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Securitization in Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) constitutes the most sweeping financial reform package since the 1930s. Title IX of the Dodd-Frank Act (“Title IX”), entitled the “Investor Protection and Securities Reform Act of 2010” enacts a grab bag of substantial changes to capital markets regulation and practices in the hope of putting back in their bottles the twin genies of moral hazard and lax regulation that are widely viewed as the tinder that sparked the great credit conflagration of 2008. Subtitle D of Title IX, entitled “Improvements to the Asset-Backed Securitization Process” (“Subtitle D”), has been of particular interest to capital markets participants both because practices in securitization markets are widely credited with contributing uniquely to the credit crisis and because of the sense of many that the resuscitation of robust securitization markets is one of the key predicates to an economic recovery.

The reforms to the asset-backed securitization process contained in Subtitle D and elsewhere in Title IX are essentially intended to remove incentives embedded in the “originate-to-distribute” model that has been discredited during the financial crisis. The most significant change is the introduction of a requirement that sponsors of nearly all securitizations and/or originators of loans sold into securitizations retain a portion of the credit risk inherent in the pool of assets securitized. However, these risk retention requirements will not apply to securitizations of assets issued or guaranteed by the United States, any state, or any agency of the foregoing, or securitizations consisting solely of qualified residential mortgage loans that conform to parameters established by regulation. The result may be the continued viability of originate-to-distribute with respect to plain vanilla residential mortgages – that is, residential mortgages insured, guaranteed or designed by the government. Residential lenders that do not wish to retain risk or do not have capital to do so may be left with an originate-to-distribute business consisting of plain vanilla mortgages. This ultimately may limit consumer choice, restrict the availability of consumer credit and stifle innovation in the residential mortgage market.

Subtitle D is not the end of the game on securitization reform because it grants broad authority to regulators, who will determine the final score based on guidelines contained in Title IX of the Dodd-Frank Act. The Securities and Exchange Commission (the "SEC") has already issued its blueprint for many of the regulations required in its proposed amendment of Regulation AB[1] (the "Regulation AB Proposal") and the Federal Deposit Insurance Corporation (the "FDIC") has also weighed in with its thoughts on reform of the rules governing securitizations by depository institutions in a rulemaking exercise (the "FDIC Proposal").[2]

This Alert will discuss principal themes of reform embedded in Title IX, with special reference to Subtitle D. These themes are risk retention, new disclosure and reporting requirements, regulation of the use of representations and warranties and regulation of conflicts of interest. It will then discuss the timing and process for regulatory implementation. Other K&L Gates client alerts address other aspects of financial reform in the Dodd-Frank Act. Additional information is available on the K&L Gates web site specially dedicated to Financial Services Reform.

Read more here.

Senate hearing on securitization October 7, 2009

To see an archived webcast.

Wednesday, October 7, 2009


  • Professor Patricia McCoy, George & Helen England Prof of Law, University of Connecticut School of Law
  • Mr. George P. Miller , Executive Director, American Securitization Forum
  • Mr. Andrew Davidson, President , Andrew Davidson & Co.
  • Mr. J. Christopher Hoeffel, Executive Committee Member, Commercial Mortgage Securities Association
  • Dr. William Irving, Portfolio Manager, Fidelity Investments

House Fin Serv Subcomm hearing Sept 24, 2009

To see an archived webcast.

  • Witness List:
    • Ms. Paula Dubberly, Associate Director, Division of Corporation Finance, U.S. Securities and Exchange Commission
    • The Honorable Susan E. Voss, Commissioner, Iowa Department of Insurance on behalf of the National Association of Insurance Commissioners
    • Mr. J. Russel Dorsett, Co-Managing Director of Veris Settlement Partners on behalf of the Life Insurance Settlement Association
    • Mr. Brian Pardo, Chief Executive Officer, Life Partners Holdings, Inc.
    • Mr. Jack Kelly, Director of Government Relations, Institutional Life Markets Association
    • Mr. Kurt Gearhart, Global Head of Regulatory and Execution Risk, Life Finance Group, Credit Suisse
    • Mr. Steven H. Strongin, Managing Director and Head of Global Investment Research, Goldman, Sachs & Co.
    • Mr. Daniel Curry, President, DBRS, Inc.

Financial Inquiry Commission hearing on subprime and securitization

The Financial Crisis Inquiry Commission has announced that it will hear from public and private sector entities in a hearing titled “Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs).”

Hearing sessions will include the following entities: the Federal Reserve Board, Citigroup, Fannie Mae, the Federal Housing Finance Agency and its predecessors, the Federal Housing Finance Board and the Office of Federal Housing.

The forum, to be held April 7-9, 2010, will also be webcast live at

SEC to propose ABS disclosure rules by end 2010

"...Within the next few weeks, in particular, Schapiro expects rules related to the use of representations and warranties in the market for asset-backed securities to be proposed.

Those will be followed by rules on ABS-related disclosures by the end of this year that will be considered for adoption early next year.

The markets are especially watching those rules as the FDIC has already acted, triggering industry concerns over regulatory overlap generating additional costs to securitizers.

Risk retention is also a key area securitizers are closely watching.

"We are working with other regulators to jointly create the risk retention rules, including the appropriate amount, form and duration of required risk retention, and the definition of qualified residential mortgages," Schapiro said..."

SEC Chair seeks legislative authority for ABS markets

"Securities and Exchange Commission Chairman Mary Schapiro called on Congress to give the SEC more authority to look at asset-backed securities, which were at the heart of the credit crisis.

Many legislative proposals call for more disclosure about these securities, but, Ms. Schapiro said, "substantive protections beyond disclosure requirements are needed."

"Creating a new act directed solely at securitizations would allow Congress to specifically tailor solutions for these investment vehicles," she said.

The chairman, speaking before a securities-industry group, said SEC staff is reviewing the regulation of asset-backed securities, but the agency doesn't have authority under current law to do all that it would like.

Securities backed by assets such as home mortgages were at the center of the financial crisis. Many securities thought to be safe turned out to contain toxic assets, such as subprime loans made with minimal credit checks.

Giving the SEC greater supervision of these securities is part of the Obama administration's larger plans for financial-regulatory reform. Draft legislation released on Tuesday by the House Financial Services Committee and the Treasury Department directs federal banking regulators and the SEC to write rules requiring creditors to retain 10% or more of the credit risk of loans that are sold for the purpose of securitization.

The goal is to prevent lenders from making loans they know are bad, then dumping all of the risk on third parties.

Ms. Schapiro also said all people giving investment advice should be subjected to a high standard of conduct regardless of whether they carry the label of investment adviser or broker-dealer.

The initiatives are part of a broad effort on the part of the SEC to restore investors' confidence in the market.

"If anyone was hoping for a respite from reform, I am afraid I will disappoint you," Ms. Schapiro said.

  • Source: "The Road to Investor Confidence" Chairman Mary Schapiro, U.S. Securities and Exchange Commission, SIFMA Annual Conference, New York, New York, October 27, 2009

ABS Regulation

"In one final example, I believe there may be gaps that should be filled in the asset-backed securities (ABS) market. I have asked the staff to broadly review our regulation of ABS including disclosures, offering process, and reporting of asset-backed issuers. The staff is considering a number of proposed changes, which are designed to enhance investor protection in this vital part of the market.

However, not all problems with ABS can be addressed under our current rulemaking authority. So, I believe that legislative action is also necessary to deal with some of the issues that have been highlighted by the credit crisis.

As you know, the statutes governing the offer and sale of securities were written decades before asset backed securities were even dreamed of. The laws were written for corporations or other entities with active management attempting to grow a business.

In contrast, asset-backed securities are generally securities that are backed by a discrete pool of self-liquidating financial assets. And asset-backed securitization is a financing technique in which financial assets, in many cases themselves less liquid, are pooled and converted into instruments that may be offered and sold in the capital markets.

Most legislative proposals aimed at improving securitization, suggest amendments to the securities laws that are focused on the disclosure of material information. But substantive protections beyond disclosure requirements are needed for the ABS arena.

That's because of the unique character of securitization and the role it plays in the national economy. Creating a new act directed solely at securitizations would allow Congress to specifically tailor solutions for these investment vehicles — much like the Investment Company Act of 1940. And, it could be done without compromising or changing the fundamental structure and underpinnings of existing statutes.

Similar to the Investment Company Act, the ABS Act could have substantive restrictions or requirements for the trust that issues the securities and for related parties. Such a statute could set minimum requirements for the pooling and servicing agreements, such as requiring strong representations and warranties about the assets being securitized and procedures for ensuring those representations and warranties are followed. That's in addition to the disclosure requirements of the Securities Act, which would continue to apply when ABS securities were offered and sold.

Undoubtedly, as new laws take effect and new regulations are implemented, additional gaps will appear in the regulatory fabric. We will remain focused on assuring that they are appropriately addressed."

Securitization, transparency and XBRL

"...The solution to unstructured non-comparable asset-backed securities is to make the securities as transparent as public company securities with structured, comparable, transparent disclosure. Thanks to advances in technology since 2004, such a system is now practical and effective.

In 2007, before the ultimate collapse of the mortgage-backed securities market, hedge funds paid to analyze the securities using structured, standardized, comparable disclosure. Today's solution is to expose the same information to public market scrutiny using the same technology the hedge funds used.

It is not a great leap. In 2008, the SEC required that GAAP facts -- much more complicated than the vast majority of mortgage securities facts -- be reported in a computer language called eXtensible Business Reporting Language, or XBRL. This industry standard language empowers investors to analyze those facts more efficiently.

While we can't expect grandpa to parse every one of the 15,000 or so standard data tags (not to mention custom data tags required for unique company reporting) making this information available to the market as a whole in GAAP format -- even GAAP on paper --proved effective for many decades. That's what market scrutiny is all about.

Asset-backed securities are much less complex then public companies -- at their heart, they simply represent a future flow of funds. But unlike public company securities, they lacked GAAP's structure and transparency, making it more difficult for investors to judge the risk of default than it is to judge the potential of a business to continue to profit.

In paper format, it would have been difficult or impossible to provide such transparency for asset-backed securities. Even today, the SEC's EDGAR system holds thousands of them in ASCII and HTML format, but because there's no common structure, the securities are opaque. You can print them on the paper those standards were designed to emulate, but based on recent experience, the market does not find that information particularly useful.

The challenge of limiting modern financial analysis to the two dimensions of paper is one reason XBRL has become standard building practice, and in many cases a standard building code, for business reporting around the world. It could be the basis for better building codes for any type of investment or security.

The basic principle of securities law that's served the U.S. well since the end of World War II is that if you want the public to invest in your business, you must disclose all the material facts about how you're building your business not just to your investors, but to the entire market, so that the power of market scrutiny can be brought to bear on your business.

You can seek private investment, in which case you're allowed to be less transparent, but these exemptions have been limited so as not to create what we know today as "systemic risk." That is, they were sufficiently limited until the total market capitalization of asset-backed securities began to approach the total market capitalization of all public companies.

Taller buildings need stronger building codes. It can mean the difference between a business cycle and a meltdown.

The good news in finance is that the XBRL technology exists to create strong transparent building codes without imposing the costs and constraints that the builders and architects feared back in 2004. The hedge funds that used XBRL in 2007 proved it was cost effective.

More good news is that SEC Chair Mary Schapiro has directed her staff to take a fresh look at the asset-backed securities building code. If the SEC approaches this project with a combination of the vision it used to implement GAAP in the last century and the understanding that modern transparency requires modern technology, the asset-backed securities market could get back in the fight."

FDIC actions on securitizations

FDIC issues proposed rule on safe harbor for bank-sponsored securitizations

On May 11, 2010, the FDIC's board of directors issued a Notice of Proposed Rulemaking (the "NPR") regarding proposed revisions (the "Proposed Rule") to the safe harbor provided at 12 C.F.R. §360.6 (the "Safe Harbor").

The original Safe Harbor, which was established by the FDIC in 2000 as a "clarification" of existing rules, offered federally insured depository institution ("IDI") sponsors of securitizations, as well as investors and rating agencies, assurance that the FDIC would not use its powers as a conservator or receiver for a failed IDI to disaffirm or repudiate contracts in order to reclaim, recover or recharacterize as property of the failed IDI any financial assets transferred by that IDI in connection with a securitization or participated, so long as the transfer or participation satisfied the conditions for sale treatment under generally accepted accounting principles (the "GAAP").

Revisions to the Safe Harbor became necessary because of changes to GAAP, for sale treatment of certain transactions and for consolidation of certain entities, threatened the effectiveness of the Safe Harbor – specifically, FAS No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 ("FAS 166") and FAS No. 167, Amendments to FASB Interpretation No. 46(R) ("FAS 167"), which are effective for reporting periods that begin after November 15, 2009. (For more information on FAS 166 and FAS 167, see the June 16, 2009 Alert.) In response, the FDIC issued an interim rule (initially in November and subsequently extended in March) (the "Interim Rule") that continues until September 30, 2010 the protections afforded to transactions that comply with the Safe Harbor under the prior accounting rules. (For more information on the Interim Rule and the need for revisions to the Safe Harbor, see the November 17, 2009 Alert and the March 16, 2010 Alert).

