Part One: Basel II - Bottomline Impact on Securitization Markets

The overhaul of the international regulatory capital system (International Convergence of Capital Measurement and Capital Standards, a Revised Framework, or Basel II, published in June 2004) creates new incentives for how banks measure risk and allocate capital. These new incentives will influence bank investment and portfolio management strategies and, thus, have an important impact on financial and asset markets where banks and financial institutions are significant players.

Securitization is one of the critical markets where the advent of Basel II has been generating intense industry discussion and debate. Despite this keen interest in the bottomline impact of the new Basel II securitization framework, there has been surprisingly little quantitative research and systematic analysis in the securitization area.

This report provides quantitative analysis of how Basel II will affect the securitization markets. More specifically, the amount of capital Basel II will require a bank to hold for an unsecuritized pool of assets is compared to the capital charge on a securitization of these same assets. These deals include residential mortgage-backed securities (RMBS), credit card asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), and collateralized debt obligations of corporate assets (CDOs). For each of these product categories, Fitch has evaluated securitized portfolios of higher, medium, and lower risk assets that are broadly representative of the types of transactions commonly seen as part of the rating process.

Key Findings

Fitch’s research has yielded a number of interesting findings about the potential impact of Basel II on banks and the securitization markets:

• Under Basel II, banks generally would be required to hold less capital against rated securitization positions than against unrated positions, particularly on tranches falling in the middle of a structure (i.e. mezzanine positions). Thus, the Basel II securitization charges could potentially give banks a regulatory capital incentive to target the rated portion of the securitization market.
• It appears that the optimal capital strategy for banks using the internal ratings-based (IRB) approach to regulatory capital (which will likely include the larger, more complex financial institutions) is to invest in rated securitized notes rather than holding or investing in a comparable pool of unsecuritized assets directly on balance sheet. An exception is the case of CDOs, where the IRB capital charges on the rated securitized structure appear to be closely aligned with the charges on the unsecuritized pool of assets.
• For unrated securitization structures, Basel II appears to give IRB banks a slight capital incentive to hold the underlying pool of assets instead of the securitized notes.
• From a regulatory capital perspective, Basel II appears to have little if any impact on an IRB bank’s decision to securitize corporate debt and residential mortgage assets (i.e. through CDO and RMBS transactions).
• However, Basel II seems to establish fairly strong capital incentives for banks to securitize commercial mortgages and credit card receivables (i.e. through CMBS and credit card ABS structures).
• Basel II could influence how securitization deals are structured, with banks facing strong regulatory capital incentives to minimize their exposure to subinvestment-grade tranches.
• Under Basel II, banks using the standardized approach to regulatory capital (which is generally geared to smaller, less complex institutions) will face regulatory capital incentives to invest in lower rated securitization positions, potentially leading to erosion in the credit quality of their holdings of structured notes.

Background on Basel II Securitization Framework

The new Basel II capital framework is designed to align the charges on banks’ assets, including securitization positions, more closely to the underlying economic risk of the exposure.

Basel I: Arbitraging the Rules

An important objective of this closer alignment of regulatory capital to risk is to address the capital arbitrage strategies that flourished under the 1988 Basel Capital Accord (Basel I). Basel I applies a flat 8 per cent capital charge on all corporate assets and 4 per cent charge on all residential mortgage lending, irrespective of the underlying credit quality of the borrower. Thus, on very high-quality assets, the amount of capital that banks have been required to hold under the Basel I regulation exceeds the level of capital needed to cover the economic risk of the asset.

One way of illustrating that the Basel I capital charges are excessive on higher quality assets is to compare the 4 per cent regulatory capital charge on mortgage lending with the amount of Fitch enhancements typically supporting the various rating levels across prime RMBS structures. The 4 per cent Basel I charge on residential mortgages exceeds the amount of enhancement Fitch generally would require at the AAA rating level for prime RMBS deals (assuming that the probability of default in a base case is roughly 3 per cent or less on the underlying mortgage portfolio). This comparison shows that the 4 per cent Basel I charge overstates the capital needed to cover the economic risk on highquality mortgages and provides clear incentives for banks to securitize these assets rather than hold them on balance sheet.

Therefore, Basel I has presented banks with an incentive to reduce their regulatory capital requirements by shedding these higher quality assets from their books. One popular method has been to securitize them, with originating banks often holding on to the riskiest first loss positions to help support the deal. In this manner, banks have been able to decrease their Basel I capital requirements without necessarily reducing their economic risk exposure.

Since the 1988 accord does not explicitly address securitization, many countries have individually tried to establish regulatory capital rules to help curb these arbitrage plays, such as the US recourse rules. While this patchwork of national rules has been a useful stopgap, the need for a consistent regulatory capital framework for securitization became clear to regulators and, therefore, has been an important catalyst for Basel II efforts.

