The Obama Administration Proposes Reforms to Securitization Markets

January 1, 0001


On June 17, 2009, the Obama Administration proposed a sweeping plan for regulatory reform to modernize and protect the integrity of the United States financial system (the “Plan”), including measures to strengthen the integrity of the securitization markets. The Plan proposes enhanced regulation of the securitization markets in an effort to address the sources of risk concentration that developed in recent years in the securitization markets. Such risk concentration has been attributed to the perceived opacity and misalignment of incentives and interests of market participants. The Plan contains specific proposals (1) to align the interests of originators and sponsors involved in the securitization process with investors’ interests by limiting the ability of originators and sponsors to outsource risk and tying their income to their products’ performance and (2) to enhance the transparency of securitization markets and the process by which securitized assets are rated.

Aligning Incentives

As the demand for consumer lending increased, fueled by the growing ability to securitize pools of asset-backed securities (“ABS”), misalignments developed at all levels of the securitization process. Assets were pooled into ABS, ABS were sold to investors, and investors resold ABS on the secondary markets at increasing speeds, with loan originators, sponsors, and traders being compensated based on volume of transactions completed rather than performance of the underlying collateral, in which they retained no economic interest. At the same time, the level of scrutiny applied to the underlying collateral and primary borrower’s risk decreased, thus decoupling the traditional link between borrowers and lenders. To correct this perceived bias toward short-term productivity over long-term collateral performance, the Plan proposes measures that require market participants to retain a portion of the risk they create and link their compensation to the performance of the assets that underline ABS.

  • Risk Retention/Skin-in-the Game: Originators or sponsors of securitized credit exposures will be required to retain a material economic portion (five percent) of such exposures’ credit risk

The Plan calls upon federal banking agencies to promulgate regulations that would require that loan originators and sponsors retain, for a to-be-determined period of time, five percent (5%) of the credit risk of securitized exposures that they create.[1] Such regulations would prohibit the originator from directly or indirectly hedging or otherwise transferring such risk. Regulators will specify the permissible forms of risk retention (e.g., first loss position or pro rata vertical slice) and would have the authority and flexibility to amend or waive these new risk-retention guidelines on an as-needed basis (e.g., by setting lower risk retention thresholds or permitting case-specific hedging). Requiring originators and sponsors to retain some measure of the risk that they help securitize is designed to inject renewed rigor into the process by which originators and sponsors assess the quality and risk profile of the collateral supporting ABS.

  • Pay for Long-Term Performance: Compensation of market participants will be tied to longer-term performance of the loans underlying ABS

Federal regulators are tasked under the Plan with creating rules that align the compensation of originators, brokers, sponsors, underwriters and others involved in securitizations with the longer-term performance of securitized assets. These rules will likely require that sponsors provide standardized representations and warranties regarding the risk associated with their loan origination and underwriting practices. New rules would also require deferral of securitization fees and commissions, which would be disbursed to originators, sponsors and others over time, be tied to the performance of the underlying collateral (not simply the volume of transactions completed), and subject to haircuts for subsequently discovered underwriting or asset quality problems. The Plan’s approach to deferring compensation and subjecting it to long-term asset performance hurdles is intended to incentivize market participants to focus on the quality of ABS created over the quantity of ABS issued.

Increasing Transparency

The Plan also proposes to address securitization practices that are perceived as opaque or as an impediment to investors’ ability to value and assess the risk of ABS and their underlying collateral. Third-party investors typically have no access to the terms of the loans or the value of the collateral that backed ABS. In addition, in the period leading to the current financial crisis, investors invested in increasingly heterogeneous ABS that obscure risk and relied heavily on credit ratings that failed to distinguish between structured and unstructured ABS pools. The Plan aims to restore transparency in the securitization and in the credit rating processes, thereby giving investors greater access to better information upon which to base their investment decisions.

  • Transparency in the Securitization Process: Standardized disclosure practices will inject transparency and consistency into the securitization process

The Plan directs the Securities and Exchange Commission (“SEC”) to continue developing standardized disclosure practices[2] for originators, underwriters and credit rating agencies. These practices are expected to include, for each ABS, disclosure of loan-level data (classified by broker, originator and sponsor), broker, loan originator and sponsor compensation and risk retention practices, and the terms of legal documentation used. This information would be made available to credit rating agencies and investors. It is expected that investors and credit rating agencies would use such information under the standardized disclosure practices to assess the quality of assets underlying ABS and the risks (e.g., credit, market, liquidity and other risks) of the ABS, from the time of securitization through the life of the product. Certain securitization practices, such as the legal terms upon which ABS is created, may also be standardized. Moreover, certain types of ABS may be subjected to standardized collateral-specific practices. For instance, proposed regulations concerning residential ABS may permit servicers to modify home mortgage loans under certain circumstances if such modifications would benefit the ABS as a whole. The Plan’s mandate of increasingly standardized securitization practices is intended to facilitate transparency, to provide investors with greater insight into the ABS in which they invest, and ultimately to stabilize the securitization markets.

