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Formulating the rules to implement the Dodd-Frank Act has proven to be challenging. Regulators both missed and moved deadlines to accomplish this monumental task.
For the securitization industry, this means ABS issuers will have to deal with the uncertainty until these market-changing regulatory issues get mapped out.
According to Dodd-Frank language, regulators are required to implement the rules 270 days from the passage of the act, which means an
Despite the delays in the risk retention rules, for instance, there hasn’t been a rush by issuers to get deals done ahead of regulations. However, industry players believe that once regulators map out the parameters for securitization, this will likely lead to greater issuance volumes.
“As rules come out, there is always a problem with interpretation, so there is a concern that while most of the provisions won’t have retroactive implications, there could be an impact even on the future transfer of assets with respect to existing securitizations – such as revolving structures,” said
Kohler also believes that the reason regulators want to include servicing provisions in with risk retention is because they are following the chronology of what happens in a mortgage securitization.
“Their first mission was to fix the origination and underwriting functions. Then they realized there were real problems in the servicing area,” he said. “Once they get past servicing, it’s likely they will find that there is still a huge problem because issuers need a balance sheet to place long-term mortgages on.”
Before the mortgage crisis, long-term conforming mortgages were held on the GSEs’ balance sheets, which were effectively placed in the capital markets as GSE securitizations. For private-label deals, investors around the world bought up the different tranched-up pieces. However, since tranching is currently disfavored, the industry must now find investors who want to take on that long-term risk.
“The people who used to do it before – the hedge funds of the world, the pension funds – are much more risk averse,” Kohler said. “It could be that once they get past the servicing issue, they could find that no one will want to buy these loans unless the mortgage rates are at least multiple percentage points – not basis points – higher to incentivize new institutional investors to take mortgage loans and mortgage securities on their balance sheets for an extended period of time. Banks themselves through Dodd-Frank and Basel III are seeing their capital requirements increased for holding mortgage loans and securities, so whatever appetite they had for long-term investment will be decreased.”
Kohler believes that, at some point, there will be enough impetus to do deals from an economic standpoint, and when market participants are chomping at the bit to do a securitization, they will have to figure out how much future uncertainty they are willing to live with.
This uncertainty plays out more on the mortgage side versus the auto sector, where deals continue to get done. “The uncertainty around these issues is a real factor if you are trying to figure out how to restructure your business and what your strategy will be going forward,” said
He added that “the uncertainty plays more on when people plan on where they will make investments, and the bigger issue is around mortgage loans. Dodd-Frank will push some consumer financing out of banks to nonbank entities like REITS, hedge funds and private equity funds – various different kinds of financing entities that are not regulated as banks. Dodd-Frank adds a lot of cost to securitization, but more cost in the banking sector than elsewhere.”
The long-term effect of that, according to Marlatt, is that some business will be taken away from banks. “It’s hard to start up these new companies when regulations haven’t settled yet, delaying some of the movement away from banks; that development will start to accelerate when rulemaking settles down,” he said.
As a result, Marlatt said that MBS investors are also taking a “wait and see” attitude on how things will play out. “They will be looking for more return, and that has not connected in the marketplace yet to find a market clearing spot between the added costs on the origination side and the added yield that one would assume investors will be looking for going forward to compensate them for the greater risk than they thought they had in the last round,” he stated.
The only source for yield and the only way costs on the issuer side can be covered is from the interest rates on the mortgage assets. “Right now interest rates are so low there wouldn’t be enough money in the available interest rate to cover the expenses and added yield, which is one of the reasons why you don’t see people feeling really compelled to get deals done,” Marlatt said. “If mortgage rates were higher and people could see how all those costs and yields would fit in, it would make a deal materialize to a much quicker and greater extent.”
Risk Retention, No Deal Breaker
The good news is that the risk retention requirement will not preclude issuers from securitizing.
“It won’t be a deal breaker in all cases,” said
In credit card deals, for instance, there is less concern because inherent in those programs is the requirement that the sponsors retain at least 5% of the receivable pool.
Most sponsors retain the first-loss position and, in the case of credit card and floorplan trusts, a representative share of the collateral via the seller interest. Additionally, most ABS sponsors have multiple funding sources to finance the retained position in a securitization, said
A concern is the effect the risk retention requirement will have on sponsors who are hoping to get off-balance-sheet treatment. The proposed 5% requirement could stress the ability to get off balance sheet and GAAP accounting treatment, but in many cases securitization issuers are no longer eligible for off-balance-sheet treatment to begin with.
Some Clarity on Risk Retention
Risk retention under Dodd-Frank requires securitizers to hold not less than 5% risk retention in any ABS that they sell out into the market. The rule also asks that regulators prohibit sponsors from hedging this risk and from transferring it to anyone else.
The measure, requiring lenders to have “skin in the game,” is meant to help reform the securitization market, protect the public and the economy against irresponsible lending practices and facilitate economic growth by allowing for safe and stable credit formation for consumers, businesses and homeowners.
