New regulation rules could destroy asset-backed trading
JP Morgan is reportedly warning that rules around the amount of capital banks must hold, which are expected to be implemented in early 2019, could nearly wipe out secondary trading in most kinds of asset-backed securities. The bank claims that reduced liquidity could raise the cost of securitisation, which would cut off a funding channel for some issuers, and in turn, inflict higher borrowing costs on to consumers. The impact on some asset classes, such as commercial mortgage-backed securities, will be so pronounced that it will not make sense for banks to make a market in them, effectively ending trading in that asset class. The only sector that would escape these ramifications would be securities issued by the government agencies, Fannie Mae and Freddie Mac. 

JPMorgan is sounding the alarm about bank capital rules on the horizon that could nearly wipe out secondary trading in most kinds of asset-backed securities.

Reduced liquidity could raise the cost of securitization, cutting off a funding channel for some issuers, which would, in turn, feed into higher borrowing costs for consumers.

The rules were set in motion by the Basel Committee in 2012, when it introduced a capital framework called Fundamental Review of the Trading Book, designed to modify the capital requirements for fixed-income trading books. They are expected to be implemented in early 2019 but the analysts expect banks to comply well in advance.

In a report Wednesday, analysts at JPMorgan said all major asset classes could get slammed, with some, such as commercial-mortgage backed securities, affected so punitively that it wouldn't make sense for banks to make a market in this asset class anymore — that is, hold enough of them to facilitate trading.

The only sector relatively unaffected would be agency mortgage-backed securities — those issued by Fannie Mae and Freddie Mac.

The rules, then, could help strengthen the position of the GSEs in the mortgage market, further shrinking the role of the private sector. This would be presumably an unintended consequence given the administration's goal of increasing the role of the private sector in mortgage origination.

The FRTB rules are expected to be published this month. Subsequently, each country's regulators will adapt them to their own jurisdiction.

JPMorgan analysts said their interpretation is based on how they’re currently written. Things could change.

The FRTB consists of three capital charges that would apply to securitization deals. The one that would raise costs the most is designed to address market risk.

It's a function of such disparate factors as interest rates, equities, foreign exchange and credit spreads. The JPMorgan analysts said that for securitizations, this particular charge is basically designed to cushion against extreme spread volatility.

In its current iteration, that charge would require banks to hold an amount of capital that would equal the losses of a deal under a massive increase in spreads. For instance, a bank would have to hold enough capital against a senior tranche in a jumbo mortgage bond to fully absorb the loss of a 400-basis-point blow-out in spreads.

Currently banks can opt out of a standardized approach to calculating capital, using instead an internal ratings-based model. The FRTB would require a standardized approach for securitization trades.

The analysts said the hardest hit bond tranches will be those high up in the capital structure. And within those senior bonds, longer-dated paper will require the most additional capital.

In a specific example, the analysts calculated that the proposed required FRTB capital for NAVSL15-3B, a bond backed by government-guaranteed student loans, would be 236% of the transaction’s market value.

So why would a bank bother?

The analysts think such a radical repricing of keeping securitizations on trading books could stretch out the spread between bid and asking prices or torpedo any incentive for a bank to make a market for most of these bonds.

Their hope is the final rules will be less punitive. "This has to be resolved by regulators for capital to move down to a reasonable level," they said.

The FRTB is an initiative from the Basel Committee on Banking Supervision. It's meant to replace measures instituted under Basel 2.5.

A brief by the International Swaps and Derivatives Association explains: "While Basel 2.5 was implemented in the immediate aftermath of the financial crisis as a stop-gap measure to lift trading book capital requirements, the FRTB is primarily aimed at consolidating existing measures and reducing variability in capital levels across banks."