19 May 2016

European Parliament: Report on STS securitisation is published

Securitisation allows investors to directly hold investments in real economy assets, without being responsible for the origination or servicing of these assets. Instead of directly owning loan portfolio´s institutional investors can buy bonds of SPV´s holding securitised assets like residential mortgages. The structure and tranching of the securitised portfolio allows investors to tailor the risk-reward combination of their investments according to their risk appetite.

Securitised products are often designed as tranched instruments. Tranches of different risk profiles are created in order to satisfy different risk appetites by investors. However, there is a clear trade-off involved with tranching a securitised asset portfolio. Tranching encourages reliance on ratings, stresses the robustness of modelling and exposes investors to human errors of judgement. In particular, tranching creates greater risk of modelling error, potentially with high impact for the smallest of errors1, which legislators have tried to mitigate by reforming rating agencies and better controlling internal models. Besides, risk-sensitive requirements for banks allow for a capital treatment differentiation per tranche that addresses this specificity of securitisation.

Credit ratings may generate "cliff edge" risks since downgrades can translate into substantial harshening of the regulatory treatment of a securitisation deal. This results into in-built fire-sales and similar instruments by financial market participants to pre-empt higher capital charges in the case of a downgrade. For those reasons, the use of external ratings by banks for the calculation of their capital treatment when holding positions in securitisation is banned in the US and remains controversial in the EU.

In the aftermath of the crisis credit standards were sharpened in many member states and for a part harmonised under EU law. The Mortgage Credit Directive sets a framework to be for example when banks are assessing the creditworthiness of potential lenders. These developments have further secured a floor for the credit quality of assets originated within the EU. The STS framework does contain certain boundaries for the credit quality of the assets that can be used in a securitisation that want to qualify as STS. Loans that have been restructured less than three years before they were securitised cannot be part of a STS securitisation. Bad loans are therefore excluded.

The important role Credit Rating Agencies played in the run up to the crisis, has led to the sector to be regulated. Within the European Union rules were adopted for the CRA’s that reduced the conflict of interests and tried to reduce the reliance on credit ratings in the system. The STS proposals do not directly address the problems that might occur with credit rating agencies rating securitisations. The determination of STS eligibility was consciously left for the issuer and investor to make, not relying on a third party like a rating agency to take this responsibility of their shoulders.

The Commission proposals does not ban non-STS securitisation, it merely defines the perimeter of an upper segment made out of STS products. Yet, creating a two-tier market presents complex challenges because it requires the introduction of clear, quickly-applicable and uniformly-enforced criteria for the STS concepts. Doing so without setting the bar neither so low that mistakes of the past will be allowed by loopholes, nor so high that the criteria will undermine the market take-up, or over-step into each investor's specific demand and appetite for various levels of investment risks.

By contrast, the lower tier of non-STS securitisations should not be unduly penalised and, with proper rules and supervision defined above, should remain attractive for certain very specialised and more risk-prone investors. The aim is not to eliminate risk, but to ensure that those who take the risk are aware of its nature and have sufficient assets to cover up for losses. The timing and the transitional provisions for introducing such a change in the market should also be carefully examined and considered.

Dividing the market does not solve structural issues. For example, as it does not benefit from public agency support like in the US, the EU market must be more stable on its own and that implies being open to every solution. As argued above, beyond the scope of this legislative proposal, mechanisms to ensure the stability and liquidity of securitisation in times of stress must also be considered.

Full paper

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