June 28, 2016    5 minute read

STS Securitisation: Is Europe Learning From The Past?

CDO, CDS and moral hazard    June 28, 2016    5 minute read

STS Securitisation: Is Europe Learning From The Past?

“We are creating an ownership society in this country, where more Americans than ever will be able to open up their door where they live and say, welcome to my house, welcome to my piece of property”

George W. Bush

It is at that particular point in recent history when the nation with the highest levels of inequality rate decided that everyone suddenly deserved a home of their own, that the primordial cells of the recent financial crisis saw the light. From there on, the well-known escalation of events saw the financial sector involved in an artificial growth in the American housing market, pushed upward by an expanding mortgage market, fed in turn by a wanton originate-to-distribute securitisation model, that allowed banks to fully externalise the credit risk of the loans. If CDOs, CDSs, moral hazard and a hypothetical collusion between Investment Banks and Rating Agencies are added in that scenario, the worse financial crisis after 1929’s is obtained. We all know how it ended, how those primordial cells found fertile ground to grow up and explode in the 2008 financial crisis. We all know how the financial crisis then turned into a global recession: most of us are living in a nation that has seen many enterprises failed from 2008 on, in a credit crunch financial context, and has probably adopted austerity measures in the same period. Someone is, unfortunately, living in a country that has been bailed out.

Ex-post, the duty of the financial institutions of the entire world is to look in depth at the recent past, to understand how the securitisation market could be redesigned. From “financial weapon of mass destruction, carrying dangers that, while now latent, are potentially lethal”, as Warren Buffet described the securitisation market, to an efficient and useful financial instrument.

At the core of the European legislation, something is moving in that direction. One of the most important building block of the Market Capital Union, the plan of the European Commission to mobilize capital in Europe, fostering growth and jobs creation, is the building of a “Standard, Transparent and Standardised” (STS) Securitisation Framework, a common set of European laws that will regulate the European Securitisation market.

What are the principal features of the STS Framework proposed by the European Commission? How will it contribute to the growth of the European market?

In a learning-from-the-past behaviour, the Commission has developed a detailed legislation to be discussed by the European Parliament, whose main articles focuses on taking measures designed to prevent the securitisation to be used in a harmful and unprejudiced way.

New Rules

First at all, the legislation imposes a Risk Retention Ratio (Art. 4), according to which the originator bank will have to keep at least 5% of the value of the securitised credits on its balance sheet. That measure will eliminate the possibility to implement a perfect originate-to-distribute model that would give the banks the space to act irresponsibly: if a 5% of the assets will be retained, the banks will avoid subprime mortgages and be very careful in the lending policies.

Second, at Art 3, the bill gives the Due Diligence duty:  institutional investors will have to carry out a due diligence assessment to estimate the risk of the individual securitisation, of the underlying assets and of all the features of the securitisation that can have an impact on the performance. Moreover, the institutional investor will have to monitor the exposures on an ongoing basis and regularly perform a stress test on them.

Third, the Art. 5 imposes Transparency Requirements. The originator Bank and the SPV will have to provide to the investors a fixed list of information, obviously free of charge: an investment prospectus, an asset sale agreement that will demonstrate the novation of the relationship given by the credit transfer from the bank to the SPV, the administration and the cash management agreements, details regarding the structure of the deal and the cash flows dynamics. EBA, ESMA and EIOPA will develop technical standards about the process of information providing. All this is aimed to create a constant and transparent flux of information from the originators bodies to the investors, and to eliminate the asymmetry of information, a factor that played a key role in the recent financial crisis.

Moreover, the legislation provides Simplicity Requirements, according to which the seller will provide warranties that the assets are in a safe condition, a single emission of securitised products will have to be backed by a pool of homogeneous assets, and the underlying exposure will not include securitized products and assets in a default status.

Furthermore, the Art. 9 gives the Standardisation Requirements: the originator bank will have to satisfy the risk retention requirement (Art. 4). Interest rate and currency risks will have to be hedged by the SPV by subscribing derivatives and any reference to the interest payments to the holders will have to be simple, not based on complex formulae or derivatives.

Last but not least, a part of the bill is dedicated to the Supervision: the supervisory authorities will be chosen in function of the body oversaw. So, for instance, the ECB will supervise systemic Banks, and appropriate administrative sanctions will be imposed by the authorities to the banks and SPVs that will fail to respect all the features imposed by the legislation here summarised.

In conclusion, the European institutions are working on the creation of an innovative and flowing European securitisation market. It is based on the conviction that, if implemented, in a context of good expectations about the future, it will help both the demand side for funding, in particular the SMEs requests of financing, and the offering side, opening a wide spectrum of new real economy long-term investment opportunities for those financial entities that are not allowed to do so directly, such as pension funds. It is time for the securitisation to redeem and show the world its potential.

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