As with its December 15, 2009 Advance Notice of Proposed Rulemaking (the "ANPR"), which was discussed in the December 22, 2009 Alert, the five-member board approved the issuance of the NPR by a vote of 3-2, with Comptroller of the Currency John Dugan and Acting Director of the Office of Thrift Supervision John Bowman voting against approval. In particular, Comptroller Dugan noted that, with Congress on the verge of passing comprehensive and coordinated legislation on financial regulatory reform that would apply to all securitizations (as opposed to securitizations issued by IDIs only), he believed the FDIC should defer acting at this time. Chairman Sheila Bair, however, argued that it is prudent to act now, especially considering that the legislative process might take another several months to complete. Chairman Bair further noted that the NPR is consistent with the approach currently being contemplated by Congress and the SEC's proposed new rules for asset-backed securities ("Proposed New Reg. AB") that would make significant revisions to Regulation AB and other rules regarding asset-backed securities. (For more information on Proposed New Reg. AB, see the April 13, 2010 Alert.) She also stated that the FDIC would be happy to work with other regulators down the road if any changes are necessary.

The Proposed Rule builds on many of the revisions proposed in the ANPR. However, there are several notable differences from the ANPR, including:

  1. the removal of the 12-month seasoning requirement for securitizations that include residential mortgages ("RMBS");
  2. the addition of a requirement that sponsors reserve 5% of the cash proceeds from any RMBS for one year to cover repurchase obligations;
  3. the addition of a requirement to disclose whether a conflict of interest exists in the servicing of the assets;
  4. a limitation of the requirement that compensation be paid over time (rather than at the closing of the offering) to apply to only credit rating agencies, which may be paid no more than 60% of their compensation at closing; and
  5. certain changes to the disclosure requirements to conform to Proposed Reg. AB.

To see full note.

FDIC seeks to toughen rules on banks’ securitizations

The Federal Deposit Insurance Corp. is proposing new rules on banks’ sales of securities backed by loans and leases, including limits on the pay of companies involved, after past practices helped create the worst financial crisis since the Great Depression.

The U.S. agency’s board voted to seek comment on possible conditions for bank securitizations at a meeting today in Washington. Banks would have to follow the guidance to win a so- called safe harbor that prevents the FDIC from seizing the assets bundled into their securitizations when it winds down failed institutions, making the bonds attractive to investors.

Policy makers are seeking to transform the almost $4 trillion U.S. market for securitizations not created by government-supported entities. Risky lending enabled by asset- backed bonds and investor losses on debt including subprime- mortgage securities led to a collapse in the world’s economies.

“We’re trying to strike a middle ground here” between those who want to eliminate securitization completely and those who want little to change, FDIC Chairman Sheila Bair said at the meeting. “I look forward to eventually finalizing strong, common-sense standards.”

The U.S. House last week passed a financial-overhaul bill that includes a requirement that loan originators and companies that package debt into securities retain 5 percent of the credit risk, among additional changes including ones related to disclosures. The Senate is considering similar modifications.

Compensation Block

The FDIC’s board agreed to issue a so-called advance notice of proposed rulemaking, in which the agency will ask for comment on 35 questions and offer a version of what the securitization conditions might look like, according to an e-mailed copy of the planned notice.

It plans that approach rather than other options that could move more quickly toward final regulations because of interference from other regulators, said Joshua Rosner, an analyst in New York at investment research firm Graham Fisher & Co., said.

“The agency’s push to create smart, rational market- and investor-friendly standards seems to be running into opposition from other regulators who have repeatedly demonstrated their inability to separate what’s good for banks and issuers with what’s good for markets,” Rosner said in a telephone interview.

In its “sample” rule, the FDIC suggests, among other things, blocking for home-loan bonds any more than 80 percent of the compensation for lenders, securitization sponsors, credit raters and bond underwriters from being paid upfront, with the rest due over five years and based on asset performance.

Risk Retention

It also proposes requiring sponsors to retain 5 percent of credit risk of all securitizations, as well as barring from securities any home loans less than a year old, or that don’t rely on documented borrower income.

Comptroller of the Currency John Dugan raised objections at the meeting to several ideas that he said might be part of rule changes. Those included: a ban on external support for issuances; the creation of the same disclosure requirements for private placements as public offerings; six-class limits for some securitizations; and the requirements for risk retention and the seasoning of mortgages ahead of securitizations.

Dugan and Office of Thrift Supervision Acting Director John Bowman, two of the five members of the FDIC’s board, said the agency may hurt banks competitiveness if it doesn’t act in tandem with other regulators such as the Securities & Exchange Commission and Federal Reserve, and may be best served waiting for lawmakers to finish deliberations.

Industry Reforms

“It would be far preferable to have rules that would apply across the board, as envisioned by the legislative proposals, than adopt a rule that applies only to insured depository institutions,” Dugan said.

The House legislation, approved 223-202, was weakened from a proposal to require as much as 10 percent risk retention, and allowed regulators to exempt commercial-mortgage bonds whose riskiest slices are bought by third parties doing due diligence.

The industry also is seeking to reform itself in some ways, with the American Securitization Forum today releasing guidelines for so-called representations and warranties on loans put into residential mortgage-backed securities. Such contract clauses can require lenders or issuers to repurchase debt that fails to match promises on its quality.

The New York-based trade group argued that the guidelines would help address the objectives of proposals that would require issuers or originators to retain slices of securitizations. The FDIC’s ideas include objectionable ones, the ASF said in a statement.

Credit Needs

“A number of the proposals presented today may inadvertently slow the restart of the securitization markets at a time when American consumers and small- and medium-sized business most need the credit availability that these critical markets provide,” Tom Deutsch, deputy executive director of the securitization group, said in an e-mailed statement.

New accounting rules sparked concern among bond buyers and rating firms that the FDIC would be able to tap the pools of debt underlying credit-card securities to protect its deposit insurance fund after banks fail. That halted sales of such bonds in October and early November after issuance totaled $10.7 billion in September, according to data compiled by Bloomberg.

The rules from the Financial Accounting Standards Board took effect for fiscal years starting after Nov. 15, and require issuers to include assets and liabilities of securitized debt on their balance sheets in many circumstances. The FDIC last month agreed to grant safe harbors for bonds sold through March, unfreezing the market for credit-card securities, with Bair saying she wanted to seize on the opportunity to improve practices before granting a further extension.

Taking Comment

Bair said today that the sample conditions that the FDIC is considering are consistent with lawmakers’ proposals, though the agency will consider suggested changes from regulators, consumer groups, lenders and others, with a particular focus on the thoughts of “the buy-side community” of debt investors.

The comment period will last for 45 days after the publication of the rulemaking notice in the Federal Register, which is expected in about two weeks, Greg Hernandez, an FDIC spokesman, said in an e-mail.

Securitization or Participation After March 31, 2010] FDIC, December 15, 2009

FDIC extends "safe harbor" status for securitization

U.S. bank regulators extended a policy on Thursday that protects securitized assets in the event that a bank fails and is seized by regulators.

The Federal Deposit Insurance Corp said its board approved an extension of the protection until Sept. 30, 2010, as it tries to craft permanent rules designed to revive the securitization market, but with stronger standards.

FDIC Chairman Sheila Bair said in a statement that the extension will give the agency time to adopt final standards and the industry time to transition to new standards.

"We will continue to seek broad agreement on securitization reforms that can be implemented by all the regulatory agencies," Bair said.

In December, the FDIC proposed a new treatment for so-called "safe harbor" protection for securitized assets.

The new standards, if approved by the FDIC board, would only protect securitized assets - such as those based on mortgages and auto loans - from failed banks under certain conditions.

Those conditions include banks voluntarily retaining an ownership interest in the loans they package into securities, known as keeping "skin in the game."

Banks would also have to tighten underwriting standards and disclose more details about the underlying assets, which could include individual mortgages and other debt backing the bonds.

The proposal is designed to spur responsible securitizations, by offering banks extra protection for the loans.

Industry groups are concerned the proposal threatens to undermine the securitization market and choke off an important source of credit.

They have said that under the FDIC's proposal, investors would bear the burden of the loss of the safe harbor if any of the securitization preconditions are not satisfied.

Comptroller of the Currency John Dugan, who serves on the FDIC board, has criticized the FDIC's proposal as aiming to reform only a portion of the securitization market, potentially creating an uneven playing field.

Securitizations fueled the recent financial crisis because bad loans were packaged and then sliced and diced into securities that widely spread risk through the financial system.

The market for securitizations froze during the crisis and has only recently begun to thaw, largely due to government support.

Remember FAS 167? The new accounting standard will eliminate qualified special-purpose entities (QSPEs) and lead to banks putting billions worth of securitised assets — mostly credit card trusts — back onto their balance sheets from 2010.

The proposed rule also caused a bit of consternation among ratings agencies and analysts - with many concerned that the new requirements would mean a loss of so-called ’safe harbour’ status which to date had protected off-balance sheet securitisations. The concern was that the Federal Deposit Insurance Corp (FDIC), the organisation responsible for insuring US bank deposits, could start seizing the securitisations in the event of a bank’s bankruptcy.

But, it looks like on Thursday the FDIC has decided not to go down that route:

NEW YORK -(Dow Jones)- The U.S. Federal Deposit Insurance Corp. on Thursday extended a rule to help the securitization market, roiled by new accounting regulations.

The banking regulator’s board decided that existing securities backed by consumer loans, mainly credit card debt, as well as new bonds issued before March 31, 2010, won’t lose their so-called “safe harbor” treatment. The FDIC will, in effect, not be able to raid the assets backing these securities even if the lending institution files for bankruptcy.

Saving securitisation via safe harbour status. Try saying that 10 times fast.

Word to the wise though, the FDIC jury is still apparently out on bonds issued after March 31 next year:

The FDIC will issue further guidance on new rules for bonds issued after March 31, 2010 on Dec. 15.

FDIC completes securitization of failed bank assets

Today, the FDIC announced the closing of a $471.3 million securitization of performing single-family mortgages from 16 failed banks. The FDIC stated that is the first time during the current financial crisis that the FDIC has sold assets in a securitization transaction.

The transaction consisted of three tranches of securities, including approximately $400 million senior certificates that represented 85% of the capital structure and were guaranteed by the FDIC. The senior certificates were offered and sold pursuant to 3(a)(2) of the Securities Act of 1933, which exempts from registration securities guaranteed by an instrumentality of the United States. The senior notes offered “sold at a coupon of 2.184 percent and [are] expected to have an average life of 3.66 years.” The subordinated certificates, which were retained by the failed bank receiverships, “comprised of a mezzanine and an over collateralization (OC) class representing 15 percent of the capital structure.”

The FDIC’s pilot program is generally in line with its proposed Securitization Safe Harbor Rule, with exception of “certain limited differences necessitated by the origin of the collateral and the absence of information available from the failed banks.” The FDIC has utilized several strategies to sell assets from failed banks including securitization, which is primarily one of the ways the FDIC intends to “maximize the value of these assets for the benefit of creditors of the failed banks.”

FDIC considers securitisation of failed bank assets

"The Federal Deposit Insurance Corporation is considering securitising some of the failed bank assets in its receivership, according to a policy advisor at the agency.

“The FDIC is looking at all options to maximise the value of the assets in receiverships, and one of those options is securitising pools of loans,” says Michael Krimminger, a special advisor for policy at the agency, which insures bank deposits as well as managing receiverships.

The FDIC has assumed the assets of 120 banks that have failed this year, in comparison with 25 in 2008, and an average of four per year in the preceding decade. Most recently, five banks shut down for business on November 6, including United Commercial Bank (San Francisco), Prosperan Bank (Oakdale) and United Security Bank (Sparta).

The number of “problem banks” is also rising, reaching 416 at the end of the second quarter, up from 305 at the end of Q1. The combined assets of problem institutions total $299.8 billion, the highest level since the fourth quarter of 1993.

If the FDIC does decide to proceed with a securitisation programme, it will follow the same path as the Resolution Trust Corporation (RTC) in the 1990s. The RTC was a state-owned asset management company established in 1989 to liquidate the assets of thrifts that failed during the savings and loan crisis. Between 1989 and 1995, the RTC closed or resolved 747 thrifts with assets of $394 billion.

In addition to direct asset sales and the forming of joint ventures with private companies, the RTC actively used securitisation as a means to increase asset recovery values. Between June 1991, the month of its first deal, and December 1995, the RTC completed 72 securitisations backed by residential and commercial mortgages with a total value of $42 billion.

However, the most recent financial crisis has caused trillions of dollars’ worth of securitised assets to plummet in value, giving rise to widespread investor doubt about the viability of securitisation as an asset class.

Despite this, some analysts insist securitisation could be an effective tool in the FDIC’s efforts to resolve the assets of failed banks. The global head of securitised strategy at Citi, Darrell Wheeler, says: “The investors have been quite active in buying, and in today’s market where you have corporates that are rated single-B and are going for 8% or 9% yields, many of the consumer asset-backed securities are one of the last places investors can find a reasonably safe and good yield in return.”

