The Securities and Exchange Commission voted 5-0 on Wednesday to issue new regulatory proposals covering the $2 trillion-plus asset-backed securities (ABS) market. Chairman Mary Schapiro calls the plan a "fundamental revision" in how the ABS market would be regulated.
"At one time, the securitization market provided trillions of dollars of liquidity to virtually every sector of the economy," Schapiro says. "But securitization has also fostered poor lending practices by encouraging lenders to shift their risk of loss to investors." Sound underwriting practices in the mortgage-backed securities part of the ABS market "took a back seat to immediate profits," she says, resulting in investors largely withdrawing from the market when those securities went so bad after the U.S. housing bust.
Shapiro adds that the proposals "are intended to better protect investors in the securitization market by giving them more detailed information about the assets that are pooled into ABS, more time to make their investment decision, and the benefits of better aligning the interests of issuers and investors." That alignment would be created through a requirement that issuers retain some of the risks, or keep some "skin in the game," Shapiro says, when they sell ABS.
"The Crisis's Immediate Trigger"
Highlighting the role that mortgage-backed securities (MBS) played in the current financial crisis, former Federal Reserve Board Chairman Alan Greenspan, testifying at a separate hearing on Wednesday before the Financial Crisis Inquiry Commission, said that "while the roots of the crisis were global, it was securitized U.S. subprime mortgages that served as the crisis's immediate trigger." He especially pointed to government-sponsored enterprises Fannie Mae and Freddie Mac as creating outsize demand for MBS at the urging of the Department of Housing and Urban Development and Congress to expand funding for affordable housing.
ABS values are based on the values of specific assets that back, or get pooled into, the securities. Those assets can include mortgage loans, student loans, credit card payments, auto loans and nearly any other kind of asset that provides a steady flow of payments. Securitization helps expand the availability and lowers the cost of credit for homeowners, consumers and businesses because as lenders pool the assets into securities and sell them to investors, the lenders then get more money to turn into loans. Major players in the asset-backed securities market include JPMorgan Chase (JPM) and Citigroup (C), which issued $62.8 billion and $41 billion in the securities, respectively, last year, according to Asset-Backed Alert.
A central feature of the SEC's approximately 600-page rule proposal, which the public will have 90 days to comment on, is to require new disclosures about the particular assets bundled into the securities.
The plan calls for ABS issuers to file standardized information with the SEC about specific loans in the pool at the time the asset is securitized and on an ongoing basis. Issuers would be required to file on the SEC website a computer program of the contractual cash flow provisions, called "waterfall payments," that govern how the borrowers' loan payments are distributed to different classes of investors, how losses are divided among those classes and when fees are paid to loan service providers (which collect loan payments and distribute them to investors according to the waterfall provisions).
How Much "Skin" Is Enough?
However, the two Republican commissioners, Troy Paredes and Kathleen Casey, are expressing some concerns that the disclosures could violate consumer privacy.
"One also has to take notice of certain personal privacy interests that could be comprised if more detailed [information] is to be publicly available," Paredes says. He adds he voted to approve the proposal to move the process forward.
Paredes also questions another feature of the rule that would require issuers of most ABS to retain at least a 5% interest in the securities in order to be able to issue them quickly under the SEC's "shelf" registration system. That system allows issuers to skip several time-consuming steps and allows them to take securities to market more rapidly than they could under the standard registration system.
"More rigorous analysis is required than has been offered before concluding that a particular percentage or form of risk retention is appropriate," Paredes says.
Another criticism: ABS originators that are able to securitize through the GSEs Fannie Mae and Freddie Mac, which are exempt by law from registering with the SEC, "will gain a further competitive advantage" over private originators, Casey says. She and Paredes are calling on Congress to remove the GSEs' legal exemption from the securities registration process.
A Diminished Role for Credit Ratings
However, SEC Commissioner Luis Aguilar commended the proposal for requiring for the first time that substantially the same information investors receive in public ABS offerings be provided to investors in unregistered private placements. "This is appropriate," Aguilar says, "because many have concluded that a contributing factor to the crisis was a lack of disclosure about, and understanding of, asset-backed securities," including collateralized debt obligations.
But Aguilar expressed concern that the proposed rules would not apply to all structured finance products sold as private placements. "While this aspect of the proposal is designed to improve the information available in unregistered offerings of structured finance products, its effectiveness could be limited," he says. The proposed rules would not apply to structured finance products sold under some exemptions for private sales, he says.
Among other things, the new proposal would give investors at least five days to consider the investments before an asset-backed security could be brought to market.
It would remove references to ABS credit ratings as an eligibility requirement for shelf registration. Credit ratings for many ABS deals were often too high, giving many investors a false sense of security and contributing to the financial crisis. Instead, new criteria would be established for shelf registrations of asset-backed securities, including the 5% equity retention, and a certification requirement by the chief executives of issuers attesting that investors have a reasonable basis to believe the securities will produce cash flows described in the prospectus.
To keep ABS transactions from fleeing to private markets, where some types of ABS, such as collateralized debt obligations, are sold, issuers of those securities would have to provide investors, upon request, the same information that would be required in the public markets.
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