Formulating the rules to implement the Dodd-Frank Act has proven to be challenging. Regulators both missed and moved deadlines to accomplish this monumental task.
For the securitization industry, this means ABS issuers will have to deal with the uncertainty until these market-changing regulatory issues get mapped out.
According to Dodd-Frank language, regulators are required to implement the rules 270 days from the passage of the act, which means an April 17 deadline that is unlikely to be met. As of press time, some of the regulations have just entered the proposal phase and still have a way to go before they are ironed out into effective legislation.
Despite the delays in the risk retention rules, for instance, there hasn't been a rush by issuers to get deals done ahead of regulations. However, industry players believe that once regulators map out the parameters for securitization, this will likely lead to greater issuance volumes.
"As rules come out, there is always a problem with interpretation, so there is a concern that while most of the provisions won't have retroactive implications, there could be an impact even on the future transfer of assets with respect to existing securitizations - such as revolving structures," said Kenneth Kohler, senior of counsel at Morrison & Foerster (MoFo).
Kohler also believes that the reason regulators want to include servicing provisions in with risk retention is because they are following the chronology of what happens in a mortgage securitization.
"Their first mission was to fix the origination and underwriting functions. Then they realized there were real problems in the servicing area," he said. "Once they get past servicing, it's likely they will find that there is still a huge problem because issuers need a balance sheet to place long-term mortgages on."
Before the mortgage crisis, long-term conforming mortgages were held on the GSEs' balance sheets, which were effectively placed in the capital markets as GSE securitizations. For private-label deals, investors around the world bought up the different tranched-up pieces. However, since tranching is currently disfavored, the industry must now find investors who want to take on that long-term risk.
"The people who used to do it before - the hedge funds of the world, the pension funds - are much more risk averse," Kohler said. "It could be that once they get past the servicing issue, they could find that no one will want to buy these loans unless the mortgage rates are at least multiple percentage points - not basis points - higher to incentivize new institutional investors to take mortgage loans and mortgage securities on their balance sheets for an extended period of time. Banks themselves through Dodd-Frank and Basel III are seeing their capital requirements increased for holding mortgage loans and securities, so whatever appetite they had for long-term investment will be decreased."
Kohler believes that, at some point, there will be enough impetus to do deals from an economic standpoint, and when market participants are chomping at the bit to do a securitization, they will have to figure out how much future uncertainty they are willing to live with.
This uncertainty plays out more on the mortgage side versus the auto sector, where deals continue to get done. "The uncertainty around these issues is a real factor if you are trying to figure out how to restructure your business and what your strategy will be going forward," said Jerry Marlatt, also a partner at MoFo. "It's less of an issue for operations like auto loans because you won't change that business until you figure out what the rules of the road are, so you will go ahead and do deals - the rules aren't having the same kind of impact; people aren't hesitating to do securitizations and investors aren't afraid to invest."
He added that "the uncertainty plays more on when people plan on where they will make investments, and the bigger issue is around mortgage loans. Dodd-Frank will push some consumer financing out of banks to nonbank entities like REITS, hedge funds and private equity funds - various different kinds of financing entities that are not regulated as banks. Dodd-Frank adds a lot of cost to securitization, but more cost in the banking sector than elsewhere."
The long-term effect of that, according to Marlatt, is that some business will be taken away from banks. "It's hard to start up these new companies when regulations haven't settled yet, delaying some of the movement away from banks; that development will start to accelerate when rulemaking settles down," he said.
As a result, Marlatt said that MBS investors are also taking a "wait and see" attitude on how things will play out. "They will be looking for more return, and that has not connected in the marketplace yet to find a market clearing spot between the added costs on the origination side and the added yield that one would assume investors will be looking for going forward to compensate them for the greater risk than they thought they had in the last round," he stated.
The only source for yield and the only way costs on the issuer side can be covered is from the interest rates on the mortgage assets. "Right now interest rates are so low there wouldn't be enough money in the available interest rate to cover the expenses and added yield, which is one of the reasons why you don't see people feeling really compelled to get deals done," Marlatt said. "If mortgage rates were higher and people could see how all those costs and yields would fit in, it would make a deal materialize to a much quicker and greater extent."
Risk Retention, No Deal Breaker
The good news is that the risk retention requirement will not preclude issuers from securitizing.
"It won't be a deal breaker in all cases," said Kenneth Marin, a partner at Chapman and Cutler. "For the most part, and depending on the asset class, it's a surmountable obstacle and won't be a deterrent for securitization. It's more of a case of waiting for the final rules. Proposed rules [recently] came out, and the industry will have a better grasp of the effect once we have digested what the regulators are proposing."
