CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

Even though Dodd-Frank got one of our Golden Turkey Awards, issuers doing public deals must heed these new rules. Some things are clear: Rule 193 only applies to registered deals after December 31, 2011 and does not extend to Rule 144A and private placements, and the rule does not detail the nature or type of the required due diligence reviews or the content of required disclosure.

One might ask: to what extent will issuers (or other securitizers) be subject to additional legal exposure? In CMBS land, we already do detailed loan-level disclosure subject to 10b-5 materiality standards. All securitizers already have detailed underwriting policies and procedures and mortgage loan sellers and sponsors understand the value of internal due diligence standards, so does this new rule really bring with it any new headaches? You bet. Here’s a few:

(1) Scope - the rule requires compliance by “issuers” but it remains unclear whether the goal of the regulators was to include other deal parties like sponsors, depositors or loan sellers within the scope of the new rule. Could the authors, having used the word “issuers,” intended to limit the scope to issuers? Unlikely, according to industry chatter so far; instead, the expectation is that the rule will apply to parties beyond the issuer, including sponsors and depositors. So loan sellers and their counsel must deal with this – at least for now.

(2) Experts - the rule permits the hiring of a third party to conduct the due diligence review but it also requires that the third party consent to being an expert for ’33 Act purposes if the issuer (or other securitizer) “attributes” the review to that third party. What if you hire and rely on your accountants to comfort diligence data? And what if your lawyers review loan documents? If you think that accountants and lawyers will sign up for expert liability under the ’33 Act, I’ve got a bridge for sale. So just steer clear of “attributing” the review to third parties, right? Not so fast: there is some unclear commentary and related discussions among deal parties, questioning exactly what types of third-party back-up reviews may require expert consent even if the securitizer does not fully attribute the review to the third party. This one is also playing out as we blog.

(3) Hot Potato (or Risk Allocation) – How the foregoing scope and expert considerations get fleshed out impacts how lawyers and deal parties will allocate risk including by way of drafting and backing up offering document disclosure, negotiating indemnification agreements and providing 10b-5/159/Reg AB negative assurance letters and opinions. 

Wait, there’s more holiday spirit included in the hang-em-high stocking stuffing provisions of Item 1111(a)(8) of Reg AB. A securitizer is required not only to disclose specific asset deviations with respect to underwriting criteria but they must also disclose the identity of the entity responsible for determining that an asset should be included in a deal pool notwithstanding its deviations. Never mind the Reg AB II certifications that we recently discussed here - anybody eager to sign up for these due diligence determinations? We blogged about this last year when the rule was first published and what we thought then remains true. Rule 193 is likely to expand issuer liability and legal concern while producing little in the way of better disclosure. Just what we need right now.

Seasons greetings! And more to come.

By: Devin Swaney

Today's panel not surprisingly reiterated much of what we've been posting on this blog about credit risk retention, namely that the number one point of contention with the rule is its mere existence. Second is that pesky premium capture cash reserve account (PCCRA). One panelist restated, as many comment letters have, that banks are not in the business of storing costs and profits until they can perhaps recoup them down the road, and that although some investors may have liked the general idea of the PCCRA, for the most part they have acknowledged the PCCRA just doesn't work. Not to mention that such a beast was not even contemplated in the Dodd-Frank Act. This panel seemed to agree that the PCCRA would be a game ender. If it was intended to combat horizontal risk retention manipulation, one panelist noted that's a legitimate goal and is supported. But if the consequence is preventing an issuer from recouping its costs and making a profit, where's the incentive to do a deal in the first place?

The NPR also enumerated arguably conservative criteria for the Qualified Residential Mortgage (QRM), each of which such mortgage would be exempt from the risk retention requirements. One panelist asked-- if you define an exception so narrowly, have you eliminated the exemption that Congress intended? And he reiterated the purpose of the QRM-- to ensure safe and sound underwriting, not to establish a gold standard for residential mortgages.
 
Panelist Tom Deutsch, the Executive Director of the ASF, noted that industry groups tended to focus on the price differential when commenting on the risk retention NPR, whereas consumer groups came to the same conclusion about the rule (it needs some major overhaul), but in a different way. Consumer groups, he said, speak in terms of social inequality and argue that the QRM will create a two-tier structure with social policy implications-- that those who fall outside the QRM won't get as good a deal, not entirely unlike the GSE conforming loan limit structure. Tom noted that QRM isn't relevant until GSE reform occurs anyway, because the GSEs aren't subject to the risk retention rules as long as they are in conservatorship, and that GSE reform is not happening in the near future. Another panelist discussed the small pool problem that may occur if few QRMs are originated. He pointed out that loans may need to be warehoused longer to amass larger pools. It has been proposed by those in the industry that securitizations blend QRM and non-QRM in a securitization and calculate the risk retention requirement based on a weighted average basis.

There are compelling arguments that the regulators got this one wrong. And with so many comment letters addressing so many points, if the regulators put out a final rule that looks pretty much like the NPR, they will be accused of not taking into account all the solicited comments received. On the other hand, if the regulators put out a final rule that barely resembles the NPR, they will take flack about not soliciting public comment. The regulators were given
an arduous task in a relatively tight timeframe. And much is riding on the final outcome.

By Laurie Nelson.

The industry was left to guess as to whether the Dodd-Frank Act would result in a “springing” filing requirement for ABS issuers. In January, the SEC issued a no-action letter stating that an enforcement action would not be recommended if an ABS issuer “continues to determine its reporting requirements based on the standards set forth in Section 15(d) of the Exchange Act immediately prior to enactment” of the Dodd-Frank Act subject to certain conditions. Since the Rules do not state that the no-action letter is overturned or superseded, ABS issuers who suspended their filing of Exchange Act reports prior to July 22, 2010 should be able to continue to rely on the no-action letter if all the conditions set forth in the no-action letter are satisfied.

The Dodd-Frank Act gave the SEC the broad authority to draft a final rule such that the SEC could have provided for automatic suspension of the filing requirement in a variety of circumstances. For example, CREFC and the MBA commented to the SEC that CMBS issuers should be permitted to suspend reporting under the old Section 15(d) standard because of the “Investor Reporting Package” which is given to all CMBS investors pursuant to CMBS pooling and servicing agreements and which contains the same information that would be provided under Section 15(d). Alas, the SEC’s Rules provide only very limited circumstances when the duty to file may be suspended -- if all outstanding ABS are held by affiliates of the depositor or if no ABS are outstanding. The Rules provide for the timing of the suspension of the duty to file to be tested at the beginning of the semi-annual fiscal period rather than annually as proposed. The SEC states in the Rules that the increased frequency of the required assessment makes it “harder to evade the reporting requirements as well as reduce[s] costs imposed by requiring reporting for the remainder of the year when the ABS are held solely by affiliates of the depositor.”

