Skin Game: Dodd-Frank and the Regulation of Asset-Backed Securities
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Skin Game: Dodd-Frank and the Regulation of Asset-Backed Securities
- 1. Speculative Debauch Podcasts SKIN GAME: Regulation of the Asset-Backed Securities Market After Dodd-Frank Part 4 (or possibly, 5) of a series September 12, 2010
Editor's Notes
- And so, now we have a final bill – called the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, which was signed by the President on July 21 st , 2010.
- Dodd-Frank changes the substantive law, but it is more of an outline - the bulk of the law will be written by administrative agencies and DF mandates a new rulemaking approach - the SEC, the OCC, the FDIC, and the Federal Reserve are instructed to put their heads together and draft one set of uniform implementing regulations for the risk retention part of the law. What’s more, the agencies don’t have much time – the law gives them 270 days (that’s Friday, April 8, 2011) to produce a draft and the RMBS draft rules must become effective no less than one year after first being published in the Federal Register. Other rules may take up to two years to become effective. Enforcement, on the other hand, remains divided. The SEC will continue to police the output of non-bank issuers and the banking agencies will police deals sponsored by banks.
- The rules the agencies will be jointly drafting concern retention of deal risk by ABS issuers. What it means is that the people who assemble the deals (the law calls them “securitizers” – defined as any person who “organizes or initiates and asset-backed securities transaction”) will be required to invest in them, too. DF creates a minimum requirement that ABS securitizers retain 5% of the risk associated with every deal they assemble – so, in the case of the $800 million Lehman mortgage deal we’ve been discussing (LMT 2007-7), Lehman would have been required to keep $40 million of the risk. This $40 million in retained risk could not have been hedged – in other words, Lehman couldn’t go into the market and buy a credit default swap to zero out the risk that LMT 2007-7would blow up. DF gives the agencies power to allocate some of the risk retention burden onto originators, but it is a zero-sum game and any risk reallocated to the originator relieves the securitizer. The agencies are required to write special risk retention rules for CDO’s and other ABS-backed-by-ABS.
- QRM - The regulatory agencies are directed to work with HUD and HFA to create a special set of standards for “qualified residential mortgage” securitizations. QRM deals must be insured, the pools must be composed of properly underwritten mortgages and the mortgages must be free from default-inducing trickery like teaser rates. Sponsors of QRM securitizations will be exempt from risking their skin in their own game. The agencies also have power to partially or totally exempt government-guaranteed ABS securities (so, not Fannie and Freddie) and other asset-types so long as the exemption promotes high quality underwriting, appropriate risk management, reasonable access to credit, investor protection, or is otherwise in the public interest.
- DF requires a whole bunch of new disclosure to investors in registered ABS deals – including loan, or asset-level disclosure. The idea underlying this requirement is that if investors have information about every mortgage in the pool, for instance, they’ll be able to do their own due diligence and won’t be forced to rely on the suspect output of credit rating agencies. The SEC alone is charged with writing these rules. The SEC may require loan-level or asset-level disclosure if it finds such disclosure necessary to help investors independently perform due diligence. Registered ABS deals will also be required to disclose how much the asset originators were paid and how much risk they have retained.
- Structurally, all NRSROs are now required to have a board of directors with at least half of the members independent. They must design and implement a system of internal controls over rating quality and conflicts of interest. The internal control process is to be overseen by a designated compliance officer. Monitoring all these new requirements will be the newly-minted SEC Office of Credit Rating. The Office of Credit Rating has its work cut out for it – DF assigns to it the authorship of a very long list of new rules.
- In April, the SEC proposed a wholesale revision of Regulation AB, it’s disclosure rule governing ABS deals. In some ways, revised AB mirrors the ideas in DF, but the SEC goes further. The SEC’s proposal would create an independent regulatory structure for ABS deals – they would be registered on different forms and subject to a different level of review. While DF gives the agencies power to require loan-level disclosure if they find it necessary, Revised AB mandates loan-level disclosure for all ABS deals. Additionally, revised AB would remove the private offering exemption for ABS transactions unless sponsors agree to provide investor disclosure comparable to that provided to investors in registered deals. Revised AB also requires 5% risk retention, but only for deals registered using the new ABS shelf prospectus.
- In May, the FDIC proposed to amend its “securitization safe harbor” rule that exempts ABS transactions by banks under FDIC receivership from the FDIC’s asset reclamation and contract avoidance weapons. The safe harbor is meant to make ABS offerings by banks in receivership more palatable to investors. To qualify for safe-harbor protection deals must be simple, stable, and thoroughly disclosed. CDOs and other re-securitizations are not eligible. No more than six tranches of securities may be issued, use of leverage is constrained, and payments must be tied to income. The proposal also requires disclosure at least as extensive as that required by the SEC’s proposed rule. Sponsors are also required to retain a non-hedgable 5% interest in every deal.