Chris Dalton Chief Executive Officer 3 Spring Street, Sydney NSW 2000 T +61 (0)2 8243 3906 M +61 (0)403 584 600 E cdalton@securitisation.com.au www.securitisation.com.au 23 September 2015 Mr Andrew Alexandratos Head Market Risk & Models Australian Prudential Regulation Authority 400 George Street Sydney NSW 2000 andrew.alexandratos@apra.gov.au Dear Mr Alexandratos AUSTRALIAN RESPONSE TO IOSCO S PROPOSED RISK MITIGATION PRINCIPLES I refer to your respective discussions with the Australian Securitisation Forum s OTC Working Group chair, John Elias, and chief operating officer, Alex Sell. The background to the discussions was to seek some understanding as to the status of APRA s response to the following IOSCO s Requirements: 1. Margin requirements for non-centrally cleared derivatives (IOSCO Margin Requirements); and 2. Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives (IOSCO Mitigation Standards, and together with the IOSCO Margin Requirements, the IOSCO Principles). We understand from those discussions that APRA is in the midst of settling internally what its policy position ought to be in response to the global regulatory mandates referred to above. The purpose of this letter is to provide detailed background as to the nature of securitisation transactions, and why, specifically, we consider it inappropriate for securitisation entities to be considered covered entities for the purposes of the IOSCO Principles; and ADI swap providers need not hold additional regulatory capital on the grounds that they already enjoy senior, secured status in securitisation SPVs. (To do otherwise would mean requiring regulatory capital for risks that are already mitigated in excess of those levels contemplated in the IOSCO Mitigation Standards.) 1
We focus below on securitisation but the analysis similarly applies to covered bonds. 1. Background on the ASF, the securitisation industry and typical securitisation structures The ASF is the peak industry body representing participants in Australia s securitisation markets. Its 85 corporate members range from issuers (banks and non-banks), institutional investors (fund managers and superannuation funds), trustees, credit rating agencies, accounting and law firms, data vendors, and others involved in the securitisation value chain. An outline of a typical securitisation structure is set out in Annexure A. This annexure also includes some details in relation to covered bond transactions. 2. Covered entities The IOSCO Principles are to apply to financial entities and systemically important nonfinancial entities - to be known as covered entities. We understand that the definition of covered entities will be determined by APRA for Australia, and as such we are seeking to ensure that this threshold issue is dealt with definitively and swiftly to avoid uncertainty, and ultimately to prevent the harmful consequences stemming from the need to margin. The protections already developed for securitisation structures (specifically, that swap counterparties have first-ranking security) means the cost-benefit-analysis concludes in not mandating margining or collateral nor imposing additional regulatory capital. Detailed analysis is at Annexure B, but in short: (a) (b) (c) margining will not result in a reduction in contagion or systemic risk rather, it has the potential to increase this risk; the margin requirements in relation to non-cleared swaps will create structural and operational issues for the industry and negatively affect securitisation cash flows; and these impacts will have serious economic consequences for the securitisation industry, which could threaten its viability, with flow on consequences for the broader economy. 2
The requirement for the securitisation entities to comply with the IOSCO Mitigation Standards would demand seismic structural and operational changes without delivering meaningful risk mitigation. We have outlined detailed analysis of this issue in Annexure C. 3. Conclusion As noted in our below analysis, we consider that securitisation entities should not be considered covered entities for the purposes of the IOSCO Principles (and, likewise, counterparties to securitisation entities should not otherwise be impacted as a result of their contracting with securitisation entities). This would give the Australian securitisation industry certainty on this issue and remove negative consequences for the industry and economy. We would like to meet with you in the coming weeks to discuss this matter. I will be in touch to see if we can schedule a mutually convenient time to meet. Yours sincerely Chris Dalton 3
ANNEXURE A TYPICAL SECURITISATION TRANSACTIONS We have set out in this annexure a brief summary of typical securitisation transactions. In the final paragraph, we also note some brief details of covered bond transactions. Broadly speaking, securitisation typically involves the issue of financial instruments (or notes ) by a special purpose vehicles (each, a securitisation entity), the proceeds of which are used to acquire or lend against the security of assets which are the primary collateral for the repayment of the notes. Payments of interest and principal on the notes are generally made from collections received on the designated pool of assets transferred to and owned by the securitisation entity. Swaps are often used to hedge interest rate and currency positions. While they are not in any way exotic or speculative in nature, as their terms need to reflect the underlying asset pool, these swaps would likely not satisfy the requirement for central clearing. Generally, the seller/originator of the assets retains a direct equity interest in the asset pool through holding a residual income unit or like security. In the majority of the cases the originator or seller of the securitised assets also continues in a servicing role and hence has a direct interest in ensuing the assets perform optimally to generate the expected level of economic return to the original seller or originator. In Australia, asset classes that are commonly securitised include residential mortgages and equipment and/or automobiles receivables, such as leases and chattel mortgages (by both ADI originators and non-adi originators). Fundamental legal principles of a securitisation structure The key principles of a typical securitisation structure are: 1. Bankruptcy remoteness The risk of the securitisation entity becoming insolvent must be remote in accordance with well-established legal practices. The securitisation entity is typically either a trust or a special purpose company, but in Australia is more commonly a trust. 