The Rules clarify that securities held of record by a broker, dealer, bank or nominee for any of them for the accounts of customers are considered held by the separate accounts for which they are held. So if an investment bank is an ABS issuer and holds securities in its name for the benefit of other non-affiliated investors, it cannot suspend reporting. Conversely, if an unaffiliated bank or broker holds ABS for affiliates of the ABS issuer, the unaffiliated status of the broker or bank will not preclude suspension of reporting.

The Rules also provide that an issuer may not suspend reporting if securities are acquired and resold by affiliates as part of a plan or scheme to evade the reporting obligations of Section 15(d).

Also, the filing of the certification on Form 15 is now a condition to the suspension of the reporting obligation.
 

By Laurie Nelson.

In the August 2 letter to the regulators, the representatives stated that the proposed PCCRA was never discussed during Dodd-Frank Act deliberations and urged the agencies to “perform a rigorous cost-benefit analysis to determine the effect of the PCCRA requirement on economic growth and the vitality of the U.S. securitization market before finalizing the risk retention rule.”

Stay tuned for a future post by me on this if such rigorous analysis is actually performed. My analysis sans the rigor:

• Cost of keeping the PCCRA in the rules: Big fat hindrance to the economic growth and vitality of the U.S. securitization market
• Benefit of keeping the PCCRA in the rules: Zilch

By: Laurie Nelson
 

In the realm of mortgage reform, the Dodd-Frank Act was designed to prohibit lenders from steering any consumer toward a residential mortgage loan that the consumer cannot repay or that has predatory characteristics and from steering consumers away from QMs and toward non-QMs. Under the Dodd-Frank Act, a mortgage lender is presumed to have satisfied the ability-to-repay requirement and receives some protection from liability when it originates a QM (and exactly how much protection is still open to debate).  (See our OnPoint explaining the difference between the proposed safe harbor and rebuttable presumption alternatives for QM).

The GAO analyzed a proprietary database of loans originated from 2001 through 2010 from CoreLogic, Inc. to assess the potential impact of mortgage-related provisions in the Dodd-Frank Act on the availability and affordability of mortgage credit. The GAO notes up front that such analysis may not be fully representative of the mortgage market as a whole. It also reviewed housing and mortgage market research and interviewed mortgage industry stakeholders-- including those representing mortgage lenders, securitizers, investors and consumers. 

What I’ll call an “abstract” of this GAO report can be found on page 58.  Here, the report states that limited data and research show that certain provisions could provide benefits to homebuyers and the larger mortgage market, but that the ultimate impact of the Dodd-Frank Act’s mortgage-related requirements is not yet known and will depend, in part, on regulatory actions, decisions to fund housing counseling and mortgage market adjustments that have not yet occurred.

On the up side, it appears that the bulk of loans do meet QM criteria; on the down side, there’s a sizable hole in the data and final regs may exclude even more loans.

Let’s take a look at what the report says:

The Dodd-Frank Act specifies nine QM criteria, but gives regulators the authority to add, subtract or modify the QM criteria as they see fit. The GAO examined five of the nine QM criteria specified and states that it generally found that most mortgages would likely have met such individual QM criteria. However, the GAO notes that the impact of the full set of QM criteria is uncertain, partly because it could not analyze the other four QM criteria and partly because federal agencies could establish different criteria as final regulations are developed. Maybe I’m not grasping the extent of the usefulness of this examination because it seems rather useless. Moving on…

Generally, the Dodd-Frank Act requires securitizers of RMBS to retain at least five percent of the credit risk of any residential mortgage securitized that does not meet specified criteria. In its report (which focuses on risk retention for RMBS), the GAO notes that key decisions that have yet to be made (including the characteristics of mortgages that would be exempt from risk retention requirements, the form(s) of risk retention that would be allowed, the percentage that securitizers would be required to retain and risk sharing arrangements between lenders and securitizers) could affect the availability and cost of mortgage credit as well as the viability of a private mortgage securitization market. However, the GAO report makes a number of recommendations for rulemakers to consider when crafting the final risk retention requirement, including a recommendation that the requirement be tailored to each major class of securitized assets.

Additional uncertainty arises, the GAO notes, from provisions in the Dodd-Frank Act concerning homeownership counseling and regulation of high-cost loans which could enhance consumer protections and improve mortgage outcomes for some borrowers. As required under the Dodd-Frank Act, HUD has initiated plans to establish an Office of Housing Counseling to perform a number of functions related to homeownership and rental housing counseling, including establishing housing counseling requirements and standards and performance measures; certifying individual housing counselors; conducting housing counseling research; and performing public outreach. Findings from the GAO’s limited research on housing counseling for mortgage borrowers are reported to be mixed, with some studies suggesting that some types of counseling can improve mortgage outcomes and other studies’ findings less clear. 
 
Yet again, the GAO acknowledges data limitations and notes that although lenders have generally avoided making “high-cost loans,” additional information on mortgage costs would be needed to assess the extent to which a newly expanded definition of high-cost loans under HOEPA would affect mortgages that may be made in the future. In addition to expanding the definition of high-cost loans, the Dodd-Frank Act requires that borrowers undergo counseling with a HUD-approved counselor before taking out a high-cost loan. Industry stakeholders who spoke with the GAO indicated that the new definition of high-cost loans would further increase disincentives for originating mortgages with potentially predatory terms and conditions. Additionally, they said that lenders would likely continue to avoid offering high-cost loans because the strict penalties and liabilities attached to such loans make them risky to originate and difficult to securitize.

So far this birthday party leaves a lot to be desired. 

By Laurie Nelson.

First, our Strengths and Opportunities:

• We’re coming out of the deepest and most torturous recession in 70 years. The financial markets came close to collapsing, credit evaporated, the U.S. housing market went into a tailspin and commercial real estate values dropped between 30% and 40%. But things are demonstrably getting better. All downturns end and are followed by sustained periods of recovery, right?
• Interest rates are at insanely low levels. I’m still trying to wrap my brain around a one-month LIBOR of 20 bps and ten-year Treasury below three percent.
• Bank balance sheets have repaired (some), the financial market has crept back from the edge of oblivion. There’s money to be lent.
• Cap rates have dropped like a rock from ’08 and ’09 and higher valuations resulted. In some CBDs, prices are within single digits of pre-fall highs.
• The GSEs might be in conservatorship, but for dead people, the Twins are pretty damn active market participants. They should have a recurring role on True Blood.
• The housing market must be near its bottom. It just must! The experts have been predicting the bottom for 24 months and eventually they have to be right. When the bottom’s reached, the consumers will find their courage and the consumer sector of the economy, some 70% of GDP, should start to perform more like normal.
• The stock market’s going great guns, there’s trillions of dollars on the balance sheets of corporate America.
• With a little luck, we won’t spend more lives and treasure on more wars and wacky governmental recovery initiatives.

