Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission*
Aug. 28, 2013
Today, the U.S. Securities and Exchange Commission (“Commission” or “SEC”), acting jointly with the Federal banking and housing agencies, re‑proposes rules to require credit risk retention by sponsors of asset-backed securities (“ABS”), as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). It is important to note that today’s re-proposal is one of various actions taken or proposed by the Commission to improve the ABS market. Accordingly, today’s action should be considered in that context, and I encourage commenters to address that multi-pronged approach. In that regard, I urge the Commission to adopt robust rules requiring loan-level disclosures in ABS offerings, which were originally proposed more than three years ago.
The failures evidenced in the ABS market caused untold damage and must be prevented from occurring again. Ultimately the Commission and other regulators must develop a comprehensive and effective approach to reform the abuses in this complex market, while preserving its potential benefits.
Securitization turns illiquid assets like mortgages, commercial loans, and other receivables into marketable securities. Investors purchase such asset-backed securities based on the credit quality and expected cash flows of the underlying assets. By enabling banks and other lenders to free-up capital by selling the loans they originate, securitization increases the availability of credit for consumers and businesses alike.
However, when originators have the ability to securitize and sell their loans, the financial institution that makes the credit decision does not have to bear the risk of default or delinquency. To the contrary, the “originate to distribute” model incentivizes volume over quality, as the lender pockets the origination fee but passes the credit risk, like a hot potato, to the ABS market.
As a result of such distorted incentives, underwriting standards for residential mortgages and other loans deteriorated drastically in the years leading up to the financial crisis, contributing to both the expansion and inevitable collapse of the credit bubble.
The advent of loans with reduced or non-existent documentation requirements; interest only, negative amortization, and balloon payment loans; and adjustable rate mortgages with “exploding” payments and other exotic products dramatically increased the degree of risk in the mortgage market. However, such additional risks were often difficult for investors to assess because the securitization process does not just transfer ownership of the underlying loans, it bundles, divides, and repackages them as well. The lack of transparency exacerbated the moral hazard resulting from the separation of originator and capital provider, leading to an over-reliance on credit ratings and increasing opportunities for conflicts of interest.
Risk retention can help repair the broken incentives of the securitization market, by making sure that the securitizer (or, in some cases, another party with the capacity to perform meaningful due diligence) has enough “skin in the game” to promote effective underwriting practices. Under the re-proposal, unless an exemption is available, the securitizer will have to hold a qualifying 5% economic interest in the credit risk of the securitized assets. The retained interest is measured by fair value, as determined in accordance with GAAP, so securitizers have an incentive to make sure that the risks of such assets are fairly priced. Thus, risk retention should work hand-in-hand with rules to promote transparency and reliable disclosure.
It should be noted that even before adoption of the Dodd-Frank Act, the Commission recognized the need to address the manifest failures of the ABS market. In April 2010, the Commission proposed revisions to the existing rules for ABS transactions, referred to collectively as “Reg. AB 2,” including proposed rules that would:
- Require the filing of tagged, computer-readable information about pool assets, both at the time of securitization and on an ongoing basis;
- Require an ABS issuer to file a computer program modeling the flow of funds (or “waterfall”) provisions of securitization transactions, to help investors analyze the offering and monitor ongoing performance;
- Provide investors with more time to consider information about the collateral pool before the need to make an investment decision;
- Require disclosure provisions in private ABS transactions, as a condition to the safe harbor exemption; and
- Revise requirements for shelf-registration to replace eligibility criteria based on credit ratings.
In July 2011, the Commission re-proposed the shelf-registration requirements and requested additional comments on loan-level disclosure. The Commission also stated that it planned to re‑propose the waterfall computer program requirement.
However, another two years have passed, and investors are still waiting for the Commission to address the serious concerns regarding transparency in the ABS market. The Commission must act promptly to adopt Reg. AB 2, as proposed, and to re-propose and adopt the waterfall rule.
Robust, loan-level disclosure requirements are important for the protection of investors, particularly since the joint risk retention rule re-proposed today would exempt a broad swathe of residential mortgage backed securities from the risk retention requirement. Section 941 of the Dodd-Frank Act requires an exemption for asset-backed securities that are collateralized exclusively by residential mortgages that qualify as “qualified residential mortgages” (or QRMs), as the agencies shall define by rule.
As jointly proposed by the six agencies, the re-proposal would define QRM—and thus extend the statute’s exemption—to equal the definition of “qualified mortgage” (or QM), as that term is defined by the Consumer Financial Protection Bureau under the Truth in Lending Act. If that definition is adopted in the final rule, it would include all loans that meet the following requirements:
- Regular periodic payments that are substantially equal;
- No negative amortization, interest only, or balloon features;
- A maximum loan term of 30 years;
- Total points and fees that do not exceed 3% of the total loan amount (with alternative caps for small loans up to $100,000);
- Payments underwritten using the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment is due, including mortgage related obligations;
- Consideration and verification of the consumer’s income and assets, including employment status if relied upon, and current debt obligations, alimony, and child support; and
- Total debt-to-income ratio that does not exceed 43%.
