What the SEC's conflict of interest proposal may mean for mortgages
March 2, 2023 3:17 PM
A revised and reissued Securities and Exchange Commission proposal aimed at preventing conflicts of interests in securitizations and related transactions could have implications for a vehicle used to manage mortgage risk.
The proposal, which stems from a Dodd-Frank Act requirement, would set restrictions on securitization participants engaging in certain transactions for a year after the initial sale of a security and place prohibitions on particular deals.
The proposed rule also may have particular implications for credit-risk transfers that Fannie and Freddie Mac use to manage mortgage exposures.
Credit risk transfers involve pacts in which private investors share losses on reference pools of loans through special purpose entities after the government-sponsored enterprises have absorbed a certain amount. In exchange for agreeing to take on that potential risk, the private investors receive regular payments that are dependent upon the performance of the loans.
"My read is Fannie and Freddie will be exempted out of this for their own MBS, but they won't be exempted out of this for CRT," said Mark Calabria, senior advisor at the Cato Institute and former director of the Federal Housing Finance Agency under the Trump administration.
Others don't interpret the proposed rule this way.
"There's certainly ambiguity here as to what this applies to and how," said Ed DeMarco, president of the Housing Policy Council and formerly acting director of the Federal Housing Finance Agency during the Obama administration.
Fannie Mae in a 10-K filing indicated that current government ties would likely exempt its MBS from the restrictions in the proposal. However, it also acknowledged that there's some uncertainty on that point.
"While the SEC indicated in the proposing release its intent to exempt us from the rule while we are in conservatorship, questions remain…and we are still assessing the potential impact of the rule on our credit-risk transfer transactions during conservatorship."
The FHFA declined to comment on the proposed rule. Freddie also did not have an immediate comment available.
The proposal, which stems from a Dodd-Frank Act requirement, would set restrictions on securitization participants engaging in certain transactions for a year after the initial sale of a security and place prohibitions on particular deals.
The proposed rule also may have particular implications for credit-risk transfers that Fannie and Freddie Mac use to manage mortgage exposures.
Credit risk transfers involve pacts in which private investors share losses on reference pools of loans through special purpose entities after the government-sponsored enterprises have absorbed a certain amount. In exchange for agreeing to take on that potential risk, the private investors receive regular payments that are dependent upon the performance of the loans.
"My read is Fannie and Freddie will be exempted out of this for their own MBS, but they won't be exempted out of this for CRT," said Mark Calabria, senior advisor at the Cato Institute and former director of the Federal Housing Finance Agency under the Trump administration.
Others don't interpret the proposed rule this way.
"There's certainly ambiguity here as to what this applies to and how," said Ed DeMarco, president of the Housing Policy Council and formerly acting director of the Federal Housing Finance Agency during the Obama administration.
Fannie Mae in a 10-K filing indicated that current government ties would likely exempt its MBS from the restrictions in the proposal. However, it also acknowledged that there's some uncertainty on that point.
"While the SEC indicated in the proposing release its intent to exempt us from the rule while we are in conservatorship, questions remain…and we are still assessing the potential impact of the rule on our credit-risk transfer transactions during conservatorship."
The FHFA declined to comment on the proposed rule. Freddie also did not have an immediate comment available.
The history behind it
To understand what the proposal could mean for structured credit-risk transfers, it helps to know its origin.
Section 27B of the Securities Act, the statute within Dodd-Frank that requires the rulemaking "was a response to transactions years ago that some regulators and members of Congress characterized as … 'designed to fail' by securitization participants so that they could facilitate extrinsic side bets in the form of short positions in the transaction," said Christopher Horn, an attorney at Mayer Brown whose practice is focused on structured finance.
The SEC cites an example involvinga Wall Street firm and a hedge fund manager planning on taking a position where he'd benefit from the poor performance of subprime mortgages in an investment vehicle. In that instance, the Wall Street firm allowed the manager "to play a major but hidden role" in selecting the assets that went into it.
Section 27B of the Securities Act, the statute within Dodd-Frank that requires the rulemaking "was a response to transactions years ago that some regulators and members of Congress characterized as … 'designed to fail' by securitization participants so that they could facilitate extrinsic side bets in the form of short positions in the transaction," said Christopher Horn, an attorney at Mayer Brown whose practice is focused on structured finance.
