At numerous conferences this year, including the Commercial Real Estate Finance Council (CREFC) Annual Conference in New York, one particular topic has remained at the forefront: global capital requirements, which have the potential to become impediments to providing financing via securitized products. Just based on how much time was spent on the subject at these events, we believe that regulatory treatment of certain instruments is and will become a key driver of investment demand and liquidity in the coming years versus any typical collateral analysis investors currently consider.
Of particular investor focus recently are various regulators’ evaluations of what actually constitute “high-quality” liquid assets in order to calculate the Basel III liquidity coverage ratio and the associated market value haircuts. This topic has transcended international borders, as regulators seem to have interpreted what “high-quality” and “liquid” mean through somewhat of a national policy lens, perhaps without knowing the impact of decisions made in other countries. As a result, there is still uncertainty as to what final standards may emerge for global institutional investors, as rules will likely be further adjusted.
What Are The LCR And HQLA?
As part of Basel III, regulators designed the Liquidity Coverage Ratio (LCR) to ensure that banks have enough high-quality liquid assets (HQLA) on hand to cover the total net cash outflows over a prospective 30-calendar-day stress period. The ratio has total HQLA as the numerator and net cash outflows as the denominator.
Each nation has divided potential HQLA into three levels, 1, 2A, and 2B, with increasing market value haircuts applied to the HQLA assets based on the level, in an attempt to allow for fire sale-like liquidation conditions that could occur in an economic crisis. Additionally, the levels include some general caps on the total percentage of assets and certain types of assets that can be held. Under the general regulations, most level 1 assets may be included with no haircut, level 2 assets receive a 15% market value haircut, and level 3 are haircut by 25%-50%, although different instruments in each level may have varying haircuts.
|Levels For Potential HQLA|
|Level 1 assets (0% haircut, covered bonds at least 7% haircut)||(a) Coins and banknotes.
(b) Certain central bank reserves.
(c) Certain central or regional government assets or claims.
(d) Certain third-country government/central bank assets or claims (typically must be rated ECAI 1)†.
(e) Certain assets issued by credit institutions.
(f) Extremely high-quality covered bonds (ECB member states).
|(a) Federal Reserve bank balances.
(b) Foreign withdrawable reserves.
(c) Securities issued by or unconditionally guaranteed as to timely P&I by the U.S. Treasury.
(d) Liquid and readily marketable securities guaranteed by any other U.S. government agency.
(e) Certain liquid and readily marketable securities that are claims on, or claims guaranteed by, a sovereign entity, a central bank, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, and European Community, or a multilateral development bank.
(f) Certain debt securities issued by sovereign entities.
|Securities issued under the National Housing Act Mortgage Backed Securities (NHA MBS) program may be included as level 1 assets.
For non-foreign non-DSIB institutions, holdings of NHA MBS and CMBS where the minimum pool size is less than $25 million may be included as level 1 assets.
Sovereign and central bank debt securities, even with a rating below ‘AA-‘, should be considered eligible as level 1 assets only when these assets are issued by the sovereign or central bank in the institution’s home country or in host countries where the institution has a subsidiary or branch.
|Level 2A assets (15% haircut)||(a) Certain regional government, local authority, or public sector entities assigned a 20% risk weighting.
(b) Certain third-country government/central bank/regional government/local authority/public sector entities assigned a 20% risk weighting.
(c) Certain high-quality covered bonds (ECB member states rated ECAI 2).
(d) Certain third-country covered bonds rated ECAI 1.
(d) Certain ECAI 1-rated corporate bonds.
|(a) Certain obligations issued or guaranteed by a U.S. GSE (Freddie Mac, Fannie Mae, Farm Credit System, Federal Home Loan Bank).
(b) Certain obligations issued or guaranteed by a sovereign entity or a multilateral development bank.
|Covered bonds that were issued by Canadian institutions before the Canadian covered bond legislation coming into force on July 6, 2012, may be included as level 2A assets if the other requirements are met.|
|Level 2B assets (25%-50% haircut)||(a) Certain asset-backed securities.
