On Tuesday, December 15, 2009, the Federal Deposit Insurance Corporation (the “FDIC”) released an Advance Notice of Proposed Rulemaking (an “ANPR”) regarding proposed amendments to its securitization “safe harbor rule”.1 The ANPR poses 35 questions that suggest the FDIC is considering comprehensive regulation of bank-related asset-backed securities (“ABS”), using its authority to repudiate contracts of failed banks in order to do so.

Background

When banks fail, the FDIC is generally appointed as receiver or conservator of the bank’s assets and liabilities. Among its powers as receiver or conservator is the power to repudiate any “burdensome” contract, repudiation of which it believes would promote the orderly administration of the bank’s affairs.2 Banks that securitize assets typically transfer them by contract to a special purpose securitization vehicle, and that contract is among those that the FDIC could theoretically repudiate. The insolvency of a non-bank would generally be administered in a bankruptcy proceeding rather than an FDIC insolvency proceeding. While bankruptcy trustees also have the power to repudiate contracts, such repudiation powers generally only apply to executory contracts (i.e., contracts under which the obligations of the parties have not yet been substantially performed). The FDIC has the power to repudiate all contracts of an insolvent bank, which is why asset transfer agreements may theoretically be repudiated in a bank insolvency even though such contracts would generally not be considered executory contracts.

In order to remove the uncertainty that its repudiation authority would otherwise cause concerning securitization contracts, in 2000 the FDIC adopted a so-called “safe harbor rule”3 (the “Old Safe Harbor”) pursuant to which the FDIC would not use its repudiation authority to recover assets transferred in a securitization if the transfer constituted a “sale” under generally accepted accounting principles (“GAAP”). The FDIC safe harbor made it easier to legally isolate banksponsored securitizations from the insolvency risk of the sponsoring bank, and thereby to achieve ratings of the securitization based on the quality of the underlying assets and the integrity of the securitization structure rather than on the rating of the sponsoring bank.

On June 12, 2009, the Financial Accounting Standards Board promulgated FAS 166 and 167, effective for reporting periods that begin after November 15, 2009. The effect of FAS 166 and 167 is that the assets of some bank-sponsored securitizations may have to be consolidated on the balance sheets of selling banks. On-balance-sheet accounting would call into question the applicability of the Old Safe Harbor. Without the Old Safe Harbor, bank-sponsored securitizations arguably could be treated as secured borrowings by the selling bank, which could make it difficult to achieve ratings for securitizations that are above the rating of the sponsoring bank and could limit banks’ access to the capital markets to finance lending operations.4

In order to avoid disruption in the markets, on November 12, 2009, the FDIC issued a transitional interim rule continuing the safe harbor rule until March 31, 2010. The interim rule grandfathers all securitizations issued prior to March 31, 2010 that otherwise comply with the Old Safe Harbor, so long as those securitizations meet the requirements for sale treatment under GAAP in as effect prior to the effectiveness of FAS 166 and 167.

Questions Focusing on Securitization Structures, Disclosure, Compensation and Retention

General. The ANPR issued last Tuesday poses 35 questions in six areas. The text of the questions is reproduced in Annex A hereto. The nature of the questions makes it clear that the FDIC is considering issues related to the structure of securitization transactions that go far beyond the issues that would typically determine whether the conservator or receiver of an insolvent bank could recover assets previously sold to a securitization vehicle.

The public will have 45 days after the ANPR appears in the Federal Register to provide comments. The FDIC will then issue a formal notice of proposed rulemaking containing the specific language of a revised rule that the FDIC would plan to adopt in final form by March 31, 2010, effective at that time.

Different Rules for Different Asset Classes? The FDIC asks whether it would be advisable to adopt different safe harbor rules for different asset classes. For example, a special rule for residential mortgage-backed securities (RMBS) might need to be more detailed in light of “demonstrated greater difficulties” RMBS have encountered.

Capital Structure. The FDIC asks whether leveraged tranches of ABS should be eligible for the safe harbor and whether there should be a limit on the number of tranches in a securitization. This question seems to reflect a view on the part of the FDIC that multi-tranche structures are per se more risky than simpler structures and that simplicity equates to lower risk.

