Mandatory compliance with the Securities and Exchange Commission's (SEC) Regulation AB is a mere six months away, and even the most hardened of procrastinators are beginning to feel the heat. Among the many implications of the sweeping new rules, shelf registrations for revolving asset securitizations must be substantially revised. Financial institutions' computer systems in many cases require substantial modifications (particularly those of institutions who pioneered the origination of these assets) in order to track data for newly mandated static pool disclosures.

On the accounting front, proposed revisions to FAS 140's requirements for securitization accounting sale treatment could be effective as early as the second quarter of 2006, although the third quarter of next year is a safer bet. Finally, the US banking regulators have already established the framework for implementing Basel II, the proposed international bank regulatory capital regime, although it is unlikely to be fully in place in the US until mid- to late 2008. Some of the largest securitizers of revolving assets are today making strategic decisions based on an assumption that the final rules will not differ greatly from these proposals.

Highly sophisticated master trusts have evolved over the past 15 years to facilitate the securitization of credit card receivables and other revolving, short-term assets, such as dealer floorplan loans, insurance premium finance loans and trade receivables. These resilient structures, unconstrained by the strict structuring requirements that tax law imposes on mortgage-backed securities, are continuously modified to meet the ever-changing needs of investors and issuers. The regulatory and accounting requirements expected in 2006 and beyond will further prove their resilience. Accommodating these changes will, however, test the good humour and patience of the bankers, lawyers, accountants and regulators charged with the task.

The disclosure challenges

In the course of developing their comprehensive disclosure regime for asset-backed securities, which purports to primarily codify SEC staff guidance given over time in no-action letters and in staff comment letters for particular securities registrations, the SEC staff was lobbied extensively by a number of institutional investors. These investors maintained that certain issuers were providing extensive static pool information to rating agencies and credit support providers, and that this information should be provided to all investors as required disclosure items for registration statements and prospectuses.

Issuers have traditionally included information regarding historical losses, delinquencies, yield and payment rates in the prospectuses for their revolving asset securitizations. This information is presented for a year-to-date stub period and for each of the preceding five years. The prospectus will also contain tables showing certain non-historical data, such as account age, average balance, average credit limit and geographic distribution of obligors, as of a recent cut-off date. This presentation of historical and point of sale portfolio information has been viewed by issuers, underwriters and their internal and outside counsel as legally adequate disclosure of material information regarding the receivables and accounts. This view is generally the subject of a letter from one or more of the principal counsel for the transaction, addressed to the underwriters and commonly referred to as the 10b-5 opinion.

The static pool information purportedly demanded by investors would show the loss, yield and payment performance of the securitized accounts over time separately for each of several groupings of accounts by year (or possibly other shorter periods, such as semi-annual or quarterly) of origination. A rapidly growing accounts and receivables base can mask increasing losses to some extent when the historical information is presented on the traditional aggregated basis. For instance, receivables in accounts that have not been in existence long enough to be charged off (generally nine months) go into the aggregate outstanding receivables number that total losses are divided by in computing the gross loss percentage. This effect, if material, is often noted in the footnotes or lead-in to the relevant tables, and the traditional delinquency tables serve to warn investors if a high proportion of the receivables, including receivables in newly originated accounts, are heading towards charge-off.

The SEC staff found that industry arguments that static pool information for revolving asset securitizations was generally not material "were belied by the universal and sustained comment we have received from investors that they would find the information very important in making their investment decisions". As a mitigating factor against requiring the investor-requested data, the staff has included in the lead-in to their detailed description of the newly required static pool disclosures (which in its final version added credit scores and delinquencies) the words "unless the registrant determines that such information is not material". The staff also stated that they were not necessarily condemning past disclosure practices and provided helpful transitional relief, including a less stringent liability standard for pre-January 1 2006 static pool information.

One or more large issuers may seek to take advantage of the materiality exclusion and delete one or more specified items, such as credit scores (which have historically rarely been disclosed even on an aggregated basis) from their static pool tables. But the staff, warns in the lead-in to Regulation AB that, where the issuer has historically provided such information to the rating agencies, convincing the staff that the information is not material to investors will be difficult. The staff encourages issuers to explain in the prospectus any omission of their specified static pool data. (Although there is not a material difference between encouraging and requiring when it is the SEC who is speaking.) An issuer will face potential liability for an explanation as to why omitted information is not material to investors. Given that this risk can be avoided by including some arguably non-material information, there seems to be little reward for an issuer's good faith pruning of irrelevant, and possibly even confusing, material.

