In comparison to the ongoing regulatory onslaught in Europe and the United States, we in Canada appear to have gotten off pretty lightly and may even have felt that this was completely justifiable given our country’s performance and the high performance standards maintained by Canadian assets throughout the financial crisis. Although there is little we enjoy more than a good dose of smugness, if we review the regulatory surge in its international context, we may have second thoughts about what may await us.

In their July 2011 report entitled Report On Asset Securitization Incentives, the Joint Forum, consisting of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors, while recognizing the potential benefits of securitization, acknowledged that “reforms are necessary to address the incentive conflicts and misalignments highlighted during the crisis, which distorted risk transfer, increased structural complexity and opacity, and led to extreme leverage in the financial system. If such negative aspects of securitization are limited through rules and supervisory frameworks that better align incentives and promote appropriate disclosures, the foundation should be in place for a sustainable and responsible securitization market”.

The Report goes on to say, however, that, due to a number of factors, a meaningful recovery in the securitization market is not imminent. Apart from negative perceptions of securitization as an investment class and other macro-economic factors, one of the main factors hampering the recovery is identified as concerns about the timing and content of regulations across sectors. In designing and implementing these regulations, “authorities should strive for consistency across global markets and sectors, taking into consideration local market circumstances, underlying business models, and each jurisdiction’s legal system. Such consistency should help limit opportunities for cross-border and cross-sector regulatory arbitrage for products having the same economic profile, and should create a level-playing field for issuers as well as investors.”

Some of the Joint Forum’s main recommendations include increased transparency through disclosure, raising origination and underwriting practices and standards for assets that are securitized and developing measures requiring originators and securitizers to retain an appropriate level of risk in the securitization transaction.

These remarks echoed those of IOSCO’s Task Force on Unregulated Financial Markets and Products contained in their Implementation Report of March 2011. They cite an earlier report which made recommendations about regulatory approaches to be considered by financial markets regulators. The key recommendations concerning securitizations dealt with:

  1. Disclosure,
  2. Retention of economic interest,
  3. Investor suitability, and
  4. International coordination and regulatory cooperation.

A survey had been circulated to members to determine the level of implementation of the recommendations.  It was found that most jurisdictions, including Canada, were either enhancing or considering enhancement of their disclosure requirements. Most had also endorsed the skin-in-the-game concept and “are expected to implement the requirement for original sponsors to retain long term economic exposure to securitization.” Apparently Canada, Hong Kong and Japan were the outliners and they were said to be “still considering the appropriateness of implementing this concept.”

Based on the survey responses, the task force made two further recommendations. First, it recommended that regulators encourage improvements in disclosure standards for private or wholesale offerings of securitized products. Second it recommended that regulators engage in international co-operation toward convergence of national regulations where desirable.

As may be recalled, last year’s CSA proposals did not include anything relating to risk retention, but merely asked whether such rules were necessary or appropriate. In recent discussions with OSC personnel engaged in the regulatory review, it was confirmed that they in fact are still considering these matters and are presently engaged in a review of whether or not risk retention rules should be mandated in the Canadian market. Most of all, they appear to be sensitive to the risk of regulatory arbitrage, the main remedy for which, if you will recall from the Joint Forum Report, is thought to be consistency of regulations across markets. Another consideration which may eventually have some bearing on this point involves the Dodd-Frank Act itself. There have been recent applications to the SEC by the Europeans and Australians to carve out from the application of the Dodd-Frank risk retention rules a broader exemption than the currently-proposed 10% safe harbour, in essence a blanket safe harbour for investments from jurisdictions which have functionally equivalent risk retention rules. If this proposal is accepted and if Canada does not implement such rules, Canadians would be comparatively disadvantaged in respect of financings to U.S. investors. Consequently, once the Dodd-Frank risk retention rules have been settled, I do not think we should be at all surprised if the CSA were to propose similar rules for the Canadian securitization market.

In any such deliberations, the CSA must take into account the differences between the Canadian and American markets. In their submission to the SEC, the Australian Securitization Forum set out characteristics of the Australian housing loan market that sets it apart from the U.S. market, characteristics which largely apply to the Canadian counterpart:

“First, all Australian housing loans are full recourse loans. Indeed, unlike the majority of housing loans in the US, if a borrower defaults on their home loan (or any other form of consumer financing), the borrower remains liable for the full amount of that loan, even if there are insufficient proceeds obtained from the enforcement and sale of a borrower’s home to repay the outstanding balance of the loan. The lender has the ability to bankrupt the borrower in order to recoup this residual amount which significantly reduces borrower speculation and strategic defaults. Second, Australian housing loans are not tax deductible, which encourages the borrower’s rapid repayment of such housing loan resulting in home equity creation. Third, the Australian housing loan market did not experience the “originate-to-distribute” phenomenon that encouraged imprudent mortgage originations in the US housing loan market, the consequence of which led to many of the defaults in US RMBS securitizations. The sponsors of securitisations of Australian housing loans are affiliated with the entities that originate the loans. Finally note the Australian residential mortgage loan-to-value ratios at origination have traditionally been relatively low. These factors have contributed to relatively low default rates in Australia and a tendency by Australian borrowers to make every effort to repay their housing loans. This objective, already accomplished in the Australian RMBS market, is the driving forces behind the QRM and other “qualified asset” exemptions from the risk retention requirements under the Proposed Rule.

