The Securities and Exchange Commission's (SEC) renewed proposal to prohibit conflicts of interest in securitizations is critically flawed and would impose significant impediments to the ongoing functioning of the asset-backed securities market, industry advocates said recently.
Influential representatives of participants in the asset-backed securities (ABS) market spelled out these and other concerns in recently submitted comment letters regarding the re-proposed rule.
Among the hard critics, the Structured Finance Association (SFA) in particular said that "all of our members, including our investor members, agree that the re-proposal is critically flawed," and that the rule "would impose significant impediments to the continued health functioning of the ABS and broader financial markets."
In fact, the SFA said, compliance with the rule would "not so much be burdensome as it would be impossible," and that the "result will be a lesser availability of credit, greater risk, and greater instability to our financial markets."
Major trade associations including the Securities Industry and Financial Markets Association (SIFMA) and the American Bar Association's structured-finance and securities committees, voiced similar concerns. The Loan Syndications and Trading Association (LSTA) pointed to the proposal's definition of "conflicted transaction," noting the proposed rule would be particularly problematic for collateralized loan obligations (CLOs), because there are "similar actors and active markets in the underlying CLO assets."
The LSTA said the rule could potentially impede "even the most basic, constructive and everyday loan market and portfolio management activities," thus dampening the leveraged loan market in which CLOs play a major role. The trade group urged the SEC to rescind the proposal and propose a "more appropriate rule" under Section 27B of the Securities Act of 1933, and at a minimum limit conflicted transactions to those intentionally designed to benefit from the loss in value of securitizations that are designed to fail.
A request for clarification
Not all of the comment letters voice opposition. Investment Company Institute (ICI), representing regulated investment funds in including mutual funds and exchange-traded funds (ETFs), offered measured support for the idea.
"As investors in [ABS] markets, our members generally support the re-proposed rule and believe it would serve to protect ABS investors against certain conflicts of interest which may be raised by the activities of securitization participants," the ICI said.
The ICI, however, did ask the SEC to clarify proposed rule's scope, starting out by confirming that long-only ABS investors—the ICI's core constituency—should not be considered deal sponsors that could face conflicts of interests. And it noted concerns that the proposed definition of "conflicted transaction" could inadvertently capture routine hedging transactions using ABS indices by an affiliate or subsidiary of a securitization participant that's unconnected to the securitization.
To avoid that result, the ICI recommended that the SEC not treat as a conflicted transaction "a fund or adviser (as a fiduciary on behalf of a fund or other client) taking a position on an ABS index that includes ABS for which an affiliate served or serves as a securitization participant."
While ICI is representing a specific segment of market participants, the SFA says it represents the "entire value chain" of the securitization market, and it describes the proposed rule as having a much broader and more profound impact on the market. Like several other institutions commenting on the proposal, it said the two-month comment period ending March 27 was too short to analyze the impact adequately and called its letter "preliminary."
"We plan to a follow-up letter within 90 days hereafter, expanding on our initial comments" and providing more details on how to revise the proposal and a cost benefit analysis, the SFA said in its 35-page letter.
More follow-up coming
The LSTA, in fact, plans to follow up with two additional letters, after the first one discussing why CLOs are not the "structured-to-fail transactions" existing law seeks to prevent, "underscored by CLOs' remarkable long-term performance record." A second letter will address concerns with the proposal's breadth and complexity, and a third will explain in detail the challenges it presents for CLOs and corporate loans.
In their joint 76-page letter, SIFMA and the Bank Policy Institute "remind" the SEC that the comment period for the original proposal was three months, and it was extended by another two months. The letter says the proposed rule "should not be adopted," calling it "both excessively broad and vague," and instead the commission should propose a "more tailored" rule.
"There are no pervasive regulatory issues in the securitization market that warrant the breadth of the proposed rule," the comment letter says.
Better Markets, which typically supports investor protections, opened its letter by recalling several of the infamous transactions that led to the original conflict-of-interest proposal and were structured and marketed by Wall Street's largest banks, including Goldman Sachs' ABACUS synthetic CDO, J.P. Morgan's and Citigroup's "CDO squared" products.
"ABS are especially prone to abuse due to their complexities," Better Markets said, adding that "as we saw play out in the run up to the financial crisis of 2008, conflicts of interest in securitizations can have devastating impacts on even sophisticated, institutional investors."
