Even though the Securities and Exchange Commission (SEC) has given securitization issuers six months to omit credit ratings from ABS registration statements filed under Regulation AB, the ABS industry still has to work on a long-term solution to the unintended consequences of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
"We expect that regulators, issuers and the rating agencies will find a way to reconcile the conflict between Dodd-Frank and the SEC disclosure requirements," wrote researchers from Wells Fargo. "However, in the near term, new ABS issuance is likely to be constrained. We find it ironic that the ABS market is being hindered by references to credit ratings at a time when the SEC and other regulators are proposing less reliance on credit ratings."
Even before the signing of the Dodd-Frank reform act, there have been existing deterrents to securitization, sources said. For instance, even though the Federal Deposit Insurance Corp. extended Safe Harbor protections under more strict regulations, the capital requirements are already much higher because of the lack of off-balance sheet treatment under FAS 166/167. Hence, sources said that ABS issuance would have remained low regardless.
In a research note, JPMorgan Securities analysts said that whether or not "rating agency personnel need to provide consent for a deal before it can be registered with the SEC, it is likely that given the looming uncertainties, issuance will decrease further over the near term from its already muted pace."
Analysts added that while the market might expect some of the upcoming ABS transactions to be privately issued as a "safety precaution," the type and amount of issuance over the longer term will depend on how Reg AB as well as the repeal of Rule 436(G) are ultimately interpreted.
New issuance volume will be less than it would have been without the repeal. Analysts believe that this benefits "longer-duration spread product and could cause spreads to tighten faster than we initially anticipated," they said. This will happen as ABS buyers rush to purchase bonds amidst an already supply-constrained scenario.
By repealing Section 436(G) of the Securities Act of 1933 the Dodd-Frank act opens rating agencies to unprecedented liability for the quality of their ratings on ABS transactions, analysts from Barclays Capital said in a research note.
As a result, immediately after President Obama signed the Dodd-Frank act and because of the difficulty assessing this new liability, Moody's Investors Service, Standard & Poor's, Fitch Ratings and DBRS pulled back from the new-issue securitization market (see chart on rating agency statements on the next page).
Section 436(G) previously protected rating agencies from liability for their ratings, which are considered opinions rather than expert advice.
To close an ABS transaction, it must have a rating from one or more nationally recognized statistical rating organizations (NRSROs). When ratings are mandated, Barclays analysts explained, the SEC regulations require the ratings be disclosed and released by the agency in the public offering documents. The failure to disclose this information could be considered a material omission and would potentially subject the issuer and underwriter to further liability.
Indeed, the signing of the Dodd-Frank act into law caused havoc in terms of temporarily halting ABS issuance, something that lawmakers did not anticipate. "Given previous congressional and administration support for the consumer ABS market, it seems clear to us that the intent was not to halt securitization in its tracks," Barclays analysts said.
Taking away the exemption has placed the rating agencies in an uncertain situation, and so they "obviously are going to be cautious about potential liabilities," a legal expert said.
"Essentially, the way the rule had worked was that liability in securities laws applied to accountants and lawyers, where they consent essentially as an expert," he added. The exemption from expert status was abruptly taken away from the rating agencies, "so they could be subject to liability standards under the securities laws and have lost control," the legal expert said.
"If an investor sues, they can't foresee any of that - so now the issuer has to get consent from the rating agencies to have their rating on the offering document," the expert said.
Another option, he said, would be to just leave out the bond's risk profile as part of the offering document.
The 144A Route
A solution being floated around in the ABS market is for issuers to take the private/144A market route, where public filings with the SEC are not required.
However, Bank of America Merrill Lynch analysts said that limiting ABS issuers to the 144A market could reduce the options available to many investors.
With a considerable portion of consumer and commercial securitization issuance stemming from the public market, many investors will not be able to participate in the 144A market and it would therefore not be a long-term solution, BofA Merrill analysts noted.
Additionally, a shift to the 144A market could also have the potential of increasing funding costs to issuers - which would eventually be passed on to consumers. Some issuers might choose to reduce origination volumes if faced with rising funding costs, BofA analysts said.
