The late addition is Article 17 of the credit criteria of the EU regulatory framework for securitization. The problematic language is almost identical to a clause laid out in the "simple, transparent, standardised" (STS) requirements for European asset-backed securities, which forbids the use of self-certified loans in securitizations.
The fact that self-certified loans are not STS-eligible is not in itself controversial. However, that the clause dealing with self-certified loans has been added to another document laying out credit criteria for all European securitizations, therefore banning the inclusion of these loans in any European deal.
Article 17 of the credit criteria document reads: “Where the underlying exposure of securitizations are residential loans; the pool of those loans shall not include any loan that is marketed and underwritten on the premise that the loan applicant or, where applicable, intermediaries were made aware that the information provided by the loan applicant might not be verified by the lender.”
The ban on self-certified loans would disqualify a high percentage of Europe’s legacy loans from appearing in any securitization issued after January 1, 2019.
“This has Europe-wide ramifications and we have all been scratching our heads about this,” Richard Hopkin, managing director and head of fixed income, capital markets at the Association for Financial Markets in Europe (AFME) told GlobalCapital. “The problematic wording first appeared after European Council Committee of Permanent Representatives (COREPER) approved the text.
“There has been a copy over of the perfectly reasonable exclusion of self-certified mortgages from STS to create a complete prohibition of any securitization which contains as much as one self-certified mortgage.”
‘Refinancing seriously constrained’
In the UK, self-certified loans resulted in the borrower and lender entering into an agreement where certain criteria, such as income, would not be verified by the originator. The practice was made illegal in 2010 in the UK, though the language in the new rules does not appear to apply exclusively to this kind of loan.
“Clearly self-certified mortgages are caught up in this but they are yesterday’s product," said Hopkin. "It is already illegal across Europe to originate self-certified mortgages — rightly so.
"There are existing financings of legacy portfolios which contain these mortgages and those are likely to be badly affected because their refinancing options are now seriously constrained.”
Hopkin added that the ban will limit the ability of investors to buy and securitize the mountain of NPL debt weighing on Europe’s banks.
“This ban has just pulled the ground from under their feet by cutting out a source of refinancing for the money they have already put on the table.”
The language is also problematic because it does not apply just to income, and the law as written would cover any information that a borrower was aware that a lender might not check.
“The language isn’t particularly well worded and at the moment there is a lot of speculation about what this really means and we are just trying to understand what the EU is trying to do,” a mortgage lender said. “As it’s currently worded it really could mean anything and there is a lot of things that we need to find out.
“If you really read this in its extreme context it’s shocking, but we hope it won’t be applied as written.”
Late change
It is understood that the addition of Article 17 to the credit criteria for securitizations was a late change the European Commission made following trialogue (the EC, the EU and the European Parliament) discussions and before COREPER ratification, which comprises the head or deputy heads of missions from EU member states.
Paul Tang, the European Parliament’s rapporteur for the STS file, told GlobalCapital that the assumption from all parties involved when writing the rule was that the self-certification ban “should apply to the future, not the past” and the regulation was designed to be forward looking.
But an unintended consequence of the regulators’ ban on self-certified collateral would be to hinder issuers’ ability to package legacy mortgages into future securitizations. At this point, the text of the rule has been agreed upon and is unlikely to change. Short of further clarification from the European Banking Authority (EBA) or the European Securities and Markets Authority (ESMA), it is likely that there is little that can be done to amend or clarify the rule.
According to analysts at Nomura, the language in the bill would not just affect the UK market. While UK non-conforming RMBS would be the most affected asset class, there are several deals from the Netherlands, Nordic countries and Ireland which would fail this test and be banned from issuing.
The analysts pointed out that the language is particularly confusing because it also appears to allow for self-certified mortgages as long as the borrower was not made aware that certain information might not be verified.
Buy-to-let concerns
The regulation would be particularly problematic for the buy-to-let sector, where rental income is often considered more important than a borrower’s salary.
“There is a chance that buy-to-let mortgages will also be caught up in this because the wording is so vague,” said Hopkin. “It is normal and prudent for lenders to ask for lots of information but to rely more on some items than others. In buy-to-let, lenders may ask for both rental income and salary but effectively underwrite on the rental income only. That [type of] mortgage could fall afoul of these rules.”
Deutsche Bank analysts estimated that 26 of the 47 UK non-conforming ‘2.0’ deals (those issued after the financial crisis) and four of 26 buy-to-let ‘2.0’ deals contain self-certified loans.
It is unclear how many other deals could also be brought in under the wider scope of Article 17.
The analysts added that while true self-certified mortgages clearly run afoul of the regulation, it might be “prudent to assume” that fast-track mortgages could also be captured.
