Structured finance professionals aren’t losing much sleep over a new regulation barring federally-insured banks from engaging in certain kinds of swaps with vehicles that issue asset-backed securities.
But there’s plenty of anxiety about a separate proposal that would require ABS vehicles to post variation margin — basically additional cash — everyday on the swaps they tend to engage in.
Swaps are agreements to exchange one set of cash flows for another. They are commonly used to protect against interest rate mismatch in a deal that pays a fixed rate of interest but is backed by floating-rate loans, for instance. This can raise the credit quality of a deal to a point where it is palatable to target investors. The same goes for a security denominated in a different currency than the underlying collateral.
The swap counterparty to the ABS vehicle is frequently a bank that is a member of the Federal Deposit Insurance Corp. This is why regulators seeking to limit financial risk borne by taxpayers are tightening the screws on this sector, especially in light of how certain types of swaps, and certain types of securitizations, stoked the financial crisis.
In December, Congress enacted a provision of the Dodd-Frank Act requiring FDIC-insured banks engaging in swap transactions with a securitization trust to either “push out” the activity to an uninsured affiliate or cease the business altogether. Swaps used to mitigate risk or those involving asset-backeds that meet certain quality criteria are exempt.
It remains to be seen how those exemptions will apply, however. The compliance deadline is July 16.
The Commodity Future Trading Commission (CFTC), which oversees the vast majority of the swaps market, declined to comment on the ABS swaps push-out rule.
Industry professionals believe that regulators understand that the swaps transactions between banks and ABS vehicles are used to mitigate risk, rather than for speculative purposes. “It’s pretty straightforward,” said a person who has spoken with a number of market participants on this issue. “These kinds of swaps are typically on a bank’s books as part of their asset-liability management.”
Even when banks can’t justify being a counterparty in order to mitigate risk, the rule still allows them to engage in a swap provided the ABS is of high quality. But as Julian Hammar, of counsel at Morrison Foerster, pointed out, the regulators have yet to define what that means.
At any rate, the pushout isn’t expected to have much of an impact. Evan Koster, partner at Hogan Lovells, said the push out rule could affect the market — perhaps hobbling the economics of lower-quality deals.
But, he added, the margin rule is where the industry focus remains.
In a Nov. 24 letter to regulators, the Structured Finance Industry Group argued that requiring vehicles to post margin would increase costs for issuers to the point where securitization would be unviable for some.
This would lead to a drop in issuance, and in certain sectors, the unavailability of securitization as a funding source.
Swaps listed on a derivative clearing organization already must post margin. The majority of swaps are cleared, according to CFTC data. For instance, in interest rate swaps — the largest category — $192.7 trillion were cleared on a notional basis as of January 9 while $111.4 trillion were uncleared.
But currently swaps involving asset-backeds are more commonly uncleared. The proposal would extend margin requirements to these.
“Basically the rule is whatever must be cleared by a clearing house must be cleared,” said Koster. “But a significant amount of the swaps that securitization vehicles do are conditional or have optionality and can’t be currently cleared.”
One of the main reasons ABS vehicles use swaps is to obtain a high investment-grade rating. Without the swap, the rating would be lower, potentially limiting investor appetite to those seeking yields that would be too high for the transaction to make economic sense.
In the letter, SFIG said that the overcollateralization and other structural features of a typical ABS vehicle are enough to mitigate the risk taken on by the counterparty of an ABS swap.
Indeed, the group argued that in addition to normally being at the top of the payment-priority chain in an ABS vehicle, the swap counterparty is already secured by collateral that exceeds the cash that would be posted as margin.
Exactly — or even roughly — what volume of securitizations in the U.S. use swaps is not clear. SFIG said given the over-the-counter nature of these swaps it’s impossible to quantify.