Correcting Some of the Flaws in the ABS Market

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [August 27, 2014] the Commission takes an important step to protect investors and promote capital formation, by enhancing the transparency of asset-backed securities (“ABS”) and by increasing the accountability of issuers of these securities. The securitization market is critical to our economy and can provide liquidity to nearly all the major economic sectors, including the automobile industry, the consumer credit industry, the leasing industry, and the commercial lending and credit markets.

Given the importance of this market, let’s also remember why we are here and the magnitude of the crisis in the ABS market. At the end of 2007, the ABS market consisted of more than $7 trillion of mortgage-backed securities and nearly $2.5 trillion of other outstanding ABS. However, by the fall of 2008, the securitization market had completely seized up. For example, in 2006 and 2007, new issuances of private-label residential mortgage-backed securities (“RMBS”) totaled $686 billion and $507 billion, respectively. In 2008, private-label RMBS issuance dropped to $9 billion, and flat-lined in 2009.

The market crisis also highlighted the unreliability of the credit ratings in mortgage-backed securities. For example, between the third quarter of 2007 and the second quarter of 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage-backed securities. In addition, credit ratings agencies downgraded over 90% of the AAA-rated subprime RMBS originated prior to the financial crisis to junk status.

These facts reflect the serious structural flaws in the ABS market that resulted in significant investor harm. These flaws include the following:

  • First, investors, as compared to other parties in the securitization chain, such as the originator of the underlying loans, lacked basic information and time to assess and correctly price ABS. In addition, assets were securitized into increasingly complex and opaque instruments, which made it that much more difficult for investors to understand and to assess the risk.
  • Second, because there was very little available information about the quality of the underlying assets, investors often relied solely on the fact that ABS carried an investment grade rating. However, as has been well documented, these credit ratings spectacularly failed to accurately measure and describe the risks associated with certain ABS. In fact, during the crisis, securities worth allegedly billions of dollars and rated “investment grade” collapsed in value. In this regard, I am pleased that today the Commission considers rules designed to address issues with the performance of the credit ratings agencies that came to light during the financial crisis.
  • Third, making money in the ABS market relied more and more on securitizing increasingly risky assets, like subprime mortgages, and subsequently offloading the risk onto investors. Unfortunately, most investors had little ability to mitigate the opaqueness surrounding these investments. To compound the problem, some banks and finance companies knew they could quickly sell their loans into the securitization market where somebody else would end up owning the risk, so they turned a blind eye to, or worse, encouraged, shoddy lending practices and increasingly risky loan structures. Thus, not only did the interests of investors not align with the originators or sellers of ABS; but, ultimately, these predatory practices put investors at risk of serious harm.

Given the tremendous harm to investors in the ABS market, in April 2010, the Commission proposed major revisions to the registration, disclosure, and reporting requirements for ABS offerings. Now, more than four years after the original proposal, the Commission is finally adopting rules intended to improve the reliability of registered ABS offerings.

Specifically, today’s rules will require timely and standardized disclosure in the prospectus and in Exchange Act reports of asset-level information for issues that are backed by real estate mortgages, automotive loans and leases, and debt securities. Today’s rules also provide investors with a minimum period of at least three business days to review transaction-specific information before making an initial investment decision.

Beyond enhanced disclosure and reporting requirements, the Commission is also adopting new eligibility criteria for ABS shelf registration. The shelf registration process allows companies to access the market quickly, such as when conditions are favorable and investor demand is high, by offering and selling securities on an accelerated basis, without prior SEC staff review of transaction-specific disclosure. Under the prior rules, if a nationally recognized statistical rating organization (“NRSRO”) rated the ABS as “investment grade” and the securities met other criteria, the ABS could be offered “off the shelf.”

As I previously mentioned, however, deficient credit ratings contributed significantly to the financial crisis. As a result, new eligibility requirements will replace the investment grade ratings requirements and will require ABS issuers to meet certain transaction-specific and registrant-specific criteria that are designed to ensure that ABS issuers exercise greater oversight and care in making required disclosures. These new shelf registration provisions should result in more reliable prospectus disclosure and more effective mechanisms for exercising investor rights under the transaction documents. This is especially appropriate for a security that can be issued to the public in an expedited manner without prior SEC staff review.

However, even with today’s action, the Commission has not completed its ABS-related work. I believe that asset-level disclosures are important to investors’ ability to make informed investment decisions, and the disclosures provide real transparency to the market about these securities. Moreover, these disclosures impose discipline on issuers to provide a full and clear picture of the composition and characteristics of their ABS issuances. It is also important that investors get timely access to as much ABS transaction-related information as possible before they invest in such offerings. As I have heard from a wide variety of investors, these disclosures are necessary and useful.

It is therefore crucial that the Commission complete the other outstanding ABS proposals in order to address the regulatory regime in this space. These include:

  • Requiring issuers to provide asset-level information across almost all asset classes—including equipment loans and leases, student loans, and inventory financings—as was mentioned in the 2010 proposal;
  • Requiring issuers to provide the same disclosure for ABS issued pursuant to private offerings and resold under Rule 144A, as is required for registered offerings;
  • Requiring the filing of a “waterfall” computer program that models the contractual cash flow provisions of ABS; and
  • Requiring that transaction documents be filed, in substantially final form, by the date the preliminary prospectus is required to be filed.

It is also critical that the Commission and other government agencies tasked with adopting risk retention rules promptly adopt final rules that fulfill that mandate. These risk retention rules are necessary to address the concerns that, without skin in the game, the securitizer of the assets will not be incentivized to exercise appropriate diligence in putting together the asset pools. The idea is to align the incentives of the securitizer with the interests of investors.

It is my hope that the Commission’s staff prioritizes the outstanding proposals with all due haste. The Commission must complete its work in the ABS marketplace in order to provide greater investor protections, regulatory certainty, and clear rules of the road.

Today, I will vote to approve the rules being considered. Although I would have preferred that it had occurred sooner, I appreciate that the Commission is now taking action. While there is much work in front of us, the rules being considered today are an important step forward.

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