So, that’s all good and, voila, a functioning commercial real estate mortgage market and a growing economy result. I’m feeling good, so far.

But hold on, let’s look at the Weaknesses and Threats:

• While some parts of the banking sector and the financial services sector are well on their way to health, not all is well. There still are a lot of outstanding questions about what lurks on the balance sheets of institutions large and small, and whether the full story of repair has been played out.
• We can’t seem to get to a budget. Yet it seems that, at some point, this Ponzi scheme of continuing to borrow and spend must stop. Could you imagine what would happen if the Treasury’s borrowing costs went up 500 bps really quickly? Portugal, anyone?
• Commercial real estate is increasing in value not because more butts are in seats and more sales are happening (although there’s some of that), but because of the changes in cap rates. When one lives by cap rate moves, one can die by cap rate moves. What happens if we stop believing an optimistic narrative that things will continue to get better? If that narrative is disrupted, it could turn ugly in a hurry.
• Interest rates are extremely low. Where are they going to go? How long can they actually stay at these historically anomalous levels? At some point, they have to go up. We’ve certainly seen commercial real estate markets operating robustly with an eight handle on the ten year, but how do you go from three to eight? Maybe if that happens over a decade, all’s good. If it happens over a quarter, it’s bad.
• Europe is a disaster. We shot right by Spain on the road to Italy. Europeans are playing world class kick the can and as long as a common currency is off the table, there’s no way out. Europe’s Hotel California contagion moves from sovereign to sovereign and then from major international bank to major international bank. It will be hard to keep all this away from the shores of this economy.
• The government seems to be, or at least is perceived by market players as being, hostile to capital formation. That, by itself, creates a miasma of doubt and uncertainty which chokes off momentum. Add to that our new and as yet untested regulatory burden and one wonders if growth can win out. Oh sure, there are some good reasons behind the current regulatory transformation, but for every safeguard there is a cost. For every provision designed to prevent something bad in the future, there is a drag on capital formation now. Dodd-Frank and its progeny will have an enormous and yet not fully appreciated impact on the ability of all markets to grow and innovate in a way critical to the successful re-acceleration of our economy. Risk retention is, perhaps, the most visible current face of Dodd-Frank. No matter how the final regulations turn out, they will, with a moral certainty, decrease the availability of affordable credit to the commercial real estate market and to the broader economy.

So throw all of that onto the scales and try to get comfortable about the sustainability of this recovery. As long as they play music, I’m going to dance. Just don’t make me tell you when the band’s going to take a break.

By Rick Jones.
 

The OTA is, at this point, less a distinct structural feature than a notion built around the idea that a third-party ombudsman would be a good thing for investors. It is very much still in the process of evolving. While clearly not yet jelled, here and now, the core characteristics shared by most of the 2011 OTAs include: (1) the OTA conducts an annual audit of the performance of the special servicer and reports in some fashion to the bondholders; (2) the OTA exercises non-binding consultation duties with respect to major decisions related to specially serviced loans after the B-piece buyer has lost control; and (3) the OTA reviews and verifies certain calculations (e.g., with respect to appraisal reduction and net present value determinations). More as outliers, in some deals the OTA consults on whether a loan should be transferred to special servicing and, in some deals, the OTA is entitled to recommend the termination of the special servicer under certain circumstances. In at least two atypical cases, the OTA actually functions as something like a controlling class representative, in one case, for any period during which the related B-buyer is affiliated with borrowers in the pool, and in another case, at such time as the B-buyer’s interest burns off.

So what’s in it for the OTA? The OTA’s compensation typically consists of a per-annum strip from the deal, similar to servicing or trustee compensation. In some deals, the OTA is entitled to additional compensation in the form of consulting fees, e.g., based on a range of fees on a per-loan basis in connection with the OTA’s review of specific major decisions (e.g., workout or modification decisions) with respect to specially serviced loans. In those deals, payment of the OTA’s consulting fees is often limited by the right of a servicer to waive or reduce the consulting fees, the seniority of a servicer’s right to similar consent fees or a servicer’s limited obligation to collect the consulting fees from the related borrower under the mortgage loan documents. So query as to whether an OTA will ever get those consulting fees.  At least one lesson learned so far regarding consulting fees: if a loan hasn’t closed yet, incorporate specific references into the underlying loan documents that clearly require the borrower to pay the fees.

The OTA is also typically entitled to reimbursement from the deal of its expenses, although some deals cap the reimbursement of the OTA’s expenses by prohibiting reimbursement through a reduction of interest or principal payments otherwise ear-marked for the B-piece, thereby insulating the B-buyer from risk associated with the reimbursement of the OTA’s expenses.

What rights do deal parties have to terminate the OTA? Termination of the OTA is similar to termination of a servicer or trustee. Upon certain events of default or upon an affirmative vote of bondholders, the trustee may be required to boot the OTA. And, typically, the OTA has fairly standard resignation rights, e.g., including the right to resign because legal compliance demands it or upon seeking a bondholder vote or finding an appropriate replacement.

Under the Dodd-Frank risk retention NPR, if risk retention will be met by a B-piece buyer in a deal with an affiliated special servicer, an OTA will be required. The regulators’ OTA would have consultation rights regarding major servicing decisions and the right to recommend the replacement of the special servicer through a byzantine voting structure where such recommendation would be implemented by the trustee unless a majority of each class of certificateholders votes to retain the servicer. As B-buyer risk retention is seen as a preferred modality for satisfying risk retention, this provision, if included in the final rule, will assure a future for the OTA in CMBS. So maybe the OTA is here to stay. But the risk retention NPR itself is subject to uncertainty and a recently extended comment deadline, so stand by to see what the regulatory elves will ultimately give us.

It is hard to declare that either the current OTA or the regulators’ vision of an OTA is a game changer thus far.  It seems that some deal parties may prefer to eliminate the role, and it isn't clear that  the role really does all of the things that the IG investors dreamt about during the interregnum. The OTA’s authorities and compensation are limited.  Nevertheless, the deals keep calling for the OTA, and its consultation duties are currently in effect for some deals. Because the OTA is only beginning to spring into action on some deals, the jury is still out as to what extent the OTA’s role will mitigate conflict risk and provide enhanced, useable information to bondholders.  One thing is clear no matter your point of view: we may as well welcome the OTA to the party. 

