Analysis of non-compliant loans in German synthetic mortgage-backed securities transactions

Over the term of a securitisation transaction the concept of non-compliance enables a securitising bank to classify a securitised loan as materially non-compliant with transaction-specific contractually agreed requirements. Such a loan becomes unqualified for loss allocation to the account of the protection sellers. Therefore non-compliant loans can directly affect transaction performance and the extent of risk transfer that is actually achieved with the transaction. The concept of non-compliance is incorporated in many securitisations independent of the underlying assets or structure.In Germany there are currently no specific regulatory provisions in place regarding this concept. However a bank can use discretion when classifying a loan as non-compliant and could thus report non-compliant loans strategically. This hypothesis is tested based on a unique data set. The potential regulatory effects associated with such conduct are elaborated. Suggestions are made for a more adequate regulatory treatment of non-compliant loans.