Europe has had to take a long, hard look at the internal workings of its securitization industry. What has resulted is a long line of market initiatives that will help shape the future of the market and presumably avoid any catastrophic loss for future deals.
But, industry sources said that although the initiatives encourage good camaraderie among securitization players, there is a very real threat that regulators might step in.
What European ABS players want to avoid is this imposed regulation.
However, if the industry cannot come up with adequate solutions, it's likely that regulators, pressured by politicians, will have to introduce formal measures to rein in loan products that go out into the marketplace.
To be sure, over the last year, the European securitization market has been besieged by regulatory proposals looking at different areas of the market and determining what can or cannot be done for future structures. Whether or not these projects will result in a specific outcome is still unclear. Industry players said they expect to see concrete changes in deal transparency and disclosure in the coming months.
In the U.K., the Treasury Committee's report on financial stability and transparency released in the beginning of March said that many structured products were far too complex. The committee argued that banks' origination and distribution systems are characterized by loose underwriting standards. Banks, the committee said, have fewer incentives to do rigorous due diligence on products to which they are not exposed.
Asset management lobby groups are also urging the European Commission to introduce rules governing structured products to bring them closer in line with investment fund regulation. The Commission has called for evidence on the need for further regulation, and market reports said that there have been 80 responses to the EU's call. There will be an open hearing in June or July based on the responses, and a policy paper is likely to be released in October.
But securitization industry players said that the level of disclosure and transparency for structured products is nowhere near the same level as the information that exists for asset management funds.
"At the end of the day, you have to wonder whether the call for more transparency will actually make the market better," an industry sell-side source said. "Striving for a more transparent market is a worthwhile venture and can change things for the good, but many of these deals have always given a decent amount of disclosure. The problem we are experiencing at the moment is that buyers just don't want this paper."
Bertrand Huet, managing director and European legal and regulatory counsel at Securities Industry and Financial Markets Association (SIFMA), said that the actual policy response that will have the most impact on the ABS market is the roadmap set out by the Economic and Financial Affairs Council (ECOFIN) last year.
The industry is moving beyond what the politicians have asked for and is looking to make disclosure practices much more consistent across jurisdictions, Huet said. This quest for a better, more uniform transparency is an initiative that SIFMA and the European Securitization Forum (ESF) have long since advocated, and these associations had already taken several steps toward this goal before the credit crisis started last summer.
SIFMA, along with the ESF, the Commercial Mortgage Securities Association (CMSA), the European Banking Federation (EBF), the European Association of Co-operative Banks (EACB), the International Capital Market Association (ICMA) and the London Investment Banking Association (LIBA), is currently putting together a data report that will be issued on a quarterly basis and that will debut at the end of June. The report will look at things such as collateral types, jurisdiction ratings information, spread changes, where the paper is distributed and what type of investor is buying.
The groups have also published a three-pronged initiative aimed at improving market transparency and addressing the concerns that emerged from the ECOFIN meeting in Portugal last year following the eruption of the credit crisis. At the meeting, European finance ministers put together a roadmap that called for, among other things, measures to improve transparency in the securitization markets by the middle of 2007.
"The European Regulators and the industry have been working together for some time now on transparency issues," said Carlos Echave, a securitization partner at Mayer Brown & Platt. "The regulators are listening to the industry but they have their own views on the issue and might not follow the all the recommendations from the industry which favor self-regulation. The ESF had already made much progress toward improved transparency prior to any credit crisis and most market participants are being very helpful but the market can't have disclosure without limits."
Huet said that the ESF's position as an association that includes all types of securitization market participants allows it to tap all relative parties in the securitization world, which means that the ESF could collect the information it is aiming to provide in its initial data report due at the end of June. However, legal issues still exist that determine just how much can be disclosed and what password-protected information would limit who had access to some of the information out there. In some cases, there is a legal requirement that certain information not be available to all, bound by confidentiality or data protection requirements.
The ESF and a number of European buy-side associations are discussing with investors which areas of transparency would be most valuable to them, Huet added.
"These are concerns that need to be addressed in the market," said Kevin Hawken, a securitization partner at Mayer Brown. "The industry needs to find ways to satisfy investors' need for more information while complying with limits on disclosure that arise under existing securities laws, data protection laws and contracts."
There is still a huge amount of work left to be done, and industry sources said it's unlikely that a timeframe for implementation can ever really be set because much of this work requires the approval and the participation of several different groups.
"On bank regulatory capital issues, there is coordination between European and U.S. regulators, as they are working together within the Basel Committee to review the Accord," Echave said. "On transparency and valuation issues, which may lead to changes to securities markets regulations, is where there seems to be less coordination."
Technical Issues
Regulators have managed to forge ahead with several initiatives as, over the course of the last nine months, the market has seen a share of new regulatory developments take hold.
The U.K. implemented a statutory framework for specific supervision for U.K. covered bonds in March of this year, bringing the U.K. in line with other European jurisdictions that issue covered bonds under legislative frameworks and are now compliant with the guidelines of public company UCITS (Undertakings for Collective Investments in Transferable Securities). This enables U.K. issuers to take advantage of the more favorable 10% risk weighting.