By: Devin Swaney.

On its face, and we absolutely have to start here, it says a securitizer who monetizes either an IO or earns a premium on the sale of P&I bonds, has to put that money in a box. That box serves as a first loss reserve for any losses on the loans for the life of the deal. The authors muse (they almost seem to chuckle) in the commentary that it’s unlikely that anyone will ever do this because it is onerous and therefore securitizations will be done without premium. Huh? Why, in Heaven, would a bank hire an origination team, build out technology, make loans, warehouse and hedge loans and assemble a pool for sale if it was not going to make a profit? I mean, we all know greed has a bad odor these days, but, good heavens, this is still a capitalistic economy, isn’t it?

Now, about the actual text of premium capture. In conversations following publication of the NPR, the regulators have told anyone who asks that the premium capture provisions were not properly drafted, and that what it really is all about is ensuring that the securitizer, who elects to satisfy risk retention with a horizontal first loss piece, retains 5% of the value of the underlying loans (the NPR curiously uses the term “par” to mean value). Regulators have gone on to say this is easy to achieve if securitizers would just stop their nefarious practice of stripping coupon and attach that interest to the first loss piece where it should always have been in the first place. Then, the bottom 5% would equal 5% of the value of the loans in the pool.

Disturbing, huh? And on so many levels.

First, this suggests that the regulators think that originators and securitizers can and should be responsible for stopping the business cycle and consequently loan losses are mostly attributable to bad underwriting which can be fixed by a strong regulatory whip hand. Regrettably, in the real world credit cycles are, well, cyclical. Securitizations, which typically have a term in excess of ten years, will see a full cycle. There is no way to make loans that are so good that they will all perform for ten years. The NPR suggests that the regulators think that’s tough nuggies and that if the originators and securitizers are sufficiently cowed by regulation, they will insulate investors from the cycle. Can not happen.

Second, the NPR suggests the regulators think if you put enough coupon on the B piece, it will trade at par and not at the deep discount common today. Wrong. This paper trades at a deep discount because of the likelihood of principal losses, not an inadequate coupon. See cycles, above. I cannot imagine how much coupon would need to be attached to the first loss bond to get a par bid, but it’s sure to God more than the excess coupons floating around your typical securitization.

In the real world, to get 5% of value in the B piece, the B piece would have to represent more than 10% of the total deal, probably penetrating into the investment grade certificates. What would this accomplish, that is, besides vastly increasing the cost of funds to the borrowers and materially impairing capital formation? We’re a touch light on B piece buyers right now. How many would we have if they need to buy 10% of the Pool? Buying that mezzanine paper is not the business model of the B piece investors and they will not want this paper. I simply don’t get it. To make this scheme work, both originators and investors would have to do things for regulatory reasons they would not do when following their economic best interest. Anytime both counterparties to a trade are doing things for purely regulatory reasons, something is deeply wrong.

Let’s put aside for the moment the whole notion of whether skin in the game has any science behind it (that train has regrettably left the station). Let’s also put aside that the CMBS market has functioned relatively efficiently. The losses in CMBS are not vastly disproportionate to the underlying performance value of the real estate markets. (It’s not resi, it’s not resi, it’s not resi.) We’ve got Dodd Frank and we’re stuck with it. Yet Dodd Frank leaves enough wiggle room for the regulators to craft regulations that are fundamentally aligned with how business is really done, and which, in fact, will improve investor protections and facilitate the successful and efficient operation of capital markets.

Dodd Frank gave the regulators the tools. The Congress recognized the need for flexibility with respect to CMBS. The statute included the concept of a qualified commercial mortgage which because of its relative conservatism would require no risk retention. The regulators gave us a box that’s so small that less than ½ of 1% of all deals done in the past ten years, would qualify. That’s silly. The legislation gave the regulators the opportunity to use high quality reps and warrants as an ameliorative factor for risk retention. This opportunity was completely ignored. That’s inexcusable.

Within the context of this law, the regulators should be using their regulatory power to improve the alignment of the interest of investors and securitizers. Look, investors are happy to take the risk of mortgage loans. That’s the business they’re in. What they cannot underwrite and where regulations can be useful is to protect against loans which are poorly underwritten, poorly documented and not properly and transparently disclosed. Now that’s a doable and estimable goal for regulation. That’s in the tradition of the Securities Act and the Exchange Act. Good regulation improving markets. This will not.

I think it’s fair to say what Congress intended was a regulatory regime that encouraged good underwriting of mortgages, an embrace of industry best practices, support for strong representations and warranties, and good disclosure. That would improve the efficacy and sustainable operation of the capital monies. That’s not premium capture.

Now, I kind of get how a retained interest by a sponsor or by a party whose business it is to take the enhanced risk of a first loss piece is a sort of short-hand for the protections promised by good reps, good underwriting and good disclosure. But risk retention ought to make sense in the context of how markets really function. If we’re going to honor Dodd Frank’s embrace of the B buyer as a risk retention modality, risk retention by B buyers has to make sense for the business plan of the buyer. That means the holder of the B piece should not be obligated to hold it forever, should be able to hedge and lever the paper. First, an investor will know if the originator and securitizer assembled a “good” pool within a couple of years at the outside. By that time, you know whether the loans were well-originated, well-structured and supported by good disclosure. Making the holder hold longer than that is to stick a B buyer with the consequences of the credit cycle. Second, why shouldn’t a holder hedge? Hedges represent investment and reflect competent management. Finally, the B buyer needs to lever to make its business model work. That market is non recourse. They need to volunteer for recourse to satisfy risk retention? That’s insane.

I am not sanguine about how we take the Risk Retention NPR forward and get to an outcome that enhances the alignment of interest between bankers and investors, and that improves the safe and efficient operation of capital markets. There’s just so many bad ideas and so many missed opportunities in the NPR and it just seems unlikely that the authors will be prepared to walk back on some of the more startlingly bad choices made.

But we don’t have much choice, right? We’ll do our best to engage and provide constructive comments before the (completely unrealistic) June 10th deadline. Once a final rule is issued, we’ll remain engaged and keep the conversation going until implementation confronts us sometime in the middle of 2013. What else is there to do?
 

