Resolving the primary drought for RMBS issues may have less to do with transparency and more to do with pricing. Nonetheless, a regulatory tsunami promises to hit hard and could wring out the more traditional players from the market's future.
"It's agreed that to kick-start issuance you need to provide a strong basis for securitization and have best practices and standards in place," said Douglas Long, executive vice president in business strategy at Principia Partners. "From that perspective, the industry has already done a huge amount. For me, the issue is one of timing - regulatory proposals are urgently being pushed through but, at the same time, standards are still being finalized by the industry, so we have a chicken and egg situation."
There are several such proposals that are still feeding through that indicate the industry is setting itself up to be a better, more sustainable market. The Basel requirements that include higher capital charges for those that invest in securitizations, for instance, are an example of where investors already have more specific details on what they have to do to demonstrate due diligence and the ability to understand the risk characteristics of assets in which they've invested.
"There is always a lag time between when regulations are passed and implemented in the industry, but the securitization industry should take encouragement from the fact that it has moved relatively quickly to get this far," Long said.
Unfortunately, despite the best efforts put forth amid the financial crisis, the word "securitization" has left a resonant distrust across all corners of society and, as such, lands the industry in the political hotbed of regulation.
A Brief History
Enter the Federal Deposit Insurance Corp. (FDIC). In response to the new accounting rules FAS 166 and 167 - which amend existing rules for off-balance-sheet, special-purpose securitization vehicles, and possibly force the banks to bring the SPVs back onto their books - FDIC revised its Safe Harbor rules.
Under existing regulations, any assets held by an SPV that had been created by a failed bank are outside the FDIC's reach because of their off-balance-sheet status. This gives securitization investors comfort that assets will be protected even if the originating bank gets into trouble.
"That portion of the Safe Harbor, as originally adopted, was conditioned upon satisfaction by the subject securitization of the conditions for sale accounting," Mayer Brown partners said in a special note on the Safe Harbor regulation. "Because the accounting changes make it difficult for securitizations to achieve sale accounting, this requirement threatened to make the repudiation portion of the Safe Harbor unavailable at least for transfers completed after the accounting changes took effect."
In November, the FDIC said it would continue its existing policy through March but warned that longer-term conditions for receiving the Safe Harbor would be needed. Under the extension, transactions need not achieve sale accounting, so long as they meet the conditions for sale accounting that applied prior to the recent changes (again, other than the legal isolation condition).
In December 2009, the FDIC proposed more extensive amendments to the Safe Harbor to apply on a permanent basis. The FDIC initially planned to propose enhanced disclosures, compensation limits and a requirement that originators retain a 5% piece of securitized assets. For mortgage assets, only loans kept on the books for a year could be securitized, and securitizations would be restricted to six tranches.
Having received extensive public comment on those proposals, the FDIC extended the interim relief to provide more time to finalize the permanent changes. The FDIC's Board of Directors earlier this month approved an extension through Sept. 30 of the FDIC's Safe Harbor rule.
Why Close the Market?
The FDIC has stated publicly that it wants to ensure that securitizations serve as a valuable liquidity management tool, not a source of losses to banks and the Deposit Insurance Fund. The Safe Harbor proposal, the agency said, is intended to outline best practices for the industry not squeeze incentive out of using securitization.
When the original Safe Harbor rule was issued in 2000, auditors and accountants expressed concern that the FDIC might try to recapture a loan that had been securitized back into the receivership and terminate the contract by which the loan was sold using the agency's repudiation power.
"Now the FDIC is again providing comfort to the investment community as to how it will perform the role of receiver," said Christopher Whalen, co-founder of Institutional Risk Analytics, in an industry note. "But does it make sense for the agency to give comfort to investors using the same ground rules as in 2000, especially when securitization of private-label, nonconforming residential mortgages helped create the financial crisis? No, it does not."
The FDIC rule is focused particularly on RMBS securitizations because there is clear evidence that this asset class is where most of the problems originated. The FDIC is focused on issues that investors, banks and many others have raised - transparency, simpler capital structures, clear terms defining the transaction, strengthened loss mitigation and risk retention.
Despite the strong opposition voiced by the securitization industry, the FDIC insists that it is proposing what the industry needs. Michael Krimminger, deputy to the chairman for policy at the FDIC, said that for nonbank institutions, the misaligned incentives of the past didn't support the safe and sound practices that would have avoided some of the losses suffered by several industry players.
"The FDIC spoke to many investors and what they ask for is more transparency," Krimminger said. "We've offered to work with those that help structure deals and have not gotten constructive ideas. The most we get is that we shouldn't do anything - let the market work it out on its own."
The problem is that the industry feels the FDIC is "fixing" securitization at the expense of overcomplicating Safe Harbor. The situation is compounded by there being so many parties putting a hand in to regulate the securitization industry - who all share the common aim of restarting the market, so they need to work together.
While the Safe Harbor certainly has its good points, tying the Safe Harbor with securitization regulation is creating uncertainty for the very same investors that the FDIC is aiming to protect.
