The public comment period has now closed on new regulatory proposals that financial firms retain some of the credit risk for the collateralized securities they issue—and as with all things related to the Dodd-Frank Act these days, critics abound.
The overall complaint was that the proposed rules, issued jointly by the Securities and Exchange Commission and five other financial regulators, leave too many details about calculating credit risk or granting exemptions unclear. Most questions centered around the creation of a new Section 15G of the Exchange Act, which would require issuers of asset-backed securities to retain at least 5 percent in the credit risk of the collateralized assets that undergird those ABS offerings. The regulation also prohibits transfer or hedging of that risk.
A quick refresher: Asset-backed securities (ABS) are derivative investments, where a financial firm bundles together a large group of debts—home mortgages, say, or car loans or student loans—and then sells tranches of the revenue stream from those mortgages to investors. When those underlying assets default more than expected, investors in the ABS are left in the lurch. At best those investors usually file lawsuits; at worst the mess causes a financial crisis, as witnessed in 2008.
The Dodd-Frank Act sought to seal up that weakness by forcing ABS issuers to retain some of the credit risk in their offerings, so they'd pay more heed to the validity of the underlying assets in the first place. Not surprisingly, financial firms and their advocates dislike the idea and the extra costs it would impose on them.
“The concept of [credit risk retention] is problematic as it creates cost to securitizers,” says Michael Gambro, partner at law firm Cadwalader, Wickersham & Taft. The structures to implement “CRR” will create additional costs to financial institutions, he says, resulting in higher costs imposed on people or businesses trying to secure loans.
If history is any guide, Gambro says, the whole concept of CRR is questionable. Some companies that had disappeared in the aftermath of the sub-prime mortgage crisis did retain some portion of their ABS deals, he notes, but they still failed. And even if ABS issuers do retain some credit risk, they can't do much when the underlying loans start going into default anyway.
Evan Drutman, partner at law firm Alston & Bird, says risk retention won't fix underwriting problems in mortgage lending practices—especially the risk that people taking out the underlying loans misrepresent themselves, either by error or outright deceit. “The greatest risk is in the representation of warranty, especially in mortgage loans, where there are no guarantees that borrowers will not falsely misrepresent the information given to qualify for loans,” he says.
Drutman also says the financial industry is unhappy with another detail of the proposed rule: that ABS issuers can no longer sell the interest-only tranche of their securities in the secondary market. Historically, that tranche has been a highly profitable part of the whole ABS offering.
“The greatest risk is in the representation of warranty, especially in mortgage loans, where there are no guarantees that borrowers will not falsely misrepresent the information given to qualify for loans.”
—Evan Drutman,
Partner,
Alston & Bird
Commenters also questioned the regulators' proposed methods to calculate what 5 percent of the credit risk actually is. They argued that the proposed methods aren't uniform; each one yields a different result, based on the portion of the ABS tranche it is applied to.
Premium Capture Reserves Account
In addition to the 5 percent credit retention, ABS issuers would also be required to make an upfront payment into a “premium capture cash reserves account” for the life of the securitization. The reserve account would be used to absorb losses on securitized assets until all the tranches are paid in full or the issuer is dissolved.
But that idea of a premium reserves account wasn't in the original Dodd-Frank language, critics say. “It was … something regulators came up with,” says Kenneth Kohler, senior counsel at law firm Morrison Foerster. According to Kohler, the premium reserves requirement will take away the incentive of bringing securitized deals to market. “It is punitive of regulators to prevent a private marketer from profiting in securitization deals,” he says.
Gambro says questions were raised even among regulators themselves on the feasibility of mandating the premium reserves account: “Some regulators, like the Office of Comptroller of the Currency and the Federal Reserves Board, have indicated that they themselves do not know how the rule on the reserves account is being structured.”
Exemption Issues
Although regulators intend to provide some exemptions to the rule, many doubt that the stringent requirements proposed so far will offer any relief. In question is the narrow definition of the qualified residential mortgage (QRM) clause. QRMs are mortgages issued with 20 percent downpayments, with the borrowers' ratio of housing payment-to-income and debt-to-income falling between 28 and 36 percent. If your ABS offerings are full of those high-quality loans, the thinking goes, you're exempt from the 5 percent risk retention.
SECURITIZATIONS PER YEAR
The following chart from the Securities and Exchange Commission shows the total number of U.S. asset and mortgage-backed securitizations issued during the years 2002 to 2009:
Source: SEC Proposed Rule on Credit Risk Retention.
Kohler questions the feasibility of such a stringent QRM definition in a time when the housing market is so bad. Mortgage bankers have already stiffened their criteria for loan applicants, he says, and a 20 percent downpayment is beyond what many middle-class Americans can afford. “The downpayment and ratio requirements will mean that only the rich can qualify for those housing loans,” he says.
The proposed QRM definition will also end up disqualifying many mortgages currently held by issuers, he says. The result? Those lower-quality mortgages will go into ABS offerings that get purchased by Fannie Mae or Freddie Mac, essentially assigning that higher risk to taxpayers. “Nobody really knows to what extend will the private market be willing to give out loans to non-qualified QRMs,” he says.
In addition to other items mentioned in the exclusion clause, loans previously qualified by federal loan lenders such as Freddie Mac and Fannie Mae are exempted from the upcoming CRR rules. Drutman says the exemptions of federal lenders from the rule will result in disadvantages to private firms. “Market sentiment on the QRM issue is if federal lenders are not subject to QRM, then why should private firms be subjected to it?” he asks.
What Comes Next
ACCEPTABLE RISK RETENTION
Below Cadwalader explains what types of risk retention forms are permissible and what asset categories are exempted from the rule:
Permissible Forms of Risk Retention
Vertical Risk Retention
Horizontal Risk Retention
CMBS B-Piece Buyer Retention
L-Shaped Risk Retention
Revolving Asset Master Trusts (Seller's Interest)
Representative Sample
Asset-Backed Commercial Paper Conduits
Premium Capture Cash Reserve Account
Hedging, Transfer and Financing Restrictions
Treatment of Government-Sponsored
Enterprises
Asset Category Exemptions from the Risk Retention
Qualified Residential Mortgages
ABS Backed By Qualifying Commercial,
Commercial Real Estate, or Automobile Loans
Underwriting Standards for Qualifying
Commercial Loans
Source: Cadwalader on Proposed CRR Regulations.
Kohler expects regulators to adopt a moderate approach in the final version of the rule—which, according to the SEC, should still be adopted by the end of this year. Kohler expects to see a compromise on the standards for a QRM exemption between what the market wants and the 20 percent downpayment threshold regulators proposed. “I expect regulators to have a more relaxed criterion of around 10 percent downpayment instead of the 20 percent,” he says.
Drutman says in all likelihood, credit risk retention is here to stay. “There is something about it that resonates with regulators,” he says. (Indeed, U.S. Rep. Barney Frank, co-author of the Dodd-Frank Act, was always a strong advocate of the idea as Congress drafted the law.) Drutman is more skeptical that the premium reserves account will survive into the final language.
Gambro concurs, saying that regulators will most likely respond to the overwhelming comments received from the public. “It will be rational to conclude that regulators will come up with something to mitigate the reserves account or better still, get rid of it,” he says.
Citing the recent U.S. appellate court ruling that struck down the SEC's rule for shareholder proxy access—where the court said the SEC failed to do a proper cost-benefit analysis of the rule—Drutman says market advocates will be watching that again closely with this new rule. “That is the wild card that market players can look into,” he says.
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