While we wait for the other shoe to drop, perhaps it would be worthwhile to review the general state of play and try to better understand what it may mean for the securitization industry. Previous postings reviewed the various SEC proposals for Reg AB II individually. Taken as such they are unsettling. Collectively, they are truly alarming. If implemented these proposals would, most notably, require all participants in the public ABS markets to:

  1. provide mandatory asset-level disclosure of an extraordinarily burdensome nature which may be inappropriate and/or unavailable in respect of several asset classes;
  2. perform or arrange for a third party to perform an asset review and disclose the findings and conclusions;
  3. disclose all demands for the repurchase of assets due to alleged ineligibility and arrange for related third party opinions on an ongoing basis;
  4. require a minimum 5% risk retention in a “vertical slice” across all issued securities;
  5. provide investors with a waterfall computer program capable of ABS modeling; and
  6. provide CEO certification regarding the sufficiency of the pooled assets to generate the scheduled payments to investors.

In addition, the disclosure requirements would, in effect, be extended to private transactions by requiring securitizers to deliver public-level disclosure to private investors on demand. If the final regulations remain in the form proposed, it is difficult to reasonably contemplate any scenario in which the viability of the securitization financing platform will not be severely compromised. If one was to judge intentions by actions, one might think that the SEC’s actual agenda was to curb runaway household debt by choking off the supply of credit. This would be contrary to public policy imperatives which generally recognize that a revitalized supply of credit, which in large part depends upon a reignited securitization market, is a key component to a lasting economic recovery.

The Reg AB II proposals were a response to the SEC’s analysis of the origins of the financial crisis. According to this view, the collapse of the ABS market was attributable to declining underwriting standards resulting from the dominance of the originate-to-distribute model in the RMBS market and a general lack of transparency in the market which masked the decline. When unexpectedly severe losses resulted, confidence in ABS ratings in general evaporated, giving rise to the systemic loss of liquidity and credit which characterized the financial crisis. The SEC’s proposed solutions roughly address each of the elements of the problem as described above. First, transparency is to be enhanced by improved disclosure. Second, measures are to be taken to improve the quality of securitized assets. Finally, investors are to be weaned off of an unwarranted reliance on credit ratings.

Enhanced Disclosure

As an initial step the SEC has proposed mandatory asset-level disclosure in all public shelf transactions. As indicated in an earlier post, this has raised grave concerns relating to non-RMBS asset sectors since, it has been contended, some of the mandatory disclosure is not applicable beyond RMBS and, given the much greater number of assets in, for example, auto transactions, the sheer volume of disclosure this proposal would entail would be extraordinarily burdensome.

It is reasonably to be hoped that a more tailored approach will be adopted although the amount of required disclosure will undoubtedly increase in any case. Furthermore, the disclosure should not be mandatory. Rather issuers should be able to disclose what they can and explain why they are not able to disclose other matters or why such other disclosure is inapplicable or immaterial.

The SEC has also proposed that issuers conduct (or hire third parties to conduct) asset reviews and disclose the results. Given that this disclosure is mandated under the Dodd Frank Act, it is practically certain that it will be incorporated in the final regulations and will likely also apply in part to private transactions including many offshore transactions.

Finally, the SEC has proposed that any investor in a Rule 144A transaction will be entitled, on request, to the equivalent of the disclosure, including the enhanced disclosure described above, available in a public transaction. As argued in a prior post, this is an uncalled for intrusion upon the right of parties to contract freely and would be materially detrimental to the private market and would be especially crippling to the ABCP market. It would deprive many issuers of the ability to securitize their assets at all, especially those who access the private market because they are unable to satisfy all public market requirements. If investors want public-level disclosure they can restrict themselves to investing in the public market. Otherwise they should be free to agree to accept reduced disclosure. Issuers should not be put in the position where, despite agreement to the contrary, an investor can, in effect, extort greater disclosure than was bargained for. Given the complexity of ABS, it may not be unreasonable, however, to restrict the “accredited investor” exemption to those who have some degree of experience in investing in structured products.

There are numerous advocates of the view that the only proper role of securities regulators is to make rules relating to disclosure. Investors should be given all the information they need to make their investment decisions. If they need third party help analyzing the data then they can get it. Beyond this, however, the regulators have no business at all interfering with the structuring of transactions. While this argument has the merit of ideological purity, due to the complexity of ABS transactions and the shock administered by the financial crisis, it may not be conducive to attracting the broad base of investors necessary to support the market. Accordingly, the SEC may not be wrong in thinking that certain structural requirements may also be necessary.

Improved Underwriting

The centrepiece of the Reg AB II proposals, as well as the Dodd Frank Act provisions relating to securitization, is the proposal relating to risk retention. As described in a previous post, the SEC has proposed a minimum 5% “vertical slice” of all issued securities be retained by the securitizer. By requiring securitizers to maintain “skin in the game” and aligning their interests more closely to those of all classes of investors, the SEC hopes to encourage improved underwriting standards and, as a result, improved asset quality.

