Governments in developed markets have been extremely reluctant to infringe upon private sector contracts, and rightly so. But recent moves point to a change of heart as the scale of the economic crisis starts to overwhelm state budgets and popular anger at the financial sector grows.
To a greater or lesser degree, the interventions taken undermine investors already strained ability to anticipate the expected cashflows of the underlying assets in securitisations, and in the worst cases threaten the structural integrity of deals.
In recent weeks, the UK has obtained and the US government has signalled that it will seek the authority to abrogate contracts in an emergency.
In the UK, the Banking Act 2009 came into effect in February. The law gives the government unprecedented and wide ranging powers to deal with failing deposit-taking institutions in a special resolution regime (SRR), including partial or total transfers of assets to a newly created bank or other buyers, conversion of the failed institutions securities, and to terminate or impose intra-group contracts.
The markets have already seen a hint of how the government might use these powers in the resolution of Bradford & Bingley. Several months after the UK nationalised the bank and sold off its branch network and deposits, the government let B&B change the terms of its subordinated debt to allow deferral of interest, sending the lower tier two market into uproar.
But the powers granted under the Banking Act are far broader and have caused considerable concern in the securitisation market that assets or claims in transactions could become separated from the associated liabilities. The rating agencies have warned that the legal uncertainty created by the bill may have an impact on ratings, although they are waiting to see how the Act is implemented before taking action.
"While there are no assurances on how the UK Treasury may use its powers, our assessment of all the information we currently have leads us to believe that we can still rate existing transactions involving UK deposit-taking institutions up to and including the AAA level," said S&P in a note.
The government has also enacted secondary legislation with safeguards designed specifically to protect "structured finance arrangements" (SFAs), among other relationships, but lawyers fear that the protections are too narrowly worded.
The safeguards prevent cherry picking through partial transfer of rights and liabilities involved in a capital markets arrangement, as defined in the Insolvency Act.
"The consultation refers to a safeguard for SFAs in respect of partial transfers only," said Allen & Overy in a brief on the safeguards consultation. "A key point is that, in our view, a safeguard for such arrangements needs to apply more widely in order to provide meaningful protection. While concerns in respect of netting, set-off and security interests may be addressed by keeping various interests together in a partial transfer scenario, the potential disruption to SFAs under the Banking Bill is more pervasive and unable to be addressed by simply keeping the interconnecting parts of SFAs together."
For instance, the safeguards do not explicitly protect the future transfer of interests under contract, for example the perfection of title transfer for securitised mortgages, or trust and servicing arrangements involving the bank in the SRR.
"On a high level, the government has shown a propensity to protect securitisations," says Dipesh Mehta, an RMBS analyst at Barclays Capital. "So it probably wont affect true sale., but I expect more detailed legal opinions on each transaction going forward. Its on a granular level, like loan modifications, that specific provisions and points in securitisation documentation could be overridden. Particularly if you look at other government initiatives with the recession getting worse and an increasing number of repossessions, you can imagine the initiatives becoming effective. If theyre not allowed in securitisations, the banking bill particularly for part/fully government owned banks could be used to get around that."The US has proven far less willing to take banks into public ownership or amend terms of existing instruments, but the political mood has shifted sharply in the last few months. As EuroWeek was going to press, the administration was preparing to ask Congress for the authority to seize any systemically important financial institution on the verge of failure, buy or guarantee assets, and in extremis rip up contracts.
A more concrete threat is the so-called "cramdown" legislation that has already been passed by the House of Representatives and is awaiting a Senate vote. The law would include mortgages on first homes to be included in individual bankruptcy estates, allowing judges to lower the principal balance and interest rate as part of a resolution.
Critics of the plan in the securitisation industry fear that the law could encourage borrowers to enter bankruptcy. Barclays Capital estimates that delinquencies and bankruptcies could rise by as much as 50% if the law is passed and warns that many borrowers fail to meet even their restructured debt payments. The Congressional Budget Office estimates an additional 350,000 bankruptcy filings over 10 years.
Moreover, the move represents another challenge to valuing securitisations, as it would override loan modification limits and raise doubts over the nominal principal amount underlying the securities. Principal losses from cramdowns would have to be written down immediately by junior investors and sometimes even for senior tranches.
"Some Prime Jumbo and Alt-A transactions contain bankruptcy carve out provisions that allocate bankruptcy losses separately and pose a much greater risk of loss to senior bond holders," wrote partners at PriceWaterhouseCoopers in a report, Proposed cramdown legislation: What does this mean for the mortgage industry? "Bankruptcy loss threshold limits were set low as cramdown loss exposure did not exist when these deals were issued. A change in bankruptcy law allowing mortgage cramdowns would allocate a larger portion of realised losses to the AAA rated tranches in deals with carve out provisions."
