On a day when JP Morgan Chase is out marketing its first new issue CMBS in a while, we have to look at what the non-government securitization market will look like after the storm passes.
Deloitte Partner Ann Kenyon penned their latest monthly newsletter on the securitization market. She was kind enough to allow me to share it with my readers.
Though it can only speculate about what the eventual new rules will look like, Ann is in a unique position, as Deloitte’s practice in the field of “matching numbers” on new-issue securitizations is far larger than any other accounting firm’s share.
After the break, the May issue of Deloitte’s Speaking of Securitization.
The SEC’s Reg AB: Back to the Drawing Board
By Ann M. Kenyon
In the 8th edition of our Securitization Accounting booklet (January 2010), we said:
―In the wake of the financial tumult in the past few years, most participants in the securitization industry agree that there will be an increase in reporting to meet the demand for greater transactional transparency for investors. That said, there has been little agreement as to what will constitute those new requirements…Among industry participants, there have been many ideas bandied about. Some thoughts center around further reporting on servicing; others focus on ensuring that all the required documentation underlying the assets in the pool is in place and conforms to the transaction documents. Still others talk about the need for transactional financial statement reporting. We can’t wait to see how all this turns out
Be careful what you wish for…
On April 7, 2010, the SEC announced its proposed Reg AB amendments dealing with the offering process, disclosure and ongoing reporting of asset backed securitizations*. In its mammoth 667 page document, the SEC has outlined how it intends to improve the disclosure underlying the initial offerings, subsequent take downs, and ongoing reporting for all asset backed securitizations, even private placements. As we were not the first to summarize the key provisions of the proposal and, at this point, many organizations have produced such synopses, we won’t repeat those recitals here.
[*In its proposal, the SEC defines all asset types, from residential and commercial mortgages to credit card, student loan and auto loans and leases as ―asset backed securities‖. We will follow the same convention in this paper.]
What is the Proposal’s Impact—Or Unintended Consequences?
Most participants in the securitization industry are eager to facilitate both investor and general public confidence in structured finance. Accordingly, while there is much to ponder and debate, the industry has welcomed these proposals; they have been long anticipated, and reducing the uncertainty with respect to the regulation of structured finance products can only be viewed as a positive step in restoring the robustness of the market. Nonetheless, there are certain to be many controversial aspects that will lead to pleas for changes in the final rule based on cost-benefit considerations.
Given the proposal’s size and comprehensiveness, most industry participants are, even now, still digesting the proposed requirements. At this writing, however, these are some of the questions that many inquiring minds are contemplating:
If adopted as proposed, could an issuer still bring a deal to market quickly? Could an issuer be in a position to go to market quickly after identifying an opportune window for issuance?
Even at the industry’s most fevered point, the time it took for an issuer to bring a deal to market would vary greatly, in large part dependent on investor appetite, the issuer’s familiarity with the securitization process, asset type, issuance venue (public vs. private), etc. It is probably fair to say, though, for most securitizers with shelf registrations who regularly accessed the public market with a common asset class/pool (residential mortgages, for example), a transaction could be consummated within a 15 – 30 day period. Thus, many securitizers were able to act very quickly whenever they identified an opportunity to obtain desirable pricing for the deal or had an immediate funding need.
In these proposals, the SEC expresses the intent to slow down the timing for deals. While explicitly acknowledging its view that if an investor does not feel ready, for whatever reason, to make an investment decision, then the investor’s refusal of such purchase is always an option, the SEC has decided to propose a five day waiting period in response to repeated expressed investor concern that this community historically has had insufficient time for appropriate analysis.
So, as a practical matter, could a deal still come to market rapidly? It is probably fair to say that ―speedy‖ would be difficult, but perhaps over time ―expeditiously‖ might be achievable. Should the proposals be adopted as currently issued, an issuer has to provide all deal documents, the collateral level data and the waterfall (electronically) at least 5 business days prior to sale. Should any information change in these submissions (save data relating to pricing or fees), then the documents/data files/waterfall programming have to reflect those changes and the five day time clock resets. Heretofore, many transactions had changes in the composition of the collateral pool constantly, in some cases almost right up until closing. Should that process continue, execution time would certainly lengthen, since the five day waiting period would constantly be restarting. In all likelihood, however, as issuers grew used to the new requirements, many steps in the securitization process would now be performed sequentially instead of concurrently, all in order to avoid triggering the waiting period repeatedly.