NPL headacheThe Article 17 headache is magnified for European NPL securitizations, which have been key to unburdening European banks in recent months. While NPL securitization has come in fits and starts, European authorities committed this month to actively encouraging asset managers and private equity firms to take on some of this exposure. But this rule could cut off a vital source of funding for the firms that have been the most active buyers, discouraging private equity firms from investing in and securitizing European NPL portfolios. “This will create huge uncertainty for mortgages across Europe, said AFME’s Hopkin. “NPLs all begin life as performing, and one reason they become non-performing is because of poor underwriting. So, if you dig into the detail you will find shortcomings in lending standards which could be caught by this wording in many countries. “For the fresher and more pressing problem of NPLs across Europe, to ban securitizations of these assets altogether could be very damaging.” For many private equity houses which have already taken on NPL exposure in Europe they will be unable to finance these existing portfolios through securitization after 2019. It is also doubtful whether some of the NPL transactions which have already taken place in Europe would have been possible under these rules. The precautionary recapitalisation of Monte dei Paschi di Siena (MPS) was dependent on a securitization of the bank’s NPL portfolio. The senior tranches in that deal were guaranteed by the Italian government’s guarantee scheme (GAC) and the junior and mezzanine notes were sold to the country’s Atlante rescue fund. A literal reading of the ban on self-certified loans means that the MPS deal likely would have been illegal. The same can be said for Banca Carige’s NPL GAC transaction this month, which was largely backed by residential loans. If the records do not support that lender certification took place, the pipeline for securitizations of legacy loans could all but shut, and it is understood from sources in the market that some transactions have already been put on hold. |
Potential for change
Market participants were left wondering if the language of the rule can be changed. At first glance, the odds are slim. The text is final and has been approved by both the ECON Committee of the European parliament and COREPER, although the European Parliament will vote on final text of both documents in October.
Bank of America Merrill Lynch analyst Alexander Batchvarov wrote that one solution could be the introduction of a cut-off date for mortgage origination.
“The ban on securitization of self-certified mortgages could be imposed only on mortgages originated on or after a specific point in time, say January 1, 2019,” he wrote. “This shifts the focus from date of securitization to the date of mortgage origination.”
He added that a related clause allowing for the refinancing of transactions containing self-certified mortgages originated before January 1, 2019, could also be beneficial.
It is possible that Article 17 will be removed when it comes to be voted upon in the European Parliament in October, though this is unlikely. It could also be amended, but this would involve a full plenary session of parliament and the reopening of the discussion on STS.
Another way to amend the rule would be through the regulatory technical standards (RTS) which European regulators will draw and will determine how the rules are applied, eliminating some of the confusion.
Whether the EBA and ESMA shed any light on Article 17 and its application will likely determine market reaction over the next two years.
If there is no amendment made to the rule then a number of existing securitizations would face the possibility of extension given they could no longer be refinanced.
Deutsche Bank analysts noted that not being called might not even be economically negative for holders of a number of post-crisis bonds, especially their senior and senior mezzanine tranches, given the step-up in coupon they are set to pay.
If the regulation goes ahead in its current form, then it would be likely that it could be applied to other forms of financing too.
“If these mortgages are banned, and therefore cannot be included in a securitization, then why are they not banned from other forms of capital markets finance such as covered bonds?” asked Hopkin.
The general feeling among sources in the market is that, given the EU’s goal has been to make securitization more accessible and efficient as a source of funds for Europe’s economy, Article 17 is a disappointing last minute addition that could derail much of the market’s efforts made since the crisis.
Brexit relief for the UKGiven the potential impact on UK non-conforming and buy-to-let mortgages, many of which are held by UK Asset Resolution Limited (UKAR), it would be in the interests of the the UK to act quickly to amend Article 17 should it go through as written. Batchvarov writes that it is unlikely that the UK would not adopt Article 17 into law through the repeal bill which will transfer existing EU law on to UK statute books. This could be amended after Brexit, although Batchvarov added that this is still only a distant possibility. However, there is a solution which could mean that the rule would not be applicable in the UK when Brexit occurs. Clause 9 of the bill put forward to the UK parliament to repeal the European Communities Act of 1972 would allow ministers of the crown to “make legislative changes which they consider appropriate for the purposes of implementing the withdrawal agreement.” If Article 17 cannot be changed at an EU level then the UK government could amend it so that it was applied differently to the UK come Brexit. However, this would have to be done before March 2019 as the power expires on the day the UK exits the EU. After that, any amendment will have to go through the same legal challenges as any other change to EU law, which could take years. |