The conference report of the Dodd-Frank Wall Street Reform and Consumer Protection Act includes significant changes to creation and regulation of asset-backed securities (“ABS”) (see Title IX, Subtitle D). The three most significant areas in the bill deal with (1) risk-retention requirements, (2) disclosure and reporting requirements, and (3) representations and warranties in ABS offerings.
Under the bill, the Federal banking agencies must publish rules to require securitizers of ABS to retain an economic interest in at least 5% of the credit risk for any asset that the securitizer conveys to the a third party. This requirement is intended to keep a securitizer’s “skin in the game,” so that the securitizer has a disincentive to take unnecessary risks. There may be exceptions or exemptions, prescribed by rule or regulation, to this risk-retention requirement for securitizations (i) of “qualified residential mortgages,” when the securitizer certifies to the SEC as to the effectiveness of the securitizer’s internal controls for ensuring that all of the assets are actually qualified residential mortgages, (ii) that are in the public interest and for the protection of investors, (iii) of assets issued or guaranteed by the United States or an agency of the United States (other than Fannie Mae or Freddie Mac), (iv) of assets issued or guaranteed by any state (or political subdivision), which are also exempt from the registration requirements under the Securities Act, and (v) of other assets, including any loan or other financial asset made, insured, guaranteed, or purchased by an institution that is supervised by the Farm Credit Administration.
In addition, the rules must establish standards for the retention of an economic interest in collateralized debt obligations (“CDO”), securities collateralized by CDOs, and similar securities. The rules may vary among securitizers of different classes of assets, but in no event will a securitizer be permitted to hedge (or otherwise transfer), directly or indirectly, the retained risk.
Disclosure and Reporting Requirements
The SEC will adopt regulations requiring each issuer to disclose, for each tranche or class of securities, information regarding the underlying assets to facilitate, to the extent feasible, comparing data across securities in similar types of asset classes. These regulations must also disclose asset-level or loan-level data, as appropriate, to allow investors to independently perform due diligence on the ABS and the assets underlying the ABS. Further, certain issuers of ABS may have ongoing reporting requirements, equivalent to reporting requirements under the Exchange Act. Finally, an issuer of registered ABS must review the assets underlying the ABS and disclose in the registration statement the nature of the issuer’s review.
Representations and Warranties in ABS Offerings
Any securitizer of an ABS offering must disclose the fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer so that investors may identify asset originators that have clear underwriting deficiencies. In addition, nationally recognized statistical rating organizations must include, in any report accompanying a credit rating decision related to an ABS offering, a description of the representations, warranties, and enforcement mechanisms available to investors and how those representations, warranties, and enforcement mechanisms differ from issuances of similar securities.
Other Significant Changes Related to the Regulation of ABS
The bill eliminates the transactional exemption from the registration requirements under the Securities Act, under Section 4(5), for the sale of certain promissory notes secured by first liens on residential and commercial real estate and participation interests therein.
The bill prohibits underwriters, placement agents, initial purchasers, and sponsors of ABS and synthetic ABS from engaging in any transaction that would involve or result in a material conflict of interest with respect to any investor in the transaction for a one-year period following the first closing of the sale of the ABS or synthetic ABS. This prohibition does not apply to (i) hedging activities connected to positions or holdings related to those activities that are designed to reduce specific risks associated with the positions or holdings, or (ii) purchases or sales of ABS or synthetic ABS to provide liquidity for such securities, or (iii) bona-fide market-making activities.
These provisions represent major changes in the regulation of the ABS market. It is clear that the House and Senate have attempted to address two of the major issues often raised in the discussion of how the ABS market contributed to the financial crisis: the lack of any risk retained by securitizers and the inability to assess the assets underlying the ABS. What is unclear, is how the regulations to enforce these statutory requirements will work in the market, and how the market will respond to these requirements.