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SEC Pushes Historic Transparency
Asset Securitization Report--SourceMedia (May 1, 2010)
By John Hintze
Providing public deal-like disclosures on private placements? Issuers retaining a 5% stake in offerings issued from securities shelves? Requiring issuers to provide loan-level data regularly, even in the private market, and for asset classes where such detailed data has never been available?
All that and more. The Securities and Exchange Commission's (SEC) 667-page proposal to amend Regulation AB, affecting the ABS market, aims to shine a bright light on what has been a murky and, at times, very dark market in terms of information about offerings' underlying assets. And by requiring issuers to disclose much more information, the agency seeks to place more of the analysis burden on the shoulders of investors, who all too often have relied on the credit rating agencies' ratings instead of delving into the numbers themselves.
The proposal would also require issuers to retain a 5% "vertical" piece of their offerings issued from shelves at the SEC, slicing through from the top-rated tranches to the deepest subordinated ones.
The combination of new and more rigorous disclosures and the risk retention requirement are likely to draw howls in comment letters due Aug. 2. And some of the loudest howls are likely to arrive from issuers in the private 144A market, which they have tapped mostly to avoid the disclosures the proposal would require.
Indeed, the proposal would likely alter the ABS market fundamentally on several fronts and even likely shrink it, at least for the foreseeable future. Ed Gainor, a partner at Bingham McCutchen, called the proposal "historic," adding that he doesn't use that term "lightly."
Gainor said that for 50 years, the SEC has not regulated the private markets. Since the 144A market was adopted 20 years ago, he said, by following its rules issuers received a valid private placement and resale capability in the institutional market, without having to go through the SEC registration process and its disclosure requirements. "The SEC has clearly made the determination that based on what happened in the financial crisis, they can no longer make that assumption and it must be regulated," Gainor said.
Most of the more complex transactions based on mortgage assets that imploded most severely, such as CDOs, were in fact sold in the 144A market. CDOs are just one of the 10 ABS asset classes categorized in the proposal - from auto loans to equipment loans to floor plan financings - that may use the 144A market. The collateral in many of those other asset classes, however, performed comparatively well over the last two years. Now, those issuers, too, must provide essentially the same information required for a registered offering, if investors ask for it.
"In any structured finance product - the proposal is very broad - the issuer has to agree to provide to any investor that requests it the same information that would have been provided in registered offering," Gainor said.
That would include prospective investors, who currently can research the underlying assets on their own using information such as CUSIP numbers but cannot legally receive data pertaining to the assets from issuers or vendors, who can provide it only to actual investors.
"Issuers are going to have to do a lot more work to comply with these regulations, and that could potentially make issuing in the private ABS market less efficient. So in the near to mid-term it's likely going to hurt the private-placement market," says Susan Troll, credit analyst at T. Rowe Price. She added, "I'm a little worried that market is going to suffer from less supply."
Several issuers contacted to ascertain their views on the new 144A disclosure requirements, including CarMax Business Services, Harley Davidson Financial Services and Ford Motor Credit, either declined to comment or did not respond by press time. Nevertheless, the 144A market would still retain some advantages over alternative sources of financing for some issuers, said Geoffrey Hurley, a partner at New York-based Dechert.
For example, although a 144A issuer must provide the new disclosures upon request, if its financing needs are urgent it can still avoid the SEC's at times lengthy and costly pre-review process that is required for individually registered offerings. And 144A offerings are subject to only SEC Rule 10b5 liability, whereas public deals are also subject to Section 11 and Section 12 of the Securities Act of 1933, which respectively apply to registration statements and prospectuses.
Offerings in the 144A market, as well as individually registered offerings, also avoid the 5% risk retention requirement that the SEC proposal would impose on registered shelf offerings, which have far and away been the primary way to issue ABS.
Although sometimes issuers retained a portion of offerings, typically it was a highly subordinated piece. Or, Hurley noted, in asset classes such as CMBS, issuers would find a knowledgeable real estate investor to purchase the bottom class of unrated securities. "Now the SEC is saying that first it wants the sponsor to retain it, and it doesn't just want the sponsor to retain the bottom piece but 5% of each class," Hurley said.
John McElravey, an ABS analyst at Wells Fargo, said that this is going to increase issuers' funding costs, but whether it inhibits an issuer's use of the ABS market depends on its cost of financing elsewhere. "If bank funding is still more expensive after the 5%, then you'll still go to the ABS market. But this narrows the gap," McElravey said.
The Bigger Hurdle
A bigger hurdle imposed by the proposal on shelf offerings - as well as individual public offerings - would be the requirement to provide regularly updated loan-level data on the outstanding issues. Now, shelf eligibility is tested only when the initial shelf registration statement is filed. Then issuers can periodically offer securities from the shelf without going through the regulatory process again, as long as the securities have an investment-grade rating at the time of the offering.
Under the proposed rules, compliance with the eligibility requirements would be tested periodically, and an issuer would lose its ability to do further shelf offerings for a period of time if it falls out of compliance. In addition, shelf offerings would not have to carry a rating.
"The SEC has viewed the rating agencies' performance prior to the credit crisis with some disfavor, so now it wants to reduce investors' reliance on credit ratings, and it doesn't want SEC rules to require them," Gainor explained.
