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Regulating Securitisation:
Key Lessons from the Financial Crisis &
Recent Developments
Timothy J Brennan
IFC/WB Securities Markets Group
April 30, 2010
Key Lessons – What went wrong ?
• Leveraging and tranching/retranching – including resecuritisations (e.g. CDOs of ABS, etc)
• Over reliance on ratings, rating agencies
• Deterioration in underwriting standards (at originator level)
• Weakness in modeling assumptions, models flawed, misplaced confidence in housing price
data, non-correlation assumptions, etc.
• Incentive problems inherent in ‘issuer-pays’ rating agency model
• Incentive problems associated with ‘originate-to-distribute’ model
• Inadequate regulatory oversight/supervision – esp. of non-bank mortgage originators
• Regulatory gaps causing scope for regulatory arbitrage
• Outright fraud / market manipulation ?
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Business Considerations
• Four main reasons to securitise:
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Balance sheet management
Capital management
Liquidity
Risk transfer
• First two of these were particularly important drivers for US banks, less so for US nonbanks. Typically accounting changes should only impact balance sheet management – not
capital management. But banking regulators (in US and globally) are linking these.
• In emerging markets, securitisation is far more valuable as a tool to diversify financing
sources, address liquidity issues by locking-in long-term funding and/or benefit from the
transfering of credit risk
• Raises interesting questions: what will new regulatory environment mean for US banks vs.
certain US non-bank financial institution ? What are likely implications for EM issuers ?
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Proposed Changes in Basel II Framework
Purpose: to address weaknesses in risk-based capital framework as revealed by the crisis
Pillar I – amended treatment of ‘resecuritisations’
• RBA risk-weight tables for both standardised and IRB approaches have been revised to
provide higher risk weightings for any ‘resecuritisation’ exposures
• Detailed guidance on which exposures to ABCP are vs. which are not to be treated as
‘resecuritisation’ exposures, e.g.
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Liquidity facilities
Credit card and auto lease structures – nb. generally won’t be treated as
‘resecuritisations’ provided all the receivables are held in a single trust
Repackagings of single securities
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Proposed Changes in Basel II Framework (cont’d)
Pillar 2 - changes to the supervisory review process
• To address weaknesses in risk management practices, new guidance clarifies supervisory
expectations with regard to:
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Directors and senior managers understanding the risk profile of the bank as a whole
Capturing firm-wide risk concentrations arising from both on- and off-balance-sheet
exposures and securitisation activities, including the potential impact of noncontractual commitments, implicit support, as well as reputation risk on risk
exposures, capital, and liquidity
Banks establishing incentives that reflect the long-term risks and rewards associated
with their business models
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Proposed Changes in Basel II Framework (cont’d)
Pillar 3 – enhanced market discipline
• Basel committee also requires additional disclosures relating to six topics:
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Securitisation exposures in the trading book
Sponsorship of off-balance-sheet vehicles
The IAA and other ABCP liquidity facilities
Resecuritisation exposures
Valuation methods for securitisation exposures
Pipeline and warehousing risks
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Proposed Changes in Basel II Framework (cont’d)
Trading Book Changes - focus on market price risk and interest rate risk issues as opposed to
credit risk considerations (which is the main focus of the Banking Book Paper)
• Purpose: to address the fact that majority of losses that banks faced in the crisis occurred in
the ‘trading book’ and also concern that the current framework for market risk fails to
capture some key risks
• Market risk rule imposes a capital requirement that is meant to address both general market
risk and ‘specific risk’
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general market risk approached by calculating a VaR measure using internal models.
‘Specific risk’ is meant to cover changes to value of a position caused by factors
other than broad market movements e.g. event and default risk, idiosyncratic
variations, etc. Certain banks (with regulatory ok) can use internal models to
determine specific risk. Others must calculate a specific risk ‘add-on’ (typically
done by multiplying the risk of each position by a weighting factor ranging from 0-8%
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Proposed Changes in Basel II Framework (cont’d)
• New ‘Specific Risk’ charges - Regardless of whether a bank has approval to model ‘specific
risk’, all banks market risk capital requirement will include a new ‘Incremental Risk Capital
Charge’ similar to the standard ‘specific charge’ approach which this is meant to replace.
