Corporates and financial firms likely to pursue the securitization of assets as a source of funding face significant new regulatory requirements in 2017. However, the special purpose vehicles (SPVs) they set up to issue the securities appear likely to get some relief in terms of posting margin.
Risk retention rules for all securitization asset classes besides residential mortgages went into effect Dec. 24, 2016, and will require most issuers of asset-backed securities (ABS) to retain a 5% slice of the deal, giving them “skin in the game.” Although the securitization market is mostly tapped by banks and other financial companies, large manufacturers such as auto companies and equipment manufacturers often have finance subsidiaries that lend to customers buying the companies’ products.
“The big story for 2017 will be watching how various securitization issuers will implement the risk retention rule,” said Jan Stuart, a finance and securities partner at Mayer Brown who focuses on structured finance, in a recent webinar.
Regulators provided issuers with several options to retain that risk, so finance departments must determine which one best suits their companies. Securitizations typically have several tranches carrying different levels of risk, and issuers can either retain a “horizontal” interest, holding on to 5% of the bonds that would bear first loss should the deal go sour, or a vertical slice that retains 5% of all the tranches issued to third parties, or a combination of the two.
The horizontal approach requires valuing the retained slice at fair value, information for which issuers may tap their underwriters, rating agencies or other third parties, but which will require additional work.
“There seems to be a consensus in the market that the [issuer] should consider multiple data points for the calculation, but the final valuation must be made from the issuer’s own determination,” Ms. Stuart said, adding that asset-backed securities (ABS) issuers without the resources to comply with the rules can instead issue in the private market.
Another new requirement that will become apparent for issuers in 2017 is disclosures of data at the securitized loan level. Reg AB II went into effect Nov. 23, 2016, and Ms. Stuart said that issuers preparing for its implementation over the last year have found the data requirements extensive and collecting it time consuming. She said that to tackle the additional requirement, securitizers of auto loans and other types of assets have banded together to address technical and interpretative questions regarding the new rules.
Corporate finance departments considering ABS issuance should monitor the Trump administration’s appointments to lead the Securities and Exchange Commission and other agencies. For example, Ms. Stuart said, the SEC still has “unfinished business” with respect to the asset-level data requirement, and current proposals could extend the rules to additional asset classes including equipment financing and student loans.
“Depending on new leadership at the SEC, additional rules for these asset classes may be forthcoming,” she said.
Corporate finance executives can breathe a small sigh of relief with respect to margin rules. In general, the margin rules, which went into effect for the largest swap counterparties last September and are slated for everyone else March 1, apply to the special purpose vehicles (SPVs) that issuers use to issue the securities, although there’s some relief for captive finance companies and their related securitization entities. However, the Commodity Futures Trading Commission’s specifications to determine whether an entity is a captive or not, including a requirement that 90% or more of the assets that the entity is financing are manufactured by the parent company or another subsidiary, can be difficult to measure and compute.
“We’ve seen issuers struggle with this, especially in cases where mergers and other corporate transactions blur the lines of what should be considered affiliated entities with the corporate parent,” Ms. Stuart said.
If the issuer cannot take advantage of the exemption for captives, it must post both initial and variation margin. Ms. Stuart said that the high dollar threshold that should be reached to require initial margin makes that less problematic, but variation margin would require a daily measure and marked-to-market valuation of the financial entity’s covered swaps.
“This requirement is particularly hard for securitization entities that usually have monthly settlement dates and generally are not structured to have unaccounted for cash available to make this margin posting,” Ms. Stuart said.
In fact, Acting Chairman J. Christopher Giancarlo announced a no-action relief Feb. 13 that maintains the March 1 deadline but essentially gives swap dealers a grace period until Sept. 1 to comply with it, since the inability of their end-user customers to comply with it could have resulted in a cessation of hedges.
“Global systemic risk is not reduced by the abrupt cessation of risk hedging activity by American life insurance companies and retirement funds at a time of enormous changes in financial rates and global asset values,” Mr. Giancarlo said. “This action by the CFTC does not change the scheduled time of arrival for the agreed margin implementation. It just foams the runway to ensure a safe landing.”