Wheeler says the FDIC could successfully securitise “several billion dollars’ worth of assets”, including credit cards, consumer loans and student loans. “To the extent those markets are now open, those will be the most likely ones to come first. New appraisals on seasoned commercial mortgage portfolios would make them securitisable. And the same could probably be said for prime residential mortgages,” says Wheeler.

The president of commercial real estate finance and investment management firm CW Capital Asset Management, David Iannarone, who was involved in the RTC’s CMBS transactions, says investors are “definitely interested” in potential deals by the FDIC, and may not need any government-backed guarantees to put them at ease with the prospect. “I think they see the upside potential when the market begins to come back,” he says.

Not all investors are convinced, however.

“Securitisation tells you active management is not allowed,” says Ron D'Vari, chief executive officer at asset management firm New Oak Capital. “When you say securitisation, I don’t know if that means they’re going to put non-performing assets in a vehicle and hope that they will somehow through time secure themselves.

“Securitisation means passiveness. That’s what so far has been the meaning of securitisation, and that’s not good for the market, that’s not good for anybody.”

SEC proposes new securitization rules

The Proposed Rules:

Specifically, the Commission's proposals would:

  • Require the Filing of Tagged Computer-Readable, Standardized Loan-Level Information
  • Require the Filing of a Computer Program That Gives Effect to the Waterfall
  • Provide Investors with More Time to Consider Transaction-Specific Information
  • Repeal the Investment Grade Ratings Criterion for ABS Shelf-Eligibility
  • Increase Transparency in the Private Structured Finance Market
  • Make Other Revisions to the Regulation of ABS

SEC adopts proposed rules on securitizations April 7, 2010

The Securities and Exchange Commission (SEC) voted today to move forward with new skin-in-the-game regulations.

Under the proposal, issuers of securitization will be required to retain 5% of each tranche being bonded. In theory, this will help prevent structured finance vehicles that show a greater potential for loss. The proposal will also require loan-level data disclosure.

Trade bodies representing private-label securitization traditionally opposed the risk retention provisions, and asked for exemptions to be placed in recently proposed regulatory reform, though at least for one that stance appears to be softening.

“We support in principle the efforts of the SEC to increase the transparency and effectiveness of the disclosure and marketing practices for ABS,” said Tim Ryan, CEO of the Securities Industry and Financial Markets Association, a group representing securitization market players. “We look forward to working with the SEC to refine the risk retention provisions and other aspects of this proposal.”

In reading additional comments from the industry, SEC commissioner Troy Paredes describe the cyclical pitfall such a regulation, if not keenly incorporated, may have on the securitization market. In short, he said the industry is concerned that Fannie Mae (FNM: 1.10 0.00%), Freddie Mac (FRE: 1.34 0.00%) and Ginnie Mae will be able to increase market share without much competition.

“By increasing the cost of securitization, mortgage-backed issuances under government sponsored entities will maintain a competitive advantage over the private market, further driving up the cost, and lowering the availability, of nonconforming loans,” he said.

The lack of availability with lower the rate of origination which will, in turn, reduce the number of assets available for securitization.

Paredes also said the SEC will need to work closely with other federal agencies in regards to their securitization platform, though he did not specifically mention the Federal Deposit Insurance Corp. (FDIC), which has entered the structured debt market with pseudo-securitizations.

Unlike the private-label industry, the FDIC is all for risk retention. FDIC chairman Sheila Bair said in a release today, “I applaud today’s vote by the SEC to propose new standards under the securities laws for the securitization market.”

Bair says the proposals will mean more than simple risk retention, adding “essential elements of reform” that emphasize transparency, loan quality and investor due-diligence. In the statement, Bair also lauded her own ‘Safe Harbor’ regulations that are currently under consideration.

As with risk retention, there remains a nagging investor uncertainty until the final provisions become mandate. Bair says the Safe Harbor will work with, not against, the SEC ruling.

“Notably, the SEC’s proposed new standards will extend to the nonbank ’shadow sector, demonstrating a common approach that will further the ultimate goal of ending arbitrage and implementing securitization reforms across the entire market,” she said.

The SEC concluded its meeting today by approving the measure to consider risk retention requirement. There will be three more months of industry commentary before the SEC makes a final vote.

Securitization and FAS 166/167

"The Federal Reserve's program to revive the markets for U.S. securitized debt may be disrupted and credit to consumers choked off if planned accounting changes are implemented in 2010.

New rules by the Financial Accounting Standard Board, in the form of FAS 166 and 167, will force banks to put securitized debt back on balance sheets and retain continued exposure to the risks related to transferred financial assets, by eliminating the concept of a "qualifying special-purpose entity".

The amount of capital available for making new loans to consumers for credit cards and mortgages may be restricted as a result.

"There are potentially huge consequences of the FASB changes. There are concerns over whether bank balance sheets will be stretched to the breaking point because of the amounts recorded on balance sheets," said John Arnholz, partner at law firm Bingham McCutchen.

Used as a crucial funding tool for issuers in the asset-backed market, securitization allows lenders to remove existing debt from their books, package the loans and later sell them as securities to investors. This allows the flow of credit to continue to consumers.

"If you get off-balance sheet treatment, that provides a more efficient use of your balance sheet and has been the foundation of the structured finance market. Bringing it back on balance sheet would have an impact on all your various financial ratios," said Mike Kagawa, portfolio manager at Payden & Rygel.

The American Securitization Forum recently asked U.S. bank regulatory agencies for a six-month moratorium relating to any changes in bank regulatory capital requirements resulting from the implementation of FASB's 166 and 167.

"We believe that this action is necessary to avoid a potentially severe capital and credit shock to the financial system as of January 1st, when the new accounting rules generally take effect," said the ASF.

The role that securitization has assumed in providing both consumers and businesses with credit is striking with currently over $12 trillion of outstanding securitized assets, including mortgage-backed securities, asset-backed securities and asset-backed commercial paper, the ASF said.

Industry experts said the accounting changes threaten to setback the huge strides made by the Fed's emergency loan program, the Term Asset-Backed Securites Loan Facility, known as TALF, launched earlier this year.

Through the program, the Fed was able to bolster consumer lending and reopen the securitization market for consumer ABS, nearly shutdown by a deep credit crisis in 2008. The program also drove the high costs of funding dramatically lower.

However, issuance under the program may suffer a sharp setback if banks retrench from making new consumer loans amid capital constraints created by heavier debt loads and new accounting and administration costs. The increased costs to banks are likely to filter down to the consumer in the form of higher borrowing costs, as well.

Global oversight of securitization

Joint Forum issues report

BIS - Complexity, transparency and ratings

Given the market organisation reviewed above, the recent crisis brought to light at least three key structural weaknesses: too much complexity, insufficient transparency and an over-reliance on ratings. All of these tend to exacerbate existing incentive misalignments, while creating various information problems of their own.


A key driver of complexity is the practice of tranching, which allows for the bulk of a given securitisation to be financed by AAA investors. The tranching of payoffs increases the layering between the performance of the underlying assets and the risk-reward profiles of the tranches held by final investors.

As discussed above, links between tranche payoffs and the underlying asset pool performance are further complicated by existing tradeoffs between the protection provided by subordination and other structural features.

Additional complexities arise when a structure itself contains tranches of other securitisations (ie resecuritisations, including ABS CDOs). By implication, more complicated links between tranche payoffs and pool performance will also increase the difficulty for final investors to obtain a clear picture of the risk and return profile of their stakes.

Overall, assessments of value and risk will tend to become increasingly dependent on models, which themselves are subject to uncertainty, as small changes in assumptions can lead to major differences in the risk assessments.


Securitisation, while increasing the distance between borrowers and lenders, essentially assumes that incentives – for activities such as the proper screening of borrowers – are preserved along the securitisation chain. Historically, reputational considerations have been assumed to act as a control mechanism for the behaviour of originators, but the crisis has illustrated that this did not work sufficiently in the US mortgage context. This type of failure, in turn, puts a premium on the availability of information for proper deal analysis, particularly for those securitisation markets that have historically not provided such information.


One result of increasing complexity and limited transparency has been an over-reliance on ratings. A key issue in this context is that tranching causes ratings of structured securities to behave differently from traditional corporate bond ratings. Specifically, once downgrades of a tranched security occur, they will tend to be more persistent and severe than for corporate bonds.

This results in a non-linear relationship between the credit quality of underlying assets and that of tranched products, which will tend to magnify changes in the valuation of securitisation tranches relative to those observed for the underlying asset pool. Investor reliance on ratings, unless supported by other measures of risk, can thus lead to mispriced and mismanaged risk exposures as well as unfavourable market dynamics if these exposures have to be unwound (Fender et al (2008)).

It is now clear that many investors (including the arranging banks and their risk managers) were not fully aware of the fundamental differences in corporate bond and structured finance ratings, or of the nature of the risks they were taking on with structured products. That is, the disciplining function of investor scrutiny that would have been necessary to align incentives along the securitisation chain was not exercised.

An important question is to what extent investors’ lack of understanding was due to too little information being available or, rather, to their failure to demand and appropriately process the information that would have been necessary to conduct appropriate risk analysis.

Much of the surprise in terms of the performance of securitised instruments occurred among investors in AAA securities, who were probably relying excessively on ratings. Interestingly, some of the most sophisticated institutions were found to be holding AAA-rated tranches and have taken the most severe valuation losses. This included tranches that these institutions themselves had originated, but which were considered “safe” or appropriately hedged (eg via “wraps” sold by specialised insurers).

BIS - Designing retention guidelines for securitizations

One issue gaining particular attention in this context was the securitization chain and its infl‡uence on incentives. This was because, by putting some distance between originators and investors, the process of securitisation can weaken incentives for proper screening and due diligence along the chain.

This, in turn, can contribute to a lowering of lending standards and a gradual deterioration in the credit quality of assets included in the collateral pools of securitised instruments.2

Concerns like this are not new. It has long been recognised that securitisation, while adding economic value through features such as the tranching of risk, can also give rise to incentive incompatibilities and other information problems.3

In particular, compared to the relationship between individual borrowers and lenders, securitisation relies on a diverse group of originators, servicers, arrangers and investors who are linked through a complex network of relationships. The efficiency of these relationships depends importantly on whether the institutional setup of the securitisation process preserves the disciplinary power of market forces.

Indeed, market participants have sought to devise contractual features and institutional arrangements to address these issues. Still, events leading into the crisis suggest that, despite these efforts, incentive problems can accumulate within the securitisation process and that adjustments may have to be made to avoid similar problems in the future.

One proposal that has gained recent attention in this context is tranche retention. Under such an arrangement, the originator or arranger of a securitised instrument would be required to have some “skin in the game” in order to maintain the appropriate incentives to screen and monitor borrowers.

Equity tranche retention, in particular, has been advanced as a measure to revitalise securitisation markets in the wake of the …nancial crisis.4

The public sector has also taken note. The International Organisation of Securities Commissions (see IOSCO, 2009) has recommended that regulators should "consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation." The European Union has adopted a proposal requiring originators to hold at least 5% of the securitised portfolio, where the form of retention may be chosen from among a list of options, including a percentage share, or "vertical slice".5

The U.S. is also considering a retention proposal (see U.S. Treasury, 2009).

This paper aims to contribute to these ongoing discussions. In particular, it examines the power of di¤erent contractual mechanisms to in‡fluence an originator’s choice of costly e¤ort to screen borrowers when the originator plans to securitise its loans. The question addressed is whether some mechanisms lead to more screening than others, and under what conditions.

We focus on three potential mechanisms: the originator holds the equity tranche of a structured …nance transaction; the originator holds a “vertical slice” of the portfolio (a share of the entire portfolio without subordination features); and the originator holds the mezzanine tranche rather than the equity piece of a securitisation. The analysis illlustrates that the type of contract used to align incentives will a¤ect the amount of screening that the originator will undertake.

The differing screening incentives generated by di¤erent mechanisms derive in large part from the varying sensitivities of the retention mechanisms to a systematic risk factor, which plays an important role in the determination of borrowers ’default probabilities and asset values. In fact, the equity tranche can be shown to be more sensitive to the realisation of systematic risk than the entire portfolio.6

EU Article 122a

In this issue of The Institutional Risk Analyst, we feature a comment by Richard Field of TYI LLC about the evolution of the market for asset-backed and structured securities (all “ABS” below) in the European Union. While everyone in the risk community focuses on the question of what will emerge in the way of capital requirements for financial institutions under Basel III, the key to the future of finance is emerging now with the implementation by the EU of something called “Article 122a.”

The first thing to notice is that the EU rule is a direct challenge to the U.S. regulatory community. The degree of disclosure required of both issuers of securities and the EU institutional investors who purchase them is greater than that currently in the U.S. or proposed under the SEC rules on Reg A/B. Now our friends at the SEC will understand our comments on same, where we asked the SEC to mandate that issuers supply all material data on ABS transactions. To do any less means that the U.S. will become a second-class market compared with the EU.

The second key aspect of the EU rule on ABS that is worthy of note is that implementation will very quickly divide those financial institutions which are compliant and those which are not. Banks which are not in compliance with the EU rule on ABS will be obliged to offer investors significantly higher yields on debt than those banks which are compliant. Investors will also be subject to a level of scrutiny as to their method of valuing and tracking the changes in the experience of the collateral underlying these securities.

