The German financial regulator, BAFin, is looking to rework the dynamics of structuring synthetic securitizations.

Some issuers have already felt pressured, believing that the regulator might decide on a document that would create some major disincentives for the use of securitization. The latest buzz is that the regulator is set to move ahead with its new circular by the end of the year, but just what will be decided remains a matter of discussion.

According to Merrill Lynch's International Structured Product Monthly, published last week, the new circular on the treatment of securitizations should be released in the coming months. The document, said analysts at the bank, is expected to "officially" limit interest sub-participation to future profits, or excess spreads.

Sub-participation tranches benefit from all the gross interest income from the reference pool as well as additional assets outside of the pool. The motivation behind the use of interest sub-participation is to achieve the maximum regulatory capital relief at the lowest possible cost. By pledging all future interest receipts on the reference pool in exchange for losses incurred by the junior swap holder, originators are able to sell the equity piece cheaply due to the interest guarantee backing it, explained one market source. "Origina-tors were in effect capitalizing on the old Basel concept of holding regulatory capital only against their principal liabilities, as opposed to interest liabilities," added the market source.

The BAFin has since started applying a stricter view, more in line with Basel II, and originators are therefore being asked to check with their regulators on a case-by-case basis in order to be approved for regulatory capital relief.

The popular belief among sellers was that the BAFin would have already implemented this limitation by now, so the threat of disallowing interest sub-participation prompted originators to bring their planned issuance forward in order to benefit from it, which could explain the lack of CMBS this year to date. "Disallowing the interest sub-participation this year did not reduce volumes overall but pushed certain issuers to issue ahead of time - some of 2002's year-end deals may have come in January [and] February 2003 instead," said Katie Hostalier, on the structured finance research team at Commerzbank.

While its understood that the BAFin is, at present, in the midst of reviewing a draft of the circular, the draft proposal is still only being talked of internally, said one market source. It's speculated among some industry players that the BAFin might not make a direct ruling on the use of interest sub-participation, though going forward its use might not automatically result in regulatory capital relief.

The issue at the moment lies in the level of risk the originator retains indirectly through interest sub-participation.

Typically, if the actual reference pool falls below 10% of the original balance, assets from outside the reference pool can support the junior swap, so long as total assets don't exceed 10%. "Alternative solutions put forward have been the capping of the interest available to the junior swap holder or the building of a reserve fund through synthetic spread captured from the reference pool," said Hostalier. "One should nevertheless bear in mind that by keeping an indirect link to the pool's performance, the originator [has the incentive] to keep servicing the pool efficiently."

The interest sub-participation issue has not put pressure on volume, and the industry does not expect it to until a specific ruling is dictated. A ruling on interest sub-participation was originally expected to be employed by the beginning of this year, and RMBS synthetic issuance (see ASR 9/22/03) has remained relatively robust just the same. According to a Commerzbank report on the sector, at least another E23 million (US$26.9 million) of risk transfer is expected by the end of this year.

Originators, bankers and lawyers are not specifically bothered about the issue of the ISP being disallowed but rather that it does not automatically allow regulatory capital relief any longer, explained one market source. "It would seem that until a ruling has specifically been passed - and it's not clear when that will happen - a case- by-case analysis with the regulator will determine the way forward for the parties involved," said Hostalier.

The document will as well insist that foregone interest or principal in the event of a restructuring, instigated by a credit event due to failure to pay or bankruptcy, is included in the realized loss definition. "Although restructuring as a credit event is not allowed currently for bank loan portfolios, the regulator is set to ensure that any costs due to a restructuring are borne by investors, rather than the bank counterparty," reported Merrill Lynch.

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