We have reached a hiatus; a moment to pause and reflect…just before impact. I’ve called this time-out as we enter a period which is likely to be the most influential for securitization markets since Ginnie Mae first sold securities backed by a portfolio of mortgage loans almost 40 years ago to the day.
The volume of work and level of coordination already undertaken by participants in the securitization industry, its working groups, regulatory bodies and government over the last two years has been staggering. The one constant during that period was the regularity with which industry bodies put forward this set of recommendations, or that set of proposed changes to regulation. The combined misgivings and failings of the market were quickly uncovered. Best practice guidelines and standards for originators and investors were soon put forward, both in the US and in Europe. There was momentum. The wave of stimulus packages has had varying effects on the broad stabilization of global securitization markets. The time has come to analyze the potential impact of all that has been proposed and the exit of government support before sweeping changes are finalized.
Proposals rapidly emerged to help shape the development of regulatory policy with the aim of improving the quality and amount of capital held by financial institutions and introducing rules and diligent risk management practices for portfolios of securitized assets. Recommendations tackled the issues of complexity and a lack of transparency by suggesting ways to standardize terms and structures. In September 2009, the culmination of much of this research, analysis and market consultation was presented to international leaders at the G20 in Pittsburgh with the goal of driving a globally viable, coordinated regulatory response.
The result was agreement and mutual recognition across the G20 on what must be achieved to restart the securitization markets on a sound basis. The ultimate goal of course is to revive the market and support the provision of credit to the real economy. Core reforms focusing on capital, liquidity, cross-border resolution and enhanced risk management have been given deadlines. The EU CRD II and III are good examples of this progress and regulatory convergence, with the directives due to be implemented by early 2011.
It becomes murkier when we start to look at how individual national responses to the myriad new capital and liquidity requirements and accounting changes gel together. This highlights how the combined impact of implementing changes on a national, uncoordinated basis would pose some tricky questions for institutions’ balance sheets, the economics for structured finance investors and in turn the overarching goals of the G20 to stimulate the flow of credit.
There is cause for optimism having come this far but there is a need to iron out the final creases before issuers and investors have the confidence to come flooding back. Before September there was a sense of momentum towards implementing international reform. Now, as more regulation comes through around the globe, it is natural that the framework for international coordination and reform is under stress and at risk of fragmentation.
Focus now is turning to the investor community and how it will react. Lots of work has been done on the ground by bodies like the American Securitization Forum (ASF) and its EU equivalent, the Association for Financial Markets in Europe (AFME), to bring transparency and standards to issuance, origination and servicing practices. Recommendations last year by organizations such as the International Organization of Securities Commissions (IOSCO), facilitated a more coordinated response from the international regulatory community. Its reports included guidelines for increased disclosure and due diligence, the idea of “skin in the game” for issuers and the screening of investor suitability. Investors are sandwiched between changes being made to issuance standards, and top down reforms which will influence the extent to which they are able to participate in the market.
From the bottom up, we can see these recommendations filtering through in various market initiatives. Look at the operating requirements that were outlined for participation in the US Treasury Department Public Private Investment Program. They drew many parallels with the investor due diligence requirements outlined by IOSCO and clear wording in the Basel II Securitization Framework Enhancements regarding an investor’s need to understand the risk and performance characteristics underlying structured finance securities. Any investor in ABS or MBS assets will need to demonstrate these kinds of core competencies going forward to stand up to new mandates. We can also see good practices being pushed through by the ECB. It is looking to make loan-level disclosure a prerequisite to being eligible for central bank funding. Investors’ access to this valuable source of liquidity will be determined by their ability to provide full disclosure and transparency into the collateral they post.
Critical to a smooth transition is the effective convergence of different streams of regional reform and other market initiatives. It is the impact of these in combination that we must now focus on. Take the FDIC’s recent pre-implementation notice of its revised safe harbor rule as an example. The old safe harbor, an important safeguard against FDIC intervention in the event of a bank failure, was nullified with the introduction of new accounting standards FAS 166 and 167. Few securitizations now meet the off-balance sheet standards for sale accounting treatment and, as a result, do not comply with the preconditions for the application of the original FDIC safe harbor.
The revisions in the Advanced Notice of Proposed Rulemaking (ANPR) introduced many elements of best practice guidelines we have seen elsewhere which are certainly welcome. New ideas, such as a 12-month seasoning period for loans prior to origination, seem sensible. This is a prime example of the challenge facing the regulatory community though; the conflict caused as regulation converges. The revisions stipulated a unilateral approach to transactions’ capital structures, disclosure requirements, documentation and asset retention. This has concerned investors and the professional bodies representing the industry. The initial result has been greater investor uncertainty. The regulatory screw was tightened.
The US government’s grip on mortgage securitization enabled it to exert a greater influence on the requirements originators and investors must comply with to benefit from the rule. Instead of a clear-cut safe harbor that rebuilds confidence, we are temporarily left with something more akin to a port in stormy waters. The FDIC has always listened closely to the market and in hearing its response has taken swift action to try to allay concerns, pushing out its original deadline of March, to September.
It is a sign that while reforms are crucial they can work against the long term goal of enticing players back to the market unless carefully evaluated. The impact of such changes must be analyzed in conjunction with market participants and other legislation. The introduction of mandates must continue to be done in a coordinated way to ensure a level playing field for the industry and to see that the right incentives are in place for all parties involved in securitization. Timing of implementation is always crucial of course and any possibility for regulatory arbitrage must be avoided.
During this phase of reflection the market and those that oversee it are asking how the proposals on the table can best work in unison. Impact analyzes being carried out by The Financial Stability Board and Basel Committee, due to be announced in coming weeks, should bring more clarity and can hopefully provide the next stepping stones for reform. Investors need more information about the effect regulatory proposals will have on their future involvement in structured finance. There is much they can and are already doing to implement best practices.
From a practical perspective, the one overriding theme investors are being reminded of is the need to have the infrastructure, culture and operations in place to fully understand the underlying risk characteristics of the deals in their portfolio - from initial investment, through ongoing analysis, risk oversight and disclosure. Whatever happens next, that is a necessity and will be vital in preparation for regulatory impact.