Richard kindly arranged the discussion in a Q&A format to break this heretofore obscure but important subject into bite-size pieces. See the earlier comment by Richard Field ('Event of Default and the Year that Wasn't Really; Richard Field on Covered Bonds and the Need for Better ABS Disclosure', April 12, 2010).

Q: What is Article 122a?

A: It is an amendment to the European Capital Requirements Directive. Specifically, it requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.

Q: Without getting into the specifics of Article 122a, why should anyone outside of Europe care about it?

A: Because compliance with Article 122a is necessary if an issuer wants to sell tranches of structured finance securities to European credit institutions at the lowest cost to the issuer. According to the Securities Industry and Financial Markets Association (“SIFMA”) in its May 2009 Highlights, “the article applies to any EU credit institution (e.g. bank, dealer or investment firm) that invests in or holds securitization positions in either its banking book or trading book e.g. as an investor or dealer. As a result, [it] will be required by any originator globally who wants to sell/trade securitization tranches to/with EU credit institutions. For example, if an EU or US auto ABS issuer wants to sell auto loan ABS tranches to a European credit institution, it will need to comply with the EU retention requirements and also provide sufficient information for EU investor due diligence.”

SIFMA reported that the “extension of Article 122a to other EU investors such as insurers and hedge fund managers is already under consideration (the Solvency II legislation recently approved by the European Parliament requires the Commission to adopt implementing measures on investment in securitization products, including a retention provision, and a similar provision is included in the current EC proposal on regulation of hedge funds). Article 122a is also likely to be applicable to non-EU trading desk operations of European credit institutions.”

Q: What types of securitized exposures does Article 122a apply to?

A: According to SIFMA, “Article 122a will apply to all securitized exposures which broadly include all cash and derivative instruments that are credit-tranched, with certain types of transactions scoped out, such as those based on an index, syndicated loans, purchased receivables or credit default swaps where these instruments are not used to package and/or hedge a securitization.”

Q: When does Article 122a take effect?

A: On or after January 1, 2011, the requirements of Article 122a apply to all new securitizations. After December 31, 2014, the requirements of Article 122a apply to all existing securitizations.

Q: What are the penalties under Article 122a?

A: The failure by either investors or issuers to meet the requirements of Article 122a result in their holding more capital against the security. At one extreme, if there is no compliance with the requirements, investors are required to hold approximately 100% capital against their investment. There is a certain sensibility to the idea that investors cannot invest with leverage in securities where the investor is bidding blindly because they do not know what they are buying and will subsequently own.

Q: What are the requirements of Article 122a for issuers?

A: There are two basic requirements: retention and disclosure.

There is a five percent (5%) retention requirement for the issuer regardless of the type of underlying asset. Even as this article was being written, there is still debate between the regulators and the industry as to the form of the retention. For example, the retention could be a vertical or horizontal slice of the deal.

Much more important than the retention requirement is the disclosure requirement. Issuers are required under Paragraph 7 of Article 122a to “ensure that prospective investors have readily available access to all materially relevant data on the credit quality and performance of the individual underlying exposures, cash flows and collateral supporting a securitisation exposure as well as such information that is necessary to conduct comprehensive and well informed stress tests on the cash flows and collateral values supporting the underlying exposures.”

This disclosure requirement argaubly sets the new minimum global standard and ought to be the foundation for compliance with the disclosure initiatives being undertaken by the European Central Bank, the Bank of England, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission.

Q: What are the key elements of the disclosure requirement?

A: In order they are the terms perspective investors, readily available access materially relevant data and the ability to use the data in the analytic models of choice by the investors.

Q: What is important about the term perspective investors?

A: Since there are prospective investors in both the primary and secondary markets, the disclosure requirement applies over the life of the deal.

Q: How are issuers going to ensure that prospective investors have readily available access to the information disclosed?

A: Regulators have interpreted this to mean that the impediments in terms of search, accessibility, usage and cost should not be overly burdensome on investors. For example, the ECB has proposed in its public consultation the creation of an information infrastructure with a data portal at its center to capture the data from issuers and make it available to investors. The cost of this data portal should be built into the cash flow waterfall and therefore investors could access the information in one place for free. This is better than the alternative of having multiple data portals, each of which has a monopoly on a few issuers, which charge investors for accessing their information. Since Article 122a applies to issuers on a global basis, the data portal must also be global. To prevent differences emerging in the disclosures to investors in different countries, all investors should have access to the data so they all have the same information.

Q: What is materially relevant data on the credit quality and performance of the individual underlying exposures?

A: There are two components that make up materially relevant data. First, there are the specific data fields for each underlying exposure. Second, there is the frequency with which this data is updated.

Q: What are the specific data fields for each underlying exposure?

A: The information systems of the loan or receivable originator and, if separate, the firms that do the daily billing and collecting function provide the answer. For each individual underlying exposure, it is every data field these firms track. By definition, since it costs them money and they are in the business of originating, billing and collecting, these firms only track in their information systems data fields that they think are relevant to assessing the credit quality and monitoring the performance of an individual underlying exposure. While these data fields might not be identical across all firms, for each firm the data fields represent what their experience has shown them to be important. It is far better and no more expensive to provide these data fields in a standardized, borrower privacy protected format to comply with Article 122a than it is to use a reporting template with a subset of these data fields.

Reporting templates have serious problems. There is an assumption that all the relevant data fields are actually included in the reporting template. Unless the template has all the data fields that experience has shown are important, that is unlikely.

Q: What if the missing data fields are in fact critical for assessing the underlying collateral and knowing what you own?

A: At a minimum, if the issuer is not already disclosing all the data fields in their information systems, then it has to incur an additional expense each time a new data field is added to the reporting template. More importantly, templates do not guarantee standardization of the data in each data field. As pointed out in the July 24, 2010 The Economist, “big banks need IT reform almost as badly as regulatory reform. Banks tend to operate lots of different databases producing conflicting numbers.” If the data is not standardized, its value to investors and members of the ABS ratings community is minimal.

Q: How frequently does the data need to be disclosed so that investors can access all materially relevant data?

A: The data should be updated on an observable event based basis so that all data on each underlying exposure is current. Observable event based reporting is different from real time reporting or reporting on every underlying exposure every day. Observable event based reporting occurs only for those underlying exposures that have an observable event (payment, delinquency, default, or insolvency filing) on the days when there are observable events.

Observable event based reporting is the standard that regulators require credit institutions use for monitoring their on-balance sheet loan and receivable portfolio. The reason credit institutions use this type of reporting is that it reflects how their databases are updated. For example, the credit institution might receive a check at 10 in the morning, but it does not know that it has good funds until 4 in the afternoon. As a result, the credit institution does not update its system for a loan payment until after it knows it has good funds. Packaging the underlying exposures into a structured finance security does not change best practice for monitoring their performance. Since this data is already available, it is inexpensive to provide to investors so they too can use best practices to monitor the performance of the underlying exposures.

If issuers do not disclose sufficient information for investors to do their due diligence and monitor the performance of the underlying collateral, they are required to hold more capital against their retained interest position. Observable event based reporting is the only reporting frequency that can guarantee that investors can meet the requirement to know what they own and insure that investors will not have to hold additional capital. Once per month or less frequent reporting frequencies have the known problem that they were the industry standard for reporting prior to the credit crisis and they did not prevent the crisis nor subsequently unfreeze the market. This suggests that they are not the appropriate frequency for reporting so that investors could comply with the requirement to know what you own.

Q: Is any information besides the data on the underlying exposures necessary so that the disclosures by the issuers are usable by investors?

A: In short, along with the data on the underlying exposures, issuers must also provide an easy to understand explanation of how the deal works so that investors can put the structural elements of the deal into the analytic, valuation and stress-testing models of their choice.

The need for this explanation of how the deal works is discussed in Paragraph 5 of Article 122a as it applies to stress tests of the cash flow. Investors require “all structural features of a securitization that would materially impact the performance of their exposures to the transaction such as the contractual waterfall and waterfall related triggers, credit enhancements, liquidity enhancements, market value triggers, and deal-specific definition of default.”

This method of disclosure of how the deal works is a sharp contrast with the SEC proposed revision to Regulation A/B that issuers provide a Python software program with the structure of the deal. Disclosure of how the deal works under Article 122a retains the element of if it is too complicated for the investor to understand and translate to their analytic and valuation models of choice, then they do not know what they own if they buy it and they should hold more capital against it.

Q: Is there any reason that issuers cannot meet the December 31, 2010 deadline for compliance with Article 122a for all new securitisations? Is there any reason that regulators should grant additional time for compliance if they do not since the lack of compliance will make it very difficult for the issuers to sell their securities?

A: The answer to both questions is no. Issuers and the servicers involved in the daily billing and collecting of the underlying exposures are easily able to report all the data fields that they track in their data systems on an observable event basis. Issuers are in the best position to explain each structural element of a security and how they work together. In addition, the information technology exists to provide both the underlying exposure data and the structural features at very low cost. As a result, compliance is easy and several issuers are likely to comply to gain a competitive advantage over those issuers who do not comply and also to ensure ongoing access to the capital markets for funds.

Some issuers might not meet the December 31, 2010 deadline. The most likely reason is because they adopted the strategy of waiting for the regulators. Not all issuers want to report all the data fields they track on a borrower privacy protected basis so that investors can truly know what they own. For them, compliance has been put on hold as they wait for regulators to finish developing reporting templates that set minimum disclosure requirements. This is a difficult time consuming task because it requires identifying every data field that is important for monitoring and valuing each underlying loan or receivable. Some issuers have concluded that this task lets them off the hook for compliance while they argue over the material relevance of each data field to include in the templates. Their reasoning is how can regulators expect or force them to comply with specific disclosure rules when these templates do not currently exist and they are not even certain that they actually track each data field in the template?

To avoid all template related problems and have all issuers meet the December 31, 2010 deadline, regulators should postpone resolution of the template issue. Even if the ECB floats a trial balloon of templates for all types of underlying exposures in September, regulators should simply require that all data fields be reported on a borrower privacy protected basis. After this has been done for several years, then regulators can look at what data fields were actually used by investors and issue a formal template.

Q: What are the requirements of Article 122a for investors?

A: That they use the information provided by the issuers to do and can demonstrate that they have done their homework on each structured finance investment. As mentioned earlier, the penalty for not doing this is the investor will have to hold significantly more capital against its positions.

Q: Why is Article 122a the key to the future of finance?

A: Underlying Article 122a is the assumption that investors will return and continue to provide liquidity through all future credit cycles without the need for government credit guarantees if they have all the information they need to value structured finance securities. Reopening and keeping open the structured finance market is important because credit institutions will have less balance sheet capacity for holding loans and receivables under the higher Basel III capital requirements. Central bankers need a functioning structured finance market to satisfy the credit needs of the global economy and let them unwind their balance sheets.

Q: Would Article 122a effect Covered Bonds?

A: Covered bonds are not explicitly mentioned in Article 122a as requiring disclosure by the issuers. However, given how closely the structure of covered bond securities parallels structured finance securities, it is reasonable to think that both the know what you own provision and the disclosure provision should apply.

Currently, covered bonds are issued with no disclosure on the underlying exposures. Rather, there is a promise by the issuer to replace the underlying exposures if they fail to perform. As Washington Mutual showed, this promise is only good so long as the issuer is solvent. When the issuer goes bankrupt, the investors are reliant on the performance of the underlying exposures to make all interest and principal payments. In the absence of disclosure, how can investors evaluate the underlying exposures to see if this is possible?

Today, investors in a covered bond are making a blind bet on a pool of loans and the bonds trade based solely on the credit rating of the issuer. By providing disclosure into the underlying exposures, the bonds could instead trade on the basis of the credit strength of the loan pool. This change is significant as it makes covered bonds more attractive to purchase.

IOSCO publishes disclosure principles for ABS


The ABS Disclosure Principles provide guidance for listings and public offerings of ABS, defined as those securities that are primarily serviced by the cash flows of a discrete pool of receivables or other financial assets that by their terms convert into cash within a finite period of time, such as RMBS (residential mortgage-backed securities) and CMBS (commercial mortgage-backed securities), among others.

The principles are based on the premise that the issuing entity will prepare a document used for a public offering or listing of ABS that will contain all material information, clearly presented, that is necessary for full and fair disclosure of the character of the securities being offered or listed in order to assist investors in making their investment decision.

The ABS Disclosure Principles will complement IOSCO’s existing disclosure standards and principles, which include International Disclosure Standards for Cross-Border Offerings and Initial Listings by Foreign Issuers (1998)2; Principles for Ongoing Disclosure and Material Development Reporting by Listed Entities (2002)3; General Principles Regarding Disclosure of Management's Discussion and Analysis of Financial Condition and Results of Operations (2003)4;International Disclosure Principles for Cross-Border Offerings and Listings of Debt Securities by Foreign Issuers (2007)5; and Principles for Periodic Disclosure by Listed Entities (2010)6.

