Market participants are usually vocal when it comes to describing their reaction to a new regulatory proposal. But one source who spoke to Risk.net was literally lost for words following the European Commission’s (EC) publication of the review of the European Market Infrastructure Regulation (Emir), which included a requirement for securitisation special-purpose vehicles (SSPVs) to post margin on over-the-counter derivatives.
The amendment took the market completely by surprise and could have disastrous implications for already subdued European securitisation volumes. Both lawyers and market participants have warned if SSPVs are subject to margin requirements, it will force originators to turn to other means of refinancing loans, such as private placements.
“People will find a number of transactions of the type they would have done in the past become economically infeasible due to the margining requirements, but rather than there being no transactions, people will find other ways to raise finance, so you might see more private deals,” says David Shearer, a partner at law firm Norton Rose Fulbright.
For regulators, this might be an unwanted consequence, as private placements tend to be more opaque, making it harder to track market flows and risks.
“Once you are outside the securitisation definitions, all the reporting requirements will fall away and it will be quite hard for regulators to now know where the risk in the system has gone. Previously, there was an incentive to carry out public securitisation deals, where at least there were prospectuses, rating reports and investor reports, so there was some transparency about what deals had been done and what leverage there was in the financial system,” says Shearer.
On May 4, the EC published its long-awaited review of Emir. The regulation mandates that firms classed as either financial counterparties or substantial non-financial counterparties whose derivatives positions exceed a clearing threshold (NFC-plus) must exchange margin on non-cleared OTC derivatives.
In the original Emir text, SSPVs were classed as NFCs. The threshold test for NFCs allows them to exclude derivatives positions used for hedging. As SSPVs only use derivatives to hedge the interest rate or currency mismatch between the underlying loans and issued notes, they are almost always below the threshold (NFC-minus).
In the review, the EC proposes broadening the definition of a financial counterparty to include SSPVs, alternative investment funds and central securities depositories. The EC stated these additions to the definition of financial counterparty will ensure all entities, “which due to the nature of their activities are financial counterparties”, are appropriately defined.
I suppose this would be potentially another reason to do a securitisation-style deal that didn’t technically qualify as a securitisation for European Union regulation. There is that dangerVincent Keaveny, DLA Piper
The EC has also introduced a new subcategory of financial counterparty that will be exempt from the clearing obligation if they are below the threshold set for the NFC-minus category.
For interest rate or currency derivatives, the thresholds are set at €3 billion (£2.3 billion) of aggregate month-end average derivatives positions for the months of March, April and May.
Although this is almost certain to exempt SSPVs from the clearing obligation, the change to the status of financial counterparty will also bring SSPVs under the remit of the variation margin (VM) requirements for non-cleared derivatives. All financial counterparties were required to begin posting VM from March.
This threatens to make all SSPVs economically unviable, warn lawyers and market participants, because securitisations do not currently hold cash specifically to post as collateral. As a result, originators will have to find other ways to refinance assets; one suggestion is through private placements.
“I suppose this would be potentially another reason to do a securitisation-style deal that didn’t technically qualify as a securitisation for European Union regulation. There is that danger and possibility that would be the result,” says Vincent Keaveny, a London-based partner at law firm DLA Piper.
Private placements are technically not securitisations, but their features can be similar. In recent years this type of transaction has increased, due partly to regulation. Keaveny points to the capital requirements regulation (CRR), which includes a requirement for originators to retain 5% of a securitisation they issue, as one reason for transacting a private placement.
“We have certainly seen people doing that. There are various reasons why people will do that. Amongst them is avoiding the 5% retention obligation. That is a reason why some of these private deals are structured in these particular ways,” says Keaveny.
An example of a private placement that could avoid margining is the use of special-purpose vehicles (SPVs) to offload commercial mortgages in single tranches.
“With commercial mortgages, what has been happening in the last few years is that where banks or non-banks have originated loans they have tended to syndicate the loan to investors. Some of those investors can’t invest in loans directly, so they have asked for the loan to be structured as a security instead, through a special-purpose vehicle. The SPV would have issued a note as a single tranche secured on the commercial mortgage loan, which allows those investors to participate in the loan,” says Erik Parker, an asset-backed security strategist at Nomura in London.
As there is only a single tranche that is going to an investor, it is not classed as a securitisation. The requirement to margin is only on SSPVs, so by virtue of being a non-securitisation SPV, the private-placement vehicle would still be classed as an NFC-minus and not have to post VM.