The SEC cites an example involving
Why it may apply to credit risk transfers
Whether CRTs have enough in common with this type of scenario to create a need for reform is a matter of debate. The commission's comments do make specific reference to synthetic securitization transactions involving special purpose entities, which suggests they might, but in other ways they are dissimilar.
"In these kinds of deals, you do have a SPE that's selling credit protection to a bank or a GSE for some reference pool of mortgages or other financial assets, and the bank or GSE is getting a premium for that," said Horn. "But that credit protection buying and selling feature is intrinsic to the deal and doesn't bear any family resemblance to the sorts of conflicts of interest that Section 27B was meant to address."
Credit risk transfers do have a selection process that may make them vulnerable to potential conflicts of interest, according to Calabria.
"Fannie and Freddie pick which loans go into those deals," said Calabria. So it's theoretically possible that someone on the GSE side, which is packaging the credit risk for sale, could purposefully put loans more likely to go into default into the reference pool.
However, DeMarco said the selection process for CRT pools has not been hidden as it was in the subprime mortgage transaction referenced in the proposal.
Originally, CRT reference pools aimed to match a particular GSE's distribution of different loans. Later, they were pegged to specific securitized pools, he noted.
"All that is disclosed," said DeMarco.
"In these kinds of deals, you do have a SPE that's selling credit protection to a bank or a GSE for some reference pool of mortgages or other financial assets, and the bank or GSE is getting a premium for that," said Horn. "But that credit protection buying and selling feature is intrinsic to the deal and doesn't bear any family resemblance to the sorts of conflicts of interest that Section 27B was meant to address."
Credit risk transfers do have a selection process that may make them vulnerable to potential conflicts of interest, according to Calabria.
"Fannie and Freddie pick which loans go into those deals," said Calabria. So it's theoretically possible that someone on the GSE side, which is packaging the credit risk for sale, could purposefully put loans more likely to go into default into the reference pool.
However, DeMarco said the selection process for CRT pools has not been hidden as it was in the subprime mortgage transaction referenced in the proposal.
Originally, CRT reference pools aimed to match a particular GSE's distribution of different loans. Later, they were pegged to specific securitized pools, he noted.
"All that is disclosed," said DeMarco.
How the proposal could change things
Disclosure may not be enough, given that the wording of the proposed rule refers to "prohibition" of conflicts of interest. The proposal currently does not permit disclosure as a means of addressing a conflict of interest, which is unusual, Horn said.
"Disclosure is often the principal means by which conflicts of interest are addressed in other laws and regulations, including conflicts between investment advisers and their advisory clients under the Investment Advisers Act and between banks and their customers and counterparties under the Volcker Rule," Horn said.
If the SEC moves forward with the proposal, Fannie, Freddie and any private companies (such as JPMorgan Chase) that have engaged in credit-risk transfer transactions may have to take a step that addresses the conflict of interest concern, Calabria said.
That wouldn't necessarily stop CRT activity, but it could mean it'll need to be implemented in a new way to address conflict-of-interest concerns, potentially slowing it, Calabria said. A third-party trustee could select reference-pool loans, for example.
But Mike Gill, senior vice president of capital markets at the Housing Policy Council, said it's "highly speculative what the outcome is going to be."
"Disclosure is often the principal means by which conflicts of interest are addressed in other laws and regulations, including conflicts between investment advisers and their advisory clients under the Investment Advisers Act and between banks and their customers and counterparties under the Volcker Rule," Horn said.
If the SEC moves forward with the proposal, Fannie, Freddie and any private companies (such as JPMorgan Chase) that have engaged in credit-risk transfer transactions may have to take a step that addresses the conflict of interest concern, Calabria said.
That wouldn't necessarily stop CRT activity, but it could mean it'll need to be implemented in a new way to address conflict-of-interest concerns, potentially slowing it, Calabria said. A third-party trustee could select reference-pool loans, for example.
But Mike Gill, senior vice president of capital markets at the Housing Policy Council, said it's "highly speculative what the outcome is going to be."
Broader implications for other types of risk sharing?
One of the questions that's arising as the proposal goes through the comment period currently set to end March 27 is whether it could have implications for other forms of risk sharing outside structured CRTs, which have the closest ties to securitization.
