Evaluating the Impact of New Securitization Regulations and Basel III on New Issuance

At several times over the last year, we have sounded the alarm that the long-term negative impact on bank financing activity coming from the virtual vise that recent accounting rule changes, new securitization regulations and the impending implementation of Basel III liquidity standards is enormous.

As market data continues to accumulate, now we can see what the future may look like.  Last week the Financial Times ran an article describing how the “hang over” associated with the residual effects of a continuing over-abundance of subprime mortgage product is starting to be proven out by the continued slow recovery of the new issuance market for securitisations.  This, in itself, is an important observation.

However, also displayed in this article was a graph depicting just how far the bank issuer market in Europe has swung over the past 9 or 10 Quarters.  Whereas, in the heady days of the early to mid 2000’s, European banks, just like their US counterparts, were placing 90% or better of their securitisations off the balance sheet and, as result, freeing up valuable capital for other lending opportunities.  Now the game has changed.

The recent spate of legislation and regulation has delievered a strong, perhaps fatal blow to off-balance sheet structures, as investors, skittish about how secure their claims might be in an off-balance sheet structure, are staying away from more traditional financings. 

In their place, covered bonds have become the darlings of the issuance community but what the below chart reveals is a truth that we have always known.  There is clearly a limit to how many covered bonds can be issued and, unlike true off-balance sheet securitisations, this upward limit is directly tied to the capital base of the bank issuing the covered bonds. This fact was never more evident than in the  following chart:  Euro Securitization Recovery Lags osp 6-11

Clearly, the chart shows a trend away from off-balance sheet financing among the European banks that had tradtionally relied on securitisation to sustain their business models.  Essentially, by bringing these asset “back on the balance sheet” the banks are reducing their leverage.  Some may view this as good thing.  We do not; especially when we see such a dramatic reduction in leverage. 

What seems to be driving these trends is a combination of the new regulations themselves, issuer uncertainty as to how many of these complex regulations will affect their activities and, perhaps most importantly, uncertainty among investors who have little faith in their abilities to count on new off-balance sheet structures receiving the arm’s length protections from regulatory recourse that structured finance investors had come to take for granted for more than 25 years.

If the regulators of the global structured finance markets wanted any empirical evidence about how their new regulations are being received in the “real world”,  look no further than this chart. 

We would suggest that a similar chart of the US market would probably look worse.  However, the euro market view is bad enough.  For the last two quarters nearly as much securitised assets have been kept on the balance sheets of european issuer banks as have been moved off their balance sheets. 

We see this trend as unsustainable and something which should sound an alarm with both European and US regulators that something needs to be done very soon.  That something should include a return to most of the time-tested structural techniques and regulations that supported the securitisation markets for so many years.

Canadian Regulators Follow-step and Decide to Extend Securitization Rules Comment Period

Apparently taking a page from their US counterparts, the Canadian Securities Administrators (“CSA”) have decided to extend the comment period for the recently proposed new securitization rules.

The comment period for the draft rules, which were first published on April 1, 2011, was set to expire on July 1, 2011.  However, late last week the CSA decided to extend the comment period to August 31st.  No doubt that this is linked to the recent decision by US regulators to push their own comment period deadline for issuer risk retention into August.

Given the close relationship between the two markets, the decision by the CSA to see what happens with the US regulations, before committing to their own set of regulations, only makes sense.

Perhaps another hint that rationality may yet prevail in the final form of the new rules in both markets.

Perhaps a Crack of Daylight in New Regulatory Regime for Securitization

Word this week that the six major US regulatory bodies may be bowing to pressure (and logic) coming from Congress and the markets to “re-think” the recently proposed risk retention rules for US securitizations. 

Could this be the first sign that this long, drawn out fight between initially under-informed legislators and then narrow-focused regulators (i.e. the “conventional wisdom crowd”) and proponents who have tried to point to 25 years of a successful securitization market leading up to the 2007 crisis (“the sanity crowd”) is turning a corner?  We certainly hope so.

This week’s decision to extend the comment period for the so-called “QRM” provision coming out of Dodd-Frank to August 1st would seem to be a good sign for the RMBS markets and with the risk-retention rule being one of several particularly penal rules coming out of the recent rush to “fix” securitization, we could be witnessing a reversal of fortune.

Two dots that have not been connected elsewhere is the impending departure of Sheila Bair from the FDIC and this decision to extend the comment period beyond her departure date.  We don’t see this as a mere coincidence, as even this week, Ms. Bair continues to stand behind all of the new rules and regulations instituted during her tenure.  We suppose that you can’t really blame her, as any significant trend away from what has been proposed or is already on the books over the next several months and years would only diminish her legacy.

For our part, we care much more about getting it right then we do about protecting a legacy or two.  We applaud the decision to re-visit the risk retention rule and we hope it opens the doors for a re-visit of safe-harbor and balance sheet treatment for securitizations.

SEC Continues to Pick Through CDO Bones

Yesterday’s Financial Times carried an article related to the latest news surrounding the US Securities and Exchange Commission’s probe of CDO structures that were completed at the height of the market’s period of insanity leading up to the credit market crash in 2007.

The story line seems to be similar to the investigation of Goldman Sachs and its ABACUS structure that was brought to market in 2007.  The general storyline was that Goldman intentionally structured the transaction, which utilized late vintage sub-prime mortgages for collateral, to fail.  Now word comes that the SEC is investigating a Merrill Lynch structure that was structured on behalf of a hedge fund client, Magnetar.  The CDO, known as Norma was managed by a new York-based firm called NIR Capital Management.  One holder of the securities, Rabobank had sued Merrill (BoA) in 2009 alleging that the arranger intentionally overvalued many of the loans in the collateral pool.

These investigations are not only complex in content but the whole notion of trying to recreate individual motivations and the timing of those motivations is difficult at best.  Add the particularly volatile conditions in the markets in 2007 and we are sure that good arguments will be made on both sides of these transactions as to what actually went down.

One truth that can often be forgotten in these “Monday morning quarterback” scenarios is that most of these firms were not in the business of completing one or even a few bad deals and then running for the hills like Jesse James.  Most CDO managers and deal arrangers were in the business of building reputable franchises and would not have survived to do another deal, if the trade was bad enough, given the high levels of competition in the CDO market at the time.

We’re not suggesting that there couldn’t have been bad deals done by folks with bad intentions.  We would just hope that people recognize that there are likely just as many sharp investors realizing that a litigation strategy might be a way to fix some bad trading decisions made at a time when we were all so smart.