WORD ON THE STREET: In the years leading up to the financial crisis, the nearly $10 trillion securitization market provided liquidity to almost every sector of the economy, from residential real estate to student loans to credit card debt. Lenders were able to make new loans and credit available to a wide range of borrowers and companies seeking financing. In conjunction with low interest rates and rising home prices, securitization helped fuel the real estate boom of the last decade.
In the area of mortgage-backed securities (MBS), sound underwriting practices often took a back seat to immediate profits, however, and underwriting standards deteriorated. When home prices stalled and declined, poorly underwritten mortgages began to default, and the securities backed by the mortgages lost their value.
The result was a broad crisis in the securitization market, whose aftereffects are still being profoundly felt. Nearly every residential MBS (RMBS) offered in 2010 was federally backed, and only one publicly registered residential mortgage-backed securities transaction completed an offering last year.
As one research consultant put it in The Wall Street Journal, "Investors are on strike." In the aftermath of the crisis, would-be investors are waiting for needed reforms in the securitization market before they are willing to wade back in.
But efforts to implement the reforms that would bring investors back to the market are being met with strong – and what I believe to be short-sighted – resistance.
Look at the numbers: While other asset classes have recovered to varying degrees, the volume of registered RMBS has fallen from $609 billion in 2006 to just $231 million last year. In addition, the number of unregistered, or 144A-eligible asset-backed securities (ABS), has fallen to a fraction of the volume offered in 2004. Those figures will not significantly improve until investors again feel confident – and that confidence will only come with better standards.
I am sure that today, few – if any – industry professionals would ignore the lessons of the last few years and assume the risks that enabled the mortgage crisis.
As time passes, though, memories fade. An improving economy makes risks seem smaller, while the pressure to assume risk in search of profits can rise. And people have an almost infinite ability to convince themselves that "this time, it's different." Eventually, conditions accumulate for another crisis like underbrush in a dry forest, waiting for a spark to touch them off.
And so it is important to translate lessons learned at great cost into permanent reform while memories are still fresh. This was a driving force behind the Dodd-Frank Act and for the securitization rulemakings that we at the Securities and Exchange Commission (SEC) have undertaken separately.
While there were a number of factors contributing to the securitization slowdown, there are three areas of particular concern to the SEC:
- lack of accountability among participants in the securitization chain,
- flawed credit ratings, and
- investors' lack of tools and information to value the securities properly.
Each of these problems has eroded investor confidence, and without willing investors, the securitization markets cannot possibly come back. I'd like to discuss each in turn and what the SEC can do about them.
Lack of accountability
One of the root causes of the mortgage crisis was that many originators were not accountable for the loans they made, loosening underwriting standards and passing off the entire credit risk to investors through securitization. It is no wonder that investors remain wary.
Congress sought to address this concern through the risk-retention requirements in the Dodd-Frank Act. In March, the commission, along with federal banking and housing agencies, proposed rules that push accountability further up the securitization chain. These rules would require that a securitizer retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells or conveys to a third party.
The proposed rules take into account the heterogeneity of securitization markets and practices and reduce the potential for negative impacts on the availability and cost of credit by offering the sponsor a menu of options with which to satisfy its risk-retention requirements.
The public-comment period on this proposal has been extended to Aug. 1, and we look forward to reviewing your comment letters. I am aware of concerns regarding the proposed premium capture cash reserve account, and I encourage commentators on that aspect of the proposal to recommend revisions or alternatives that would still ensure that the issuer does not avoid the requirements by structuring around an option to retain risk.
Another provision of Dodd-Frank requires issuers to undertake a review of the assets underlying the ABS and to disclose the nature of the review and the review's findings and conclusions. Our rules implementing this requirement establish a minimum standard of review, which should increase the issuer's accountability for the assets placed in the pool.
We also are concerned with accountability for representation-and-warranty mechanisms built into underlying transaction agreements. Many of these reps and warranties have proven to be ineffectual, frustrating investors attempting to assert their rights.