"If the FDIC goes further than necessary, they risk putting an undue burden on issuers, and they have to be careful of overburdening the industry in something that looks driven by political expediency," said Dan Castro, chief risk officer at Huxley Capital Management.
The FDIC maintains that securitization is a valuable tool in the financial markets, but it also understands that there is a need to guard against certain things and to develop a set of best practices to ensure that everyone is on the same footing.
Krimminger believes that the proposal is straightforward - transparency and a capital structure based on underlying loans and not on the credit quality of the tranche are needed.
"Another aspect that the industry needs to address is compensation that is based on long-term performance of the deal, not based on how many deals you do," he said. "Last but not least, you need to make sure the servicer has a clear understanding of who they owe their duties to and who has which responsibility, and avoid the tranche warfare in present structures."
Furthermore, the concept of risk retention resonates in nearly all material proposals made globally. The FDIC believes it must be discussed in the context of U.S. market operations.
Krimminger said that, despite the harder-line stance it is taking with the Safe Harbor proposal, the FDIC still very much supports the return of a private-label ABS market.
"We think it's important to have a mortgage market that's not entirely supported by the government; we need the banks back in there lending, but investors are essentially telling us that they need more transparency to deal structure and a more transparent market altogether," he said.
What better pledge for the future of the private-label securitization market than the intent to become an issuer down the line. The FDIC has acquired quite a large portfolio of failed banks that is expected to grow this year.
The FDIC has already tested the waters through its structured credit sales that have been well received by investors looking for debt yielding more than Treasurys. Last month it issued three deals under its $3.85 billion Structured Sale Guaranteed Notes 2010 series. Barclays Capital is the sole bookrunner on the deals. All of the offerings are backed by residential mortgage loans and construction loan assets from failed banks that the FDIC took over.
At the moment, the agency is considering all different types of transaction structures that would also include the likely use of a securitization deal.
"We view securitization as a valuable tool for selling assets," Krimminger said. "For critics of the Safe Harbor to say that we want nothing to do with private-label securitizations is wrong when we ourselves are looking to issue in this market."
Wrong Place, Right Time?
Supporters of the Safe Harbor proposal say that what the FDIC is doing is simply ensuring that history won't repeat itself.
Whalen, in a comment piece written for ASR sister publication American Banker, said that its "revealing" that the institutions leading the opposition against the FDIC proposal on securitizations were the very ones responsible for the destruction of the private-label securitization market.
"These critics have no credibility and should be rebuked for having the temerity to voice any opposition," he wrote.
Armando Falcon, CEO of Falcon Capital Advisors, said that the Safe Harbor modifications ensure that bank securitization activities adhere to best practices and do not pose an excessive risk to the Deposit Insurance Fund.
"Given the past experience, it seems that enhanced best practices would be necessary to revive confidence in bank securitizations," he said.
But the opposition says the securitization industry already has significant Securities and Exchange Commission (SEC) disclosure requirements via Regulation AB, which is currently being reevaluated by the SEC.
"Public securitizations already have to be in compliance with Reg AB, and issuers must continue to provide periodic reporting to stay in compliance," said Tom Deutsch, executive director of the American Securitization Forum (ASF). "If the issuer would suspend its required periodic reporting and go into conservatorship or receivership, the investor would lose the Safe Harbor because the issuer is no longer in compliance with Reg AB."
On this note, Deutsch said it is unclear whether the FDIC Safe Harbor is worth the agency's focus. "Investors are uncomfortable with the fact that if an issuer is no longer in compliance with Reg AB, then the investor loses the Safe Harbor," he said. "The rationale isn't clear to me why it is necessary to directly link the SEC's disclosure requirements to the FDIC's Safe Harbor."
Deutsch said that he is not aware of any investors who are in support of the FDIC proposal to link the Safe Harbor to additional securitization requirements unrelated to it. The ASF membership is also represented by many industry buysiders.
The ASF submitted a comment letter in response to the Safe Harbor proposal that included feedback from both issuers and investors, all saying that the Safe Harbor is not the right place to deal with securitization regulation and that the FDIC is not the appropriate regulator to push these regulations.
"What investors are looking for is a watertight Safe Harbor - so this is an aspect of securitization they don't have to worry about," Long said. "They want more of a guarantee that if the conditions are met there is no risk of external intervention."
As far as the work toward creating a more transparent market, ASF's Project RESTART has made significant strides in detailing significant market best practices for RMBS structures.
"The primary reason we have not seen RMBS issuance isn't because there is a complete lack of data; it's because pricing is still too wide on outstanding securities," Deutsch said. "Additional transparency is important and will be helpful, but additional transparency is not the difference between a new deal getting done or not."
More Coordination: A Solution?
Much of the uncertainty in the market stems from the fact that regulatory changes are slated to hit the market from several fronts. The latest example of this is Sen. Christopher Dodd's (D-Conn.) bill that includes revised proposals for risk retention and transparency. However, it is unclear whether the measures the Hill proposes to take will mirror those that have been proposed under the FDIC proposal.
