The Securities and Exchange Commission (SEC) put on hold one change that could have shuttered the ABS market starting in early January. But a long line of proposals marching into 2011 will keep ABS compliance departments busy and, in some cases, may fundamentally alter the market.
The Dodd-Frank financial reform statute enacted in July repealed the SEC's Rule 436g that exempted rating agencies as experts and their ratings from being included in registration statements, which would subject these firms to Section 11 liability. When the law passed, the rating agencies essentially stopped rating deals and the market briefly halted, until the SEC extended the exemption to January. On Nov. 23, the SEC extended the exemption indefinitely.
Tom Deutsch, executive director of the American Securitization Forum (ASF), explained that without the exemption, investors could have argued that ratings predict the future performance of an ABS transaction. Then, if a souring economy adversely impacted the transaction and resulted in investor losses, those investors could have sued the rating agencies - holding them liable for potentially millions of dollars.
In that case, Deutsch said, "It seems unlikely the ratings agencies would consent to the inclusion of their ratings in the prospectus."
Despite the ratings agencies' eroded creditability since the credit crisis initiated in 2008, the absence of ratings likely would have severely impeded the public ABS market if not halted it altogether. With that urgent concern resolved, however, a slew of proposed or soon-to-be proposed regulations are anticipated to be approved in 2011 that could significantly reshape the securitization market.
High on the priority list is the imminent risk-retention proposal prompted by Dodd-Frank, which sets a July 2011 deadline for final rules to be approved. The statute, however, provides little detail on just what shape those rules should take, giving much discretion to regulators and leaving market participants on the edge of their seats.
In its proposal to amend Regulation AB, issued last April, the SEC suggested issuers retain a "vertical" 5% slice through all the various layers of an ABS deal. That retention requirement, however, would have applied only to shelf offerings.
Dodd-Frank, on the other hand, requires a rule affecting all ABS, although it provides for significant exceptions.
The Federal Deposit Insurance Corp., too, has proposed the vertical slice, as well as an alternative requiring issuers to retain a representative sample of the loans in the securitization. Whichever approach the regulators ultimately choose, the shape of risk retention is only one of several issues that a rule must address.
Edward Gainor, a Washington, D.C.-based partner of law firm Bingham McCutchen, said another is whether risk retention rules will apply to re-securitizations of already originated loans. One more, he said, is that "some securitizers are regulated financial institutions with capital requirements, so if they have to retain 5%, it could create capital issues for them."
Richard d'Albert, principal and co-chief investment officer at Seer Capital Management and previously global head of structured credit at Deutsche Bank, said risk retention serves to align the interests of the buy-side and sell-side. "So from our [buy-side] perspective, we wouldn't want to see [a proposal] watered down."
The sell-side perspective is less sanguine. D'Albert noted that the statute's ambiguous language could be interpreted to require both the loan originator and the securitizer to retain risk, resulting in double risk retention. Or, regulators may require issuers and originators to split the retention requirement, or if the securitizer buys the loans outright it may have to retain the entire risk requirement, leaving the originator with no requirement at all.
"There's also an accounting issue surrounding this," d'Albert said. "If I'm a securitizer and I have to hold a certain percentage of a deal, it's not clear the accountants would consider the transaction as off-balance sheet."
The impact of the risk retention issue will depend heavily on another Dodd-Frank proposal anticipated shortly that defines the qualified residential mortgage (QRM) exemption. That's because qualifying loans would be exempted from the risk retention requirements. "This will become the most important definition in the mortgage origination space," said Jason Kravitt, a partner at Mayer Brown.
The ASF published a framework to define a QRM Nov. 9, including numerous factors such as income verification, equity in property, debt-to-income, and property valuation. Ultimately, though, six federal agencies, including the banking agencies and the SEC, will have to hammer out the definition, for mortgage loans as well as non-mortgage loans.
"For non-mortgage assets, the statute says regulators should develop guidelines that say what qualifies as high quality assets, but it gave no detail," Gainor said.
Also favorable to ABS investors and much less so to issuers are disclosure requirements stemming from both the proposed Reg AB amendment as well as Dodd-Frank. An SEC proposal issued Oct. 13, prompted by the statute, opens the door to requiring issuers as well as ratings agencies to disclose much more of their due diligence findings to investors.
The rating agencies, for example, would have to review an issuer's representations and warranties and disclose their analysis to investors. "So an investor can see whether the securities have limited buyback provisions or if the reps and warranties have been cut back," d'Albert said.
In addition, issuers would have to disclose due diligence findings, whether performed in-house or by a third party. For example, issuers buying loans for a securitization will often use a third-party such as Clayton Holdings to analyze the quality of those loans and whether problems, such as missing documentation, may exist for at least some of the loans. The proposal would require issuers to disclose those findings to investors, who before were not privy to that information.
"All of that is a huge plus for investors, because the transparency allows us to do a more thorough evaluation of how risk compares among issuers - who has more robust reps and warranties, whose due diligence identifies more exceptions, etc.," d'Albert said.
The SEC's proposed amendment to Reg AB also would require issuers to provide electronic versions of waterfall models, which display the flow of repayments between the numerous shareholder classes in an ABS security, as well as to disclose reams of loan-level data. In comment letters, investors expressed delight at the prospect of more data.
The ASF noted investor support in its comment letter, but the trade group - representing both sides of the securitization market - focused more on the plight of issuers. It noted the costs and complexity of the proposal, which the ASF said prompted issuers to question whether under such a rule "a viable securitization market will exist at all."
Kravitt said the proposal's most disconcerting provision would require these disclosures for private deals as well, if investors and even prospective investors ask for them. Kravitt added that the Republican gains in the Senate and especially the House of Representatives are likely going to result in significant criticism of public disclosures applying to private deals. "That makes the decision more difficult for the SEC," he said.
Gainor also pointed to the "lower profile" provision of Dodd-Frank prohibiting issuers, underwriters and sponsors from participating in any transaction within a year after the securitization closes that would constitute a material conflict of interest with investors in the securities.
Sen. Carl Levin (D-MI) inserted the provision into the bill at the eleventh hour and also wrote a letter to regulators stating its purpose is to prevent securitizers from creating ABS and then betting against it, as Wall Street firms such as Goldman Sachs have been criticized for doing. Gainor said, however, that the provision's language is written so broadly that regulators could interpret it to prohibit common practices, such as servicers of the loans in an ABS deal investing in the subordinate tranche, since the servicer could be perceived as favoring that portion of the deal.
Other potential regulations that could impact the ABS market include language pushed by Sen. Al Franken (D-MN) that would prohibit ABS issuers from choosing the agency to rate an offering. That language did not make it into Dodd-Frank, but if a study of the issue does not find a better alternative, the statute calls instating it.
There's also concern about the so-called Volcker Rule, which would prohibit banking organizations from investing in hedge funds and private equity funds, and if read broadly could prevent those organizations from engaging in certain securitizations.
The Financial Stability Oversight Council is studying the impact of the Volcker Rule, and organizations such as the ASF have written letters stating that should it come to fruition, it should clarify the exclusion of ABS activities that might otherwise fall under its scope.