Basel II: Better Measure of Economic Risk

Basel II is intended to curb the incentives for banks to engage in regulatory arbitrage in two ways.

First, Basel II aligns regulatory capital on unsecuritized assets much more closely to underlying economic risk than Basel I, providing potential capital incentives for banks to hold credits to higher quality borrowers on balance sheet rather than securitizing them. One of the critical Basel II innovations for aligning regulatory capital to economic risk is the IRB approach, which measures a bank’s regulatory capital based on the default risk (probability of default [PD]) and loss severity (or loss given default [LGD]) of its credit exposures.

IRB banks will need to generate internal estimates of the PD of each asset. To determine the loss severity on corporate and commercial real estate assets, the more sophisticated IRB banks (the so-called advanced IRB banks) will be able to estimate LGD based on internal estimates, while other IRB banks (the foundation IRB banks) must use a fixed 45 per cent LGD assumption. For retail assets (e.g. residential mortgages and credit cards, among other assets), Basel II does not distinguish between foundation and advanced banks; rather, all IRB institutions will provide their own estimates of both PD and LGD on these exposures.

IRB banks then must translate the PD and LGD estimates into a capital charge using mathematical formulas provided in the Basel II regulation. The IRB approach for unsecuritized assets is basically a credit risk model, though one that has been designed by regulators to meet their prudential objectives.

The second element of Basel II’s stemming of regulatory arbitrage is its treatment of securitized positions held by banks. Basel II applies relatively stringent regulatory capital charges on junior securitization tranches, meaning that originating banks will face higher costs if retaining these positions as credit enhancement for structured transactions.

Basel II provides a range of methods for banks to determine the regulatory capital charges on their securitization holdings, depending on whether the bank will implement the IRB approach or, for banks with less sophisticated risk measurement systems, the standardized approach to credit risk.

The securitization charges for IRB banks depend on whether the position held has a credit rating from a recognized credit rating agency:

• For all securitization tranches with a credit rating, IRB banks must use what is known as the ratingsbased approach (RBA). The RBA links the capital charge to the external credit rating of the position, meaning that better rated positions benefit from lower Basel II capital charges.
• For unrated securitization exposures, IRB banks must use a formula specified in the Basel II regulation that generates a capital charge based on various attributes of the structure and the riskiness of the underlying assets (the supervisory formula). These attributes include, most importantly, the IRB charges on the underlying pool of assets (which, under the Basel II securitization rules, is known as KIRB), as well as the level of enhancement supporting the tranche, the thickness or relative size of the tranche, and the granularity or number of exposures in the pool.
• Thus, a bank holding both rated and unrated positions within the same securitization structure would apply the RBA to the rated tranches and the supervisory formula to the unrated exposures.

In comparison, banks using Basel II’s standardized approach to credit risk are given only one method for determining their securitization charges, which like the RBA, links the capital charge to the credit rating of the securitization position held.

However, unlike the RBA, the standardized charges are generally set higher than the RBA charges; for example, an AA rated tranche will require more capital if held by a standardized bank than by an IRB bank. Another point of departure is that the standardized charges are generally less differentiated than the RBA charges. For instance, the standardized approach applies the same 8 per cent charge on all tranches rated BBB+ through BBB-, while the RBA distinguishes between the differing risk profiles of these positions. With standardized and IRB banks facing different capital charges on the same exact securitization exposures, Basel II could potentially introduce new forms of regulatory capital arbitrage.

For unrated securitization positions, standardized banks must hold $1 of capital for every $1 of exposure (known as a ‘dollar-for-dollar’ capital charge), a strong capital disincentive against holding unrated tranches. The goal of Fitch’s research on this topic is to determine how the new Basel II capital framework will affect the securitization markets. More specifically, the Basel II charges for sample portfolios of unsecuritized assets are calculated as if they were held on balance sheet, and then the Basel II charges on a securitization of each of these portfolios are calculated. The primary focus of this report is on IRB banks, as these tend to be the more sophisticated institutions that are most active in the securitization markets.

Portfolios: Representative Sample of Deals in the Market

To develop a broader picture of how Basel II could affect the securitization markets, Fitch’s analysis covers a range of portfolios representing different underlying assets and risk levels. More specifically, RMBS, credit card ABS, CMBS, and CDOs of corporate debt are evaluated. For each of these product categories, Fitch assesses the portfolios of higher, medium, and lower risk assets underlying them. The portfolios are representative of but not necessarily identical to actual portfolios and have been made anonymous for the purposes of modeling the Basel II charges.

