Speech by SEC Commissioner:
Realigning Incentives in the Securitization Market
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
SEC Open Meeting
March 30, 2011
As we have learned from recent experience, weaknesses in the securitization market contributed to the financial crisis.1 One such weakness was the misalignment of incentives that resulted from the separation of borrowers and lenders in the securitization chain.2 Under the “originate-and-distribute” business model, lenders did not bear the credit risk of borrower default, which led to a deterioration in credit quality of the underlying assets.3 Instead, that risk was passed on to investors.4
In response to these weaknesses, Congress directed the Commission and other agencies to require securitizers to retain some of the risk under the loans they were securitizing.5 By requiring sponsors6 to retain meaningful exposure to the credit risk of the underlying assets, Congress sought to ensure securitizers had strong incentives to monitor the quality of the assets they packaged.7
In order to be effective, the risk retention must be meaningful. The proposal seeks to accomplish this in a variety of ways. A sponsor must retain no less than five percent of the credit risk of assets within an asset-backed security,8 and the securitizer is prohibited from evading the risk retention requirements by hedging or transferring the credit risk that they are required to retain.9 The proposed rules also include a special “premium capture” mechanism designed to prevent the sponsor from structuring a deal in a way that would reduce its retained exposure to the underlying assets.10
But, I am interested to hear from the public whether the proposal does enough to ensure the retained risks are meaningful. For example, the proposal would permit securitizers to select a form of risk retention from a menu of options.11 While this provides flexibility to the sponsor, the proposal specifically seeks public input into whether this approach could be gamed.12 Our proposal asks a series of questions in this vein that I would like to highlight:
- Are there any kinds of securitizations for which a particular form of risk retention is not appropriate?
- Are there ways that sponsors could avoid the risk retention requirements in an effort to reduce or eliminate their risk retention requirements?
- Do the conditions and limitations in the proposed rules effectively limit the ability of the sponsor to structure away its risk exposure?
The weaknesses revealed by the financial crisis can only be addressed through meaningful improvements in the securitization markets. While the Commission has already taken certain steps in this area, more still needs to be done.13 Therefore, I look forward to hearing from commenters on whether this proposal achieves that goal.
I support the proposal, and I thank the staff for their hard work.
1 See Asset-Backed Securities, Release No. 33-9117 (April 7, 2010) [75 FR 23328] (“The financial crisis highlighted a number of concerns with the operation of our rules in the securitization market”); see also, Macroeconomic Effects of Risk Retention Requirements, Chairman of the Financial Stability Oversight Counsel (Jan. 2011), available at http://www.treasury.gov/initiatives/wsr/Documents/Section 946 Risk Retention Study (FINAL).pdf (“As the recent financial crisis demonstrates, securitization, without appropriate reforms, can cause significant harm to the economy”).
2 See Id. at 42 (“A chain of securitization may involve multiple participants that may serve the function of originator, sponsor, servicer, or trustee. One concern that has been debated is whether the model of securitization where loan originators do not hold the loans they originate but instead repackage and sell them as securities may create a misalignment of incentives between the originator of the assets and the investors in the securities, which misalignment may have contributed to lower quality assets being included in securitizations that did not have continuing sponsor exposure to the assets in the pool”); see also, Macroeconomic Effects of Risk Retention Requirements, supra n. 1, at 3 (“The securitization process involves multiple parties with varying incentives and information, thereby breaking down the traditional direct relationship between borrower and lender”).
3 Report of the Senate Committee on Banking, Housing, and Urban Affairs regarding The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-176 at 128 (2010) (“Senate Report”) (“[U]nder the ‘originate to distribute’ model, loans were made expressly to be sold into securitization pools, which meant that the lenders did not expect to bear the credit risk of borrower default. This led to significant deterioration in credit and loan underwriting standards, particularly in residential mortgages”); see also, Enhancing Investor Protection and the Regulation of Securities Markets—Part I: Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, 111th Congress, 1st session, p.67-68 (2009) (Testimony of Professor John Coffee) (“Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because they did not expect to hold the resulting financial assets for long enough to matter”).
