The scene opens with John Smith, a partner with a major New York law firm representing clients in exotic asset securitizations, and David Jones, a partner with another major New York law firm representing clients in more mainline securitizations, were standing at the back of the conference room waiting for their panel discussion about the recently adopted SEC ABS Rules to begin.
"Hi David, how are you doing?" asked John.
Pretty well John," responded David. "Are you ready for the presentation?"
"Actually, you know, there is a fundamental issue I would like to discuss," he said to David.
"What's that?" asked David.
"It's about the ABS definition," said John.
"What do you mean?" asked David.
"Well, I am a bit frustrated by it," said John. "You know my clients do funkier deals that don't meet the definition, and studying it with their perspectives in mind the definition doesn't always seem to work," John replied.
"Why get frustrated?" asked David, "The ABS definition has been around for over 10 years."
"Well, you know David, it wasn't really an issue when it was just used to define who could do ABS shelf deals. But when the definition gets used to determine who gets the benefit of the alternate registration and disclosure regime and who doesn't there's a lot more at stake."
David was nonplussed, "I think you should be happy that the SEC so clearly acknowledged that the kind of information solicited by the traditional regime about operating businesses is largely not relevant to ABS - and was willing to codify a regime that solicits information material to securitizations - like the assets, structures and service providers."
John nodded. "Oh, I agree with all that! My point is that the definition is under-inclusive - it fails to pick up many deals which should be included in the new regime."
David seemed unaffected. "Well it doesn't affect me. As far as I can see there is nothing wrong with the definition of asset-backed security.' As far as I can tell it's been perfectly fine for 10 years and, in fact, it now has a greater scope than it did previously."
John tried to explain, perhaps a bit clumsily, "Not really man. From my perspective the definition was already outdated when it was adopted for the S3 shelf more than 12 years ago. And frankly, the exceptions that have now been attached to it create internal contradictions and..."
David cut him off. "What do you mean by internal contradictions'?"
John tried to explain, "Look, the basic rule says that a deal is only a securitization if you issue securities that are supported by a discrete pool of financial assets that by their terms are to convert into cash, right?"
"So that means no hard assets
and by extension no nonperforming assets, right?"
"Right, they won't self-liquidate through obligor payoffs so you have to sell them off to realize their value."
"Ok, but then we have this exception for lease securitizations in which up to 65% of the pool can come from the residual value of autos after the leases mature."
"Yeah, so what? Are you saying the SEC shouldn't have done that? I think it's great," said David.
"No - I am certainly not saying they shouldn't have done that. I am glad they did it too. But my point is if we can see our way to accepting 65% hard assets as long as they come from lease terminations, why not allow hard assets from the beginning?" asked John.
"Look, auto-lease securitizations are an accepted and recognized asset class in the public securitization markets, the SEC understands it, it's tested and so on," said David emphatically.
"Ok, but we can take up to 50% of the pool from the residual value of any other type of hard asset - airplanes, computers, widgets - so long as the asset was first subject to a lease. Why not just allow the hard assets in even if they were never subject to leases?"
"First of all, don't forget that the 50% limit for non-auto leases is for non-shelf deals. You are limited to up to 20% for non-auto lease shelf deals," said David, correcting John. "But the point is the same: the SEC is comfortable with lease securitizations."
"But David, that an asset is subject to a lease until the lease terminates doesn't change the fact that you still have to have someone manage and realize the value of the hard assets after the lease terminates. If you are willing to accept that risk for any asset as long as it was once tied a lease, why not go farther?"
"They will only take that kind of
disposition risk with leases. That's it," said David.
"I don't think that is really true," offered John.
"Really? How so?" asked David.
"Well, what about all those balloon mortgages in CMBS deals?"
"What about them? They totally fit the definition of an asset-backed security! The notes require payoff at balloon maturity by their terms!"
"Yes, literally they do. But the practical reality is that the notes are nonrecourse and won't be paid off unless the hard asset - the real estate - can be refinanced or sold off. So shouldn't we just acknowledge that the note is, at least for this purpose, sort of meaningless and that its payment is dependent on realizing the value of the underlying asset? To say that only cash flow structures based on financial assets are ABS is proved wrong by the SEC's exceptions - leases and CMBS balloons. By the way, I feel the same way about the discrete pool requirement."
"What's wrong with the discrete pool requirement?" asked David with frustration in his voice.
