The Securities and Exchange Commission (SEC) proposals to require issuers to provide investors with more information about loans underlying ABS would apply to municipal bonds and could have far-reaching effects on the muni market, several lawyers said last week.
The SEC earlier this month proposed the two sets of rules and has asked the public to comment on them by Nov. 15. They would implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act designed to provide more transparency in the ABS market and avoid problems that led to the financial crisis in 2008.
The requirements were added to the regulatory reform legislation to make certain there would be no replay of the events leading to the subprime loan-triggered crisis, when the originators of such loans had no incentive to ensure they performed well and essentially walked away from them when they did not.
However, muni market lawyers, issuers, and other market participants say the new law and rules are so broadly written that they would cover municipal securities and could hamper single-family housing bond and student loan bond transactions, as well as pooled financings and even leases or installment sales.
“It is extraordinarily broad,” said Roger Davis, a partner at Orrick, Herrington & Sutcliffe. “It potentially makes the transactions more burdensome.”
The lawyers want to alert market participants of the potential impact the proposed rules could have on municipal bonds and to push them to urge the SEC in comment letters to exempt munis.
“This is potentially serious,” Davis said. “Attention should be paid to it. The industry should give the SEC some help and guidance in how to formulate the appropriate rules.”
Municipal bonds backed by mortgages, other loans, and leases are very different from traditional ABS and should not be treated similarly, the lawyers said.
“I think this was a mistake. I think that munis should not be deemed to be asset-backed securities,” said Ken Roberts, a partner at Hawkins, Delafield & Wood. “There’s no experience of student loan and housing authorities walking away from their loan portfolios. I don’t think that this is what Congress had in mind.”
Municipal bond issuers have very different motivations than ABS issuers, according to Roberts. Muni transactions are intended to further some public purpose rather than generate profit, and issuers have to meet certain program requirements. These transactions have little, if any, track record of insolvency, he said.
Housing and student loan groups also are worried about the proposed rules.
“We haven’t seen the SEC differentiate between ABS asset classes and that’s something we’d like to see,” said Vince Sampson, president of the Education Finance Council (EFC), which represents nonprofit and state-based student loan providers that it says are public-purpose organizations dedicated to making college more affordable.
The concerns stem from the Dodd-Frank law, which defines the term ABS very broadly to mean “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset.”
The law also gives the SEC discretion to determine which securities are ABS. The law states that ABS can include “a security that the commission, by rule, determines to be an asset-backed security.”
That is a much broader definition than has previously applied in the commision’s ABS rules and, at a minimum, would include single-family housing bonds and student loan bonds, according to market participants. It also could include pooled financings and financings secured by loans, leases, installment sales, or any other “self-liquidating financial asset,” the lawyers said. The SEC stated in the ABS rules it proposed on Oct. 4 that they would apply to munis.
“If a municipal entity issues securities collateralized by a self-liquidating pool of loans that allow holders of the securities to receive payments that depend primarily on cash flow from those loans, that security would fall within the definition of a [Securities Exchange Act of 1934]-ABS,” the commission said.
The proposed rules would “require any securitizer to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer, so that investors may identify asset originators with clear underwriting deficiencies.”
They define securitizer as “an issuer of an asset-backed security” or “a person who organizes and initiates an [ABS] transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.”
As a result, muni bond issuers could be required to disclose in forms submitted to the SEC the extent to which there are nonconforming loans in their loan portfolios backing bonds and the extent to which those nonconforming loans have been removed, several lawyers said.
In its request for comments, the SEC asked not whether, but how, the guidance should apply to munis.
“Should we provide further guidance regarding the application of proposed Rule 15Ga-1 to securities issued by municipal entities that would fall within the definition of Exchange Act-ABS?” the commission asked. “Is it clear what types of municipal securities a municipal securitizer would have to provide representation and warranty repurchase disclosure under [the proposed rule]? If not, please identify those types of municipal securities that are not clearly covered and explain why they are not clearly included or excluded by the proposal.”
The SEC proposed another set of ABS rules on Oct. 13 that would require issuers, or third parties they hire, to review the assets or loans underlying the securities. The issuers would have to disclose the findings in forms filed with the SEC.
When commission members met to consider proposing the rules, chairman Mary Schapiro said: “With the responses to these requests for comment, we will be in a position to include a minimum review standard in the final rule if we determine that would be in the best course for investors in the market.”
Market participants worry that any minimum standard adopted would apply to municipal financings.
In its request for comments on the proposed rules, the SEC said the requirements “would apply to issuers and underwriters of ABS that exempted securities as defined in … the Exchange Act, including government securities and municipal securities.”
However, the commission asked, “Should such … securities be exempt from this provision?”
Muni market groups became concerned about Dodd-Frank provisions on asset-backed securities earlier this year, particularly the credit-risk retention requirement, which would require ABS issuers to retain at least 5% of the debt they issue.
The provision was designed to make sure loan originators have “skin in the game” and an incentive to make sure the loans are good. But market participants claimed the provision would make no sense for muni issuers for several reasons, including that issuers have no money to purchase loans. The SEC has not yet proposed rules to implement the provision.
Thirteen groups wrote a June 13 letter to Senate Banking Committee chairman Christopher Dodd, D-Conn., and House Financial Services Committee chairman Barney Frank, D-Mass., urging them to “make explicit that municipal securities are not included under the definition of 'asset-backed security’ as defined in section 941 on regulation of credit-risk retention.”
In addition to the EFC, the groups included the Government Finance Officers Association, the National Council of State Housing Agencies, the National Association of Local Housing Finance Agencies, the Securities Industry and Financial Markets Association, and the Regional Bond Dealers Association, now called Bond Dealers of America.
As a result, Dodd-Frank states that the rules “shall … provide for … a total or partial exemption for any asset-backed security issued or guaranteed by any state of the U.S., or by any political subdivision of a state or territory, or by any public instrumentality of a state or territory that is exempt from the registration requirements of the Securities Act of 1933.”
But several lawyers said the exemption would only apply to the credit-risk retention requirements and not to the other ABS provisions of Dodd-Frank, including the disclosure requirements.
The conference committee that hammered out the final law said in a Joint Explanatory Statement or report on the law, with regard to the new ABS rules: “Regulators also are required to issue total or partial exemptions from risk-retention and disclosure requirements for municipal securities and for securitizations of assets issued or guaranteed by federal agencies, as long as the exemption is in the public interest and for the protection of investors.”
That language, however, leaves it up to the SEC to determine what exemptions would apply to munis.