The ABS market faces myriad new regulations causing disruption in some securitization sectors, including the creation of new ABCP conduits.
However, the so-called Volcker Rule, proposed in mid-October by the Securities and Exchange Commission and banking regulators, would not only crimp specific markets like ABCP but more importantly reshape the ABS and broader fixed-income markets.
The rule, called "Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds," aims to prohibit or restrict proprietary trading, including investments in "private funds" such as hedge funds and private-equity funds, by broker-dealers with commercial bank affiliates.
ABCP and the Proprietary Trading Issue
On the surface, ABCP conduits do not appear to engage in proprietary trading, at least according to the common notion in which a trading entity puts its capital at risk to bet on the price movement of an asset. Comments from market participants are due Jan. 13.
From a regulatory perspective, however, private funds include any issuer that relies on exemptions to the Investment Company Act of 1940, most commonly under Sections 3(c)(1) and 3(c)(7), which were originally intended for vehicles more closely resembling private-equity funds and hedge funds.
ABCP conduits typically also rely on those exemptions, and so constitute private funds and fall under the Volcker proposal.
"The problem with the Volcker Rule is that in attempting to define what private-equity funds and hedge funds are, the regulators used shorthand that sweeps in a lot of other structures," said Jason Kravitt, co-head of Mayer Brown's securitization practice.
Kravitt said most of the ABCP vehicles, including those he has played a role in designing, have used those exemptions because there are few restrictions on the types of assets that can be put into them.
In fact, that may be part of the reason the Volcker proposal's language hits ABCP hard, since conduits accepted an increasingly wider variety of often riskier assets leading up to the financial crisis.
An article by attorneys at Chapman and Cutler published earlier this year in the Journal of Structured Finance noted that ABCP originated in the early 1980s to enable banks to provide their customers with more cost-efficient money-market financing of trade and lease receivables and other commercial assets.
However, it quickly became a financing tool for assets ranging from equipment-lease receivables to insurance premiums to commercial and residential mortgages to funding commitments under credit default swaps.
Many of the programs emerging, including now-moribund structured investment vehicles (SIVs), were no longer fully or significantly supported by banks, and the volume of transactions that fell under the ABCP umbrella ballooned to $1.2 trillion in the summer of 2007, according to Chapman and Cutler.
In the wake of the financial crisis, the law firm said, that volume has plummeted to less than $400 billion and comprises mainly traditional ABCP transactions. Those programs issue highly rated notes with maturities not exceeding 270 days, use proceeds to acquire assets from unaffiliated originators, and can access committed liquidity from one or more highly rated liquidity providers.
Narrowing the Scope
Even more conservative traditional programs, however, would face hurdles under the Volcker proposal.
Kravitt said that regulators apparently sought to narrow the broad sweep of the proposed rule by providing an exemption to ABCP programs that securitize loans, defined as loans, receivables and leases. That's the majority of assets put into ABCP conduits these days. While that is a good start, Kravitt said, the Volcker proposal does not exempt those transactions from Section 23A of the Federal Reserve Act.
The Fed rule prohibits banks that sponsor, manage or advise a conduit fund from providing loans or other forms of credit extensions to the fund. So while the Volcker proposal permits banks to sponsor and hold ownership interests in ABCP conduits that qualify for the loan securitization exemption, they can't provide those conduits with credit enhancement or liquidity facilities.
Chapman and Cutler said in an Oct. 26 client alert that the Financial Stability Oversight Council, conforming with its Dodd-Frank Act responsibilities, noted in its report on the Volcker Rule that Congress did not want the statute to inhibit loan creation. The law firm went on to say that the current proposal therefore "appears to be inconsistent with Congressional intent."
The client alert mentions ways to work around the Volcker proposal hurdles in a limited fashion and that, based on clients' and its own discussions with regulators, the intent is not to shut down the traditional, multi-seller conduits. It adds that a safe harbor or other measures to ensure that structure's viability could arrive, but there is no "assurance that any such relief will be available."
Kravitt said banks could also choose to rely on Section 3(a)(5) or 3(a)(7) exemptions from the Investment Company Act, but they present significantly greater restrictions on the types of assets that can be used and other factors.
The Volcker proposal would also have a significant impact on the overall liquidity of the ABS market. However, it is only one of a long list of outstanding regulatory initiatives that could negatively impact securitization, and specifically the ABCP market.
In a report last January, Fitch Ratings noted six additional yet-to-be-resolved issues impacting ABCP, including Basel III's liquidity coverage requirements, the SEC's Reg AB-II and the Dodd-Frank Act's risk retention rules.
Chapman and Cutler's article actually lists 14 issues that would prompt fundamental changes to ABCP structures and describes additional regulatory proposals that would increase compliance costs.
That regulatory uncertainty has clearly been an important factor behind the dearth of traditional ABCP conduits created over the last few years.
"The regulatory overhang has been going on for a long time," said an ABCP analyst at a major institutional investor. "Upper management doesn't want to commit to a new conduit."
Volcker Rule and Fixed-Income Markets
If the final Volcker Rule echoes the proposal, it will clearly be among the top contenders to not only inhibit ABCP activity but impact the overall ABS market.
In fact, it would dramatically reduce the liquidity-providing activities of bank-affiliated Wall Street firms in the less liquid realms of the ABS market, especially for privately placed issues. And since many of those brokerages, the likes of Citigroup, Goldman Sachs and JPMorgan, are major players in the market, securitization stands to become a much less viable source of financing.
In fact, the Volcker proposal hits the bond market, and consequently the ABS market, harder than any other security market.Trading in U.S. government bonds, hedging and underwriting IPOs and other transactions to minimize price swings are forms of principal trading that are exempted by the proposal. But virtually all others are considered prohibited proprietary trading.
Market making is also permitted, but only if a trading house is "making continuous, two-sided quotes" and "holding oneself out as willing to buy and sell on a continuous basis." That's all but impossible in the ABS and broader fixed-income markets, where there is no exchange to post quotes and there are hundreds of thousands of CUSIPS compared to thousands in the equity market.
In addition, there's no formal designation for market makers, and that important liquidity-providing activity is performed by dealers when the need arises - hardly fitting the criteria to be a market maker under the Volcker proposal.
Hardy Callcott, a partner at Bingham McCutchen, said that buy-side investors trading less liquid bonds often want a dealer to commit capital to take their positions. "But the way this has been proposed, that probably will not count as market making," Callcott said. "I think this will have a severe effect on liquidity in the fixed-income markets."
In addition, the Volcker proposal requires broker-dealers to make markets in a bond CUSIP if the dealer is to use its own capital to facilitate client trades in that bond. Those broker-dealers tend to be part of Wall Street's biggest banks, which have massive capital bases. So if the final rule limits their roles as market markers in ABS and other fixed-income, neither will those institutions be able to use their capital to facilitate customers' large trades - another punch in the liquidity stomach.
Brad Hintz, an analyst covering the securities and asset-management businesses at Sanford C. Bernstein, said most market participants anticipated the Volcker proposal prohibiting "non-client facing" trading, rather than trades aimed at helping a client buy or sell a block of securities. But in fact the proposal was much more onerous than expected.
In a "quick take" to clients, Hintz noted that the proposal has an "almost Napoleonic code" tone, presuming "improper proprietary trading if a desk books more revenues from price movements and risks than commissions and bid-offer spreads."
Given that Wall Street firms earn part of their keep providing liquidity to market participants, a final Volcker Rule resembling the proposal will likely hit their bottom lines. Bernstein estimated that the Volcker proposal would knock a third off broker-dealers pre-tax margins stemming from fixed-income to 17.6% from 24.9%.