by Lisa Filomia-Aktas, EY

E&Y_SSF_2014.qxd 15/7/14 08:46 Page 1 The US securitisation market: a period of re-emergence by Lisa Filomia-Aktas, EY The structured finance market is beginning to rebound as the path forward becomes clearer. Some of the uncertainty from regulatory reforms has been reduced with the finalisation of Volcker, a re-proposal on risk retention and the issuance of additional guidance on the integrated capital framework. As legislation relating to consumer mortgages and uncertainty regarding housing finance reform continues, the mortgage-backed securities (MBS) market saw a decline in activity during the beginning of 2014 while the commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) markets held strong. 1 The 2014 mortgage-related market, including agency and non-agency pass-throughs and collateralised mortgage obligations, is experiencing a decline both in issuance and trading volumes when compared with prior periods. The continued decline in issuance has occurred in both agency issuance and non-agency volumes; however, the agency share of issuance also continued to decline. The refinancing volume decreased as mortgage rates began to increase. In addition, increased documentation standards made it more challenging to qualify and also contributed to the decline in volume. With the change in leadership at the Federal Housing Finance Agency (FHFA), certain initiatives, including the g-fee (guarantee fee) increase have been slowed, hampering the private label market. Government-sponsored enterprise (GSE) risk-sharing activity continued with the third Structured Agency Credit Risk (STACR) deal by Freddie Mac and Fannie Mae s second Connecticut Avenue Securities (CAS). Single-family rental securitisations are heating up as steep home prices and other economic factors are preventing would-be homeowners from entering the market and institutional investors are turning homes into rental properties. The 2014 asset-backed market is off to a better start, with Lisa Filomia-Aktas, Partner Ernst & Young LLP tel: +1 212 773 2833 fax: +1 866 863 8115 email: lisa.filomia@ey.com

E&Y_SSF_2014.qxd 15/7/14 08:46 Page 2 2 an increase in outstandings, higher trading volumes and a rise in issuance led by the auto sector and followed by credit cards. Collateralised loan obligations (CLOs) are also flourishing while equipment and student loan ABS continue to shrink. The CLO market adjusted quickly to the new Volcker rules, which initially hindered issuance by structuring CLOs as loan-only securitisations instead of allowing for small bond buckets (see further information on Volcker later on in this chapter). In addition, the CLO market saw CLO 2.0, which refinanced callable 2012 CLOs with tighter spreads and typically shorter average lives than new CLOs. Risk retention Dodd-Frank established a requirement for securitisers to retain not less than 5% of the aggregate credit risk of assets collateralising an issuance of ABS. However, regulators can require less than 5% retention for an asset if the originator of the asset meets prescribed underwriting standards that indicate a low credit risk. Direct or indirect hedging or other transfers of risk by the securitiser are generally prohibited. This so-called skin in the game requirement is intended to provide sponsors with a meaningful incentive to monitor and control the quality of securitised assets and align the interests of the sponsor with those of investors. On August 28, 2013, a re-proposal was issued to allow the risk retention to be satisfied via a vertical retention, 5% of each tranche; a horizontal retention, 5% of ABS first-loss position (or fully funded horizontal cash reserve account); or a combination of the two methods. Other methods that would mitigate consolidation risk by the securitiser continue to be discussed. These include retaining a representative sample, 5.264% of the aggregate pool to be securitised, or a participation interest, a 5% pari passu interest in the aggregate pool to be securitised. For the representative sample method, there would need to be a validation of representativeness on all material pool characteristics to keep it conceptually consistent with the other allowed methods. The 5% credit risk retention would be based on the fair value of the interests issued. Several exceptions to the use of fair value were proposed, including using the total unpaid principal balance of the investors ABS interests outstanding for revolving master trust deals. The requirement to retain 5% may be reduced for low credit-risk items. For residential mortgages, there is a full exemption from risk retention if all the assets of the trust are qualified residential mortgages (QRM). QRM parameters will likely be close to qualifying mortgage (QM) requirements, which Congress established to demonstrate that consumers have a reasonable ability to repay the loan according to its terms. Full exemption was also proposed for ABS issuances collateralised by assets issued or guaranteed by the US, and reduced risk retention was proposed for blended pools of qualified commercial real estate loans, qualified commercial loans and qualified automobile loans. Establishing a process and controls to ensure assets meet the qualified provisions, including timely remediation of non-compliance, will be critical for those seeking these exemptions. Risk retention rules could impact whether securitisation transactions are recorded on or off balance sheet and force higher capital to be held by issuers. Securitisers who have power the servicer or asset manager in the transaction would need to consolidate the entity if the interests they hold provide an obligation to absorb losses or the right to receive benefits of the entity that could potentially be significant to the entity. Generally, securitisers who provide the servicing and use the vertical retention method will not find themselves consolidating the securitisation vehicle; however, securitisers or servicers that utilise the horizontal retention method may consolidate the entity. The representative sample and participating interest methods being discussed would likely eliminate the consolidation risk from risk retention as the retained interest is outside the securitisation vehicle. Consolidation could have a significant regulatory capital implication as the risk transfer would not be recognised, and capital would need to be held on the underlying assets. The prohibition against hedging or transferring retained credit risk expires on the latest of the following: (i) total unpaid principal balance of securitised assets has been