By: Rick Jones

I was thinking back to the client event like this that we held in late September of last year in connection with an American Securitization Forum Sunset Seminar.  The theme at the time was largely the unintended consequences of the Dodd-Frank Act (which, at the time, we were all still trying to fully digest).  We've since commented on proposed regulations related to Section 943 (related to disclosure of breaches of securitization representations and warranties) and Section 945 (related to due diligence requirements) and have seen final regulations promulgated by the SEC on those rules.  More importantly, we have finally seen the multi-agency collaborative effort on proposed rules related to risk retention.  We spent weeks last fall agonizing over what the risk retention proposed rules might look like.  We then spent many more weeks early this year waiting for the proposal to finally come out.  Better late than never.  The proposal is far from perfect but at least it has finally arrived and we can get on with trying to fix it as best we can.

We hope to soon have some certainty on what the ground rules are so we can get the securitization business back in full swing.  There will be a lot of long industry-wide conference calls hosted by CREFC, MBS, SIFMA and ASF as we all come up with our wish lists of fixes to risk retention before final comments are due in early June.  I'm looking forward to our next client event when we all look back and congratulate ourselves for laying the groundwork for a market recovery.

By Ralph Mazzeo.

The proposed Rule, some 370 pages long, is an impressive, albeit deeply flawed, attempt to implement a law that we all knew at the time could not be implemented without a massive rule making lift. It is absolutely critical that the industry comment robustly and thoughtfully, and the regulators engage thoughtfully and with an open mind to make this complex and comprehensive set of regulations do the job intended by Congress while not fundamentally impairing the function of the capital markets.

Let’s go back for a bit of history. Risk retention was one of the hallmarks of the Dodd-Frank legislation. With the industry’s thanks, Senator Crapo was successful in ensuring some asset specific flexibility was baked into the statute regarding CMBS, particularly, the notion of the B piece buyer as an alternative to the simplistic vertical sponsor slice. (We, here at Dechert, have commented on this repeatedly in the past, including here, here and here.) There’s not much point on rehashing what was in the statute (and I promise not to give in to my strong impulse to again cry: “What were you thinking?!?”). We have 5% risk retention required by statute and, unless the statute is amended or repealed, we’ll have to live with that. What I want to do here is focus on how the regulators took that statutory guidance and are proposing flawed specific rules.

So here’s the takeaway:

• The 5% risk retention can be achieved in a number of ways, including a vertical, horizontal or L-shaped slice retained by the sponsor.
• This retained risk cannot be sold, levered on a non-recourse basis or, in many material respects, hedged.
• The 5% sponsor retained risk requirement can be reduced (at the discretion of the regulators) if the securitized loans meet prescriptive underwriting standards and adequate controls required by the proposed Rule. These underwriting standards and controls are very rigorous, and it’s fair to say that many loans that typically would be securitized in a conduit operation would not meet these standards. While the guidelines of a qualified commercial real estate mortgage meanders on for several pages, just look at some of the high points here: DSCR of at least 1.7 (for most properties), LTV of 65%, no subordinate liens on the property, borrowers who have not defaulted during a two year lookback period, etc., etc.
• The sponsor can share a portion of that risk retention with an originator who contributes at least 20% of the loans in the related securitization up to that originator’s percentage contribution (but remain “responsible” for the transferees’ compliance with the proposed Rule).
• The retention obligation can be met by a qualified B piece buyer in a qualified transaction. Here, the corset’s been tugged pretty tight. To qualify for the B piece buyer risk retention alternative, a number of criteria must be met, the most important is that the B piece buyer must retain the 5% on the same basis applicable to the sponsor.
• Curiously, the proposed Rule is silent on what happens if an Originator or B piece buyer fails to hold its position as required by the Rule. The sponsor must monitor and “tell” if its sees a violation. What then?
• An Operating Advisor will be required if the Special Servicer for the transaction is an affiliate of the B piece buyer, or, for that matter, to any other party to the transaction (curious that). Moreover, and I missed this in my first reading, an Operating Advisor must be appointed even if the Special Servicer is not affiliated with the B piece buyer if the B piece buyer has customary CCR removal rights over the Special Servicer.
• This version of an Operating Advisor is, compared to current 2011 practice, a Super Operating Advisor. The Operating Advisor can “recommend” removal of the Special Servicer if it concludes the Special Servicer is not doing an adequate job. I put “recommend” in quotation marks as that recommendation must be implemented unless each class of bond holders affirmatively votes to reject that advice. That’s a vote that will never happen (see here also for discussion on bondholder voting).

We’ll return to many of these points in more detail in subsequent commentaries, but fundamentally, two good questions here. First, does the Operating Advisor’s Special Servicer termination right really improve pool performance and is it really desperately wanted and needed by investors? Second, can you sell enough B pieces if the B piece buyer cannot be an affiliate of or control the Special Servicer? Good questions. The answer to the first is maybe. Unfortunately, the answer to the second is no.

Moreover, there are no rules to mediate how a regulator (or which regulator) can agree to a reduction of the 5% threshold based on these mitigants. How does one plan, absent some fairly mechanical relationship between the delivery of mitigants and the reduction of the risk retention?

Two last words on risk retention. First, if 5% risk retention is required across the board, borrowing costs are simply going to go up. Particularly in light of the complete absence of any compelling evidentiary basis for the assertion that risk retention means better loans, it’s sad to see us pour sand in the saddlebags of the commercial real estate industry just when an expansion of credit is so critically important. (I said I wasn’t going here, but, oh well). Second, none of this applies to the GSEs, at least in their conservatorship. Now there’s a shocker.

Finally, even though this commentary is CMBS specific, I cannot talk about the new proposed Rule without mentioning the Premium Capture Provision. Yikes! They can’t possibly be saying that one may not earn a profit in securitizing loans, can they? Capitalism anyone? This is the ultimate above-the-fold headline for this regulatory Nantucket Sleigh Ride. This provision actually says that securitization cannot occur at a price above the outstanding principal balance of the loan plus costs.

I get where this came from. The regulators were concerned that somehow the 5% retention would be subverted through the unseemly earning of a profit. In this through-the-looking-glass world view, profit and capital are conflated and somehow banks will still do business for free! There is also a notion, current in regulatory circles, that securitizers don’t make conservative loans at low coupons because the securitization of those loans produces diminished profits, whereas securitization of really bad loans with high coupons produces high profits. That is clearly not true, but an ideological commitment to that notion is the underlying genetic material from which these provisions were birthed. The headline, of course, is that: “Government Ends Securitization Business, Capital Markets Starve for Capital”.

Certainly, this notion will be mediated as the comment period progresses, although I am very fearful that conversations will be captured in a price control dialogue where the regulators’ response to said headline is OK, we’re not offended by profits, just by excessive profits. Let’s discuss how much profit is acceptable. That path leads to damnation. Price controls never work, but their appeal never seems to fade away.