Accounting sale treatment challenges

The existing, and now quite stale, exposure draft of proposed amendments to Financial Accounting Standard Board (FASB) Statement No 140 contains requirements for accounting sale treatment that threaten aspects of revolving asset securitization programmes. There was intense lobbying from the industry immediately after it was published in June 2003. Reports of subsequent compromises and accommodations calmed the industry, but until they are fleshed out in a new exposure draft, no one should breath easy.

More to the point, the reported compromises themselves are problematic in some respects. In particular, the proposed additional restrictions on the direct payment of existing master trust securities with the proceeds of newly issued securities could limit or eliminate funding options available to issuers.

Under the reported compromise proposal, issuers will retain the ability to refinance their outstanding master trust securities by allowing these securities to be paid from principal collections and then issuing replacement securities. Unfortunately, the sold assets will come back onto the issuer's books each month in an amount equal to the principal collections paid to investors (or, as is more common, set aside in a principal funding account to pay investors on a single bullet maturity date), and the issuer will need to come up with another source of funding for new receivables that would have been financed with the principal collections being used or set aside to pay the maturing securities.

In theory, the resulting liquidity crunch can be avoided by issuing a paired series of securities to a commercial paper (CP) conduit or other variable funding investor. The newly issued series is drawn down (the amount borrowed is increased) each month to provide replacement financing for the maturing series. At the end of its amortization period, the maturing series will have been replaced by an equal amount of paired series securities, with no negative effects on the issuer's liquidity. Alternatively, the full principal amount of the new paired series can be issued to typical term investors on a single closing date on or before the first amortization date for the maturing series, and the proceeds can be placed into a pre-funding account, to be used each month to replace the maturing series as it pays down (or as it accumulates principal to fund a bullet maturity).

Both methods have drawbacks: the first method restricts the issuer's funding sources to commercial paper conduits (or programmes that mimic them) and the second method involves having twice the principal amount of securities outstanding during the amortization period, resulting in negative arbitrage with respect to the securities that must be backed by highly rated short-term investments rather than invested in high yielding receivables. Another drawback of the second method has been the SEC's 25% limitation on the amount of proceeds that could be used for prefunding. Regulation AB gives relief to master trusts, allowing them to devote an amount of proceeds up to 50% of the total assets of the master trust to prefunding, in effect allowing 100% of the proceeds of any particular issuance to be used for prefunding unless the proposed issuance is providing financing equal to half or more of the master trust's total assets.

Neither of these methods accommodates the issuance of CP-like securities directly out of the master trust. These securities, referred to as extendibles, are issued to money market fund investors on a discounted basis for short, CP-like terms and are expected to be repaid at maturity with the proceeds of newly issued extendibles (similar to the rolling of CP). In the event of a market disruption, the securities may be paid from master trust principal collections, including shared principal collections allocated from other master trust series that are not then in amortization. Shared principal collections can be substantial in a large master trust with multiple series having staggered maturities. To the extent that the maturing extendible securities cannot be paid entirely from available principal collections, they are covered by a liquidity facility that is only one-third the amount (and cost) of the facility typically required for CP. This saving of required third-party liquidity becomes even more significant as the regulators ratchet up the regulatory capital requirements for such facilities (less-than-one-year-annually-renewable facilities no longer carry a 0% capital charge).

The increasingly popular master trust issuance option doesn't work if the extendible securities cannot be paid directly with proceeds of new securities. Also, rolling from temporary CP conduit financing to term securities will be less efficient if an issuer loses the possibility of negotiating a refunding takeout of the conduit financing (the accountants can generally be persuaded to bless such a takeout if it is contemporaneously negotiated and is not a thinly disguised issuer call option).

The pay-down of master trust securities with the proceeds of newly- issued master trust securities will be allowed under the expected FASB proposal, but only if decision-making with regard to the new issuances is limited to parties than cannot benefit (other than to a trivial extent) from their decisions. This would seem to require issuers to hire independent third-party programme managers who would decide when and how to refinance maturing master trust securities. Issuers may be able to become comfortable with third parties hired by them deciding such things as whether extendibles should have a 30-day or 45-day targeted payment dates. It is more difficult to imagine them being comfortable with an independent third party deciding such things as whether the term securities that will refinance a CP-conduit-financed piece should mature in three years or five years.