E&Y_SSF_2014.qxd 15/7/14 08:46 Page 3 reduced to 33% of the original unpaid principal balance; (ii) total unpaid principal obligations under the ABS interests issued have been reduced to 33% of the unpaid principal obligations of such interests at closing; or (iii) two years after closing. There are exceptions relating to both CMBS and RMBS that include expirations beginning five years after the date of closing. Establishing a process to ensure compliance may be challenging as retained interests will need to be tagged and controls will need to be put in place to ensure the restrictions are not violated. Volcker Rule On December 10, 2013, the federal financial agencies approved the Volcker Rule, which prohibits a banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in, sponsoring or having certain relationships with covered funds. Although the focus is hedge funds and private equity funds, the definition of a covered fund brings certain securitisation vehicles into the Volcker world. Compliance varies according to several factors, including the size of a bank s assets; however, unless the conformance period is extended, banks will need to comply by July 2015. A bank securitising assets will need to go through a complex array of criteria to determine if the securitisation vehicle meets the definition of a covered fund and, if so, whether it meets one of the covered fund exemptions or exclusions, such as being a loan securitisation, a qualifying asset-backed commercial paper (ABCP) conduit, static securitisation pool (Rule 3a-7 under the Investment Company Act) or a real estate securitisation (section 3(c)(5)(C) of the Investment Company Act). Should the analysis conclude it is a covered fund, the bank would be restricted from holding an ownership interest and from providing certain transactions, such as liquidity facilities or hedges, to the securitisation entity. There is an ABS issuer exemption allowing a banking entity to acquire or retain an ownership interest in, or act as a sponsor to, a covered fund that is an issuing entity of asset-backed securities in connection with directly or indirectly organising and offering that issuing entity. The maximum permissible investment in a single covered fund organised and offered under the ABS issuer exemption, and other permitted activities, is 3% of the total fair market value of the outstanding ownership interests in the fund (the de minimis ownership limits). However, recognising the need for the Volcker Rule to be consistent with the expected risk retention requirements, Volcker allows banks to hold what is required under risk retention but not greater amounts. Added challenges for interests held under the ABS issuer exemption relate to a Tier 1 capital limit and capital deductions. The aggregate value of all ownership interests of a banking entity may not exceed 3% of the Tier 1 capital of the banking entity. Furthermore, a banking entity is required to deduct the value of its ownership interests from Tier 1 capital, the value being the greater of historical cost (plus earnings) and fair market value of such ownership interests. This capital deduction will impact the bank s economic analysis of securitisation transactions. The name of the transaction cannot share the bank s name, have a variation of the bank s name or have bank in its name. Also required are written disclosures to prospective and actual securitisation investors informing the investors that they and not the bank will bear any losses in the securitisation beyond the bank s permitted investment in that securitisation. Regulators are already evaluating banks progress toward compliance. Once banks identify holdings in ABS not allowed under Volcker, they will need to restructure or divest them by the end of the conformance period. In addition, compliance programmes at both the business unit and the enterprise level will have to be established to ensure ongoing adherence to the requirements. Basel III (capital and liquidity) In July 2013, US regulatory agencies finalised the integrated regulatory capital framework. One of the most notable requirements and changes for securitisation exposures includes a due diligence requirement. A comprehensive understanding of the features of a securitisation that would materially impact the 3

