Securitization market executives may want to reconsider their summer vacation plans. Not only are significant rules stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act likely to be issued soon, but an earlier proposal amending Regulation AB, which had been put on the backburner, may be finalized over the next few months.
The Dodd-Frank-related rules, which have been widely anticipated, relate to risk retention, including premium capture risk reserve accounts, and to conflicts of interest.
A proposal to amend Reg AB, commonly referred to as Reg AB II, was approved for public comment by the Securities and Exchange Commission in April 2010. The comment period ended in August of the same year, shortly after Dodd-Frank was signed into law. Since then it's been widely assumed that the proposal, which revises disclosure and reporting rules for public securitization deals and imposes similar disclosures to private Rule 144A transactions, would remain on hold until regulators met their Dodd-Frank deadlines. Issuers of riskier and more complex deals typically have opted for the 144A market, as have issuers of highly rated deals seeking fewer regulatory requirements and disclosures.
The talk in Washington, DC, however is that final rules are likely to be released by August of this year. The SEC declined to comment.
Reg AB II
When Reg AB II was first issued it created an uproar, not only because it requires deal sponsors to provide loan-level disclosures, even for offerings in the 144A market but because it requires them to hold on to specific percentages of their bond offerings. Then came multiple provisions of Dodd-Frank that will impact securitization in ways that could be just as significant. For example, the risk retention proposal, issued jointly by seven regulatory agencies in the spring of 2011, subsumed the retention requirements and added others.
Investors typically support the concept of sponsors having more "skin in the game" as well as greater disclosures, but they also harbor concerns about asphyxiating regulation. Paul Jablansky, head of structured products at Western Asset Management, said his firm supports the spirit of Dodd-Frank and other industry proposals, but he acknowledged the perilous line that regulators must walk. "Our hope is that regulators will find the right balance between instituting capital market reforms, protecting the interests of consumers and maintaining liquidity in the bond market," he said.
Steve Whelan, a partner at law firm Blank Rome, escorted several industry representatives to meetings with regulators in mid-May. He said SEC officials asked whether loan-level disclosures would create excessive work for issuers and investors, whether they could potentially reveal confidential information about borrowers, whether group-level data was sufficient and whether market participants are capable of getting the information they need about deals on their own.
Whelan said the biggest institutional investors are already doing the latter. "If a major life insurance company is the lead investor in a private placement, and it wants granular disclosures for three, four or five of the asset pool's obligors, it's going to get that information." He has heard final rules are likely to be issued this summer.
John Arnholz, a partner at law firm Bingham McCutchen, noted that Reg AB II also requires 144A issuers to file the kind of periodic financial filings required of SEC registrants, such as quarterly 10Q and annual 10K reports, and to make available their cash-flow waterfall models using the Python programming language. He questioned the usefulness of such requirements.
"Does this create additional costs without sufficient benefit, or just the opposite? Are these rules going to bring back confidence to the market? That's the great unknown," Arnholz said.
Premium Capture Cash Reserve Accounts
A provision to the risk retention rule requiring deal sponsors to set up cash reserve accounts to capture premiums was a big surprise when regulators introduced it last spring, although it was welcomed by some participants. Premium capture cash reserve accounts (PCCRAs) are designed to stop issuers from getting around risk retention requirements. For example, an issuer offering $100 in bonds backed by at least some unqualified assets could satisfy its retention requirement by retaining $5 of those bonds. But if the bonds are issued with a premium of $10, which could happen if they are structured as interest-only securities, the issuer would hold less than 5% of the risk in the deal.
Institutional investors, including Metropolitan Life Insurance and Prudential Financial, submitted comment letters supporting the accounts. "It is key that regulation ensures that the spirit of the risk retention rules cannot be circumvented through creative transaction structuring. The premium capture cash reserve concept set forth in the proposed risk retention rule aims to address that issue," Jonathan Rosenthal, senior managing director of global portfolio management at MetLife, wrote in a comment letter.
Issuers, however, have put up a stink. The U.S. Chamber of Commerce recommended eliminating the PCCRAs, as did a coalition including the Securities Industry Financial Markets Association (SIFMA) and a bevy of real estate market trade organizations. "The PCCRA will fundamentally alter the economies of the RMBS and CMBS business models and effectively eliminate the incentives for securitization," the coalition wrote in a letter submitted Jan. 20, 2012.
