Editor’s Letter

To start this Winter 2015 issue, Rachel George and Tim Mohan explain how the recent financial crisis demonstrated that, in contemporary markets, liquidity risk comes less from the outflow of deposits and more from cash demands associated with a range of wholesale borrowing and interbank financial arrangements. Hence, banking regulators across the globe saw a need to change their approach to regulating the liquidity risk of banks. They explain how the final liquidity coverage ratio (LCR) requirement will increase the costs incurred by U.S. banks that participate in the securitization market through extending commitments in securitization credit facility transactions, sponsoring securitization of their own assets, or investing in structured finance securities. In concluding their article, they question whether the new regulation designed to improve the liquidity risk profile of banks will reduce overall market liquidity by steering banks away from the securitization market.

Charles Sweet explains the U.S. SEC’s observation that “the financial crisis highlighted that investors and participants in the securitization market did not have the necessary information and time to be able to fully assess the risks underlying asset-backed securities and did not value asset-backed securities properly or accurately” and how Regulation AB II is intended to address those shortcomings. He notes that while the SEC did not adopt the most game-changing aspect of its proposals—which would have required issuers to provide investors in Rule 144A offerings the same information as in a public offering—many of the requirements that it did adopt will still change the offering process significantly, including the requirement to prepare and file a preliminary prospectus three days before pricing an issue, the need to provide new asset-level data, and the requirement for CEOs to sign certifications for each offering.

Meredith Coffey explains how the final U.S. Credit Risk Retention Rule for Securitizations offers very little relief for collateralized loan obligations (CLOs) and therefore will result in a continuing, although smaller, CLO market. Prior to the new rules taking effect in two-plus years, managers will be incented to do as many CLOs as possible. After the rules go into effect, investors are expected to migrate toward risk retention survivors who have or can find the capital to retain the risk, whether through existing resources, borrowing, parent companies with substantial capital, or working with their parents or investors to develop majority-owned affiliates that can purchase and retain risk. Ms. Coffey points to the role of CLOs in stabilizing the U.S. loan market and maintaining price stability by purchasing from other investors, such as hedge funds or mutual funds, who have to meet redemptions. To the extent CLOs are reduced, their place may be taken by less stable investors, leading to a more volatile, expensive loan market.

In assessing the overall impact of emerging legislation, including the new Regulation AB II, the new liquidity coverage ratio requirements, and the new credit rating agency rules, on asset-backed securities (ABS), Jason Kravitt, Sairah Burki, Manish Kapoor, and Calvin Wong see increased burdens but a few bright spots as well. The new asset-level data reporting requirements and shelf-eligibility requirements, including third-party asset review and CEO certification, in Regulation AB II and due diligence reporting requirements in the credit rating agency rules will require additional work for issuers. The lack of liquidity treatment for ABS and residential mortgage-backed securities (RMBS) in the LCR requirements will constrain securitization. But investors will welcome the increased asset-level data requirements and standardized static pool disclosures in Regulation AB II and third-party due diligence disclosures required by the new credit rating agency rules. Meanwhile, the continued prevalence of rating shopping in U.S. securitization markets underscores the failure of recent regulatory initiatives aimed at curbing the practice and the need for an alternative approach that balances the interests of all key stakeholders.

Noah Melnick, Caird Forbes-Cockell, Mark Middleton, and Jacques Schillaci note that applying the Volcker Rule is already complex, but it becomes even more complicated for vehicles that issue, on multiple occasions, separate series of notes backed by separate collateral pools. Although they share the same corporate issuer, each series of notes issued is completely separate from each other series, and only the collateral underlying that particular series is available to creditors relating to that series. Examples include participations in pools of loans established by banks and variable annuity contracts, the return on which is based primarily upon a pool of securities purchased with the proceeds of their issuance and maintained in a “separate account” at an insurance company, largely without recourse to the general account of the insurance company. The authors argue in this article that two portions of the Volcker Rule relating to determination of what constitutes a prohibited hedge fund or private equity fund must be applied on a collateral pool by collateral pool (i.e., a series by series) basis and not more generically to the nominal corporate issuer and/or all its issued series in aggregate. In other words, for a banking entity considering whether the Volcker Rule is implicated by a particular contractually “ring-fenced” series of notes (CR series) under a multi-issuance, special-purpose (MSPV) program, it would generally look only to that particular CR series. Of course, the desirability of intentionally being involved in an MSPV program that has some CR series that are covered funds and others that are not is highly questionable.

