The full implementation of Basel III is still years away, but it is already impacting key areas of the securitization market such as mortgage servicing rights. The impact of its liquidity ratios on market participants will likely be felt as early as this year.

Basel II and related rules in 2010, dubbed Basel 2.5, have already reshaped the securitization market by easing capital requirements on investment-grade transactions and ramping up those requirements on the non-investment-grade variety. Basel III, which won't be fully implemented until 2018, incorporates the earlier Basel capital rules and refines how they are applied, and it also introduces new liquidity ratios by which banks must abide.

U.S. banking regulators are anticipated to issue a proposal to adapt Basel III provisions to the U.S. banking industry in the first quarter 2012, and following the typical timetable they may issue final rules as soon as the year end. Even if the proposal is delayed, the Basel III timeline remains in place, and liquidity ratios will begin ramping up in 2013, impacting banks holding securitized assets on their balance sheets.

"Most ABS have three- to five- year lives, so bank investors are conscious that they may still have these assets on their balance sheets when the rules come into force," said Robert Cannon, an associate in the capital markets department of Cadwalader, Wickersham & Taft's London office.

The Basel requirements directly impact banks, which are major investors in securitized assets and providers of funding to support the market. Although the risk weightings for securitized debt under Basel II are more attractive for banks than under Basel I, the proposed Basel III liquidity rules will likely increase the cost to banks of providing credit in traditional securitization structures, such as ABCP conduits. The proposed rules are almost certain to shift ABS market dynamics, often to the detriment of issuers.

The overall impact may be greater in Europe, where banks have tended to hold more ABS on their books than their U.S. counterparts. However, top-tier banks such as JPMorgan and Wells Fargo - the ones impacted by Basel guidelines - are among the biggest mortgage servicers, for loans they have originated and hold on their books as well as loans that have been securitized and sold to third-party investors.

Basel III, however, greatly reduces those banks' incentives to play the servicer role. Mortgage servicing rights (MSRs), along with significant investments in the common shares of unconsolidated financial institutions and deferred tax assets that arise from temporary differences, are each limited to 10% of a bank's common equity when calculating Tier 1 capital. And, starting Jan. 1, 2013, a bank must deduct the amount by which the aggregate of those three items exceeds 15% of its common equity component of Tier 1 capital. Any portion that is not deducted will be risk weighted at 250%.

"Basel III makes financing MSRs as an asset punitive from a capital standpoint," said a top securitization banker at one of the top bank servicers. "It will essentially take banks out of the business of lending against (MSRs), pushing those assets into the capital markets."

That means institutions are going to have to step into the role now played by banks, but that will most likely bode poorly for loan originators seeking to sell MSRs. "There are fewer players in the capital markets that understand MSRs and are willing to invest in them compared to banks, so you would expect financing costs to go up," the banker said.

How U.S. banking regulators will adapt Basel III's MSR guidelines will become clearer in their soon-to-arrive proposal, said Alok Sinha, principal and leader of Deloitte & Touche's banking and securities practice. "But international guidance already results in fairly tough treatment for mortgage servicing rights. We could see some sales of MSRs by banks."

The Basel guidelines for rated securitizations are likely to impact virtually all ABS, especially non-investment-grade bonds and re-securitizations such as CDOs and CLOs, Sinha said. He added that U.S. banking institutions are likely to see additional costs compared to non-U.S. banks because the Dodd-Frank Act prohibits the use of external ratings from rating agencies. And recent U.S. accounting changes have, in effect, obviated the use of the Internal Assessment Approach (IAA), in which banks produce ratings internally using methodology similar to the rating agencies for exposures to ABCP programs.

Non-U.S. banks can still use the IAA, but U.S. banks now are restricted to the supervisory formula approach (SFA), which the banker described as "cumbersome, time consuming, and data intensive, often requiring originators of assets to present data in different ways than they're used to in ABS transactions."

U.S. banks are currently ramping up their systems to comply with SFA, and those additional costs will likely be passed on to issuers. The U.S. regulators have recently issued a proposal for a simplified SFA (sSFA) as an alternative to the use of ratings. However, this is currently applicable to only trading book securitizations.

"It is much harder to meet the data, modeling and other operational criteria under the complex [SFA] that Basel has instituted," Sinha said. He added, however, that if banks are able to obtain all the required data, SFA can provide opportunities for capital relief. "SFA is beneficial in many instances if you're able to do it. It depends on your ability to get a lot of data about the underlying pools [of loans].

Basel's rating requirements were actually a part of Basel 2.5, and their impact has already been felt acutely by the largest U.S. banks. "European banks can put lending facilities on much more quickly and cleanly," the banker said. On Dec. 16, U.S. banking regulators proposed a simplified SFA as a part of a broader proposal setting out alternative ways to assess the creditworthiness of debt and ABS assets without using ratings. Basel III adds some capital-requirement twists to Basel II and institutes new liquidity-ratio requirements. Rather than fully deducting ABS rated 'BB' or lower from regulatory capital, Basel III applies a 1,250% risk weighting to Basel's 8% capital requirement, in most cases resulting in a full deduction of those assets from capital.

But because of changes in the way Tier 1 and Tier 2 capital are calculated under Basel III, said Cannon, "You end up in significantly worse position. In some cases the Tier 1 capital a bank must hold would be more than the value of the asset, even though that seems counterintuitive."

Basel III's new liquidity ratios are also likely to hinder banks' participation in the ABS market. The liquidity coverage ratio (LCR), for example, requires banks to maintain sufficient high-quality assets to cover projected outflows over a 30-day period - a rule designed to inhibit the wholesale bank runs prevalent during the 2008 financial crisis. The definition of high-quality asset in Basel III, however, was not designed to include ABS, an exclusion that would almost certainly damper banks' enthusiasm to hold ABS on their books. The banker said there currently is a lobbying effort underway to have ABS designated a sufficiently liquid asset to use in the LCR equation, but banks have already started phasing in the requirements. "The market is already evaluating banks for compliance with the LCR, and banks are saying publicly where they stand even before the test is phased in," he said.

Sinha noted that the Basel Committee's Quantitative Impact Study estimated that the largest banks would see a shortfall of $1.73 trillion to comply with the LCR. "The liquidity ratios are unlikely to go through in their current form and will likely be revised after additional study," Sinha said.

Nevertheless, proponents of using ABS in the LCR may be disappointed. Cannon noted that while ABS may be relatively liquid under normal market conditions, the objective of the LCR is for banks to maintain assets that will be highly liquid even under stressful situations. "When markets have shut down, at that point ABS wouldn't necessarily be very liquid," Cannon said.

If the Basel Committee remains unmoved on the LCR issue, companies are likely to see a cost increase for the funding they currently receive through ABCP programs. The banker said that under Basel III, U.S. banks will have to hold significant amounts of LCR-qualifying assets on their balance sheets to support liquidity backstops for ABCP maturing in less than 30 days. Holding these assets will increase banks' costs to provide those facilities and, ultimately, that cost increase will be passed on to issuers.

That should push issuers to issue traditional term ABS instead. However, "term markets are not there in sufficient size to absorb a mass refinancing of conduit exposures," the banker said, "So the conduit exposures will remain in place, and banks are going to have to hold assets to satisfy LCR. The question is how much of cost gets passed through to issuers, and what other structural changes to securitized lending can be implemented to minimize those costs."

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