July 22, 2010
Dodd-Frank Forum: Reforming Asset Securitization
Posted by Christine Hurt

So, a million years ago I worked on a few asset securitizations.  Our assets were used car loans, which actually have a really high default rate.  But there wasn't any used-car securities crisis.  But, following the 2008 Financial Crisis, asset-backed securitizations (ABS) seemed extremely dangerous, particularly securitizations of residential mortgages.  (If there is anyone out there who hasn't read Michael Lewis' description of the growth of this industry in Liar's Poker, please remedy this right now.)  Mortgage-backed securities (MBS) because the "special purpose vehicle" of the 1008 crisis.  But what made them so dangerous?

First of all, it was an extremely large market, so when the stress hit the underlying asset, mortgages, it affected a large number of investments, all in the same way.  Also, the housing market works in tandem with the economy as a whole, so downturns in the housing market seems very sensitive to stresses int he economy as a whole.  OK, but a lot of investments go bad.  Why are these special?  One argument is that the the underlying assets were a lot worse than the investors thought.  First, the incentives of the loan broker/originator to originate a risky loan and pass it off as OK.  Then, the incentives of the "securitizer" (a new word from Dodd-Frank) to pass of a bunch of risky loans to investors as OK.  Then, the credit ratings agencies did a bad job of rating the securities.  Then, the investors who suspected the risk of the asset thought they hedged their risk with credit default swaps, perhaps not realizing that everyone else was swapping with the same, not-so-creditworthy counterparties.  So, any reform would at the very least need to fix the incentives of the originators and securitizers and the transparency of the asset.  (I'll leave the credit ratings agency reforms to someone else!)

And Dodd-Frank actually seems to hit the nail on the head here.  Section 941 requires securitizers and originators to retain a portion of the credit risk for any asset securitized or any slice of a slice of a slice of an asset that is securitized.  For many ABS, this will mean not less than 5% of the credit risk.  Now, how will this be measured?  Not sure.  But, I do know that the securitizer/orginator may not hedge that retained risk.  So, theoretically, if you have to hang on to the underlying assets, you will be somewhat picky about what assets you securitize.  But, here's the kicker.  There will be an exception for "qualified residential mortgages."  These mortgages will be the least risky, so if your asset pool is made up entirely of qualified residential mortgages, then you are exempt from risk retention.

In addition, Section 941 authorizes the SEC to promulgate new regulations on disclosures of registered ABS, including risks at the asset level or loan level, if the assets are loans.  Also, disclosures would identify loan brokers and originators and the compensation system for the brokers and originators.  Also, issuers would disclose their level of risk retention.  These seem like good disclosure requirements.

One of Larry Ribstein's threshold questions for Dodd-Frank is whether the market would have regulated this better.  This could be an empirical question.  For issuances of ABS or MBS in the past 18 months, what have disclosures looked like?  Have issuers begun to compete by claiming that their underlying loans are particularly strong on various fronts or that the issuer is retaining ownership in the assets or in the risk of the assets.  I'm not sure if this market has rebounded enough for us to measure what investors are demanding in bond indentures for these types of issuances, for example. 

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