With Northern Rock's failure still on everybody's mind, the U.K. financial regulator Financial Services Authority (FSA) has stepped in to ensure that U.K. banks are adequately prepared to support securitization structures under crisis scenarios.
Last December, the FSA began prepping a new scheme that attempts to curtail future bailouts by other U.K. banks facing a situation similar to Northern Rock. According to the proposals under discussion, the FSA can seize and protect depositors' cash when a bank gets into financial difficulties.
Among the initiatives discussed is the development of a series of triggers that would allow the FSA to step in to protect deposits and to access more information to assess a bank's liquidity situation.
The FSA intends to develop U.K. policy in line with international work being undertaken by the Basel Committee on Banking Supervision and the Committee of European Banking Supervisors (CEBS). The FSA paper draws on how banks and building societies coped with the recent market turbulence. It also analyzes the liquidity risks inherent in some of the newer structures, such as SIVs, and other off-balance-sheet or contingent arrangements. The regulator takes its commitment one step further by reviewing its own existing policies and the banks' liquidity management.
The European Commission has launched a public consultation on possible changes to the Capital Requirements Directive (CRD), specifically 2006/48/EC and 2006/49/EC. "The purpose of Directives 2006/48/EC and 2006/49/EC is to ensure the financial soundness of banks and investment firms and provide the very backbone of day-to-day prudential supervision of these institutions; it follows that this legal framework needs to be regularly updated and refined to respond to the needs of stakeholders," the Commission said.
The consultation takes place in the context of ongoing work related to the CRD at various supervisory and industry forums. The review of the CRD, said the Commission, is in part also a response to the recent recommendations of the G-7 Financial Stability Forum. Opinions are sought on large exposures, hybrid capital instruments, supervisory arrangements, waivers for banks organized in networks and adjustments to certain technical provisions.
"The suggested measures concerning large exposures and hybrid capital instruments and the adjustments to the technical provisions are largely based on advice from the CEBS," said the Commission, adding that the working document did not constitute a formal Commission proposal. Nevertheless, informal discussions have already started in the European Banking Committee. The consultation is open until June 16. Any technical changes required for liquidity to return to the market will feed through this CRD process.
In the coming months, the European Commission will also carry out consultations on possible changes in the CRD, which incorporates into European Union law the Basel II rules on the minimum capital that should be held by banks and investment firms to cover their risks. This will lead to legislative proposals in September on the necessary amendments, which the Council and Parliament have been urged to see enacted by April 2009.
There are some concerns that once any changes in Europe are implemented, Europe will have a framework that is not applicable to other countries and thereby present a competitive disadvantage for European banks.
"It's important that regulators and policymakers are globally coordinated," Huet said. One of the issues for policymakers is the problem of risk retention - because the bankers flogged the whole risk, there is a question as to whether the originator or the arranger has enough commercial incentive to originate high-quality assets.
"But this is an issue that clearly can't be looked at in isolation," Huet said. "Because in this particular area, the International Financial Reporting Standards (IFRS) accounting standard requires that you get rid of the whole risk in order to achieve off-balance-sheet treatment."
Enhancing Basel II
The Basel Committee also plans to enhance Basel II in response to the criticisms the new accord received in reaction to the credit crisis. Market responses claiming that the new accord failed to place adequate restrictions on bank trading and, as a result, contributed to the problems are misdirected because, under Basel II, banks are not allowed to use the credit pricing models that have failed to perform. Instead, the crisis highlights the Basel I regime's inefficiency.
The committee plans to take extra steps to strengthen the resilience of the banking system, including changes to the capital treatment of liquidity facilities, trading book credit exposures and complex structured credit products. Specifically, it is looking to revise the framework to establish higher capital requirements for certain complex structured credit products, such as "resecuritizations" or ABS CDOs, which have caused the majority of losses during the recent market turbulence.
The committee is also looking to strengthen the capital treatment of liquidity facilities extended to support off-balance-sheet vehicles such as ABCP conduits. Additionally, there are plans to strengthen the capital requirement for trading book exposures of structured credit and to move away from a value-risk-based system for these illiquid securities. To address this, there will be an "event risk" proposal released for consultation later this year.
Huet said that what changes arise from the Basel II consultation may feed into further changes for the CRD.
Where the road will lead is still uncertain. All these changes are clearly toward a path that creates an environment of more valued transactions for the future. Industry players believe that this forward-looking agenda will help regain confidence in the market, although it's unlikely that any of the changes will immediately bring investors back.
"We have seen some crucial solutions," Huet said. "The Bank of England's special liquidity scheme and the Federal Reserve's term securities lending program are things that help banks funding any qualifying assets, which has sent a very positive signal to the market that liquidity is improving, which has a knock-on benefit in terms of investor sentiment.
Market sources said that the rebuilding of banks' balance sheets as well as the clearing and deleveraging of the overhang should be nearing an end in Europe. Another sell-side source said that the ECOFIN has requested that banks begin disclosing their outstanding exposures.
How fast-acting or how effective the reforms will be remains to be seen. The industry is working with many proposals looking at different areas of the market, and this goodwill that aims to fix the rift in the market is at least a tangible positive that has come out of the current turmoil.
"The concern is to make the market work again," Hawken said. "And regulators along with the industry are concentrating on getting back in motion."
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