To better reflect the diversity of securitization deals found in the marketplace today, a range of structures are evaluated. These include market conventions and features that are often seen in the various securitization products covered in Fitch’s study. For instance, some securitizations have equity tranches (e.g. CDOs and higher risk CMBS), while in other structures, the most junior tranche is rated BBB (e.g. credit cards). Some of the structures in Fitch’s research include only the securitized notes (e.g. CDOs), while others incorporate additional enhancement features, such as reserve funds (e.g. RMBS) or excess spread (e.g. credit cards). Additionally, to simplify the analysis, the RMBS transactions are assumed to be pass-through structures rather than the more commonly used and more heavily structured master trust programs.

Results: Basel IIMs Impact on Securitization Markets

Fitch’s research reveals a number of interesting and, in some cases, rather stark findings about how the securitization markets might potentially be affected by the advent of Basel II.

Lower Capital Charges on Rated vs. Unrated Securitization

Generally, IRB banks will have to hold less capital on rated securitization tranches than on tranches that do not have an external rating from a recognized credit rating agency (in Basel II parlance, an external credit assessment institution [ECAI]). That is, in certain cases, the RBA generates much lower capital requirements than the supervisory formula on the same securitization position, which might provide incentives for IRB banks to target the rated portion of the securitization market.

Incentives to Invest in Rated Structures Differ Across Product Types

The differences in capital charges between the RBA and supervisory formula are most pronounced for the credit card ABS and CMBS transactions. As illustrated in the chart at right, the supervisory formula generates approximately three to four times as much capital as the RBA across the same securitization structure on all but one of the credit card ABS and CMBS deals evaluated in this study. For example, for both the lower risk and medium risk CMBS portfolios, the total supervisory formula charges across the entire securitization structure (i.e. summing the charges on each tranche) are 3.8 times higher than the corresponding RBA charges on the same structure.

By comparison, for the CDO and RMBS deals, the supervisory formula and RBA capital charges appear to be aligned much more closely. In all CDO and RMBS deals except one, the supervisory formula results in no more than 1.5 times as much capital as the RBA and, in fact, less capital than the RBA on the lower risk RMBS transaction evaluated in this study.

Incentives to Obtain a Rating Vary Across Securitization Capital Structure

Another interesting facet of this comparison is that the degree of difference between the RBA and supervisory formula charges seems to vary based on where the tranche falls within the securitization structure.

The RBA and supervisory formula charges on the most senior, high-quality tranches appear to be closely aligned. Likewise, at the lowest end of the credit spectrum, highly subordinated positions (like equity tranches) face comparably stringent charges under both the RBA and supervisory formula.

This alignment between the RBA and supervisory formula at the high and low ends of the credit quality spectrum largely reflects the caps and floors that Basel II applies to the supervisory formula, which bounds the resulting capital charges.

As illustrated in the top right chart, which uses the higher risk CDO transaction as an example, the supervisory formula and RBA result in essentially the same capital charges on the four ‘AAA’ rated tranches and, at the opposite end of the structure, on the equity tranche. By comparison, for this same CDO transaction, the supervisory formula charges are about three to four times higher than the RBA for the ‘BB’ and ‘AA’ rated tranches and almost 12 times higher for the ‘A-‘ tranche.

Indeed, for tranches that fall in the middle of the credit quality spectrum, the RBA generates significantly less regulatory capital than the supervisory formula. This difference in capital for the middle tranches is further highlighted in the chart at right, which shows that the supervisory formula generates about 10-15 times more capital than the RBA on tranches rated ‘BBB’. This disparity between the RBA and supervisory formula at the ‘BBB’ rating level is evident across each of the product categories (credit card ABS, CDO, CMBS, and RMBS).

Largest Incentives for Obtaining Credit Ratings in Middle of Quality Spectrum

Thus, whether by design or not, IRB banks generally will have to allocate less capital against rated securitization tranches than against unrated tranches, which, in turn, seems to create a regulatory capital incentive for banks to target rated (as opposed to unrated) securitization products. The apparent Basel II capital incentives for obtaining a credit rating on securitized positions seem strongest for the middle layers of a securitization structure.

IRB banks holding rated, as opposed to unrated, tranches will generally benefit from lower capital charges on their securitization holdings under Basel II. Credit ratings provide market participants with transparent, objective, and timely measures of credit risk. The structured ratings process is grounded in explicit and well-defined methodologies, sophisticated risk models and robust analytics, and ongoing monitoring and surveillance of the performance of the transaction – important factors for supervisors and market participants that rely on credit ratings to help better understand and monitor a bank’s securitization exposure.

Next week on gtnews, part 2 of this article will discuss issues such as Basel II’s influence over deal structuring and how certain securitization products are more attractive for IRB banks.