Finance Alert: European Commission Releases Proposals on Securitization

On September 30, 2015, the European Commission released two sets of proposals[1] whose express intentions are to regularize the treatment of securitizations across firm and national boundaries in the European Union (EU) and to adjust the capital requirements for securitization exposures to better reflect their risk. The Securitization Proposal not only standardizes the treatment of securitizations across the EU; it also introduces a special category of securitizations that are referred to as simple, transparent and standardized (STS). The Capital Proposal, in turn, not only suggests detailed changes to the general rules but also proposes to allow entities holding securitization exposures to STS to hold less capital against such exposures than might otherwise be required. The introduction of a new and specific category of simple, transparent and standardized securitization with its own more lenient regulatory capital treatment has been promoted heavily by certain industry bodies for some years now, and has been long and eagerly awaited by the market.

When the Securitization Proposal is finally adopted, the regulation it contains (the Securitization Regulation) will enter into force on the twentieth day following its publication in the Official Journal of the European Union. It will apply to securitizations whose securities are issued on or after such entry into force. However, existing securitizations may be treated as STS if they satisfy the requirements of the regulation; the revised due diligence requirements apply to institutional investors (i) when there are, after December 31, 2014, additions to or substitutions for underlying exposures held by securitization vehicles that issued securities and (ii) when the exposure is to a securitization vehicle that issued securities on or after January 1, 2011. Some provisions in effect prior to the entry into force of the Securitization Regulation will continue to apply to securitization positions that were outstanding as of such entry into force. Original lenders, originators and sponsors will remain subject to the current risk-retention rules until new regulatory technical standards are adopted pursuant to the Securitization Regulation; similar transition provisions apply with regard to the disclosure provisions applicable to securitizations.

The Capital Proposal does not contain complicated transition provisions. Once adopted, the regulation it contains (the Capital Regulation) enters into force and applies on the twentieth day after its publication in the Official Journal. However, if institutions notify the relevant competent authority by a certain date, they may apply certain current provisions to all securitization positions outstanding on the date of entry into force. These provisions include the current securitization provisions in the Capital Requirements Regulation (which would be replaced by the Capital Regulation) and the related capital (own funds) requirements.

The Securitization Proposal

General Provisions

Under the Securitization Proposal the burden of compliance would no longer rest solely on the buyers of securitization exposures (i.e., the investors). Depending on their roles, other parties to a securitization transaction would become directly responsible for compliance and would also be subject to extensive disclosure requirements that are intended, in part, to make it easier for investors to comply with their diligence obligations. The amount of information that a sponsor is required to disclose, and an investor is required to review, is quite substantial, even for non-STS transactions, and investors will, it appears, need to be able to do a fair amount of financial modeling.

The definitions of the terms indicating the other parties to a securitization would remain largely unchanged. However, in satisfaction of a recommendation of the European Banking Authority, the definition of “originator” would be narrowed to preclude the use of special purpose entities without “a broad business purpose.”[2] Little is said about what would constitute such a purpose other than that an originator would need to be able to meet payment obligations “from resources not related to the exposures being securitized.”[3] The nature and size of the relevant payment obligations are unclear, as is the required breadth of the business purpose. Moreover, the information just described is contained in the explanatory text of the Proposal, and not in the regulatory text. The regulatory text itself contains somewhat confusing wording on this issue. Paragraph (19) of the preamble (the portion of the text containing “whereas” clauses) states that an originator should securitize only exposures that satisfy underwriting criteria that are no less stringent than those applied to exposures which the originator does not securitize. If this were a generally applicable criterion, then the broader business purpose of an originator would have to at least include a wide financing business. Although paragraph (19) is stated generally and without reference to STS transactions, it is found in the midst of other paragraphs that deal with STS. The actual regulatory provision that expresses this requirement also appears only in the STS provisions, which suggest that it is not of general applicability.

The only relevant provision in the non-STS portion of the Securitization Proposal merely provides that, for purposes of the risk-retention provisions only, an entity cannot be treated as an originator if it “has been established or operates for the sole purpose of securitizing exposures.”[4] Under these circumstances, only the meaning of the word “sole” and the general language in the explanation are available to determine what kind of purchaser of securitization exposures might count as an originator. In STS transactions, however, the more specific requirement referred to above would be applied pursuant to Article 8(6), with the apparent consequence that entities engaging in STS transactions may have to work with a more stringent definition of “originator” than they do when engaging in non-STS transactions.