A second significant change would no longer permit issuers to suspend filing reports for shelf offerings after a year has passed - the current practice for most ABS issuers. Instead, issuers would have to continue filing periodic reports, including the annual 10K, 10D monthly distribution reports, and 8K reports, as long as the securities are held by investors. "If you don't file those reports, you would lose your shelf eligibility," Gainor said.
He added that the reporting would be "very burdensome" for asset classes such as RMBS, because events outside the issuer's control could cause it to miss a filing deadline. "Under the new rules, every time a 10D is filed, usually monthly, the RMBS issuer will have to file 150 data fields for every loan, updating whether it's delinquent, whether the servicer is doing loss mitigation strategy, etc.," Gainor said, noting, "It's an extremely high level of information available to investors every month."
Improved disclosures about ABS are the primary goal of the SEC's proposal, and investors tend to view increased disclosures favorably. "Additional disclosures are always better, and then investors can wade through the data presented to them and hone in on what they believe to be the important drivers of collateral performance," said John Thompson, vice president of structured finance, focusing on consumer ABS and some MBS, at Advantus Capital Management.
Loan-level data for MBS has been available to investors for at least a decade. However, as has become apparent throughout the recent credit crisis, many investors relied on analysis by the ratings agencies, buying 'AAA'-rated ABS without scrubbing the underlying loans themselves or using vendors' tools to do the analysis.
Loan servicers have provided loan-level data for many years, at least at the origination of an offering. However, complex deals such as CDOs that contained loans or referenced them from multiple RMBS were very difficult to analyze because the securities' loan data-fields often were labeled differently and/or contained different levels of detail. As a result, normalizing the data to effectively analyze it across the different securities required significant resources and effort, or the use of a vendor such as Loan Performance, which is now owned by Corelogic.
Some investors, such as hedge fund Paulson & Co., which shorted the Abacus CDO arranged by Goldman Sachs, must have done such analysis - the firm declined to comment. But clearly most did not.
The SEC's proposal would essentially eliminate that investor hurdle by requiring issuers to provide investors - and prospective investors - with loan-level data in eXtensible Markup Language (XML), not only at the start of the offering but through the life of the securities. That requirement would apply to CDOs as well, should they ever return.
In addition, issuers would have to provide a so-called "waterfall program," which models the offerings' anticipated cash flows, using the Python open-source programming language as a standard. Today, issuers provide those cash-flow expectations in the prospectus and may also provide investors with the waterfall model in electronic form to plug in the loan data. Investors also may rely on vendors for those programmed models or - if they have the resources - build them on their own. The main difference now is that issuers must file those programs with the SEC.
"There's a bit of an art translating the English [from the prospectus] into algorithms," said Ann Kenyon, head of Deloitte & Touche's securitization advisory group, adding that the SEC proposal currently is "silent" about how investors are to ascertain the accuracy of an issuer-provided waterfall program.
Ned Meyers, chief marketing officer for Lewtan, noted that requiring issuers to create the waterfall programs could subject them to new liability. "If somebody models a trigger wrong and one class of bondholders gets paid when another should have ... what happens now?" Lewtan provides ABS-related services, including the development of waterfall programs and since 2009 has normalized loan-level data.
Gainor agreed. "If the program is wrong," he said, "it could be a source of liability. I think people will be concerned and careful, but it shouldn't stop them from doing deals."
Nevertheless, the waterfall requirement is not markedly different from what standard practice has been. Likewise, servicers have typically made loan tapes containing loan-level data available publicly, enabling vendors to normalize that data. In addition, the RMBS industry has made headway adopting the American Securitization Forum's Project RESTART disclosures, an initiative the trade group began in 2007 to restore a measure of trust in the ABS market. The SEC's disclosure requirements largely echo the voluntary standards set out in RESTART.
Such loan-level data, however, is generally not provided for asset classes outside of RMBS, such as equipment or auto loans, and certainly not in a standardized format. Although the collateral backing those asset classes has performed relatively well, they, too, would have to provide investors with regularly updated, standardized data at the loan level under the SEC proposal.
"Never was loan-level information available" for ABS outside of RMBS, and instead investors had to rely on aggregated data, Thompson said. He added, "You would like to be able to use the additional information supplied, so I think we as an organization will definitely need to begin discussions about how we want to best prepare. We'll have to internally plan for how we will manage that new data."
Troll noted that the SEC would require different disclosures for each of the asset classes it has defined, and "that's a good thing." However, she said, "I think a lot of these new rules are actually aimed at parts of the ABS market that led to a lot of the problems," such as RMBS, "and other asset classes like those backed by consumer loans, which have held up well and did not lead to the crisis, are being lumped in with other asset classes."
After proposal comments arrive, the SEC will have to digest them to formulate a final rule, a process sources estimate taking upwards of a year, although of late the SEC has moved quickly formulating new rules. During that process, a final rule could include less demanding language than the proposal's or, given the current political climate and regulatory zeal, it may not.
Perhaps more worrisome now to market participants than the proposal's details is the number of proposals for new rules at the federal level. Thompson noted that rule proposals that would affect the ABS market are also bubbling at the Federal Deposit Insurance Corp. and on Capitol Hill. "What would be most beneficial to the industry, as long as there are going to be changes, is if these organizations came up with one comprehensive list for what they want securitizations to look like, as opposed to several sets of rules," he said.