Remarks at ABS Vegas 2016

Michael S. Piwowar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Piwowar’s recent remarks at ABS Vegas 2016. The complete publication, including footnotes, is available here. The views expressed in the post are those of Commissioner Piwowar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

ABS Vegas is a unique conference, bringing together issuers, investors, credit rating agencies, law firms, accounting firms, and other service providers. A properly functioning securitization market requires robust participation from all involved. Listening to the comments from a number of the panelists at this conference has been quite enlightening and I particularly appreciate the fact that diverse points of views are represented.

Before I proceed further, I need to correct a few misperceptions about SEC participation at this conference that were perpetuated by the recent film, The Big Short. First, none of us have been lounging out by the pool. Second, none of us are seeking any jobs with investment banks. And, finally, because Las Vegas is full of security cameras watching our every move, I will not be literally walking through any revolving doors while I am here.

As the website for ABS Vegas proclaims, this is the “largest capital markets conference in the world.” As a markets regulator, I agree with that characterization. However, the prudential, or banking, regulators like to call this the “largest shadow banking conference in the world.”

While a balanced view of the securitization market may not fit into an Oscar-winning adapted screenplay and a fact-based speech on SEC regulation of the securities market may not fit the so-called “shadow banking” view of jurisdictional grabbing prudential regulators, let me first turn to the benefits and risks of the securitization market and then to what the SEC has done in recent years with respect to securitizations and credit rating agencies. I will then turn to where we go from here, and end with observations of recent developments in European securitizations.

The Securitization Market

As our country’s capital markets regulator, the SEC’s tripartite mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Securitization can transform illiquid assets like mortgages, auto loans, credit card receivables, and future sales of David Bowie albums into marketable securities. By serving as an efficient means of allocating scarce capital, securitization supports economic growth, business development, and job creation. Securitization further fosters resiliency by diversifying the funding base of our economy.

There are many other benefits associated with securitization, including the potential for reduced costs of, and expanded access to, credit for borrowers, the ability to match risk profiles for specific investor demands, and increased secondary market liquidity. Because banks and other originators can move loans off of their balance sheets into asset-backed securities (ABS), securitization can increase the availability of credit for both businesses and individuals. In many instances, securitization can allow a person to obtain more favorable terms than can be obtained from a bank or other financial institution.

Thus, the ABS market serves as a critical source of capital, providing funding for home and automobile loans, credit cards, and many other purposes. Yet, as shown during the recent financial crisis, investors may abandon the ABS market if they do not believe they possess sufficient information to evaluate the risks associated with a particular asset-backed security and to price it accordingly.

The financial crisis revealed that many market participants and regulators were not fully aware of the risks underlying residential mortgage-backed securities (RMBS). During the financial crisis, I served at the White House as a senior economist for the President’s Council of Economic Advisers. In that role, I personally observed the difficulties in obtaining reliable data about the quality and performance of underlying RMBS assets. This lack of transparency also contributed to the overreliance on credit ratings by market participants and regulators.

What the SEC has done so far

In the aftermath of the financial crisis and subsequent passage of the Dodd-Frank Act, the SEC has undertaken several rulemakings to improve the regulatory framework governing ABS transactions. In 2011, the Commission adopted rules regarding the use of representations and warranties in the ABS market to implement Section 943 of Dodd-Frank. These rules require ABS issuers to disclose the history of the requests they received and repurchases made by them related to their outstanding asset-backed securities. The SEC also adopted rules to implement Section 945 of Dodd-Frank, by requiring ABS issuers to conduct a review of the assets underlying those securities and make disclosures about those reviews.

In September 2014, the SEC adopted amendments to revise Regulation AB and other rules governing the offering process, disclosure, and reporting for asset-backed securities. In so doing, we implemented Section 942(b) of Dodd-Frank, which requires the Commission to adopt regulations setting forth data format standards for ABS issuers to facilitate comparison among similar asset classes and to disclose asset- or loan-level data, if such data are necessary for investors to independently perform due diligence. In my view, the enhanced disclosure requirements can facilitate better, more informed decision-making by both regulators and investors. The new disclosure should directly reduce informational asymmetries and moral hazard problems.

