Banks are applying a well-honed strategy to mitigate regulators' recent proposal to determine capital requirements for assets that include securitizations.
The strategy consists of expressing empathy for regulators' intentions, highlighting the provisions' adverse impact on the capital markets and economy and requesting a delay for further analysis. That's been the template for many of the comment letters financial institutions have submitted to weigh in on a range of proposed rules stemming from the Dodd-Frank Act. But in the case of regulators' proposal to replace ratings with an internal methodology, banks may have a point. Nobody wants a repeat of the recent financial crisis, when public ratings clearly failed to alert investors to the dangers embedded in securitizations.
The regulators' proposal, titled Risk-Based Capital Guidelines: Market Risk; Alternatives to Credit Ratings for Debt and Securitization Positions, removes third-party ratings from the regulatory-capital equation and replaces them with an internal methodology. Except the new approach, called the simplified supervisory formula approach (SSFA), appears to apply regulatory requirements haphazardly and even at times confuse where risk lies.
According to a Feb. 7 letter submitted to regulators by the American Securitization Forum (ASF), the Securities Industry and Financial Markets Association (SIFMA), the American Bankers Association (ABA) and other major trade groups, the proposed rule may, in some instances, assign prime and subprime auto loans the same risk weight. They also point to the capital charge on a senior tranche in a prime auto loan securitization that is actually higher than the senior tranche in a subprime deal.
"As a result, SSFA as proposed will in certain circumstances require the same amount of capital to be held against riskier junior securitization positions as against less risky senior securitization positions in the same transaction," the letter said (see graphic on p. 13).
The ASF followed up with bank regulators the week of Feb. 27 to discuss what it sees as the proposal's weaknesses as well as a modified version of the SSFA that it views as more in line with market risks and the Basel II rules that non-U.S. competitors must follow. The following week, or the week of March 5, the ASF was scheduled to do "some briefs for staff and members of Congress to make sure they are aware of the significant curtailment of the availability of credit that the proposals would have," said Tom Deutsch, executive director of the ASF.
The ASF, however, has met numerous times with banking regulators since the start of 2011 to provide input, and the agencies' proposal published in the Federal Register Dec. 21 remains highly problematic from Wall Street's perspective. Most banks and their trade organizations' letters say they agree with moving to alterative methods to apply capital requirements. However, they view the SSFA as punitive especially to non-investment-grade and even some investment-grade ABS.
The joint comment letter said that "with respect to securitizations, they (i) discourage banks from underwriting, purchasing and making a market in or engaging in secondary trading in less risky securitization positions and (ii) result in negative effects on the availability and liquidity of credit to American consumers and businesses that will have significant adverse effects on the recovery of the U.S. economy."
A few comment letters are more supportive of the proposal. The Mortgage Insurance Companies of America (MICA), representing the private mortgage insurance industry, noted that it had long alerted regulators to the "hazards of structured MBS," including concerns about the industry's reliance on credit rating agencies.
Consequently, MICA "commends" parts of the proposal requiring risk weightings for structured positions and routine assessments of risk and assets underlying ABS. "Initial ratings at issuance proved to be a very poor predictor of real credit risk for MBS and, thus, the [proposal's] ongoing risk valuation for assets underlying ABS will prove a significant improvement over prior regulation," wrote Susan Hutchinson, executive vice president of MICA.
However, rather than replacing ratings with the SSFA, MICA is a proponent of unaffiliated and well-capitalized providers of credit risk mitigation, which can include credit insurance as well as credit derivatives. "When capital is placed at risk ahead of a bank's trading or banking book, there is no opportunity for arbitrage, investors and regulators can quickly identify strengths and weaknesses in overall credit risk and correlation risk within a banking organization is dramatically reduced," Hutchinson said.
Americans for Financial Reform (AFR), a coalition of consumer-oriented organizations, goes a step further. Its comment letter said that while the proposal does create a simple procedure for attaching a capital charge to securitized assets, "it is far from being a reasonable or reliable standard of 'credit-worthiness' as mandated in the statute."
The letter goes on to say that "undercapitalized tail risk in senior securitization positions" was at the heart of the 2008 financial crisis, which demonstrated how structured finance enabled the arbitrage of regulatory capital rules and market discipline by concealing credit risk in securitization structures.
"Yet it is highly questionable whether the SSFA ensures that risky but senior positions will be adequately capitalized," the letter said. It added that regulators should restrict the complexity of the securitization structure "so that subordination can be measured in the simple and predictable fashion assumed in the SSFA formula," and that the SSFA procedures should take more advantage of improved loan-level data.
The AFR also questioned whether the risk capital charges in the proposal are sufficient, noting that Moody's Investors Service found that the five-year loss rates on 'Aaa' and 'Aa' securitizations between 1993 and 2010 were 6.25% and 38%, respectively. "Compare this to the 1.6% capital that will be reserved against investment-grade senior tranches - the vast majority of the securitization - under the SSFA proposal," the AFR said.
Overly burdensome capital requirements, however, could pummel a fragile economic recovery. The Commercial Real Estate Roundtable (CRER) noted that CMBS have accounted for 25% of all outstanding commercial real estate debt over the past two decades. They made up as much as 50% of that debt at the market's peak in 2007, accounting for $240 billion in new CMBS issuance. That number plummeted to $12 billion in 2008 and $2 billion in 2009.
Issuance is anticipated to remain at an anemic $30 billion this year, as approximately $600 billion in CMBS loans and more than $1.2 trillion in outstanding commercial mortgages mature over the next five years. Many of those transactions will have to be refinanced but may face a shortage of investors, especially if banks face more severe capital requirements.
Any "changes that effectively discourage banks from securitization would create considerable difficulties for the market," the CRER said. The group added that regulators should perform a cost analysis to refine the proposal to mitigate unintended consequences and reissue the proposal.
State Street noted its concern that the SSFA lacks "sufficient risk-sensitivity and is therefore likely to significantly overstate the amount of capital required to support securitized assets." The giant custody bank, with $21.8 trillion in assets under custody and $1.9 trillion under management, went on to note that with the exception of prudently written mortgages, which would carry a risk weighting of 4%, all other categories of securitized assets are assigned a fixed 8% risk weighting. In addition, the minimum capital requirement for asset securitizations under the proposed methodology is 1.6%, or three times the current Basel III approach.