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On June 17, the Obama Administration released its recommendations for reform of our financial regulatory system (the “Proposal”)1, as described in our clients and friends memorandum2 summarizing the Proposal. This memorandum explains the impact the Proposal would have on the securitization and related markets. Specifically, the Proposal would require:
The Proposal notes that a significant problem in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset backed securities (“ABS”) were issued. To address this issue, the Proposal would:
How sponsors and originators are to retain credit risk in securitized assets is not at all clear; nor is it clear how 5% of credit risk is either quantifiable or retainable. Would the originator or sponsor have to hold 5% in the form of the first loss position, a pro rata vertical slice of each tranche or a participation in each loan or would puts, guarantees, or similar credit loss sharing arrangements suffice?
Further, while the logic of this requirement appears sound in theory, in practice, it likely will cause the failure of small mortgage companies that do not have sufficient capital to carry such retained interests. Even for well-capitalized institutions, it is likely that, for some, the cost of retaining an interest in what is sold would eliminate any slim profit margin under which they currently operate. As a result, there could be fewer mortgage originators in the market, which could result in less competition and possibly higher borrowing costs to consumers.
In addition, the recent accounting changes promulgated in FAS 166 and FAS 167, which go into effect later this year, would disallow off-balance sheet treatment for many sponsors and originators, particularly those that service the related loans, if required to retain credit risk in securitized assets. On-balance sheet treatment could make securitization economically not feasible for many sponsors and originators, which could have the effect of further exacerbating the lack of liquidity in the securitization markets.
To further address the Proposal’s goal of incentivizing lenders and securitizers to consider the performance of underlying loans after the ABS are issued, the Proposal requires that compensation of brokers, originators, sponsors, underwriters, and others involved in the securitization process should be linked to the longer-term performance of the securitized assets, rather than only to the production, creation or inception of those products. Specifically, the Proposal:
While the compensation proposals may be appropriate, in practice it will be difficult to determine if a loan default occurs due to lax underwriting, changed circumstances of the borrower (e.g., loss of job, divorce, etc.) or changed market conditions.
If the accounting changes are implemented, securitization may no longer be an economically attractive option for many originators. As a result, similar to the impact of the risk retention proposal, there could be fewer originators in the market, which could result in less competition and possibly higher borrowing costs to consumers.
The Proposal expresses concern regarding the lack of transparency, standardization and ongoing reporting in ABS transactions. While disclosure requirements for ABS transactions were codified and standardized to a degree with the adoption of Regulation AB in 2005, additional changes to the disclosure requirements, both at the time of the offering and on an ongoing basis will impact securitization transactions. Although the Proposal acknowledges that the industry is working to standardize and increase transparency and the SEC is also currently working on improving disclosure and standardization, the Proposal highlights specific issues that need further improvement:
Although many of these proposals are likely to be non-controversial, as the ABS industry has in many respects recognized the need for increased transparency and standardization,3 these industry-developed standards and practices could potentially conflict with SEC mandated disclosures. It will be important to coordinate industry-led efforts with the efforts of regulators to ensure that a coherent, consistent disclosure and reporting regime is adopted. Any increase in disclosure requirements, particularly if the required information is difficult to obtain, will likely increase costs of ABS transactions, and revised ongoing reporting requirements will potentially require significant outlay by service providers to update systems to monitor and track new reporting requirements. Further, the development of increased disclosure requirements may delay the ability of ABS issuers to start securitizing again, as the time needed to prepare for these changes is likely to be significant.
It is unclear how disclosure regarding the compensation of brokers and originators would be implemented, particularly in light of the Proposal’s recommendation to change how these parties are compensated. In certain types of transactions, such as RMBS, from a practical perspective it may be difficult to provide disclosure on compensation of brokers given the number of potential brokers involved with the loans in one transaction.
