The latest plans of international regulators for capital adequacy requirements threaten to cripple the securitization industry, bankers reckon. Proposals from the Basle Committee on Banking Supervision would force banks investing in asset-backed securities to hold a much larger amount of capital in reserve than for corporate bonds of the same credit rating.
“The securitization group seems to have set off on its own path, which does not align with the Basle II process at all,” says a UK banker.
“The extra capital requirement, which is not justified, will harm securitization unless it is changed,” says Mark Nicolaides, a securitization partner at Mayer, Brown, Rowe&Maw. “The regulators are going to impair the ability of people to do deals, and they’re going to increase the costs of doing deals.”
The rationale of the Basle proposals is to make sure banks put enough aside to cover investment losses. The proposals set a standard rate of 8% as the typical amount a bank should hold against an investment. Then, a multiple known as a risk weighting is applied depending on how risky the product is.
A double-B corporate bond is risk weighted at 150%. So a bank buying such a bond must set aside one-and-a-half times the 8% base rate of capital – $12 million – in reserve for every $100 million it buys. No bank likes to tie up large amounts of capital against static assets, so the higher the reserve required the less attractive the investment becomes.
It’s small wonder the proposed weightings for securitizations have angered bankers. Under the simpler of two options available for banks to calculate capital requirements, an asset-backed bond rated double-B to double-B-minus has a weighting of 350%, more than twice that of a corporate bond with the same rating. Under the more advanced approach a bank would also be forced to set aside much more capital.
The Basle Committee says it has reasons for taking this stance. “Rating agencies estimate either default probabilities or expected losses but the regulatory capital regime is based on the concept of unexpected losses,” says a committee spokesman. “The relationship between expected and unexpected losses is different between securitization tranches and corporate bonds.”
A good track record
Industry groups such as the European Securitization Forum, the International Swaps&Derivatives Association and the British Bankers’ Association are lobbying for the proposals to be changed. Bankers say there is no evidence to suggest that asset-backed securities are any more risky than corporate bonds. They argue that the performance of securitizations over the past 20 years proves the regulators wrong. Between 1978 and 2000 there were only 116 defaults on structured securities, according to a Standard&Poor’s report published in September 2001. That was fewer than one in a hundred of the total number of credits rated over the same period. “Sound cashflow structures coupled with rigorous rating criteria proved to be the key to the strong credit performance of structured securities,” the study concludes.
The data covers enough time to include recessions as well as booms, and statistics for the performance of asset-backed bonds during the present economic difficulties are also positive, according to Scott Rankin, executive director at the European Securitization Forum. Meanwhile, by contrast, scandals such as Enron and WorldCom show how unreliable corporate credits can be.
Bankers say the Basle Committee is also guilty of double counting. The regulators base one method of determining capital requirements on the ratings produced by agencies such as S&P. They then impose an extra credit charge for asset-backed positions. This is based on criteria the agencies will have considered already, say the banks.
Simon Hills, a director of the British Bankers’ Association, says: “For example, Basle proposes a risk weighting depending on the number of exposures in the portfolio on a deal. But this is one of the issues already taken into account when the agencies assess a structure.”
The committee’s distinction between expected and unexpected losses is double-counting, too, say bankers. The agencies do not simply extrapolate from past data to forecast expected losses, as the regulators maintain. Their calculations account for extensive possible losses too.
Just how much damage extra capital charges would do remains hard to say.
Banks buy about 20% of double-B rated asset-backed bonds. This seems a small number, but as Alexander Batchvarov, managing director of international structured credit research at Merrill Lynch, says: “The impact is greater than the numbers suggest. If you can’t sell your double-B tranche you don’t have a deal.”
If Basle II were extended to insurance companies, as has been unofficially mooted by some regulators, it would cover about 90% of the potential investment in double-B asset-backed bonds. The likely impact would be a rise in the cost of funding to issuers.
Batchvarov says: “What would investors rather hold – a double-B UK prime mortgage securitization and have a 350% risk weighting, or a B-minus Argentine risk and have a weighting of 150%?” How high funding costs might rise remains to be seen.
Rob Mannix (rmannix@iflr.com) is editor of Euromoney’s sister publication International Financial Law Review