In credit card deals, for instance, there is less concern because inherent in those programs is the requirement that the sponsors retain at least 5% of the receivable pool.
Most sponsors retain the first-loss position and, in the case of credit card and floorplan trusts, a representative share of the collateral via the seller interest. Additionally, most ABS sponsors have multiple funding sources to finance the retained position in a securitization, said Bank of America Merrill Lynch analysts.
A concern is the effect the risk retention requirement will have on sponsors who are hoping to get off-balance-sheet treatment. The proposed 5% requirement could stress the ability to get off balance sheet and GAAP accounting treatment, but in many cases securitization issuers are no longer eligible for off-balance-sheet treatment to begin with.
Some Clarity on Risk Retention
Risk retention under Dodd-Frank requires securitizers to hold not less than 5% risk retention in any ABS that they sell out into the market. The rule also asks that regulators prohibit sponsors from hedging this risk and from transferring it to anyone else.
The measure, requiring lenders to have "skin in the game," is meant to help reform the securitization market, protect the public and the economy against irresponsible lending practices and facilitate economic growth by allowing for safe and stable credit formation for consumers, businesses and homeowners.
The rules are written jointly by six regulators, which include the Federal Deposit Insurance Corp. (FDIC), the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Housing Finance Agency and the Department of Housing and Urban Development. The risk retention regulations must meet certain standards regarding the level and form of risk retention. Once issued, these jointly prescribed regulations would become effective a year later for RMBS and two years later for all other ABS.
As required under Dodd-Frank, the Federal Reserve Board completed the risk retention study. In the related report, the Board said that "in light of the heterogeneity of asset classes and securitization structures, practices and performance, rulemakers consider crafting credit risk retention requirements that are tailored to each major class of securitized assets."
The Board also stated that "this approach is consistent with the flexibility provided in the statute and would recognize differences in market practices and conventions, which, in many instances, exist for sound reasons related to the inherent nature of the type of asset being securitized. Asset-class-specific requirements could also more directly address differences in the fundamental incentive problems characteristic of securitizations of each asset type, some of which became evident only during the crisis."
FDIC officials held a press conference on March 29 ahead of an agency meeting to discuss the risk retention proposal and the all-important missing piece of the puzzle - the qualified residential mortgage (QRM) definition.
The agency also discussed the minimum servicing requirement for QRMs. According to an FDIC official, this rule will require that the servicers have the proper incentive and that they align their interest with borrowers. This was done so servicers provide risk servicing and help borrowers facing financial difficulties to look at various risk-mitigating options.
The servicing requirements included in the FDIC proposal will not replace ongoing interagency efforts to develop national mortgage servicing standards. The agency also left open to comment whether a national approach would be more effective in addressing servicing problems over its proposed QRM criteria.
In its proposal on risk retention released last Tuesday, the FDIC said the securitization sponsor is required to hold risk retention. The agency said that regulators have created varied options from which sponsors can select so that they can apply whichever approach they believe is most appropriate for the type of asset security backing the securitization.
The proposal also laid out seven options for how a sponsor could structure risk retention. These alternatives include a so-called "vertical slice," in which a sponsor holds 5% of each tranche in the securitization. Alternatively, sponsors can also hold a "horizontal" piece, in which their first-loss position would be on the whole securitization. A third option would involve sponsors taking an "L-shaped interest," in which the 5% interest would be split 50-50 between a vertical slice and horizontal loss position.
While the GSEs are under conservatorship, their risk retention is covered by the guarantee, which is about the best risk retention that could be had, said an FDIC official during the conference call. However, the GSEs and any successor entity will continue to be covered by that ongoing guarantee as long as they are backed by the U.S. government.
During the call, the FDIC also noted that despite much of the attention surrounding risk retention, it is not a new concept.
"It's been there all along, just in a different form," an FDIC official said. "The form that has been used has been an overcollateralization pool that provides for risk retention."
The official added that the way the market applied risk retention was not working. This is why the FDIC has taken this whole process and applied it in a way that it believes will keep the market from being able to game the system and result in true risk retention.
"The overall discount being applied here should not be significantly higher than what was applied to the more stabilized market prior to the bubble," the official said.
There are certain exceptions to risk retention requirements, the primary one being the QRM. This standard, the same FDIC official said, ultimately features the idea that, for certain assets underwritten with certain standards, these mortgages can be written by the sponsors with zero risk retention.
"By being conservative and by being prescriptive, they are easily understood and will help make the whole process more transparent," the official said.
