A mix of uncertainity and optimism
The American Securitization Forum returned to Las Vegas for its annual conference and attendance was up. For 5,000 participants, the overriding sense was that the market was getting back to business as best it could. Uncertainty remains, though, and the question was asked whether enough of a U.S. securitization market will remain to keep that many people busy in 2012.
From what I saw and heard, there will be. For a start, any organization involved in the structured finance market must now do much more than before to even get a seat at the table. Uncertainty still bridles the optimism, however.
U.S. housing remains the biggest roadblock to the economy’s return to health and, in turn, the future private residential mortgage-backed securities market. While many predict home prices will bottom out this year, it’s not a given. Investors in private-label RMBS continue to seek higher yields to compensate for downside risk. Government policies that prevent home prices from reaching their natural bottom may delay the revival of the private RMBS sector.
DODD-FRANK IMPLEMENTATION
Did you know that only 13% of the Dodd-Frank Act has been implemented? Mandatory risk retention for issuers and the ambiguous definition of what constitutes a qualified residential mortgage should be finalized to bring greater clarity. Other amendments that must be made include sections on government-sponsored enterprise reform. These still don’t seem to include a policy whereby the private sector can be effectively eased back in, and the government gently sidled out.
Many participants mispriced risk in the mortgage markets during the years leading up to the crisis. A perfect storm of well-documented events led to the GSEs being one of the biggest losers. Implicit government guarantees to prevent further losses would only be a Band-Aid for the housing market, not an antidote. It is the government and the industry’s responsibility to push through prudent underwriting, standard loan-level information and consistent disclosures so investors can understand the performance and value of any given deal or securitization. In an ideal world, guarantees should only reflect the real risks.
CREDIT RATINGS ALTERNATIVES
Another headline on the regulatory agenda is market alternatives to credit ratings in risk-based capital. Capital allocation should, as far as is possible, reflect risk. Any exposures an investor has to mortgage securitizations must be clearly understood; scenario analysis should be performed to simulate the potential expected losses or prepayment risks. Cash flows should be projected based on an investor’s best and worst-case assumptions of future credit performance. Ratings played this role in the capital allocation mix in the past. The rating always intended to reflect that intrinsic credit quality, but we all know that fundamental assumptions to those models were wrong.
Removing ratings makes it challenging for regulators to craft capital standards that are sensitive to gradations of credit quality. Rather than remove ratings from the process altogether, they should be embraced as another point of reference — an independent benchmark to cross reference an investor’s own analysis and assumptions.
The ASF said the key to “the selection of any measurement of creditworthiness for securitization exposures is promoting risk management, adequately capturing the risks of particular exposures, providing for timely and accurate measurement of changes in creditworthiness and minimizing opportunities for regulatory arbitrage.”
Instead, the alternatives to ratings proposed in a notice of proposed rulemaking are more simplified, formulaic approaches to calculating risk-based capital. These could penalize U.S. investors disproportionately for holding even the highest credit quality notes in a new, super-transparent, jumbo-filled RMBS. They could have to hold as much as 20% capital, compared with around 7% for their European Union counterparts who fall under the already implemented Basel II securitization framework enhancements.
Basel II and Basel II.5, which advocate the ratings-based approach, have been deployed in European jurisdictions. However, it is very clear that investors and issuers cannot rely on ratings when providing disclosure or making investment decisions. Any use of a rating must be justifiable through the disclosure of independent credit analysis undertaken for any deal. It seems a more commonsense approach to allocate capital based on perceived and carefully calculated credit risk exposure.
Many in Europe may still think capital charges are punitive and that rules mandating securitization investors to do their own analysis are a bit condescending, but at least there is a process in place to demonstrate an understanding of risk — and then allocate capital accordingly. U.S. proposals take what is already a well-defined and internationally accepted framework and then, in a bid to be more transparent, oversimplify risk-weightings.
Interestingly, notices from the Basel Committee recently pointed out how European Union banks are already looking at ways to find capital relief for higher risk securitization tranches. The model is pretty simple, but sounds like a regulator’s worst nightmare. A bank buys protection on mezzanine tranches from hedge funds or other counterparties in order to de-risk their balance sheet. To eliminate the resulting counterparty exposure, the fund must post collateral with the bank in the form of cash assets. This mechanism provides capital relief for banks and a source of good returns for funds with higher target yields.
It may look like banks are trying to pull the wool over the regulator’s eyes but even Basel acknowledges that this method can significantly reduce credit risk, provided portfolio guarantees are “direct, explicit, irrevocable and unconditional.”
The securitization market is just waiting for politics to catch up so it knows where it stands and so it can move on without regulatory uncertainty sapping market confidence.
Douglas Long is the executive vice president of business strategy at Principia, a structured finance software provider.