Under the IRCC:
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Capital charge for any securitisation exposure will be the same that would apply
were the position held in the banking book (with exceptions that would apply for
certain correlation trading portfolios)
The capital charge for other credit products will be required to capture credit
migration risk as well as default risk
The earlier 4% weight risk weight for liquid and well-diversified equity portfolios will
be eliminated, subjecting these portfolios to the standard 8% charge for equities.
• Additional requirement for ‘stressed VaR’ calculations - as an add-on to the general market
risk component. (Actual losses experienced in the crisis exceeded those estimated by current
10-day ‘shock’ VaR calculations. New approach calls for a one-year observation period when
doing stressed VaR calculations)
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Proposed Changes in Basel II Framework (cont’d)
Coordination among / differences between EU, US and other regulatory approaches
• Actions of the Basel Committee do not have direct legal effect in participating countries:
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In US, implementation of proposed changes requires one or more notices of proposed
rule making with opportunity for public comment (e.g. US SEC proposed regulations
were released for comment on April 7, 2010)
In EU, requires legislative or rulemaking action at both EU level and in EU member
states: EC started process by draft amendments to the Capital Requirements
Directive (CRD) on same day that Basel Papers were released. EU Draft Directive
which is broadly in line with Basel Committee changes will be put to EU Parliament
in first half of 2010.
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Changes to FASB Accounting Standards
Purpose: to address accounting rules which may have resulted in inadequate disclosure,
reporting and/or measurement of risks associated with securitisation activities
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Statement 166 – which details amendments to FASB Statement 140 and changes the
accounting standards that determine whether a transfer of receivables in a
securitisation should be treated as a ‘sale’ or as a ‘financing’.
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Statement 167 – which details amendments to FASB Interpretation 46(R) and changes
the standards used to determine whether reporting entities should consolidate the
types of special purpose entities (SPEs) commonly used in securitisation transactions.
• For calendar-year reporting entities, both of these amendments came into effect on
January 1 2010
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New FDIC rules to reflect FASB accounting changes
• FDIC Rulemaking – FDIC is planning new rules to reflect the issuance of FAS 166 and 167
• Purpose: Since 2000, FDIC has provided important protections (a ‘safe harbour’) for
securitisations by US banks by confirming that, in the event of a bank failure, it would not
use its special statutory powers to reclaim loans transferred in such transactions, as long as
an ‘accounting sale’ had occurred. The proposed new FDIC rules aim to clarify how FDIC will
apply its receivership powers in the future since most new securitisations are likely to be
characterised as ‘secured financings’ rather than qualifying for’ off-balance sheet’ or
accounting sale treatment
• Establishes what kind of securitisations will be eligible for ‘safe harbour’ treatment
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No re-securitisations unless these meet certain conditions
All payments of P+I linked to pool assets, no links to other market or credit events
and no unfunded or synthetic securitisations
Credit structures: limited to max 6 tranches, no sub-tranches and no other structures
“designed to increase leverage in the capital structure”
Credit quality can’t be enhanced using external support or g’tees. But liquidity
facilities OK
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New FDIC rules to reflect FASB accounting changes (cont’d)
• Establishes a series of specific (prior and ongoing) disclosure requirements
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Sponsors to provide more detailed info prior to issuance and monthly while O/S
Continuous provision of performance data on underlying assets while issue is O/S
Addition disclosure which applies only where the pool assets are residential mortgage
loans : e.g. loan level data, affirmation of compliance with U/W standards etc.,
third party due diligence report confirming compliance with U/W standards, limits on
how long a Servicer can make temporary advances etc
• Establishes various origination and retention requirements
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For all securitisations: Sponsor must retain minimum 5% economic interest in credit
risk of the assets transferred. And this retained interest cannot be transferred or
hedged.