The ABS Disclosure Principles would also provide guidance if a Document is required:

  • when a financial intermediary that has participated in a public offering of securities later sells to the public the securities that were unsold in the original public offering; or
  • when the issuer has sold securities in a private placement to any party who then resells those securities to the public.

These principles would not provide guidance for securities backed by assets pools that are actively managed (such as some securities issued by investment companies), or that contain assets that do not by their terms convert to cash (such as collateralized debt obligations).

IOSCO addresses oversight of securitized products

The final recommendations contained in the Final Report address issues of concern with respect to:

  • securitised products, including asset-backed securities (ABS), asset-backed commercial paper (ABCP) and structured credit products such as collateralised debt obligations (CDOs), synthetic CDOs, and collateralised loan obligations (CLOs); and

Final Recommendation 1 – Wrong Incentives

IOSCO acknowledges industry responses in the securitisation market and recommends the following regulatory responses

  1. Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation in order to appropriately align interests in the securitisation value chain;
  2. Require enhanced transparency through disclosure by issuers to investors of all verification and risk assurance practices that have been performed or undertaken by the underwriter, sponsor, and/or originator;
  3. Require independence of service providers engaged by, or on behalf of, an issuer, where an opinion or service provided by a service provider may influence an investor's decision to acquire a securitised product; and
  4. Require service providers to issuers to maintain the currency of reports, where appropriate, over the life of the securitised product.

Final Recommendation 2 – Inadequate risk management practices

IOSCO acknowledges industry responses in the securitisation market and recommends the following regulatory responses:

  1. Provide regulatory support for improvements in disclosure by issuers to investors including initial and ongoing information about underlying asset pool performance. Disclosure should also include details of the creditworthiness of the person(s) with direct or indirect liability to the issuer;
  2. Review investor suitability requirements as well as the definition of sophisticated investor in the relevant market and strengthen these requirements, as appropriate, in the context of the relevant market; and
  3. Encourage the development of tools by investors to assist in understanding complex financial products.

Final Recommendation 3 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements are needed to regulatory powers to support TC recommendation #1 and #2 in a manner promoting international coordination of regulation.

Credit Default Swaps

Final Recommendation 4 – Counterparty Risk and Lack of Transparency

IOSCO encourages industry responses in the CDS market and recommends the following regulatory responses:

  1. Provide sufficient regulatory structure, where relevant, for the establishment of CCPs to clear standardised CDS, including requirements to ensure:
  • a) appropriate financial resources and risk management practices to minimise risk of CCP failure;
  • b) CCPs make available transaction and market information that would inform the market and regulators; and
  • c) cooperation with regulators;
  1. Encourage financial institutions and market participants to work on standardising CDS contracts to facilitate CCP clearing;
  2. The CPSS-IOSCO Recommendations for Central Counterparties should be updated and take into account issues arising from the central clearing of CDS;
  3. Facilitate appropriate and timely disclosure of CDS data relating to price, volume and open-interest by market participants, electronic trading platforms, data providers and data warehouses;
  4. Support efforts to facilitate information sharing and regulatory cooperation between IOSCO members and other supervisory bodies in relation to CDS market information and regulation; and
  5. Encourage market participants' engagement in industry initiatives for operational efficiencies.

Final Recommendation 5 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support TC recommendation #4 in a manner promoting international coordination of regulation.

IOSCO believes that the recommendations relating to CDS might be used, or tailored, to inform general recommendations for other unregulated financial markets and products, in particular, standardised and non-standardised OTC derivative products where such products may pose systemic risks to international finance markets or could contribute to restoring investor confidence. Further work in this area, taking account of industry initiatives, may be necessary.

The Task Force was co-chaired by the Australian Securities and Investments Commission (ASIC) and the Autorité des Marchés Financiers (AMF) of France.

Proposed changes to Basel II (July, 2009)

Source: Basel II capital framework enhancements announced by the Basel Committee Basel Committee on Banking Supervision (July 13, 2009)

"Under the Basel II enhancements approved at the July meeting, the Committee is strengthening the treatment for certain securitisations in Pillar 1 (minimum capital requirements). It is introducing higher risk weights for resecuritisation exposures (so-called CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the credit conversion factor for short-term liquidity facilities to off-balance sheet conduits. The Committee is also requiring that banks conduct more rigorous credit analyses of externally rated securitisation exposures.

The Committee is issuing supplemental guidance under Pillar 2 (the supervisory review process) of Basel II. This guidance addresses the flaws in risk management practices revealed by the crisis. It raises the standards for:

  • firm-wide governance and risk management;
  • capturing the risk of off-balance sheet exposures and securitisation activities;
  • managing risk concentrations; and
  • providing incentives for banks to better manage risk and returns over the long term.

The supplemental guidance also incorporates the FSF Principles for Sound Compensation Practices, issued by the Financial Stability Board (formerly the Financial Stability Forum) in April 2009. The Committee, through its Standards Implementation Group, will begin work immediately on the practical implementation of these principles.

Basel II capital charges for securitization

Under the Basel II enhancements approved at the July meeting, the Committee is strengthening the treatment for certain securitisations in Pillar 1 (minimum capital requirements). It is introducing higher risk weights for resecuritisation exposures (so-called CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the credit conversion factor for short-term liquidity facilities to off-balance sheet conduits. The Committee is also requiring that banks conduct more rigorous credit analyses of externally rated securitisation exposures.

"Basel II banking regulations are sooooo boring.

But Basel II’s effects on securitisation are fascinating, right?

Let’s begin.

Rating agency Fitch is guiding us through the Basel II regulations, currently being rolled out around the world, and their impact on securitisations — the financial exotica that are RMBS, ABS, CDOs and the like.

Here’s what Fitch says on the matter: A core objective of Basel II is to close the regulatory capital arbitrage that exists under Basel I. Basel I’s crude approach to measuring risk gives banks an unintended capital incentive to securitise high quality, low‐yielding assets and retain low quality, high‐yielding assets, since the amount of capital required against each is identical. This tactic of securitising high quality assets and retaining riskier exposures, including subordinate tranches, decreases Basel I capital requirements without necessarily reducing economic risk exposure.

This is something we’ve heard before. Specifically, the idea that the modified Basel II rules will effectively kill the market for complex products, since they require more capital — in some cases up to 3.5 times more — to be held for some securitisations. In other words, banks will no longer want to hold onto the riskiest tranches of securitised stuff, and without banks to hold the mezzanine tranches, they can’t sell the less risky tranches to others.

Here’s what Fitch has to say about the capital weightings for different shades of securitisations:

Finally, both the standardised and IRB approaches feature a “cliff” in securitisation capital charges between investment grade and non‐investment grade exposures. This ramp‐up in Basel II charges is broadly comparable to the profile of average annual structured finance impairment rates, which also increase markedly when crossing below the investment grade threshold (see Chart 1).

In practice, that cliff effect looks like this:

What’s interesting, however, is that Fitch doesn’t think this will lead to fewer securitisations but to more:

This cliff effect is also one of the reasons behind the recent growth in re‐securitisation activity as banks are repackaging distressed or heavily downgraded securities to achieve higher ratings on the resulting senior tranche, which in turn translate into lower capital charges if retaining the senior tranche.

Let’s rewind a bit here.

The point of Basel II is to neutralise capital arbitrage risk:

Basel II is designed to neutralise this arbitrage opportunity by aligning regulatory capital charges more closely with economic risk, thus reducing capital incentives both to securitise high quality assets and to retain subordinate tranches. By promoting greater risk‐sensitivity, Basel II moves closer to achieving capital neutrality (or capital charges that are identical for both an unsecuritised pool of assets and a securitisation of these same assets). Since the securitisation process typically changes the form but not the overall amount of risk within a pool of assets, the total capital charges on the unsecuritised pool should equal the total charges across the full securitisation structure.

That should result in the kind of regulatory framework the Basel Committee is aiming for — one in which banks decide to securitise assets based on actual economic interests rather than pure capital arbitrage.

So does Basel II succeed in creating equal charges for unsecuritised and securitised assets?

Fitch has helpfully calculated a few capital requirements on sample securitisations under Basel II. Here are the results for the Internal Ratings-Based methodology (where banks are allowed to use their own empirical models to estimate probabilities of default) and the standardised approach (using external credit assessments - i.e. ratings agencies). The blue ‘underlying assets’ bars are basically the unsecuritised versions of banks’ assets:

In the CMBS and Credit Card ABS examples using the standardised approach, the unsecuritised assets require more capital than their securitised counterparts. Now, Fitch is very clear that these are illustrative examples only and that readers should not generalise based on these results. The reason for that, Fitch says, is because capital weightings for securitisations under Basel II are extremely sensitive to a variety of factors.

For instance:

Simple scenario testing illustrates the dynamic nature of Basel II … For the sample CMBS transaction in this study, assume instead that (1) the PD [estimates of probability of default] is 0.60% instead of 0.75% (eg the IRB bank uses different empirical data or default risk models to estimate PD) and; (2) the four senior tranches (which together account for over 90% of the structure’s total notional exposure) maintain their credit ratings but that the two lowest tranches (which only account for about 7% of the deal’s total exposure) incur a two to three notch downgrade (ie the ‘BBB’ tranche is downgraded to ‘BB’; the ‘BB’ tranche falls to ‘B+’).

The rather stark disparity in capital charges in the base case (ie 5.4% capital if unsecuritised versus 2.5% if securitised) is now perfectly aligned (ie 5% capital on both an unsecuritised and securitised basis) in this new scenario. A relatively small shift in risk measures (ie decreasing PD by 0.15% and a few notch downgrades affecting only 7% of the capital structure) has fully neutralised what was previously a two‐fold difference between the unsecuritised and securitised Basel II charges.

What should be becoming clear here is that the structure of the resecuritisation is a crucial element in deciding capital weightings under Basel II.

A subtle change in the structure — default assumptions, credit enhancement, etc. — can result in a vastly different capital requirement:

Given the “cliff” in Basel II securitisation charges across the investment grade threshold and the acceleration in charges when moving down the ratings scale, it is apparent that relatively subtle differences in capital structure can have a significant impact on the resulting Basel II charges. Marginal changes in the portion of the capital structure rated below ‘BBB‐’ (and, particularly, the portion rated below ‘BB‐’ and requiring a 100% capital charge) have a magnified impact on overall Basel II charges for the transaction.

Basel II’s risk‐sensitivity goes a long way towards closing Basel I’s regulatory capital arbitrage, which was driven in large part by crude risk‐weighting approaches resulting in the same blanket capital charges applied to differing risk exposures. Under Basel II, however, the same or similar risk exposures could in many instances face different capital charges, potentially creating new forms of regulatory arbitrage in which banks hold a given risk exposure based on the methodology and form generating the lowest capital requirements. This potential arbitrage stems partly from Basel II’s flexibility in providing a range of calculation approaches tailored to different banks, risk quantification methodologies, risk measures, asset types and forms of risk exposure.

In other words, more of the same kind of behaviour in which banks have been engaged for the past decade or so.

IMF on securitization

IMF's view of securitization and the crisis

Source: United States: 2009 Article IV Consultation—Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion IMF, July 9, 2009, page 5

  • 1. At the root of the crisis, investors, intermediaries, and regulators failed to grasp both the weaknesses in the securitization model and the attendant risks posed by dramatic growth in increasingly complex securitization. Between 2002 and 2006, asset backed securities (ABS) issuance more than doubled to $840 billion—roughly the size of bank credit flows—financed by domestic and foreign investors. While greatly facilitating the expansion of credit, securitization activity also reduced transparency about the distribution of risks, increased reliance on ratings (which bred complacency about risks in high-rated securities), and moved risk outside the core banking system (Box 1). In addition, skewed incentives eroded underwriting standards on underlying loans, although this did not become apparent until later.
  • 2. Falling volatility led market participants and regulators to underestimate risks, particularly in the housing market (Figure 1). Low volatility also reinforced a prevailing view that financial innovation was beneficial in spreading risk to peripheral (and presumably, non-systemic) institutions. Relatedly, prudential supervision and regulation focused heavily on the core banking system, although its share of financial intermediation shrank as securitization burgeoned. Meanwhile, continuously rising house prices became the new norm, and rising home ownership was attributed to improved access to credit. In tandem, the share of the overall financial sector in corporate profits reached a historical high of about twice its long-run average, apparently validating the view that financial innovation enhanced efficiency (Figure 2).
  • 3. At a macro level, a seemingly virtuous circle developed—especially in the real estate market (Figure 3). Home mortgage lending rose over 50 percent during 2002−05; the share of Alt-A and subprime loans surged to a third of new mortgage originations in 2005 compared with less than 10 percent at the start of the decade. The government-sponsored mortgage enterprises (GSEs) rapidly expanded both their securitization of prime mortgages and their purchases of nonprime mortgage-backed debt. As the credit-fueled housing bubble inflated, rising real estate prices fed consumption out of housing wealth; saving out of disposable income fell and briefly turned negative during 2005.
  • 4. But over 2006 and 2007, cracks began to appear in both financial markets and the broad economy. Real estate prices and residential investment peaked, and as the housing downturn gathered pace, default rates on subprime mortgages rose and then surged. The deteriorating real estate market put increasing stress on intermediaries: in August 2007, measures of banking system stress—the Libor-OIS and TED spreads—jumped to as high as 100−200 basis points, 5 to 10 times pre-crisis levels, while spreads on credit default swaps for major banks began a steady upward trend. Against the background of growing financial strains that increasingly affected real activity, the Federal Reserve cut its policy rate by 100 bps over the second half of 2007, but the macro-financial feedback loop nevertheless intensified; and by end-year, the economy was in recession.

