Source: www.breakingviews.com is Europe’s leading financial commentary service.
Securitization has been one of the big growth areas of the capital markets. So it is no surprise that investment banks and a ratings agency are concerned about the proposed new Basle II rules on bank capital. These, they fear, could act as a major drag on market development.
The new Basle accord threatens their earnings from securitization, a technique whereby loans are converted into tradable securities. It does this by both reducing the incentive for banks to securitize their loans, and making the process itself more capital-intensive.
The proposals themselves are fiendishly complicated. But the complaints focus on two areas. One is that the new accord reduces the capital charge banks have to take against certain classes of loans, such as mortgages, personal loans and smaller company loans, that tend to be heavily securitized under the existing regime. This concession, it is argued, makes it less likely that banks will securitize the same volume of these assets in future as they do now.
The second beef is that the new accord actually penalizes securitization. Take as an example the case of a bank securitizing a pool of five loans with a total value of $100, against which it is obliged to reserve in aggregate capital of $10. The bank issues 10 tranches of securities against the loans, each with a capital value of $10. The tranches tier down from a triple-A rated top one to a first-loss or equity-like tranche at the bottom that is unrated.
Many banks tend to retain some or all of the bottom equity tranches of the loan, not least because they are hard to sell. Standard & Poor’s argues that in certain circumstances the securitizing bank that did this would have to reserve more capital against its stub position than it had against the underlying loan. In our example, a bank that retained the bottom slice of the securitization might end up reserving more than $10 against its holding.
Soaring capital costs The net result would be that the capital required to back securitization business would go up. Indeed, in the latest study of the likely impact of Basle II undertaken by major international banks, participants concluded that the rules would force them to double the amount of capital they devoted to securitization, assuming constant volumes of business. Given the need to get a return on that additional capital, the cost of securitizing a loan should rise.
Huge sums are at stake if this happens. S&P, which warns that Basle II could lead to a “significant decrease” in volumes, says $650 billion of loans were securitized in the US last year, and $135 billion in Europe. Securitizations generated approximately one-third of the $8 billion of gross fees earned by banks in the debt capital markets during the first half of this year, according to Dealogic.
For ratings agencies, securitization probably represents a far bigger slice of the revenue pie. Structured finance accounted for 46% of global ratings revenue at Moody’s during the second quarter of the year. What’s more, it is growing faster than the rest of the business. Unlike Moody’s, S&P and Fitch are part of wider businesses that don’t disclose as much detail. But securitization is still hugely important to them.
The banks and ratings agencies are likely to mount a fierce attack on the accord. And they have some good arguments. It seems perverse, for instance, that banks should be forced to set more capital aside against securitized assets. It is hard to see how securitization itself makes a loan any more risky. An even stronger argument is that the proposals go against the Basle Committee’s stated intention of making the impact of the accord neutral on markets. Their main enemy is time. The accord is due to be set in stone at the end of this year.
Of course, if the accord ultimately stands and securitization volumes do fall, borrowers will fund themselves through different channels. The revenue won’t just disappear. However, bankers say securitization is more profitable for them than managing unsecured deals. And the same probably goes for the ratings provided by S&P and its competitors.
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