Copying and distributing are prohibited without permission of the publisher.


Tectonic drift: structured finance and regulation across the Atlantic

09 Jun 2011

US and European authorities are pursuing the same regulatory agenda for structured finance, but following different paths — with Europe further ahead. Will this mean the fragmentation of a once-global market, or will the market agree common standards to suit all jurisdictions? Owen Sanderson reports.

Skin in the game: it’s the slogan of the new era in structured finance regulation, as authorities on both sides of the Atlantic try to align incentives for originators and investors. Europe is much further ahead, with final guidelines on Article 122a of the European Commission’s Capital Requirements Directive (CRD II) coming into force at the start of the year. Master trust sponsors have until 2014 to comply, but issuers in the market this year have largely been compliant.

Elana Hahn, structured finance partner at Morrison Foerster in London says: "Does risk retention matter? The jury is still out. In some product classes, banks have always retained some of the risk. One could argue that a contributor to the credit crisis was banks holding too much risk — investment banks had started drinking their own Kool-Aid."

US regulators are still mulling implementation of risk retention rules, as introduced by the Dodd-Frank Act. Though similar in intention, US rules are vastly different in application — they hit issuers, not investors. In Europe, credit institutions that buy securitisations without a 5% risk retention or without doing sufficient due diligence risk a punitive capital charge; in the US, issuers may be prohibited from issuing securities altogether without holding a risk retention.

Hahn says the different focus makes sense on a big picture level.

"Crudely speaking, originators in the US originated bad assets, which investors in the EU bought," she says. "So it makes sense for the US to regulate originators and the EU to regulate investors."

Nicole Rhodes, consultant counsel at Allen & Overy, says: "It’s quite difficult for authorities in the different jurisdictions to broker consensus among themselves. The FDIC, the SEC and other US agencies struggled to establish their own consensus, and in Europe, if it was easy to agree on risk retention, we’d have seen something from CEBS before Dec 31."

The EU rules and the US proposals also differ in scope — US authorities are looking at a long and varying list of exempted categories, including CMBS, top-quality residential mortgages, and CLOs. EU rules apply to anything that looks like a securitisation, which has caused howls of anguish among CLO managers.

Managed arbitrage CLO generally buy senior or mezzanine loans for their portfolio, meaning the originator of the loan already retains risk.

"CLO managers also have incentive-based sub management fees — thus satisfying the rationale of risk retention," says Hahn. "It makes sense to have a product carve-out if you’ve satisfied the basic principles, but this wouldn’t be allowed under 122a as currently drafted."

Meanwhile, US regulators have looked at extending the scope of risk retention to ban premium capture instruments, such as the ‘X’ note in CMBS transactions. As CMBS is typically a risk transfer instrument, the ‘X’ note allows the structuring bank to capture some profit up front. Regulators might retort that securitisations should not be used to sell whole capital structures and transfer risk, but CMBS market participants have complained that these proposals could effectively shut down the market.

Hahn says the US political process has seen more activist lobbying than in Europe.

"My US colleagues have been surprised at the speed with which 122a passed in the EU," she says. "But the EU has the opposite problem — new broad-stroke rules come in very quickly and comprehensively without the details being fully developed, while ideas can evolve more in the US. It’s debateable which is better."

Out in the open

Alongside the risk retention requirements in Europe come tougher standards on standardisation and disclosure from several sources. Article 122a obliges credit institutions to do due diligence on securitisations which in practice means being able to show that they have done so. Issuers have had to improve their disclosure, with many launching website-based programmes.

"Some originators opposed transparency measures, particularly those with highly granular portfolios — the whole point of securitisation is to create manageable, marketable securities out of large pools of underlying assets," says Hahn. "How helpful is it for investors to get loan level data on a £6bn master trust? The first thing an investor would do is aggregate it."