Strapped for cash
Many sources who spoke to Risk.net have stressed how difficult the requirement to post margin will be for SSPVs as they are not currently designed to hold the cash needed for margining.
There are several ways in which SSPVs could find the collateral, but each one has its own pitfalls. It would make the SSPV uneconomical for the originator, make the notes issued by the SSPV less attractive to investors or strip away the vehicle’s protection against credit losses.
The originator could place the cash for margining in the SSPV at the point of origination. Obviously, that has a direct cost for the originator, but it is not clear how much cash would have to go into the vehicle to cover margin requirements. The SSPV could face the scenario of not having enough cash to provide for the margin calls.
“Every additional cash requirement a transaction generates, somebody is going to have to put the cash into the deal for that purpose, and the greater the cash requirement, the more challenging the economics of the transaction become because of the cost involved in providing that cash,” says Keaveny of DLA Piper.
Another option is to siphon off the cashflow generated from the underlying assets to pay the noteholders of the SSPV. However, if the SSPV started siphoning off this cashflow, ultimately it would make the notes much less desirable to hold, because it would increase the risk of non-payment to junior noteholders. It would also lead to negative implications for the notes’ credit rating, raising problems for investment funds with a mandate that sets the minimum credit quality of assets held.
“It is difficult to see how they could start posting margin and retain AAA status. The various credit-rating agencies rating these SSPVs will look at these structures and look at costs. Currently, those ratings won’t include any element for margin,” says Nick Railton-Edwards, head of research at documentation consultancy Derivatives Risk Solutions.
For existing deals, Moody’s Investors Service has already labelled the proposed Emir requirement “credit negative” in a report it published on May 11, because it would be difficult for the SSPV to replace a hedging counterparty on the same terms as it had before the margining requirement was introduced.
In practice, an issuer is unlikely to trade with a new counterparty if it is required to exchange marginJane Soldera, Moody’s Investors Service
The Emir review does not amend the application date for derivatives on which SSPVs would have to post margin. If the proposal is left as currently drafted, SSPVs would have to post margin on any derivatives contracts entered into after August 16, 2012.
“After the revised margining requirements begin, replacing a counterparty would require entering into a replacement swap with margining. In practice, an issuer is unlikely to trade with a new counterparty if it is required to exchange margin,” Jane Soldera, a senior credit officer at Moody’s Investors Service, said in the report.
The final alternative source of cash that some SSPVs could rely upon is the reserves they build up over the life of the transaction.
“The SSPVs might start with a minimal level of cash provided for reserves and then ramp it up for the first 18 months of the deal out of the excess profit that is being generated in the transaction. So, instead of taking out excess profit, they trap it to build up cash reserves and that can be a relatively capital-efficient way of generating the reserves,” says Keaveny of DLA Piper.
Not all SSPVs take this approach. The ones that do it tend to offer residential mortgage-backed securities. The problem with raiding such stockpiles is that it takes away any protection the vehicles have against credit losses.
“There are some structures where some of the cash is trapped to build a reserve, but that is set aside to cover potential credit losses and is not intended to be used for potential margining,” says Parker of Nomura.
The SSPV could also turn to a lender to act as an additional liquidity facility, specifically to provide margin when needed. The lender could either be subordinated or ranked senior, but again, both ways are far from perfect.
“They would have to find someone to act as a subordinated lender to the vehicle and provide additional funds. There would need to be further drawings whenever the collateral requirement increased. That would be quite a difficult obligation for lenders to commit to, because anyone who is providing that finance basically knows that almost all of their capital is at risk and the only source of repayment is the collateral if the swap doesn’t actually get called,” says Shearer of Norton Rose Fulbright.
If the lender is subordinated, they would have to be incentivised by the SSPV with high returns on the cash they provide.
“From a ratings perspective, if the subordinated lender was a regulated entity, they are probably looking at best at a B or BB-type rating on the subordinated loan, which from a capital perspective would be quite penal to them,” says Parker of Nomura.
Alternatively, the SSPV could rank the lender’s claim higher than that of the noteholders. This wouldn’t eliminate the cost to the SSPV, but it would be cheaper than margin financed by a subordinated lender.
The problem is how the rating agencies might look upon having more liabilities ranked senior to the noteholders. In the claims on SSPVs, the counterparty to the hedge is ranked senior to the noteholders. Adding another claim could raise questions from the rating agencies as to whether junior or senior noteholders will get all of their claims fulfilled.
