Global Consensus Building For Legislation to Reform and Restart Securitization Markets

With the US House having passed legislation reforming securitization as part of broader regulatory reform, there is a growing global consensus that restarting private-label securitization markets under a reformed regulatory regime is critical to limiting the fallout from the credit crisis. In keynote remarks at the recent American Securitization Forum seminar, Australian Securities Commissioner Greg Medcraft said that securitization markets around the world must be reshaped with coordination, convergence and caution.

There must be coordination between securities regulators and accounting standards setters so that a change in one area does not have an unintended consequence in another More broadly, given the global securitization market, there must also be overall dialogue between regulators and legislative authorities at a global level.

There is also a need for regulatory convergence on issues like retention of economic interest, the skin in the game concept that is in the House bill, and the standardization of disclosure. While implementation may be tailored to the peculiarities of the local market, he averred, mutual recognition or equivalence between jurisdictions must be considered. Without convergence of regulation, he cautioned, cross-border capital flows may be constrained and opportunities for regulatory arbitrage may emerge.

Separately, regulators need to cautiously devise a measured response to ensure the sector is not overloaded with too many regulatory initiatives which could stifle the securitization markets recovery. Most regulators are aware of the compliance burden that the new initiatives impose, he noted, but see this as necessary to restoring investor trust and confidence in the market.

Also speaking at the securitization forum, Comptroller of the Currency John Dugan said that securitization works on different levels and there is simply no credible replacement for it. Reformed securitization will help consumers and businesses by increasing the availability of credit on terms that might otherwise be unavailable. Investors will benefit from the greater variety of investment products and increased secondary market liquidity.

Loan originators will be able to transfer some or all of the risks of ownership to parties more willing and able to manage them. Moreover, the sheer size of the securitization market demonstrates how important this source of credit has been for the economy.

The Comptroller noted that originations of asset backed securities in the public and Rule 144A markets were about $1 trillion lower in 2009 than they had been just three years earlier. He said that it is not realistic to think that the banking system could fully replace this decline in credit any time soon

According to the IMF, securitization can provide the financial system with cost-effective, capital-markets-based funding, and has the added benefit of dispersing credit risk outside the banking sector to investors able to manage it. Securitization that involves tranching has the added advantage of allowing risks to be more closely matched to investor desires, and should result in more credit growth, depending on the amount of retained risk and capital requirements. The key to using these markets successfully is to ensure that market participants and authorities have the knowledge, resources, and information to price and manage the risks accurately. Only then will the real benefits be attainable.

The IMF cautioned that reform legislation should not aim to take securitization markets back to their high octane levels of 2005–07, but rather to put them on a solid and sustainable footing. The IMF also said that the return to a more robust securitization market will not be instantaneous, as it will take time for the new policies to be put in place and become effective.

Even under a reformed regime, credit rating agencies will continue to play a key role in the securitization process. Thus, legislation should minimize incentives for rating shopping and ratings-related regulatory arbitrage. Credit rating agencies should disclose methodologies and publish rating performance data to enhance investor due diligence and credit rating agency competition. At the same time, as with the House bill, ways should be found to reduce or even eliminate regulatory reliance on ratings.

In the IMF’s view, skin in the game retention requirements should not be imposed uniformly across the board, but 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.

The IMF also called for the improvement of disclosure and transparency standards all along the intermediation chain, including tightening the standards for off-balance-sheet treatment of risk exposures, accounting standards that require more tabular presentations of data, and making transaction performance data more widely available. However, care should be taken to emphasize the materiality of the information and not overburden securitizers and investors by releasing irrelevant information.

Moreover, securitizer compensation should be linked to the longer-term performance of the securitized assets. Quantity targets for the origination of loans and other compensation incentives to pass risks along the intermediation chain should also be discouraged.

Securitization products should be simplified and standardized to the extent possible to improve liquidity and reduce valuation challenges. Although industry bodies are usefully working to standardize transaction legal documentation, little interest is seen in taking this to the product structuring level.

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