IMF Praises Obama Administration Proposal to Restart US Securitization Markets

Restarting the US private securitization markets is critical to limiting the fallout from the credit crisis, says the IMF in a report on financial stability. But, in restarting securitization, regulation must strike the right balance between allowing financial intermediaries to benefit from securitization and protecting the financial system from the instability that may arise if the origination and monitoring of securitized assets is not based on sound principles. At the end of the day, the value of securitized products relies on the quality of the underlying assets.

The IMF’s vision is a restarted securitization market that reliably permits lenders to redistribute risk to others without the undue use of leverage and complexity. The new securitization will require improving accounting, disclosure, and transparency rules all along the intermediation chain, and reducing investors’ blind reliance on credit rating agencies. In addition, securitizer compensation should be better linked to the longer-term performance of the securitized assets. Securitization products should be simplified and standardized to the extent possible to improve liquidity and reduce valuation challenges.

Securitization is a process that involves repackaging portfolios of cash-flow-producing financial instruments, such as mortgages, into securities for transfer to third parties. Structured finance techniques entail dividing the cash flows into tranches or slices. Tranche holders are paid in a specific order, starting with the senior tranches (least risky) working down to the most risky equity slice.

Securitization product issuers were poorly incentivized to conduct the appropriate due diligence on loan originators, including the review of financial statements and underwriting guidelines. In an effort to incentivize stronger issuer due diligence, the Obama Administration is proposing to amend securitization-related regulations to incentivize issuers to retain an economic interest in the securities-backed products they issue, the so called skin in the game.

The Administration’s legislative proposal contains several risk retention options, including retaining the equity tranche and equal amounts of all tranches. Regulations would require loan originators or sponsors to retain five percent of the credit risk of securitized exposures. The regulations would prohibit the originator from directly or indirectly hedging or otherwise transferring the risk it is required to retain. This is critical to prevent gaming of the system to undermine the economic tie between the originator and the issued asset-backed securities.

Anticipating the Administration’s proposals, the House has passed legislation that would begin the reform of the securitization process by introducing extensive new requirements for residential mortgage products and lending practices. The Mortgage Reform and Anti-Predatory Lending Act of 2009, HR 1728, would encourage a return to sound underwriting practices by prohibiting mortgage lenders from relinquishing all responsibility for the bad loans they make and sell to Wall Street.

Under the measure, lenders will now be required to keep skin in the game and retain a 5 percent stake in any home loan they make and sell. The House action mirrors the European Union, which amended the Capital Requirements Directive, which sets out the rules for Basel II implementation in Europe, to provide incentives for securitizers to retain at least 5 percent of the nominal value of originations.

The House legislation would also push assignee liability that ensures that some entity in the securitization chain remains legally liable for securitized loans that do not meet certain ability-to-pay and “net tangible benefit” standards. While supporting the House legislation, the IMF said it is important that the legal liability be quantifiable at origination and capped at some reasonable level. Otherwise, loan origination would be curtailed, due to a withdrawal of mortgage-backed security market financing for loans that carry assignee liability.

The IMF generally applauded the Obama Administration’s legislative proposal to force securitizers to retain some of their credit risk exposures so that they have more skin in the game to better align their interests with investors.

However, the IMF is concerned that the these proposals may be so blunt that they will either be ineffective at providing incentives for better securitizer behavior, or alternatively, may slow the market recovery.

More broadly, the IMF said that regulations mandating skin in the game retention requirements should not be imposed uniformly, but instead tailored to the type of securitization and underlying assets to ensure that those forms of securitization that already benefit from skin in the game and operate well are not weakened. Also, the effects induced by interaction with other regulations will require careful consideration.

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