Corrigan Counterparty Risk Management Policy Group Issues Report on Reforming Global Markets; Examines Role of SEC Reg. AB
The Counterparty Risk Management Policy Group has issued report detailing a forward-looking integrated framework designed to advance the global reform of securitization in light of the recent market turmoil. While the report centers on sound corporate governance and enhanced risk management, it also granularly examines FASB standards for off-balance sheet vehicles and comes up with a sophisticated investor model for investing in high risk asset-backed securities based on SEC rules. The report also examines the efficacy of due diligence practices mandated by SEC Regulation AB in light of the subprime crisis. The co-chair of the policy group is Gerald Corrigan, former President of the New York Federal Reserve Bank. This is the third report by the policy group.
The policy group strongly recommends that high-risk complex securitized financial instruments be sold only to sophisticated investors. In establishing standards of sophistication for investors and counterparties in high-risk complex financial instruments, said the group, the overriding principle should be they should be capable of assessing and managing the risk of their positions in a manner consistent with their needs and objectives.
Specifically, it will be important to develop a workable definition of sophisticated investor. In this regard, the policy group looked to the approach followed by the SEC in Rule 144A, which defines and lists various types of entities which the SEC calls qualified institutional buyers. These QIBs are entities that own or invest in at least $100 million in securities that are not affiliated with the QIB. Similar regulatory definitions are employed in other jurisdictions, noted the policy group, including under the European Union’s Markets in Financial Instruments Directive (MiFID).
For its part, the Corrigan group has listed the minimum qualifications a sophisticated investor should possess, including the capability of understanding the risk and return of the complex securitized product and the financial resources to withstand potential losses. The report also states that financial intermediaries should adopt policies to identify when it would be appropriate to seek written confirmation that a counterparty possesses these characteristics.
The policy group also questioned why the due diligence procedures for asset-backed securities mandated by SEC Regulation AB did not work better during the subprime crisis. All publicly registered asset-backed securities are subject to Regulation AB, which dictates registration, disclosure and reporting requirements.
In the asset-backed markets, due diligence involves the issuer or underwriter hiring an accounting firm to check data integrity. Regulation AB mandates a formal agreed upon procedures (AUP) letter from the accountant reporting the findings of this confirmatory analysis. The AUP letter has two parts: (1) verification of the accuracy of historical data; and (2) comparison of the data tape to the actual loan files through tape-to-file procedures. The issuer provides the accountants with sample documents and data related to the transaction pool of receivables, including a prospectus supplement and the composition of receivables. To verify historical data, the accountants recalculate a selection of key data and performance metrics and compare their findings with those of the issuer to ensure accuracy.
Regulation AB also specifies disclosure in four key categories: static pool data, credit enhancement, transaction parties, and pool assets. Regulation AB also contains extensive disclosure guidelines regarding the securitized asset pool. For example, the credit underwriting process description must include details of any internal credit grading scales and a description of any economic or other factors that may affect the pool assets.
While the policy group has some recommendations concerning due diligence, it is left with the question of what went wrong in the process and how diligence practices might have contributed to the unexpected nature of the losses associated with a number of asset-backed securitizations. In the group’s view, this problem appears to have arisen more from a general reliance by all market participants, including the rating agencies, on historical information in assessing the potential for losses, rather than systemic shortcomings in due diligence.
In any event, the group strongly urges underwriters and placement agents to redouble their efforts to adhere fully to the letter and spirit of existing diligence standards, and seek opportunities to standardize and enhance such standards. Enhancements suggested by the group include requiring all firms to follow statistically valid sampling techniques in assessing the quality of assets in a securitization and encouraging disclosure to investors of due diligence results, including making the AUP letter publicly available.