Securitisation Update May 2008

28 May 2008

Contents

• Expansion of RBA repo-eligibility criteria
• Further federal government liquidity initiatives
• ASIC debenture advertising guidelines
• Finance Broking Bill
• Basel II revisited – regulatory proposals may make some securitisations more expensive
• Proposed changes to rating agencies’ code of conduct and rating agencies’ response
• Financial Stability Forum
• Personal Property Securities Bill 2008

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Expansion of RBA repo-eligibility criteria

In an attempt to ease the liquidity crunch in the Australian financial system, the Reserve Bank of Australia (RBA) announced on 6 September 2007 an expanded list of securities it is prepared to accept under repurchase agreements (repos).

The first stage of this expansion took effect on 17 September 2007 when the list of securities eligible for the RBA’s repo operations was extended to include:

• bills and certificates of deposit issued domestically by any Authorised Deposit-taking Institution (ADI) which holds an Exchange Settlement (ES) Account at the RBA. The remaining term to maturity of these securities must be no more than 12 months, and
• Australian dollar bonds issued by an ADI that holds an ES Account and is rated A3 or above by all major credit ratings agencies that rate it, and in any event, by at least two such agencies. Subordinated and structured securities will be excluded.

The second stage of this expansion took effect on 8 October 2007 when the list of securities eligible was extended to include:

• Australian dollar domestic-issued residential mortgage-backed securities (RMBS) with a public rating of AAA or equivalent from one of the major rating agencies, and
• Australian dollar domestic-issued asset-backed commercial paper (ABCP) rated P-1 or equivalent by one of the major rating agencies.

A list of currently eligible RMBS and ABCP can be found on the RBA website. If requested, provided an appropriate application is submitted to the RBA, other RMBS or ABCP can be added to the relevant lists. However, the RBA must be satisfied that the security meets its requirements which, in the case of RMBS, include the following:

• it must be tradeable in the secondary market
• it must make regular coupon payments
• there must be a true sale of mortgages into a bankruptcy remote SPV, and
• it must be lodged, and all transactions must be settled, in the Austraclear System.

The cash value provided by the RBA for eligible RMBS and ABCP is based on the value of the underlying assets (valued assets) and a margin. Valued assets comprise:

• prime domestic full-doc residential mortgages (including in securitised form) insurable by an acceptable mortgage insurer, and
• similarly qualified low-doc residential mortgages (including in securitised form) up to a maximum equivalent of 10 per cent of the value of all underlying assets.

Mortgages and other assets in the pool underlying the RMBS or ABCP that do not meet the requirements for valued assets will be fully discounted by the RBA. A margin of 10 per cent. will be applied to the valued assets underlying the security.

Where the RBA cannot identify a timely market price for RMBS or ABCP, the security will:

• in the case of RMBS, be valued at 90 per cent of par value, and
• in the case of ABCP, be valued at BBSW plus 100 basis points

until a market price can be identified from a recognised and independent source.

The RBA must be provided, on an ongoing basis, with details on the composition of the eligible mortgages underlying the security, including the share of prime domestic full-doc residential mortgages, the share of domestic low-doc residential mortgages and a list of mortgage insurers represented in the pool and the share of mortgages that each covers.

APS 120 – APRA produces ‘internal securitisation’ guidelines for ADIs

On 13 March 2008, the Australian Prudential Regulation Authority (APRA) sent a letter to all ADIs, in which it stated its support for initiatives designed to provide ADIs with alternative sources of liquidity. APRA also stated that any proposed structure whereby an ADI securitises a portion of its loan portfolio to create eligible securities for repos with the RBA can be designed to meet APRA’s prudential requirements subject to the following provisions:

• The securitisation must not result in a reduction in regulatory capital requirements for the ADI. The ADI is expected to treat the entire pool of securitised loans as on-balance sheet assets for capital adequacy purposes.
• The capital treatment above will continue until such time as the ADI can demonstrate that it fully meets APRA’s requirements for obtaining capital relief for securitised assets. This includes, in particular, the requirement that the ADI not hold a disproportionate amount of the securities issued by a securitisation vehicle into which it has originated assets.
• For the time being, the securities issued under such structures will not be considered by APRA to be a part of the ADI’s liquid assets for the purpose of scenario analysis modelling or high quality liquid assets under APS210 Liquidity.
• On an ongoing basis, the ADI must report the total amount of the securitised assets to APRA.
• These securitisations must be included in the disclosures on securtisation activity required under APS330 Capital Adequacy: Public Disclosure of Prudential Information.
• The ADI must notify APRA when it establishes a contingent liquidity securitisation.

Impact in the market

The effect of the RBA’s stance has been immediate. Since the beginning of 2008, a number of ADIs have ‘internally securitised’ their mortgage books via repo eligible RMBS issues in order to establish greater access to liquidity if required in the future, including:

• Westpac
• Members Equity Bank
• Bank of Queensland
• ANZ
• Macquarie Group
• St George
• National Australia Bank
• Commonwealth Bank, and
• Suncorp.