It is not surprising that this proposal has generated much negative response, mostly depending on the argument that this type of risk retention is not appropriate for those asset sectors, other than RMBS, which did not experience a decline in underwriting standards or elevated losses during the financial crisis. As outlined another post, this criticism was echoed by the Federal Reserve Board in its Dodd-Frank mandated report. As a result, it is expected that the SEC’s risk retention proposals will be modified to better reflect the legitimate differences between asset classes.

However, given the Dodd-Frank requirements, it is clear that minimum risk retention of some sort will form part of the permanent regulatory landscape. Both the SEC and Congress were evidently not impressed by arguments that the crisis was solely RMBS-related and thus other sectors should be excluded from the scope of remedial measures. The lesson they took from the crisis was that system-wide chaos could be generated by events in just one sector and it would be a mug’s game to try to guess in what sector the next crisis may originate.

To further encourage improved underwriting standards, in effect by outing unreliable originators, the SEC has also proposed that disclosure be made in respect of all assets that have been the subject of a fulfilled or unfulfilled demand for repurchase or replacement. Once again, due to its Dodd-Frank imprimatur this proposal is probably and regrettably going to become entrenched in the final regulations and be applicable to private (including offshore) as well as public transactions. Nevertheless legitimate concerns have been raised about the incentives this proposal may create due to the stigma that may be attached to disclosing any such demand, no matter how unjustified, and the perceived exit opportunities thereby created as an unintended consequence.

In addition, it has been proposed that securitizers obtain a third party opinion in respect of each unfulfilled demand for repurchase. As argued in a previous post, this proposal is not likely to be effective. It is not clear that qualified third parties could be found to give such an opinion and the rules do nothing to allow trustees to identify breaches or resolve disagreements. It is hoped that this proposal will be discarded or replaced with one more likely to produce the anticipated results.

Reduced Reliance on Ratings

Improved disclosure and improved asset quality are worthy but, in the SEC’s view, insufficient objectives. Somehow investors must be pried away from reliance upon ratings in making their investment decisions. One might think that the events of the past three years would be sufficient to accomplish this but apparently not.

Notwithstanding its insistence on increased transparency as a key component of its proposals, it is implicit that the SEC does not believe that investors can be left to their own devices. Indeed, increased detailed disclosure will make it more and not less difficult for a broad range of investors to understand the already complex investment products on offer. Therefore, someone else has to be found to fill the rating agencies’ traditional role of gatekeeper. The SEC’s nominee is somewhat surprising. Through its proposals requiring CEO certification (thereby compromising the non-recourse feature of ABS funding) and securities law liability relating to waterfall computer programs, as well as the vertical slice risk retention proposal, the SEC has apparently tapped the securitizer.

How this choice is expected to provide comfort to investors is somewhat mystifying. While the potential for increased liability and loss may have a sobering effect on securitizers, the more likely result will be a dampening of their enthusiasm to participate in the market at all rather than to participate more responsibly. In any case, securitizers are not in a position to provide the qualified and independent credit analysis which is what investors actually need. As recognized by the SEC, most investors in the public sphere are not capable of conducting such a review themselves or interested in hiring a third party to do it for them. Apparently rating agencies are no longer to be trusted to do so. The question then is, who should and indeed can perform this essential function?

In their commentary prepared for the C.D. Howe Institute entitled, The Canadian ABS Market: Where Do We Go From Here?, David Allan and Philippe Bergevin have written that “ABMTN structures and the resulting securities are complex: effective gatekeepers need to be more than qualified and well-intentioned. They must have the visceral and adrenal acuity that is found only when one faces material economic risk based on their own assessment.” The authors believe that the natural gatekeepers for ABS transactions are investors in investment-grade mezzanine tranches backed by the same portfolios supporting the senior tranches. These investors would not rely on rating agency assessments in making their credit determination and would be a much preferred source of protection to senior investors than the rating agencies. They suggest that the regulators can achieve their purposes by requiring the placement of a mezzanine tranche of a specified minimum size with an arms-length third party as a condition for accessing public markets.

This is a powerful suggestion which has much to recommend it. In order to attract the depth of mezzanine investor that would be required to support the market, however, the return on investment would need to be significant. But the resulting certainty may well be worth the price. In any case, its biggest virtue may be that no other option seems viable at all. Whether or not it is on the SEC’s radar screen is not known.

I think it is fair to sum up by saying that the original Reg AB II proposals were in many respects overreaching or simply wide of the mark, observations which have been made by numerous commentators. Whether the SEC is interested in taking such views on board remains to be seen. The final rules will reveal its true attitude to this market: whether it wants to regulate a revitalized securitization industry or simply to make sure that it can never cause problems again. We will take stock again as matters develop. In the meantime, let’s just forget all about it and have a merry holiday season. Cheers for now.