Last-minute revisions to European securitization regulation are raising concerns about the ability of banks to unload over €1 trillion of bad loans – considered a crucial step in boosting lending and jump-starting the region’s flagging economy.
The latest draft, released in July, unexpectedly bans the securitization of mortgages where borrowers certify their own income, rather than providing documentation to the underwriter.
These kinds of loans have been banned in the U.K. since 2010. But they are currently used as collateral in a number of securitizations, including some that have been making timely payments for a considerable amount of time. The rules would make such deals difficult to refinance.
They would also make it difficult for banks in other EU countries such as Italy, Ireland, and The Netherlands to move forward with plans to unload portfolios of nonperforming loans. These portfolios are typically sold to private investors who depend on securitization for funding.
Securitization is a key feature of the EU’s €8.8 billion recapitalization plan for Italian bank Banca Monte dei Paschi di Siena SpA (Monte Paschi), for instance.
In the U.K., an asset-resolution government body is holding for sale billions in non-conforming pre-crisis mortgages. Last year, U.S. private equity group Cerberus purchased £13 billion in old Northern Rock loans; it subsequently securitized them in a £6.2 billion transaction.
The draft rules would go into effect after Jan. 1, 2019, if the final language adopted by parliament were to be published in the Official Journal (the EU’s version of the U.S. Federal Register).
In a report published Tuesday, the London office of bond rating agency DBRS criticized the revision as a “solution in search of a problem,” saying it would create huge problems for U.K. banks and investors because of the relatively large volume of self-certified loans in existing non-conforming pools.
DBRS laid out the case that the ban would be ineffective in narrowing the credit risk of these portfolios, depress portfolio prices and shut out some investors due to additional compliance costs.
The report echoed many preliminary legal opinions that the late addition of the text was not well thought out.
In a July client briefing, law firm Clifford Chance said the wording was surprising, since there was already a ban on self-certified loans in transactions classified as simple, transparent and standardized (STS), which receive more favorable capital treatment.
The rule, as written, would “create significant problems not only for new transactions after 1 January 2019...but for existing transactions that need to be refinanced after that date,” the briefing states.
The STS rules stemmed from recommendations by an EU Council plan to create a capital markets union, with more standardized investment conditions across the continent that would attract more international money in EU asset-backeds. Under development for more than two years, they were finalized in May.
Previously, the prime area of concern for the asset-backed industry was the EU Parliament's proposal to slap a 20% risk-retention standard on securitizations. That idea has since withered away, having been scaled back to the current 5% mark.
Many of the self-certified mortgages in these existing deals have minimal risks because they have been making timely payments for a decade, some analysts point out. They are all either on the books of a “wide range” of EU institutions that either originated them or “have subsequently acquired these portfolios as part of the general trend of bank deleveraging that has occurred over the last few years,” the Clifford Chance client letter stated.
In its report, DBRS noted that securitizations involving self-certified mortgages are expanding across Europe through government liquidations of non-performing or re-performing mortgages issued before the financial crisis. The agency this year rated a €419.8 million European Residential Loan Securitization 2017-PL1 DAC out of Ireland, as well the first post-crisis non-conforming securitization out of The Netherlands with the AAA-rated €157.7 million Delft 2017 B.V. transaction.
The “initial income verification status of non-performing and re-performing borrowers is of low significance to the expected performance of distressed mortgage portfolios,” according to DBRS.
The new rule’s potential burden on these and other deals is just starting to emerge. Market prices will fall from investors uncertain if the portfolios will obtain (or retain) the STS certification if or when they are refinanced (typically after 3, 5 or 7 years). DBRS also stated removing the securitization financing strategy will limit participation, much of which involves private equity.
Warehouse financing could also be jeopardized, since the EU treats warehousing as a form of securitization, according to DBRS.
In addition to aspects of market harm, noted DBRS, the new proposal is also wholly unnecessary. Based on data from 800,000 U.K. mortgages it has tracked, only 0.12% are classified as self-certified, and of those 3.4% of self-certifieds were ever more than 90 days in arrears.
Self-certified mortgages also have much lower rates of default and delinquency that other mortgage loans with a borrower history of court judgments or having a forbearance.
Banks and non-regulated firms acquiring NPLs have likely already vetted underlying loans for portfolio sales or servicing as re-performing loans. A servicer has likely already performed some income-verification on these loans, and “in either case, self-certification of the borrower’s income at origination no longer matters for such loans.”
Analysts also express concern whether the ban would impact securitization of “buy-to-let” mortgages for investor-owned properties, many of which are still being issued under stricter underwriting policies. Applying the self-certification ban to buy-to-let would be “questionable from a policy perspective,” according to a client alert published last month by global law firm Allen and Overy.
The confusion over the rule also extends beyond the types of transactions affected. According to the Allen and Overy memo, the new rule makes it unclear who the regulation applies to –the original lender or the sponsor of a transaction, and which one would be liable for a breach of the STS rule.
