Live From the ABS East

Posted on October 4, 2010 by Ralph Mazzeo

Dechert attorneys kicked off ABS East by hosting a Day 1 cocktail party at the Fontainebleau that was well attended by our friends and clients.

Day 2 of ABS East is underway. The Monday opening panel-- Restoring Confidence and Rebuilding the Industry: The Role of Securitization-- drew a pretty full house.

The general consensus is that the regulatory bodies are in the way and will cause delay in the recovery of the securitization market. I won't go so far as to claim it wasn't broke and didn't need some fixing, but it's clear the fixing to come is going to take a while. Without definitive rules, potential issuers can not evaluate the cost to enter the market. If we had a more targeted response to our problems from Congress and the regulators we could avoid this delay.

On the resi front, clearly the GSEs have crowded out private issuance, which has been facilitated by Congress and the Fed. Whereas commercial real estate found a natural bottom, the feeling is that resi never did. And, as one panelist put it, "distressed loans continue to pose a lingering cloud preventing meaningful recovery." The question was posed as to why there was nothing much after Redwood in the resi space. Again, the GSEs are dominating that space. Conforming loan limits have never been higher and it's increasingly more difficult to even qualify for a jumbo loan under current underwriting criteria. With CMBS, it's possible to get a reasonable number of loans. RMBS requires many more loans and there's competition for the best loans.

With respect to spreads, it does seem like investor interest is there but there's too much money chasing fewer products. Because new issuance remains low, there remains a downward pressure on spreads on existing product which is a great indicator.

Is there a role for the ratings agencies in the next generation of the securitization market? Obviously the ratings agencies think so-- because it's about analytics, and benchmarks, not just ratings. And ratings add liquidity. What remains key to investors is transparency. Investors say the ratings agencies were not as transparent as they should have been. They say ratings agencies get a lot of information and should be forced to disclose more to investors. Ratings agencies say the info should come from the issuer... There was a lot of information available in RMBS deals, but in auto deals, not so much. Yet auto deals have weathered the storm relatively well. So much info is out there, but most people don't have the infrastructure to analyze it. There will be a huge build-up of info but what will people do with it? Processing that information is an expensive process. And the end user will ultimately bear the cost of it.

Any discussion of the recent legislative and regulatory issues ultimately leads to the question-- Does Washington even want a securitization market? At the end of the day, yes. It's a necessary piece of the economic puzzle. The Fed is clearly in favor of securitization. On the legislative side it's murkier. The public still wants to assign blame. And there's little evidence that's changing. The risk is still significant that public sentiment goes the wrong way. As a result, we ended up with a legislative response that was overly broad and not strategic in its approach.

The real question is need. Investors and bankers say there's definitely a need. It's just a matter of defining what securitization is going to look like.
 

By Ralph Mazzeo and Laurie Nelson.
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ASF Sunset Seminar: What to Expect from the Dodd-Frank Rulemakings

Posted on September 24, 2010 by Ralph Mazzeo

The general theme of the American Securitization Forum Sunset Seminar held on Wednesday at Dechert's NY office was the unintended consequences of the Dodd-Frank Act. Our largest conference room was packed with over a hundred securitization industry players all searching for the best predictions on the shape of the massive amount of regulations coming our way over the next few months. First on the agenda was a discussion of the repeal of Rule 436(g) and the resulting Securities Act liability for rating agencies. Dodd-Frank's intent was to improve the value of ratings by making rating agencies more accountable to investors. Unfortunately, the rating agencies would not consent to their ratings being disclosed and the entire public securitization market was stopped cold. Not helpful for a market struggling to return to "normal.” We have the temporary fix issued July 22 of this year in the form of an SEC No-action letter green lighting the omission of ratings in registration statements, but what happens next? Most likely-- the SEC will amend Reg AB Items 1103 and 1120 to not require ratings in registration statements. However, the SEC is considering requiring ratings in non-ABS registration statements, so how likely is this most likely solution really? Other ideas—in no particular order of likelihood: Congress will reinstate 436(g). Doubtful. The SEC will extend the No-action letter indefinitely. Perhaps. Ratings agencies assume the liability or are indemnified by issuers. Maybe. One panelist predicted that in the short run, we'll have uncertainty; and in the long run, more uncertainty. Consensus is that there's a long road ahead and harmonization amongst the regulators and applicable agencies is key. Also keep in mind as this unfolds that rating agency accountability is also to be achieved under Dodd-Frank by new private rights of action against ratings agencies (and other parties) leading perhaps to nationally certified class actions. As a result, the rating agencies will be seeking comfort and indemnity from issuers on the accuracy of data given to them in the course of their diligence.

The discussion turned to conflicts of interest and the prohibition against engaging in any transaction that would result in a material conflict of interest with respect to any investor for one year following closing (other than hedging activity or market-making/sales to provide liquidity for the ABS). An example of this conflict would be underwriting ABS then shorting the synthetic ABS that references the first ABS. One issue raised with respect to compliance is the problem of information barriers between departments at investment banking institutions.
 