Enough. We have 60 or 70 days to comment, and then 2 years before implementation. A lot of deals and a lot of palaver (not to mention a Presidential election) will pass over the dam between now and then. The industry has to act, make its case, engage honestly, openly and transparently, and move this regulatory framework to a place that delivers on the promises made in the law in a way that permits capital formation to continue to flourish. It can be done.

By Rick Jones.

Congressman Garrett noted in his remarks that the portfolios of the GSEs are a combined $1.5 trillion-- a book with a lot of interest rate risk and a lot of unrealized gain. He said this portfolio needs to be unwound sooner rather than later. He wants to see the GSEs on the federal budget-- on the books of the U.S. government-- and he noted that in private industry, there has been a movement toward on-balance sheet and questioned why this wasn't so in Washington.

Knowing his audience, he stressed that securitization has to play a huge, vital, integral part in the resurrection of the mortgage market, and he said that securitization is vital to the movement of capital around the country. He noted the unsustainability of FHA insuring 50% of new originations and the government underwriting 95% of the mortgage market. The Congressman stated he is firmly committed to a purely private U.S. mortgage market over time, free of government subsidies or guarantees. He acknowledged concerns associated with a purely private market but also said there are competing concerns with models that include government support.

Addressing assertions from critics, the Congressman asked whether home price increases and higher down payments would be so bad (possible results of the 30-yr fixed rate mortgage not surviving without a government guarantee). He questioned whether the government is able to price catastrophic credit risk and pointed to a shoddy track record. He posited that there are other ways to keep a TBA market viable aside from a government guarantee and noted that the government steps in at the end of the day perhaps because it is allowed to, and that allowing it to increases the chances the government will do so. He noted that a discussion of servicing standards in connection with QRM never came up in crafting Dodd-Frank and suggests regulators not take the servicing issue into account. In the Risk Retention breakout session later in the morning, Tom Boemio (Sr. Project Manager, Policy, Board of Governors of the Federal Reserve System) concurred and asked: Why have servicing standards in connection with the highest quality loans only-- and not the rest?

The Congressman said there is no role for government assistance except in connection with first-time home buyers, and such assistance should be on-budget and transparent. Finally, he said that the government has to play a big role because the private sector isn't-- the old chicken-egg thing. [His prepared remarks can be found here].

At the February 7 General Session that followed, Martin Hughes of Redwood Trust further addressed the chicken and the egg issue noting that "uber government support is stifling the return of private securitization." He acknowledged that government bids are attractive and there's been no incentive for banks to sell to non-agency, and that reducing the government's role would be a game changer. Addressing the circular problem, he did note that if the government backs out before the private sector is up and running, there are sure to be problems but he suggested the status quo needs to be tested. Stating that "issuance velocity leads to issuance velocity," he also noted there are too few prime loans to get real issuance velocity. Hughes agreed that, yes, investors are mad, and investors have demands and opinions with respect to servicing practices but he believes those demands can be met and that prime jumbo can have safe attractive yields.

Hughes summarized the general sentiment by stating we need the new rules of the road-- final rules so that market participants can adapt and move ahead-- because uncertainty has been an enormous headwind. And we have uncertainty as to what the rules are and, in addition, how those rules are to be interpreted. Stay tuned for more from ASF.

By Laurie Nelson.

An issuer has strict liability for misstatements and omissions in a public deal. So what’s really added here?  An issuer can now be liable for bad disclosure about the nature of its diligence process or if its diligence failed to provide “reasonable assurance” that the disclosures were “correct”.  Now that’s new and different!  I don’t know what “reasonable assurance” means, but I suspect if we round up the usual suspects at the trial bar, they will tell us it means something, by God!  One more count in every complaint!

This only applies to registered deals and in the CMBS space registered deals are beginning to look like the dodo.  But the SEC staff mused in the preamble to the Rule that a similar regulatory regime for the 144A market might be appropriate and they’re a fixin’ to think about it.  Joy. 

Also one should not discount the argument that, as the SEC has concluded that this information needs to be provided to meet its standards for adequate disclosure, mischief could be concocted by our usual suspects right now.  If this disclosure is appropriate in 2012, why not now?

Another new rule, Rule 15Ga-1 (release here (pdf)), is more straightforwardly and more immediately problematic.  Rule 15Ga-1 requires an issuer to disclose, in a very complex and burdensome way, its past history of demands for the repurchase of assets -- successful, unsuccessful or otherwise -- for breaches of representations and warranties on pool assets.  The SEC is also requiring, in Rule 17g-7 (released with Rule 15Ga-1 above), that rating agencies include in their reports a description of the issuer's reps, the enforcement mechanisms to address breaches and how each differs from such provisions in "similar securities".

All this kicks in by the first quarter of 2012 as well, and it applies to all securitizations, public and private. SIFMA, in its comment letters on these rules (available here and here) stressed how burdensome this was, how little actual probative information it would deliver to investors, by giving investors data about unrelated asset classes and unsuccessful or even unpursued claims, and how, at least in CMBS, put-backs were really extraordinarily rare in any event.  And what in the world do rating agencies do with a "similar securities" standard?

All for naught.  We’re now going to have to learn to live with this.  Note how extraordinary it is that issuers of private 144A deals will now have to make public filings.  If that doesn’t blur the distinction between the public and private markets (which I sort of think is what the SEC has in mind), what does?

While Rule 15Ga-1 doesn’t kick in for a year, this will cause issuers a very substantial amount of work, starting now, to get ready for next year.  Below the Rule's headlines, a lot of detailed compliance and mechanics questions will need to be answered in the process.  How comforting that the Rule contains an analysis by the SEC of its expectations of the cost of compliance.  And here’s the headline: the compliance costs won’t be bad at all!  It makes risible reading.

Beyond the additional costs, extra work and potential liability imposed by these Rules, which are bad enough, this first batch of Dodd-Frank regulations tells us that complying with the fullness of Dodd-Frank is going to be a lot worse.  In a significant way, Dodd-Frank was built on the basis of unsupported conjecture, received wisdom and ideological certitudes.  Dodd-Frank booted much, if not most, of the actual sausage-making to the reconciliation and launched dozens of regulatory processes. 

The regulatory handcuffs will magnify the underlying subtext of Dodd-Frank - that we have insufficient regulatory restraints on the behavior of market participants and we need more to avoid a return to the edge of apocalypse.  Regulators will regulate.  Close calls and unclear, skeletal legislative direction will be settled in favor of more, not less. 

Consequently, the industry faces a daunting rear guard action in the 112th Congress to try to mediate what will likely be excessively burdensome and intrusive rules.  No matter how well this goes, capital formation will get harder and more expensive.  Will all of this really help investors and prevent irrational exuberance and excess?  