2. Assets quarantined from originator/seller insolvency The beneficial ownership of the assets held by the securitisation entity is isolated from the insolvency risk of the seller by achieving a true sale of those assets from the originator/seller. The economic risk on the asset pool is shifted from the originator/seller to the securitisation entity. In the event of the originator/seller becoming insolvent, the assets will not be included in the originator/seller s assets as part of its insolvency proceedings, but are available to creditors of the trust including noteholders and swap providers. 4
3. Limited recourse/non-petition language The recourse of the secured creditors of the securitisation entity is limited to the assets (i.e. the mortgage or other receivables) of that securitisation entity. Secured creditors are also bound by non-petition language which limits their right to petition a court to commence insolvency proceedings. Amortising assets limited life securitisation entity. The asset pool in a typical securitisation is amortising. As the asset pool of mortgages or other receivables are repaid by borrowers, principal is passed through to noteholders. On this basis, swaps provided to a securitisation entity are typically linked to the notional value of one or more asset classes (e.g. fixed-rate loans) in the amortising asset pool. 4. Security Security is granted over the assets of the securitisation entity in favour of a security trustee. If an event of default (including non-payment to a swap provider) arises the security trustee is able to enforce the security acting on instruction from the secured creditors. A swap provider will typically rank senior or pari passu with the senior rated noteholders (typically the AAA tranche in a rated structure). 5. Tranching of securities Traditionally, securities or notes issued in securitisation transactions are tranched to reflect a different degree of credit risk (i.e. one class of creditors is entitled to receive payments from the underlying pool before another class of creditors). Securitisation techniques Securitised assets can be originated within the banking system (i.e. by ADIs) or outside the banking system (e.g. corporate balance sheets or by non-adi lenders), as described below. Securitisation techniques typically contain the key principles of securitisation structures described above. We provide some further detail on some common structures used in the Australian market below. 1. Warehouse Arrangements Facilities typically funded by banks (typically the major banks and the international banks with a presence in Australia). Warehouse arrangements generally involve regular asset sales by the seller into the securitisation structure but can also, for example, provide temporary funding for an acquired portfolio prior to that portfolio being in whole or in part termed out into a capital markets transaction, or provide funding for assets that are more difficult to term out in the capital markets. Typically an originator/seller may enter into a warehouse transaction, with funding provided by 5
an ADI that is not related to originator or seller (Non-Related ADI). Warehouse arrangements may be structured with a single tranche or with more than one tranche of notes. A lower tranche of notes (seller note) may be held by the seller/ originator of the assets. Tranching in this way is one of the means by which credit support can be provided to the more senior class of notes. This may be undertaken so that the financial instruments issued by the securitisation entity achieve certain levels of creditworthiness required by their rating. 2. Asset-Backed Securities (ABS) and Residential Mortgage-Backed Securities (RMBS)) These are the most common securitisation transactions utilised by ADIs. For longerdated assets, originators/sellers are able to achieve asset-liability maturity match funding via issuing ABS into the domestic and global capital markets. The decision to issue term securities rests with the seller (e.g. the non-bank or ADI originator). Similarly the originator/seller decides which third parties to appoint to the securitisation transaction, such as the dealers, trustee and rating agencies. Covered bond transactions share many similar characteristics with securitisation transactions. However, in covered bond transactions, the Australian banks are the issuers of the covered bond - not the special purpose vehicles. The bank issuer makes an inter-company loan to the special purpose vehicle to enable the special purpose vehicle to acquire the cover pool of assets. The special purpose vehicle then provides a guarantee of the issuer s obligation to bond holders. This guarantee will be called upon in an event of default in respect of the bank issuer. The cover pool of assets permits the special purpose vehicle to continue to make scheduled payments on the bonds following an issuer event of default. The bond holders benefit from security granted by the special purpose vehicle over the cover pool to secure the special purpose vehicle s obligations, including in respect of the guarantee. Swaps would invariably be entered into to hedge and smooth interest rate flows in the transaction. 6