Only for RMBS: all loans must be seasoned, ie. originated within prior 12 months
Requires additional affirmations of compliance with all origination and U/W
standards
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New FDIC rules to reflect FASB accounting changes (cont’d)
• Other Considerations:
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Transfers must be bona-fide transfers, arms length and not to an affiliate/insider
Adequate consideration to have been paid
Security interests must be properly perfected, etc
• Outcome/Impact:
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Grants a ‘safe harbour’ to participations (as distinct from outright loan sales)
provided they also meet the new test of an ‘accounting sale’
Provides for a ‘transition period’ by grandfathering any securitisations done prior to
September 30, 2010 (nb. extended from March 31, 2010 initially) and
Preserves FDIC’s rights to step in and exercise its statutory and fiduciary rights in
cases where: (i) a transaction remains in monetary default beyond a specified
period of time (10 days) and/or (ii) the FDIC as receiver or conservator provides a
written notice of repudiation of the securitisation agreements
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SEC Proposed Rules to Increase Investor Protection
Purpose: revise the disclosure, reporting and offering process for Asset-Backed Securities
(ABS) to better protect investors in the securitisation market
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Require filing of tagged, computer-readable standardised loan-level information
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Require filing of a computer program that gives effect to the ‘waterfall’ associated with
specific ABS transactions
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Provide investors with more time to consider transaction specific information
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Repeal the investment-grade ratings criterion for automatic ABS shelf-eligibility
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Increase transparency in the Private Structured Finance market
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SEC Proposed Rules to Increase Investor Protection (cont’d)
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Consider various other revisions to regulatory framework for ABS, e.g.
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Standardise certain static pool disclosure requirements
Amend the Regulation AB definition of ABS to ensure investors have sufficient
information about the securities
Require additional information regarding originators and sponsors (e.g. the
amount of a sponsor’s publicly securitised assets that, in the last 3 years, have
been subject of a demand to repurchase or replace
Lower the threshold change in the material pool characteristics that triggers filing
of a Form 8-K (pursuant to Item 6.05) from 5% currently to 1% going forward
Specify, in addition to the proposed loan-level requirements, the disclosure that
must be provided on an aggregate basis relating to the type and amount of assets
that do not meet the underwriting criteria as described in a prospectus; and
Mandatory 5% risk-retention by originators
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IOSCO – Disclosure Principles for ABS Offerings
• Purpose: to provide guidance to international securities market regulators with respect to
reporting and disclosure principles for public offerings and listings of ABS worldwide
• Applicability is confined to listings and public offerings of ABS that are backed by discrete
pools of assets which convert into cash within a finite period of time (ie. excludes securities
backed by asset pools that are actively managed or that do not by their terms convert to
cash (such as CDOs or some securities issued by ‘investment companies).
• Calls for more detailed and comprehensive disclosure and reporting, e.g. enhanced static
pool discosure data, so that investors can better understand how comparable pools
originated earlier are performing, strengthened disclosure of all affiliations and other
relationships between all parties to a securitisation, disclosure of features of any credit
enhancement or other support facilities, any derivatives included in the structure etc.
disclosure of all ratings assigned and by whom assigned, plus disclosure of any preliminary
ratings which may have been assigned to same transaction, etc
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US Senate: Dodd Bill on Financial Reforms
• Purpose: Establish a new regulatory framework to prevent recurrence or mitigate the
impact of financial crises that could cripple financial markets and damage the economy.
• Proposes new regulations for over-the-counter derivatives requiring these to be traded on a
recognised exchange, settled and cleared centrally and introducing new trade reporting
requirements in order to enhance transparency in the derivatives market generally
• Proposes new regulations to strengthen the oversight of rating agencies and directs the SEC
to write a new set of rules that will address incentive problems inherent in the ‘issuer-pay’
model.
• Proposes a new regulatory framework to govern securitisation activities, including enhanced
disclosure and reporting requirements, publication of due diligence reports on the asset
pools being securitised, tougher reps and warranties , and mandatory credit risk retention
requirements for originators/sponsors
• Proposes creation of a new Financial Consumer Protection Agency and better coordination
between different regulators to monitor both participants in the securitisation market and
overall systemic risk.
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Key Issues for Emerging Market Regulators
Will these reforms work (in the US and other developed international markets) ?
• Will the new rules and regulatory framework curb abuses seen during the crisis and lead to
better protection of investors in ABS ?
• Will the new rules and regulatory framework still be flexible enough to allow use of
securitisation to facilitate banking sector growth, credit and economic expansion generally ?
How relevant are some of these ‘lessons’ for emerging markets and EM regulators ?
• Should EM regulators consider introducing similar regulatory reforms to govern securitisation
activities in their home markets ? And, if so, which ones are more or less relevant ?
• Particularly in countries where securitisation markets are still nascent, how can regulators
ensure that they harness the benefits of securitisation while guarding against some of the
abuses which caused the financial crisis in the US and global ABS markets ?
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