At least in CMBS, I think not. It’ll make some trial lawyers happy, though.

By Rick Jones.

Last night Dechert welcomed over a hundred clients to DC Coast for dinner and cocktails - the room was filled with participants from every corner of the industry. The general atmosphere of the event was certainly more optimistic than in previous years - there's a definite sense that the industry is getting back to work.

Today's events rounded out with a forum on Financial Reform and Legislative Proposals (Rick was among the panelists) and a brief speech from Senator Chuck Schumer. These programs were well attended - the Government's regulatory framework - Dodd Frank, GSE reform, covered bond legislation - were the central topics of interest this year. The clear takeaway from this session is that we are no closer to a cogent regulatory scheme than we were last year (and may be further away given the recent power shift in Congress).

By:  Matt Clark.

CREFC President Lisa Pendergast opened with a warming message to attendees highlighting the great work CREFC and its members have done during the past 12 months, making special note of the commencement, in earnest, of the "healing process" of our industry that is now in full effect.

The important work that CREFC's members do for our industry should be noted. DC is a particularly appropriate venue for this year's conference. The work CREFC has accomplished on behalf of the mortgage industry in Congress - specifically as it relates to Dodd-Frank - has been critical. Moreover, the work of the CREFC Task Forces (literally hundreds of industry participants motivated solely by a desire to shape CMBS 2.0) has made amazing progress in developing best practices for Loan Underwriting, Representations and Warranties, PSA's and Annex-A’s.

The conference now underway, we will certainly be posting more as the conference develops.
 

By: Matt Clark

Section 942

Generally, the disclosure requirements of Dodd-Frank Section 942 overlap significantly with the SEC’s proposed rules to revise Reg AB.

Causing a recent stir is Section 942(a) of Dodd-Frank which amended Section 15(d) of the Securities Exchange Act (the “Exchange Act”) to exclude ABS, as defined in the Exchange Act (a definition that is more broad than the Regulation AB definition), from the automatic suspension provisions of 15(d). Prior to enactment of Dodd-Frank, Section 15(d) automatically suspended the duty to file ongoing Exchange Act reports after any fiscal year other than the fiscal year in which the related registration statement became effective - if the securities of each class to which the registration statement relates are held of record by fewer than 300 persons. As a result, for most issuers of ABS, Exchange Act reporting obligations suspended after the filing of one annual report on Form 10-K. Dodd-Frank Section 942(a) further authorizes the SEC to suspend or terminate Section 15(d) reporting requirements for any class of ABS on such terms and conditions and for such periods as the SEC deems appropriate.

The SEC is proposing in new Exchange Act Rule 15d-22(b) to permit suspension of the reporting obligations for a given class of ABS pursuant to Exchange Act Section 15(d) for any fiscal year, other than the fiscal year within which the registration statement became effective, if, at the beginning of the fiscal year, there are no longer ABS of the class that were sold in a registered transaction held by non-affiliates of the depositor. The SEC is also proposing to update Exchange Act Rule 15d-22 to indicate when annual and other reports need to be filed and when starting and suspension dates are determined with respect to a shelf takedown, and is proposing to amend Exchange Act Rule 12h-3(b)(1) to exclude ABS from the classes of securities eligible for suspension since Rule 12h-3 tracks the language of the Exchange Act. Comments to the SEC pertaining to the proposed rules are due on or before February 7, 2011.

Note that on January 6, 2011, the SEC issued a “no-action” letter to the American Securitization Forum (“ASF”) confirming that the SEC staff would not recommend enforcement action if an ABS issuer continues to determine whether its reporting requirements for existing transactions are suspended based on the standards of Section 15(d) prior to the enactment of Dodd-Frank. The “no-action” relief is subject to certain conditions.

Dodd-Frank imposes no rulemaking deadline in connection with Section 942.

TITLE II – Orderly Liquidation Authority

You may have happened upon my December 13, 2010 blog entry addressing concerns about FDIC treatment of preferential transfers under the Orderly Liquidation Authority (“OLA”). Since then, on December 29, 2010, the FDIC issued a letter from the FDIC General Counsel addressed to the ASF concluding that the treatment of preferential and fraudulent transfers under the Dodd-Frank OLA provisions was intended to be consistent with the related provisions under the Bankruptcy Code, and indicating that a formal regulatory resolution to the issue will be addressed by the FDIC Board of Directors. The FDIC published an NPR on October 19, 2010, with a deadline of November 18, 2010 for comments addressing the proposed rule and January 18, 2011 for comments on additional questions. Final rules are expected to be released by the FDIC in March 2011.

Coming any day now…

Section 945

Here’s a hot button topic. Section 945 of Dodd-Frank (amending Section 7 of the Securities Act of 1933) states that the SEC shall issue rules relating to the registration statement required to be filed by any issuer of an ABS (as defined in the Exchange Act) that require such issuer to perform a review of the assets underlying the ABS and to disclose the nature of such review.

On October 19, 2010, the SEC published an NPR and comments were due November 15, 2010. In addition, the SEC proposed a new rule and form to implement Section 15E(s)(4)(A) of the Exchange Act, added by Section 932 of Dodd-Frank, which requires an ABS issuer or underwriter to make publicly available the findings and conclusions of any third-party due diligence report.

The SEC final rule is due by January 17, 2011 (within 180 days after the date of Dodd-Frank enactment).

Section 943

Another hot button topic and another SEC final rule due by January 17, 2011 has to do with representations, warranties and repurchases in connection with ABS. In accordance with the requirements of Dodd-Frank Section 943, the SEC’s proposed rules would require ABS issuers to disclose fulfilled and unfulfilled repurchase requests across all transactions. In addition, they would require nationally recognized statistical rating organizations to include information regarding the representations, warranties and enforcement mechanisms available to ABS investors in any report accompanying a related credit rating, including a preliminary rating. The SEC’s NPR was published on October 13, 2010 with a comment deadline of November 15, 2010.
Dechert LLP worked with the Securities Industry and Financial Markets Association’s Securitization Group drafting two comment letters to the SEC in connection with Dodd-Frank Section 943 and Section 945 (the two comment letters can be found at: http://www.sec.gov/comments/s7-24-10/s72410-33.pdf and http://www.sec.gov/comments/s7-26-10/s72610-30.pdf).

