BANK OF ENGLAND COMPELS BANKS ON TRANSPARENCY. Author: Dave Colling

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1 BANK OF ENGLAND COMPELS BANKS ON TRANSPARENCY Author: Dave Colling

2 INTRODUCTION Recently, the Bank of England revised the levels of information required for asset-backed securities (ABS) and whole loan portfolios that are offered as collateral. The new levels far exceed those of the past. Complying with these new eligibility requirements represents a very significant challenge for those lenders in the UK that want to preposition and /or borrow funds under the Bank s Discount Window Facility (DWF) and other facilities against loan portfolio collateral. In November 2010, The Bank of England (BoE) published detailed requirements and reporting templates for loan-level reporting of residential mortgage portfolios, mortgage-backed securities (RMBS) and covered bonds. The Bank also stated that it will be publishing criteria and reporting templates for other loan asset types during Since April 2011, the BoE has broadened the range of eligible collateral for its DWF to include high-quality, wholeloan portfolios. Lenders that want to draw funding against loan portfolios under the DWF must now preposition such portfolios with the BoE, obtain the Bank s pre-approval and commit to provide monthly loan-level performance updates in the prescribed reporting template. The BoE intends to start applying incremental haircuts for non-compliance in December 2011 for assets backed by residential mortgage loans. The schedule for haircut deductions for other loan asset types has not yet been published. To ensure compliance with the revised reporting standards, the BoE has announced that failure to report or achieve the required reporting standards will ultimately result in pledged assets incurring a 100% haircut when utilised as collateral for any BoE liquidity facility. With this announcement, the Bank is sending a clear message to the market the levels of information required to be submitted by participants, both at the level of the ABS transaction and the underlying loan-level data, undoubtedly reflect the intention of the Bank to bring about more transparency for ABS transactions. REGULAR LOAN-LEVEL REPORTING The Bank also published detailed eligibility requirements for RMBS and covered bonds backed by residential mortgages. They are the first to contain comprehensive descriptions of reporting guidelines provided by the Bank for loan portfolios. The requirements extend to whole loan portfolios containing residential mortgage loans being prepositioned in the DWF. The Bank will continue publishing detailed requirements for other asset classes throughout 2011 and beyond. The specific information requirements for RMBS and covered bonds backed by residential mortgages, which will be made available to all interested parties via a secure website include: Loan-level data Anonymised data that is to be provided using the applicable template published by the Bank on at least a quarterly basis or within one month of an interest payment date. Transaction documentation Prospectus and closing transaction documents. Transaction summary Required for new issuances, to conform to the appropriate template provided by the Bank. Standardised monthly investor reports Required within one month of the relevant reporting date. Cash flow models (not applicable to covered bonds) A cash flow waterfall model is required to be made freely and readily available to all interested parties. The model must accurately capture how incoming cash is applied through the tranched capital structure given the priority of payments. Cash flow models may be provided either directly on a website maintained by, or on behalf of, the transaction originator or arranger, or via a proprietary format on the platform of a third party provider. The form of the model may be a spreadsheet, a web page or accessed via a proprietary tool. In all cases, the calculations must be transparent and understandable and users must be able to save the results. What s more, access must always be free of charge to users. EQUITY DERIVATIVES STANDARDISATION: A Critical Element in Curbing Systemic Risk 2

3 TECHNOLOGY 3 OPERATIONAL CHALLENGES The prepositioning process with the BoE represents significant operational challenges. Institutions are discovering that they need to devote significant time and deploy substantial additional resources to obtain initial approval and continued loan-level reporting compliance. Challenges include: Data gathering Lenders will be required to collect, assemble, maintain and report monthly immense amounts of data (for example, the reporting template for residential mortgages contains 202 data points (104 mandatory) for each loan in the portfolio/pool). For many institutions, this data will not be all in one place; it is likely to exist in multiple locations, across legacy systems and within documents. Ongoing reporting Lenders will be required to dramatically upgrade their information management and reporting infrastructures for both existing and new transactions. Wholesale amendments to documentation Lenders may be forced to amend both new and existing standard documentation in order to comply with eligibility requirements. Credit scores There is a lack of consistency and standardisation of external and internal credit scores. As a result, lenders are expected to face substantial costs with few resources and under significant implementation time pressure. The costs of eligibility compliance (e.g., external legal opinions and independent portfolio audits) must be borne by lenders. Also, as a direct result of the credit crisis and subsequent downturn in the securitisation markets, many lenders have reduced staff and will require additional resources in order to comply with the eligibility and information reporting requirements. IMPLEMENTATION TIMESCALE An aggressive implementation period for residential mortgage portfolios has also been specified by the Bank. To avoid escalating haircuts on prepositioned or pledged collateral, banks must review, establish and update infrastructure and processes to capture, regularly collect and report dynamic updates at the required levels, utilising the appropriate template by November To achieve this tight deadline, lenders need to review internal processes and instigate any necessary changes now. A generic timeline for all asset classes has been defined by the BoE, and a more specific timeline for residential mortgage portfolios has been announced following the publication of detailed requirements for that asset class. The Bank started processing prepositioning applications in January Since April 2011, the Bank began accepting loan portfolios as pledged collateral under the DWF. Implementation period There will be an implementation period of 12 months for each asset class following the publication of detailed requirements. During this period, securities that do not meet the new transparency requirements will be accepted as collateral by the Bank without penalty. Participants are expected to use this period to put required systems and processes in place. Transition period There will be an additional 12-month period following the implementation period, during which time securities that do not meet the new requirements may remain eligible, but will be subject to escalating haircuts. 3