One way to provide better assurance that the assets whose credit risk investors purchase meet the criteria required under the contractual provisions is through our fast-track "shelf eligibility" requirements. As you know, the commission proposed ending reliance on investment-grade ratings in determining shelf-eligibility early last year – an idea subsequently incorporated into Dodd-Frank.
Instead, the commission proposed requiring a new provision in pooling-and-servicing agreements that addresses representations-and-warranties violations. This provision would require that an independent third party periodically furnish an opinion regarding the obligated party's decisions to repurchase or not to repurchase any loans that the trustee put back to the obligated party for violation of the representations and warranties.
A number of commentators felt that this proposal was too "clunky" and that a third-party opinion would not be an effective means of fully resolving disputes. I continue to believe that some type of mechanism to better redress breaches of representations and warranties and give real meaning to this important investor protection is very important to investors in ABS. Our staff is currently working to address commentators' concerns while still achieving this goal.
The necessity of balancing risk and reward is a key to rational investment decisions and a linchpin of market self-regulation. Aligning the interests of originators, securitizers and investors by ensuring that entities at every step in the securitization process are accountable for the risks they assume and pass on will make the market more stable and rational.
Flawed credit ratings
A second weak link in the securitization chain was the failure of rating agencies to adequately detect problems in the securities they rated – magnifying the dangers of the inadequate underwriting practices increasingly adopted by originators. Here again, it was people and institutions that invested in these securities that ultimately suffered the bulk of the harm resulting from failures occurring earlier in the securitization process.
As the Financial Crisis Inquiry Commission noted, "The three credit-rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval�.This crisis could not have happened without the rating agencies."
The ultimate effect of flawed ratings was exacerbated by over-reliance on ratings throughout the market and the sheer number of instruments receiving high ratings. On one hand, fixed-income investors in search of low-risk vehicles and institutions required by state and federal laws – or by their own investment criteria – to hold highly rated securities could choose between only a small handful of corporate issuers with AAA ratings.
On the other hand, as late as January 2008, 64,000 ABS were rated AAA.
Unfortunately, as the Senate Investigations Subcommittee found, "Over 90 percent of the AAA ratings given to subprime RMBS originated in 2006 and 2007 were later downgraded by the credit-rating agencies to junk status."
The commission is currently pursuing reforms aimed at improving transparency and the credit-rating process.
On May 18, the commission issued a series of proposals to establish new requirements for credit-rating agencies registered with the commission as nationally recognized statistical rating organizations (NRSROs).
These proposed rules, stemming from the Dodd Frank Act, would do the following:
- Give market participants access to important information about providers of third-party due-diligence services and their findings regarding the assets underlying securities.
- Require a provider of third-party due-diligence services for an ABS to provide a certification that includes their findings and conclusions to any NRSRO that is producing a credit rating for the security. The NRSRO would, in turn, be required to disclose any certifications it receives.
- Increase the amount of information an NRSRO must disclose about the assumptions behind, and limitations of, its credit ratings, and about the performance of its credit ratings for different classes of ABS.
These proposals follow two separate sets of rulemakings issued in 2009, in which the commission added new requirements for NRSROs that included:
- Requiring new disclosure by NRSROs regarding whether and how they rely on the due diligence of others to verify the assets underlying a structured product.
- Prohibiting NRSROs from structuring the same products that they rate.
- Requiring an NRSRO that is hired by issuers, sponsors, or underwriters to determine an initial credit rating for a structured finance product to disclose to other NRSROs that it is in the process of determining such a credit rating.
- Requiring an NRSRO to obtain representations from the issuer, sponsor or underwriter that it will provide the information it provided to the hired NRSROs to other NRSROs, as well.
Investors, too, can play a role in reducing reliance on rating agencies and facilitating increased competition among rating agencies, which should help to improve ratings and which was a goal of the Credit Rating Agency Reform Act of 2006.