IMF - Life and death of securitization

Source: United States: 2009 Article IV Consultation—Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion IMF, July 9, 2009, page 6

"Securitization made the U.S. financial system brittle. First, by creating a direct link between U.S. retail borrowers and investors (including those abroad), it increased the supply of mortgage finance, and fuelled the housing boom.

Second, by creating a long production line—from lender to bundler to servicer to investor—it gave rise to severe principal/agent problems and information asymmetries, allowing credit standards to slip and risk to be obfuscated and mispriced.

Third, by parking $9 trillion in special purpose vehicles, it impeded needed loan modifications on a large amount of credit, worsening the impact of the tail event that was the U.S. house-price bust.

Failures occurred along the securitization chain.

Lenders had limited incentives to maintain prudent underwriting and monitoring standards, as risks were transferred away; instead they focused on maximizing fees. Investors relied on credit ratings, rather than performing due diligence, especially as structures became more complex. They also put faith in protective structures such as over-collateralization and liquidity backstops, but in the event, these were of little protection given poor underwriting.

The rating agencies, receiving a large and increasing share of their total income from a narrow set of issuers that dominated the bundling business, used often flawed methodologies and data inputs (themselves difficult for investors to evaluate, given the limited transparency).

As a result, investors severely underestimated risks; and no one anticipated the scope and depth of subsequent downgrades. Also, in the face of soaring delinquencies on the underlying loans, servicers lacked the resources and incentives to carry out the most appropriate loss mitigation strategies (see Kiff and Klyuev, IMF Staff Position Note 2009/02).

Several initiatives are underway to address these problems (see also the discussion of past steps in IMF Country Report 08/255, including pp 31–32):

  • Aligning incentives: The Treasury’s June 17 Regulatory Reform paper proposes that originators retain five percent of the credit risk of securitized exposures, and the House Mortgage Reform and Anti-Predatory Lending Act would make bundlers legally liable for poor underwriting. The Treasury paper also proposes to link securitizers’ compensation to the longer-term performance of the securitized assets.
  • Disclosure: The Securities and Exchange Commission (SEC) may propose revisions to rules and forms to improve offering and disclosure requirements for asset-backed securities. The American Securitization Forum is leading industry efforts to improve disclosure practices.
  • Rating agencies: The Treasury paper also calls for rating agencies to differentiate ratings on ABS from those on other debt and for improved disclosure, including ratings performance metrics. In December 2004, the International Organization of Securities Commissions issued a credit rating agency code of conduct, calling for firewalls between sales and analytic functions, and the SEC made more specific regulations in 2008. Also in 2008, rating agencies agreed with the New York Attorney General to implement a fee-for-service revenue model for MBS ratings—with originators required to pay the agencies whether or not they were ultimately selected to rate the security (to reduce “ratings shopping”).

These may be useful steps, but more can be done. The Regulatory Reform proposes improved transparency, as well as risk-retention requirements that will help strengthen incentives for sound underwriting, although care must be taken to manage attendant risks in the core banking system. Encouraging simpler, more standardized, better capitalized structures through market codes of conduct or regulatory action could facilitate investor due diligence, and reduce the risk of mistakes in the ratings process. In addition, a broader legal “safe harbor” for servicers to modify underlying loans would protect them from lawsuits, better enabling them to pursue loss-mitigation efforts aimed at maximizing the value of the pool."

The Australian securitization market

Towards the end of 2009, an improvement in sentiment led to an increase in the level of private sector participation in RMBS transactions. This was documented by Guy Debelle in a speech at the Australian Securitisation Conference on November 18, 2009.

Debelle noted that private sector participation in RMBS transactions had increased from around 20 per cent (meaning that on average the private sector invested 25 cents for every dollar that the Government invested in RMBS) in late 2008 to around 60 percent (i.e. $1.50 of private money for every dollar of public money) towards the end of 2009. These figures include only transactions that were ‘supported’ by the AOFM; there were also a number of standalone deals in late 2009, undertaken by Members Equity Bank, Bendigo and Adelaide Bank and Westpac Bank. Including these in the calculation, the ratio improves to about 75 per cent (i.e. $3 of private money for every dollar of public money invested in RMBS).

Indeed, the private sector’s contribution to the five RMBS deals that have priced in 2010 has been around 81 per cent, implying that over $4.25 of private money has been invested for every $1 of public money invested this year.

  • Source: "Whither Securitization?" Guy Debelle, Assistant Governor (Financial Markets), Reserve Bank of Australia, Address to the Australian Securitisation Conference 2009, Sydney – 18 November 2009

"... The banks themselves also used securitisation as a funding source whenever it was cost effective to do so. In the case of the smaller regional banks and some building societies and credit unions, securitisation was an important means of funding. Prior to mid 2007, regional banks securitised around one-third of their housing loans while the major banks securitised less than 10 per cent. As a result, despite their smaller size, the regional banks accounted for roughly 40 per cent of RMBS issuance whereas the major banks accounted for 20 per cent.

Demand from domestic and non-resident investors for RMBS was very strong in the years leading up to the credit market turmoil, supporting the robust growth in the market. This was evident in the steady decline in spreads to swap on AAA-rated prime RMBS at issuance from around 40 basis points in 2000 to less than 20 basis points in mid 2007.

At least one-third of the investors in Australian RMBS were offshore structured investment vehicles, the now notorious SIVs. These entities funded themselves with short-dated paper, of less than 365 days, to purchase longer-dated assets such as RMBS, in large part to arbitrage capital rules. They were, in theory at least, off-balance sheet vehicles, back-stopped by credit lines from their parent financial institutions..."

APRA requires bank self assessments on securitizations

To all locally-incorporated authorised deposit-taking institutions:


Prudential Standard APS 120 Securitisation (APS 120), which became effective in January 2008, requires authorised deposit-taking institutions (ADIs) to undertake, and provide to APRA upon request, written self-assessments of each securitisation in which they participate.

In line with this requirement (paragraph 18), APRA has requested and reviewed a number of self-assessments.

India central bank increases disclosure requirements

The Indian central bank on Monday increased disclosure requirements for banks who sell securitised assets, to increase transparency for investors under the enhanced Basel II framework.

The Reserve Bank of India said banks needed to clearly state what role they had played in the securitisation of an asset, including whether they were an originator, investor, provider of credit enhancement or liquidity provider while securitising assets.

Following is the link to the notification:

“In light of the wide range of risks arising from securitisation activities, which can be compounded by rapid innovation in securitisation techniques and instruments, minimum capital requirements calculated under Pillar 1 are often insufficient,” RBI said.

The risks which needed to be addressed under securitisation include credit, market, liquidity, reputational risks, potential delinquencies and losses on underlying securitised exposures, exposures from credit lines, the central bank said.

Banks should state policies for recognising liabilities on their balance sheets for arrangements that could require them to provide financial support for securitised assets.

“Innovation has increased the complexity and potential illiquidity of structured credit products. This, in turn, can make such products more difficult to value and hedge, and may lead to inadvertent increases in overall risk,” the RBI said.

The central bank also asked banks to quantify the aggregate amount of on-balance sheet and off-balance sheet securitisation exposures along with details on the type of exposure.

According to the master circular on the prudential guidelines on capital adequacy, banks have to set aside 50 percent from Tier-I capital and 50 percent from Tier-II for a securitised exposure.

The RBI also urged banks to incorporate forward looking capital planning that identified possible events or changes in market conditions that could adversely affect them.

Conflict in US and UK bankruptcy treatment of ABS swaps

  • Source: [Europe’s ABS currency-swap exposure] Credit Risk Chronicles, February 15, 2010

Original posted on FT Alphaville by Izabella Kaminska:

Back in January, a US court rather controversially decided that claims of a Lehman Brothers special purpose vehicle — to which the bank was a counterparty — should not be subordinated to other creditors.

As the FT commented at the time:

It is a controversial ruling which will be closely scrutinised for its implications for the structured products and derivatives markets.

Judge Peck decided on Monday that a provision that would normally subordinate Lehman’s claims is unenforceable under US bankruptcy law. The decision goes against a ruling by the English courts last summer which determined that a group of investors in the vehicle should be paid ahead of the failed bank in its unwinding.

While the above decision was always going to have far-reaching implications for structured product and derivative markets, a recent note from BarCap draws attention to the implications for Europe’s ABS market.

One concern, it turns out, is Europe’s beloved use of embedded swaps in ABS deals for the purpose of hedging out interest-rate, basis and currency risk. These, it seems, are hedged out in exchange for credit risk.

Usually this is considered acceptable because even though the swaps undergo mark-to-market gains and losses over the life of an ABS transaction, the fact that the notes are supposed to be hedged over the life of the transaction means gains and losses have no discernible “real-world consequence” for noteholders.

In the event of early termination, however, payments are positioned senior to those noteholders. As BarCap explain:

…should a swap be terminated early, mark-to- market gains and losses can indeed play an important role: a termination payment equal to the mark-to-market amount may be due to be paid by the swap counterparty suffering a mark-to-market loss to the counterparty enjoying a mark-to-market gain. These termination payments are often senior to the notes in European ABS cashflow waterfalls, just as is typically the case with regular swap payments.

However, there is one important exception — a swap provider bankruptcy. In this scenario payouts are subordinated to those of noteholders:

If the swap provider enjoys a mark-to-market gain, the transaction is obligated to make a corresponding payment; to ensure that making such a payment does not result in payment shortfalls to noteholders in the transaction upon its due date (and possibly an event of default under the notes), said swap termination payment is commonly subordinated to note payments if the termination payment results from the bankruptcy of the swap counterparty.

Except, as Barclays Capital points out, due to the US Lehman SPV ruling this scenario has potentially been flipped around for US swap providers. As BarCap explain:

Given the prevalence of swaps in European ABS structures, the risk that US law could apply to securitisations governed by UK law is a considerable concern.

The good news, according to the analysts, is that interest-rate or basis swaps would only ever expose noteholders to losses on the interest component of total payments — a substantially smaller sum than the principal component. What’s more, there’s less chance of a US swap provider going bankrupt in the first place because the crisis is waning.

The bad news, however, is that currency swaps reflect a much bigger concern. As BarCap note:

By contrast, currency swaps apply to the interest and the principal components of the swapped notes’ total payments and are therefore of greater concern.

Although, even here there is an upside:

…in many European ABS transactions that use currency swaps, only some notes are swapped into a currency different from the currency of the collateral – the smaller the proportion of total note notional swapped into a different currency, the smaller the transactions’ overall exposure. In addition, European ABS structures may have multiple currency swap providers, reducing the exposure to any one counterparty.

That said, despite the immediate risk to European ABS being reasonably contained, BarCap say there is still the chance of extensive ratings actions to come. They cite Fitch as follows:

“Following the completion of analysis of any securities placed on RWN, the ratings of these securitized notes could become credit-linked and downgraded to the level of the counterparty. Specifically, if a downgrade is warranted, higher-rated tranches would likely be downgraded to the counterparty rating, which is between ‘AA’ and ‘A’ in most SF transactions”.

Federal Reserve's view of securitization crisis

Image:CSE securitized deal table Fed.jpg

Creation of CSE program may have increased securitization deals

Source:The Role of the Securitization Process in the Expansion of Subprime Credit Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. 2009-28, April 2009 (page 5)

"In October 2003, the SEC proposed amending a series of rules which reduced capital requirements on certain brokerdealers. The rule change came in response to The European Union’s (EU) Conglomerates Directive which required that affiliates of U.S. broker-dealers be subject to consolidated supervision by a U.S. regulatory authority. Formally adopted in April 2004, the rule change established an alternative method of calculating capital requirements for the largest independent broker-dealers that were not already subject to capital regulation from a regulatory authority.

Broker-dealers taking advantage of the alternative capital contribution would be classified as a “Consolidated Supervised Entity (CSE)” and would realize an estimated 30-40% reduction in capital deductions. In short, we argue that in 2004 the event endowed five of the largest brokerdealers with additional capital which could be used to increase production of securitization deals.

Because we know which banks owned which loans serving as collateral in securitization deals, we examine whether the five CSE banks did indeed increase their demand for subprime mortgages relative to competitor banks that did not experience a change in capital requirements."

"The authors assert that the process, including the assignment of credit ratings, provided incentives for securitising banks (underwriters) to purchase loans of poor credit quality in areas with fast-rising house prices. Increased demand from the secondary mortgage market for these types of loans then, according to the paper, facilitated easier credit in the primary mortgage market, and ’round and ’round subprime went. Sounds sensible.

But one thing in the paper in particular jumped out at us — the role of underwriters, who so far have escaped attention of the same scale being lobbed at the credit rating agencies. (Though many people think they shoulder as much of the blame — if not more — as the agencies).

