Sunday, January 16, 2011

More on Article 122a and the Implication of the Ibanez Decision

As readers of this blog know, Article 122a of the European Capital Requirements Directive requires that credit institutions investing in structured finance securities be able to prove that they know what they own.

What does prove that you know what you own mean?

It means that these credit institutions have to document their due diligence process for each structured finance security and show that they actually completed it.  For example, Article 122a specifically cites the need for these investors to look at the individual underlying assets backing the structured finance security.

What if a credit institution cannot show that it knows what it owns?

There are two basic penalties for failure of a credit institution to demonstrate that it knows what it owns.

  • The credit institution cannot use leverage to support its portfolio of structured finance securities.  The portfolio has to be financed using only the capital of the credit institution.
  • If the credit institution is acting as a fiduciary, it is liable for any losses on the structured finance securities.  The only way out of this liability would be to disclose that the credit institution is blindly betting on the value of the structured finance securities.
Where does the Ibanez decision come in?

The Ibanez decision directly impacts the due diligence European credit institutions should perform to show that they know what they own.  With the Ibanez decision, European credit institutions know that

  • The collateral that was represented by the issuer as being assigned to the trust supporting the structured finance security is not always assigned.  Therefore, the European credit institutions cannot rely on issuer representation that there is collateral backing the security.
  • Trustees will confirm that they received the collateral even when they did not.  Therefore, the European credit institutions cannot rely on Trustee representation that there is collateral backing the security.
The bottom line is that European credit institutions now have to confirm for themselves that each of the individual loans/receivables that was represented as being assigned to the trust was in fact properly assigned and received by the trust.

Absent first hand knowledge of the proper assignment of each individual loan/receivable and receipt by the trust, under the Ibanez decision, European credit institutions do not know what they own.  At best, they have to assume they are buying non-asset backed structured finance securities.

The industry trade groups and lobbyists have been pushing the argument that Ibanez was a unique situation with limited applicability to other structured finance securities.

Adam Levitin in a recent posting titled "Ibanez:  About that Loan Schedule...." addresses the issue of is Ibanez unique and not a cause for additional due diligence to confirm the proper assignment of the collateral or is Ibanez applicable across a wide swath of structured finance securities.
So how do other PSAs fare under the Ibanez metric?  I've been looking at them, and it seems that there are lots of RMBS deals where the schedules in the PSAs are possibly insufficient to meet the Ibanez standard.  And that means that there are lots of RMBS trusts that might not be able to successfully foreclose in Massachusetts or maybe in any other title theory state. 
Bottom line, given the penalties and liabilities under Article 122a and the inability to prove that they know what they own, European credit institutions would be better off not purchasing any more structured finance securities.

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