What follows is the first installment of a two-part series on the potential impact of the new Basel framework on the structured finance market
The Basel Committee's development of a new capital framework has one major aim: to better align regulatory capital with economic risk (and in so addressing the shortcomings of the 1998 Accord). For securitization, it does have an important corollary. As notes Alexander Batchvarov, research head at Merrill Lynch, in the firm's International Structured Credit Weekly: "The better Basel II achieves such objective of realigning regulatory capital with bank exposures' risks, the smaller the incentive for banks to securitize such exposure in order to reduce regulatory capital."
What's more, the cost of securitization could increase incrementally as a result of unfavourable regulatory treatment.
Although Basel has been pushed to the end of 2006, with full implementation slated for 2007, much of the work will be done from this point forward, as banks come to grips with the complicated formulas underpinning the New Basel Capital Accord.
The timetable is as follows: at the end of April, the Basel Committee published its third consultative paper (CP3). This will be followed by a 90-day period for comments, and in the last quarter of 2003 the publication of the final version of Basel II. In between 2004-2006, banks will prepare for implementation, which will be on Jan. 1, 2007.
Market participants believe that, aside from small clarifications and formulae calibrations, this last paper is pretty much what securitization originators and investors can expect to see when the final version is released. They say, however, that there is still time for comments and for some final amendments.
At this point, the market seems most focused on digesting the Standardised Approach, which the majority of the banks are expected to use. Under the Standardised Approach, the Basel regulators continue to discriminate in favour of corporate bonds, such that the risk weightings for investors in double-B rated securitizations increases to 350% compared with just 100% for sovereign, bank and corporate exposures. But it gets worse at the single-B level, where the guidelines will require a deduction of capital for securitization exposures, compared to between 100% to 150% for the other categories (see table).
There is an ongoing debate as to the fairness of this treatment. Opponents argue that the regulators have not considered the data showing that ABS is no more risky than corporate bonds, and, in many studies performed by the rating agencies, has proven to be less volatile.
The Committee's securitization group says, however, that higher capital requirements are justified for lower-rated securitization tranches. One of the main arguments is that more subordinate securitization tranches tend to be relatively thin and exhibit more severe losses in the event of default then similar rated corporate exposures.
Although Fitch Ratings believes that these charges are over-punitive when compared to corporates, Fitch analysts say they support the higher capital charges for triple-B and lower rated structured tranches than for similarly rated corporate exposures, particularly given the potential higher loss severity on subordinated structured tranches.
Even so, Fitch's average annual default and migration statistics from 1991 to 2001 are more favourable for structured products than for similarly rated corporates. In spite of this, Fitch says it predicts increased ratings volatility in the structured market and, as some of the newer asset classes experience more severe historical stresses, structured performance statistics are likely to trend over time close to those of corporate bonds.
As Fitch Managing Director Olivier Delfour explained, "Although we believe that the rating categories mean the same thing, whether they are for a bank, corporate or sovereign, what we are also saying is that Fitch ratings are addressing the probability of default, not the loss given default." Delfour contends that lower-rated ABS tranches may recover less than similarly rated corporate exposures. "We believe that the loss in percentage of the [securitized] exposure may well be larger when compared to a corporate bond which ranks senior in the capital structure."
Delfour believes, however, that Basel's differentiation seems excessive.
The Committee's concern is with the possible concentration of risk in the more subordinated notes of a securitization transaction, and members are concerned that the loss given default is higher in a securitization structure.
While a Fitch rating speaks to probability of default, a rating from Moody's Investors Service assesses both the probability of default and the expected recovery. Still, the Basel Committee feels that there is not enough information on subordinated tranches of ABS and remains concerned with the unexpected losses.
Merrill's Batchvarov comments that, "We are not convinced of some of the arguments behind the higher risk weightings for lower-grade ABS exposures in terms of the risks such exposures add to a bank portfolio and their correlation with such portfolio."
Treatment of exposures
Under the Standardised Approach, banks are allocated regulatory treatments for their exposures as follows: regulatory retail portfolios, 75%; SME loans, 75%; mortgage lending, 35%; commercial real estate, 100% (could be lower under certain conditions); venture capital and private equity investments, 150% or higher, at the discretion of national regulators.
At first glance, it appears that, from a regulatory capital perspective, it's not advantageous to use securitization for mortgage portfolios, SMEs and retail portfolios. Conversely, it will be more advantageous to securitize commercial property, as well as venture capital and private equity investments.
These considerations, however, do not address the need for funding, but merely a bank's view on capital relief. There is still an ongoing debate as to how Basel will affect the types of assets that will be securitized going forward.
The European market continues to grow at a decent pace. This year, RMBS volumes are expected to double 2002 numbers. While balance sheet management is still important, funding is also becoming an important motivation for securitization. This is evident in the large programmatic issues of the UK master trusts, which benefit both in terms of funding diversification, and, to some extent, pricing considerations. As such drivers gain importance, market participants are less worried that securitization could dry up post-Basel.
Northern Rock, for instance, has publicly stated that it would like to derive one-third of its funding from securitization, seeing a real benefit in maintaining sources of
"In this first quarter around 70% of total assets securitized were residential mortgages," said Fitch's Delfour. "Under the present regulatory capital rules residential mortgages benefit from lower risk weightings." This implies that capital allocation does not seem to be the driving force behind this market, Delfour adds.
From the investing point of view, under the Standardised Approach, bank regulated investors could be more motivated to buy the riskier bonds of sovereigns, corporates and banks, rather than securitizations. Merrill's Batchvarov comments that the role of banks as investors in subordinated securitization tranches should be expected to decrease, "as the placement of the latter may become more dependent on the investment appetite of non-regulated entities."
It is immediately noticeable that, under the Standardised Approach, there is a far greater involvement of the rating agencies in Basel II. This will not change the ratings approach, "As we obviously have great confidence in our ratings," Fitch's Delfour said. "It is possible that some local regulators might want to monitor more closely the rating agencies, but we have no particular concern with that. One positive effect may be to promote more transparency. "
Batchvarov adds, "We expect ratings to continue to play a major role in the securitization market, probably more so than in the corporate market. In that respect further improvement in rating approaches and models for securitization tranching will likely become a matter of urgency, given the significant differentiation of risk weights by tranche's credit rating."