4 Additional escalating collateral haircut deduction following implementation period* Date Event Period Haircut Nov Detailed eligibility requirements published. Implementation period commences. Mortgage template issued. Prior to Dec Dec % 5% April 2011 Nov DWF accepts pre-approved Whole Loan Portfolios as eligible collateral. Mortgage loan implementation Period ends. Transition period starts. Escalating Haircuts introduced Jan Feb March 2012 April % 15% 20% 25% Nov Mortgage loan Transition Period ends May % June % July % Aug % Sept % Oct % Nov % *Plus market value adjustment 100% Figure 1: Implementation Timescale THE GLOBAL REPORTING LANDSCAPE Both the EU and US have enacted or announced similar enhanced transparency regulations designed to provide investors with the tools, data and information needed to exercise in-house due diligence and valuation on their ABS investments. Within the EU, Article 122a of the Capital Requirements Directive came into effect on January 1, 2011 for new transactions. Among other things, Article 122a imposes various due diligence requirements on credit institutions investing in asset-backed securities. As with the BoE, this further drives increased disclosure and transparency in ABS. On December 16, 2010, the ECB announced that it would make loan-by-loan disclosures a requirement for ABS to be eligible for the Eurosystem collateral framework. Since December, the ECB has issued loan-level reporting templates for RMBS, small and medium enterprise loan securitisations (SME) and commercial mortgage-backed securities (CMBS). Like the BoE, the ECB also intends to apply haircut deductions for reporting non-compliance at a future date and, ultimately, also render non-compliant securities ineligible for repo purposes through the Eurosystem. The date for mandatory reporting has not yet been announced. In the US, the SEC, together with other Federal Agencies, has been active in promoting enhanced transparency and reporting. Recent rules proposed or enacted by the SEC have addressed a number of securitisation reforms, EQUITY DERIVATIVES STANDARDISATION: A Critical Element in Curbing Systemic Risk 4

5 TECHNOLOGY 3 including certain Dodd-Frank Act provisions targeted at enhancing the disclosure of asset-backed securities, risk retention requirements, prohibitions on conflicts of interest, due diligence reviews of securitised assets by issuers, the repurchase request disclosure by issuers and repurchase mechanics disclosure by NRSROs. Section 942 of the Dodd-Frank Act directed the SEC to adopt new regulations affecting the level of disclosure required for ABS. By the time the Dodd-Frank Act was enacted, however, the SEC had already begun the process of reforming ABS disclosure. In early 2010, the SEC proposed sweeping reforms to Regulation AB, the regulatory provisions that govern offerings of asset-backed securities. Known as Reg AB II, the reforms included new disclosure requirements for loan-level reporting of ABS, risk retention requirements for shelf (program) offerings, electronic reporting requirements and an extension of certain disclosure requirements to previously exempted private offerings of ABS. The proposals in Reg AB II represented a new level of securities disclosure and would require filing asset data files with the SEC, as well as a waterfall computer program, which gives effect to the flow of funds provisions of the regulations. These regulations have been further underscored by changes to the FDIC s safe harbor rule, which affords true sale treatment for transfers by US banks to the bankruptcy remote vehicles used in securitisation financing. The changes to the safe harbor rule are now tied to a number of conditions requiring enhanced disclosure and risk retention by banks wishing to undertake securitisations. CONCLUSION Before the recent financial crisis, securitisation markets often operated in an asymmetric environment where rules were opaque and standards varied. Useful, timely disclosures to investors regarding the performance of loan-level collateral were difficult to access, if available at all. Inefficiency, mistrust and confusion reigned, all to the advantage of issuers and the disadvantage of investors and the public. Now that regulators have recognised the industry s earlier failings and have begun to address the process of securitisation, two questions remain: Have we finally said good-bye to the wayward practices of the past and put a framework of stable, transparent securitisation markets in place that work for everyone? Will the new regulations contemplated by the BoE, ECB, SEC and others work to produce a vibrant and liquid market instead of perpetuating a rigid and inefficient opaque system that is permeated with continued mistrust and unable to support the financial intermediation necessary for a self-sustaining global economic recovery? Only time, combined with comprehensive, meaningful and transparent reporting, will tell. 5