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Further Federal Government debt market initiatives

The Federal Treasurer’s office announced on 20 May 2008 that the Australian Office of Financial Management (AOFM) will be able to accept a wider range of collateral for the purposes of its securities lending program. This means that market participants will be able to raise liquidity through the AOFM by using the same range of assets that are RBA ‘repo-eligible’. Details of the proposals have not yet been released.

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ASIC debenture advertising guidelines

On 19 December 2007, ASIC released Regulatory Guide 156 – Debenture Advertising (guide). The guide sets out the standards that ASIC expects debenture issuers and publishers of debenture advertising to meet when marketing debentures that are offered to retail investors.

Coverage

‘Advertisement’ is defined broadly to include any comment on, and promotion of, debentures in the course of media programs and publications (including on websites). Statements made in a prospectus however will not fall under the guide, as these will continue be regulated under the Corporations Act 2001 (Cth) (Corporations Act).

Statements made over the telephone or in any correspondence in response to inquiries about debentures offered to retail investors are subject to the same regulation regarding misleading and deceptive conduct as advertisements.

Advertising standards

The guide establishes the following standards for advertisements of debentures that are offered to retail investors:

• all advertisements should include a prominent statement to the effect that investors risk losing some or all of their principal investment
• interest rates should only be quoted if accompanied by a prominent disclosure of:
  1. a current credit rating of the debenture from a recognised credit rating agency (and what the rating means or where to find this out), or
  2. a statement that the debenture does not have such a credit rating (and what this means (that is, that no independent assessment of risk has been made)).
• reference should not be made to the investment ratings of the debenture or the issuer, or to credit ratings issued by an entity other than a recognised credit rating agency
• advertisements should state that the debenture is not a bank deposit
• advertisements should not suggest that a debenture is, or compares favourably to, a bank deposit
• advertisements should not suggest that there is little or no risk of the investor losing their principal or not being paid interest—specifically, ASIC warns against use of the words ‘secure’, ‘secured’, ‘guaranteed’, ‘safe’, ‘deposit’, ‘first ranking’ and ‘no fees’
• advertisements should not state or imply that the investment is suitable for a particular class of investor (for example ‘suitable for a conservative investor’), and
• statements in advertisements should be consistent with all corresponding disclosures on that subject matter in the prospectus.

Application to publishers and the media

ASIC expects publishers and the media who deal with advertisements for debentures to:

• be aware of the risks that debenture products pose, and
• adopt systems and controls to detect and refuse advertisements that do not comply with the guide.

ASIC believes that publishers can be imputed with knowledge of the standards set out in the guide—this may prevent publishers from relying on section 1044A ‘General defence or relief for publishers’ of the Corporations Act and section 12GI(4) ‘Defences’ of the Australian Securities and Investment Commission Act 2001 (Cth) (ASIC Act).

Where a publisher contributes to the content of the advertisement, ASIC will regard the publisher to be in the same position as the issuer in terms of responsibility.

Possible consequences of non-compliance

Debenture issuers who fail to comply with the advertising standards set out in the guide risk making false or misleading statements or engaging in misleading or deceptive conduct under sections 1041E and 1041H of the Corporations Act and sections 12DA and 12DF of the ASIC Act. ASIC’s regulatory options include issuing a stop order and/or seeking an injunction under section 739(6) of the Corporations Act, and investigating potential criminal action for contraventions of section 1041E of the Corporations Act or section 12DF of the ASIC Act.

Implications for securitisation

While the majority of issuance of securities in the Australian securitisation market is to wholesale investors, and the offering of those securities is undertaken in a manner which does not require disclosure to investors under the Corporations Act, there have been some securitised offerings to retail investors. Where such offerings to retail investors are made, or proposed to be made, the guide will be relevant to those sponsoring the issue as well as those printing the relevant offering documents.

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Finance Broking Bill

In November 2007, the Ministerial Council on Consumer Affairs of New South Wales released an exposure draft of the Finance Broking Bill 2007 (NSW) (Bill) as part of an effort to introduce a consistent national regulatory framework for the mortgage broking industry, and to provide greater consumer protections in the industry.

A national regulatory framework for the mortgage broking industry is something that has been mooted for a number of years, with a plethora of commentators criticising the existing state-based regulations as being inconsistent and inadequate.

The Bill represents an important step towards harmonisation in this regard. While the Bill is proposed for introduction in New South Wales, the ultimate intention is for near-identical legislation to be introduced in the other states and territories. Public submissions regarding the Bill closed in mid February 2008.

Coverage

The Bill applies to a broad range of credit products (such as loans regulated by the Consumer Credit Code, equipment finance loans and various other business and investment loans) and broking structures (such as mortgage brokers, finance brokers, single line broking, aggregators and franchised organisations) except where the applicant is a business entity which employs more than 20 people (100 if a manufacturing business) or where the credit sought is more than $2 million.

