Charles Littrell, Executive General Manager - Australian Securitisation Forum, Sydney
Today I propose to briefly review APRA’s take on the Australian securitisation market, in the context of our statutory mission. Then I will outline APRA’s current thinking on how to secure the benefits of securitisation for Australia, while reducing the potential for problems that we have seen emerge over the past five years.
Section 8 of the APRA Act states:
APRA is to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality and, in balancing these objectives, is to promote financial system stability in Australia.
APRA interprets the first part of this statutory instruction as an optimisation problem. To wit: we seek to maximise safety, constrained by the need to avoid undue damage to the Australian financial system’s efficiency, competitiveness, contestability, and competitive neutrality.
The second part of the statutory instruction adds the need to ‘promote’ financial stability. So we end up with two objectives and four constraints.
How does securitisation fit into APRA’s objectives and constraints? From the 1990s to the mid 2000s, rather well; from 2008 through say 2011 less well; and now we want to discuss reforms that will make Australian securitisation more satisfactory in prudential terms than it has been in recent years.
In theory, and from the mid 1990s to the mid 2000s in practice, securitisation was largely a winner in APRA statutory terms. Any glance at the spreads on home loans, for example, supported the idea that securitisation helped increase competition. A look at the names of the lenders and brokers for home loans suggested that securitisation was also promoting contestability and competitive neutrality, as smaller regulated lenders and unregulated lenders were much better placed than previously to enter the market, and compete profitably with the largest banks. There were however some issues with systemic stability, as increased access to cheaper home loan financing helped create, if not a bubble, then a quite frothy home lending market from around 1998 to 2003. In the event, APRA and RBA action in arenas other than securitisation, and generally sensible self-control by Australian lenders, averted, at least so far, any substantial problems in home lending.
Globally and in some instances locally, this benign view of the good fit between securitisation and APRA’s statutory objectives changed rapidly from 2007 and particularly 2008. The apparently inevitable rise of securitisation in Australia reversed sharply, a trend which now shows some sign of moderating.
In traversing the last five years, we have learned at least four lessons about securitisation.
First, lending models based upon laying off all the funding and all the capital to other parties, the so-called "originate to distribute" model, create unacceptable agency risks. Allowing lenders to lend without the constraints associated with putting their own money, or at least their shareholder money at risk, too easily leads to an unrestrained focus upon lending volume at the cost of lending quality. This insight has led to more global focus upon "skin in the game" for the original lender, and any new Australian securitisation regime will need to respect this outcome.
Second, a number of international firms, using the complexities of securitisation and structured credit more generally, created investments that were more likely to fail than was advertised. Australian regulated entities were the victims rather than the instigators of these schemes, which I suppose is some comfort.
Third, as illustrated in this chart, the securitisation markets can suddenly close even to the highest quality underlying assets in the simplest structures. Had the public sector not supported Australian securitisation via the AOFM then this chart would have been even flatter since 2008, with near zero issuance for approximately 18 months. The securitisation market’s vulnerability to near-total closure means that liquidity risk is at least as high in securitisation as it is in normal banking, and the usual cautions associated with lending long and borrowing short apply.
Finally, the fact that securitisation markets can close even to good credits, for extended periods, means that securitisation-reliant business models are at risk of being placed in de facto run-off. This strongly suggests that no prudentially regulated lender should rely too heavily upon securitisation for funding. As shown in this chart, closing securitisation markets were an inconvenience for the largest Australian banks, but were a strategic constraint for some of our mid-sized ADIs. Happily for the ADIs and the Australian economy, depositors have more than covered the gap, but we cannot always rely upon this outcome.
In addition to these core lessons, you will recall that APRA last made major changes to the securitisation requirements in APS 120 in January 2008. Our intent was as a supervisory matter to check the ADI industry’s implementation of the new approach, which among other things no longer required APRA pre-approval for each issue. What we discovered in subsequent supervisory reviews was not always pleasing. Too many ADIs had engaged in securitisation without completing some of the basic governance requirements, including board oversight. Some ADIs had interpreted the rules, particularly on risk retention, in a way which ranged between ‘convenient’ and ‘wrong’. Less troublingly but not well catered for in the current APS 120, a number of ADIs had commenced securitisation for funding purposes only.
From 2010 until now, APRA has issued a number of ad hoc industry letters. These letters are intended to allow the securitisation market to continue, until APRA has the ability to undertake more fundamental reforms to the relevant prudential infrastructure. For the past two years Basel III has taken centre stage for prudential reform purposes, and neither APRA nor industry has had the capacity to address securitisation in any fundamental way. It is also the case that the Basel Committee and IOSCO, among others, continue to develop international frameworks for securitisation, and APRA intends to comply with those frameworks as they reach completion.
Happily, APRA’s policy development capacity is now freeing up beyond Basel III. After conducting initial and informal discussions with some participants in the securitisation markets, we are currently drafting a discussion paper to commence the process of prudential reform for securitisation.
In our proposed reforms, APRA intends to push three themes:
- explicitly catering for funding-only securitisation, subject to some prudential limits;
- greatly simplifying the overall prudential regime; and
- addressing the lessons learned about securitisation which I previously referred to: agency risk, liquidity risk, and business model risk.
I remind listeners that today’s talk is not the discussion paper. APRA has considerable work and consultation in front of it to turn today’s themes into specific prudential proposals.