These requirements will help counteract some of the worst abuses that poisoned the “originate to distribute model,” but the QM definition is nevertheless broad enough to exempt from risk retention some fairly risky loans, including loans with low down-payments, high loan-to-value and high debt-to-income ratios, and borrowers with less-than-immaculate credit histories.
Evaluating the risks inherent in such mortgages requires careful due diligence. Such due diligence cannot be effective, unless investors have access to timely and reliable information regarding the collateral pool, including origination channel and other information relevant to the securitization process. Accordingly, my willingness to support the joint re-proposal on risk retention is conditioned on the expectation that a robust Reg. AB 2 will become effective on or before the effective date of the final the risk retention rules.
As always, I look forward to comments on today’s re-proposal; particularly those from investors. Without the capital provided by investors, there can be no securitization market.
I appreciate the hard work of the staff, including the Commission’s Division of Economic and Risk Analysis, and the other agencies involved in this rulemaking.
[*] The views expressed herein are those of Commissioner Luis A. Aguilar and do not necessarily reflect the views of the Securities and Exchange Commission, any other Commissioner, or the Commission’s staff.
 Pub. L. No. 111-203, 124 Stat. 1376 (2010). Section 941 of the Dodd-Frank Act amends the Securities Exchange Act of 1934, 15 U.S.C. § 78a et. seq. (the “Exchange Act”) to add a new Section 15G. Section 15G of the Exchange Act requires the Commission, OCC, the Federal Reserve Board, FDIC, and, with respect to residential mortgages, the Secretary of Housing and Urban Development and the Federal Housing Finance Agency, acting jointly, to prescribe credit retention rules in accordance with such statute.
 Commission actions to protect investors in the ABS market include: (i) final rules requiring securitizers to disclose fulfilled and unfulfilled repurchase requests, and requiring nationally recognized statistical rating organizations (NRSROs) to include information on warranties and enforcement mechanisms in ABS credit rating reports (SEC Rel. No. 33-9175, Jan. 20, 2011, http://www.sec.gov/rules/final/2011/33-9175.pdf); (ii) final rules requiring ABS issuers in registered transactions to perform due diligence on underlying assets and disclose the nature and findings of such review (SEC Rel. No. 33-9176, Jan. 20, 2011, http://www.sec.gov/rules/final/2011/33-9176.pdf); (iii) proposed rules to implement Section 621 of the Dodd-Frank Act by prohibiting material conflicts of interest between those who package and sell asset-backed securities and those who invest in them (SEC Rel. No. 34-65355, Sept. 19, 2011, http://www.sec.gov/rules/proposed/2011/34-65355.pdf; comment period extended, SEC Rel. No. 34-66058, Dec. 23, 2011, http://www.sec.gov/rules/proposed/2011/34-66058.pdf); (iv) re-proposed rules to replace credit ratings as eligibility criteria for “short-form” registration of ABS securities offerings (SEC Rel. No. 33-9244, July 26, 2011, http://www.sec.gov/rules/proposed/2011/33-9244.pdf); and (v) as discussed in more detail herein, proposed rules requiring disclosure of loan-level information and other disclosure enhancements in ABS offerings (SEC Rel. No. 33-9117, Apr. 7, 2010, http://www.sec.gov/rules/proposed/2010/33-9117.pdf; additional public comments requested, SEC Rel. No. 33-9244, July 26, 2011). The Commission has also proposed several rules to reform the credit rating process generally, and the Commission’s staff has undertaken a study and reported to Congress on the credit rating process for ABS and other structured finance products, the conflicts of interest associated with the issuer-pay and subscriber-pay models, and the feasibility of establishing a system for assigned ratings. See, Report to Congress on Assigned Credit Ratings As Required by Section 939F of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dec. 2012); See, Cmr. Luis A. Aguilar, Remarks at the Credit Ratings Roundtable, Washington, D.C. (May 14, 2013), http://www.sec.gov/News/Speech/Detail/Speech/1365171515642. The proposals described above have lingered far too long. I urge the Commission to complete the task of adopting these essential reforms without further delay.
 Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (January 2011).
 Asset-Backed Securities, SEC Release No. 33-9117 (April 7, 2010) [75 FR 23328].
 Re-proposal of Shelf Eligibility Conditions for Asset-Backed Securities and Other Additional Requests for Comment, SEC Release No. 33-9244 (July 26, 2011) [76 FR 47948]
 See, 15 U.S.C. § 78o-11(c)(1)(C)(iii), (4)(A) and (B). The statute directs the agencies to define QRM jointly, taking into consideration underwriting and product features that indicate a lower historical risk of default, provided that the definition of QRM shall be “no broader than” the definition of “qualified mortgage” (or QM), as that term is defined by the Consumer Financial Protection Bureau (“CFPB”) under the Truth in Lending Act. 15 U.S.C. § 78o-11(c)(1)(C)(iii); § 78o-11(e)(4).
 The CFPB regulations implementing the rules for a QM provide several definitions of a QM. The joint re-proposing release proposes that a QRM would be a loan that meets any of the QM definitions.