APRA's clarification of its policy on the regulatory capital treatment of certain securitisation exposures held by ADIs goes some way to meeting industry concerns, but leaves some unresolved questions.
By contrast, the second stream of Government banking reforms allays concerns over the effects of the policy on funding costs for originating ADIs, and gives some incentives for growth, especially in the bullet RMBS market.
What was APRA's position in August?
In a letter from APRA to all ADIs on 26 August 2010, APRA stated its view that originating ADIs that hold or retain the most subordinated tranche(s) in a securitisation, absent any externally provided credit enhancement (other than lenders' mortgage insurance and/or excess spread), will not be considered to have transferred significant credit risk to third parties for the purposes of paragraph 13 and Attachment B, paragraph 2 of Prudential Standard APS 120 Securitisation (APS 120).
Accordingly, originating ADIs that hold or retain the most subordinated tranche(s) of a transaction will be required to hold capital against the entire pool of securitised assets as if they were on-balance sheet in accordance with Prudential Standard APS 112 or APS 113 (as appropriate). This is even if the relevant subordinated notes are rated and/or constitute less than 20% of the value of the notes on issue (which is the investment test in paragraph 8 of Attachment F of APS 120, on which originating ADIs had relied).
APRA also advised that it would not look favourably on originating ADIs entering into arrangements between themselves to purchase subordinated tranches of other ADI originated securitisations.
The industry reaction to the 26 August letter was negative. The key concern was that APRA's approach would make the funding costs for originating ADIs significantly more expensive and less economically viable. The market for subordinated tranches in securitisations in Australia is relatively thin, particularly since the GFC. The Australian Office of Financial Management's (AOFM) mandate does not (and, as noted below, apparently will not) extend to investing in tranches rated below AAA and therefore AOFM cannot assist this market. This concern was particularly directed at ADIs who are not able to sell down existing holdings of subordinated tranches issued under their securitisation programmes, and who may be unable to find investors for subordinated tranches issued under future deals.
How has this been clarified by APRA?
In its 10 December 2010 letter, APRA expanded on its earlier view by announcing that it is prepared, subject to its prior approval and as an alternative to the capital treatment required under APS 120, to allow an originating ADI that retains any subordinated tranche(s) of a securitisation to deduct those holdings from its Tier 1 capital.
The deduction would be capped at the dollar amount of the total capital required as if the pool of securitised assets were held on-balance sheet. The required deduction would be reduced to the extent that the ADI sells down the subordinated tranches to "genuine third-party investors".
APRA stressed that this alternative capital treatment is only an interim measure that will apply to both existing and future securitisation transactions until the Basel Committee's enhancement to the Basel II framework comes into effect from 1 January 2012.
Although APRA's 10 December letter is welcome as an indication of flexibility on the part of APRA, it does raise a number of issues, including:
the letter distinguishes between "senior tranche(s)" and "the most subordinated tranche(s)" but does not clearly state the difference between the two. For example, does "any subordinated tranche(s) of a securitisation" refer to AAA rated subordinated Class AB-style notes?
the letter refers expressly to the "originating ADI", so presumably the mere fact that an ADI holds subordinated notes from another ADI's securitisation transaction will not require a deduction from Tier 1 capital for that exposure;
a deduction from Tier 1 capital seems quite a draconian treatment for subordinated notes that may for example be AA rated, especially when, theoretically, the originating ADI could use the proceeds generated by the securitisation to invest in riskier assets that have a 100% or higher risk weighting (but still less than a full deduction from Tier 1 capital). It is also not clear how many ADIs would have transactions in the current market that would give them a better capital treatment for a deduction from Tier 1 capital than holding the relevant assets on-balance sheet; and
the letter is silent on what constitutes "significant credit risk", and why holding some of the most subordinated tranche(s) of notes is necessarily inconsistent with a transfer of significant credit risk.
Second stream Government banking reforms support the securitisation market
As we noted on Monday, the Australian Federal Government's package of banking reforms announced on Sunday 12 December 2010 will open the door to covered bonds. The second stream of the reforms will also support the securitisation market by:
Third tranche of support for RMBS market
Given the importance of smaller lenders having access to the RMBS market, a further $4 billion has been committed to the AOFM for investing in AAA rated Australian RMBS tranches.
The Government has emphasised that the program will only be directed at assisting issuances by regional banks, building societies, wholesale mortgage lenders and mutual credit unions and that "not one dollar will go to the big banks". It will be interesting to see if this will include investments in securitisations originated by lenders who have not previously been funded under the AOFM programme, such as non-conforming lenders.
Given APRA's stance in relation to the regulatory capital treatment of subordinated tranches held by originating ADIs (as discussed above) there may be industry support for further changes to allow the AOFM to invest further down the credit curve.
Accelerate development of bullet RMBS market
The AOFM and Treasury will accelerate the design of the most appropriate structure for facilitating issuance of bullet RMBS securities (that is, securities providing for single repayment of principal on maturity) by smaller lenders, as opposed to traditional RMBS (which are structured as pass-through securities).
The bullet structure has been a recent innovation to open up the RMBS market to a new class of investors which traditionally invest in corporate bonds with a similar repayment profile. Furthermore, given that recent bullet RMBS securities have been structured so that they qualify for inclusion in the UBS Composite Bond Index, the potential pool of investors could also include institutional investors acting on behalf of Australian superannuation funds.
It should be noted that Treasury and the AOFM have the option of directing the Government's third tranche of $4 billion to facilitate the development of the bullet RMBS market for smaller lenders.
You might also be interested in ...