Key provisions

The Bill imposes greater obligations on brokers (which is defined to include intermediaries):

• mandatory licensing – licence applicants will be subjected to probity checks, must hold a prescribed level of professional indemnity insurance, be members of an approved external dispute resolution scheme, and meet certain educational qualifications and skills requirements
• borrower assessment – brokers are deemed to act as agents of consumers and must:
  1. ascertain, by making appropriate inquiries, that a borrower has the capacity to repay (intermediaries must make their own inquiries in satisfying this obligation), and
  2. irrespective of any business purpose declaration by a borrower, verify that the borrower’s sole or predominant purpose in applying for credit is in fact business or investment.
• disclosure – brokers must disclose, in writing, certain prescribed information to a borrower prior to the provision of broking services (including the broker’s fees and commission arrangements);
• finance broking agreements – must be signed by and given to a borrower prior to the provision of broking services;
• liability of credit providers – strict liability on credit providers for any compensable conduct by unlicensed brokers who act on their behalf; and
• additional remedies/sanctions – provision is made for consumer remedies (such as compensation) and disciplinary proceedings against brokers.

Relevance to securitisation

The Bill provides that a credit provider (for example, an ADI) may be liable for the conduct of an unregulated broker regardless of whether that credit provider has any control over that person. The Bill also provides an avenue for aggrieved consumers to apply to the Supreme Court of New South Wales for ‘stay of enforcement action‘. In a securitisation context, such action may affect the due and punctual repayment of the principal and interest on which the issuer and investors rely, therefore transferring the financial risk of improper conduct at the consumer/broker level from brokers to secondary credit providers, the investors.

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Basel II revisited - regulatory proposals may make some securitisations more expensive

Plans set out in April 2008 by the Basel Committee could make securitisation more costly. Among the proposals aimed at making the banking system more resilient to financial shocks is an enhancement to Basel II that establishes higher capital requirements for complex structured credit products. CDOs of other securitised products, such as ABS CDOs, are singled out. Accordingly, structures with two or more levels of securitisation like ABS CDOs and CDOs squared will therefore attract greater capital charges. As the proposals are in a developmental stage, the market view is that it is not possible to predict the amount of fresh capital required. Nor is it known whether the requirements will be assessed according to ratings (as per Basel II) or some other mechanisms. Notwithstanding these unknowns, most players assume that some large banks will have to start raising capital as a result of the changes.

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Proposed changes to rating agencies’ code of conduct and rating agencies’ response

On 26 March 2008, the International Organisation of Securities Commissions (IOSCO) published proposed changes to the voluntary Code of Conduct Fundamentals for Credit Rating Agencies as part of a report, ‘The Role of Credit Rating Agencies in Structured Financial Markets’ (report). The proposed changes include requiring the credit rating agencies (CRAs):

• to provide more information about their ratings processes. One specific change is to require CRAs to provide information that enables investors/subscribers to understand the basis of ratings
• to use information of sufficient quality in their ratings processes and to refrain from rating a product if ‘the complexity or structure of a new type of rating creates doubt about the feasibility of a rating action’, and
• to be more objective by, for example, prohibiting the analysts from making recommendations in the design of structured finance products that the CRA will also rate.

On 25 April 2008, five CRAs (including Fitch Inc., Moody’s Investors Service, Inc. and Standard & Poor’s Rating Services) sent a joint response to IOSCO on its report.

The CRAs are broadly supportive of IOSCO’s proposals but they are concerned that the recommendation that ‘[each] CRA should adopt reasonable measures to ensure that the information it uses in assigning its rating is of sufficient quality to support a credible rating’ is too onerous. The CRAs are looking at additional measures regarding the quality of data used in the rating process but state that they should not be responsible for ‘guaranteeing the quality of that information’.

In their joint response, the CRAs commit to implementing a number of measures to enhance CRA performance and confidence in the credit rating process. The measures include:

• prohibiting analysts from making proposals or recommendations about the creation or design of securitisation products
• disclosing general information about fees charged to structured finance issuers, and
• indicating clearly the attributes and limitations of credit rating opinions.

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Financial Stability Forum

On 12 April 2008, the Financial Stability Forum (FSF) presented a report which made a number of recommendations to improve the resilience of the financial markets.

The FSF report recommends action in six key areas:

• strengthened prudential oversight of capital, liquidity and risk management, for example, the introduction of increased minimum capital requirements for structured credit products
• to be more objective by, for example, prohibiting the analysts from making recommendations in the design of structured finance products that the CRA will also rate
• enhancing transparency and valuation, for example, improving the disclosure of risk associated with structured credit products
• changes in the role and uses of credit ratings, for example, improving the quality of the rating process and refraining from rating products where the complexity or structure of the product raise serious questions as to whether the product can be rated
• strengthening the authorities' responsiveness to risks, for example, ensuring regulatory authorities have the resources and expertise to adequately oversee financial risk, and
• robust arrangements for dealing with stress in the financial system, for example, enabling central banks to provide liquidity against a wide range of collateral and maturities and improving national arrangements for dealing with failing banks.

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Personal Property Securities Bill 2008

On 16 May 2008 the draft Personal Property Securities Bill (PPS Bill) was released. Consultation and briefing sessions are being conducted by the Attorney-General’s Department, commencing on 26 May 2008. It is proposed that the PPS Bill will come into force in 2010. Our previous commentary on these proposals can be found here.

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