The FASB is now due to release a revised exposure draft of FAS No 140 in July. The industry will have 60 days in which to comment on this new exposure draft, which is to be followed by a final statement either before the end of 2005 or in the first quarter of 2006. Hopefully the financial institutions most likely to be adversely affected are already fully prepared to argue for relief.

Waiting for Basel II

A recent impact study shows that Basel II's internal ratings-based (IRB) proposal for determining regulatory capital requirements for the larger US banks could result in reductions in required capital levels for these banks. These findings caused the US regulators of financial institutions to delay a final Basel II implementation proposal that was to have been released in June of this year. Despite this study, and reports of sceptics in certain quarters, the Federal Reserve continues to champion the Basel II proposals. The earliest that the new regime could be fully effective in the US is January 1 2008, but financial institutions are taking it into account in managing their revolving asset businesses.

A preview of the new IRB regime, as it would affect large US banks holding retail credit assets, such as credit card receivables, was issued for public comment by banking agencies in late October 2004. The proposal defines qualifying revolving exposures (QREs) as loans that are revolving, unsecured and unconditionally cancellable by the bank with a maximum credit limit of $100,000. QREs would include most credit cards issued to individuals (but not to small businesses) and checking overdraft lines and protection programmes for individuals.

Using the internal ratings-based methodology, a bank might determine required capital for its credit card business as a whole. Alternatively, it could segment its credit card operations based on credit scores or other underwriting criteria and compute required capital levels for each segment. Many banks have multiple programmes, including acquired programmes and co-branded programmes that are managed as separate businesses from both a credit and a marketing perspective. In the case of banks operating in multiple countries, a segment is not allowed to cross national boundaries. Within the US a bank may use multiple legal entities within a single centrally managed programme, in which case the segment analysis can cross entity lines, but then the required capital so computed must be proportionally allocated to each legal entity.

Required capital for each segment is determined by plugging bank-determined loss probability and severity numbers (which must be "consistent with those used for internal risk management purposes") into a quite intimidating formula, one component of which is an asset value correlation specified by the regulators as 0.04 for QREs, 0.15 for residential mortgages and between 0.03 and 0.16 for other retail exposures (determined by taking into account the loss probability of the particular asset). The resulting required capital level for a bank's prime credit card programme can be substantially less than the current 8% minimum, possibly making securitization a less attractive alternative to on-balance-sheet funding.

For banks that choose to make full use of segmentation to reduce overall required capital, a possible interaction with the SEC static pool requirements should be noted. Banks will need to provide the regulators with a rationale that is "carefully delineated and well documented" for any proposed segmentation. The availability of such information could cause the SEC staff (encouraged by investors) to require disclosure of pool data that is similarly segmented.

A hunger for information

One hopes that the SEC staff understands that investors have an insatiable appetite for information. An investor can probably make a good argument that every bit of obligor information possessed by the originating financial institution would be useful to them. One or more of these investors can use proprietary computer programmes to obtain a competitive advantage over other investors who don't have these resources. Even if they don't use all this information at any given moment, it could become useful in the future to other parts of their institutions that might seek to acquire consumer accounts, consumer business segments, or even whole companies. Given the SEC's other priority of fairness and level playing fields (evidenced by among other things Regulation FD), the staff should be alert to the inequitable effect of information that is so detailed that only a handful can be expected to benefit, arguably at the expense of others equally deserving of protection.

Author biography

Edward De Sear McKee Nelson Edward De Sear's practice focuses on asset-backed securities, with extensive experience in the areas of securitization of credit card receivables, dealer floorplan receivables, mutual fund fees, tobacco settlement payments and legal fees, life settlements, distressed assets, project loans, foreign future flows and catastrophe risk coverage assets. He represents issuers, underwriters, credit enhancers and placement agents. De Sear authored "The Evolution of Credit Card Structures: Are They Flexible Enough for Today's Challenges?", which appeared in the Summer 2004 issue of The Journal of Structured Finance, and was recently appointed to be a member of the journal's editorial board. As a lecturer and panelist, De Sear has participated in numerous conferences held in the US and Latin America on asset-backed securities and securitization. Before joining McKee Nelson, De Sear was a partner in the New York office of Orrick, Herrington & Sutcliffe, where he served as chairman of the firm's structured finance group. He received a JD from the University of Virginia School of Law in 1973, and an AB from Columbia University in 1968. De Sear is a member of the board of governors of the Columbia Club of New York, and was named one of the world's leading practitioners in the field of securitization by Chambers USA America's Leading Lawyers for Business 2004.