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ABS market: regulatory action must ensure Europe’s competitiveness back
The regulatory response to the shortcomings of the current model must be targeted to encourage financial services activity in Ireland and Europe. Ireland must be a central participant in shaping this new regulatory landscape to ensure the further development of the financial services industry, writes Gerard Scully.
Current activity
The news is not good in the ABS market. The level of global issuance is at an all time low. According to the European Securitisation Forum report for Quarter 3 - 2008 - “the (term securitisation) market … remains frozen” and global structured product issuance has fallen from USD 2,500bn in 2007 to an estimated USD 594bn in 2008. Many investment banks have restructured their operations, reducing their credit trading operations and culling their ABS origination and structuring teams.

Times are tough.
Having said that, asset backed deals continue to be launched into the market, but there has been a decided shift in the way business is being done. Most large investment banks are issuing asset backed securities on a private placement basis in order to repo them into the ECB. There is no obligation to have a listing in relation to public placements, therefore, there is little incentive for those securities to be listed and this has implications for transparency in the market.
Gerard Scully

How can order be restored? Getting the analysis right
The first thing that needs to be addressed to resolve the problems in the market is to design measures that are based on sound analysis - to date this has been somewhat of a challenge.

• Not all Asset Backed Securities are same
Firstly, some commentators rather naively tar all asset backed securities with the same brush. It seems obvious, but it is worth saying, that there are fundamental differences between these securities because of the different types of assets backing them. Commercial mortgages are different to residential mortgages. Securities backed by credit card receivables and auto loan receivables are different again. Collateralised Debt and Loan Obligations are another animal entirely. Beyond the assets involved there are also geographic specific factors that need to be considered. Ireland is not the US, and Germany is not Asia.
All of this is extraordinarily simple but some of the analysis has fallen short of the mark by being extraordinarily simplistic.

• Who or what is to blame?
In seeking to identify a root cause of the current credit crisis, most commentators will identify sub prime mortgage loans in the USA, but it goes beyond that. Many of these loans were apparently originated on, at best, a negligent basis and, at worst, a fraudulent basis. The credit rating agencies who rated these deals did not deliver sufficient in-depth due diligence. This, in turn, led to ratings which did not reflect the true value of the securities into which these loans were packaged.

The securities subsequently originated, were packaged in CDOs which delivered a level of opaqueness which ultimately rendered the market unworkable. A bad situation was made significantly worse by the co-incidental adoption of accounting standards which required that asset backed securities be accounted for on a mark to market basis. The valuations for such securities were to be derived by accountants and administrators from the market. Nobody, prior to the adoption of the accounting standards, stopped to think that there was no incentive whatsoever for market participants to provide realistic valuations to such accountants or administrators. Therein lies a fundamental problem. Until such time as the market creates a mechanism for such securities to be valued, and indeed an incentive for market participants to provide such valuations, then the demands of the accounting standards cannot be realistically satisfied.

• What do Investors say?
Most commentators suggest that the asset backed securities of the future will be simpler and more discreet, with backing assets that are clearly specified from the origination of the deal. Part of the problem, which gave rise to the current credit crisis, relates to the fact that securities were originated with backing assets that were not capable of identification by investors and, importantly, not capable of delivering transparent pricing. This is the core issue and yet has not featured prominently on the radar.

Having taken some time to speak with the investor community in relation to these assets, I have found that the views vary in relation to each asset class and geographic region. Most investors express little dissatisfaction with the degree of transparency relating to European RMBS, as the assets in question have clearly been identified from the outset. Equally, this is the case with commercial mortgage backed securities, credit card receivables, trade receivables and auto loans. The factor which distinguishes all these securities from those which triggered the current credit crisis is the fact that the assets or loans which are the subject matter of the securities are clearly identified. Clear identification of the assets enables investors and the servicers of the securities to arrive at fully transparent pricing.

• Real solutions required, not optical responses
Clearly, we need analysis that goes beyond allocating blame. We also have to be wary of the obvious calls for more regulation, particularly those that are based on the type of simplistic analysis outlined above. Undoubtedly, the regulatory landscape will be re-shaped; the priority now is to ensure that the authorities develop a grounded understanding and analysis of the problem and then we can all confidently move to designing responses.

The European response
• So what is the EU response to all of this?
A recently proposed regulation, which is currently in draft form, seeks to create an obligation for the administrators of special purpose vehicles (companies - termed as Financial Vehicle Corporations – FVCs) which issue securitised debt to provide statistical information to the ECB on a quarterly basis relating to the financial activity of the FCV sector. The definition of FCV applies to an “undertaking” which is constituted (established) pursuant to Community or national law – therefore within the EU.
The objective of the draft regulation is to provide the ECB with greater statistical information relating to securitisations within the EU, including their valuations. The objective presumably is to ensure a better understanding of finance flows within the EU. As a political and technical response to the current credit crisis this is a laudable approach. There is, of course, the age-old problem for regulators of, on the one hand, trying to find the balance between establishing appropriate standards and compliance obligations consistent with policy objectives, and on the other hand, creating an environment which drives legitimate and desirable market activity elsewhere (e.g. to the Cayman or Channel Islands). To avoid this trap, and to address the desired policy objectives, it would seem that any regulation would have to be imposed at investor level - those of investment funds, pension funds and insurance companies. Such entities would have to be regulated such that they would only be permitted to purchase securities issued by FCVs which are regulated within the EU. If this is not done then FCVs will merely relocate outside the EU and thus avoid the application of the regulation and other such measures. This is a significant competitive point and poses a significant risk for the EU.

Much of the current regulatory proposals - including at EU level - require further development. The objective should be to deliver an appropriate and functional framework for financial services for the 21st century which is capable of preserving the competitiveness of Europe in the area of financial services. Europe needs to ensure, that in whatever response is implemented, that it is careful not to incentivise an exit of even more financial service activity offshore or to Switzerland. We have already seen a steady outflow of fund promoters from London to Switzerland. This is not in Europe’s interest. It is important to ensure that any solutions are targeted and do not drive financial service activity away from Europe.

What can Ireland do?
What emerges from the current regulatory debate may serve to present Ireland with a significant opportunity for further development of our financial services industry. Ireland has an opportunity to present itself as a 21st century financial services location.

Ireland needs to put itself at the forefront of any discussions seeking to develop regulatory responses to the current credit crisis. We have a real role to play to ensure that any solutions proposed are capable of working and do not have unintended negative consequences for Europe in general and Ireland in particular.

The pivotal role of Ireland in the process of developing the prospectus directive enhanced our credibility as an authoritative and legitimate voice in this policy area. Ireland needs to continue to assert its voice in shaping the new regulatory paradigm. We have the expertise in this jurisdiction to contribute constructively to this process and Government should ensure that it is leveraged. It is important to our reputation as a jurisdiction that we do so and it must be prioritised.

In summary, a sophisticated analysis of the problem and a considered and smart regulatory response is required. Furthermore, it is essential for Ireland’s future as an international financial centre to be at the forefront of efforts to reshape the global securities markets.
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