Further, the U.S. housing bubble arose in circumstances which were to a significant degree created by the unique policies of U.S. governments. In Free Fall: How Government Policies Brought Down the Housing Market (Wallison and Pinto, April 2012), the authors describe how the government-imposed affordable housing goals of the GSEs (Fannie Mae and Freddie Mae), the Community Reinvestment Act, mortgage interest tax deductibility and other policies created artificial demand which also distorted the private mortgage market and fueled the mortgage asset bubble:

“If the government had not created a ten-year bubble by making massive investments in subprime and other low-quality mortgages, the private sector would never have been drawn into the subprime market in such a significant way. The weakening of financial institutions in the mortgage meltdown-and the resulting financial crisis-would never have occurred.”

In an earlier paper, Dodd-Frank and Housing Finance Reform: A Cure That’s Worse Than The Disease (April/May 2011), Wallison contended that the key flaw in the Dodd-Frank Act is its effort to control the quality of mortgages by imposing regulation and regulatory costs on lenders and securitizers. Wallison argued that it was demand for product, rather than supply, which was responsible for the quality of the mortgages that originators and securitizers produced. “But the notion that securitizers were responsible for the low quality of the mortgages they distributed led the framers of the Dodd-Frank Act to focus their regulations on securitizers, rather than on the quality of the mortgages themselves. The animating idea was that if securitizers were required to take risks through the risk-retention device, they would seek out and securitize higher-quality mortgages.” This focus will, he argued, have significant adverse effects on the market. The five percent risk retention amount, which cannot be hedged or sold, can only be carried by a securitizer that has a substantial balance sheet thus providing the largest banks with a significant advantage. In addition, various provisions of the Dodd-Frank are so complex that “there is virtually no way small originators can be expected to comply. They will be driven out of the origination business as effectively as small securitizers will be driven out of the securitizion business.”

Wallison suggested that mortgage lending and particularly securitization are by their natures susceptible to a gradual weakening of underwriting standards. “This is because housing prices frequently become a source of speculative investment, causing booms or busts. As housing prices rise in bubbles or booms, they tend to obscure delinquencies and defaults, and both lenders and investors come to believe that ‘this time is different’ or that continued rising prices will compensate for weak underwriting standards.”  He concluded as follows:

“The housing finance plan outlined in the [Dodd-Frank Act] is largely unworkable. If it goes into effect, the risks it imposes on regulators will substantially raise mortgage costs, and the risk-retention and [Qualified Residential Mortgage] provisions will not have the intended effect of reducing the origination of subprime or other weak and risky mortgages. Moreover, the act will impede the development of a robust private securitization market and, to the extent that a private market develops, ensure that the largest banks continue to dominate it.”

In contrast to the flawed approach of the Dodd-Frank Act, Wallison instead proposed that the focus should be on the product entering the securitization chain:  only prime mortgages (to be defined by statute) would be eligible for securitization, a simple measure which would prevent the deterioration of mortgage underwriting standards in the future. The elements of prime mortgages which he described are broadly similar to the eligibility criteria commonly applied in Canadian RMBS transactions. As an additional proxy for risk retention, consideration could also be given to allowing only seasoned mortgages to be securitized.

It should be apparent, however, that the implementation of any such proposal would have significant policy implications. While it may have a salutary stabilizing effect on the market for prime mortgages, it would almost certainly also result in a more restricted market for non-prime mortgages, at least in comparison to that which existed prior to the crisis, due to the consequential adverse effect on pricing and liquidity. As reported in this space on April 27, the introduction of the federal Jobs, Growth and Long-Term Prosperity Act, by restricting eligible covered bond collateral to loans having an LTV ratio of less than 80%, will result in driving potential funders to non-prime borrowers into the private RMBS securitization market. Implementation of the proposal described above would frustrate any such movement thereby having a significant and, perhaps, permanent adverse effect upon the ability of non-prime borrowers to obtain mortgage financing at all. Whether or not to significantly dampen, if not eliminate, the non-prime mortgage loan market is obviously a significant policy choice which must be carefully considered by all of the relevant regulatory and governmental participants and not simply the CSA.