That act's overarching goal, as stated in its legislative history, was to "improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency and competition in the credit rating industry." I encourage institutional investors to revisit their organizational documents that delineate the criteria for investments.
If your documents require a specific rating by a specific rating agency, I urge you to revisit it. If investors are not allowed to invest in securities rated by new NRSROs, how will more competition that may improve the quality of ratings develop?
Ratings should serve as a check on originators and issuers of RMBS, and be an additional source of accurate risk assessment for investors. In a world where risk cannot be measured exactly, these reforms should at least ensure that investors have an opportunity to evaluate ratings against a backdrop of third-party findings and improved rating-agency practices.
Investors' lack of tools and information
Realistic analysis of risk by investors is a key component of stable and efficient markets.
However, investors must have access to accurate and useful information. Unfortunately, as the mortgage bubble expanded, investors over-relied on ratings, even as market discipline declined.
I remember that when Regulation AB was adopted in 2004, the commission and its staff endured a lot of criticism and accusations of over-regulation – accusations that look pretty absurd in hindsight. Unfortunately, today, we are hearing echoes of that earlier criticism.
With proper information, investors actually become partners in the pursuit of stable markets. This is why I believe that improving the quality and timing of disclosure to investors will have the most beneficial impact on this market of any of the reforms now under way.
In April 2010, the SEC proposed changes to Regulation AB that would transform a one-dimensional system into a vastly more transparent system that allows investors in ABS to more easily and efficiently assess the securities and the underlying assets.
As proposed, this transparency would include:
- standardized terms and definitions, so that investors can easily compare the assets underlying different offerings;
- pool characteristics provided on a granular basis, with issuer discussion of exception loans;
- timely investor access to transaction agreements; and
- sufficient time for investors to process the information.
The April 2010 proposal also included several other significant changes to Regulation AB, requiring:
- a computer program of the contractual cashflow provisions of the securities;
- enhanced descriptions relating to static pool information, such as a description of the methodology used in calculating the characteristics of the pool performance;
- static pool information for amortizing asset pools that comply with the Regulation AB requirements for the presentation of historical delinquency and loss information.
- the filing of Form 8-K for a 1% or more change in any material pool characteristic from what is described in the prospectus, rather than for a 5% or more change, as currently required.
Provisions of the Dodd-Frank Act also address the need to put better information in investors' hands. Issuers will be required to report on the performance of the underlying assets and the securities on an ongoing basis, rather stopping after a single annual report.
And rules adopted under Section 943 require disclosure related to representations and warranties in ABS offerings, which will shine needed sunlight on underwriting practices and the responsiveness of sponsors.
Investor decisions ultimately drive the financial markets. When investors do not have the proper tools and information to make sound decisions, the consequences can be dire for investors' accounts, for capital allocation, for the financial markets and for the economy as a whole.
Ensuring access to detailed information and time enough to analyze it is an effective and a cost-effective way to bring vitality to the ABS markets.
I am determined that we will pursue and require the greatly enhanced disclosure in this market that investors must have, in the near term.
What's next?
For all the progress we have made, there is still a great deal of work ahead of us.
We will be re-evaluating our April 2010 AB proposals in light of the changes brought about by the Dodd-Frank Act, and I expect we may re-propose a few of these, such as the tests for shelf eligibility.
In addition, I look forward to a constructive dialogue dedicated to improving the information available to investors in the unregistered market. I know there is some concern about our proposal to impose registered offering disclosures in the Rule 144A market, particularly with respect to asset classes that have not historically been offered on a registered basis, so that there aren't explicit requirements to import from registered deals to Rule 144A deals.
But I believe it is important for us to address concerns about information gaps in the unregistered markets, and we should be able to craft a regulatory solution that appropriately balances the competing concerns.Â
Mary L. Schapiro is chairwoman of the U.S. Securities and Exchange Commission. This article was adapted from a speech Schapiro gave before the American Securitization Forum 2011 Annual Meeting in Washington, D.C., on June 22. The complete speech can be accessed here.
