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Besides Basel rules banks must also implement U.S. regulators’ proposed risk-retention rule requiring banks to retain 5% of RMBS they sponsor. Image: Fotolia.
Besides Basel rules banks must also implement U.S. regulators’ proposed risk-retention rule requiring banks to retain 5% of RMBS they sponsor. Image: Fotolia.

Basel Goes Easy on RMBS, At Least for European Banks

FEB 6, 2013 10:44am ET
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The Basel Committee on Banking Supervision’s decision to allow banks to include highly rated residential mortgage-backed securities into their calculation of a new liquidity coverage ratio is undoubtedly good news for European RMBS, which was at risk of losing its biggest buyers. Depending on how local regulators interpret the changes, however, they may offer less benefit than hoped for to banks in the United States.

Other new assets slated for inclusion in LCR calculation are corporate debt securities with ratings between BBB- and A+ and certain kinds of exchange-traded common equity.

In addition, the Basel Committee significantly delayed implementation of the LCR by requiring banks to maintain only 60% of the LCR by 2015, which was the original implementation deadline. Banks must then phase in an additional 10% each year thereafter.

David Weiss, an analyst at Aite Group, described the changes as “significantly watering down” the LCR requirement. However, he said, the Basel Committee has so far not loosened other new rules, such as significantly higher capital requirements, and regulators in the United States and Europe have separately issued rules aimed to prevent future financial-system upsets.

Weiss said a major question is whether the recent decision represents a first step toward further loosening of the Basel requirements or is instead a one-off move.

“If you think of [all the new regulations] as a deep hedge against further market disruptions, then this could simply be taking a little off that deep hedge,” Weiss said.

Besides Basel’s risk capital rules, for example, banks must also implement U.S. regulators’ numerous new rules stemming from the Dodd-Frank Act, including the proposed risk-retention rule that would require banks to retain 5% of securitizations they sponsor, encouraging them to pool higher-quality loans.

“Some would say the Basel Committee gave in to bank pressure,” said Alok Sinha, principal and leader of Deloitte & Touche’s banking and securities practice, “but rules like risk retention will have a countervailing effect.”

More Basel III loosening, however, may be in store. Jason Kravitt, a partner at Mayer Brown, noted that banks today are viewed by many as overly stingy with their credit, so lumping additional restrictions on them becomes problematic. He said that he sees the LCR decision as likely the first step toward more loosening.

“It’s an attempt to reach a balance: Being prudent without killing the goose that lays the golden egg,” Kravitt said.

In terms including RMBS in the LCR, which requires banks to hold enough high-quality liquid assets on their books to buffer cash outflows over 30 days, the decision may ultimately represent a bigger boon to European banks. That’s because one of seven criteria to allow RMBS into the LCR is that the underlying mortgages must be “full recourse” loans, in which the borrower is fully liable for the loan, even if the property’s value falls below the value of the loan.

“This would mean that RMBS, including so-called ‘walk-away’ mortgages in the United States, would not appear not to qualify, based on the current proposal,” said Jeremy Jennings-Mares, a partner at Morrison Foerster.

A study published in June 2010 by the Federal Reserve Bank of Richmond found 11 states, including California, the largest U.S. housing market, that either do not permit full recourse mortgages or have rules making it too onerous for banks to pursue full recourse. The American Securitization Forum, in its Jan. 17 weekly report, also included Texas among the non-recourse states, bringing the number to 12. Given that RMBS pools tend to be geographically diversified, the Basel Committee’s rule change would appear to exclude most RMBS that pool U.S. mortgages.

In another possible hurdle for U.S. banks, JPMorgan’s securitization team, in its Jan. 11 weekly report, pointed out that the Basel Committee’s “wording would seem to make it now apply to Fannie and Freddie MBS,” because another of the criteria for inclusion in the LCR is that loans must be subject to risk retention and, as JPMorgan noted, agency MBS is not subject to risk retention as long as the government-sponsored agencies remain in conservatorship.

That said, regulators of each country must align Basel rules with their own regulations. The Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corp. proposed market risk rules in July that seek to align regulatory capital rules for U.S. banking organizations with the Basel III capital standards, and they are expected to issue a similar proposal for the LCR component.

Not only must U.S. regulators address the recourse issue, but the Dodd-Frank Act forbids the use of ratings in any measure of bank capital. “So it will be interesting to see how U.S. regulators write the rules and whether they reference ratings from a liquidity standpoint,” Sinha said.

Even if U.S. regulators craft language to accommodate those issues, there is little expectation that including RMBS in the LCR will significantly impact the RMBS market by prompting banks to buy more of these securities to retain on their books. In part that’s because of the implementation schedule delay. “In the end, we believe the most important aspect of the LCR ruling for MBS is the delay of the implementation, which may slow the pace of accumulation of liquid assets,” noted JPMorgan in its report.

In addition, the new, riskier assets to be included in the LCR, referred to as Level 2B assets, are capped at 15% of total high-quality liquid assets, and haircuts of between 25% and 50% must be applied.

The haircut for RMBS is 25%, meaning a bank holding $100 million of RMBS would only be able to count $75 million in the LCR calculation, while the haircut for corporate bonds is 50%.

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