September 7, 2010

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 perspective 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.