The risk-based capital (RBC) rules put into effect by the Federal Financial Institutions Examinations Council at the start of the year were a long overdue, and the effects after the first six months - while difficult to quantify specifically - are certainly pervasive, industry players agree. On the one hand, smaller home equity issuers are being squeezed out of the market due to the tougher rules on residuals. But the rules have also brought to investors to the ABS market, helping drive down spreads to historical lows.
Yet market sources stressed that demand in 2002 for ABS paper has not been fueled solely by the new RBC rules. The market is the beneficiary of several fortuitous factors piquing investor interest both domestically and internationally, including the often-touted flight to quality, and the need for investment alternatives to agency and U.S. Treasury debt as issuance from those entities dwindles.
Long on the regulatory drawing board, the need for new RBC rules was given impetus by a number of high-profile financial failures - the most recent involving Superior Bank, and the most scandalous involving First National Bank of Keystone. Both incidents were tied to residuals, although fraud played a large role with Keystone.
Under the new rules, double-A to triple-A ABS requires 20% risk weighting, single-A ABS requires 50%, triple-B ABS requires 100%, and double-B requires 200%. Single-B rated ABS and lower, as well as unrated tranches, are not eligible for a ratings-based approach.
Owen Carney, president of Bank Capital Markets Consulting, explained that regulators grew concerned about certain characteristics of securitization. For one, securitization lends itself to specialization. Prior RBC rules encouraged bank entities to sell the best assets and keep the worst on their books, since the capital charges were the same regardless of the quality of the assets. Hence, some small and mid-sized banks ended up with pools of low risky loans concentrated in a single asset class.
"The regulations dealt with this, but unfortunately the small guys are getting squeezed out," Carney said.
What's regrettable, Carney argued, is that the new regulations, which were debated for 10 years or more, were issued in the wake of the scandals. "It was kind of an angry reaction to the failures, and while these regulations are supposed to prevent failures, they will also prevent good guys from participating in the market." His main beef is that the regulations "do not take into account the quality of assets or capital."
But what the regulations do, however, is encourage issuers to think very differently about how they manage their risks, said Joe Donovan, ABS group co-head and managing director at Credit Suisse First Boston. "Now you can manage your retained risk by selling it."
In the old days, Donovan said, the only consideration was funding. "Why would I pay triple-B spreads and still have the same capital charge?" Donovan asked. "You didn't get the benefit to sell down. Now you get more capital relief."
While issuance has been crimped for some home equity securitizers, the effects of the new RBC rules have been salutary elsewhere. The fact that highly rated ABS paper now carries the same capital implications as agency debt broadens the investor base. "It's making a difference in the liquid names, now that they're on par with Fannie and Freddie with a 20% risk weighting," said Peter DeMartino, director and head of ABS and mortgage credit research at Salomon Smith Barney. "If you haven't bought ABS in the past, the first place you're likely to traffic is in the liquid Big Three auto names and the top tier credit card names."
Elsewhere, small to mid-sized banks can now look to HEL paper as a substitute for mortgages. "It's less painful" to hold ABS paper, said Alex Roever, head of ABS research at Banc One Capital Markets. And for the big investors who are familiar with the sector, the new RBC regs allow them to leverage themselves a bit more.
While both DeMartino and Roever said these RBC developments do not account for all the spread tightening seen this year, Roever said it's certainly "one of the reasons bonds are trading at historically narrow levels." Indeed, by early June nearly all sectors were at six-month lows.
For example, triple-A, three-year credit card paper is trading at about five over Libor, with a one-year high of 13. Triple-A, two-year owner trust auto paper is trading at about six over swaps, with a one-year high at 22. Meanwhile, triple-A, two-year home equity paper is trading at about 41 over swaps, with the one-year paper at 79.
"There are lots of reasons" for this tightening, DeMartino said, but the bottom line is "more investors are buying these products."
Also, it's not just triple-A paper that is drawing a larger investment base. According to Roever, European investors and structured finance CDOs have been snapping up the lower-rated paper, broadening the market for these bonds.
"Foreign banks have been helpful in stepping down in credit quality," Roever said. "They like the more spready stuff.".