ANNEXURE B Application of IOSCO Margin Requirements 1. We do not believe that securitisation entities should be subject to a margining requirement in respect of swaps for the following reasons: (a) (b) (c) margining will not result in a reduction in contagion or systemic risk rather, it has the potential to increase this risk; the margin requirements in relation to cleared swaps will create structural and operational issues for the industry and negatively affect securitisation cash flows; and these impacts will have serious economic consequences for the securitisation industry, which could threaten its viability, with flow on consequences for the real economy. 2. We have expanded on these reasons in paragraphs 3 to 10 below. No reduction in contagion or systemic risk 3. The main purpose of the proposed margining requirement is to reduce systemic risk. Australian securitisation transactions should be exempt from a margining requirement as they already mitigate the risk of default arising from their reliance on OTC derivatives, and hence systemic risk, through their use of the legal and structural protections outlined below: (a) Bankruptcy remoteness The assets of each securitisation entity are segregated under a bankruptcy remote structure. Under each securitisation transaction, the recourse of the swap providers and other creditors following default is confined to a defined asset pool. Moreover, each securitisation swap is entered into for a specific hedging purpose or defined activity, or a series of such transactions (typically subject to defined rating agency criteria). The administrators of the securitisation entity (i.e. trustee and trust manager) cannot make operational decisions other than those prescribed in advance under the documentation. (b) Security limits counterparty credit risk Swap providers have the benefit of a security interest over all of the securitisation entity s assets and rank above (or at least equal to) senior noteholders in an enforcement scenario (for further details see paragraph 7 below). (c) Assets quarantined from seller insolvency The beneficial ownership of the assets held by the securitisation entity is isolated from the insolvency risk of the seller by achieving a true sale of those assets from the seller. Under the true sale, the economic risk on the asset 7
pool is shifted from the originator/seller to the securitisation entity. In the event of the seller s insolvency, the assets will not be included in the seller s assets as part of its insolvency proceedings, but are available to creditors of the trust including noteholders and swap providers. (d) Protection against swap provider insolvency Creditors are protected against the risk of swap provider default by the substantial security package. In the case of rated transactions, the leading rating agencies also require swap providers to post collateral (or otherwise novate or obtain alternative credit support, such as guarantees) to cover a securitisation entity s swap exposure, unless the swap provider is sufficiently rated. (e) Limited recourse and non-petition language Securitisation entity creditor recourse is limited to the trust s collateral (e.g. mortgage or other such receivables). Creditors are also bound by non-petition language, which limits their right to petition a court to commence insolvency proceedings against the securitisation entity. This serves further preserves the integrity of the security (i.e. the collateral) available for senior creditors and their rights against other creditor claims. 4. In summary, Australian securitisation transactions already build in robust protections against systemic risk, including legal risk. Imposing a margin requirement on securitisation swaps will not reduce systemic risk beyond the levels already achieved through these protections. 5. In addition, as securitisation swap activity is relatively limited and motivated primarily by hedging of underlying cash flows and exposures, the systemic risk reduction achieved by a margining requirement for securitisation swaps is likely to be limited, regardless of whether the above protections are in place. Structural and Operational issues 6. If a margining requirement was imposed on securitisation swaps, the securitisation entity would be required to collateralise its swap exposures by the posting of (presumably) initial and daily variation margin. 7. Under current securitisation structures, securitisation entities do not have access to funds for margining. Instead, swap providers exposures are collateralised by the pool of underlying assets, which eliminates the need for the securitisation entity to post daily margin. Because swap exposures are secured over the entire pool of trust assets, the swap provider has access to a much larger pool of collateral than would be posted under margin rules, arguably providing greater protection than liquid margin would. 8
In effect, the security arrangements remove the credit requirement for margin, as the swap exposure to the securitisation entity is instead covered by the pool of underlying assets. 8. Any shift from the current non-liquid security arrangements to a liquid margin requirement will present a number of significant structural, commercial and operational challenges. Namely, (a) (b) margin calls will need to be funded either through a loan facility or cash reserves (funded out of cash flows generated by the securitisation entity assets). This will result in additional funding costs which would probably be payable ahead of other securitisation entity creditors (including noteholders). This will affect the cash flow analysis for securitisation programmes and, in particular, dilute the return to the income unitholder (i.e. excess spread would reduce); to the extent margins are funded by a bank, the bank would need to be bought into the security and pre and post-enforcement waterfalls. Custodians may also be involved in holding the securitisation entity s and swap provider s initial margin. Any margin funding banks or custodians would need to meet rating agency criteria in order to be properly integrated into transactions, which could require the