6 APPENDIX 1: MANDATORY RESIDENTIAL MORTGAGE LOAN LEVEL DATA FIELDS TO BE REPORTED Field Number TAG Field Name Field Number TAG Field Name AR138 Static Valuation Date AR113 dynamic Interest Revision Date 1 AR166 dynamic Account Status AR115 dynamic Interest Revision Date 2 AR57 static Account Status Date AR117 dynamic Interest Revision Date 3 AR171 dynamic Arrears 1 Month Ago AR84 static Lien AR172 dynamic Arrears 2 Months Ago AR174 dynamic Litigation AR169 dynamic Arrears Balance AR65 static Loan Currency Denomination AR36 dynamic Bankruptcy or Individual Voluntary Arrangement Flag AR235 static Bankruptcy or Individual Voluntary Arrangement Flag AR197 dynamic Bankruptcy or Individual Voluntary Arrangement Flag (Second Borrower) AR236 static Bankruptcy or Individual Voluntary Arrangement Flag (Second Borrower) AR3 static Loan Identifier AR55 static Loan Origination Date AR61 static Loan Term AR180 dynamic Loss on Sale AR7 static Borrower Identifier AR79 static Mortgage Indemnity Guarantee Attachment Point AR21 static Borrower's Employment Status AR78 static Mortgage Indemnity Guarantee Provider AR45 dynamic Bureau Score Date AR170 dynamic Number Months in Arrears AR206 dynamic Bureau Score Date (Second Borrower) AR155 static Number of Buy to Let Properties AR43 dynamic Bureau Score Provider AR31 static Number of County Court Judgements or equivalent - Satisfied AR204 dynamic Bureau Score Provider (Second Borrower) AR227 static Bureau Score Provider (Secondary Borrower AR217 static Bureau Score Provider (Primary Borrower AR192 static Number of County Court Judgments or equivalent - Satisfied (Second Borrower) AR33 static Number of County Court Judgments or equivalent - Unsatisfied AR194 static Number of County Court Judgments or equivalent - Unsatisfied (Second Borrower) AR44 dynamic Bureau Score Type AR19 static Number of Debtors AR205 dynamic Bureau Score Type (Second Borrower) AR228 static Bureau Score Type (Secondary Borrower AR218 static Bureau Score Type (Primary Borrower AR130 static Occupancy Type AR66 static Original Balance AR135 static Original Loan to Value AR46 dynamic Bureau Score Value AR137 static Original Valuation Type AR207 dynamic Bureau Score Value (Second Borrower) AR58 static Origination Channel / Arranging Bank or Division EQUITY DERIVATIVES STANDARDISATION: A Critical Element in Curbing Systemic Risk 6

7 TECHNOLOGY 3 AR220 static Bureau Score Value (Primary Borrower AR230 static Bureau Score Value (Secondary Borrower AR5 static Originator AR71 dynamic Payment Due AR100 dynamic Cumulative Pre-payments AR70 static Payment Frequency AR181 dynamic Cumulative Recoveries AR72 static Payment Type AR67 dynamic Current Balance AR173 dynamic Performance Arrangement AR109 dynamic Current Interest Rate AR1 dynamic Pool Cut-off Date AR108 dynamic Current Interest Rate Index AR2 static Pool Identifier AR110 dynamic Current Interest Rate Margin AR97 dynamic Pre-payment Amount AR141 dynamic Current Loan to Value AR26 static Primary Income AR143 dynamic Current Valuation Amount AR8 static Property Identifier AR145 dynamic Current Valuation Date AR131 static Property Type AR144 dynamic Current Valuation Type AR59 static Purpose AR178 dynamic Date of Default AR175 dynamic Redemption Date AR56 dynamic Date of Loan Maturity AR69 static Repayment Method AR156 static Debt Service Coverage Ratio AR122 static Restructuring Arrangement AR177 dynamic Default or Foreclosure AR118 dynamic Revised Interest Rate Index AR120 static Final Margin AR119 dynamic Revised Interest Rate Margin AR121 static Final Step Date AR114 dynamic Revision Margin 2 AR90 static Flexible Loan Amount AR116 dynamic Revision Margin 3 AR91 static Further Advances AR179 dynamic Sale Price AR88 dynamic Further Loan Advance AR189 static Second Borrower's Employment Status AR128 static Geographic Region AR28 static Secondary Income AR154 static Gross Annual Rental Income AR6 static Servicer Identifier AR27 static Income Verification for Primary Income AR136 static Valuation Amount AR29 static Income Verification for Secondary Income AR32 static Value of County Court Judgments or equivalent - Satisfied AR112 static Interest Cap Rate AR193 static Value of County Court Judgments or equivalent - Satisfied (Second Borrower) AR111 dynamic Interest Rate Reset Interval AR34 static Value of County Court Judgments or equivalent - Unsatisfied AR107 static Interest Rate Type AR195 static Value of County Court Judgments or equivalent - Unsatisfied (Second Borrower) 7

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