The rules are written jointly by six regulators, which include the
As required under Dodd-Frank, the
The Board also stated that “this approach is consistent with the flexibility provided in the statute and would recognize differences in market practices and conventions, which, in many instances, exist for sound reasons related to the inherent nature of the type of asset being securitized. Asset-class-specific requirements could also more directly address differences in the fundamental incentive problems characteristic of securitizations of each asset type, some of which became evident only during the crisis.”
The agency also discussed the minimum servicing requirement for QRMs. According to an
The servicing requirements included in the
In its proposal on risk retention released last Tuesday, the
The proposal also laid out seven options for how a sponsor could structure risk retention. These alternatives include a so-called “vertical slice,” in which a sponsor holds 5% of each tranche in the securitization. Alternatively, sponsors can also hold a “horizontal” piece, in which their first-loss position would be on the whole securitization. A third option would involve sponsors taking an “L-shaped interest,” in which the 5% interest would be split 50-50 between a vertical slice and horizontal loss position.
While the GSEs are under conservatorship, their risk retention is covered by the guarantee, which is about the best risk retention that could be had, said an
During the call, the
“It’s been there all along, just in a different form,” an
The official added that the way the market applied risk retention was not working. This is why the
“The overall discount being applied here should not be significantly higher than what was applied to the more stabilized market prior to the bubble,” the official said.
There are certain exceptions to risk retention requirements, the primary one being the QRM. This standard, the same
“By being conservative and by being prescriptive, they are easily understood and will help make the whole process more transparent,” the official said.
The primary characteristics for a QRM rely on the borrower’s debt-to-income ratio calculated both on the front end, where the household debt and all costs associated with the home should be 28% of the borrower’s income, and the back end, which comprises all other debt that should be calculated at no more than 36% of a borrower’s income. Aside from requiring a 20% down payment, the borrower cannot have a 60-day delinquency on any debt obligation within the past two years. A maximum 80% LTV would be required to purchase a home.
As such, the risk retention exemption will apply to only the most conservative underwriting standards and will leave out a long list of products such as negative amortization, interest-only payments or significant interest rate increases that add risk to mortgage loans.
According to a report in ASR sister publication American Banker, regulators will also consider possible alternatives to the QRM.
The report said that they will find out whether the proposed definition is too narrow and suggest at least two alternatives. Under one plan, regulators would create a second class of loans that are exempt from a 5% risk retention requirement but include at least some risk retention amount between 0% and 5%. Under another plan, regulators can broaden QRM criteria to capture more loans but enforce a tougher risk retention requirement for loans that fall outside that status.
Rep and Warranty Issues
The underlying securitization documents have a provision that requires the seller to repurchase assets in the event of a breach of rep and warranty.
Under the Dodd-Frank regulation on reps and warranties, the securitizer needs to disclose all instances of such repurchases. In terms of how reps and warranties will affect the marketplace, most of the discussion has been about how to comply with the disclosure requirements and how to report the repurchase history on the different types of deals issuers have done. There also remain questions regarding categorization of transactions when disclosing repurchases by asset class.
For many securitization asset classes aside from residential mortgages, repurchases just do not happen. Moreover, for a number of asset classes there has never been an instance of repurchase. However, the rules do require that these issuers still have to make a disclosure and then once a year state that they have not made a repurchase. “The one area where the rep and warranty repurchase rules might be a deterrent is for issuers that fund only through asset-backed commercial paper conduits,” Chapman’s and Cutler’s Marin said. “Issuers who have never before been required to submit filings with the
Many commentators have opposed the Reg AB II formulation and, in fact, have proposed an arbitration procedure as the principal alternative advanced by the industry, which they say is more workable and fair.
Structural improvements on the arbitration for breaches of representations and warranties, as used in
According to a note published by Fitch Ratings, if there is a breach that the seller cannot cure, the seller is obligated to repurchase the loan no later than 120 days following discovery of the breach. If a resolution to a breach is not satisfactory to both the seller and the originator, either party may enter into arbitration. The finding of the arbitrator shall be final and binding upon the parties.
“The item that is mentioned by Fitch as a positive in the repurchase area is a glass half full or half empty, depending on who is looking at the glass,” Kohler stated. “Fitch applauds the repurchase procedure for its clarity in setting forth who has the right and obligation to review defaulted mortgage loans for rep and warranty breaches, what the time frames are and what the procedure is for resolving disagreements – mandatory arbitration.”
But the Redwood approach is less favorable to investors than the process specified under the proposed Reg AB II for deals done off shelf registration statements (as the Redwood deals are), in which an issuer must repurchase a loan unless an independent third-party reviewer actually issues an opinion that there was no breach of a rep and warranty. “Given the likely difficulty in obtaining such opinions, and the fact that the Reg AB II procedure does not seem to leave room for a settlement or compromise that one might achieve in arbitration, the proposed Reg AB II procedure seems heavily weighted in favor of investors,” Kohler said.