Underwriters are important to securitisation deals. They structure and price securitised things like CDOs and pay themselves something like 1 to 1.5 per cent of the deal principal in return. But, like the shopping taking place among the rating agencies, we suspect there was also a degree of financial finesse occurring among underwriters.

In order for securitisation deals to receive decent credit ratings, they require some amount of overcollateralisation — which is the stuff that’s meant to protect higher tranches by absorbing the first losses — the equity tranche. The size of the equity tranche depends on the quality of the underlying collateral, lower quality deals typically require a bigger equity tranche, and vice versa.

And who funds that equity tranche?

The underwriters. So, assuming that fees don’t vary too much, underwriting banks are basically incentivised to structure deals so that they require the smallest equity tranche possible. That’s not a bad thing in itself — it’s basically structuring the deal as efficiently as possible — but we imagine it came in tandem with a decline in the amount of credit enhancement provided and the quality of the underlying collateral. At the very least, as the authors of the paper note, it seems that some underwriters were buying up loans in areas with fast-appreciating house prices but lower average credit quality, to keep funding cheap."

In this article we analyze financial and economic circumstances associated with the U.S. subprime mortgage crisis and the global financial turmoil that has led to severe crises in many countries.

We suggest that the level of cross-border holdings of long-term securities between the United States and the rest of the world may indicate a direct link between the turmoil in the securitized market originated in the United States and that in other countries.

We provide a summary of empirical results obtained in several Economics and Operations Research papers that attempt to explain, predict, or suggest remedies for financial crises or banking defaults; we also extensively outline the methodologies used in them. The intent of this article is to promote future empirical research for preventing financial crises.

Understanding the securitization of subprime mortgage

Authors: Adam B. Ashcraft and Til Schuermann

In this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise.

We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down.

We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending.

We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time.

Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century Financial during 2006.

ASF project on residential securitization transparency and reporting

On July 16, 2008, the American Securitization Forum (“ASF”) announced the public launch of ASF’s Project on Residential Securitization Transparency and Reporting (“ASF Project RESTART” or the “Project”), which is a broad-based industry-developed initiative to help rebuild investor confidence in mortgage and asset-backed securities, restore capital flows to the securitization markets, enhance market lending discipline and, ultimately, increase the availability of affordable credit to all Americans.

The Project has been recognized by senior policymakers and market participants as a necessary industry initiative to improve the securitization process by developing commonly accepted and detailed standards for transparency, disclosure and diligence that each appropriate market participant will be expected to implement. ASF members participating actively in the Project include institutional investors, issuers, originators, financial intermediaries, servicers, rating agencies, due diligence professionals, trustees, outside counsel, outside consultants, data modelers and vendors, as well as ASF’s professional staff.

When mortgage loans are made by an originator, they are either held by the originator for its own account, sold as a “whole loan” to an investor or pooled with other loans to be deposited into a securitization. Mortgage loans can be bought and sold numerous times throughout their lives, so loans are often sold as whole loans before being placed into securitizations by ensuing purchasers. If the mortgage loan is sold, the originator will make “representations and warranties” concerning the terms of the loan and its origination. If a “defect” is later found in the loan resulting in a breach of the representations and warranties, the purchaser will “put back” or return the loan to the seller who is obligated to repurchase it (if the repurchasing party is not the originator, then the repurchasing party will likely return the loan to the originator).

In securitizations, representations and warranties are used to appropriately allocate the risk of “defective” mortgage loans between the issuers of the securities and the investors who purchase them. Much like a defective product is returned to the store from which it was sold, a defective mortgage loan will be “returned” to the issuer (or an affiliated originator or loan seller) through its removal from a securitization trust for cash or a qualified substitute loan.

Some commentators have expressed concerns that originators did not sufficiently mitigate the risk in the loans they were making to borrowers that were later sold into residential mortgage- backed securities (“RMBS”) trusts. Some believe that the lack of “skin in the game” did not provide sufficiently aligned incentives between originators and investors to ensure that the loans underlying RMBS were of adequate credit quality.

The risk or “skin in the game” traditionally retained by originators of RMBS is embodied in the representations and warranties that issuers provide with respect to the mortgage loans sold into the securitization trust, which are designed to ensure that the loans are free from undisclosed origination risks, leaving the investor primarily with normal risks of loan ownership, such as the deterioration of the borrower’s credit due to loss of employment, disability or other “life events.” For the reasons set forth below, many market participants, including investors and rating agencies, have indicated that the traditional representations and warranties and their related remedy provisions have not sufficiently provided a means to return defective loans to the originator of the loans. Because of this, the ASF has sought to address any alignment of interest issued in future securitization transactions by enhancing and standardizing the representations and warranties as well as developing stronger repurchase obligation provisions.

Another factor in the future success of the RMBS market will be an increase in the standardization of the transaction agreements. Capital commitment decisions by loan originators, financial intermediaries and fixed-income investors, as well as risk assessments by rating agencies, are more easily and efficiently made when contractual provisions are consistent across issuers. Increased standardization in a securitization transaction creates additional liquidity in the market because the due diligence process required to make an investment decision becomes more efficient. One of the areas where standardization is especially crucial is in the representations and warranties that issuers provide to investors, which help ensure that the mortgage loans in a given pool are of a certain quality.

Consistent with previous ASF efforts to help standardize aspects of securitization pooling and servicing agreements (the “PSAs”) such as the ASF’s Model Provisions for Reg AB compliance, ASF members have worked over the past year to produce a standardized set of representations and warranties that would be acceptable to rating agencies, issuers and investors alike. A broad-based working group for this phase of the Project, consisting of issuers, originators, credit rating agencies and investors, has met extensively to develop a model set of representations and warranties, which are intended to provide enhancements to the representations and warranties provided in future securitization transactions and to more appropriately allocate the risk associated with origination and underwriting practices related to loans placed into securitization trusts. Today, the ASF is requesting comment on this set of ASF Model RMBS Representations and Warranties (the “Model Reps,” attached hereto as Attachment I), which represents the third major work stream of the Project.

The Model Reps have been developed in direct response to certain challenges currently confronting many RMBS transactions. Insufficient representations and warranties and inadequate repurchase provisions may have prevented many defective loans from being removed from securitization trusts, resulting in realized losses on the issued RMBS.

The Model Reps were developed primarily to

  • (i) appropriately allocate origination risks between issuers and investors,
  • (ii) express customary market representations and warranties in the same, transparent

language across transactions,

  • (iii) provide a “market norm” against which investors and rating agencies can measure the representations and warranties contained in a particular transaction and
  • (iv) provide enhanced investor protections over what had been previously provided in “pre-

crisis” transactions.

New securitizing schemes emerge

Developers Diversified deal ends CMBS drought

U.S. mall owner Developers Diversified Realty Corp (DDR.N) snapped an 18-month dry spell in the U.S. commercial mortgage bond market by selling $400 million of securities on Monday with help from an emergency Federal Reserve lending program.

The deal was the first to be sold under the Fed's Term Asset-Backed Securities Loan Facility, known as TALF, for new issue commercial mortgage-backed securities (CMBS), a key funding tool for office, retail and apartment buildings during the real estate boom.

"We believe the deal is a crucial first step in restarting the private-label CMBS market, which has been closed since June 2008, and channeling a much-needed source of capital to the commercial real estate universe," Barclays Capital said of the first TALF deal in that segment.

The sale is an important stepping stone in the $700 billion CMBS market, seen by central bankers as one of the biggest risks to the fragile U.S. economic recovery. The market has suffered badly as the deep recession severely cut the rent revenue from commercial properties needed to pay debt service on bonds.

Met with strong investor interest, Developers Diversified was able to price the deal below existing levels for CMBS issues. Its $323 million AAA-rated five-year notes came at a narrower 1.4 percentage point premium to the five-year interest rate swap benchmark, for a yield of 3.807 percent, market sources said.

Underwriter Goldman Sachs lowered yield premiums from earlier guidance levels of 1.6 to 1.75 percentage points due to the strong buyer interest.

"The deal looked pretty clean from a collateral standpoint and the credit protection, between the over-collateralization and subordination, was incredibly high," said Dan Castro, chief risk officer at Huxley Capital Management in New York.

The offering also included two smaller non-TALF-eligible AA-rated and A-rated issues, which priced with 5.75 percent and 6.25 percent yields and also drew strong interest.

"It was the first deal in about a year and a half, so there was big demand for the small sale," said Castro.

Through its TALF program, the Fed aims to lower funding costs for issuers by offering investors financing to purchase the securities.

Laying the groundwork has been difficult for Cleveland, Ohio-based Developers Diversified and other borrowers trying to use the TALF program, investors said.

Developers Diversified, which owns 670 shopping centers in the United States, Brazil and Canada, began discussing the deal in June but faced an arduous task of clearing the collateral with the Fed, according to sources. Some properties may have not made the Fed's cut, since Developers had been working on a pair of issues totaling $550 million.

With funding nearly frozen by the lingering credit crunch, borrowers with maturing loans have had to endure grueling negotiations to extend current terms or face default.

Life insurance securitization

See here for Life insurance securitization

Reverse mortgages

Reverse Mortgages May Be "Subprime Revisited"

Former Countrywide execs seeks profit from collapse

"PennyMac Mortgage Investment Trust, which plans to raise $400 million in a stock offering today, is betting that the people who helped create the housing crisis will know how to profit from the cleanup.

Chief Executive Officer Stanford L. Kurland, 57, was president and chief operating officer of Countrywide Financial Corp., the loan originator whose co-founder, Angelo Mozilo, was sued by the Securities and Exchange Commission. Ten other senior officials also worked at Countrywide, whose subprime loans have suffered from a 39 percent delinquency rate, according to data compiled by Bloomberg. PennyMac hopes to make money buying mortgages from failed banks and redoing the terms.

“People who are critical of Wall Street will find with justification things to criticize here,” said Stanley Nabi, who oversees $7.5 billion as vice chairman of Silvercrest Asset Management Group in New York. “They’re going to say, ‘Look, these are the people who created this crisis, and now they’re buying this paper on the cheap.’”

PennyMac operates in a growing market. More than 1.5 million properties received a default notice or were seized in the U.S. during the first six months of 2009, a record, according to RealtyTrac Inc., which sells mortgage data.

Backed by BlackRock Inc. and Highfields Capital Management LP, PennyMac plans to charge fees similar to those at hedge funds as it tries to rehabilitate loans..."

"Separately, Goldman is working on what bankers said was a private-sector version of the UK government’s asset protection scheme. The goal would be similar – to reduce the capital that would need to be held against the assets – although Goldman has yet to find a balance between the risks and rewards that would be attractive to investors.

Investment banks do not believe they can compete with the government-sponsored APS, mainly due to scale. RBS and Lloyds between them are putting £560bn ($914bn) into the scheme. Under Goldman’s idea, it would sell an insurance product to a bank with a toxic portfolio, effectively shifting the risk of the underlying assets off the balance sheet. The insurance would require far less capital to be carried against it than the original assets.

Deutsche Bank engineered a comparable structure to facilitate the dismantling of risk at failed insurer AIG, although bankers close to that transaction said without government involvement the cost of such a structure would be commercially unfeasible."

Turn low investment grade to AAA

"Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News.

The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York...

...New York-based Morgan Stanley is copying a financing structure known as Re-REMICs that bundle mortgage securities into new bonds that often offer investors an additional layer of protection, or collateral, from downgrades. Credit-rating cuts may sometimes force investors to sell the debt and cause financial institutions that own the bonds to increase capital.

Jennifer Sala, a spokeswoman for Morgan Stanley, and Gregory Mount, a Greywolf partner, declined to comment.

Moody’s reduced the $365 million top-ranked portion of Greywolf in June by six levels to A3 from Aaa as the default rate on the loans in the CDO rose to 7 percent. The rating company cut 83 loan CDOs with the top rankings from May 28 through June 26, according to Wachovia Corp..."

Wall Street to bundle life insurance

See also Life insurance securitization.

"The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money.

Either way, Wall Street would profit by pocketing sizable fees for creating the bonds, reselling them and subsequently trading them. But some who have studied life settlements warn that insurers might have to raise premiums in the short term if they end up having to pay out more death claims than they had anticipated.

The idea is still in the planning stages. But already “our phones have been ringing off the hook with inquiries,” says Kathleen Tillwitz, a senior vice president at DBRS, which gives risk ratings to investments and is reviewing nine proposals for life-insurance securitizations from private investors and financial firms, including Credit Suisse.

“We’re hoping to get a herd stampeding after the first offering,” said one investment banker not authorized to speak to the news media."

Barclays securitized part of their balance sheet

"Barclays announces the restructuring of $12.3bn of credit market assets"

Barclays PLC (”Barclays”) today announces the restructuring of $12.3bn of credit market assets (”the Assets”) by a sale of the Assets to Protium Finance LP (”Protium” / “the Fund”).

Protium is a newly established fund whose objective is to purchase credit market assets from third parties and manage those assets over time to benefit from their long term cash flows. The Fund will begin by purchasing and managing the Assets from Barclays in the transaction announced today. The activities of Protium will initially be supported by $450m of new funding provided by the partners of Protium and by a loan to Protium of $12.6bn by Barclays.

