On June 17th, 2009, the United States Department of the Treasury released its newly crafted proposal for Financial Regulatory Reform entitled “A New Foundation: Rebuilding Financial Supervision and Regulation” (the “Plan”). The sweeping approach described in the Plan makes many recommendations for significant reforms which, if adopted, could reshape much of our financial system. One of the broad missions set forth is to “establish comprehensive supervision of financial markets.”1
Each Treasury-recommended reform meant to achieve comprehensive supervision of the financial markets will make significant changes to the way in which modern financial market participants conduct business. One area likely to see significant changes as a result of the proposal is securitization.2
The first regulatory reform recommended for the securitization market calls for federal banking agencies to require each securitization originator or sponsor to maintain an economic interest in the securitizations in which it participates. Because it is widely believed that lenders and securitizers lacked incentives to conduct adequate due diligence regarding the quality of the underlying assets being securitized, the Treasury recommends that the federal banking agencies promulgate regulations which will require “loan originators or sponsors to retain five percent of the credit risk of securitized exposures.” The Plan also recommends that such regulations prohibit hedging or risk transference in order to prevent a “gaming of the system.” Furthermore, under the proposal, the relevant regulatory agencies would be granted authority to specify the forms in which the parties involved in a securitization may retain risk, for example, a first loss position or pro rata vertical slices. Finally, the regulatory agencies will be granted the authority to adjust the requirements and standards as needed to ensure they are consistent with “safety and soundness.” Such authority would include the right to raise or lower the five percent risk retention threshold and to provide exceptions to the “no hedging” requirement. The Plan also states that the regulatory agencies should have the authority to apply requirements to securitization sponsors rather than loan originators in order to “achieve the appropriate alignment of incentives” contemplated by the proposal.
Under the proposal, regulations will also be promulgated to align the compensation of brokers, originators, sponsors, underwriters and others involved with the long-term performance of the securitized assets. This is in contrast to the current regime where compensation is generally linked to the production, creation, and inception of the securitized assets. One example in the Plan concerns a possible change in the treatment under Generally Accepted Accounting Principles, whereby the recognition of gain based upon the origination of a securitization would be recognized over a longer period of time rather than immediately. Additionally, the Plan recommends that regulators require securitizations be “consolidated on the originator’s balance sheet and their asset performance to be reflected in the originator’s consolidated financial statements.” In an effort to improve the underwriting standards used by market participants, the Plan proposes that fees and commissions paid to loan brokers and officers with no “ongoing relationship with the loans they generate” should not be paid upfront but rather over time. Under this proposal, if problems arise with the underwriting or underlying assets, the payments made to the loan officers and brokers would be reduced. The Plan also recommends that securitization sponsors be required to “provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans.”
The Plan encourages the Securities and Exchange Commission (the “SEC”) to continue its ongoing effort to improve and standardize the disclosure practices utilized by originators, underwriters and credit rating agencies involved in securitization in order to address the current lack of transparency. The Plan recommends that the SEC should be given “clear authority to require robust ongoing reporting by ABS issuers.” These goals, as stated in the Plan, may be realized when investors and credit rating agencies are given access to the information needed to “asses the credit quality of the assets underlying a securitization transaction at inception . . . .” A significant change recommended in the Plan is the disclosure of loan-level data. This means that ABS issuers would be required to disclose very detailed loan-level information which may be broken down by loan broker or originator. Furthermore, the Plan recommends that the compensation paid to the broker, originator and sponsor, along with risk retention, be disclosed for each securitization.
Additional changes recommended in the Plan deal with standardization and transparency in documentation. The Plan urges industry participants to complete the ongoing initiative to standardize and make transparent legal documentation in securitization transactions, as it is likely to aid market participants in making “informed investment decisions.” The final aspect of the proposal relating to increased transparency in the securitization market deals primarily with reporting systems used by the Financial Regulatory Authority (“FINRA”). The Plan recommends expanding FINRA’s Trade Reporting and Compliance Engine (“TRACE”), which is currently used to report corporate bond data, to include asset-backed securities.
Credit rating agencies, according to the Treasury, “failed to accurately describe the risk of rated products.” To remedy the problem, the Plan first recommends that credit rating agencies be required to “maintain robust policies and procedures for managing and disclosing conflicts of interest and otherwise ensuring the integrity of the ratings process.”
The Plan also recommends a change in the actual ratings issued. Under the recommended changes, the credit ratings assigned to structured credit products would differ from the ratings assigned to unstructured debt. The Plan recommends that credit rating agencies “publicly disclose credit rating performance measures for structured credit products in a manner that facilitates comparisons across products and credit ratings and that provides meaningful measures of the uncertainty and potential volatility associated with credit ratings.” The Plan states that the credit rating agencies should clearly and publicly disclose, in “comprehensible” terms, what the various credit ratings actually assess (e.g., the likelihood of default and/or loss severity in the event of a default). Furthermore, the Plan recommends disclosure of information regarding the methodologies used for rating structured finance products and urges that the SEC require disclosure by the credit rating agencies to the SEC of “unpublished rating agency data and methodologies.”
The final direct change to securitization practices suggested in the Plan deals with regulatory reliance on credit rating agencies. The Plan suggests that when credit ratings are used in regulations and supervisory practices by regulators, they should recognize the differences between unstructured and structured credit products with the same credit ratings. In addition, the Plan recommends that “risk-based regulatory capital requirements should appropriately reflect the risk of structured credit products, including the concentrated systemic risk of senior tranches and re-securitizations and the risk of exposures held in highly leveraged off-balance sheet vehicles.” Lastly, the Plan recommends that regulators ensure that firms are not using securitization simply to lower their capital requirements without a reduction in risk.
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1 See U.S. Treasury, Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation (June 17, 2009).
2 For an overview of the proposals set forth in the Plan affecting areas in addition to securitization, please see our June 26, 2009 memorandum previously distributed.