The two key central banks in Europe, the ECB and the Bank of England, have also launched non-mandatory transparency initiatives, by requiring loan level disclosure within standardised templates in ABS that banks present for repo. RMBS will be the first asset class where this applies, but the ECB has also drawn up templates for CMBS and ABS.

Alongside the raw data, the Bank of England requires banks to present cashflow models for structured finance deals. However, the Bank requires broadly the same disclosure for covered bonds and whole loan portfolios.

The ECB, by contrast, requires no collateral data for banks to present covered bonds for repo, and rewards this lack of transparency by lowering the haircut it imposes.

Doug Long, executive vice president at Principia, an ABS software and data firm, says: "It’s worth remembering that the ECB and Bank of England loan level initiatives are not absolute regulations like the SEC Reg AB II. Both parties offered repo funding for ABS during the crisis, and are sitting on huge amounts of ABS collateral. The central banks need to understand their own repo collateral and that drive had led to the introduction of new standards."

The ECB has taken the lead in some of the practical aspects of the new transparency initiatives, by proposing a centralised data warehouse for securitisations. The central bank has, however, taken a hands-off approach to data provision, which will see an eight member Market Group (four issuers and four investors) choose a candidate to build the data warehouse in July.

Analysts at JP Morgan said that they expected a private placement of shares in the data warehousing entity will occur, similar to the foundation of Euroclear. The data warehouse would therefore become effectively a market-owned entity.

Long says that Europe has more challenges to overcome around the commoditisation of data, with large regional variations and different data types suiting different asset classes or jurisdictions.

"Services that add value to loan data and deliver it in useful ways can help investors differentiate and get an edge — but generally speaking investors don’t need to visit the line by line, loan level information very often and stratifications of it can provide enough insight day to day," he says.

Loan level data initiatives also have to overcome differing privacy rules across jurisdictions. Bondholders must not be able to directly identify borrowers, particularly in consumer asset classes, and the information must not be so public that it can be used for marketing or identity purposes by non-bondholders.

"The [privacy] obstacles can be challenging, with varying local data protection laws," Hahn says. "I’ve been on epic conference calls across jurisdictions, just arguing about whether to block out three digits or four from a postcode. And we need compatibility with the US on top of that."

However, she adds that concerns can be overstated and that the problems are not insurmountable.

"Europe is years behind the US in this respect — loan-level data was considered the norm a long time ago, and the systems and protocols for delivering it are all well developed."

Long also points to the US, highlighting the Linc system.

"Linc provides unique identifiers for mortgages and aims to solve privacy problems by anonymising the data," he says. "Something similar to that will have to come through in Europe, though it is more challenging with diverse privacy laws across jurisdictions."

Some market participants broadly welcome the transparency initiatives, but are dubious about the ultimate benefit.

Morrison Foerster’s Hahn says: "Before the crisis, the US was the most transparent market in the world, but it just matters what you do with the transparency — it isn’t enough on its own. But the world is moving in that direction."

Large investors are quite sanguine about the modelling implications of loan level data, and third party data or software providers are ready to step in with tools to help. But one investor pointed out that past data would be much more helpful than loan-level data — past performance of collateral pools being a crucial determinant of credit quality for ABS.


Rating regulation is another area which could hinder structured finance markets, as authorities in the US and Europe draw up rules hoping to end conflicts of interest within the issuer-pays business model, and remove ratings from regulation. Without compelling alternatives to ratings as a third party measure of credit quality though, regulators are struggling to move forward.

"The trend has been for regulators to call for less rating reliance, while the ECB and the Bank of England ask for yet more ratings," says Salim Nathoo, a securitisation partner at Allen & Overy. "It’s quite perplexing, and it seems like they haven’t quite worked out what they want to achieve. It also  seems that 17g-5 isn’t really working as intended, and that the costs to originators are therefore disproportionate."

Initiatives such as repealing rating agency immunity from expert liability suits or encouraging unsolicited ratings have proved dismal failures, not least because existing regulation sits in direct conflict with some of the Dodd-Frank initiatives.