The primary characteristics for a QRM rely on the borrower's debt-to-income ratio calculated both on the front end, where the household debt and all costs associated with the home should be 28% of the borrower's income, and the back end, which comprises all other debt that should be calculated at no more than 36% of a borrower's income. Aside from requiring a 20% down payment, the borrower cannot have a 60-day delinquency on any debt obligation within the past two years. A maximum 80% LTV would be required to purchase a home.
The FDIC said the LTV ratio would be calculated without including mortgage insurance. The agency also wants the borrower to have an equity position in the home. Qualified assets such as auto loans, commercial loans, commercial real estate and residential mortgages will also not be required to retain any part of the credit risk if they meet the underwriting standards included in the proposal.
As such, the risk retention exemption will apply to only the most conservative underwriting standards and will leave out a long list of products such as negative amortization, interest-only payments or significant interest rate increases that add risk to mortgage loans.
According to a report in ASR sister publication American Banker, regulators will also consider possible alternatives to the QRM.
The report said that they will find out whether the proposed definition is too narrow and suggest at least two alternatives. Under one plan, regulators would create a second class of loans that are exempt from a 5% risk retention requirement but include at least some risk retention amount between 0% and 5%. Under another plan, regulators can broaden QRM criteria to capture more loans but enforce a tougher risk retention requirement for loans that fall outside that status.
Rep and Warranty Issues
On Jan. 20, the SEC adopted rules on representation and warranty and repurchase reporting required by Sections 943 and 945 of Dodd-Frank. Specifically, Section 943 of Dodd-Frank required the SEC to prescribe regulations on the use of representations and warranties in the ABS market.
The underlying securitization documents have a provision that requires the seller to repurchase assets in the event of a breach of rep and warranty.
Under the Dodd-Frank regulation on reps and warranties, the securitizer needs to disclose all instances of such repurchases. In terms of how reps and warranties will affect the marketplace, most of the discussion has been about how to comply with the disclosure requirements and how to report the repurchase history on the different types of deals issuers have done. There also remain questions regarding categorization of transactions when disclosing repurchases by asset class.
For many securitization asset classes aside from residential mortgages, repurchases just do not happen. Moreover, for a number of asset classes there has never been an instance of repurchase. However, the rules do require that these issuers still have to make a disclosure and then once a year state that they have not made a repurchase. "The one area where the rep and warranty repurchase rules might be a deterrent is for issuers that fund only through asset-backed commercial paper conduits," Chapman's and Cutler's Marin said. "Issuers who have never before been required to submit filings with the SEC may now be required to make a public filing in order to securitize."
Many commentators have opposed the Reg AB II formulation and, in fact, have proposed an arbitration procedure as the principal alternative advanced by the industry, which they say is more workable and fair.
Structural improvements on the arbitration for breaches of representations and warranties, as used in Redwood Trust's recently completed RMBS deal, require the master servicers to review all loans that become 120 or more days delinquent to determine if there are any breaches of representations and warranties.
According to a note published by Fitch Ratings, if there is a breach that the seller cannot cure, the seller is obligated to repurchase the loan no later than 120 days following discovery of the breach. If a resolution to a breach is not satisfactory to both the seller and the originator, either party may enter into arbitration. The finding of the arbitrator shall be final and binding upon the parties.
While Redwood Trust's handling of representations and warranties does not address the regulatory changes highlighted under Dodd-Frank's new approach to handling and reporting repurchases, Fitch believes that the model is a marked improvement from older RMBS vintages. Redwood, however, has no disclosure regarding its repurchase history - just textual descriptions of the repurchase obligations and provisions, MoFo's Kohler said.
"The item that is mentioned by Fitch as a positive in the repurchase area is a glass half full or half empty, depending on who is looking at the glass," Kohler stated. "Fitch applauds the repurchase procedure for its clarity in setting forth who has the right and obligation to review defaulted mortgage loans for rep and warranty breaches, what the time frames are and what the procedure is for resolving disagreements - mandatory arbitration."
But the Redwood approach is less favorable to investors than the process specified under the proposed Reg AB II for deals done off shelf registration statements (as the Redwood deals are), in which an issuer must repurchase a loan unless an independent third-party reviewer actually issues an opinion that there was no breach of a rep and warranty. "Given the likely difficulty in obtaining such opinions, and the fact that the Reg AB II procedure does not seem to leave room for a settlement or compromise that one might achieve in arbitration, the proposed Reg AB II procedure seems heavily weighted in favor of investors," Kohler said.
