The Obama administration unleashed its new proposal to regulate the securitization market last month.
This forward-looking, positive step sends the message that securitization is worth saving. However, not only do these regulations potentially make credit more expensive, they also increase the cost of capital and threaten the viability of securitization.
On the one hand, the government now appears ready to provide a future platform for securitization. But, on the other, the punitive rules proposed could erase the benefits of this capital markets tool. The regulations noted the benefits of securitization, particularly as a means of funneling credit to families and businesses to finance the consumption necessary to sustain economic growth. However, the government also finds faults with the current securitization model.
In its white paper on the new regulations, the Obama administration proposes that federal banking agencies promulgate regulations that require loan originators or sponsors to retain 5% of the credit risk of securitized exposures. These regulations would further prohibit an originator from directly or indirectly hedging or otherwise transferring the risk it is required to retain under these regulations. The retained interest requirement is meant to ensure that the originator and/or sponsor of a securitization continues to have "skin in the game" in the form of ongoing exposure to the assets' credit risk.
Kenneth Kohler, a partner at Morrison Foerster, said that this proposal raises a host of issues that will likely be difficult to sort out.
For example, it is unclear how the 5% retention would be accounted for on the books of the originator or sponsor - that is, at book value or at "fair value," requiring periodic mark-to-market adjustments. Also, there might be questions regarding the impact of the retention on the originator's and/or sponsor's ability to de-recognize, or treat as sold, the 95% securitized interest under the new FASB pronouncements, FAS 166 and FAS 167, which substantially changed the sale and consolidation principles previously embodied in FAS 140 and FIN 46(R).
Kohler said it was also unclear whether only one party to a securitization transaction must retain a 5% interest, or if multiple parties in a multi-step transaction must independently retain a 5% interest. For example, if an originator sells loans to a securitization conduit sponsor that actually issues the securitization instruments, must the originator and the sponsor each retain a 5% interest?
Issues arise as well by the mandate that the 5% retention be unhedged. "Clearly, the purpose of this requirement is to ensure that the originator or sponsor bears the full brunt of any credit losses on the 5% retention," Kohler said. However, this does not hold in the face of the broader principle emphasized in the white paper, that financial institutions should adhere to strict risk-management procedures.
From a risk-management standpoint, Kohler said it might not be sensible for a financial institution to retain exposure on a substantial portfolio position, at least if the protection can be economically obtained.
To the extent that hedging is not obtained, the originator or sponsor has greater exposure to credit risk and therefore itself poses a greater risk of failure, which is, in turn, destabilizing to the financial markets.
Hey, Haven't We Seen This Before?
Mike Culhane, CEO of Oakwood Global Finance, said that securitization needs to be at least cheap enough to be sustainable. If it costs more than can be covered by the mortgage rates the general public can afford to pay, then lenders won't do it. "How this legislation works in practice and how it gets legislated without trapdowns that are unintended is what's in question at the moment," he said.
The 5% skin-in-the-game concept is very similar to what the European Union (EU) is currently discussing, with Australia probably soon following suit with a similar requirement. But as always, the devil will be in the details. "In the case of skin in the game, it's a concept that has long been discussed across the world regulatory bodies," one market source said. "It would make sense if there were some coordination among them to apply the regulations the same across the board."
Culhane said that, in theory, the 5% rule that the U.S. Treasury has proposed may look a lot like the EU rule, although the coordination efforts in Europe haven't come easily. The European markets' development has historically been plagued by varying jurisdictional differences that make it difficult to apply a singular approach. Implementation of the regulation through highly political European government bodies that are feeling pressure from constituents means that the 5% rule will look different from country to country.
"If you look at the administration's proposals, a lot of them are already under way," Kohler said. He added that the Community Reinvestment Act proposal has been the subject of Securities and Exchange Commission rulemaking. The American Securitization Forum is also examining these reporting and disclosure proposals. The proposals attracting the most attention are the 5% retention rule and the proposition that mortgage industry compensation be paid over time and tied to the performance of assets. Kohler also said that the gain on sale and off-balance-sheet accounting limitations will essentially leave more assets on balance sheet.
On the upside, the move to regulate securitization at least signals that the government recognizes the importance of the function of this market in the greater scheme of the economy, but industry pundits say that the new regulations have a punitive view of the market's future.
For example, Culhane said that the 5% regulation is interesting given that the market is asking for more than that. In a better economic environment, however, non-bank originators that, at best, operate at 1% to 2% will definitely have to reconsider whether the securitization route would still be attractive.
"In the end, if these rules stick, what we'll see is a more conservative product where more volume is charged for the product," he said. "But, sourcing that equity piece will present a challenge because you'll find that few investors are willing to supply that level of support."
Accounting Regulations Another Piece of the Puzzle
While the 5% skin-in-the-game concept marginally increases the costs of doing securitizations, one real concern is how the Treasury regulation will work in conjunction with the Financial Accounting Standards Board's new FAS 166 and FAS 167. "Under FAS 166, to achieve sale treatment for a transfer of a participation (say the 95% participation), it appears the 5% retention cannot be subordinated. It must be pari passu and an identical percentage for each loan," Kohler said. "Therefore, a sponsor may get no credit enhancement benefit of subordinating the 5%, which will basically be inert."
FAS 166 and 167 will significantly change the accounting for securitizations and other off-balance-sheet vehicles. FAS 166 is essentially a revision to FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which has governed securitization accounting for years. It eliminates the concept of a qualifying special purpose entity, which automatically qualified for off-balance-sheet treatment.
