The European securitization market could see some stabilization in pricing as the European Commission (EC) moves to adopt amendments to mark-to-market regulation.
The reclassification would help reduce asset fire sales and ease the supply of ABS assets to the secondary market, thus calming the volatility of asset prices as fewer investors look to sell.
Deutsche Bank analysts reported that on the back of the news European ABS spreads appeared more range-bound, though they still stood at historic wides. The analysts added that the new accounting moratorium could help reduce any further downside to European structured finance prices.
The amendments to IAS 39 will allow bondholders to reclassify assets that are marked-to-market on their trading books either into assets available-for-sale (AFS book) or held-to-maturity categories (HTM book). Changes will apply from the start of the third quarter of 2008.
Assets held in the AFS book are marked-to-market, but go through reserves affecting equity, said Barclays Capital analyst Hans Vrensen. The actual sale of assets, including the permanently-impaired, go through the profit and loss statement. Assets held in the HTM book are valued at their notional value on the balance sheet, so there would be no impact on the profit and loss statement, or on the balance sheet.
This reclassification will bring Europe closer in line with U.S. accounting regulations. "Under U.S. GAAP, there is recognition that in rare circumstances, a re-classification could be appropriate. IFRS did not allow any such re-classification in treatment," Vrensen said. "This difference has prompted the EC to bring IFRS in line to ensure a level playing field for the accounting treatment of European and U.S. companies."
Mortgages and corporate loans in warehouse are likely to be the assets best suited for reclassification. The new option would effectively present banks with the opportunity to write-back recoverable values.
High-quality, or triple-A, priced distressed ABS and other bonds like wrapped infrastructure paper could also be candidates for reclassification, Deutsche Bank analysts said.
"Assets that would be the most conducive to being reclassified are likely to be assets in a market that is poised to experience prolonged exit illiquidity, with bid-side prices that are the most dislocated relative to fundamental valuations but where lifetime impairments are predictable," Deutsche Bank analysts said. "Assets that consume less risk weight capital will also naturally lend themselves [to] accounting reclassification, in our opinion."
Any reclassification of assets will have to be disclosed in the financial statements, along with the reclassification's impact on the profit & loss statement. While banks and asset-liability managers (insurers, pension funds) can better position themselves through reclassification and avoid the write-downs tallied in 3Q08, they must also find out whether a given reclassification is appropriate, because if reclassified the then-current mark-to-market loss will essentially be permanently locked in.
"Banks are likely to consider the full extent of their assets for potential re-classification," Vrensen said. "Also, banks might consider the views of equity investors and analysts, as the consistency of comparison between banks will likely suffer."
The amendments will become effective Nov. 1, but can be retroactively applied from July 1 and could affect third quarter bank results.
"There is a drawback for the securitization market," Deutsche Bank analysts said. "With the potential for a substantial extent of legacy ABS to be put away in banking books, there is naturally much less incentive or opportunity for private capital to be put to work in the structured credit market. Reduced liquidity and capital flows may serve to further stall the recovery of the primary securitization market, in our view."
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