Canada: Securitization Vehicles - Is IFRS The End Of The Road?

Last Updated: August 16 2011
Article by Andy Kenins, Dilshad Hassen and Peter Hatges

As confidence in these vehicles remains low for investors and IFRS eliminates some of their biggest benefits for banks, the industry needs to mitigate the impact by developing a new and more diversified range of financing sources.

One of the biggest changes in banking and credit lending over the past 20 years has been the growing proportion of bank-originated loans sold to investors in securitization vehicles. Banks have developed a host of investment vehicles to accomplish loan securitizations—asset-backed commercial paper, mortgage-backed securities, and collateralized loan or debt obligations, to name a few.

Trillions of dollars in loans have been securitized through these vehicles, allowing banks to reduce their regulatory capital requirements and manage their exposure to any one borrower. Banks have also marketed these vehicles to corporate clients, in single- or multi-seller form, creating a means for companies to securitize customer accounts and lease receivables, monetize high-quality assets, and improve how they manage their balance sheets and lending ratios.

These conduit structures have allowed the banks to generate fees for structuring and managing the vehicles, along with liquidity and commitment fees. These lucrative revenue streams have come to represent a significant part of many banking businesses.

Investor interest fails to rebound

However, securitization activity slowed to a virtual halt in 2008 as the credit crunch swept the globe and investors lost confidence in mortgage- and asset-backed securities. As the debt capital markets recover and market liquidity improves, investor interest in certain securitization vehicles remains slim. To the extent that IFRS has eliminated some benefits of securitizing assets through these investment vehicles, banks have lost a lever for optimizing regulatory capital and managing exposure. And to the extent their corporate clients begin to shy away from these structures, banks also stand to lose a key source of revenue.

IFRS reporting puts pressure on asset-to-capital ratios

Reporting debt securitizations on balance sheet under IFRS will adversely affect financial results and could diminish the financial benefits of future issuances. IFRS reporting of these vehicles will put pressure on banks' asset-to-capital ratios and limit their ability to undertake such transactions in the future. Risk-based capital ratios are less affected, muting the impact for larger banks whose assets-to-capital ratios are less of a constraint.

IFRS looks to transfers of risks and rewards

Under Canadian GAAP, securitization transactions could achieve derecognition and off-balance sheet treatment for various assets such as loans and mortgages where the bank or corporation is considered to have transferred control over the assets. But under IFRS, derecognition is more difficult to achieve because it is based on whether there has been a substantial transfer of risks and rewards as well as a transfer of control.

If the assessment of the transfer of risks and rewards is inconclusive (where some but not substantially all risks are retained), control and the extent of continuing involvement must be assessed. Under Canadian GAAP, the transfer of risks and rewards does not factor into the assessment. But in many circumstances, the IFRS assessment must go beyond just qualitative considerations to also examine quantitative measures. Banks and corporations transferring assets to investment vehicles must compare who is exposed to the risk of loss, and entitled to the rewards, before and after the transfer. Where substantially all the risks and rewards of the assets are retained by the transferor, derecognition of the entire asset under IFRS is not permitted.

Typical Canadian structures used to facilitate securitizations have required the transferor to retain a substantial exposure to the risks and rewards. The requirement served as a form of credit enhancement to support asset-backed security ratings and limit the exposure of investors and sponsoring banks. Under IFRS, these mechanisms prevent derecognition. In certain investment vehicles, a third party or the transferee assumes some, if not substantially all, the risks and rewards of the assets. Where the control criteria are also met, such vehicles offer some flexibility for achieving derecognition.

In light of the risks and rewards consideration, most existing Canadian securitization vehicles would not qualify for de-recognition under IFRS. The underlying assets would therefore need to be recorded or remain on the transferor's balance sheet.

For example, securitization transactions in which the transferor gives collateral or guarantees as a first loss against credit losses inherent in the securitized portfolio of assets may not meet the IFRS de-recognition standard where the first loss level is sufficient to cover substantially all the expected risks inherent in the assets. Increased capital adequacy requirements, lower returns on assets, and deferrals of gains and losses on such securitization transactions will result. Additionally, recognizing the transferred assets back on the balance sheet with a corresponding obligation may also strain corporations' balance sheet ratios. To avoid going offside, many corporations have had to renegotiate loan covenants and other metrics with their banking partners, lenders and other stakeholders.

Smaller institutions most affected

Smaller financial institutions with large amounts of securitizations will be most affected by the change to IFRS due to the adverse impact on their asset-to-capital ratios. The Office of the Superintendent of Financial Institutions is considering a multitude of requests from smaller institutions to increase their assigned ratios. While such relief may ultimately be provided, new assigned ratios will not likely increase beyond the existing maximums (e.g., 23:1) for larger institutions.

Institutions that take part in the Canada Mortgage Bond program are particularly affected. The program is designed to transfer interest rate and prepayment risk on underlying mortgage-backed securities back to the originator through a total return swap, also known as a "seller swap". Depending on the mortgage-backed security pools and specific terms and conditions, many institutions in Canada need to recognize the mortgages underpinning the mortgage-backed securities on balance sheet, which can significantly strain their capital ratios.

Mitigating the impact

As the implications of IFRS on securitizations take hold, there are a number of steps that banks should take to mitigate the impact:

  • Assess the impact of transactions that would fail derecognition. Consider the potential effect on capital adequacy and other ratios such as return on assets.
  • Work with investors, originators and legal counsel to develop new securitization structures that meet IFRS de-recognition requirements. In principle, to derecognize financial assets on transfer, the transferee must have given up exposure to substantially all the risks and rewards of owning the assets. Retained interests designed to cover first loss exposure, cash reserve accounts and other mechanisms designed to have the transferor retain this exposure in substance (for example, to enhance or obtain a specific credit rating) would violate this principle and need to be amended or addressed.
  • Work with corporate clients to assess whether bank-sponsored structures meet the IFRS derecognition criteria. Corporations can expect to pay a premium to have the bank sponsor of an investment vehicle or a third party investor assume first loss exposure over the transferred assets. Similarly from a sponsoring bank's perspective, where the transferor or originator of the assets sold into the investment vehicle do not assume the first loss exposure, the bank would need to accept the risk of either assuming this exposure itself or the exposure of whoever else assumes it.
  • Assess the financial impact of compromising credit ratings for securitized pools in exchange for achieving the desired capital and accounting result of de-recognition.
  • Adjust internal processes and systems for accounting for these transactions, for example, to change how transfers of risk and rewards are measured and documented.
  • Create an assessment model that incorporates the full cost benefit analysis of undertaking securitization transactions. Even if they do not meet the de- recognition norms, such transactions could have benefits as a funding alternative to raising deposits.

As for Canada Mortgage Board program transactions, where a bank transfers mortgage-backed securities under the program that do not qualify for derecognition, recognizing the underlying mortgages on the balance sheet, along with the corresponding secured financing obligations, and derecognizing the seller swap creates more challenges. Depending on how or if the bank hedged the interest rate and prepayment risks associated with the mortgage-backed securities and the program, accounting under IFRS exposes the economic hedge, adding to the income statement's volatility. Fortunately, the IFRS rules on portfolio hedging are more accommodating (with macro or portfolio hedging permissible) and so banks can apply hedge accounting to mitigate income statement volatility in some cases.

Looking ahead, while the new IFRS rules make derecognition of financial assets harder to achieve, they do not make it impossible. Canadian banks will therefore need to work with their clients and investors to develop a diversified range of appropriate financing structures and sources.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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