Now securitization sponsors must evaluate whether to consolidate or not using the variable interest entity guidelines established in FIN 46(R).
However, FAS 167 is a revision to FIN 46(R), which originally provided guidance on a quantitative test to determine the primary beneficiary of the vehicle's activity. Whoever receives the most benefit, or bears the most losses, must consolidate the securitization assets. The new standard for consolidation is based on control of assets, as well as economic interest in the vehicle.
Joseph Astorina, an analyst from Barclays Capital, noted that many bank issuers are already bringing their deals back on balance sheet as they provide support. For example, Citibank disclosed as much in its first-quarter 10-Q filing, and Barclays expects others will do the same.
Revisiting Covered Bonds
Aside from the cost factor, the Treasury may be missing the forest for the trees. To the extent that new rules require loans to be held on a bank's balance sheet, its ability to make new loans and restart the economy will be very constrained by bank capital requirements.
"If you think back to last year when the government began touting its 'skin-in-the-game' concept, it decided that covered bonds were the way to go," Kohler said. "The government had the big banks lined up and was saying that this is the way of the future, but no one actually did any deals. That would have basically been the model that is now being proposed by the administration."
Through the Term ABS Loan Facility, Kohler added, the administration has moved from demonizing securitization to accepting that it has a significant role in consumer finance, and without securitization, it will be hard to get the economy going again. However, he said that there is now a tug of war between the traditional off-balance-sheet securitization model and the on-balance-sheet covered bond model. With the regulatory proposals and the new accounting rules, it will take a very long time before securitization will see the volumes that it saw over the last decade, Kohler said.
Essentially what is being proposed is that banks move back to the old model where these institutions originated loans for portfolio. However, this negates one of the major benefits of securitization, which is that it allows banks to sell loans and recycle credit into new loans without waiting for portfolio loans to be repaid.
Kohler believes that the government faces a real dilemma with the skin-in-the-game concept versus having a robust consumer finance market. "What we are seeing is a big move toward covered bonds and other on-balance-sheet structures, which will likely limit bank lending volumes," he said. "However, it is too early to say that covered bonds will entirely replace traditional securitizations. What is clear is that there is a push more toward the on-balance-sheet model, and it will become more and more difficult to achieve gain on sale and off-balance-sheet treatment in the new environment."
Kohler's take is further supported by the new bill that was introduced in the U.S. House of Representatives titled the Equal Treatment of Covered Bonds Act of 2009 that coincided with the new regulation proposals. Developments in the U.S. covered bond market had been put on hold as the financial crisis unfolded despite the fact that regulatory efforts in 2008 to encourage development of the covered bond market were well received. Kohler said that these efforts were not sufficient to launch a U.S. covered bond market both because the efforts did not allay investor concerns regarding the treatment of covered bonds upon the insolvency of an issuing bank, and because most prospective covered bond issuers were unable to act given the extreme dislocation of the capital and credit markets.
"Covered bonds have the potential to provide issuers with an alternative to securitization as part of a well-diversified liquidity management program and to provide investors with an asset-backed debt instrument that protects against many of the risks recently experienced in the originate-to-sell model," he explained. "However, since late 2008, federal government financial crisis recovery efforts have focused on restarting the securitization markets."
The new legislation would address at least two of the remaining impediments to the further development of a covered bond market in the U.S.
First, the legislation would provide a statutory scheme for the treatment of covered bonds upon the insolvency of a financial institution issuer, ensuring that the treatment of covered bonds upon the issuer's insolvency could not be changed by regulatory whim. Second, the legislation would provide a measure of damages that would more likely make investors whole upon an issuer's insolvency than the formula applicable under current law.
At the End of the Game?
Joe Mason, a professor at Louisiana State University's E. J. Ourso College of Business Administration, said that the rest of the Treasury proposal on regulations for the financial markets "rings just as hollow as the skin-in-the-game proposals, representing a lack of understanding of securitization markets and their development - as well as what is needed for reform and recovery." These remarks were in a commentary on the regulations that ran on the Institutional Risk Analyst.
The Treasury is proposing that credit rating agencies disclose conflicts of interest and what risks their ratings are designed to assess, report on the credit rating performance measures for structured credit products and publicly disclose additional information about the methodology used to rate structured finance products, which - by and large - they already do.
Rating agencies will be further required to differentiate the ratings they assign to structured credit products (e.g., ABS) from those they assign to unstructured debt (e.g., corporate bonds), as well as disclose non-public rating agency data and methodologies to the Securities and Exchange Commission, neither of which prevents rating agencies from repeating the same behaviors that contributed to the crisis.
"The sad fact is that lacking any significant performance history, rating agencies rated unratable products for regulatory approval and escaped liability for doing so under First Amendment protection," Mason said. "Nothing in the Treasury proposal changes that."
The Treasury Department proposes that loan-level data be disclosed to investors at inception and over the life of the securitization. However, Mason said that this data is already mandated under SEC Regulation AB and is the source of trustee data sold by many vendors.
The department also proposes contract standardization. "Most of these contracts are already standard save the economic terms of the deal: the tranche cutoffs and credit enhancement characteristics whose standardization can add liquidity to the marketplace and safety to commercial bank securitization," he said.
But, like many steps taken in this very tricky rebuilding effort, it's likely that a lot of what the Treasury has proposed won't stick - not if it's really committed to making the market work.
"Regulation alone will not solve the problems that caused the credit crisis," said Colin Melvin, CEO of Hermes Equity Ownership Services. "We must re-connect corporations with their institutional shareholders. We all have a stake in corporate success through our pensions, savings and employment. We need a financial system that works to our benefit."
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