E&Y_SSF_2014.qxd 15/7/14 08:46 Page 4 4 performance of the position is required pre-trade, in addition to post-trade (T+3) documentation and quarterly reviews. Should a bank fail to comply with the due diligence requirement, a 1,250% maximum risk weight is applied to the relevant securitisation exposure. The Basel Committee on Banking Supervision (BCBS) issued a consultative document to revise the securitisation framework on December 19, 2013. The revised framework intends to globally reduce reliance on external ratings, increase risk weights for high-rated securitisation exposures, reduce risk-weights for low-rated senior securitisation exposures, reduce cliff effects and enhance the framework s risk sensitivity. The US and the Basel Committee continue to pursue reforms related to liquidity. In October 2013, US regulatory agencies approved a Notice of Proposed Rulemaking (NPR) for the liquidity coverage ratio (LCR): Liquidity Risk Measurement, Standards and Monitoring. The proposed rule largely adopts the BCBS LCR framework with certain modifications. The LCR requires a bank to maintain a minimum amount of liquid assets to withstand a 30-day standardised supervisory liquidity stress scenario. It mandates that banks have a minimum coverage ratio of 80% by January 1, 2015 with 10% incremental increases through 2017, and that this calculation be produced daily. LCR may raise additional challenges to the securitisation market. The NPR proposes that 100% of the undrawn amount of all committed credit and liquidity facilities extended to special purpose entities (SPEs) be included in the LCR calculation. The US NPR also stipulates that Agency MBS would be treated as Level 2A High Quality Liquid Assets (HQLA) and be subject to a 15% haircut. Publicly traded RMBS and covered bonds, on the other hand, would not qualify as HQLA. for privately issued structured finance products. In February 2014, the SEC re-opened the comment period on Regulation AB II, which was originally proposed in 2010 and re-proposed in 2011, in order to solicit further public comment on an approach to disseminate potentially sensitive asset-level data. The proposal is for potentially sensitive asset-level data to be available to investors only through an issuer s access-restricted website while other asset-level data would be filed on the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. Housing finance reform and the MBS market The future of the GSEs also known as Fannie Mae and Freddie Mac will affect how MBS transactions are structured. There have been much debate and various proposals on the role the GSEs should play, if any, since they were placed in conservatorship by their regulator, the FHFA in 2008. There are proposals to transition the mortgage markets away from the GSEs toward a secondary market operating with an explicit, limited government guarantee. The future GSE model may look more like the Ginnie Mae model of today, with more of a guarantor role rather than one that leverages the balance sheet. A common securitisation platform (CSP) is currently being developed by the FHFA that should encourage private capital into the market, improve liquidity, increase transparency and reduce the GSEs liabilities. The creation of a new infrastructure combining certain functions common to both GSEs may ease the transition to a mortgage market in which the GSEs play a less prominent, if any, role at all. The CSP has now been placed in a stand-alone entity co-owned by the GSEs and the CSP plan has been narrowed to build a platform for the GSEs only, not other market participants. Regulation AB II Discussions continue as the Securities and Exchange Commission (SEC) determines the best way to revise the offering process, disclosure and reporting requirements for publicly issued ABS and impose new disclosure standards In summary The US securitisation market is re-emerging as legislative progress is made and investor appetite returns. However, the reaction by banks to the various new requirements is still uncertain. Banks will need to retain interests under

E&Y_SSF_2014.qxd 15/7/14 08:46 Page 5 risk retention but will also need to deduct amounts from capital under Volcker and meet LCR requirements while only certain high quality interests qualify as HQLA. Efforts to stimulate the private-label market are likely to continue, as are GSE risk-sharing transactions. Even with these challenges, the US securitisation market is poised to be a strong contributor to economic recovery. Contact us: EY 5 Times Square, New York, NY 10036, US tel: +1 212 773 3000 web: www.ey.com/financialservices 5