Portfolio breakdown
The following lists how an originator’s portfolio could typically be broken down in order to grasp the portfolio’s particular characteristics and to assess whether they are suitable for a potential securitization transaction. The example used is a SME CDO.
Sample breakdown
. Breakdown by product (e.g., different loan or mortgage type)
. Breakdown by relationship management responsibility (e.g., retail business banking vs. corporate business banking)
. Breakdown by country code
. Breakdown by incorporation (i.e., incorporated vs. not incorporated) . By collateral (i.e., unsecured vs. secured loans)
. By type of collateral or security held . By Standard Industry Code (SIC)
. By loans subject to the Credit Consumer Act (CCA)
. By loan size, broken down into the following buckets: £0 –<£25,000, £25,000 –<£1m, £1m –<£5m,
and >£5m.
. By initial loan term, broken down into 0 to 1 year, 1 to 2 years, 3 to 4 years, 4 to 5 years, and 5þ years
. By loans subject to offset arrangements within different banking divisions . By drawn and undrawn balances
. By repayment type (structured, amortizing or, bullet repayment) . By legal entities (of that bank or a financial institution)
. By interest profile (i.e., fixed or floating) . By interest margin
. By refinance rates
. By loan documentation (i.e., standard loan documentation vs. loans potentially subject to challenge)
. ‘‘Scheme flags’’ (e.g., for small loans guarantee schemes that are guaranteed/protected by the government and hence would need to be identified and excluded from the pool that is to be securitized)
All information should be by total number of loans in each category and by the accumulated total loan balances for each category.
Deal economics
The economics of a new transaction are driven by many factors, Basel II (and going forward Basel III) being a major one: this considers many individual factors for the calculation. As a consequence, assessing the impact of Basel II/III can only really be done on a case-by-case basis; however, the following parameters influence the regulatory capital charges:
. Applicable Basel II/III calculation rules (e.g., standardized approach vs. internal ratings–based approach or IRB)
. Asset class of the underlying collateral . Capital structure
. Collateral quality (rating)
. Pool quality (granular vs. concentrated)
. Credit risk estimates (expressed by probability of default, PD, and loss-given default, LGD) . Performance analytics processes
. Translation, interpretation, and implementation of regulatory policies (retention rules and regulatory treatment of securitization exposures)
. Investor risk desire/appetite
. Market conditions (risk-averse environment)
. Opportunity costs (i.e., regulatory capital costs for similar risk exposure alternatives)
To make it more complex, Basel III will be coming into play from early 2011 with various impact assessment and calibration exercises and properly from 2013 with a phased implementation until 2018.
The key Basel III features impacting securitization and structured finance transactions are as follows:
. Effective from December 31, 2010, capital charges for banking book securitization exposures have increased and banks are only permitted to invest in securitizations if the originator or arranger retains 5% of the risk, unhedged, for the life of the deal. If they do not comply with this requirement, additional risk charges will apply immediately (i.e., there is no remediation period to rectify) and the application of these risk weights may in some instances render such investments economically not feasible. Corporate loans held in the banking book will otherwise not be affected.
. Since December 31, 2010, capital charges have increased materially for banks across their trading books. Among other changes, banks are now subject to new ‘‘stressed’’ VaR models, increased counterparty risk charges, more restricted netting of offsetting positions, increased charges for exposures to other financial institutions, and increased capital charges for securitization exposures.
Changes to the VaR models alone may double, triple, or even quadruple regulatory capital charges for loans and bonds that are ‘‘warehoused’’ in a bank’s trading book pending syndication, depending on the bank’s risk management practices and other factors.
New investor requirements
Paragraph 4, Article 122a of the Capital Requirements Directive details the new requirements for investor due diligence and with non-compliance increasing risk weights further.
Since January 1, 2011 investors are required to
. Have a comprehensive and thorough understanding of their individual securitization position including
— the risk characteristics of the individual tranche
— the risk characteristics of the underlyings
— the originator’s or sponsor’s reputation and loss experience
. Have disclosure by originator, sponsor, or original lender of the retention of net economic interest including an understanding of the due diligence statements and disclosures
. Understand the valuation methodologies and ensure the independence of the collateral valuers . Understand all structural features that can materially impact performance
. Regularly undertake their own stress tests
. Take due care to validate and understand the relevant model methodologies, assumptions, and results.
Practical issues
The Committee of European Banking Supervisors (CEBS) consultation paper on the guidelines of Article 122a (CP40) states that ‘‘the intensity of the due diligence process may vary’’ depending on whether the investments are part of a trading or banking book. The key argument here is whether or not threshold due diligence requirements should apply to the trading book which, if this is the case, would contrast with the use of the trading book as an effective risk management tool. There appears to be an inconsistency between the CP40 guidance and the actual Article 122a requiring further clarification by CEBS.
It may also be difficult in practice for institutions to ‘‘justify’’ to regulators if and how trading book positions are held with an intention to trade, but as a result of adverse market conditions may actually not be tradable.
Reducing overreliance on credit rating agencies vs. new regulatory requirements
Industry guidelines to reduce overreliance on credit rating agencies were jointly published by AFME/
ESF, the European Fund and Asset Management Association (EFAMA), and the Investment Management Association (IMA) in December 2008. They suggest that asset managers investing in structured credit products (SCPs)
. Have an obligation to act professionally and in the best interests of their clients requiring
— competent and diligent staff
— well-articulated investment processes
— risk analysis commensurate with the complexity of the structured product invested in and the materiality of the holding
— monitoring whether any determinations, opinions, or assumptions remain valid during the transaction’s life
. Understand the limitations to any credit ratings and address the risks arising given that credit ratings are
— incomplete descriptions of riskiness
— of a one-dimensional nature
— unable to capture risks other than credit risks (such as liquidity, market, and operational risks) . Understand the methodologies and competences of rating agencies
. Acknowledge that significant areas of information are not available to those relying on credit ratings including
— expected loss distributions
— probabilities of default
— differences in credit assessment criteria
. Understand that credit ratings should not be the decisive factor in investment decisions.
However, this contrasts with some of the new regulation, particularly around ‘‘stress testing’’ suggest
ing that investors relying on CRA financial models cannot simply use the outputs but are also required to run the actual models themselves. Such models are not always made publicly available and, moreover, it may prove difficult to validate the agencies’ assumptions that are used in structuring these deals.
Penalties for non-compliance
Failure to comply with these new requirements can lead to high penalty charges by applying additional risk weights, currently proposed to be of no less than 250% of the original risk weight.
For instance, if the original risk weight is 10%, the new risk weight would be at least 10% ỵ(250% �10%) ẳ 35%.
The (proposed) impact of non-compliance and the additional risk weights that will be added as a consequence are given in Table 5.5 (examples are based on an original RW of 10%).
In conclusion, whilst it was fairly simple to undertake and determine the economic impact of securitization transactions prior to the credit crisis, it has now become an art to figure out what the real benefit is. There are ways and means of calculating the economic benefit, but this is best done on a case-by-case basis and, unfortunately, I am not able to provide you with a template-style answer.
However, it is important to recognize that Basel’s risk sensitivity is one of the key drivers of capital dynamics, and subtle nuances in a deal’s capital structure can a have sizable impact on the regulatory costs.