The loan will be used primarily to fund the purchase of the Assets from Barclays. As part of the transaction any excess cashflows following repayment of the loan to Barclays will accrue to the partners of Protium.

Although this transaction (”the Transaction”) does not result in a different underlying credit risk profile at the commencement of the loan period, it creates a structure through which the expected value of the long term cash flows from the Assets can be maximised over time. Barclays expects it to enhance shareholder value by:

  • Restructuring exposure to the risk in the Assets thereby mitigating the potential impact of short term movement in market values and monoline downgrades;
  • Delivering more stable risk-adjusted returns, given the Assets’ multi-year duration and their cash flow characteristics; and
  • Securing long term access to an experienced team specialising in managing credit market assets.

The Assets will remain on balance sheet for regulatory purposes; consequently the Transaction will not reduce the regulatory capital required for these Assets and may lead to an increase.

The Assets will be sold at current fair values and therefore Barclays expects it will record neither a gain nor a loss on completion of the sale. Barclays will not consolidate Protium for accounting purposes and will derecognise the assets. In order to provide reporting transparency in the future, Barclays will disclose appropriate information in relation to the valuation of the loan to Protium, including the performance of underlying cashflows, and the fair value of the underlying assets.

The Transaction is part of an ongoing process in Barclays to manage down the quantum and volatility of its credit market exposures as it seeks to protect and enhance the interests of shareholders.

Details of transaction

Barclays has agreed to sell the Assets to Protium for a consideration of $12.3bn, representing their fair value at the date of the Transaction. The Assets comprise structured credit assets insured by monolines ($8.2bn), RMBS/Other ABS asdsets ($2.3bn) and residential mortgage assets ($1.8bn) held in Barclays Capital. Structured credit assets comprise assets with a fair value of $3.6bn and monoline guarantees valued at $4.6bn.

At the date of the Transaction, the $12.3bn book value of the Assets was net of credit reserves of $2.3bn for the associated monoline exposure. The Barclays Capital credit market exposures including their fair values and credit valuations, as disclosed at 30th June 2009, amended for the proforma effects of this Transaction, are set out in the Notes attached to this announcement. The $450m of new funding through the issue of limited partner interests will entitle the holders to fixed payments of 7% per annum for 10 years on their initial investment, and will be amortised in equal instalments over 5 years.

Any excess cash remaining in the Fund after full repayment to Barclays of principal and interest in respect of its loan will accrue to the limited partners at the end of the 10 year period. Barclays will provide financing to Protium in the form of a $12.6bn ten-year loan for which it will seek a credit rating. The loan, drawn at completion, will be repaid during the term from cash generated by the Fund. The principal terms of the loan are as follows:

  • The loan has a final maturity of ten years, with a commercial rate of return fixed at USD LIBOR plus 2.75% (expected to amount to a cumulative total of $3.9bn);
  • Protium is obliged to pay principal and interest equal to the amount of available cash generated by the Fund after payment of Fund expenses and certain payments to the Fund’s partners; and
  • The loan is secured by a charge over the assets of Protium. Protium’s cashflow from its assets will be used first to service payment of management fees and distributions to the partners as a priority and subsequently to service payments of interest and principal on the Barclays loan.

On completion of the Transaction, Protium’s assets comprised $12.3bn of Assets together with cash and US treasuries of $800m. The cash will be deployed at the discretion of Protium in third party credit assets to generate further investment cash flow.

Protium is run by C12 Capital Management, an independent asset management firm, the principals of which are Stephen King and Michael Keeley. Stephen King was head of Barclays Capital’s Principal Mortgage Trading Group and Michael Keeley was a member of Barclays Capital’s management committee covering European financial institutions. Both ceased to be employed by Barclays Capital upon completion of the Transaction. Neither Barclays nor any of its employees is an investor in the Fund. Barclays Capital acted as advisor to Barclays on this transaction.

Commenting on the Transaction, Chris Lucas, Group Finance Director, said: “We are not seeking through the Transaction to effect a change to our underlying credit risk profile. But we are restructuring a significant tranche of credit market exposures in a way that we expect will secure more stable risk-adjusted returns for shareholders over time. We also bring in investors with an appetite for the cash flows arising from the Assets. For Barclays, this represents a good opportunity to create greater predictability of income and economic capital utilisation.”


"Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets).

To read more about the general history of securitization see Wikipedia here.

Securitization before the Great Depression

"... The original wave of securitizations took place in the 1920s, when the United States went on the greatest building boom ever. Many investors saw how rapidly real estate prices were rising and wanted in on the action. The builders and brokers were only too happy to oblige.

To be sure, the securitizations were not as complex as the ones invented in recent years, but they were not all simple either. Most were bonds backed by one commercial building whose construction was being financed, but there were also pools of residential mortgages. Some of the bonds included warrants for partial ownership of the building, and some were convertible into stock.

There was even something similar to the exotic C.D.O.’s, or collateralized debt obligations, that failed so spectacularly. Those securities were not directly backed by real estate, but were instead supported by other securities that had such backing. One 1920s bond was called a “collateral trust” security, with a claim on a building’s profits but not on the building itself.

“Easily obtainable financing via public capital markets corresponded with an urban construction boom,” reported William N. Goetzmann and Frank Newman in a paper just released by the National Bureau of Economic Research, titled “Securitization in the 1920s.”

“Regulation and centralization were glaringly absent,” they add. “Ultimately the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning our current financial crisis.”

Yet the lessons of that boom and bust have largely been ignored. Everyone remembers the 1920s and the stock market crash of 1929, but there has been little data collected on what happened to real estate securities or even on how large a market it was. It turns out that real estate securities constituted a major market, and began to falter before stocks did.

“The breakdown in their valuation, through the mechanism of the collateral cycle, may have led to the subsequent stock market crash of 1929-30,” they wrote.

If Ben Bernanke had been thinking of that, do you think he might have been more hesitant to say that the subprime mortgage crisis had been “contained” in 2007?

The paper by Professor Goetzmann, the director of the International Center for Finance at Yale University’s School of Management, and Mr. Newman, a former Yale student who is now an analyst for the hedge fund Protégé Partners, appears to be the first to delve into the available data, which Mr. Newman had to dig up.

Securitization definition

Securitization is a structured finance process that involves pooling and repackaging of cash flow producing financial assets into securities, which are then sold to investors.

The term "securitization" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities. As a portfolio risk backed by amortizing cash flows - and unlike general corporate debt - the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent.

If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.[1]

All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of securitization processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.

Securitization often utilizes a special purpose vehicle (SPV), alternatively known as a special purpose entity (SPE) or special purpose company (SPC), reducing the risk of bankruptcy and thereby obtaining lower interest rates from potential lenders.

A credit derivative (CDS) is also sometimes used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors.

Securitization has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008.

In 2007, ABS issuance amounted to $3,455 billion in the US and $652 billion in Europe. (ESF Securitisation Data Report Q2:2008, European Securitisation Forum, London, Securities Industry and Financial Markets Association (SIFMA), 2008)

Securitization, in its most basic form, is a method of financing assets. Rather than selling those assets "whole", the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or "spinning off," a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now. A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay XYZ interest on the money they borrow.

Special types of securitization

For excellent information about the following structure types please see Wikipedia here

  • Master trust
  • Issuance trust
  • Grantor trust
  • Owner trust

Recent lawsuits

Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies.[1]

Motives for securitization

Securitizing assets accomplishes many things and has many intended and unintended consequences to learn more about the following topics please see this page at Wikipedia

Advantages to issuer

  • Reduces funding costs
  • Reduces asset-liability mismatch
  • Lower capital requirements
  • Locking in profits
  • Transfer risks
  • Off balance sheet
  • Earnings
  • Admissibility
  • Liquidity

Disadvantages to issuer

  • May reduce portfolio quality
  • Costs
  • Size limitations
  • Risks

Advantages to investors

  • Opportunity to potentially earn a higher return on a risk-adjusted basis
  • Opportunity to invest in a specific pool of high quality credit-enhanced assets
  • Portfolio diversification
  • Isolation of credit risk from the parent entity

Risks to investors

  • Liquidity risk
  • Credit/default risk
  • Event risk
  • Prepayment/reinvestment/early amortization risk
  • Currency interest rate fluctuations risk
  • Contractual agreements
  • Moral hazard
  • Servicer risk

'Real money' investors return to securitization markets

Financial innovation played a key role in the crisis that led to the near collapse of the global banking system last year.

The alphabet soup of CDOs, CPDOs, CDS, ABS, ABCDS, ABCP and RMBS (see panel) that were so popular during the boom years became the poison that infected the entire financial system. A series of markets froze and values plunged, forcing banks and investors to write off hundreds of billions of dollars in lost value.

These markets are only now beginning to thaw. Some of the more complex structures – CDO squareds, for example – are not expected to return for a long time, if ever. But bankers have been sifting through the wreckage desperate to salvage the basic elements of securitisation.

“It has taken time,” says Gareth Davies, head of European ABS research at JPMorgan. He has spent much of the past 18 months explaining securitisation to government officials and company executives to help them distinguish between the more exotic and distressed corners, such as CDOs of ABS, and the essential securitisation principle of parcelling up loans or bonds into saleable securities.

“We’ve gone from a time where everyone bought ABS and fought for every extra basis point through a knee-jerk period where you couldn’t sell these deals at all. Now the debate about the future is becoming more reasoned and forward-looking,” he says.

Two deals last month heralded a tentative opening of the markets in Europe and provided a benchmark for other issuers. Lloyds sold £4bn ($6.3bn) of residential mortgage-backed securities and Volkswagen issued €500m ($740m) in car loan ABS.

Brad Craighead, head of European ABS origination and structuring at JPMorgan, who worked on both deals as a joint-bookrunner, said the two drew more than 100 different investors. Buyers were top name “real money” investors who buy bonds to hold them, rather than so-called “fast money” investors – who often sell deals quickly in the secondary market for quick profit. “Both deals were bought by investors actually trying to increase their exposure,” he says. “The two being priced alongside each other really reinforced the message that there is broad demand.”

Investor appetite is one thing but the market is not expected to return to its pre-crisis habits where new, complex structures with exotic acronyms appeared regularly. The Lloyds and VW deals were structured in simple so-called “plain vanilla” terms.

Another factor likely to change will be the amount of data buyers get. Part of the market freeze has been attributed to investors not knowing exactly what loans lay behind each security. This led some to boycott the entire sector for fear they might be holding the bad loans.

Since then, the European Central Bank and other institutions have called for investors to get more data to make the market more transparent.

Ratings agencies say they are happy to share the information they are given but issuers’ reluctance, coupled with data privacy laws in Europe, make the reality more difficult.

“If we’re presented with information, there’s no reason in our book why we’re the only ones to have that. There is some commercial sensitivity around some information but there is a dichotomy between that sensitivity and giving people the confidence to invest,” says Stuart Jennings, group credit officer at Fitch Ratings.

Even if the issue with data is overcome, few expect the market to roar back to anything like its pre-crisis size. One reason for this is the disappearance of so many buyers, particularly Structured Investment Vehicles and bank conduits – shady, off-balance sheet entities that bought many of these toxic securities and funded their purchases by issuing short-term asset-backed commercial paper.

Their disappearance, however, is no bad thing, according to market insiders.

“If there was one group of investors who over-relied on ratings and did relatively minimal credit work, it was SIVs and conduits, especially in Europe. Their investing strategy was a funding arbitrage [borrowing at low short-term rates and investing at higher ones]. Now they’re gone we’re left with a greater proportion of investors who are doing the credit work to analyse the bonds,” says one securitisation professional.

These quality investors were evident in July in the US in a striking $1.2bn RMBS deal for American General, a subsidiary of AIG. The deal was arranged by Credit Suisse which, partnering with PennyMac, the mortgage investor, sold the bonds without any credit rating.

Ben Aitkenhead, co-head of structured products at Credit Suisse, who worked on the deal, says the bank could have sold twice the amount of bonds on offer.

“You need the ratings agencies to give you the deepest pool of buyers but we proved investors are comfortable doing their own credit analysis and not outsourcing it,” he says.

Investors did, however, demand a far deeper credit enhancement – the cushion that soaks up losses before the most highly-rated tranche is hit. Before the crisis, a deal might have consisted of 10 per cent of junior paper below the senior bonds. This time, investors demanded a 40 per cent cushion.

“Investors weren’t asking for more loan-level information than normal, this cushion was about having observed the market over the last 24 months. They now demand more protection and this is likely to continue at some level,” Mr Aitkenhead says.

That the market is re-opening, even in this gradual way, is welcome to regulators and politicians as well as bankers and investors. Issuance in the US, for example, accounted for about a quarter of all credit before the crisis and an active, if reformed, market is seen in both Europe and the US as a crucial part of any lasting economic recovery.

Insiders are still publicly cautious. Most – bankers, issuers and investors – characterise the recent deals as only “baby steps” in the right direction. But all seem sure there will be a future and that, after the freeze, it is beginning to unfold."

CDO regulation

See also CDO regulation and SIVs.


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