A&O’s Rhodes says: "Dodd-Frank requires regulators to start removing references to ratings, but it imposes so many other requirements it seems that authorities are struggling to keep up. There are consultations out on a large number of these questions, huge documents that seem more like fishing exercises than carefully thought out proposals."

The repeal of 436(g), which exempted rating agencies from expert liability (meaning they could be sued if their ratings proved inaccurate), fell foul of the SEC’s listing rules, which required prospectuses to include a rating. All the main rating agencies immediately issued statements refusing to allow their ratings to be used in prospectuses, and the SEC responded by indefinitely suspending expert liability.

Rule 17g-5, which is supposed to allow agencies to offer unsolicited ratings, has been less disastrous: all US deals being issued are now 17g-5-compliant, meaning issuers allow other rating agencies access to the same information they provide to the agencies they hire.

Stuart Jennings, managing director EMEA structured finance at Fitch, says that agencies have not leapt forwards to do unsolicited ratings. "Resources are best deployed in getting the credit message through in different ways," he says. "17g-5 has led to agency commentary on specific transactions, particularly if that agency does not rate them and has a materially different view."

Even this benefit is limited though — once rating agencies have accessed 17g-5 information on a certain number of transactions, they are obliged to start producing unsolicited ratings.

European Union rules have so far been less stringent. Dodd-Frank mandated a whole series of reforms to rating agency regulation, which US authorities have been trying to implement, whereas European authorities have used distinct regulatory initiatives to bring in their rating reforms.

Both jurisdictions use similar language around rating agencies, but the direction of travel is far more obscure in Europe, with regulators, including the FSA, continuing to mint new regulations featuring ratings, while US authorities try their best to strip them out.

The grandfathering period on the ECB’s new rules came to an end in March this year, meaning all ABS that are presented for repo must have two ratings, for the first time. The Basel III rules will also continue to feature ratings, though less prominently than in the Basel II framework. But where risk weighting continues to be used, third party ratings remain the main method, with internal modelling falling even further out of favour.

Come together?

Despite divergent paths ahead for the US and Europe, most market participants were optimistic that the ABS market would find a way to cope with the requirements, with deals moving to trans-Atlantic compliance.

Morrison Foerster’s Hahn says: "I expect that we will see global regulatory convergence eventually, when the deal economics make sense. Where there’s a will, there’s a way. That may, however, mean a highest common denominator approach."

Long says: "There will be a period of imbalance, while risk retention and disclosure requirements apply to EU investors but not in the US, but eventually the industry will settle on a common ground."

He expects an iteration process towards standardisation, with issuers satisfying standards across the Atlantic. "Investors will want to be able to manage a global portfolio."

A&O’s Rhodes says: "On risk retention, I’d be surprised if we get a global standard. The G20 and other global institutions are calling for co-operation, but these calls aren’t acknowledged in the US proposals or the existing EU regime. We hope we will get ironing out of differences, but perfect alignment seems unlikely."

Even if the market achieves consensus in the medium term, it is clear that the market will continue struggling with competing and conflicting jurisdictions in the short term.

Changes such as the European Central Bank’s second rating requirement have already led to issuance bottlenecks — issuers struggled to meet the March 1 deadline for their retained deals (and rating agencies struggled to rate).

As the market gains more clarity on the detail of regulations in each jurisdiction, issuers and the wider market will carry on innovating. Regulatory uncertainty and regulatory obstacles can slow, but not stop the flow of securitisation.

Despite the regulatory onslaught, structured finance will survive in some form, as the initiatives so far do not strike at the basic principles at the heart of securitisation, whatever their implications for certain asset classes.

"Regulation and post-crisis litigation has left the core foundations of securitisation untouched," says Fitch’s Jennings. "Bankruptcy remoteness and true sale are unchallenged, except in a few selected cases."
09 Jun 2011