Rising interest rates aren’t the only thing that could bump up the cost of financing everything from autos and housing to industrial equipment next year.
A rule set to take effect in 2016 could make it more expensive to issue bonds backed by financial assets such as loans and leases. Called securitization, this is a common way for both banks and nonbanks such as captive finance companies to fund their lending. Making it more expensive might raise borrowing costs for borrowers as well.
The catalyst?
A rule recently finalized by the Federal Deposit Insurance Corp. (FDIC) and other banking regulators would impose a margin-posting requirement for uncleared swaps. This would cover banks, which are the most common swaps counterparty for securitization vehicles. A similar rule is in the works for finalization by the Commodity Futures Trading Commission (CFTC), which oversees non-bank swap dealers.
Swaps are agreements to exchange one set of cash flows for another. In U.S. securitizations, they are typically used to protect against interest rate mismatch; say, for example, when bonds that pay a floating rate of interest are backed by fixed-rate loans. Swaps can also be used to hedge against changes in exchange rates when bonds denominated one currency are backed by assets denominated in another currency.
The margin rules were mandated by the Dodd-Frank Act and are meant to reduce systemic risk.
Most swaps are cleared through a counterparty clearing house (CCP) and are already subject to a margin posting requirement. But swaps used in securitization are almost always uncleared. Players say this is a necessity; the agreements needed to hedge the risks in securitization are bespoke and don’t fit the more standardized formats required for clearing.
Cost of Compliance is Prohibitive
Many players say posting margin on a swap used by a special purpose vehicle could raise costs of securitization to a prohibitive degree.
“It’s uneconomic to do an interest-rate swap on an SPV that has to post collateral based on the mark-to-market,” said Marc Horwitz, a partner at DLA Piper, adding that deals generally don’t have a system for doing this in place.
Fortunately for existing deals, swaps currently used in in securitization are expected to be grandfathered so they won’t have to post margin.
The margin is a percentage of the total swaps exposure. The new rule applies to both initial and variation margin. The former is what must be posted upfront for the swap, the latter depends on the daily market value for the trade. Under the final rule, swaps exposure under $8 billion would not require initial margin. While this could apply to swaps in many securitizations, variation margin alone could be enough to spur changes in the market.
Trade association the Structured Finance Industry Group (SFIG) argues that ample collateralization in many securitizations — along with the fact that swaps are typically at the top of the priority of payments in a securitization — are good reasons for exempting these deals from swap margin requirements.
Evan Koster, a partner at Hogan Lovells, said that overcollateralization with receivables in securitization structures won’t do deals any good in regards to posting margin. “They’re not taking that into account on margining,” he added. “What’s accepted as collateral is very narrow for margin purposes and must be liquid or quickly converted into liquid assets.”
Could securitization vehicles just introduce new features to include swaps?
Horwitz said deals would need a different kind of collateral agent than most currently have. The collateral agents used in most securitization vehicles are managing the collateral. “They’re not necessarily experts at valuing these sorts of trades,” Horwitz said. Securitization vehicles “don’t necessarily have these operations set up.”
One exemption to margining is likely to hold: captive finance companies. In May the CFTC exempted swaps in vehicles with this segment of borrowers — in the securitization world the most familiar examples are auto loan lenders such as Ford Motor Finance — from being cleared, which meant they didn’t have to post margin. While margin requirements are now extending to uncleared swaps, there’s an understanding that captive finance companies will remain exempt.
For other kinds of issuers, the prospect of margining is likely to spur different strategies.
Three Possible Workarounds
One option is to simply issue less and rely more on other kinds of funding.
“We might see these folks go to markets other than ABS to finance their activities,” said Sairah Burki, a senior director at SFIG. She added that this would narrow funding options for borrowers that, in turn, lend in the both the consumer and commercial spaces.
Securitizers might also do deals without swaps, forcing investors to take on the interest-rate risk themselves. This could also raise costs, since investors would presumably demand to be compensated for this additional risk, particularly now that interest rates are headed higher.
“Usually there’s more demand for interest-rate swaps when the Fed is hiking rates, which is presumably happening soon,” said a market participant who declined to be quoted by name.
A third alternative is to use an interest-rate cap, rather than a swap agreement, to hedge against changes in interest rates. This is a method already employed in some deals.
“They’re a pretty common way for issuers to hedge risk,” said Andrew Butville, an assistant vice president in the ABS group at Moody’s Investors Service. He said the use of caps might grow as margining becomes a requirement.
In a cap, an issuer pays a counterparty a premium up front—one that can be substantial, depending on the maturity of the deal and other features—in exchange for an agreement that the counterparty will compensate the issuer if an interest-rate breaches a determined level. “You don’t have to worry about liquidity, because there are no funds that have to be paid by the issuer other than the initial premium,” Butville said.
No particular asset class is more impacted by the margin requirement than others. The use of swaps in each type of collateral tends to fluctuate from year-to-year. “It really depends on what’s active at the time,” Koster said.
While the rule technically takes effect in April 2016 compliance for both initial and variation margin is phased in starting the following September. There are exceptions to grandfathering. An amendment to an existing swap, for instance, could trigger requirements, sources say.
