The House of Representatives is set to debate and vote on its regulatory reform package this week. The proposed legislation includes several bills that address issues important to securitization, including the risk retention on sales and securitizations of mortgages.
A similar proposal is also pending in the Senate dealing with this "skin in the game" issue.
Although the House of Representatives amended its version of the financial regulatory reform bill by reducing the maximum retention, or skin-in-the-game, requirement to 5% from 10% in the middle of November, ABS market players said that this will still unduly constrain consumers' access to credit.
"The 5% retention rule will be less onerous but could still be a very significant impediment to the restart of the RMBS and CMBS markets," said Tom Deutsch, deputy executive director at the American Securitization Forum (ASF). This would have the most significant effect on RMBS and CMBS since the structures of credit card and many automobile ABS, for instance, "have appreciable risk retention built in," he said.
Commenting on the Credit Risk Retention Act of 2009, the ASF in an information sheet distributed to industry participants said that there are different types of loans and securitized assets that present a wide variation in expected credit performance characteristics.
For instance, prime mortgage loans have vastly diverse credit risks compared with non-prime borrowers. The ASF said that, with the significant differences, any blanket retention requirement "will be arbitrary in its application to any particular asset type."
Additionally, the blanket application of these rules to all asset classes might be problematic considering too that the auto and credit card sectors differ from the RMBS and CMBS markets in terms of underwriting standards, credit risk and performance.
"The auto loan originators may already have retained risk on the assets because of short-term financing arrangements prior to securitization," said Ralph Mazzeo, a partner at Dechert who focuses on structured finance and the capital markets. Auto and credit card assets also need to meet the eligibility tests for inclusion in a securitization. This is why, he explained, these issuers already have more incentive to have better underwriting across the board.
Deutsch added that how these retention rules would be applied is still not clear from the proposals. He explained that the proposals in both houses of Congress are not explicit about how, for instance, the first 5% retention will be implemented. Would it be applied vertically throughout the tranches, or would it be applied to triple-A or triple-B securities?
"There's a lot of ambiguity there still," he said, including whether the risk retention would apply to whole loan transactions and not just securitized deals. The House version would apply to whole loan trades, but the Senate version would not. The ASF is currently advocating for risk retention requirements to apply only to the credit risk of a securitized loan, if at all.
"It would not be appropriate to apply this policy to whole loan transactions," said Dechert's Mazzeo. He said that because the originator and then the purchaser will be holding these loans on balance sheet, there is already an incentive to have better underwriting standards. "You might have heard on the residential side that some community mortgage bankers have said that applying the retention rules to whole loans will completely devastate their business."
There are also other ways to have originator skin in game, Deutsch said. "There are superior alternatives to a sweeping 5% risk retention rule, such as stronger reps and warranties, clearer repurchase provisions and the cleaning up of poor underwriting."
Strengthening of the reps and warranties in the transactions might have had limited application previously because of the problem of implementation.
"On the RMBS side, one problem has been that the reps and warranties did not have an effective enforcement mechanism - who was going to police if they were breached and follow up on repurchases by the originator," Mazzeo explained. "Some market participants have suggested that there is a need for a dedicated third party in future deals charged with monitoring and enforcing breaches." He added that the ASF and other trade groups have focused on this issue and are evaluating how the reps and warranties and related enforcement provisions may be improved.
Impact on CMBS
Market participants, both on the ABS and CMBS side, have advocated for flexibility in implementing the retention rules, not only according to how it's applied to the various assets that need to be retained, but also when it comes to which parties are required to retain the security.
"Clearly the most important thing is that there is flexibility in the legislation so that regulators have the ability to tailor the retention by asset class," said Brendan Reilly, senior vice president of government relations at the Commercial Mortgage Securities Association (CMSA). "It is CMSA's top priority to ensure that the legislation provides flexibility to allow the retention requirement to be satisfied by either an originator, an issuer or a third party who purchases the first-loss position and retains that risk." This would, according to Reilly, recognize the uniqueness of CMBS transactions where the B-piece buyers usually purchase the first-loss piece in transactions.
He added that in CMBS, the retention is inherent because those that purchase the first-loss position provide due diligence and have skin in the game in the CMBS that they buy. However, Reilly said that the issue here is just giving regulators enough flexibility to make sure that whoever holds the assets is in the position to re-underwrite the loan when necessary. It is also about "ensuring true retention," Reilly said. "That's something that's new. In the past, the third party would purchase the first-loss position, and some held that risk and some did not."