Alternatively, Barclays analysts said, the SEC could also collaborate with the industry to alleviate the unintended results of the repeal.
There are also clear disadvantages to taking the private route. "The downside of doing so is that it's more expensive and it's not readily marketable since it's subject to restrictions, therefore less attractive than a registered offering," the legal expert said. He added that many ABS programs are registered, and this might be difficult to transform into private shelf offerings, especially if the issuer comes to market on an ongoing basis.
There are two issues here when it comes to the securitization market, according to the expert. For one, securitization deals are required to have discreet disclosure of ratings while issuers in other markets do not have to. Also, issuers in other markets could get around the disclosure issue by providing a free writing prospectus, but ABS issuers do not have this option.
Despite the obstacles, sources maintain that the 144A market for ABS can be a viable alternative if issuers and investors see insurmountable problems with doing registered deals.
For instance, bond and pension funds should find the 144A market to be slightly, if any, more difficult to trade in than the public market.
Even if issuers are worried about incremental pricing pressure, it's not as if the primary/secondary market for public ABS - with the exception of agency RMBS - is very deep right now anyway, said Omer Uzun, a managing director at Proteus Financial Group.
The market has six months to sort this out. Whether supply and demand will be balanced, and how much pricing is impacted, depends on a variety of economic factors, which no one can really anticipate or predict, he said.
In the worst case scenario, banks will have the option to issue public unsecured corporate bonds, and until a resolution to Reg AB and 436(G), this might serve as the preferable funding source, Uzun said, adding that this would be unfortunate for the ABS market.
Investors, Uzun said, still need ratings for ongoing reporting. The NRSROs may well be able to find a way to comfort investors by providing ratings after a new bond is sold. "In any case, investors should be deciding to purchase a new bond based on their own credit analysis," he added.
"This is the same issue that money market funds faced last year, before Rule 2a-7 was amended to encourage portfolio managers to rely less on ratings. There is some consistency in the underlying logic of how ratings should and should not be used," he said. "The securitization market needs to find a middle ground like the money market funds did and address this directly with the SEC."
Uzun added that accounting firms are already liable for their audits, "yet they still function every day and investors rely on their work." NRSROs should be able to find a way to work under the new liability risk.
Other sources said the Big 4 audit firms should get into the ratings business. In fact, rumors have circulated that one of the Big 4 considered registering as an NRSRO sometime last year.
The underlying issue here remains the quality and role of the ratings that the agencies have provided. "As a solution is sought to this immediate obstacle, ABS market participants have a historic opportunity to reduce their over reliance on credit ratings, in our opinion," Wells Fargo analysts said. "We propose that issuers, investors and other market participants should be seeking out ways to interact so that the sensitivity to credit ratings is less acute."
Aside from the rating agency issue, risk retention is still a part of the Dodd-Frank reform act with which securitization participants are grappling.
As has been decided for awhile now and formalized with the Dodd-Frank act's signing, the minimum risk retention required will not be less than 5% of the assets' credit risk, although this might be less than 5% of the credit risk if the originator of the assets meets certain underwriting standards to be established by the federal banking agencies under the ABS provisions.
Additionally, the new reform regulation has defined "qualified residential mortgages," which will be exempt from the risk retention entirely. The regulators also have the flexibility to adopt other risk retention exemptions or exceptions.
The final rules for risk retention will be prescribed 270 days after the Act was signed, according to Ralph Mazzeo, a partner at Dechert.
"The Commission is incentivized by Congress to focus on tightening up underwriting standards - either indirectly via risk retention or directly by issuing specific underwriting standards," Mazzeo said."We are moving away from the more complicated consumer products that we saw before the credit crisis."
On the commercial mortgage side, Congress gave some parameters to consider for risk retention including whether there is a good substitute for securitizer or originator risk retention, Mazzeo said.
