or a vertical slice of each deal, for example?

It is also unclear what effect a bright-line standard would have on different asset classes such as mortgages, credit cards and auto loans; all of which are consumer loans, but with different risk characteristics. Randy Snook, executive vice-president at Sifma, says: “This is not an area where one size fits all: different assets have different characteristics. Securitisation frees up bank capital and bank lending capacity, so it’s very much tied to economic activity. The ‘one size fits all’ rule could constrain credit creation.”

Trimming the hedge

The House bill also calls for a prohibition against issuers hedging the risk they retain; a provision industry advocates say is counterproductive when regulators are trying to promote the future safety and soundness of the financial system. “A prohibition against hedging works against the goal of creating more stability in the banking system, and would also be near to impossible to police,” says Tom Deutsch, executive director at the American Securitization Forum in New York.

He points out that banks often have offsetting transactions that may not be intended as hedges, but could be interpreted as such by regulators. Banks also typically hedge their overall portfolio risk, so a prohibition against hedging the retained risk from individual securitisations would create an unwieldy compliance burden.

Snook says: “When you look at the safety and soundness of the system, concentrated risks should be considered and banks should have the flexibility to manage those risks.”

Alessandro Pagani, senior securitised asset strategist at Boston-based investment firm Loomis Sayles, agrees with the principle of risk retention, but argues that implementing a rules-based approach to retention is fraught with difficulties and is likely to create a perverse incentive for banks to engineer deals that would circumvent the new regulations.

“My fear is that the unintended consequence of a rules-based approach to risk retention is that Wall Street will figure out a way to get around the rules,” he says.

Meanwhile, the skin-in-the-game proposals also raise accounting and regulatory capital issues as a result of recently issued standards and rules affecting the off-balance sheet treatment of securitised assets.

Specifically, the accounting questions arise from changes to Financial Accounting Standards 166 and 167, which took effect on January 1 for most banks. The modifications eliminated the use of qualifying special-purpose entities to achieve ‘true sales’ of assets. Previous rules allowed issuers to move securitised assets off their balance sheets – and consequently not have to hold punitive amounts of capital against them – which was always a primary motivation for bank issuers.

The result is that billions of dollars of securitised assets moved from off-balance sheet to on-balance sheet at the beginning of this year. Barclays Capital estimated late last year $443 billion of assets would be consolidated at the four largest bank issuers: Citi, Bank of America Merrill Lynch, JP Morgan and Wells Fargo.

Under the new rules, issuers must bring securitisations on-balance sheet if they are deemed to have a “controlling financial interest” in the vehicle, and the obligation to either absorb losses or receive benefits from the deal “that could be potentially significant”. If the company can prove that power is shared so that no one party has a controlling financial interest, consolidation is not required.

However, skin-in-the-game proposals would likely result in new deals giving issuers some of the ‘benefit’ and may result in the requirement that all loans in the securitisation be kept on the issuer’s balance sheet, not just the amount of risk to be retained. This in turn could increase the regulatory capital charges for such securitisations.

“Under the new accounting rules, it is not yet clear whether 5% risk retention would require 100% retention on the balance sheet. This would leave very little incentive to securitise because issuers would be unable to recycle capital,” says the ASF’s Deutsch. “We are certainly supportive of a better alignment of incentives between issuers and investors, but ultimately an arbitrary 5% rule is not the best way to do that. It would be better to have strong minimum representations and warranties [for the assets in a securitisation].”

Hold on to your assets

The Federal Deposit Insurance Corporation has proposed another way to ensure asset quality in securitisations meets minimum standards, by requiring that originators hold assets for a year before securitising them. The idea is to weed out fraudulent loans that default almost immediately.

This has also met with cynicism from some industry participants, in part because assets such as credit card loans have maturities shorter than a year, while mortgages are often 30-year loans for which such seasoning for underwriting quality typically takes longer than a year. More importantly, however, analysts are concerned that the increased costs and capital requirements of warehousing assets before securitisation will slow down banks’ ability to lend.

Chris Killian at Sifma says: “Warehousing assets for a year before securitising will eat up bank balance sheets and reduce their capacity to lend. It will also increase costs, which will be borne by the consumer.”

“The FDIC’s proposal does not seem to be an effective way to tackle the real issue [of systemic risk], and would squash many small independent finance companies that don’t have the warehouse lines to hold assets for a year of seasoning,” adds Pagani.

Comments on the FDIC’s proposals were due at the end of February.

Mary Schapiro, chairman of the US Securities and Exchange Commission, has taken a more radical view, claiming that existing securities laws are outdated and insufficient to regulate securitised products. In October, she called for an entirely new set of securities laws dedicated to securitisation. And in testimony before the Financial Crisis Inquiry Commission in January, she said the SEC was considering several proposed changes to “enhance investor protection in this vital part of the market”, including greater disclosure requirements as well as revisions to the eligibility standards for shelf offerings.

Gainor at Bingham McCutchen says Schapiro’s hopes for a new set of securities laws designed for the securitisation markets will likely have to be toned down, as Congress focuses on more immediate issues such as ‘too big to fail’ in financial reform and more broadly on efforts to tackle high unemployment and healthcare reform. However, the agency’s more modest proposals for greater disclosure will run in parallel to similar provisions in the House bill and proposals from the FDIC.

In seeking to prevent the regulatory pendulum from swinging too far, the securitisation industry undoubtedly has a tough political and public relations challenge.

The market is in many ways vital for the economy, cutting borrowing costs for students, home buyers and others by drawing capital from investors around the world to compete with bank loans. But for many legislators, securitisation has become a dirty word, bringing to mind the loose credit practices that helped create the financial crisis.

Striking the right balance between much-needed reform and preserving the market’s role in the economy will be hard. Getting regulators and legislators to implement reforms that complement each other will be harder still.

But as the ASF’s Deutsch says: “Unless there is regulatory consensus, it will create extraordinary problems for the restart of securitisation markets.”