The good news is that the issue of reps and warranties will likely be an aspect of Dodd-Frank that the industry will be able to deal with and will not be a major deterrent to securitization. However, a market with limited deal flow has provided little impetus for issuers to get any further on the issue of repurchase reporting.
"My sense is that we are not even on the verge of doing more deals - people are trying to get a game plan together but are not devoting effective resources yet," Kohler said.
Disclosure Under Dodd-Frank
Many provisions that relate to disclosure in Dodd-Frank are still up in the air, including that required by Section 943 under Rule 15-Ga-1 that requires ABS issuers to make quarterly disclosures of all fulfilled and unfulfilled asset repurchase requests for all of the securitizer's Exchange Act ABS trusts. These rules apply to all issuances of Exchange Act ABS, both public and private, with initial disclosure for all issuers that issued and sold such ABS in the three-year period starting Dec. 31.
According to Jon D. Van Gorp, a partner at Mayer Brown, this might present some issues for companies that have not securitized in three years. There is a question, he said, of whether they have some kind of reporting obligation. There is also the issue of whether this applies to foreign issuers, he said.
"It depends on whether an issuer has been active in the securitization markets," he said. "The key point is for those who have exited the business and haven't done a deal in three years - getting the data out there might be troubling."
Although the SEC has released its final rules on this, there "are still some open questions around how outstanding reporting will apply going forward," Van Gorp said.
Meanwhile, MoFo's Kohler said that deals like Redwood Trust might not have been done had the rules under Section 943 requiring extensive disclosure of repurchase history already applied. "The current rule is less onerous for those involved with transactions like Redwood Trust," he said. "The new rules will be a burden to deal with, and people might be up in arms once they go into effect since the rules might prove to be unworkable."
The market also has outstanding questions relating to Section 942 of the Dodd-Frank Act. Section 942(a) eliminated the automatic suspension of the duty to file under Section 15(d) of the Securities Exchange Act of 1934 for ABS issuers, although granted the SEC the authority to issue rules providing for the suspension or termination of such duty. MoFo's Kohler said the effective date of the newer suspension provision is still outstanding.
Meanwhile, Dodd-Frank Section 942(b) directs the SEC to adopt regulations governing disclosure of asset- or loan-level data needed for investors to independently perform due diligence, including information concerning any risk retained by the originator or securitizer. There are related disclosure requirements in Reg AB II, the implementation date for which remains uncertain.
"So it's as if it's in suspended animation," Kohler said. "The SEC has not given the date the market has to deal with Reg AB II or the similar disclosure requirements under Section 942(b). Participants are looking toward the beginning of 2012 for full implementation of Reg AB II."
Due Diligence Reviews
Section 945 of the Dodd-Frank Act added a new Section 7(d) to the Securities Act. Under this new section, the SEC must issue rules that require an ABS issuer to perform a review of the assets that underlie the ABS and disclose the nature of the review.
The agency has adopted Securities Act Rule 193 to implement Section 945 under Dodd-Frank. This section requires ABS issuers to perform a review of the pooled assets that underlie the ABS. Rule 193 applies only to issuers of Exchange Act ABS offered in registered offerings. This rule allows issuers to engage another third party to perform any part of the required review.
According to Tony Nunes, head of strategy and product development within the corporate trust business at BNY Mellon, common questions from their clients concern whether the required third-party review can be performed by the issuer's affiliate and what the appropriate sample size of loans is for the review, which still needs to be defined.
Aside from these, there are several items that remain unclear regarding how to conduct these required asset reviews, Nunes said, including the disclosure around the characteristics of the assets, how to provide conformity of the assets, the compensation factors and the breakdown of the assets.
There are also questions, he said, around the reviewer's liability and full responsibility, specifically about how that liability shakes out.
Nunes added that further clarity is also needed in terms of the standards - who is obligated to provide the data and guarantee the data's timeliness. "We need to be really clear about the data elements," he said. He added that the market is still trying to figure out what the levels of review are supposed to be, which includes finding out the differences between self-review and unaffiliated party review. "The separation of the duties of the third-party review improves reliability," he said.
Additionally, he said that "the framework associated with the agent's role, we still don't have enough details about that."
There are also questions about the sample size to be disclosed in a prospectus. "If the sample review size is too small, it could raise questions about the quality of the assets," Nunes said. On the other hand, he noted that if the sample size is too large, "there are cost and time issues. It's all about finding that right balance."
He added: "If there is clarity on the protocol that is visible to all parties, you could manage risk better in terms of the quality at the point of origination and ongoing monitoring."
with additional reporting by Karen Sibayan