The credit risk retention proposal covers the qualified residential mortgage (QRM) proposal as well as parameters for "qualified" loans in other markets, such as auto loans. If those parameters are met, securitizations can be exempted from the risk retention requirements. Sources tracking the issue said some type of action is anticipated this summer, whether just a portion of the risk retention proposal is finalized or the entire proposal is revised and reissued.
However, the Consumer Financial Protection Bureau (CFPB) recently delayed defining the parameters of a qualified mortgage (QM) until after the November elections (see accompanying story). The QM will establish underwriting standards on which lenders can rely to determine whether a borrower can repay a mortgage; because the QRM definition can be no broader than the QM's, its final form will have to wait as well. Dodd-Frank mandates that both rules be finalized by Jan. 21, 2013.
The credit-risk retention proposal also includes exemptions for other types of qualified loans, such as auto and commercial real estate loans, which have been criticized as straying too far from current industry practices. For example, qualified auto loans require borrowers to make down payments of 20% or more of the aggregate cost of the car, including title, registration and other fees.
Today, however, most prime auto loans typically don't require down payments of that size, or they may fall outside the strict parameters in some other way. So originators securitizing those loans would not be exempt from the risk retention requirement. As a result, issuers would likely end up either dividing their portfolios into separate pools of qualifying and non-qualifying loans or not using the exemption.
That change in industry practice may not impact the strongest prime auto issuers, those with securities rated 'A' or higher, since they already retain significant portions of their deals, said Stuart Litwin, a partner with law firm Mayer Brown. He said the new risk retention requirement can be satisfied in several ways, including holding on to the most subordinated tranches of deals or a vertical slice (a portion of each tranche) of deals.
However, the economics of lower-rated prime deals - which are rare today but are expected to return in greater number - result in issuance of lower-rated tranches and hence sponsors retaining less of their offerings, and so originating auto loans that meet the qualifying standards may become more important to them. Those sponsors, however, may not have enough loans in their qualifying pool alone to warrant a securitization.
"One alternative may be to test on a portfolio basis, rather than loan by loan," Litwin said. He added that another solution might be to give partial exemptions, for example requiring retention of only a 2.5% interest in portfolios in which only half of the loans are qualifying.
In addition, regulators requested comment on whether sponsors of securitizations of qualified auto loans should be required to repurchase the entire pool of loans collateralizing an ABS deal if a certain percentage, say, 5% to 10%, flunk the qualified auto loan test.
Whelan said that such a rule would be highly impractical and contrary to current industry practice, since issuers don't typically put proceeds from a securitization into an account to cover loans that have gone bad. Rather, they typically pay back the provider of the warehouse facility that funded the loans and use the balance of the ABS proceeds to cover other business costs.
Whelan noted that while this proposal is seemingly laudatory from an investor standpoint, institutions would be unhappy if a repurchase of more than 5% of the assets triggered prepayment of the entire deal, given the consequent reinvestment risk. "They'll likely be outraged if the government says, 'We're going to make the sponsor buy back everything',"Whelan said.
Other Regulatory Initiatives
U.S. banking regulators proposed Basel III implementation rules in mid-June, and a final rule is likely to arrive before the start of next year, when the implementation timeline begins for components such as liquidity ratios. With so much regulatory activity throughout the rest of 2012, there is a concern about the impact of structured finance issuance.
Also expected this summer, as a final rule, is the SEC's Prohibition against Conflicts of Interest in Certain Securitizations, which is designed to prevent the kinds of conflicts of interest that led the SEC to charge Goldman Sachs with securities fraud related to its Abacus 2007-ACI CLO. The proposed rule was issued last September and the comment period extended through February of this year. It would restrict persons involved in originating and distributing an ABS offering from betting against the deal for at least a year after issuance. Market participants mostly supported the proposal, suggesting either some relatively minor tweaks or expanding it to cover additional players, such as collateral managers.
The Volcker Rule, which restricts banks' ability to trade for their own accounts, could also negatively impact the securitization industry by reducing liquidity in the secondary market. After receiving a barrage of critical comment letters earlier this year from issuers, underwriters and investors alike, regulators announced that the industry would not have to be in compliance with the Volcker Rule by the July deadline set by Dodd-Frank. Instead, compliance has been delayed to July 2014, when the rule must be fully implemented. The final version is expected by year end.