The Proposal calls for a fairly dramatic overhaul of the credit ratings for structured products that could have severe consequences for the securitization industry. Specifically, the Proposal requires:
Creating a new category or other differentiation of credit ratings for structured products would result in a significant change for the industry as well as potentially severely limiting the pool of potential investors. Many investors are limited by policy, governing documents or regulation in the ratings on investments they are permitted or required to make. A wholesale change in the ratings for structured products would require changes in regulation and policies that would potentially be costly and time consuming. As a result, potential investors in ABS would be limited both initially and potentially for some time. It is not clear that all such regulations and policies would eventually be changed to match the new structured product ratings, possibly restricting the pool of investors permanently.
In addition, increased confusion regarding the meaning of ratings may result. While the Proposal is striving to improve investor understanding of the rating process and methodologies, requiring this type of differentiation will introduce a new element requiring explanation and disclosure and distract the focus from the other important issues, which are clarity and transparency in the rating process itself. A similar ratings differentiation requirement was previously proposed by the SEC and was almost universally opposed by the securitization industry, including investors.4
The proposals specifically aimed at the securitization markets focus on recommendations to remedy weaknesses in loan underwriting standards, accounting, reporting and rating agency criteria. Though not specifically addressed in the discussion of proposals for the securitization markets, the proposed regulation of the over-the-counter (“OTC”) derivatives market could have a substantial impact on whether the use of embedded derivatives in securitization transactions will be viable under the proposed regulatory reform. These proposals substantially echo many regulatory and legislative proposals that have been made over the last year with respect to OTC derivatives and credit default swaps (“CDS”), including the objectives set forth in Secretary Geithner’s Regulatory Reform of OTC Derivatives Market announced on May 13, 2009.
Specific elements of the proposed comprehensive regulation of the OTC derivatives market (including CDS) include:
For a more detailed description of the proposed regulation of the OTC derivatives market, see our clients and friends memo “Obama Proposal for Regulatory Reform as It Relates to OTC Derivatives Markets”5.
Although “plain vanilla” interest rate caps and swaps and currency swaps comprise a great portion of the derivatives used in securitization transactions, there are several factors that could make their qualification as either “standardized” or “customized” OTC derivatives problematic:
The proposal to have the SEC strengthen the regulation of credit agencies and require the rating agencies to maintain “robust policies and procedures” may lead to revised criteria for hedge counterparties in rated securitization transactions, including the possibility of increased collateral posting and reporting requirements.
The Proposal would require that all advisers to hedge funds and “other private pools of capital” register under the Advisers Act if their assets under management exceed an unspecified “modest threshold.”
If enacted in the manner proposed, many CDO managers would be required to register with the SEC. However, the precise contours of the term “private pools of capital” remain unclear, as does the status of foreign advisers. Query, for example, whether advisers that manage funds that do not invest in securities (e.g., CLOs) would be required to register. The Proposal suggests that the applicable requirements may vary across the different types of private pools, and this type of tailoring would appear to be essential if “private pools of capital” is intended to have a broad sweep. The types of disclosures that would be made to creditors and counterparties also is unclear, as there is little or no precedent for government-mandated disclosure in a non-customer, non-investor context.
1 To view the Obama Administration’s white paper, see, http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
3 For example, the American Securitization Forum initiative, Project RESTART, aims to restore investor confidence in ABS by, among other things, improving disclosure and reporting and standardizing representations and warranties on certain types of ABS. See http://www.americansecuritization.com/story.aspx?id=2655. In addition, the Commercial Mortgage Securities Association is currently working on the Investor Reporting Package 6.0 to address investor and industry concerns with respect to continuing reporting regarding commercial mortgage-backed securities. See http://www.cmsaglobal.org/IndustryStandards.aspx?id=10078.
4 While the industry supports many of the suggested changes to the rating process and disclosures, George Miller, executive director of the ASF has stated that “we strongly oppose differentiated ratings for structured credit products”. http://www.reuters.com/article/marketsNews/idUSN1734054320090617, June 17, 2009.