The good news is that the issue of reps and warranties will likely be an aspect of Dodd-Frank that the industry will be able to deal with and will not be a major deterrent to securitization. However, a market with limited deal flow has provided little impetus for issuers to get any further on the issue of repurchase reporting.
“My sense is that we are not even on the verge of doing more deals – people are trying to get a game plan together but are not devoting effective resources yet,” Kohler said.
Disclosure Under Dodd-Frank
Many provisions that relate to disclosure in Dodd-Frank are still up in the air, including that required by Section 943 under Rule 15-Ga-1 that requires ABS issuers to make quarterly disclosures of all fulfilled and unfulfilled asset repurchase requests for all of the securitizer’s Exchange Act ABS trusts. These rules apply to all issuances of Exchange Act ABS, both public and private, with initial disclosure for all issuers that issued and sold such ABS in the three-year period starting
“It depends on whether an issuer has been active in the securitization markets,” he said. “The key point is for those who have exited the business and haven’t done a deal in three years – getting the data out there might be troubling.”
Meanwhile, MoFo’s Kohler said that deals like
The market also has outstanding questions relating to Section 942 of the Dodd-Frank Act. Section 942(a) eliminated the automatic suspension of the duty to file under Section 15(d) of the Securities Exchange Act of 1934 for ABS issuers, although granted the
Meanwhile, Dodd-Frank Section 942(b) directs the
“So it’s as if it’s in suspended animation,” Kohler said. “The
Due Diligence Reviews
Section 945 of the Dodd-Frank Act added a new Section 7(d) to the Securities Act. Under this new section, the
The agency has adopted Securities Act Rule 193 to implement Section 945 under Dodd-Frank. This section requires ABS issuers to perform a review of the pooled assets that underlie the ABS. Rule 193 applies only to issuers of Exchange Act ABS offered in registered offerings. This rule allows issuers to engage another third party to perform any part of the required review.
Aside from these, there are several items that remain unclear regarding how to conduct these required asset reviews, Nunes said, including the disclosure around the characteristics of the assets, how to provide conformity of the assets, the compensation factors and the breakdown of the assets.
There are also questions, he said, around the reviewer’s liability and full responsibility, specifically about how that liability shakes out.
Nunes added that further clarity is also needed in terms of the standards – who is obligated to provide the data and guarantee the data’s timeliness. “We need to be really clear about the data elements,” he said. He added that the market is still trying to figure out what the levels of review are supposed to be, which includes finding out the differences between self-review and unaffiliated party review. “The separation of the duties of the third-party review improves reliability,” he said.
Additionally, he said that “the framework associated with the agent’s role, we still don’t have enough details about that.”
There are also questions about the sample size to be disclosed in a prospectus. “If the sample review size is too small, it could raise questions about the quality of the assets,” Nunes said. On the other hand, he noted that if the sample size is too large, “there are cost and time issues. It’s all about finding that right balance.”
He added: “If there is clarity on the protocol that is visible to all parties, you could manage risk better in terms of the quality at the point of origination and ongoing monitoring.”
CMBS 2.0 Looking for Exemption Too CMBS 2.0 Looking for Exemption Too
Last week the
The CREFC is hoping that its new set of CMBS standards will provide support to regulators as they work to implement the Dodd-Frank Act’s goal of better aligning the interests of investor and originator in the securitization market.
“The biggest concern we have as an association is crimping the availability of credit to the commercial real estate market,” said
Under Dodd-Frank, risk retention for commercial mortgages can be satisfied in a number of ways, including one or more of the following: “adequate” underwriting standards and controls; “adequate” representations and warranties and related enforcement mechanisms; and a percent of the total credit risk of the asset held by the securitizer, originator or a third-party investor.
The CREFC initiatives specifically address the Dodd-Frank mandate for commercial mortgages by creating standards for use in the market immediately while retention rules would not go into effect for an additional two years after they are finalized, or
One of the new standards’ goals is to create models for representations and warranties in an effort to have specific, uniform disclosures about the quality of loans and the underwriting principles behind all deals. The CREFC’s Model Representations and Warranties and Model Repurchase Remediation Language initiatives provide consistent and enhanced assurance by originators and issuers for their underwriting standards and loan quality as well as an efficient dispute-resolution mechanism for representation and warranty breaches.
“In the past, representations and warranties were unique to each deal,” said
The aim of these enhanced safeguards is to promote certainty and confidence in the commercial real estate finance market, which has already received some criticism over the slipping of standard in some of the latest 2011 vintage deals that have come to market.
“We believe CREFC’s standards are consistent with the risk-retention provisions in Dodd-Frank and go beyond the required government directives to improve transparency and promote a strengthened foundation,” said