Wednesday, October 14, 2009

Fitch ratings: Basel II and Securitization

Fitch Ratings has today published research exploring Basel II's regulatory capital framework for securitization, available on Fitch's web site at The web site requires users to perform a simple log on process. The report, entitled Basel II and Securitisation: A Guided Tour through a New Landscape, can also be found by linking to 'ABS' (under 'Structured Finance') and then clicking on 'Research'.

The report provides a comprehensive review of the various Basel II approaches for calculating capital charges on securitization exposures and a study of the potential Basel II capital dynamics for a sample of securitization transactions. In a separately-published paper (entitled Basel II Supervisory Formula: The Meaning behind the Maths), Fitch provides an in-depth analysis of the supervisory formula for unrated securitization exposures held by internal-ratings based (IRB) banks.

"Understanding Basel II is important to understanding the future scope and shape of securitization activity, given how bank capital requirements can influence origination, structuring and investment decisions," said Ian Linnell, Head of the EMEA Structured Finance Group at Fitch. "Recent rating volatility within some sectors of structured finance has sparked a fresh interest in Basel II amongst banks, investors, and regulators."

In evaluating Basel II capital dynamics for securitizations, Fitch calculates and compares the capital charges on an underlying pool of collateral assets relative to the total charges on the securitization of these same assets (a methodology first used in Fitch's 2005 report, "Basel II: Bottom-Line Impact on Securitization Markets"). This approach is useful in analyzing the degree of capital comparability or 'neutrality' between the unsecuritized collateral charges versus the securitization charges on a given transaction, an important consideration within the Basel II framework.

"Basel II's impact on securitization capital charges ultimately depends on a complex interplay of factors, including choice of Basel II capital calculation approach, deal structure and conventions, the type and credit quality of assets being securitized, and market conditions and investor risk appetite," said Krishnan Ramadurai, Managing Director of Fitch's Credit Policy Group. "Case-by-case analysis is therefore critical."

Additionally, Fitch notes the importance of understanding how Basel II's calibration and risk-sensitivity can affect capital charges. "Relatively subtle changes in the risk attributes of either the collateral pool or the capital structure can have a significant impact on capital," said Martin Hansen, Senior Director of Credit Market Research at Fitch. "For example, Basel II securitization charges accelerate rapidly when crossing the threshold from investment to non-investment grade, meaning that downgraded or junior tranches will tend to dominate overall capital dynamics."

In a separately published report, Fitch also provides an intuitive explanation of the IRB supervisory formula for unrated securitization exposures. The supervisory formula is technically sophisticated, requires extensive mathematical analysis to understand the drivers and dynamics of the resulting charges, but does not fully capture the heterogeneity of types of assets included in securitizations and important elements of transaction structures, such as excess spread and priority of payment arrangements.

"In practice, the supervisory formula tends to generate pronounced 'cliffs' and limited differentiation in charges across the capital structure, thus reducing its risk-sensitivity. Coupled with its demanding information requirements and limited transparency, the use of the supervisory formula could have a negative market impact if used as the primary basis for calculating regulatory capital requirements," said Atanasios Mitropoulos, Senior Director of Fitch's EMEA Structured Finance Group.

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