(b) Certain ECAI 2- or 3-rated corporate bonds.
(d) Certain restricted-use liquidity facilities.
(e) Certain high-quality covered bonds.
(f) Certain third-country government/central bank/regional government/local authority/public sector entities rated ECAI 5 or higher.
|(a) Certain IG-rated corporate debt securities.
(b) Certain publicly traded shares of common stock.
|Sovereign and central bank debt securities rated ‘BBB+’ to ‘BBB–’ that are not included in the definition of level 1 assets may be included in the definition of level 2B assets with a 50% haircut within the 15% cap for all level 2B assets.
Institutions are permitted to include long cash non-financial equity positions held against synthetic short positions as eligible level 2B assets provided certain operational requirements are met.
|*Based on our read, the Canadian regulations are built on the EU regulations. We’ve included what we believe to be the relevant OSFI notes. †Our understanding is that an ECAI 1 rating is equivalent to a ‘AA’ or ‘AAA’ category, while ECAI 2 is ‘A’, ECAI 3 is ‘BBB’, ECAI 4 is ‘BB’, and ECAI 5 is ‘B’. P&I–Principal and interest. CMB–Canada mortgage bond. ECAI–External Credit Assessment Institutions. ECB–European Central Bank. IG–Investment grade. GSE–Government-sponsored enterprise.|
Potential Jurisdictional Differences Will Significantly Influence Investor Decisions
One topic causing consternation among many market participants at the recent conferences was just how much the treatment of the constituent assets differed across jurisdictions. Currently, both the EU and U.S. versions of the rule include corporate bonds as level 2B HQLA. The EU regulation includes certain RMBS, auto loan ABS, small to mid-size enterprise (SME) loan ABS, and consumer loan ABS as level 2B HQLA, whereas the U.S. regulation does not.
Interestingly, the Canadian rules recognize the credit quality and liquidity that comes from their government-sponsored guarantee on their Canada Mortgage and Housing Corp. (CMHC) residential mortgage bonds as level 1 assets, while U.S. agency MBS is classified as level 2A under the U.S. rules. Based on our conversations with institutional investors, most are surprised and concerned about that decision. There are over $7 trillion in agency MBS outstanding (including in collateralized mortgage obligations [CMOs]), making it the third-largest bond class available to investors (U.S. Treasuries and U.S. corporates are the two largest). Also, average daily trading volume suggests that agency MBS is the second-most-traded fixed-income product after Treasuries, and has been for at least the past 10 years. It is understandable that U.S. regulators may want to distinguish between an implied and full-faith-and-credit guarantee by the government, but there may be an unintentional effect on the global bond ecosystem if investors begin to trade out of the $7 trillion agency bond market en masse and into the limited number of other potential alternatives, which would be the $12 trillion U.S. Treasury market or the less liquid, but still large, $8 trillion corporate bond market. This is especially true for domestic bank investors, who are currently the #1 holder of Agency/GSE-backed securities, and have increased their holdings since 2009 (see appendix).
Beyond the issue of deciding what is liquid and high-quality, there are valuation haircuts that are applied to HQLA (although generally not to level 1). On this issue, the EU regulations apply a 25%-35% haircut to their qualifying RMBS/ABS securitizations. This is below the 50% haircut for some other 2B HQLA, suggesting that the EU regulators may be recognizing that securitized products can help support their financial institutions and play a role in funding economic growth.
While not yet fully implemented, these levels, which include some bond products and exclude others, are already becoming a key factor in influencing bank investment demand as opposed to assessing credit risk and liquidity relative to yield. Based on conversations with institutional investors, a covered bank may invest in an EU SME loan ABS or auto loan deal versus a U.S. collateralized loan obligation (CLO) or auto loan deal based solely on the preferential regulatory treatment.
