The recent (10/22/99) submission of the Bond Market Association's proposal to the Department of Labor to make certain subordinated MBS/ABS/CMBS classes ERISA-eligible could give a much-needed boost to these subordinated sectors. If the BMA's proposals are implemented, a major new source of demand would be created for these securities, while simultaneously providing pension funds with a new array of high yielding investment products. New progress, yes. But this is not a new topic.

The BMA has discussed the issue with the Department of Labor for several years. A draft proposal was submitted by the BMA in April of this year. Their final proposal contained changes suggested by DOL.

Because BMA's proposal incorporates issues already raised by the DOL, it may increase the likelihood that some portions will be adopted. This is especially true for AAA through A subordinated securities. It is less clear as to whether the DOL will allow BBB securities.

NET - there's no guarantee as to what, if anything, the DOL will ultimately adopt. But as presently formatted, there will probably be some expansion in the range of structured securities deemed "ERISA-eligible."

Complex Law Created Anomalies

The original legislation, subsequent amendments and various exemptions made ERISA one of the most complex and frustrating areas of government regulation that fixed income markets contended with. Anyone who has tried to get a definitive answer as to whether a particular ABS security is ERISA-eligible will heartily agree.

This complex law has led to glaring contradictions and anomalies. Subordinated AA, A, and BBB ABS securities are not ERISA-eligible, yet corporate bonds with comparable ratings are. Retirement plans can invest in riskier equities, but they cannot invest in investment-grade, subordinated ABS securities. Plans can invest in commercial mortgages, but not in subordi-nated CMBS. In attempting to protect employee retirement funds, ERISA created rules that limit pension fund managers to make sub-optimal investment decisions.


When ERISA (the Employee Retirement Income Security Act) was first passed in 1974, it included a section that defined "Prohibited Transactions," i.e., investments prohibited for plan purchase. The intent was to prohibit a manager from investing a plan's money in assets that might in some way benefit any individual plan member.

As an extreme example, a plan could not invest in any company wholly-owned by a plan participant. Over time, the DOL approved a number of exemptions to the Prohibited Transaction rule for investments which, in strict reading fell under it, but in reality, had virtually no possibility of violating the spirit of the law. These came to known as Prohibited Transaction Exemptions (PTEs).

Proposal Strategy

When the BMA began to consider a formal proposal to update ERISA rules, they could have taken either of two major approaches: (1) a wholesale rewriting of ERISA legislation to remove anomalies and incorporate language enabling eligibility for subordinated MBS/ABS/CMBS securities; or, (2) specific proposals under existing law for new PTEs for a well-defined set of securities.

Accordingly, the BMA developed a request for a specific set of new exemptions covering a well-defined set of asset classes. That required approval only from the DOL, not the creation of new legislation and Congressional benedictions.

In addition, since the DOL could grant exemptions only to specific companies under an underwriter's exemption, this route meant that the BMA's proposal took the form of a proposal for exemption for an individual company.

Volume Of Subordinated Bonds

Making subordinated securities ERISA-eligible could have a significant impact on the sector. One of the reasons is that currently, relatively few of these securities are issued yearly. We adjust those earlier estimates to reflect only investment-grade subordinated bonds impacted by the BMA's proposal.

Virtually 100% of HEL and MH subs, about 80% of Jumbo whole loan subs, and about 60% of CMBS subs, are investment grade. Even then, our estimates show that CMBS is by far the largest sector, with around $10 billion of investment grade subs. This sector is so large because the base (total volume) of CMBS is large and then the percentage of that base which is subordinated (at around 30% in the aggregate, and about 18% within the investment grade portion) is much larger than in other sectors.


It is never easy to predict if, or when, a particular government regulation will change. We certainly have seen many "sure-fire" proposals disappear into a regulatory black hole, never to be heard from again.

On the other hand, some of the most unlikely changes sail right through. In the case of BMA's proposal, it appears that the basic concept of expanding the underwriter's exemption is supported by the industry, and has at least some modest acceptance by the DOL.

So it seems more likely that some version of the proposal will be enacted.

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