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Earlier this week, the Obama Administration released legislative language attached as Exhibit A to this Memo proposing changes to laws affecting asset-backed securities (“ABS”).1 The proposed legislation is the Administration’s follow-up to its June 17, 2009 release of recommendations for reform of our financial regulatory system (the “Proposal”)2, which we described in our clients and friends memorandum summarizing the Proposal3 and our clients and friends memorandum summarizing the Proposal’s impact on the securitization markets4.
The key features of the proposed legislation include:
The proposed legislation does not address certain matters addressed in the Proposal:
The proposed legislation would require federal banking agencies and the SEC to jointly prescribe regulations within 180 days requiring “any securitizer of an asset-backed security . . . to retain an economic interest in a material portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.”5 Securitizers would be required to retain at least 5% of the credit risk on any asset that is securitized.6 Securitizers would be prohibited from directly or indirectly hedging or otherwise transferring credit risk that they are required to retain with respect to any asset.7
Regulations would specify the permissible forms of risk retention (e.g., first loss position or pro rata vertical slice) that would be required and the minimum time period that securitizers would be required to retain such risk.8 Regulations would also provide for the allocation of risk retention obligations between securitizers and originators where a securitizer purchases assets from an originator.9 Federal banking agencies would have the authority to jointly adopt or issue exemptions, exceptions or adjustments to the 5% credit risk retention requirement and the prohibition on hedging.10
The obligation to retain credit risk will apply to both bank and non-bank securitizers.11 Moreover, the term “securitizer” is defined as an issuer or an underwriter of ABS.12 Based on this definition, regulations could be adopted that would impose a credit risk retention requirement on underwriters.
The proposed legislation would require continued reporting by issuers of ABS under the Exchange Act for such period of time and under such conditions as prescribed by the SEC, even if the number of holders of an issue falls below 300.13 In addition, each issuer of ABS would be required to disclose, at a minimum, asset-level or loan-level data necessary for investors to independently perform due diligence for each tranche or class of security.14 Disclosure would also be required of:
The SEC would also be required to set data formatting standards to facilitate comparison of data across securities for similar asset classes.16
The required disclosures described above apply to periodic reports filed pursuant to the Exchange Act, but do not appear to be mandated for Securities Act filings.
Under the proposed legislation, the SEC would be required to prescribe regulations requiring rating agencies to include in reports accompanying credit ratings:
The SEC would also be required to prescribe regulations requiring disclosure of fulfilled repurchase requests across all trusts aggregated by originator, “so that investors may identify asset originators with clear underwriting deficiencies”.18
Section 4(5) of the Securities Act permits savings and loan associations, savings banks, commercial banks and other similar banking institutions to sell promissory notes (and participation interests therein) directly secured by a first lien on a single parcel of real estate upon which a dwelling is located without filing a registration statement under the Securities Act.19 Interestingly, although not mentioned in the Proposal, the proposed legislation would eliminate this Securities Act registration exemption.
It is not clear why this repeal is proposed, as there is no evidence that this exemption was relied upon for mortgage loan ABS transactions in any meaningful way. We would not expect the repeal of Section 4(5) to adversely affect the private whole loan mortgage market, which generally involves negotiated sales of pools of loans between sophisticated buyers and sophisticated sellers, although mortgage market participants may have concerns about the intent of the proposed repeal.
No Proposed Changes to Gain on Sale or Consolidation Accounting or Consolidation. The Administration’s Proposal supported changes to Generally Accepted Accounting Principles that would eliminate the immediate recognition of gain on sale by originators at the inception of a securitization transaction and instead require originators to recognize income over time.20 However, the Administration’s proposed legislation does not contain any provisions related to accounting rules. So, as many people thought, it appears the references in the Proposal were to the changes to FAS 140 and FIN 46 recently adopted by the Financial Accounting Standards Board.
No Required Linking of Compensation of Loan and ABS Deal Participants to Performance of Securitized Assets. The Administration’s Proposal indicated that banking regulators should issue regulations to align compensation of market participants with longer term performance of underlying loans.21 Rather than mandating the type and method of compensation of market participants in order to link their compensation to the performance of securitized assets, the proposed legislation would require only disclosure of the nature and extent of compensation of loan brokers and originators.22
Obama Administration’s Proposed Legislative Language Regarding ABS
1 See Investor Protection Act of 2009, Subtitle E: Improvements to the Asset-Backed Securitization Process, available at http://www.ustreas.gov/press/releases/reports/title%20ix%20subt%20e%20securitization%207222009%20fnl.pdf.
2 To view the Obama Administration’s white paper, see, http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
5 See Investor Protection Act of 2009, Subtitle E: Improvements to the Asset-Backed Securitization Process, § 951, 15F(a).
9 The term “originator” is defined as “a person who sells an asset to a securitizer.” See Id. at § 951, 15F(e)(3).
11 See Id. at § 951, 15F(b)(4), indicating that the proposed regulations will “apply regardless of whether the securitizer is an insured depository institution, as defined in section 3(c) of the Federal Deposit Insurance Act (12 U.S.C. 1813(c))”.