Thursday, October 28, 2010

American Securitization Forum Urges SEC Not to Take Broad Reading of Material Conflict of Interest When Crafting Dodd-Frank Volcker Regulations

With regard to the conflict of interest provision in Dodd-Frank co-authored by Senators Carl Levin and Jeff Merkley, the American Securitization Forum urged the SEC to, consistent with legislative intent, adopt regulations specifically tailored to prohibit transactions that create a material incentive for firms to intentionally design asset-backed securities to fail or default. Section 621, one of the Volcker provisions of Dodd-Frank, prohibits firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients. In the Forum’s view, a broad reading of Section 621 could effectively lead to a contraction of available credit for consumer finance and small business, where securitization has provided a significant source of funding, including mortgage loans and auto loans.

In its letter to the SEC, the Forum cited as legislative history an earlier letter to the SEC from Senators Levin and Merkley clarifying that the intent of Section 621 is to end the conflicts of interest that arise when a financial firm designs an asset-backed security, sells it to customers, and then bets on its failure. Thus, the Forum said that SEC regulations implementing Section 621 should be crafted to prohibit the situations that result in the material conflicts of interest identified by the Senators without causing unnecessary adverse impacts on the markets for asset-backed securities.

In the view of the Forum, a broad interpretation of the phrase material conflicts of interest prohibiting any transaction relating to an asset-backed security by which a party might receive a potential profit upon failure or default of the security would inhibit many activities currently undertaken by market participants and be against legislative intent. For example, many underwriters of asset-backed securities provide transaction sponsors with short-term funding facilities such as variable funding notes and asset-backed commercial paper, whereby the underwriter provides financing to the sponsor to fund asset originations or purchases of assets.

These facilities provide essential liquidity until the assets can be packaged through a term securitization and sold into the debt capital markets. As the proceeds from the securitization are used to repay the financing, noted the Forum, a broad reading of material conflicts of interest as used in Section 621 could prohibit this funding tool, essentially cutting off one of the only available sources of credit in today’s constrained market. Similarly, a broad interpretation of material conflicts of interest could prohibit servicers of mortgage loans, auto loans, and other assets who are affiliated with the sponsor of a transaction from pursuing customary servicing activities

Moreover, an overly broad reading of Section 621 could effectively prohibit the issuance of subordinated classes of securities and interest-only and principal-only classes of securities, especially given the requirement contained in Dodd-Frank that a securitizer retain a portion of the securities issued in a transaction. A risk retention requirement is also contained in the FDIC’s safe harbor and the SEC’s proposed revisions to Regulation AB.

Further, the Forum noted that many investors in asset-backed securities seek interest rates or currencies that differ from the underlying assets, which require that the structures employ interest rate or currency swaps. These swaps are standardized and bid out to various market participants, including affiliates of the underwriter of the asset-backed transaction. An expansive interpretation of material conflicts of interest could prohibit an affiliate of the underwriter from providing such a swap, potentially depriving investors of the best possible execution.

This outcome would be outside the Congressional intent of Section 621, maintained the Forum, which sought to eliminate the improper incentives to issue asset-backed securities designed to fail, but not to prohibit the creation of asset-backed securities that allocate disclosed risks between or among separate parties. While noting that Senator Levin believes that disclosure alone may not cure material conflicts of interest in all cases, the Forum feels that disclosure would remedy perceived conflicts in situations that are clearly not instances of an asset-backed security being designed to fail.

The Forum proposed that the SEC define a material conflict of interest as being when, other than for hedging purposes, a Restricted Party participates in the issuance of an asset-backed security created primarily to enable it to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of the asset-backed security and within one year following the issuance of the asset-backed security the Restricted Party enters into such related or subsequent transaction.

By clearly identifying principles upon which market participants can determine what activities would constitute a material conflict of interest under Section 621 and which parties are subject to such restriction, the Commission can effectively eliminate the practices identified by Senators Merkley and Levin without risking unintended consequences to the efficient functioning of the capital markets. Finally, the Forum noted that Section 621 includes exceptions for risk-mitigating hedging activities, bona fide market making, and commitments to provide liquidity. The Forum agrees with Senators Merkley and Levin that appropriate hedging, market-making and liquidity commitments are necessary and proper for the development of a healthy asset-backed securities market.