Some of the other provisions are perhaps best described by comparing them with the relevant US rules. For example, the same five basic risk-retention possibilities would be retained, including the randomly selected exposure method and the reliance on nominal as opposed to fair values, neither of which is permissible in the US except for the reliance on nominal values when risk is retained using a vertical slice. More importantly, perhaps, the EBA (working with the European Securities and Market Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA))[5] is required to develop regulatory technical standards to specify the details of risk retention within six months after the Regulation goes into force, even though such standards in large part already exist.

The EU risk-retention rules continue to require that only one of the originator, sponsor or original lender shall retain the required risk, with the default retainer being the originator. They also contemplate synthetic and contingent risk retention, whereas the US rules contemplated only funded retention, with the exception of revolving trust structures. The originator, sponsor and original lender are permitted to choose which of them will be responsible for providing the information demanded by the disclosure requirements. There is no equivalent provision in the US rules.

The maximum maturity for commercial paper issued by an EU asset-backed commercial paper (ABCP) conduit would be 365/366 days, compared to the maximum US ABCP maturity of 397 days. ABCP conduits would have to provide monthly data on all cash flows and liabilities, except for the ABCP itself.

Traditional securitizations in the EU would expressly be permitted to hold (sub)participations, a practice that is less common in the US because of the difficulty of obtaining true sale opinions under those circumstances.

Because covered bonds are perceived to be similar to securitizations, the rules governing covered bonds would be amended by the Securitization Proposal.

Provisions Applicable to STS Transactions.

The provisions applicable to such transactions are broken down into those that apply to STS transactions other than ABCP and those that apply to ABCP.

Non-ABCP STS

The vehicles used in non-ABCP STS transactions will not be permitted to be managed actively, and must have underlying exposures that are homogeneous in terms of asset type, have defined periodic payment streams and do not constitute transferable securities or securitization exposures. It is here also that the requirement is stated that the originator shall originate underlying exposures using underwriting standards no less stringent than those utilized in originated exposures that are not securitized. Additional quality requirements will apply to residential loans, although not of the detailed nature specified in the US if the qualified mortgage exception is claimed. Repayment of the holders of securitization positions will not be able to depend significantly on assets securing the underlying exposures, a requirement that resembles US rules associated with the Investment Company Act of 1940 rather than the US rules on risk retention. Hedging of interest rate and currency risk will be required, but other than derivatives of those types no synthetic underlying exposures will be permitted. Substantial amounts of cash may not be trapped in the vehicle after any revolving period ends. Numerous contractual provisions relating to servicing, termination, restructuring and dispute resolution will be required.

With regard to disclosure, provisions that in some ways resemble those in Regulation AB II will be imposed. For example, certain kinds of seven- and five-year historical data will have to be provided; a sample of that data will be required to be verified by independent parties and liability cash flow models will have to be given to investors both before the pricing and on an on-going basis. Interestingly, the originator, the sponsor and the issuing vehicle will be jointly responsible for the data required by the general, non-STS disclosure provisions and will have to make such data available before pricing. Final disclosure documentation will be required within 15 days after closing.

ABCP STS

An ABCP program that wishes to qualify as STS must satisfy both program-level and transaction-level requirements. Although it may prove beneficial for ABCP programs to claim STS status, there does not appear to be any requirement that all ABCP programs satisfy the special ABCP STS requirements. The proposed new capital requirements, discussed below, may also have an effect on the viability of ABCP programs.

ABCP STS transactions must satisfy the requirements contained in the general STS portion of the Securitization Proposal, except for those relating to homogeneity of asset type, underwriting standards and business of the originator, the trapping of cash, early amortization, the contractual specification of duties, dispute resolution and the requirement to provide a liability cash flow model. The special ABCP rules have their own requirements in these areas.