Fannie Mae, for example, recently issued its first Credit Insurance Risk-Transfer deal of the year. This deal transferred $405.7 million in credit risk on $11.8 billion in single-family loans to insurers and reinsurers.
In its current form, it is unclear what impact the proposed rule could have on CIRTs, or on other types of transactions such as private mortgage insurers' credit-linked notes, Horn said.
Also, some of the wording in the SEC's commentary around the proposed rule is a bit colloquial and "doesn't fully reflect the distinction between 'conflicting interests,' which every party to any legal contract has, and "conflicts of interest,"...a legal term of art that refers to conflicts between a duty that a person owes to another and that person's own self interest," Horn added.
This is among the points industry participants are seeking clarification of during the comment period, he said.
Fannie Mae, for example, recently issued its first Credit Insurance Risk-Transfer deal of the year. This deal transferred $405.7 million in credit risk on $11.8 billion in single-family loans to insurers and reinsurers.
In its current form, it is unclear what impact the proposed rule could have on CIRTs, or on other types of transactions such as private mortgage insurers' credit-linked notes, Horn said.
Also, some of the wording in the SEC's commentary around the proposed rule is a bit colloquial and "doesn't fully reflect the distinction between 'conflicting interests,' which every party to any legal contract has, and "conflicts of interest,"...a legal term of art that refers to conflicts between a duty that a person owes to another and that person's own self interest," Horn added.
This is among the points industry participants are seeking clarification of during the comment period, he said.
A different potential challenge for structured CRT
Calabria, a critic of structured credit-risk transfers, imposed relatively higher capital charges against them while at the FHFA, stopping Fannie Mae from issuing them temporarily until the rule was re-evaluated under Biden administration leadership, but said the SEC's concern is different.
The kind of risk Calabria has been more focused on when it comes to CRT was the type evident in the pandemic, when larger disruption in the capital markets affected it, said Calabria, who recently authored a book on his experience as director of Fannie and Freddie's regulator during the period.
The potential conflict of interest risk arguably doesn't require regulation, given that participants from the example from the Great Recession mentioned were curbed through existing enforcement vehicles, Calabria said. But the Dodd-Frank Act's congressional mandate requires action, he noted.
The kind of risk Calabria has been more focused on when it comes to CRT was the type evident in the pandemic, when larger disruption in the capital markets affected it, said Calabria, who recently authored a book on his experience as director of Fannie and Freddie's regulator during the period.
The potential conflict of interest risk arguably doesn't require regulation, given that participants from the example from the Great Recession mentioned were curbed through existing enforcement vehicles, Calabria said. But the Dodd-Frank Act's congressional mandate requires action, he noted.
The need for the rule may have passed
It's possible that the SEC determines the proposed rule is no longer needed.
The SEC's commentary around it notes that many other changes have been made to regulations that impact securitization and that transactions of the type that motivated Section 27B may no longer be occurring in the market, Horn noted.
"The world we're in right now is different, so this is raising a lot of confusion and concern clouding credit-risk transfer in a way that doesn't make any sense," said DeMarco.
But because that's not a forgone conclusion and there are many paths the proposal could go on from here, including progression to a final rule without the extension many are requesting, what happens during the feedback period will be critical, Horn said.
"It's not a given that they're going to get our comments and then revise the rule and then issue a final rule," he said. "That could happen, but hopefully after the SEC works through the comments it receives, it will re-propose another version of the rule.
"Rulemaking in the area of conflicts of interest is very difficult and the SEC's many requests for comment in the proposing release make it clear that the SEC is considering all views," Horn added.
The SEC's commentary around it notes that many other changes have been made to regulations that impact securitization and that transactions of the type that motivated Section 27B may no longer be occurring in the market, Horn noted.
"The world we're in right now is different, so this is raising a lot of confusion and concern clouding credit-risk transfer in a way that doesn't make any sense," said DeMarco.
But because that's not a forgone conclusion and there are many paths the proposal could go on from here, including progression to a final rule without the extension many are requesting, what happens during the feedback period will be critical, Horn said.
"It's not a given that they're going to get our comments and then revise the rule and then issue a final rule," he said. "That could happen, but hopefully after the SEC works through the comments it receives, it will re-propose another version of the rule.
"Rulemaking in the area of conflicts of interest is very difficult and the SEC's many requests for comment in the proposing release make it clear that the SEC is considering all views," Horn added.
