In many ways, the financial crisis was at root a crisis of securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies.
The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions. The Obama Administration proposed the reform securitization by changing the incentive structure of market participants; increasing transparency to allow for better due diligence; strengthening credit rating agency performance; and reducing the incentives for over-reliance on credit ratings. Provisions of the Senate draft legislation, Restoring American Financial Stability Act, would implement these goals.
One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. Lenders and securitizers had weak incentives to conduct due diligence regarding the quality of the underlying assets being securitized. This problem was exacerbated as the structure of those securities became more complex and opaque. Inadequate disclosure regimes also exacerbated the gap in incentives between lenders, securitizers and investors.
There is a growing consensus that we have ``crossed the Rubicon’’ into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005–07. Thus, the draft legislation aims to put securitization on a solid and sustainable footing. The IMF has recognized that the return to a more robust securitization market will not be instantaneous, since it will take time for the new policies to be put in place and become effective, in part because deleveraging will continue for some time.
The draft reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell garbage to investors, because they have to keep some of it for themselves. The Senate legislation would require companies that sell products like mortgage-backed securities to keep some ``skin in the game’’ by retaining at least 10 percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. In addition, the draft would require issuers to disclose more information about the assets underlying asset-backed securities and to analyze the quality of the underlying assets.
Specifically, the draft directs the federal banking agencies and the SEC to jointly adopt regulations requiring any securitizer to retain an economic interest of not less than 10 percent in a material portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers or sells to a third party. In addition, the regulations must prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain with respect to an asset. The regulations must also specify the permissible forms of risk retention and the minimum duration of the risk retention.
The regulations must exempt the securitization of an asset issued or guaranteed by the United States, a federal agency, or a Government-sponsored enterprise, as the federal banking agencies and the Commission jointly determine appropriate. As a catch-all, the draft allows a total or partial exemption of any other securitizations, as may be appropriate in the public interest or for the protection of investors. Also, the regulations must allocate the risk retention obligations between a securitizer and an originator in the case of a securitizer that purchases assets from an originator, as the federal banking agencies and the Commission jointly determine appropriate. The regulations will be enforced by the federal banking agency with respect to any securitizer that is an insured depository institution; and by the SEC with respect to all other securitizers.
The SEC is directed to adopt regulations under the Securities Act requiring issuers of asset-backed securities to disclose for each tranche or class of security information regarding the assets backing that security. In adopting these regulations, the SEC must set standards for the format of the data provided by issuers of an asset-backed security, which must, to the extent feasible, facilitate comparison of such data across securities in similar types of asset classes.
In order to facilitate investors in performing independent due diligence, the SEC regulations must require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including data having unique identifiers relating to loan brokers or originators, The issuer must also disclose the nature and extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retained by the originator or the securitizer of such assets.
The SEC must also adopt regulations on the use of representations and warranties in the market for asset-backed securities that require each credit rating agency to include in any report accompanying a credit rating a description of the representations, warranties, and enforcement mechanisms available to investors how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities.
The regulations must also require any originator to disclose fulfilled repurchase requests across all trusts aggregated by the originator, so that investors may identify asset originators with clear underwriting deficiencies. Finally, the Commission must issue regulations relating to the registration statement required to be filed by any issuer of an asset-backed security requiring them to perform a due diligence analysis of the assets underlying the asset-backed security; and disclose the nature of that analysis.
The draft adds a definition of asset-backed security to the Exchange Act to mean a fixed-income or other security collateralized by any type of self-liquidating financial asset, including a loan, a lease, a mortgage, or a secured or unsecured receivable, that allows the holder of the security to receive payments depending primarily on cash flow from the asset, including collateralized mortgage or debt obligations. The term asset-backed security does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.
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