Our efforts to improve disclosure by ABS issuers have been complemented by increased transparency with respect to the secondary trading markets for asset-backed securities. Last June, the Financial Industry Regulatory Authority (FINRA) implemented changes to its Trade Reporting and Compliance Engine, also known as TRACE, to provide the public with post-trade price information for transactions involving asset-backed securities.

TRACE provides post-transaction pricing transparency for not only registered ABS offerings, but also for asset-backed securities offered in private placements and re-sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act. Asset-backed security transactions are available on TRACE within 15 minutes after execution of a trade.

As the Commission observed when we approved the original TRACE rules, price transparency plays a fundamental role in promoting the fairness and efficiency of U.S. capital markets. Real-time dissemination of last-sale information may aid all market participants in evaluating current quotations, because they could inquire why dealer quotations might differ from the prices of recently executed transactions. Post-trade transparency affords investors a means to test whether dealer quotations before the last sale were close to the price at which the last sale was executed. In this manner, post-trade transparency can promote price competition between dealers and more efficient price discovery, and ultimately lower transaction costs.

One final regulatory development was the adoption of a six-agency joint rule requiring mandatory risk retention by the SEC, the Office of the Comptroller of the Currency, the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation, the Department of Housing and Urban Development, and the Federal Housing Finance Agency. Unfortunately, the majority of SEC commissioners and the prudential bureaucrats adopted the rules over my objections.

For the record, I voted against the credit risk retention rules. These rules require a securitizer to retain a minimum 5% credit risk of any securitization transaction and generally prohibit the sponsor from hedging its retained interest. I was particularly dismayed by the “one-size-fits-all” approach taken by the regulators to create a flat 5% risk retention requirement for all asset classes, except for securitizations involving so-called “qualified residential mortgages” (QRMs) for which the risk retention level is zero. These were arbitrary choices.

Residential mortgages, commercial mortgages, credit card receivables, and automobile loans each have distinct and different attributes associated with their underlying borrowers. Rather than carefully examining these attributes to determine an optimal credit risk retention rate for each asset class, prudential regulators in Washington, D.C., took the easy way out—they simply set it at the maximum statutory rate and ignored the authorization from Congress to create lower risk retention requirements or use alternative methods to align interests.

Perhaps the prudential bureaucrats had their own conflict of interests in setting these requirements. After all, a prudential bureaucrat has a strong interest in self-preservation. Will a prudential bureaucrat get credit if optimally tailored risk retention rates increase economic growth and provide additional opportunities to families and businesses across America? No. Will a prudential bureaucrat take the blame if the next financial crisis—and there will be one eventually—relates at all to securitizations? Probably. Hence, what better way to side step responsibility than to refrain from using reasoned judgment and rely solely on the most risk-averse interpretation of statute instead?

Bureaucratic self-preservation might also explain the decision to adopt as broad of an exemption for QRMs as possible, so as to minimize any political fallout from the real estate and housing industries. Few will disagree that residential mortgage-backed securities played an important role in the 2008 financial crisis. For those in the audience involved in RMBS offerings, you must be quite happy with the broad exemption from the risk retention rules. For those of you in the audience who are involved in other types of securitizations that had little, if any, part in causing the financial crisis, you are probably wondering why you were unfairly targeted. Unfortunately, unlike Las Vegas, what happens in Washington does not stay in Washington.

On the other hand, perhaps the scope of the QRM exemption will have little impact. Since 2008, the federal government has backed nearly all RMBS issuances. The two government-sponsored enterprises (GSEs) that required the largest taxpayer-funded bailouts in history—the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) continue to play the dominant role in housing finance. They have a competitive advantage over private securitizations due to their lower funding costs as a result of a now explicit federal guarantee. They have essentially crowded out the private sector with respect to housing finance. In fact, during the last two years, there has not been a single public RMBS offering registered with the SEC.

Where do we go from here?