4 See Asset-Backed Securities, supra n. 1, at 42 (regarding misalignment of incentives between securitization participants and investors, citing “European Central Bank, The Incentive Structure of the ‘Originate to Distribute Model,’ December 2008, at 5 (noting that securitization is fundamentally vulnerable to certain adverse behavior since agents seek to maximize their benefits while principals cannot fully observe and control the agents’ actions”).
5 See Dodd-Frank Wall Street Reform and Consumer Protection Act § 941, “Regulation Of Credit Risk Retention,” provides in part,
“(b) REGULATIONS REQUIRED.--
(1) IN GENERAL.--Not later than 270 days after the date of enactment of this section, the Federal banking agencies and the Commission shall jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.…
(c) STANDARDS FOR REGULATIONS.--
(1) STANDARDS.--The regulations prescribed under subsection (b) shall--(A) prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain with respect to an asset; (B) require a securitizer to retain--(i) not less than 5 percent of the credit risk for any asset--(I) that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer;…(ii) less than 5 percent of the credit risk for an asset that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, if the originator of the asset meets the underwriting standards prescribed under paragraph (2)(B).”
6 For purposes of the proposed rules, the risk retention requirement is generally applied to the “sponsor” of the ABS. Section 941(b) defines “securitizer” to mean: “(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.” While the risk retention requirement is generally applied to the ABS sponsor, it would be permissible under the proposed rules to allocate a portion of that obligation to any originator that contributes a significant amount of assets to the securitized pool, which the proposal sets at a minimum of 20 percent of the underlying assets in the pool.
7 See Senate Report, supra n. 3 (“The provision intends to create incentives that will prevent a recurrence of the excesses and abuses that preceded the crisis, restore investor confidence in asset-backed finance, and permit securitization markets to resume their important role as sources of credit for households and businesses. … When securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interests with those of investors in asset-backed securities. Securitizers who retain risk have a strong incentive to monitor the quality of the assets they purchase from originators, package into securities, and sell”).
8 The statute provides that the risk retention requirements shall not apply to an issuance of ABS if all the assets in the underlying pool are qualified residential mortgages.
9 See § 941, supra n. 5; see also, Senate Report, supra n. 3, at 129 (“The regulations will prohibit securitizers from hedging or otherwise transferring the credit risk they are required to retain”).
10 See Credit Risk Retention, Proposing Release (“Securitization transactions often contain pools of assets that are expected to earn substantially higher returns compared to the financing rates on the ABS issued in the securitization. This is generally referred to as excess spread. In situations where there is substantial excess spread, the sponsor can obtain significant economic income by selling an interest based on the excess spread. If the sponsor is able to recover more than 5 percent of the balance of the pool in a short period of time, then the sponsor would be left with limited economic interest in the securitization. This is particularly true if defaults occur later in the life of pool assets. For this reason, the proposed rules prohibit the cash flows from the excess spread (or cash proceeds from selling it) to be distributed to the sponsor. This benefits investors by helping to ensure that the incentive-alignment objectives of the proposed rules are achieved”).
11 See Id. In addition, the proposed risk retention requirements would apply to securitizers of ABS offerings whether or not the offering is registered with the Commission under the Securities Act of 1933.
12 It is important to note that, in addition to the risk retention obligations, the proposed rules also contains disclosure requirements tailored to each form of risk retention. The required disclosure provides, among other things, information on the sponsor’s retained interest in the ABS transaction.
13 The Commission has recently adopted rules related to asset-backed securities pursuant to the Dodd-Frank Act, including, for example, a requirement for ABS issuers to perform a review of the assets underlying the asset-backed security, and to disclose the nature of that review; and rules related to representations and warranties that would, among other things, require securitizers to disclose fulfilled and unfulfilled repurchase requests. See, Release Nos. 33-9175 & 33-9176 (January 20, 2011).