Richard Jones, partner and co-chair at Dechert's finance and real estate group, said that, "in CMBS, the B-piece buyers are very aggressive and can throw loans out of pools. They make sure that they are getting quality to ensure they earn a return on their investment at the bottom of the capital stack." Jones said that the market should be more confident in the credit judgment of these first-loss investors because they are entirely focused on credit performance, while issuers have other economic reasons for doing a deal.
There has even been some interest in enhanced reps and warranties in CMBS. However, Jones said that in CMBS transactions, the reps and warranties have always been robust. "I don't think there's a magic bullet to prevent lenders from making bad loans or to stop borrowers from taking on significant amounts of debt in a frothy economy." He added that for the next several years, however, the market would likely remain prudent, but as time passes all the reps and warranties, recourse or skin in the game are not going to stop the psychology of business momentum.
Might Not Be Best Solution
The skin-in-the-game concept might not be the best approach to solving the problems that resulted from the financial crisis.
"At the get-go, this is one of those populist nostrums that has less policy content than populist appeal," Dechert's Jones said. "If you look at the entire financial meltdown, it was loans to developers and contractors that were by far the worst performers, and 100% of these were fully on balance sheet." Jones said that there is very little evidence that lenders with skin in the game were better performers. "Despite this, the market might be stuck with skin in the game."
Jones said that hopefully, while Congress fleshes out the details, workable alternatives to a simplistic 5% retention will be embraced, such as acknowledging the prudential impact of the CMBS B-piece buyer in preserving credit quality.
Mazzeo added that the retention proposals may undermine the progress that has been made through other government initiatives.
"You have the government spending significant amounts on the [Term ABS Loan Facility (TALF)] and the [Public-Private Investment Program (PPIP)], which are economic recovery programs that are designed to increase the availability of credit in the marketplace," he said. However, simultaneous with these types of initiatives, Mazzeo said that Congress may now pass legislation that will erode the progress made under TALF and PPIP and unduly restrict the level of future lending activity.
"Ideally we will see revisions to the legislation that recognize the value of alternatives to risk retention that will more efficiently achieve Congress' goals without hindering lending activity," he said.
Finally, the confluence of the skin-in-the-game proposals, recent accounting changes and potential regulatory changes as to risk-based capital is a particularly noxious brew for the restoration of liquid credit markets. These changes to laws and accounting, according to Jones, would have a negative feedback effect that will make the restoration of liquid capital markets far more difficult. This is not what the economy needs, he said.
FAS 167, in many cases, will require issuers, required to hold retention, to consolidate on their balance sheet assets that they don't really own and liabilities for which they don't have any contractual obligations. New risk-based accounting rules could require financial institutions to hold full RBC on these faux assets and liabilities. "This will impair capital formation at just a time where we need policies to encourage renewed lending," Jones said.
"This is an ongoing issue, depending on who retains the subordinate position and whether or not they serve as special servicer," CMSA's Reilly said. "The combination of the accounting standards and the 5% risk retention could affect the amount of capital that these institutions would lend. Asset consolidation would also impact investors who would have to retain the risk." Reilly said that the issue of consolidation creates uncertainty for market participants because the current retention rules are not clearly structured as of yet and could potentially affect the supply or demand of commercial mortgages based on the outcome of the legislation.
Hedging Needs
A concern that has been brought up regarding the latest proposals for securitization reform pending in both houses of Congress is whether the risk that is required to be retained by issuers of securities can be hedged.
"The most immediate concerns after building up a reasonable volume of business are how long you have to hold on to the assets on balance sheet and when you can hedge the interests," said Jerry Marlatt, senior of counsel at Morrison & Foerster. "The next question is what are the limits on hedging, and the current proposals are unclear about this issue."
He added, however, that it seems counterintuitive that the laws will not allow holders of the securities to hedge their exposure.
Marlatt added that it is ideal for regulators to have the flexibility to adjust the retention rules according to the different risks and circumstances that the holder of the security faces. "It's much easier to change rules rather than statutes," Marlatt said.
Timing
In terms of the timing for these proposals to come to fruition, ASF's Deutsch believes there's a strong likelihood the House version will pass in mid-December.
However, the Senate's version of the securitization proposal will likely not be considered until 2010. "There's still the issue of regulator rulemaking as well, so the final regulations would be finalized no earlier than 2011 if legislation passes in 2010," Deutsch said.
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