We propose first to define the approach to funding-only securitisation. Such an arrangement is characterised by three features:
- the originating ADI retains substantially all the credit risk, and all the capital requirements associated with the underlying asset portfolio;
- APRA’s prudential requirements will ensure that such arrangements are sensibly managed in liquidity terms; and
- the issue is not a covered bond in disguise.
Our current thinking is that we can achieve a sensible prudential outcome in the following way.
- The securitisation structure is, speaking somewhat loosely, restricted to two tranches.
- The A tranche is senior, and is likely to comprise approximately 90 per cent of a typical home loan securitisation. The expectation is that the A tranche will be AAA rated.
- All A tranche notes must be pari passu in credit seniority terms, but the A tranche may consist of issues with varying maturity, meaning that the shorter maturities are in a repayment order sense, but not a liquidation sense, ahead of the longer maturities.
- ADIs will be free to trade in their own A notes; the current 20 per cent rule would be abolished. ADIs may also trade in other issuer A notes, using risk weightings that already exist under Basel III.
- This leaves the B note, which in a funding-only securitisation is simply held in its entirety by the originator. APRA’s expectation is that the B note will comprise the current mezzanine and equity tranches of a securitisation.
Liquidity in a funding-only securitisation
APRA is still considering how best to ensure that liquidity is properly managed in a funding-only securitisation. We expect that any new arrangement will include the following features:
- the structure is consolidated with the originating ADI for Basel III liquidity purposes;
- there is a supervisory expectation that originators will seek to match the expected underlying asset tenor with appropriate liability tenors; and
- there would be some limit on the proportion of an ADI’s balance sheet that may be pledged for securitisation purposes. This means that the originate to distribute model will not be available for the entirety or even the majority of any ADI’s balance sheet.
APRA will consider whether or not we continue with our current prudential preference for pass-through structures, or whether we allow more freedom for date-based calls. This is doubtless a matter for consultation.
Securitisation for capital relief
APRA observes that the largest ADIs are primarily interested in securitisation as a funding vehicle, but some middle-sized ADIs are interested in both funding and capital benefits. This brings us to securitisation for capital relief, which boils down to: find a third party investor for the B note.
APRA’s thinking is that ADIs would be allowed a pari passu capital reduction to the extent that B notes are sold, but with a minimum retention on the order of 20 per cent of B notes to reduce agency risks associated with unconstrained and nonrecourse lending. This is the skin in the game requirement.
The B notes would look quite different from the current mezzanine and equity tranche arrangements. They are unlikely to be rated, for example, and this is good from APRA’s perspective. The A notes are intended for investors who want safety and the comfort of a strong rating. B notes are meant for investors who have themselves built serious credit analytics capacity, and in particular for investors who rely upon their own analysis, not a credit rating.
APRA’s expectation is that ADIs would place B notes with investors outside the ADI sphere. To this end, APRA intends to propose that ADIs holding another originator’s B notes will attract a 100 per cent equity deduction for any such holding. ADIs swapping B notes create no net credit transfer, but do shift risk from the original fully informed lender to less informed secondary lenders. In a systemic stability sense, APRA would much prefer to see B notes shifted to less levered investors, such as insurance companies and superannuation funds.
I note that APRA’s B note thinking and resultant prudential capital arrangements have yet to be optimised with international skin in the game requirements, and with issues such as the seller’s share, LMI cover, and profits left in or expected by the securitisation vehicle. These issues will doubtless feature in our upcoming consultation.
APRA’s prudential arrangements currently allow for synthetic securitisation, under which an ADI can enter a credit derivative, and claim capital benefits for loans remaining on the ADI balance sheet. For various reasons ADIs have been slow to take up this opportunity. Thinking more in a systemic stability sense, APRA is increasingly unconvinced that allowing synthetic securitisation is a good strategy for Australia. Accordingly, we are likely to commence consultation on the basis that synthetic securitisations will no longer produce capital benefits.
Similarly, current arrangements allow for remarkably complicated and opaque re-securitisation instruments to be originated, traded, and held by ADIs, often at low risk weights. It is not evident that these instruments have any practical use, and painfully evident that these instruments have been acquired by investors, including Australian investors, who were unable to understand the risks inherent in them.
Accordingly, APRA’s likely position for consultation is that ADIs are expected not to hold subordinated securitisation instruments, or any resecuritisation instruments, and any such holdings will attract an equity deduction. It will be up to industry to argue the case for any more liberal treatment.
Finally, APRA observes that there has been much discussion of master trusts over the years. We will be interested to hear any views on how our proposed reforms might facilitate or retard the development of master trusts.
APRA’s prudential objectives
I will close by summarising APRA’s prudential objectives.
First, we want to ensure that Australian securitisation arrangements do not encourage lax lending or tempt market participants to take advantage of each other through excess complexity.
Second, APRA expects that Australian A notes will be among the safest and simplest securitisation investments available globally. This should help restore and protect Australian access to local and global securitisation markets.
Third, we wish to ensure that credit risk is concentrated in the B notes, and that these notes are held in expert and properly capitalised hands. These hands will belong either to the originator, or to non-ADI investors with a good in-house understanding of the resultant credit risks.
Finally, we want Australian securitisation to be part of the solution, and hopefully a large part of the solution, to the Australian ADI industry’s need to find more term liabilities. Conversely, we don’t want securitisation to create unmanaged liquidity risks.
In summary, APRA aspires to a securitisation market that is simpler, safer, and over time larger, than the current prudential arrangements allow.
Thank you for your attention.