Synthetic Securitizations. The FDIC asks whether synthetic securitizations should be eligible for expedited consent. The reference to “expedited consent” appears to refer to the FDIC’s authority to grant relief from the automatic stay on secured creditors imposed in an FDIC insolvency proceeding. It appears from this question that the FDIC is considering granting some safe harbor or other comfort to investors in bank-sponsored synthetic securitizations.

Disclosure. The FDIC also asks whether disclosure requirements should be imposed, such as disclosures about the performance of the underlying debt and disclosures of representations and warranties and remedies for their breach. It also asks whether disclosures should be periodic and, if so, how frequent, and whether information should be at the asset level, the pool level, or the tranche level. The FDIC is also considering whether compensation of brokers, originators, rating agencies, advisors, and sponsors should all be disclosed and has also suggested that disclosure of underwriting standards might be appropriate, including whether the loans were underwritten at fully indexed rates or merely at teaser rates, and whether borrower income was documented. The FDIC also asks whether the disclosure requirement applicable to publicly offered ABS under the Securities and Exchange Commission’s Regulation AB should be made applicable to private placements.

Servicing Obligations. Suggesting that it is considering mandating substantive changes in securitizations, the FDIC asks whether the safe harbor should only be available, in the case of RMBS, where the servicing agreement clarifies the right of the servicer to mitigate losses by modifying underlying mortgages. It even goes further, asking whether servicers should be required to mitigate losses after a specified period (e.g., 90 days) after a delinquency. Observing that there are cases in which servicers act for the benefit of particular classes of investors, the FDIC asks whether the safe harbor should only be available where servicers agree to act for the benefit of all investors. Finally, the FDIC, noting that servicer interests can become misaligned from those of investors where servicers advance funds, asks whether the safe harbor should be reserved for those cases in which servicer advances are limited, such as for three payment periods.

Deferred Compensation. The FDIC asks whether fees payable to lenders, sponsors, rating agencies, and underwriters should be payable over a period of time such as five years, based on performance of the underlying assets. It also asks whether the safe harbor should only be available where the compensation of a servicer incentivizes loss mitigation.

Origination and Retention. In the spirit of “skin in the game”, the FDIC asks whether the safe harbor should only be available where a sponsor retains an economic interest (five or ten percent) in the sold asset and does not sell or hedge that interest. Logically, that might support a conclusion that a sale was not a true sale, and the Comptroller of the Currency, the regulator of national banks, who sits on the board of the FDIC, questioned the effect of such a requirement on bank safety and soundness. The FDIC also asked whether, in the case of RMBS, the safe harbor should be limited to securitizations of seasoned loans, e.g. loans that have been performing for at least 12 months in order to mitigate early payment default risk. In that same vein, the FDIC asked whether a requirement that compliance with such representations and warranties be reviewed within six months, coupled with an obligation of the bank to repurchase loans that are found to breach those representations and warranties, might be desirable, perhaps funded by a five percent holdback at closing of the securitization.

Analysis

It appears that the FDIC is using its authority to repudiate contracts when a bank fails as the basis to regulate comprehensively the issuance and servicing of ABS. The logic of the nexus is not immediately apparent, however it seems clear that the FDIC has an interest in further regulating the securitization activities of banks.

Many of the ideas suggested in the ANPR have been present in other regulatory proposals regarding securitization activity.5 The potential for differences, even subtle differences, in the structural limitations imposed on banks and non-banks participating in the securitization markets is troubling, as it creates the potential for competitive advantages for one group or the other that are not justified by market considerations or compelling policy considerations.

In addition, certain of the regulatory initiatives suggested by the ANPR questions, especially the suggestion of required retention of risk in connection with securitized assets, seem at odds with one of the FDIC’s primary functions: promoting the safety and soundness of insured depository institutions.

Participants in the securitization industry may submit comments on the ANPR within 45 days after the publication of the ANPR in the Federal Register, which has not yet occurred as of the date of this memorandum. Notices are generally published in the Federal Register within one week after the date of the related FDIC press release. Therefore, it is expected that the period for submitting comments on the ANPR will end on or about February 5, 2010.

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