"Well, the first part of the definition says a deal has to have a discrete pool to be an asset-backed security, but now we have these exceptions for master trusts, prefunding accounts and revolving and reinvestment structures. Aren't these exceptions so large as to disprove the general premise - that securitizations should be viewed in the first instance as only transactions with a discrete pool?"
"Not really, John," said David. "The point is to draw a circle around what should get in the ABS regime instead of the traditional registration and disclosure regime."
"But David, how do you distinguish these grey area' deals from the lease-backed residual assets or the master trust and so on? How can you find a way to make your premise about cashflow structured deals backed by discrete pools of financial assets consistent with the permitted exceptions?"
"Look John, this isn't a logic game. It's about regulation. These rules are basically saying that if you fit in the definition you will be treated as a securitization and if you fit in a slightly tighter definition you will get the benefit of the S3 shelf rule. They said in the release that if you call for a prefiling conference they will discuss it with you."
John shook his head. "David, I appreciate what you say and we'll try it out. But reading between the lines in the release it seems a little more problematic than that."
"The release says the definition is principle based. The stated principle is not about whether the securities will depend on underlying assets or the operating results of a business. No, instead it's talking about a pay-through or pass-through deal backed by financial assets, subject to exceptions that contradict the first principle. I am worried that someone at the SEC might lose track of the real issue here when we get to the grey area' deals."
"Oh come on. How so?" asked David.
"Well, what about nonperforming asset deals or synthetic deals?" asked John.
"They aren't permitted," replied David emphatically.
"Exactly my point. Let's say I had a client with a pool that was 80% comprised of performing auto loans and 20% nonperforming auto leases at or near their maturity. My client wants to structure the deal to have 80% of the deal supported by the self-liquidation of the performing auto loans and 20% supported from selling off the leases or foreclosing them and selling off the cars. Are the nonperforming auto loans so different from the residual asset exception for auto leases?"
"I don't know, but I am pretty sure they will struggle with nonperforming assets," said David.
"Why?" asked John, continuing to press the point.
"Because they want self-liquidating assets."
"But non-self-liquidating assets are already allowed - so why not these? Besides, are you saying that the traditional disclosure regime is more appropriate for this hypothetical deal as compared to the ABS regime for a deal that must liquidate up to 65% of a pool of real autos that come off terminated leases?"
"No, but I think they would struggle with it but of course you have to ask them. But what was your point about synthetics?"
"Well, let's say I set up an SPV filled with Treasurys that enters into a credit default swap referencing a pool of mortgage loans. Under the terms of the transaction, the SPV will use the Treasurys to make credit protection payments for credit losses suffered by the reference mortgage loans. At maturity, any remaining Treasurys will be used to pay off the SPV's notes. Thus the SPV's noteholders get the same economics as if the SPV had owned and pledged the actual mortgage loans."
"Sorry but it's pretty clear they don't want to allow synthetic securitizations. They feel that the performance of the offered securities should NOT come from the performance of assets outside the deal."
"But why is my hypothetical deal more appropriate for the traditional regime? There is no operating business to disclose. Just a pool of Treasuries and a reference pool of mortgage loans!"
"Sorry, it doesn't meet the definition," said David.
"I know it doesn't meet the definition - the question is, shouldn't it get the same treatment as if it did? Where is the risk? Couldn't that risk be dealt with by disclosure about the reference assets?"
"It could be abused," David replied.
"Ok, what if my client disclosed as much as if it were actually putting the reference assets into the deal on a cash basis?"
Just then the panel moderator waved at John and David, pointing at the clock. It was time for the presentation.
John knew his present discussion with David was not a topic for today's panel. "Well, thanks David. You know, I take your point that there is a regulatory reason for setting defaults defining which deals will automatically get the ABS regime and/or access to the S3 shelf. I also take your point that other sorts of deals ought to be discussed to see if they should go in one regime or the other, or even somewhere in between in a third approach.' But I hope you can see my point that the SEC definition loses the main distinction between operating company deals and true securitizations. Frankly, I worry that the definition may have a life of its own outside of just defining which deals are automatically subject to the ABS regime. I worry that the discussion of an appropriate third approach for any deal will be stifled by the principle' behind the definition."
"Okay, John. Let's talk about it some more at another time. For now, let's go do this," said David as he walked toward the podium at the front of the room... b
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