The market meltdown of 2007-2008 was a complex event and the causes will be debated for many years. Nevertheless, one of the early frontrunners for the title of “the root cause” is the “originate-to-distribute model”. In order to satisfy investors’ seemingly insatiable appetite for ABS or ABS derived securities in the years leading up to the meltdown, sponsors and originators needed vast amounts of assets. As opposed to the existing model of established originators using securitizations as a means to finance their traditional lending, loans were originated for the sole purpose of providing fuel for the securitization machine. In order to keep the machine running at capacity, assets further and further down the credit spectrum were sought out resulting in the calamities with which we are by now very familiar.
The SEC has identified the separation of the originators of the loans from the bearers of ultimate default risk, which is the hallmark of the originate-to-distribute model, as a “misalignment of incentives between the originator of the assets and the investors in the securities, which misalignment may have contributed to lower quality assets being included in securitizations that did not have continuing sponsor exposure to the assets in the pool”. In other words, in shedding the default risk, the screening incentives of the originators were diluted. In order to address this concern and create an incentive to include better quality assets in the pool, the SEC has proposed that sponsors retain exposure to the risks of the assets.
So far so good. The trouble starts with its solution to the problem: as a condition to shelf eligibility, the sponsor or an affiliate must retain a net economic interest in each securitization either by way of a minimum 5% of each of the tranches of securities sold to investors or, in the case of revolving master trusts, retention of a minimum 5% originator’s interest in the pool of assets (in each case net of certain hedge positions). This has become known as a “vertical slice”, to distinguish it from a “horizontal slice” where the sponsor retains a subordinate piece of the securitization.
The real problem with this approach is its “one size fits all” character. The collapse of the securitization industry in the United States was really the collapse of one sector-residential real estate. While it is true that this sector did increasingly utilize the “originate-to-distribute” model and while it may well be true that vertical slice risk retention would be an appropriate and effective means of aligning sponsor and investor risks in this sector, this was never the model used in many other sectors, most importantly the auto sector. Moreover, in Canada, even the rmbs sector had not fully committed to that model although it may be arguable that it would eventually have gotten there, given more time.
The SEC has asserted that “horizontal risk retention … could lead to skewed incentive structures, because the holder of only the residual interest of a securitization may have different interests from the holders of other tranches in the securitization and, thus, not necessarily result in higher quality securities”. But surely this is an over-simplification. In U.S. auto securitizations and in most Canadian public securitizations the sponsor does in fact retain considerable exposure to the risks of the assets: the assets are originated by the sponsor as part of an ongoing operating business, the originator continues to own assets that are substantially identical with those included in the securitized pool, the pool itself overcollaterizes the offered notes and the originator services the securitized and non-securitized assets itself (or by sub contract) to the same standards. In order to maximize the bottom of the waterfall proceeds which represent its profit, the originator is motivated to structure and service the deal to minimize losses. These would seem to provide strong motivations for originators to ensure high quality assets in the pools.
Provided that the breadth of the horizontal slice is sufficient to absorb multiples of expected losses, this would seem to be a perfectly adequate and appropriate manner in which to align the originator’s interests with those of investors. To mandate “vertical slice” risk retention in all circumstances would be unnecessarily restrictive and would likely have an adverse effect on the market by increasing borrowing costs for sponsors and/or reducing credit availability for consumers.