introduction of new structural features and cause significant changes to programme documentation. In addition, inclusion of an additional funding bank could actually increase system risk, rather than reduce it. In this situation, the funding bank would assume the economic risk of the payment of the margin and therefore it would be exposed to the credit risk of the securitisation entity, while the swap counterparty would be exposed to the credit risk of the funding bank. (c) sophisticated models for calculating initial/variation margin and haircuts would be needed; the securitisation entity s role would not ordinarily extend to performing these types of calculations. If the securitisation entity s role was expanded to cover this calculation function, this would involve additional costs for the transaction (as described below); and securitisation entities allocate cash collections to investors, swap providers, security trustees and other service providers on a monthly basis securitisation entities would therefore only have funds available to meet monthly margin calls, which would not fit with daily margining. 9. Navigating these challenges will manifestly produce real economy implications due to the uncertainty (and cost) as new transaction structures and practices are explored to allow for the posting of margin. Cost issues 10. The above structural and operational issues will have a significant impact on the cost and efficiency of securitisation funding. In particular, the potential cost of establishing cash reserves or margin funding facilities will result in additional funding costs that would be payable ahead of other securitisation entity creditors (including noteholders). This means there would be less money available to meet payments on the notes, and 9
Summary ultimately less excess spread. This cost outcome could bring into question the viability of securitisation funding as against other sources of funding. 11. For the following reasons, securitisation entities should not deemed covered entities and therefore exempted from the requirements,: (a) (b) (c) securitisation transactions already build in robust protection measures against contagion or systemic risk imposing margin requirements on securitisation swaps will not reduce this risk beyond the levels already achieved through existing mitigants and, in fact, has the potential to amplify systemic risk; the significant restructuring required to accommodate margining under the structures will cause a slowing down of the securitisation market as new transaction structures and criteria are assessed; and significant costs would harm securitisations economics or indeed render it not usable at all depending on rating agency analysis thereby restrict their availability as a funding tool, eroding competition in lending markets and reducing funding diversification, something that APRA seeks to avoid in its Mission. Conclusion 12. Exempting securitisation swaps from a margining requirement will give the Australian securitisation industry certainty on this issue and remove the negative consequences for the industry and real economy. 13. It will strike an appropriate equilibrium between, on the one hand, market stability and secured investor protections and, on the other, meet the Government s commitment to minimise regulatory burden for business and promote market efficiency and competition. 10
ANNEXURE C Application of IOSCO Mitigation Standards 1. We do not believe that securitisation swaps should be subject to the IOSCO Mitigation Standards because the standards would impose requirements that are plainly not intended that is, where there is no evincible benefit to the counterparties or the financial system. Further, sufficient checks and balances are already in place. For example, reporting by swap providers facilitates easy surveillance by users and the authorities of any significant or systemic exposures. 2. We have analysed below the application of each of the eight standards set out in the IOSCO Mitigation Standards: Standard 1 Scope of Coverage As noted, we do not believe that securitisation entities should be covered entities. The rationale is set out in our analysis of the remaining standards below. Standard 2 Trading Relationship Documentation If a securitisation is to be hedged, then it will be a requirement of the parties that the executed documents is in place prior to the relevant funding. This will usually be expressed as a condition precedent to funding. Any relevant rating agencies will require this as well. Execution and existence of the relevant documentation would typically be confirmed by the issuance of transaction legal opinions from deal counsel. Standard 3 Trade Confirmation As noted above, any necessary swap documentation would be put in place prior to the relevant funding. Standard 4 Valuation with Counterparties As noted in Annexure B, we consider that there should not be any margin requirement imposed on the securitisation entities. Accordingly, the issue of valuation does not arise. Standard 5 Reconciliation As this largely relates to reconciliation as against valuations, which as noted, we do not consider necessary on the basis that there should not any margin requirement, we do not consider this to be necessary. Standard 6 Portfolio Compression 11
This is not relevant in the context of securitisation transactions, where the securitisation entity will have a limited number of derivatives in place that are required to hedge asset/liability risks, as determined by the financiers, the originator and any applicable rating agencies. Standard 7 Dispute Resolution As noted above, swap transactions will typically be documented as a condition precedent to closing, so issues as to terms should not arise. In respect of valuations, we note the commentary above in respect of Standards 4 and 5. Standard 8 Implementation This is a matter for Australian authorities, and does not impact on the applicability of these standards to securitisation entities. 12