This would likely cause the ratings on the notes to be materially downgraded, perhaps even to default, which would have significant negative consequences for noteholdersErik Parker, Nomura
“If it is senior, it may appear there are larger senior-ranking liabilities ahead of the notes, which may make the ratings on the notes and/or tranche sizes a little bit more difficult to achieve, everything else being equal. If it is subordinated, the cost of it is effectively going to be fairly significant, and even if it is senior there is going to be a decent cost attached to it,” says Parker.
As the SSPV would have to review daily margin calls, it would have to operate on a day-to-day basis to either collect or post margin. If a lender were used to provide that collateral, the management of the SSPV would have to co-ordinate on a daily basis with the lender.
“Operationally, the SSPV’s activities – with respect to the calculations, invoices, payments, accounting and general managing – are largely geared around the quarterly payment date. If the SSPVs are required to action daily margining, then the management of the SSPVs and some of the other involved third-parties will have to be much more active on a daily basis, which will incur additional costs for the SSPVs,” says Parker.
A further challenge that margining will cause is the introduction of a new scenario for the SSPV to go into bankruptcy. If the SSPV failed to pay the margin on the swap, the counterparty calling the margin could treat the failure as a default and unwind the transaction.
Rating agencies may have to take this into account when first rating the notes, and if the scenario were to play out then the notes could automatically default.
“If, for whatever reason, the SSPV is unable to provide the cash or collateral in time, the entity demanding the margin could potentially call a default. That could lead to them unwinding the swap and then making their claim on the securitisation vehicle. The SSPV wouldn’t have the cash to pay the whole amount, which could then lead to a bankruptcy event of the vehicle. This would likely cause the ratings on the notes to be materially downgraded, perhaps even to default, which would have significant negative consequences for noteholders,” says Parker of Nomura.
Part of the reason why the Emir amendment took so many by surprise is that it seems to clash directly with the EC’s capital markets union plan to promote the securitisation market as an alternative non-bank source of funding.
To reinvigorate Europe’s stalled securitisation market (see figure 1), the EC has proposed the creation of a new label for high-quality securitisations, known as simple, transparent and standardised (STS) securitisations.
Railton-Edwards of Derivatives Risk Solutions believes the amendment to the Emir review could undermine the whole initiative. “You have to have a market to migrate. Putting extra pressure on a market that is already haemorrhaging personnel and capacity seems like a strange thing to do to me. I think the STS proposal makes perfectly good sense in terms of European priorities; I just don’t see how this [Emir review] matches up with them,” he says.
The STS proposal is currently being negotiated between the EC, the Council of the EU and the European Parliament. Market participants have tipped negotiations to be finalised by the end of June, because this marks the completion of the current rotating presidency of the council (Malta). The Maltese authorities apparently view STS as a key objective of their term.
An STS securitisation has to have the interest rate and currency risk hedged. For SSPVs offering STS, this rules out any possibility of avoiding margin posting by leaving the structure unhedged.
“So it is kind of a bit like Catch-22, as you are either unable to comply with the hedging requirement or unable to comply with the asset standardisation requirement,” says Shearer of Norton Rose Fulbright.But another requirement that has to be fulfilled for a securitisation to be STS is for the pool of assets to be homogeneous, which could further limit the way SSPVs try to find collateral. If originators over-issued notes, so the SSPV held a larger cash buffer to post as collateral, the deal might be characterised as a mixed-asset portfolio, which is prohibited under STS.
Even more contradictory, the STS proposal contains an exemption for SSPVs from the clearing obligation if they are offering STS securitisations. Designed as an incentive to encourage the uptake of STS securitisations, the exemption is effectively meaningless as it is uncommon for SSPVs to be large enough for the clearing obligation to apply. Nor do they tend to use derivatives subject to the clearing obligation.
“So, by virtue of being classified as a financial counterparty, the options are to either clear or collateralise your derivatives transactions. Clearing is not an option; it is not even a question because it won’t be possible. The derivatives in securitisations are bespoke and therefore illiquid. No clearing house will offer clearing services for illiquid transactions, so the parties will have to collateralise transactions rather than clear them,” says Nigel Dickinson, a London-based partner at law firm Norton Rose Fulbright.
Despite its limited usefulness to originators, the clearing exemption in the STS legislation seems to suggest European lawmakers are aware of the problems that could be caused if SSPVs are required to post margin to a central clearing house. And yet, the Emir review would introduce VM posting for non-cleared derivatives used in STS transactions, which will potentially be just as disruptive to the securitisation market as a clearing obligation.
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