Earlier this week, the Obama Administration released legislative language attached as Exhibit A to this Memo proposing changes to laws affecting asset-backed securities (“ABS”). The proposed legislation is the Administration’s follow-up to its June 17, 2009 release of recommendations for reform of our financial regulatory system (the “Proposal”)1, which we described in our clients and friends memorandum summarizing the Proposal2 and our clients and friends memorandum summarizing the Proposal’s impact on the securitization markets3.
The key features of the proposed legislation include:
- A regulatory mandate to impose a minimum of 5% credit risk retention by securitizers (no hedging allowed) for such period of time required by the applicable regulators;
- A requirement that the risk retention requirements apply to bank and non-bank securitizers;
- A definition of “securitizer” that includes issuers and underwriters of ABS;
- Continued periodic reporting under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), by issuers of ABS even after the number of registered holders falls below 300, at least for such period of time and under such conditions prescribed by the Securities and Exchange Commission (the “SEC”);
- A mandate for SEC regulations requiring (1) detailed disclosures regarding the assets underlying ABS (including loan-level detail), (2) disclosure of information identifying loan brokers and originators, the nature and extent of their compensation and the amount of risk retained by the originator or securitizer and (3) standardization of the format of data provided by issuers;
- A mandate for SEC regulations as to the use of representations and warranties, including analysis in rating agency reports of representations, warranties and enforcement mechanisms in ABS offerings, and required disclosure in ABS offerings as to historical repurchases by originators; and
- Repeal of Section 4(5) under the Securities Act of 1933, as amended (the “Securities Act”), which exempts offers and sales of mortgage notes from the registration requirements under the Securities Act.
The proposed legislation does not address certain matters addressed in the Proposal:
- There are no proposed changes to accounting principles relating to gain on sale or consolidation; and
- There is no required linking of compensation of loan brokers, originators and ABS deal participants to the performance of securitized assets.
Credit Risk Retention by Securitizers
The proposed legislation would require federal banking agencies and the SEC to jointly prescribe regulations within 180 days requiring “any securitizer of an asset-backed security . . . to retain an economic interest in a material portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.”4 Securitizers would be required to retain at least 5% of the credit risk on any asset that is securitized.5 Securitizers would be prohibited from directly or indirectly hedging or otherwise transferring credit risk that they are required to retain with respect to any asset.6
Regulations would specify the permissible forms of risk retention (e.g., first loss position or pro rata vertical slice) that would be required and the minimum time period that securitizers would be required to retain such risk.7 Regulations would also provide for the allocation of risk retention obligations between securitizers and originators where a securitizer purchases assets from an originator.8 Federal banking agencies would have the authority to jointly adopt or issue exemptions, exceptions or adjustments to the 5% credit risk retention requirement and the prohibition on hedging.9
The obligation to retain credit risk will apply to both bank and non-bank securitizers.10 Moreover, the term “securitizer” is defined as an issuer or an underwriter of ABS.11 Based on this definition, regulations could be adopted that would impose a credit risk retention requirement on underwriters.
Periodic Reporting by Issuers of ABS Under the Exchange Act
The proposed legislation would require continued reporting by issuers of ABS under the Exchange Act for such period of time and under such conditions as prescribed by the SEC, even if the number of holders of an issue falls below 300.12 In addition, each issuer of ABS would be required to disclose, at a minimum, asset-level or loan-level data necessary for investors to independently perform due diligence for each tranche or class of security.13 Disclosure would also be required of:
- the loan broker or originator of the assets backing the security;
- the nature and extent of compensation of the broker or originator; and
- the amount of risk retained by the originator or the securitizer of such assets.14
The SEC would also be required to set data formatting standards to facilitate comparison of data across securities for similar asset classes.15
The required disclosures described above apply to periodic reports filed pursuant to the Exchange Act, but do not appear to be mandated for Securities Act filings.
Representations and Warranties Relating to ABS Offerings
Under the proposed legislation, the SEC would be required to prescribe regulations requiring rating agencies to include in reports accompanying credit ratings:
- a description of the representations, warranties and enforcement mechanisms available to investors, and
- a description of how such representations, warranties and enforcement mechanisms differ from those in similar transactions.16
The SEC would also be required to prescribe regulations requiring disclosure of fulfilled repurchase requests across all trusts aggregated by originator, “so that investors may identify asset originators with clear underwriting deficiencies”.17
Elimination of Securities Act Section 4(5) Exempting Offers and Sales of Mortgage Notes
Section 4(5) of the Securities Act permits savings and loan associations, savings banks, commercial banks and other similar banking institutions to sell promissory notes (and participation interests therein) directly secured by a first lien on a single parcel of real estate upon which is located a dwelling without filing a registration statement under the Securities Act.18 Interestingly, although not mentioned in the Proposal, the proposed legislation would eliminate this Securities Act registration exemption.
It is not clear why this repeal is proposed, as there is no evidence that this exemption was relied upon for mortgage loan ABS transactions in any meaningful way. We would not expect the repeal of Section 4(5) to adversely affect the private whole loan mortgage market, which generally involves negotiated sales of pools of loans between a sophisticated buyer and a sophisticated seller, although mortgage market participants may have concerns about the intent of the proposed repeal.
Issues Not Addressed by the Proposed Legislation
No Proposed Changes to Gain on Sale or Consolidation Accounting or Consolidation. The Administration’s Proposal indicated that:
- accounting standards would be reviewed to determine how financial firms should be required to employ more forward-looking loan loss provisioning practices that incorporate a broader range of available credit information; and
- fair value accounting rules would also will be reviewed, with the goal of identifying changes that could provide market participants with both fair value information and greater transparency regarding the cash flows management expects to receive from investments.19
However, the Administration’s proposed legislation does not contain any provisions related to accounting rules. So, as many people thought, it appears the references in the Proposal were to the changes to FAS 140 and FIN 46 recently adopted by the Financial Accounting Standards Board.
No Required Linking of Compensation of Loan and ABS Deal Participants to Performance of Securitized Assets. The Administration’s Proposal indicated that banking regulators should issue regulations to align compensation of market participants with longer term performance of underlying loans.20 Rather than mandating the type and method of compensation of market participants in order to link their compensation to the performance of securitized assets, the proposed legislation would require only disclosure of the nature and extent of compensation of loan brokers and originators.21