Further, it appears that commercial mortgage-backed securities (CMBS) are excluded in all jurisdictions from qualifying as HQLA. This exclusion is likely playing a role in the limited reemergence of floating-rate shorter-duration CMBS, as that market has not seen the same recovery achieved in fixed-rate CMBS. In Europe, CMBS does not meet several of the 14 criteria recommended by the BCBS-IOSCO task force to be classified as a “simple, transparent, and comparable” securitization. These include: nature of the assets (assets backing CMBS transactions typically are heterogeneous, not homogenous), consistency of underwriting (CMBS underwriting standards can and sometimes will vary by loan circumstance, e.g. acquisition or refinancing, stabilized versus non-stabilized property), and redemption cash flows (the majority of principal cash flows in most CMBS depend on refinancing or sale of the assets at maturity). In addition, CMBS do not meet other “high-quality” securitization (HQS) guidelines published by the EU Banking Authority (see endnote), which include a credit risk criterion that limits maximum obligor exposure to 1%. We suspect that some of these parameters may be due to poor performance that came from some more transitional floating-rate CMBS pools, which usually contain three to 30 transitional properties. The 1% restriction may unnecessarily restrict the market from utilizing products such as single-borrower CMBS, which was the first type of U.S. CMBS deal to re-emerge after the financial crisis, and currently remains a significant portion of the U.S. market (about 33% of 2015 issuance year to date through July). So, it is somewhat ironic that the transparency achieved in single-loan CMBS is excluded by regulatory rules that take comfort in diverse ABS pools.
Average Daily Trading Volumes: How is Liquidity Being Measured?
Any comprehensive measure of market liquidity requires many variables, such as bid/asked spreads, spread volatility, total outstandings, the ability to transact in times of market stress (such as right after the financial crisis), trading volumes etc. Unfortunately, all of those variables are not publicly available , which creates a challenge for regulators to analyze and implement a national classification system consistent with other different international markets. In charts 1 and 2 we compiled average daily trading volumes for various fixed-income products.
Chart 1 – U.S. Average Daily Trading Volume Of Munis, Corporates, And Agency MBS 2002-2015 YTD
Chart 1 shows that agency MBS is the most liquid bond product traded in the U.S. by a wide margin, except for Treasuries. This explains investors’ concerns that it is classified as level 2A and haircut at 15%. While bid-asked spreads for corporate and municipal bonds are also consistently quoted by many market makers, the volumes are nowhere near the magnitude that can be traded in the agency market.
Chart 2 – U.S. Average Structured Finance Daily Trading Volumes Q3 2011-Q1 2015
Because of the limited overall liquidity during the 2008-2009 crisis, many investors turned to other securitized bonds products such as CMBS, as many market makers were still able to transact among accounts in large amounts in these products, albeit at wider spreads. For CMBS, this created a record of widening historical price transaction levels, but given the volumes involved, that record actually indicates that liquidity was available in a functioning marketplace. Looking at the available data since 2011 (see chart 2), CMBS clearly remains one of the more actively traded and liquid structured finance bond sectors, with average trade volumes usually exceeding $1 billion on a daily basis. The shorter duration ABS products, such as credit cards or autos, have very low trading volumes because those investors usually buy to hold for the two- or three-year term, and so market makers may be less prepared to make markets in those bond classes. As a result, and because of their shorter terms, these bonds are less likely to see price distortion. The question still exists as to whether these assets are as liquid as a super-senior CMBS class that did see bids during crisis conditions. The overall high trade volumes for CMBS are likely to come mostly from the highest-rated classes, as many investors use those classes as a swap spread or yield substitute, which suggests that the most senior class could be a potential candidate for level 2B LCR treatment, similar to the ABS/RMBS products included in the EU regulation.
Further Clarity and Research May Be Warranted Before Final Implementation
Overall, the trading data and market sizes that we were able to examine suggest that the classification systems and haircuts are generally appropriate, but may need to be further researched and enhanced before being fully phased in. One particular topic that may need to be addressed is the differences in rules by jurisdiction because these new rules will likely influence global investment decisions and which formats of financing will continue to be available to borrowers in various markets. The current international proposed rules appear to favor some bond products while disfavoring others, and thus we may see further adjustment before final implementation to avoid unintended consequences. The Federal Reserve’s proposal to include certain municipal bonds as level 2A HQLA in the U.S. regulations is one example of an adjustment currently under consideration.