Progress on the bill has slowed since it reached the Senate, however, and some amendments have been made which could lessen its impact. In particular, borrowers would have to consider any voluntary loan modification plan complying with the Treasurys guidelines before a judge could implement a cramdown.
Less drastic actions have been taken across Europe to help borrowers in financial distress. Numerous governments, including the large RMBS jurisdictions of the UK, Italy and Spain, have introduced measures to reduce interest rates for qualifying borrowers.
The earliest and widest reaching of these is Italys so-called Tremonti decree, which allows borrowers to renegotiate the floating interest rate on their mortgages to fixed 2006 levels.
The effects are hard to predict as banks and SPVs may separately choose whether or not to participate, and the impact on securitisations will depend on their choices.
For securitised loans where the bank participates but not the SPV, borrowers continue to pay the SPV the original amount and the borrower is reimbursed by the bank. Where the SPV does participate, it receives the new instalments until the traditional loan is paid off, at which point the side account in which the difference between the new payments and the original payments has been accumulating begins to be paid down. Consequently loans in participating SPVs will be extended.
While the rating agencies have been cautious in their assessment of the decree, saying that deals will have to be assessed on a case-by-case basis, Moodys warned that it may result in reduced excess spread and longer average lives.
Reduced interest payments are not the only element of the law.
"Further clouding the issue and adding another deviation from the assumptions used at initial rating of the transactions; prepayment penalties on mortgage loans have been abolished for loans granted since 2 February 2007 and lowered for loans originated earlier," wrote Mehta in a note. "This will help the incentive for borrowers to refinance and pre-pay and on its own would increase the prepayment rates as borrowers can look to remortgage at an earlier stage."
On the upside, non-participating securitisations with participating banks are likely to see improved performance as the subsidised borrowers stress is reduced. The removal of prepayment penalties, however, increases uncertainty about prepayment risk.
Indeed, despite the fact that the decree was first proposed early in 2008, the market is still very much in the dark as to how it will be implemented, reinforcing the sentiment that the uncertainty caused by retroactive government intervention or the threat of it is at least as bad as its eventual effects.
"It remains to be seen how eligibility for the scheme will be defined and interpreted by lenders," said Fitch. "It is still unclear if a borrowers eligibility will be linked to an assessment of whether the borrower is in temporary difficulty and capable of recovery. If the borrower is not capable of recovery, but is still eligible for the scheme, then there could be a widespread exercise of the payment holiday option. This could cause increases in loss severity if interest during the payment holiday period is capitalised, and could also lead to potential liquidity shortfalls for RMBS issuers and OBG guarantors."
Both the UK and Spain, meanwhile, have targeted their measures at particularly vulnerable borrowers. Spain is allowing unemployed, self-employed and retired borrowers to halve their mortgage payments (up to a limit of Eu500) for up to 24 months, with the deferred payments being capitalised and added to the balance. Unemployment in Spain has risen sharply since 2007 to become the highest in the European Union at 15%.
The move could cause liquidity pressures for RMBS, according to Fitch, but may also reduce default rates.
The UKs scheme is slightly different, requiring borrowers to demonstrate a hefty, but temporary, loss of income among many other conditions. The reduced payments end when the borrowers income improves (or a maximum pre-agreed limit), and the government will guarantee unpaid interest not recoverable from the home equity.
In the end, the impact of all these initiatives, and any future ones, on existing securitisations is likely to be modest compared to the industrys initial fears. Politicians understanding of how securitisation works and the role it plays in the wider economy has grown enormously since UK members of parliament denounced Northern Rocks Granite master trust as a tax dodge and called for it to be dismantled. Industry lobbying has ensured that legislation at least takes into account the risks to securitisations, even if it does not eliminate them all together.
Unfortunately for investors, the Granite example shows that being subject to the whim of even a sympathetic government still has dangers. After indicating that it would continue to keep the trust topped up in early 2008, the government and Northern Rocks management kept silent as the sellers share slowly dwindled, eventually breaching the minimum requirement and sending 10s of billions of pounds of RMBS into early amortisation, wreaking havoc with expected average lives. Only after the irrevocable trigger breach did the government realise that it wanted Northern Rock to expand its lending, for which Granite would have proved very useful.Until the economic crisis subsides and governments feel no further intervention is necessary, investors are going to have to live with heightened uncertainty, particularly over duration risk. And they will forever be more circumspect about the nature of their security.