Section 941

Credit risk retention. Speaking of hot button, even my mother called me to ask about this one, and I sensed she was somewhat zoned out listening to my explanation until I mentioned “skin in the game” at which point she perked up and said, “That’s what I read-- that phrase.” We can pretty much count on skin covering at least 1/3 of the torso. (Is that a horribly inaccurate 5% estimate?) Here’s where we’re at insofar as risk retention rulemaking is concerned. Numerous acronyms are on this one, including the SEC, OCC, FDIC, HUD, FHFA and OTS to name a few. The SEC plans to propose rules (jointly with others) regarding risk retention by securitizers of ABS as well as implement the exemption of qualified residential mortgages from the risk retention requirements between January and March 2011 (see SEC rulemaking timetable at: http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#0910). The final rule is due by April 17, 2011 (within 270 days after the date of Dodd-Frank enactment). However, the buzz is that risk retention rulemaking will be delayed.

Section 621

I’ll leave the Volcker Rule for another day (because, frankly, I’m hungry) and conclude with Dodd-Frank Section 621, the intent of which is to eliminate incentives for securitization market participants to intentionally design ABS to fail or default. Section 621 adds a new Section 27B to the Securities Act of 1933 entitled “Conflicts of Interest Relating to Certain Securitizations.” Section 27B(a) states that “[a]n underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security . . . which for the purposes of this section shall include a synthetic asset-backed security, shall not, at any time for a period ending on the date that is one year after the date of the first closing of the sale of the asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.” An NPR is expected to be released by the SEC any day now. Final rules are due by April 17, 2011. Recognizing that many potential and actual conflicts of interest are inherent in the ordinary course of securitization transactions, comment letters were submitted to the SEC by industry trade groups specifying conflicts of interest that should not be expressly prohibited under Section 621.

As the Muppets have sung, things are Movin’ Right Along.
 

By Laurie Nelson.

Before we do, though, I thought it might be instructive to look back a bit at the headlines of 2010 so that while we embrace exuberance again, we at least have some context to measure its irrationality.

With some nod to chronological order, here is a snapshot of the year’s Headlines:

• The Last Lingering Marquee Names of the Late Lamented Boom Finally Go!
• All the Marquee Names from the Late Boom are Rehired in Droves
• The Street Resumes Lending, Conduits Begin are Back
• Legacy CMBS Spreads Tighten
• Special Servicing Cohorts Reach New High Watermark
• Big Lifeco’s Step Up on the Biggest and Best Class A Deals
• GGP, GGP, ESH, StyTown, Hilton, Stations Crossing, etc., etc.
• Hope Note Workouts Panned
• Chinese Banks Enter Market
• Chinese Banks Enter Market
• Chinese Banks Enter Market
• Chinese Banks Enter Market
• The Repo Market Returns
• Elliot, H2 and Others
• New B Buyers Gear Up, Some Old Friends Return
• Dodd-Frank, Reg AB, 17(b)-5, FDIC Securitization Safe Harbor, Risk Retention, etc.
• It’s Finally Fall and the Crap Conduit Pipelines of the Spring Begin to Get Real
• Major Banks Return to the Fray
• The Street Begins to Buddy Up for Conduit CMBS Deals: Goldman, Citi, JP Morgan, Deutsche, Wells, BofA, UBS
• JPM Tops Lender and Bookrunner Rankings
• The Republican Congress Finally Sits Down

There is my, admittedly, idiosyncratic snapshot of a year’s worth of headlines in our little corner of the capital markets. Market pros are back in seats and have been given balance sheets to lend. Investors will buy bonds at prices that incent borrowers to borrow. There’s appetite in the investment grade and there’s appetite in the B-note sector. With interest rates benign and borrower refi needs growing, the first loan and mezzanine lending businesses are off and running. Most of the usual suspects are back in the game. The last few will join early in 2011, but, boy oh boy, watch out for China. After the year’s worth of breathlessly dramatic, often buried and awfully unthoughtful (and bone headedly insensitive to collateral damage), regulatory action, we are still in business. With a Republican Congress, there’s some hope that some of the more addled regulatory output brought to us by a panicky political class certain that we were circling the toilet bowl of the apocalypse can be ameliorated.

Notwithstanding all of the noise, the CMBS structure performed pretty well in the crucible of enormous financial strain resulting from real estate values in free fall. It will serve as a robust basis for capital formation in 2011. The warehouse financing market is back and back in a big way, with sufficient volume to meet the needs of asset accumulators. Once again, the memories of the pain of borrowing short and lending long will be suppressed. See above.

Living through 2010, it seemed pretty choppy. Looking back, it seems easier, somehow, to compose a narrative of a market well along the way to repair. You know, on reflection, I can barely remember how awful 2007 through 2009 really felt. I’m so over that. Thankfully, those who forget the past are condemned to repeat it. Otherwise, markets and we humans would have died out years ago. Let’s hear it for animal spirits in 2011.
 

By Rick Jones

WHAT? The Reform Act’s “Orderly Liquidation Authority” (“OLA”) provides that if the FDIC is appointed as receiver of a “covered financial company,” the FDIC has the power to void transfers, preferential as well as fraudulent, such that security holders end up left with an unsecured claim in the FDIC receivership if the security interest in the assets was perfected solely via UCC filing (and not, for example, by possession or by filing plus stamping)-- a different result than under either the Bankruptcy Code or, in the case of a bank, the Federal Deposit Insurance Act.

WHERE? Here.

WHEN? Now.

WHY? It has been noted by industry trade groups that the above-described outcome is most likely the result of an unintentional drafting error caused by trying to combine into the OLA section of the Reform Act both Section 547 and Section 548 of the Bankruptcy Code. Industry trade groups plan to meet with the Senate Banking Committee and the House Financial Services Committee, speak with the FDIC, and submit a comment letter under the October 19, 2010 FDIC NPR which asks for comments on the FDIC’s avoidance powers under Section 210 of the Reform Act.

HOW does this affect ABS transactions? Affected securitizations would, for the most part, include auto or equipment loan/lease (and certain student loan) securitizations. The underlying assets in these types of securitizations are generally characterized as “chattel paper” or “instruments” under the UCC and therefore the security interest may have initially been perfected solely by filing a Form UCC1. The problem arises when ultimately, under the UCC, a “bona fide purchaser” of the collateral trumps earlier perfection that was accomplished via UCC filing. This would not be the result under the Bankruptcy Code.

The legislative history and the FDIC’s October 19, 2010 NPR suggest that creditors should be similarly treated under the Bankruptcy Code and the OLA provisions. Further, no public policy supports such a distinction. Still, without further guidance, legal counsel will not be in a position to give a legal opinion as to whether a transfer could be avoided as a preference under the OLA or whether any given financial company could be determined to be a “covered financial company.”

As the musical group Bowling for Soup has sung, there will be No Opinion.

By Laurie Nelson.
 

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.