  • Transparency in the Credit Rating Process: Credit rating agencies would be required to increase the transparency and accuracy of their credit rating processes

The SEC is also directed under the Plan to enhance its regulation of credit rating agencies, with the goal of ensuring that rating agencies’ policies and procedures are sufficiently robust to manage or disclose conflicts of interest and that meaningful differentiation among credit products is provided to investors. Credit rating agencies would be required to standardize their practices so as to provide meaningful disclosure to investors regarding the risks which credit ratings are designed to assess (e.g., the likelihood and potential severity of default), as well as other material risks or differences in performance associated with different credit products of the same rating (e.g., the differing nature of structured and unstructured products). With the benefit of the enhanced transparency of credit rating methodologies and information regarding risks external to the credit ratings, the expectation is that investors will be better positioned to make their own assessments of the efficacy of such methodologies and the appropriateness of investing in the relevant ABS.

Questions Remain

By breaking the link between borrowers and lenders, the securitization market that evolved in recent years eroded lending standards, increased debt burdens, and concentrated risk, causing systemic instability and contributing to the market failure that we are experiencing today. The challenge for federal regulators charged with implementing the Plan is to guard against systemic instability without promulgating regulations that would delay the unlocking of still-seized credit markets or raise objections from a Congress wary of arresting further economic recovery. For instance, the requirement that loan originators, ABS sponsors or third-party purchasers retain a significant economic stake in the securitized assets that pass through their hands — while potentially properly realigning incentives — may restrict their ability to fund consumer and business lending and impair economic growth. Providing more risk factors alongside credit ratings may also create artificial distinctions among ABS that are largely meaningless without nuanced data regarding the underlying collateral.

In other respects, however, the Plan may not go far enough. For instance, the Plan fails to address the “issuer pay” system, whereby sponsors engage credit rating agencies to rate ABS, raising inherent conflicts of interest in the process, despite new transparency measures. It also remains to be seen whether the proposals set forth in the Plan will remain unchanged in the course of the legislative process and, thereafter, whether federal regulators will move with alacrity to adopt and implement the proposals. What is certain, however, is that, given the politically charged environment surrounding the securitization markets, originators, sponsors and traders should prepare for rules that change the way in which they are compensated and require increasing standardization and transparency in their business practices.

For a copy of the Plan, please see http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.

To view the facts sheets on the Plan, see http://www.financialstability.gov/docs/regulatoryreform/requiring_strong_supervision_reg_finfirms.pdfhttp://www.financialstability.gov/docs/regulatoryreform/strengthening_reg_core-markets_infrastructure.pdf; http://www.financialstability.gov/docs/regulatoryreform/strengthening_consumer_protection.pdf; http://www.financialstability.gov/docs/regulatoryreform/providing_govt_tools_manage_fincrisis.pdf; and http://www.financialstability.gov/docs/regulatoryreform/improving_internatl_reg_standards_co-op.pdf.

[1] This risk retention feature is consistent with an oft-cited positive feature of covered bonds. In April 2009, the representatives of the European Union member states voted in favor of a similar measure that would force banks to retain five percent (5%) of all securitized products that they retain and sell, including mortgage-backed securities. There is also currently “skin-in-the-game” legislation pending in the U.S. House of Representatives. House Financial Services Committee chairman Barney Frank (D-MA) included the proposal in proposed legislation in April 2009. That legislation, HR 1728, or the Mortgage Reform and Anti-Predatory Lending Act, reworked an earlier proposal put forth by Frank, Rep. Mel Watt (D-NC) and Rep. Brad Miller (D-NC), which, after clearing the House in 2007, stalled in the Senate.

[2] In one example of such a standardized disclosure practice, the Financial Industry Regulatory Authority (“FINRA”) will be required to expand its Trade Reporting and Compliance Engine (“TRACE”) to include ABS.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. O'Melveny attorneys Maritza Okata, Kenneth Yellen, John Stevens, and Leanna Albrecht, and summer associate Jasmine Modoor, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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