The House of Representatives and the Senate have also proposed rules that would force banks to retain some credit risk in securitization vehicles, which would virtually ensure, under Financial Accounting Standards Board rule changes, that banks would have to recognize the SPVs on their balance sheets. Again, this would increase the capital hit of securitization to the system and make them more expensive for banks to create.
Under existing proposals, the House, which in December passed the Credit Risk Retention Act of 2009, would force banks to retain 5% exposure in any securitization SPVs. The Senate proposal, issued by Dodd, who chairs the Senate Banking Committee, would force a 10% risk retention.
According to Whalen, even the President's Working Group (PWG) on Financial Services is preparing a "white paper," in cooperation with the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC), to block the FDIC reform effort.
The Federal Reserve Bank of New York and the OCC in Washington are reportedly drafting the "guidance" on reform of bank securitizations and at the request of the PWG. These PWG white papers are never released to the public, even though the Treasury acts as the de facto public affairs organ for this corporate influence group.
"The fact that the PWG is in league with the Fed and Treasury against the FDIC board is all you need to know about the politics of reforming private-label mortgage securitization," said Whalen. "If [President] Barack Obama were really interested in reforming Washington, he would disband the PWG for good. Allowing the big banks that participate in the PWG to lobby financial regulators and members of Congress without any public disclosure is a national scandal and makes a mockery of any claim by [President] Obama to be changing the business of Washington."
"It may not end up being all the same and the challenge for the industry is getting that consistency in place while introducing appropriate disclosure mandates for different reasons," Long said. "The reality is that investors want the changes on the regulatory front, but they don't necessarily want them to be tied together with Safe Harbor, which has its own role to play in increasing participation."
The Big Squeeze
As it stands, the Safe Harbor proposal could potentially squeeze the incentive out of securitization from banks, effectively wringing them out of the private-label market.
Huxley's Castro said that the next move the FDIC makes may determine whether these financial institutions would want to keep their place in the private label securitization market. "We are already seeing moves toward alternatives," he said. "In the credit card space, for instance, about $50 billion of the $130 billion of credit card ABS maturing will get securitized; the rest is going to be taken back on balance sheet until banks can determine the best funding solution. It ultimately means fewer bonds for investors and fewer alternatives for banks."
However, shutting out the banks doesn't translate to shutting down the private-label ABS market.
"In fact, there are many nonbank conduits still around to conduct mortgage-backed securitizations," said Falcon of Falcon Capital. "They will also look to enhance best practices in order to regain investor confidence in the MBS they issue. Any reduced MBS activity by the banking sector will be offset by an increase in the non bank sector."
Falcon said that it's important to also note that the FDIC has carefully considered if it is necessary to expand the scope of the Safe Harbor to securities that are carried on the bank balance sheet because of the new accounting rules.
"The FDIC has entered this with its eyes wide open to any unintended consequences. They fully understand the risk and they are well aware of the opposition," Falcon said. "With a new regulatory framework, enhanced industry best practices and greater investor awareness of the importance of sound mortgage underwriting, I think we will again see strong appetite for MBS."
He added that there will be many nonbank financial institutions positioning themselves to fill the void as the government slowly withdraws from the mortgage market. At this point, fully private-label RMBS transactions should start to happen.
Euro Regulations Less Harsh
The European Central Bank (ECB) and the Bank of England (BofE) are separately mounting efforts to regulate securitization. And unlike the U.S., these initiatives have not been met with the same industry opposition.
Why the regulatory environment in Europe has received a better response from the industry may lie with the scope of what these new proposals affect. Douglas Long, executive vice president in business strategy at Principia Partners, said that the requirements in Europe are more focused and are neither as strong nor as broad as those in the U.S.
"Take the ECB funding requirements, for instance. The new proposal is looking to get better loan-level details on collateral that is being used as part of the ECB repo window," he said. "The ECB is proposing that if you want to continue to use your securitization as collateral, then we need to know more about that asset."
In the U.K., the BofE has now also proposed that for banks to continue to use its discount window facility they must also be willing and able to satisfy more comprehensive transparency requirements, including cash-flow model and collateral pool stratification disclosure.
"All in all these proposals are a lot more targeted and can help instill best practices, both for issuers and investors," Long said. "If you want to get funding from central banks, you need to meet very specific disclosure requirements."
As Michael Krimminger, deputy to the chairman for policy at the Federal Deposit Insurance Corp. noted, globally regulators have mounted efforts to make sure players have more "skin in the game" risk-retention models. The European Union (EU) adopted its version last July and introduced the requirement of 5% risk retention by originators.
U.S. market pundits said that it is not clear that the country wants to follow Europe's lead on risk retention as it is a categorically different market that requires a different regulatory approach. It is also important to note that the EU hasn't tied up the idea of Safe Harbor with its securitization regulation.