Monday, October 22, 2012

Asset-backed securities could face tougher Basel capital requirements

Are the Basel bank capital requirements about to catch up to the global standard set by the National Association of Insurance Commissioners (NAIC)?

Regular readers know that the NAIC set the global standard in its white paper on the Future of Mortgage Finance.  In this white paper, the NAIC linked the amount of capital that an insurer needs to hold against an asset-backed security to the disclosure provided by the security.

Specifically, the white paper looked at the two dimensions of disclosure:  frequency and completeness.

There are two frequencies of disclosure for asset-backed securities ranging from covered bonds to structured finance securities:  observable event based reporting and out of date.

Under observable event based reporting, all activities like a payment or default involving the underlying collateral are reported before the beginning of the next business day.  With observable event based reporting, investors have current information and know what they own.

Out of date covers all other disclosure frequencies including once per month or once per quarter.  With out of date disclosure, investors don't have current information and therefore cannot know what they own or what they would be buying.  As a result, buying asset-backed securities that provide out of date disclosure is simply blindly betting.

There are two levels of completeness of disclosure for asset-backed securities ranging from covered bonds to structured finance securities:  complete or incomplete.

Complete disclosure for asset-backed securities involves disclosing all of the data fields tracked on the underlying collateral while maintaining borrower privacy.  Complete disclosure recognizes that the firms that do the billing and collecting of the underlying collateral are experts.  Since they are experts, it makes sense to look at all the data fields that they track as they would not track a data field they think is unimportant.

Incomplete disclosure for asset-backed securities involves disclosing a subset of the data fields tracked by the experts.

The NAIC set the global standard by indicating that asset-backed securities that provided complete disclosure on an observable event reporting basis would require less capital than asset-backed securities that provided incomplete disclosure on an out of data reporting basis.

According to a Bloomberg article,

Banks trading asset-backed securities may face tougher capital requirements and stricter oversight from global supervisors amid concerns that regulation is failing to curb excessive risk-taking. 
The Basel Committee on Banking Supervision is about to embark on a “fundamental” review of how securitization is regulated, Wayne Byres, the group’s secretary general, said in an interview last week. 
“Ultimately it’s driven at capital treatment, but it’s also about reflecting on what have we learned from the crisis about securitization, and the way risks within securitization work,” Byres said. 
The boom in the U.S. and European markets for securitized debt in the years leading up to 2008 has been identified by regulators as one of the main reasons for the collapse of Lehman Brothers Holdings Inc. and the ensuing financial crisis, as lenders struggled with a plunge in the debt’s market value. 
Securitization has also been the subject of lawsuits, amid accusations that some instruments were flawed or even designed to incur losses. 
Eric Schneiderman, the New York attorney general, said this month that a suit against JPMorgan Chase & Co. (JPM), the biggest U.S. bank, will serve as a template for other legal challenges.

Schneiderman has alleged that the Bear Stearns business that JPMorgan took over in 2008 deceived mortgage-bond investors about the defective loans backing securities they bought, leading to “monumental losses.” 
Some steps taken by regulators on securitized debt don’t take into account recent credit quality and price performance “of European asset-backed securities since the onset of the financial crisis,” Richard Hopkin, a managing director at the Association for Financial Markets in Europe, said in an e-mail. 
“We believe it is now time for policymakers to send more positive regulatory signals to the market that better reflect this evidence,” he said.
The most positive regulatory signal would be to require banks to hold 100% capital when they blindly bet on asset-backed securities that provide incomplete data on an out of date basis.

At the same time, banks should be required to hold much less capital when the asset-backed security provides complete information on an observable event basis and banks can know what they own.
AFME represents lenders and brokers including Goldman Sachs Group Inc. (GS)Bank of America Corp. (BAC)Deutsche Bank AG (DBK) and UBS AG. (UBSN).... 
In 2011, new securitized debt issuance in the U.S. was $124 billion, down from a peak of $753 billion dollars in 2006, according to data compiled by the Securities Industry and Financial Markets Association
A lack of bank-capital rules may have led to the securitization boom before the crisis, according to the International Organization of Securities Commissions.

“What will come out before the end of the year will be more a concept paper than a detailed set of rules,” Byres said. “It’ll pose some questions.” 
“Ideally, if the framework can be simplified that would be good,” Byres said. A reduced reliance on credit-rating companies, “would be good too.”
Simply adopting the NAIC's framework achieves these goals.

No comments: