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Retention rules might not be best alternative
Asset Securitization Report
December 1, 2009
The House of Representatives is set to debate and vote on its regulatory reform package this week. The proposed legislation includes several bills that address issues important to securitization, including the risk retention on sales and securitizations of mortgages. A similar proposal is also pending in the Senate dealing with this "skin in the game" issue. Although the House of Representatives amended its version of the financial regulatory reform bill by reducing the maximum retention, or skin-in-the-game, requirement to 5% from 10% in the middle of November, ABS market players said that this will still unduly constrain consumers' access to credit. "The auto loan originators may already have retained risk on the assets because of short-term financing arrangements prior to securitization:" said Ralph Mazzeo, a partner at Dechert who focuses on structured finance and the capital markets. Auto and credit card assets also need to meet the eligibility tests for inclusion in a securitization. This is why, he explained, these issuers already have more incentive to have better underwriting across the board.How the retention rules would be applied is still not clear from the proposals. "It would not be appropriate to apply this policy to whole loan transactions:" said Dechert's Mazzeo. He said that because the originator and then the purchaser will be holding these loans on balance sheet, there is already an incentive to have better underwriting standards. "You might have heard on the residential side that some community mortgage bankers have said that applying the retention rules to whole loans will completely devastate their business." Strengthening of the reps and warranties in the transactions might have had limited application previously because of the problem of implementation. "On the RMBS side, one problem has been that the reps and warranties did not have an effective enforcement mechanism, who was going to police if they were breached and follow up on repurchases by the originator:" Mazzeo explained. "Some market participants have suggested that there is a need for a dedicated third party in future deals charged with monitoring and enforcing breaches." He added that the ASF and other trade groups have focused on this issue and are evaluating how the reps and warranties and related enforcement provisions may be improved.
Richard Jones, partner and co-chair at Dechert's finance and real estate group, said that, "in CMBS, the B-piece buyers are very aggressive and can throw loans out of pools. They make sure that they are getting quality to ensure they earn a return on their investment at the bottom of the capital stack." Jones said that the market should be more confident in the credit judgment of these first-loss investors because they are entirely focused on credit performance, while issuers have other economic reasons for doing a deal. There has even been some interest in enhanced reps and warranties in CMBS. However, Jones said that in CMBS transactions, the reps and warranties have always been robust. "I don't think there's a magic bullet to prevent lenders from making bad loans or to stop borrowers from taking on significant amounts of debt in a frothy economy." He added that for the next several years, however, the market would likely remain prudent, but as time passes all the reps and warranties, recourse or skin in the game are not going to stop the psychology of business momentum. The skin-in-the-game concept might not be the best approach to solving the problems that resulted from the financial crisis. "At the get-go, this is one of those populist nostrums that has less policy content than populist appeal," Dechert's Jones said. "If you look at the entire financial meltdown, it was loans to developers and contractors that were by far the worst performers, and 100% of these were fully on balance sheet." Jones said that there is very little evidence that lenders with skin in the game were better performers. "Despite this, the market might be stuck with skin in the game." Jones said that hopefully, while Congress fleshes out the details, workable alternatives to a simplistic 5% retention will be embraced, such as acknowledging the prudential impact of the CMBS B-piece buyer in preserving credit quality. Mazzeo added that the retention proposals may undermine the progress that has been made through other government initiatives.
"You have the government spending significant amounts on the [Term ABS Loan Facility (TALF)] and the [Public-Private Investment Program (PPIP)], which are economic recovery programs that are designed to increase the availability of credit in the marketplace," he said. However, simultaneous with these types of initiatives, Mazzeo said that Congress may now pass legislation that will erode the progress made under TALF and PPIP and unduly restrict the level of future lending activity. "Ideally we will see revisions to the legislation that recognize the value of alternatives to risk retention that will more efficiently achieve Congress' goals without hindering lending activity," he said. Finally, the confluence of the skin-in-the-game proposals, recent accounting changes and potential regulatory changes as to risk-based capital is a particularly noxious brew for the restoration of liquid credit markets. These changes to laws and accounting, according to Jones, would have a negative feedback effect that will make the restoration of liquid capital markets far more difficult. This is not what the economy needs, he said. FAS 167, in many cases, will require issuers, required to hold retention, to consolidate on their balance sheet assets that they don't really own and liabilities for which they don't have any contractual obligations. New risk-based accounting rules could require financial institutions to hold full RBC on these faux assets and liabilities. "This will impair capital formation at just a time where we need policies to encourage renewed lending," Jones said.
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