Friday, November 19, 2010

Article 122a and the End of Global Securitization

On January 1, 2011, Article 122a of the European Capital Requirements Directive goes into effect.  This article requires European credit institutions, including banks and investment banks, to know what they own when they purchase a structured finance security.  Failure to do so results in the credit institution having to hold at least 100% equity capital against the investment.

Initially, knowing what you own applies to structured finance securities issued on or after January 1, 2011.  By January 1, 2014, knowing what you own applies to all structured finance securities.

What does know what you own mean?

It has been argued on this blog that know what you own for an individual security has three elements:  1) current information on the underlying collateral performance; 2) the terms of the deal; and 3) putting elements 1 and 2 into the analytic and valuation models of the investor's choice to independently value the security.

In the absence of any one of these three elements, an investor does not know what they own.  This point has been repeatedly made when discussing current information on the underlying collateral performance through the use of the Brown Paper Bag Challenge.  In the absence of any one of these three elements, an investor is blindly betting.

Could regulators decide that existing once-per-month disclosure practices are sufficient for knowing what you own?

Of course, but it is highly unlikely after they have taken the Brown Paper Bag Challenge.  Regulators know that 'when' a disclosure is made is as important as 'what' is disclosed.  This does not change even if regulators are buried under the mountain of minutia related to defining 'what' data will be disclosed by the sell-side dominated trade groups.

Why is Article 122a potentially the end of global securitization?

Currently, individual deals are designed to appeal to as many different investor groups as possible.  This includes European investors.

Under Article 122a, the capital charge effectively bars European investors from investing in structured finance securities that do not offer current information and instead offers once-per-month or less frequent reporting.

Without European investors, the market is much less global and the economic attractiveness of issuing the securities decreases.

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