Appendix: Holdings of Major U.S. Asset Types
|Holdings Of Major U.S. Asset Types|
|Top five holders as of 2009|
|Treasury securities ($7.8 trillion)*||Foreign holdings ($3.7 trillion)||Household sector ($853 billion)||Monetary authority ($777 billion)||State and local governments ($586 billion)||MM mutual funds ($406 billion)|
|Agency/GSE-backed securities ($8.1 trillion)§||Domestic banks ($1.4 trillion)||Foreign holdings ($1.2 trillion)||Monetary authority ($1.1 trillion)||GSEs ($925 billion)||Mutual funds ($603 billion)|
|Municipal securities ($3.7 trillion)||Household sector ($1.8 trillion)||Mutual funds ($479 billion)||MM mutual funds ($440 billion)||P&C insurance cos. ($369 billion)||Domestic banks ($224 billion)|
|Corporate/foreign bonds ($10.4 trillion)||Foreign holdings ($2.5 trillion)||Life insurance cos. ($1.9 trillion)||Household sector ($1.5 trillion)||Mutual funds ($1.1 trillion)||Domestic banks ($668 billion)|
|Private-label MBS/ABS ($3.0 trillion)†||Foreign holdings ($485 billion)||GSEs ($288 billion)||Domestic banks ($263 billion)|
|Top five holders as of Q1 2015|
|Treasury securities ($13.1 trillion)*||Foreign holdings ($6.2 trillion)||Monetary authority ($2.5 trillion)||Mutual funds ($795 billion)||Household sector ($640 billion)||MM mutual funds ($435 billion)|
|Agency/GSE-backed securities ($7.9 trillion) §||Domestic banks ($1.8 trillion)||Monetary authority ($1.8 trillion)||Foreign holdings ($902 billion)||Mutual funds ($820 billion)||State and local governments ($439 billion)|
|Municipal securities ($3.7 trillion)||Household sector ($1.6 trillion)||Mutual funds ($673 billion)||Domestic banks ($465 billion)||P&C insurance cos. ($320 billion)||MM mutual funds ($274 billion)|
|Corporate/foreign bonds ($11.7 trillion)||Foreign holdings ($2.9 trillion)||Mutual funds ($2.4 trillion)||Life insurance cos. ($2.3 trillion)||Household sector ($876 billion)||Private pension funds ($588 billion)|
|Private-label MBS/ABS ($1.3 trillion)||Life insurance cos. ($433 billion)||Foreign holdings ($390 billion)||Domestic banks ($138 billion)||P&C insurance cos. ($91 billion)||GSEs ($80 billion)|
|Source: Federal Reserve Z1 Release. *Incudes savings securities. §Agency- and GSE-backed securities include: issues of federal budget agencies such as those for the TVA; issues of GSEs such as Fannie Mae and FHLB; and agency- and GSE-backed mortgage pool securities issued by GNMA, Fannie Mae, Freddie Mac, and the Farmers Home Administration. †Insurance company holdings of private-label MBS/ABS weren’t broken out separately until 2011, therefore we only list the three-largest holders. GSE–Government-sponsored enterprise. MM–Money market. P&C–Property and casualty. TVA—Tennessee Valley Authority. MBS–Mortgage-backed securities. ABS–Asset-backed securities.|
Endnote: We used the following sources for this piece: “Liquidity Coverage Ratio: Treatment of U.S. Municipal Securities as High-Quality Liquid Assets,” by the Federal Register, published May 28, 2015; “Criteria For Identifying Simple, Transparent And Comparable Securitisations,” by the Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, published July 2015; and “EBA Discussion Paper On Simple Standard And Transparent Securitisations,” by the European Banking Authority, published Oct. 14, 2014.