Where do we go from here? The SEC needs to evaluate the cumulative impact of all of these new rules on the securitization markets. Already, the amount of securitizations in registered public offerings has declined between 2014 and 2015. In 2015, approximately $155 billion was raised in registered offerings, a $22 billion decrease from the prior year. Automotive ABS and commercial mortgage-backed securities accounted for just over 75% of all registered offerings. Conversely, private securitization issuances increased over the same period from $327 billion to $345 billion. Of this amount, nearly $106 billion were for CDO or CLO offerings and about $102 billion were for commercial mortgage-backed securities.

The trend of declining public offerings of securitizations has continued through the first seven weeks of 2016. For that period, public offerings were about $11.3 billion as compared to $16.4 billion in 2015 and $19.9 billion in 2014. Moreover, these numbers do not yet reflect the full impact of the rules. The effective date for asset-level disclosures required by Regulation AB is not until later this year on November 23, 2016. Although the risk retention requirements for RMBS offerings became effective in December 2015, they are not applicable to other asset classes until December 2016.

We must appropriately regulate securitization offerings, including rules that adequately align the incentives of investors and sponsors. However, we must keep in mind that unnecessary or inappropriate regulation of securitizations may lead to less availability of capital, increased borrowing rates, and a more limited supply of credit. These effects are likely to be passed on to borrowers, either in terms of increased borrowing costs or loss of access to credit, and thus will cut directly against the benefits of securitization.

I am concerned that the relative costs have made ABS issuances in the private markets significantly more attractive than registered ABS offerings in the public markets, but I am skeptical that the solution offered by some in Washington is to increase the regulatory costs associated with private offerings. If institutional investors do not understand a private offering or do not have access to the information needed to make an informed investment decision, then they should consider either refraining from making that investment or obtaining a sufficient pricing discount as compensation for that uncertainty.

Overreliance on credit ratings

As I mentioned earlier, another key contributing factor to the financial crisis was the overreliance on credit ratings by investors and regulators. When investors and regulators place too much weight on the value of credit ratings and too little on their own due diligence, the negative consequences can be severe. This statement seems rather obvious as we look back on the devastating effects of the 2008 financial crisis.

To address these concerns, the SEC has taken a number of steps to reduce investor and regulator overreliance on credit ratings. For starters, the SEC has removed references to credit ratings from our rules, as required by Section 939A of Dodd-Frank. Section 939A requires each federal agency to review any of its regulations that require the use of a credit rating. The removal of credit rating references from our rulebook—and, therefore, any implied government seal of approval of credit ratings—should encourage investors to view credit ratings in a more appropriate manner, merely one input in making an investment decision. However, credit ratings continue to be used as benchmarks in many state and local laws and regulations and these entities should consider taking a hard look as to whether such use remains warranted.

Credit rating agencies, specifically those which are nationally recognized statistical rating organizations (NRSROs), are subject to oversight by the SEC. I have always had strong concerns that our regulations do not discourage competition to the extent that we end up with an entrenched oligopoly in the regulated entity space. Although it may seem counter-intuitive, large businesses often welcome a certain amount of regulation because relatively high compliance costs can act as a barrier to entry to new competitors.

As of the end of last year, there were 10 NRSROs registered with the SEC, of which seven are specifically registered for the category of asset-backed securities. Through annual reports filed with the SEC as well as other efforts, our staff has developed insights into the state of the credit ratings industry.

It should come as no surprise that the top three NRSROs have issued the bulk of the outstanding credit ratings on asset-backed securities, accounting for nearly 91% of them. However, simply comparing the number of ratings outstanding for established NRSROs and newer NRSROs may not necessarily provide a comprehensive picture of the state of competition. This is because the largest NRSROs have a longer history of issuing credit ratings and their ratings outstanding include those for debt obligations and obligors that were rated prior to the establishment of the newer entrants.

Some smaller NRSROs have been making competitive inroads in certain asset classes, including commercial mortgage-backed securities. Additionally, some smaller NRSROs are rating newer asset classes, such as single-family rental securitizations and marketplace lending securitizations, both of which are topics of interest at this conference. Smaller NRSROs are also rating other new types of asset-backed securities and issuances, such as airport revenue bonds and property assessed clean energy (PACE) securitizations.

