Statement on Prohibiting Conflicts of Interest in Certain Securitizations
Jan. 25, 2023
While “asset-backed securities” may not be a household term, it has direct implications for millions of working households. So much so that in both 2008 and during the Covid-19 pandemic, the Federal Reserve set up emergency loan facilities to prevent interruptions in this market.
Today, the Commission re-proposes a Dodd-Frank Act rule, originally proposed in 2011, that is designed to address the harmful conflicts of interest in the asset-backed securities market that played a significant role in the 2008 financial crisis.
In 2021, market participants issued $918 billion in asset-backed securities. A well-functioning securitization market has the potential to increase liquidity and the availability of credit for consumers and small businesses, provided it operates fairly and with the full transparency that allows investors to meaningfully assess its true financial risks.
This is not how the securitization market worked in the run-up to the 2008 financial crisis. The abuses in this market are well documented in congressional investigations and by the Financial Crisis Inquiry Commission. Certain securitization participants structured asset-backed security deals while at the same time betting that these same assets would decline in value. When the shaky foundation of the securitization pipeline crumbled, asset values dropped precipitously, investors faced massive losses, and our financial system nearly collapsed.
Investors that participated in the securitization bubble had been misled to believe that their assets were being selected by an independent third-party. But in reality, this was not the case and to add insult to injury, issuers were paying credit rating agencies hefty sums to fabricate seals of approval that misled investors into thinking that they were purchasing credit-worthy and investment grade assets. This is the textbook definition of a conflict of interest and the anti-thesis of market integrity.
To minimize the chances of this catastrophic experience from occurring again, Congress included Section 621 in the Dodd-Frank Act. This provision generally prohibits sponsors, underwriters, and other participants to an asset-backed security from engaging in any transaction that would result in a material conflict of interest with respect to an investor for one-year after the first sale of the asset-backed security. It reflects the judgment of Congress that these types of conflicts can be so harmful to investors that disclosure or consent is insufficient. Importantly, the re-proposed rule would apply to both registered and unregistered securities, as well as to so-called synthetic securities often tied to subprime loans in the lead up to the financial crisis. In addition, should Fannie Mae or Freddie Mac no longer operate under conservatorship, they would also be subject to the rule to the extent they meet the definition of a sponsor.
The re-proposed rule would provide an important safeguard against the rampant misconduct that contributed to the 2008 financial crisis, which resulted in historic wealth losses, massive unemployment and millions of foreclosures. It recognizes the information asymmetries that exist between investors and the parties who design, structure, and create these often complex, and sometimes overly risky, asset-backed securities. By aligning incentives between investors and securitization participants, it would protect investors and strengthen market integrity.
I look forward to receiving and reviewing comments on the proposal, particularly with respect to the scope of participants covered, and the scope of the statutory exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making. Feedback on whether the proposal is sufficiently robust to prevent the disguising of speculative trades as hedging or market-making would also be useful. Lastly, feedback on whether the policies and procedures requirements are specific enough to enable compliance, monitoring, and enforcement would be helpful in assessing the rule’s effectiveness in protecting investors.
In closing, I am pleased to support this proposal. As always, my gratitude to all of the Commission staff for their hard work in crafting this important rule, and for their commitment to public service and to the fulfillment of the SEC’s mission on behalf of the investing public.