The Securities and Exchange Commission's (SEC) proposal of Oct. 13 to require issuers to review the underlying assets in their ABS should create a much more uniform set of review standards - to the benefit of investors. However, it could significantly alter, perhaps to the ABS market's detriment, how the reviews are performed.
Comments on the proposal, prompted by the Dodd-Frank Act enacted in July, are due Nov. 15.
Securitization issuers and sponsors have long conducted reviews of the loans underlying ABS transactions, although the reviews have varied widely in terms of the information provided and how they've been conducted. "There wasn't necessarily a requirement to do this before, but issuers of securities must review the assets because they will have liability for misstatements with respect to those assets in any offering document," said Ken Marin, a partner at Chapman and Cutler.
The SEC proposal would require an issuer to perform a uniform review, either on its own or using a third party, and disclose the results to all parties in the transaction. Currently, the regulator's proposal is vague about whether minimum review standards should be imposed and how granular the information should be. It appears to be aimed primarily at mortgage-backed securities, which have performed worse than most other types of ABS.
Back in the mortgage-loan heyday, issuers often hired multiple parties to evaluate different aspects of their loan portfolios, from collateral evaluations to borrower income verifications to compliance and credit. The parties conducting those reviews tended to apply different models and standards, creating a hodgepodge of information for investors to analyze.
"Clayton's review was customized to each customer's scope and tolerances, and to the type of product being reviewed and guidelines for the product. So reviews differed between clients and, at times, for a single client," said Steven Cohen, senior vice president and general counsel at Clayton Holdings, one of the largest providers of mortgage loan review services. "We think the proposed rules will help bring uniformity to the marketplace and help to restore confidence."
The SEC's vague language for review standards stems partly from the regulator's time constraints, since Dodd-Frank-inspired regulations must be completed within a year after the statute's enactment. However, one provision in the proposal may prompt concerns among third-party providers of due diligence services such as Clayton as well as law and accounting firms.
Edward Gainor, a Washington, D.C. -based partner of law firm Bingham McCutchen, noted two elements of the proposal that could significantly change the asset review process and potentially infringe on the statute's goal of increased transparency.
One would require third parties hired to perform the asset reviews to be classified as experts in an issuer's registration statements, thereby subjecting them to a higher standard of liability. Gainor noted that one provision of Dodd-Frank repeals the ratings agencies' exemption from being identified as expert witnesses in registration statements. So when the law passed, the ratings agencies essentially stopped rating deals and briefly halted the public bond market until the SEC gave an extension of the exemption until January.
Given the recent MBS meltdown, third-party reviews can carry more weight than those conducted by the issuers. If the proposed provision comes to pass, however, those third-party vendors may decline to perform the reviews.
"If so, then the SEC's efforts to increase transparency would have the opposite effect," Gainor said.
Marin said that to avoid the registration disclosure issue altogether, some firms may opt for types of financing that are less burdensome - other than ABS.
The proposal would also require the findings of third-party diligence reports to be filed with the SEC. The proposal language, however, is vague about whether this affects public as well as private deals, and the nature of a third party. Gainor said this has prompted the concern those third parties could include accountants whose "comfort letters" affirm that the offering document conforms with the agreed-upon procedures, and even law firms providing opinions that nothing in the registration statement is misleading.
"Suddenly these parties would find their reports filed with the SEC," Gainor said. The measure would be especially controversial should it cover privately placed offerings, "where the legal opinions and audit letters have traditionally remained between recipients" and their respective law and accounting firms, he said.
Marin noted that requiring issuers to disclose the results of third-party due diligence will "provide a disincentive to use third-party experts."
Issuers must, however, retain accountants and lawyers to deliver letters in connection with ABS offerings. "The SEC's proposal asks whether accountant and law firm letters should be considered third-party due diligence reports," Marin stated. If so, he said, "the results will need to be disclosed under the rule, but issuers may have a hard time securing the required consents to publicize these findings."
Cohen said he was unable to comment in detail on the liability issue because his firm is compiling a related comment letter. "To the extent that being an expert creates excessive liability, it could create a chilling effect among some companies competing for this business," Cohen said. "Regardless of how this issue unfolds, Clayton intends to be very active as a third-party due diligence firm."
A directive by New York State Attorney General Andrew Cuomo in 2007 prompted the rating agencies to develop detailed due diligence criteria pertaining to their asset review processes, among several other reforms. Cohen said the first time his firm worked closely with a rating agency using its new methodology was to review the loans in the $267 million, triple-A-rated, privately placed CMO for Station Place last December.
"We think the ratings agencies are a good place to look to build more specific requirements to review ABS assets," Cohen said.
Allonhill began operations as a provider of loan reviews and related services in 2008. It reviewed the $340 million in assets of Sequoia Mortgage Trust, the only non-agency, publicly issued MBS deal this year. Sue Allon, CEO and founder of the firm, is fully supportive of the expert designation. She said, "There should be a report we produce that says this is exactly what we were hired to do," noting the methodology for selecting the loans, the fields examined and their components, such as property valuations, and a summary of findings.
Allon said the granular rules created by Standard & Poor's, Moody's Investors Service and, to a lesser degree, Fitch Ratings and DBRS are currently being used when readying ABS for market. "What we're doing is taking S&P and Moody's requirements and comparing them point by point to identify who has the more stringent requirements, and those are the one we're testing to," Allon said. "Right now that's the standard."
Allon said a firm providing loan-review services should be hired precisely "because we're an expert firm." She added that issuers today are adamant to ensure they have a clear record and adhere to the highest standards. However, that creates a crush of loan review work, since reviews typically must occur in less than a month and often in less than two weeks, and require as many as 20 or 30 professionals working on a transaction.
She also noted that many issuers are seeking pre-funding reviews to see if the assets meet underwriting guidelines, followed by detailed reviews after offerings close. She said the loan-review industry has historically contracted staff, often on a short-term basis. The currently stricter requirements, even before any new SEC regulations, have required having a full-time staff. And should new regulations subject loan review firms to more liability, legal and compliance staff will have to be beefed up.
"That's two or three times more expensive," Allon said. "More liability comes with compliance offers making sure everything we're sending out is compliant; attorneys making sure reports are crafted properly; and extra proofing of these loans to make sure we got it right."