Despite the progress made by smaller NRSROs in gaining market share in some of the ratings classes, economic and regulatory barriers to entry continue to exist. Our staff has noted that one potential barrier is that the management contracts and/or investment guidelines for mutual fund managers, pension plan sponsors, and endowment fund managers sometimes specify the use of certain ratings issued by particular NRSROs. As I previously alluded to with respect to state and local laws requiring the use of credit ratings, I suggest that institutional investors with fiduciary duties similarly re-examine how and to what extent their investment managers utilize credit ratings, particularly if it may result in less due diligence and credit analysis.

European securitizations

As I have mentioned, domestic prudential regulators view securitizations with a wary eye. This is also true at the global level. On the one hand, there appears to be widespread agreement that securitization can bring about a number of benefits that contribute to economic growth. On the other hand, securitization results in credit intermediation involving non-bank entities, what the prudential regulators call “shadow banks,” that can give rise to financial stability concerns. Thus, the Financial Stability Board (FSB) has stated that regulators should “cast the net wide” to broadly monitor all non-bank credit intermediation. Securitization is one of five economic functions that the FSB has specifically identified as an area of possible concern.

Of particular note, the Financial Stability Board tends to have a strong European perspective. Twenty-two members of the forty-member FSB steering committee are Europeans, as compared to nine members from Asia (including Australia), seven members from North America, one member from the Middle East, and one member from Africa. Moreover, the vast majority of the FSB steering committee members come from central banks and prudential regulators, with only three members from capital markets regulators. The interest of the prudential regulators in non-bank sectors is not surprising. To the extent prudential regulation makes it more expensive for banks to hold credit risk on their balance sheets and to provide liquidity, such activities will migrate to non-bank sectors, such as capital markets.

To date, efforts to reinvigorate the European securitization markets have not been particularly successful. These efforts are particularly relevant in Europe, where bank-based finance has long been dominant and where the capital markets have been underutilized as a funding source. As the European Commission noted, the European securitization markets have remained subdued since the financial crisis, in contrast to the United States. This is despite the fact that, unlike the United States, the European securitization markets withstood the crisis relatively well, with realized losses on instruments originated in the European Union very low as compared to the United States.

According to the International Monetary Fund, total securitization issuance in Europe declined to a 10-year low in 2013, more than 40% below the post-1999 average. In 2014, the European Central Bank launched a program to purchase asset-backed securities in order to stimulate Eurozone lending. These efforts, however, appear to have had little effect to date.

One approach for improving the European securitization market is the establishment of criteria for identifying simple, transparent and comparable securitizations. In July 2015, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions issued final criteria for such “STC” securitizations. In September 2015, the European Commission published a proposal to create a framework for simple, transparent, and standardized securitizations. And in November 2015, the Basel Committee released a consultative document to potentially reduce the minimum capital requirements for banking institutions with respect to holdings of STC securitizations.

It will be interesting to see how this European experiment turns out. The various legal and regulatory entities involved in the STC efforts have emphasized that the STC designation does not replace the need for investors to conduct thorough due diligence. But it is an open question as to whether such warnings over time will be heeded, or whether investors and regulators may ultimately over-rely on an STC designation and contribute to a future European financial crisis. Our short-term memory of the 2008 financial crisis may remain fresh for the present, but it will not be too long before the next generation of market participants and regulators—those who have no memories of the financial crisis—commence their careers in the work force.


In closing, I would like to express my appreciation to SFIG’s efforts to improve the quality of our securitization markets. Many difficult and hard lessons were learned in the financial crisis. SFIG members have already provided valuable input into the laws and regulations that have been put into place and will continue to go into effect over the coming years. SFIG members are uniquely positioned to identify poor practices and emerging risks in the securitization markets, and to quickly resolve those issues with market-based solutions.

Thank you for your attention and your time. Enjoy the rest of this great conference. And, remember, for the remainder of this conference, don’t bother looking for me sitting by the pool or walking through any revolving doors.

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The complete publication, including footnotes, is available here.

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