European securitization market players will apparently put more "skin-in-the-game" than their U.S. counterparts if U.S. regulatory requirements for risk retention move ahead as written.
The objectives to stop the originate-to-distribute model and to come up with a set number for risk retention - which have driven legislation on both sides of the globe - have resulted in a set of different requirements on each side.
One of the main differences is that under the European Capital Requirements Directive (CRD) Article 122A, risk retention, due diligence and disclosure rules are applied to a credit institution when they are investors or exposed to securitizations. In the U.S., those same requirements are applied to sponsors or securitizers.
"The rules recently proposed have similar themes and are looking to cover similar risks in terms of aligning risks between originator and investors; however, they are going about it in a different way," explained Thomas Parachini, a partner at SNR Denton in the London office, speaking at the American Securitization Forum's (ASF) sunset seminar in London last month.
The reason the European Union (EU) regulators have made the distinction of making ABS investors more accountable is because European securitizations, particularly euro-denominated deals, are often bought up by big European banks.
"It creates a slightly different dynamic than in the U.S., where you don't really see banks as major buyers," said Lynn Maxwell, managing director at HSBC who is based in London and runs flow securitization for U.S. and Europe for the bank. She was also a speaker at the ASF seminar.
As a result, the European market is very much dependent on banks for liquidity. Maxwell said that CRD 122A was structured to ensure that the liquidity remained for bonds so that they could be sold to the banks.
However, Maxwell added that it is possible for issuers to structure a deal that isn't sold to banks and evade the raft of requirements under CRD.
"It depends - if you are doing a significant private placement for which you would pay an illiquidity premium on the bond, then you could structure it without being worried about CRD," she said. "But if you are looking to widely place a structure, then 122A is essential."
Another difference is that the CRD 122A has already been effected in Europe whereas the proposed rules on risk retention requirements in the U.S. are still being worked through.
Parachini said this could still create a situation where the final rules will either converge to look more like the CRD 122A or diverge and create opportunities for arbitrage.
Andrew Peterson, a finance partner at K&L Gates, also speaking at the ASF seminar, said that the trouble with creating such a blunt instrument as a set number for risk retention is that if it isn't applied evenly across the board, it could create problems for the market.
Along with their risk retention proposals, U.S. regulators have also presented a situation where issuers can obtain exemptions. The skin-in-the-game can also be shared between the originator, sponsor and B-piece holder. By contrast, in the EU, regulators have basically said that credit institutions that have taken a position in securitization must stick to one form of risk retention for the life of the deal.
European regulators have also said that the 5% risk retention will stick across asset classes despite their quality. German regulators have gone even further and at the end of 2012 plan to implement a 10% risk weight to all securitizations, a move that they believe will deter investors from taking on risk.
"One of the big differences is that the CRD rules seemingly provide some flexibility in the guidance on which players can comply with the rules and they seemingly give some credence to certain structures that are more aligned already with the outcome that they are seeking to achieve with risk retention," Parachini said. "So there is a logical conclusion that you can take to make these deals exempt, except the CRD didn't go ahead and do that."
As a result, the securitization industry will see no exemptions from Europe, while U.S. issuers - if they issue qualifying loans and follow the prescribed underwriting criteria under the qualified residential mortgage (QRM) - can have considerably more exemptions. It remains uncertain if the divide will affect investor and issuer behavior, Parachini added.
"If someone was incentivized by achieving 0% risk retention to focus solely on QRMs, it means that the universe of loans out there to be refinanced would go by the wayside given the strict definition of QRM," Peterson said. It is a situation that could prove most unfavorable to borrowers that fall outside of the QRM criteria.
Maxwell said that consistency is key to sending out the right message to the industry. If the whole objective of regulators was to discourage the originate-to-distribute model, then creating an environment that allows for exemption isn't consistent with that view.
"The moment you start to introduce exemptions even for high-quality collateral, what does that say about originate- to-distribute?" Maxwell said. "The asset classes that we didn't have trouble with from the originate-to-distribute model pre-crisis are being hit by a lot of rules in an effort to ensure that they do keep skin-in-the-game. Inevitably those players that used to use the model and didn't keep skin-in-the-game will be looking to use those exemptions."