"For example, if there are strong B-piece buyers who hold the first loss position and who did the proper due diligence, there may be no need for the securitizer to hold the risk," he said. "The Commission is also encouraged to develop risk retention rules on an asset by asset basis,"
The new regulation outlined instances where risk retention is not required with respect to certain high quality residential mortgage loans. Mazzeo feels that there are many important issues that will be clarified in the final regulations. For instance, the Commission will specify the exact type of retention and how long it's going to be required. Is a five-year risk retention time frame sufficient to align incentives or should it be as long as the life of the deal?
"What I'd like to see is some optionality on a deal by deal basis," Mazzeo said. "It would be beneficial for issuers and investors to work it out on an individual transaction and asset class basis - whether it be horizontal or vertical retention or some other feature that aligns the interests of issuers and investors."
There are two studies required to be done by the Financial Oversight Council and the regulatory agencies that Mazzeo believes are worth noting. One is on the effect of risk retention on the availability of credit and the other is on the feasibility of minimizing the real estate bubbles on a regional basis.
The risks brought about by the just-signed Dodd-Frank act are not limited to rating agency liability. According to Max Rudolph, owner of Rudolph Financial Consulting, LLC and fellow of the Society of Actuaries, the current version of the act leaves room for investment companies to utilize its provisions to add leverage into the financial system.
Rudolph cited the Volcker Rule, for instance, where a banking entity that organizes and offers a hedge or private equity fund is allowed to make and retain an initial investment if after a year this investment is reduced to 3% of the total ownership interests. Aside from this, the fact that GSE reform was not included as part of the act still leaves room for certain companies to make leveraged investments in both Fannie Mae and Freddie Mac.
"There is still room through these investments to utilize structured finance, for instance, to add leverage into the system," Rudolph said. "Rules were created as opposed to principles where questions about what would be the total leverage impact or what would be reasonable should have been asked."
Aside from these loopholes, down the road Rudolph said lawmakers are going to learn that didn't eliminate the arbitrage that companies could find by choosing the regulatory bodies that would govern them. The Financial Stability Oversight Council created by the new act, he said, might be too politically oriented to promote true risk management.
"That's one of the worries with the rating agencies," Rudolph said. "There's a chance to discredit a rating agency from having an NRSRO as an example of how these firms can be knocked out of business." Rather than solving the systemic problem, Rudolph said that the popularity method of taking out a company might prevail."They really didn't fix the risk there," he said.
With structured finance, for instance, he said that if there are still institutional investors who are willing to buy bonds backed by badly underwritten mortgages the problems are going to remain. The underlying problem, Rudolph said, is that many institutions outsourced their decision making to rating agencies. "You have to have an effective internal risk management process, and not one that is rules-based," he said.
He added that he does not get the impression that practices have changed to lessen the systemic risk. Rudolph believes that a rules-based regulatory reform would only lead to the same problem. "It's MBS this time; next time it's just going to be something different," he said.
He cited the problems in manufactured housing 10 years ago."They just carried that business model over and applied it to residential mortgages," he said.
"In view of the unprecedented treatment of credit ratings resulting from the repeal of Rule 436(g), DBRS is not willing to consent to the inclusion of its ratings in registration statements or prospectuses at this time. Of course, DBRS will continue to make its credit ratings and research available to the public through its normal distribution channels."
"While Fitch will continue to publish credit ratings and research, given the potential consequences, Fitch cannot consent to including Fitch credit ratings in prospectuses and registration statements at this time."
Moddy's Investors Service:
"While we will continue to publish credit ratings, given the potential legal consequences, we cannot consent to the inclusion of ratings in prospectuses and registration statements without further study. Issuers should discuss this change for the use of credit ratings in public offerings registered under the '33 Act with their legal advisors."
Standard & Poor's:
"We are currently examining the proposed legislation and expect to provide additional information to you in the future about any related new procedures or changes to our processes. We will explore mechanisms outside of the registration statement to allow ratings to continue to be disseminated to the debt markets. The proposed legislation reinforces our commitment to transparency. "
- Compiled by Matthew Silfee