Steve Ornstein questions whether the consumer finance industry has overreacted to the “ability to repay” and risk retention regulations enacted under the Dodd–Frank Act, examines whether the consumer finance industry should consider making loans that fall outside the “qualified mortgage” and “qualified residential mortgage” safe harbors, and discusses the risks and rewards to the industry for pushing the boundaries of these Dodd–Frank parameters. He notes that even though non-prime, non-qualified mortgage loans pose greater risk, they still can be originated if they are properly structured. Notwithstanding complications related to risk retention, we are likely to see an emergence of a niche market of non-qualified mortgages/non-qualified residential mortgages arising from acute credit needs of the residential mortgage markets with hedge funds, certain banks, and REITs (real estate investment trusts) leading the way. The universe of creditors making non-qualified mortgages/non-qualified residential mortgages, however, is likely to be limited in a way that restricts the flow of credit.

Faith Schwartz explains how the common securitization platform (CSP) and the single-agency security continue to be priorities for the Federal Housing Finance Agency (FHFA) and the government-sponsored enterprises (GSEs). They are progressing on schedule. Both are designed to enhance the securitization functions of the enterprises by leveraging automation and straight-through processing; but even when they are live, they will only replace a small portion of what Fannie Mae and Freddie Mac currently provide to the market. The individual enterprises will continue to be the issuers, master servicers, and bond administrators, and will continue to stand behind the single-agency securities they structure.

Citing mortgage lending standards that were too loose in the housing bubble that led to the financial crisis and then overly restrictive, hampering the recovery, since the crisis, Wei Li and Laurie Goodman point to the need to strike a balance between credit availability and risk to achieve a healthy and sustainable housing market. That requires a method for quantifying credit availability. They show the limitations of four commonly cited measures of credit availability and explain a new measure they have developed based on the aggregate probability of default of a particular vintage at the time of origination. Assuming mortgage loans made at every point in time face the same probability of different economic scenarios, such as home prices and interest rates, they measure how the probability of default compares across origination dates. In other words, their measure factors out economic conditions, such as interest rates, home prices, unemployment rates, and GDP growth rates, which are uncertain at the time of origination, to focus directly on such lending-policy variables as minimum FICO scores, down payment requirements, debt-to-income ratios, and borrowers’ income documentation—as well as higher-risk, loan-affordability features such as teaser rates, balloon terms, interest-only terms, and negative amortization schedules—that are used by lenders to judge borrowers’ default risks and make mortgage loan decisions.

The next three articles focus on structured finance in Europe, covering related themes including new regulations to address the shortcomings of the securitization market, integration of capital markets within the euro area, coordination between the securitization and covered bond markets, and development of a market for securitized loans to small- and medium-sized enterprises (SMEs).

Adam Farkas and Christian Moor assess the health of the banking system and the prospects for increased securitization in Europe. The securitization market in the EU continues to be impaired. Banks are reluctant to use securitization as a funding tool, and investors are reluctant to invest in securitization products. Nonetheless, the European Banking Authority sees a number of compelling reasons justifying the development of a sound and controlled securitization market. New EU regulations have been put in place to address the shortcomings of the securitization market and de-stigmatize the securitization product. Coordination between regulators and central banks needs to be intensified to ensure consistent securitization regulation and a well-functioning market going forward.

Helmut Kraemer-Eis and George Passaris point to the difficulty small- and medium-sized enterprises (SMEs) in Europe often have in finding financing, on the one hand, and the large stocks of relatively illiquid loans to SMEs that euro area banks are holding on their balance sheets, on the other hand. The authors believe these illiquid loans can be pooled, transformed into liquid assets, and securitized. Recovery and development of the primary securitization markets can play a role in unlocking credit supply to the benefit of SMEs and economic recovery, but there are a number of structural roadblocks that have to be addressed, including regulatory issues. A compelling case can be made for public support to revive this market. In this context, not only does the supplied volume matter, but the positive signaling effect, triggered by the public involvement, can be equally important. The authors point out that transparency should be a prerequisite for any structured transactions. Hence, they say, “a particular focus should be put on the promotion of simple structures and well-identified, transparent underlying asset pools with predictable performance (‘high-quality securitization,’ or HQS) to revitalize the securitization market—and such a definition should include SMESec transactions.”

Andy Jobst explains the role of covered bonds along with securitization in the European Central Bank’s current policy efforts to support aggregate demand via further monetary easing, which can promote greater integration of capital markets within the euro area. The effective combination of covered bonds and securitization also represents a first step toward supporting broadening external sources of long-term finance for SMEs, as banks in the euro area are still focused on raising capital and are weighed down by impaired assets.

Maram Ahmed provides a review of the basic principles of Islamic finance followed by a case study of the project financing for Texas independent oil and gas producer East Cameron Partners in the first-ever sukuk issuance in the United States. The case study is a constructive example of how Islamic project finance can adhere to the principles of Shari’ah in a Western environment. Although the project was governed by U.S. law, it was able to indirectly accommodate Shari’ah principles and in turn to protect the rights of sukuk holders in a non-Islamic jurisdiction.

Henry A. Davis

Editor

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