The applicable transaction-level requirements can be summarized as follows. Underlying exposures must be homogenous by asset type; their weighted average life may not exceed two years and no underlying exposure may have a remaining maturity of more than three years. There is an express prohibition on any underlying exposure being secured by a residential or commercial mortgage (although somewhat inconsistently, another provision establishes standards for residential loans). After a seller’s[6] default or acceleration event, cash may not remain trapped in the conduit. Sellers must, by negative implication, be engaged generally in extending credit, since the underlying exposures they originate must be originated pursuant to underwriting standards at least as stringent as those applied to exposures that are not securitized. A number of other requirements apply with regard to terminations and the replacement of servicers, swap counterparties, etc., including a provision that requires the sponsor to conduct diligence with regard to the seller’s underwriting standards servicing capabilities and collection processes.

The program-level requirements for ABCP STS include a prohibition on resecuritization and on the creation of additional tranches using the credit enhancement. Sponsors must be EU-supervised credit institutions, must provide a liquidity facility and support all the securitization positions at the transaction level, and must cover all liquidity, credit and material dilution risks as well as all transaction and program costs. All interest rate and currency risks must be hedged, and no other derivatives may exist in the program. Various contractual protections and arrangements must be present, and the originator, sponsor and securitization vehicle must be jointly liable for compliance with the generally applicable disclosure requirements. Disclosure documents must be made available in draft before pricing and in final within 15 days after the closing. It is unclear which pricing and which closing are being referred to.

ESMA must be told that a securitization meets the STS requirements, maintain a list of STS transactions and develop (in cooperation with the EBA and the EIOPA) regulatory technical standards for compliance with the STS requirements. Member States of the EU are charged with the responsibility of developing sanctions, including criminal penalties, for violations of the provisions in the Securitization Proposal, although the Proposal sets some limits to the severity of those sanctions.

The Capital Proposal

This Proposal is specifically paired with the Securitization Proposal in an effort to make the treatment of securitization more uniform, to adjust the capital requirements to better reflect the current understanding of the riskiness of various positions and to establish special requirements for STS transactions. It does this by, among other things, restating relevant portions of the Capital Requirements Regulation.

Among other things, the Capital Regulation would establish a new hierarchy of methods for computing capital required to be held in connection with securitization exposures, namely, the specially adapted Internal Ratings-Based Approach, External Ratings-Based Approach and Standardized Approach, in that order. In addition, the Capital Regulation spells out the detailed conditions that must be satisfied if the sponsor of an ABCP conduit wishes to obtain permission from the competent authority to use the Internal Assessment Approach. Although these conditions may require considerable effort to satisfy, they do not require the conduit to be STS.

In connection with the establishment of the new hierarchy, the Capital Regulation would recalibrate the formulae used in the various approaches and allow the broader use of a look-through approach to set a cap on the capital requirements for senior securitization positions. In addition, the conditions under which a look-through approach can be used to cap overall capital requirements for securitization exposures would be broadened. On the other hand, the capital requirements for resecuritizations would be subjected to a higher floor (100 percent). A risk weight floor of 15 percent would be set for all securitizations; however, senior positions in STS transactions would be given a floor of 10 percent.

For capital purposes, ABCP programs would be permitted to use the rules applicable to STS transactions if certain risk-weight requirements are satisfied and the aggregate exposure value of all exposures to any single obligor does not exceed one percent. In other words, there would be a strict diversification requirement, but that requirement would not apply to trade receivables that are fully covered by eligible credit protection provided by an institution.

Non-ABCP securitizations would be required to satisfy a similar but slightly different set of criteria in order to qualify for the capital treatment accorded to STS transactions. The one percent limit on the aggregate exposure to any single obligor would apply here as well.[7] Because of the wider range of permissible asset classes among the underlying exposures, there would be a somewhat more extensive list of maximum permissible risk weights. Exposures secured by subordinated mortgages would be permitted to be included only if all loans secured by mortgages ranking prior to the subordinated mortgages in the pool were also included. No loans that have a loan-to-value ratio of more than 100 percent and are secured by mortgages on residential property could be included.

Conclusion

The viability of the changes sketched above can be tested only by carefully considering the exact, complicated and extensive details of the two Proposals, of which only a very partial description could be provided in this Alert. Furthermore, such viability may well also depend in part on the regulatory technical standards that the EBA, ESMA and EIOPA will be required to adopt.