The EU CRD changes to Rule 122a segregate financial institutions between those that comply and those that don't.
Noncompliance would mean having to offer investors higher returns on debt compared with the banks that are compliant.
Essentially, the rule requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.
In this way, the rule forces investors to scrutinize their analysis and monitoring of the performance of collateral backing these securities. Failure to do so would result in a significant capital charge - as much as 100% as a capital buffer is even a possibility.
In a note authored by Richard Field of TYI and published by theInstitutional Risk Analytics(IRA), Field explained that if there is no compliance with the requirements, investors are required to hold approximately 100% capital against their investment.
As such, investors can't invest with leverage in securities where they are bidding blindly because they do not know what they are buying and will subsequently own.
Rule 122a therefore poses much more of an investor restriction as opposed to the Dodd-Frank Act, which is framed as a restriction on securitization.
In Europe, it seems that investors have a bigger indirect role to play in influencing issuers to provide full disclosure. "In the US, regulatory bodies have taken greater responsibility here," explained Douglas Long, executive vice president in business development and product strategy at Principia Partners. "The difference is reinforced by the way originator retention proposals are being enforced on either side of the pond. In the U.S. issuers will be responsible for proving to regulators that they have retained a 5% portion of any new issue. In Europe, however, Rule 122a places the onus on investors to have a clear internal audit trail, which demonstrates how they have gotten comfortable with any particular originator's disclosure. Issuers will instead be pressured by investors to provide sufficient ongoing disclosure regarding the 5% slice they hold. Failure to do so effectively would depress an investor's valuation of a deal as they will price the additional capital charges tied to non-compliance."
The European Union (EU) rule is a direct challenge to the U.S. regulatory environment. "The degree of disclosure required of both issuers of securities and the EU institutional investors who purchase them is greater than that currently in the U.S. or proposed under the [Securities and Exchange Commission (SEC)] rules on Reg AB," said Chris Whalen, an analyst at IRA. "Now our friends at the SEC will understand our comments on the same, where we asked the SEC to mandate that issuers supply all material data on ABS transactions. To do any less means that the U.S. will become a second-class market compared with the EU."
More immediate are the implications for U.S. issuers still looking to tap the EU investor base.
According to the Securities Industry and Financial Markets Association (SIFMA) in its May 2009 Highlights, "The article applies to any EU credit institution (e.g. bank, dealer or investment firm) that invests in or holds securitization positions in either its banking book or trading book e.g. as an investor or dealer. As a result, [it] will be required by any originator globally who wants to sell/trade securitization tranches to/with EU credit institutions. For example, if an EU or U.S. auto ABS issuer wants to sell auto loan ABS tranches to a European credit institution, it will need to comply with the EU retention requirements and also provide sufficient information for EU investor due diligence."
"We don't have the sense that the U.S. banking community has really tapped into the scope of Rule 122a," said Nicole Rhodes, securitization counsel at Allen & Overy. "It gets complicated when you havedifferent retention regimes applying to the same deal and it could get tricky if the retention regimes are very different."
Rhodes explained that the provision under the Dodd-Frank Act calls for retention of 5%, but in Europe retention placeholders can vary from jurisdiction to jurisdiction. The capital requirement directive, of which 122 A is an amendment, allows the member stated to add on to the retention requirement. A case in point, Germany has provided for a minimum retention requirement of 10%. Rhodes said the EU banking authorities are working toward filling in such gaps created by the text of Rule 122a.
"Right now, if you are issuing to a European investor base, you have to consider how to marry up the different retention requirements but originators may find it difficult to structure around these inconsistencies," Rhodes said.
The rule, she added, will also likely affect hedge funds and Undertakings for Collective Investment in Transferable Securities or UCITS. The Solvency II legislation recently approved by the European Parliament requires the European Commission (EC) to adopt implementing measures on investment in securitization products, which includes a retention provision, Rhodes said. A similar provision is included in the current EC proposal on regulation of hedge funds. Rule 122a is also likely to be applicable to non-EU trading desk operations of European credit institutions.
Rule 122a will apply to all new securitizations on or after January 1, 2011. After December 31, 2014, the requirements of Rule 122a will apply to all existing securitizations.
Rhodes said that the industry is still working toward clearing up some of the confusion regarding implementation of the rule to existing ABS.
"The provision doesn't work out as well in existing securitization context," she said. "It raises questions in some deals like program and conduit arrangement and can make complying with the rule a bit tricky."
Principia's Long noted that central banks in Europe have already implemented similar measures to get a greater basis of information on loan-level data.
"The Bank of England and the European Central Bank now require bank investors to provide additional levels of information if they want to continue to post collateral for funding via their repo facilities. [securitization] issuers will need to make all the relevant loan and issuance detail available to investors as per central bank demands," he said. "Otherwise investors will be more reluctant to buy because they can't then post notes to the central bank program."
The U.S., Long said, is being more strict on issuers but the potential push back from the buy side in Europe could be enough to force issuers to provide disclosure similar to that being introduced by the SEC's Reg AB.