No seminar can be complete without a discussion of "skin in the game" and the goal of improved underwriting. Only time will tell on whether we will see a horizontal or vertical slice requirement or a variety of alternatives. There was also talk about the residential mortgage reform provisions in Dodd-Frank. In a nutshell, no loan can be made unless, in a reasonable and good faith determination, the borrower has the ability to pay. At first glace it makes pretty darn good sense. In practice, however, it’s difficult for a lender to predict whether a borrower can in fact repay a loan. Will a lender be penalized for failing to accurately assess a borrower’s earning potential? Applicable Dodd-Frank criteria includes the borrower's credit history, current income, financial obligations, DTI, LTV and other factors including expected income. A lender needs to focus on regularity of income but can consider irregularity…. It was noted that no member of Congress could get a loan today when, even though the above-mentioned criteria aren't weighted, expected future income needs to be taken into account.

The safe harbor for qualified mortgages basically means non-traditional mortgages are out. Thirty year fixed is the new black. If a loan doesn't meet the definition of a qualified mortgage and it's in foreclosure, a claim can be asserted against the assignee (for any claim the borrower could have made against the original lender). The likely result is that lenders will originate only qualified mortgages.

Of course, if you originate a "qualified residential mortgage" under Dodd-Frank you can be exempted from the related risk retention requirements. Since historical performance data is required for any “qualified residential mortgage,” no new loan product type will ever be exempt from Dodd-Frank risk retention requirements. Expect more thirty year fixed. Consumers will certainly have more protection but they will also have access to much less credit as the markets struggle to reconcile competing regulations and deal with unintended consequences.

The usual themes were reiterated – disclosure, transparency, skin-in-the-game — as was the likely consequence — that there won’t be as many loans to securitize. There’s a lot of rulemaking going on in the District and will be for the next 6 months to a year. We can expect changes— and pain.

By Ralph Mazzeo and Laurie Nelson.
 
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Unintended Consequences Redux

Posted on September 2, 2010 by Rick Jones

I know I return to this theme a lot in this column, but the Unintended Consequences Watch needs to be manned day and night. Today let’s talk about 17g-5. This esoteric sounding SEC rule is intended to diminish the perceived failings of the rating agency culture which has been fingered as one of the principal causes of the “Late Unpleasantness”. The notion was that the rating agencies, hired by the issuers, were mired in conflicts of interest and there were few, if any, structural safeguards to protect investors from bad ratings.

17g-5 provides that rating agencies must require a party retaining the agency to rate an asset backed security (including CMBS) to establish and maintain a password-protected website for all other rating agencies. The website must contain all information provided to the rating agency in connection with the rating. This pertains whether information is provided in writing or orally and to information provided by the issuer or by anyone on behalf of the issuer. The information must be loaded into the website simultaneous with its delivery to the retained rating agency. This was purported to provide a structural counterpoint to the pressure for continuously lower levels by issuer procured ratings.

This has some superficial appeal. To the extent that investors were concerned about conflicts of interest, unsolicited ratings seems an antidote to these perceived concerns. Indeed, on first blush, it’s hard to see an argument that unsolicited ratings are bad.

But on first blush I thought the financial crisis that began about three years ago last month, would be over by Thanksgiving. The story of 17g-5 is yet another reminder that financial systems are much more complex than rule makers perceive them and wish them to be. Welcome back, yet again, to the wonderful world of unintended consequences.

In this case, what has flowed from the desire to do good by providing multiple opinions of value to the investors is a system which is likely to degrade the quality of information and analysis available to investors.

The heart of Rule 17g-5 is the simultaneous sharing of information. Again, sounds good but here’s what’s happening. Bankers legitimately concerned with liability are insisting that there be only one conduit of information from the issuer’s side to the rating agency. So no lawyers and no third parties are having direct contact with the rating agencies and, more importantly, the rating agencies can’t have contact with them. Moreover, the rule treats oral and written communication alike and requires all to be simultaneously transmitted to all rating agencies through the website. No one is quite sure how to deliver oral communication to all the rating agencies simultaneously through the web-based delivery system. Are transcripts needed? Can summaries be provided? How simultaneous is simultaneous? Bottom line: oral communication is being suppressed.

The consequence? The rating agencies have a much poorer picture of what they’re rating than they had before. Just think of conducting a business transaction in mime. Documents are never entirely clear. Documents describing highly complex structured finance transactions are REALLY not clear. How often do you call up someone in a transaction and say, I don’t get it, what are you trying to do here? So rating agencies have been left to try to discern what’s going on from the bare documentation and take a view without the benefit of the normal give and take of the conference call. Rating by charades!

Rating agencies are going to get it wrong. They may get it wrong in ways that results in lower subordination levels or higher. It’s inevitable, and not their fault. If you actually had to do a deal, any deal, without talking to the other side, can you imagine how wrong that deal might come out? So that’s what we’ve got. In an effort to level the playing field and create competition, we are degrading the quality of ratings. At a time when it’s clearly vital that the marketplace gain renewed confidence in the rating exercise, we’re creating reasons for lack of confidence. Explain to me exactly how that’s a good thing.
 

By Rick Jones.
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