If this is true, then the length of time it would take to bring a transaction to market would certainly extend from what we had seen historically. As issuers grow familiar with the ramifications on the securitization process and its consequent impact on changes to the data that need to be filed, it is likely that an organized, prepared and savvy issuer could still get to market expeditiously.
What are the effects of the 5% risk retention requirement on consolidation?
In the proposal, the SEC reminded issuers that accounting conclusions are always ―facts and circumstances‖ based; it was the staff’s expectation, however, that based on this requirement, in conjunction with the concepts expressed in FAS 166 and 167 (under codification, now ASC 860 and 810, respectively), that an increased number of securitization transactions would be on-balance sheet. Putting aside whether the risk retention proposal interferes with legal true sale (a legal determination and thus outside the scope of this paper), the question really centers on whether or not this requirement changes the consolidation analysis.
To review: under FAS 167, an issuer of a securitization would consolidate the special purpose entities used in the transaction (in accounting parlance, the variable interest entities, or VIE) if the issuer meets a two pronged test:
- Does the issuer have the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and
- Does the issuer have a financial interest in the VIE that obligates the issuer to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE?
For purposes of this discussion, let’s assume that the issuer has retained servicing, and servicing is deemed to be the activity that most significantly impacts the economics of the VIE. Consequently, this mythical issuer has passed the control part of the consolidation test. Thus, what is the impact of the 5% risk retention requirement should this proposal pass?
As we have all grappled with the new consolidation concepts since the issuance of FAS 167, there has been general agreement that an issuer/servicer would likely be deemed the primary beneficiary (or consolidator) should it also hold an interest of 10% or greater in the VIE, assuming such interest required the holder to absorb losses or receive benefits from the VIE; in most cases, the 10% interest would be considered to be significant to the VIE. Conversely, if the issuer has an interest that is minimal, generally considered to be lower than 5%, then absent any other factors (see below), that interest would not be viewed as an interest that is significant to the VIE.
The quandary is: with the proposal requiring a 5% vertical slice, would that interest, in and of itself, be potentially significant?
It is unclear from the proposal whether the SEC thinks that a 5% interest is potentially significant. While a 5% vertical slice would not generally represent a quantitatively significant interest, it is unclear whether, in this context, the interest would represent a qualitatively significant interest.
We do know that issuers will need to consider other factors, beyond just the 5% interest, when assessing significance. For example, we have assumed our issuer above has retained servicing. If the servicing fee paid to the issuer represents more than adequate compensation (i.e., above market rates) for the servicing function and thus the issuer had a servicing asset, that fact should be taken into account in the analysis of significance. Additionally, if there are non-standard representations and warranties that provide additional financial benefits or pose additional risks to the issuer/sponsor, then that factor should also be considered. Also, the holder of a first loss piece would have the potential to realize upside if prepayments and/or defaults in the underlying asset pool are less than expected – this would also need to be considered in the ―could potentially be significant‖ analysis.
Finally, it should be remembered that for many asset classes, there was historically no market for unrated and below investment grade tranches of bonds, resulting in the issuer’s retention of those classes. Should that continue to be the case (and that certainly is likely) the issuer in this situation, in combination with a 5% risk retention requirement, will most likely have two titles: (1) issuer and (2) primary beneficiary.
Now that the waterfall is proposed to be programmed in a language called Python, filed on EDGAR and available for investor download, what concerns does that present to the securitizer?
In a proposed new requirement to the disclosures mandated for a public securitization, the SEC has put forth the proposition that the priority of payments outlined in every deal—the waterfall—needs to be converted into an open source language called Python and filed, along with all the other data requirements, with the SEC. It is anticipated that between the increased level of collateral data posted—remember, the issuer now has to submit loan level detail (for asset classes other than credit cards) with specified data fields–and the waterfall programming, any potential investor will have the necessary information and tools to perform a more informed analysis prior to making an investment decision.
While it can be argued that investors always had access to the waterfall information since the priority of payments was described in the offering documents, converting the narrative of such calculations into their parallel algorithms can be a daunting task. One potential positive of this requirement may be to enhance the clarity of the language in the document, and highlight potential areas of differing interpretation among the deal parties. Historically, it was not uncommon for the offering documents to describe a slightly different calculation than that remembered by the deal participants (or reflected in the underlying pooling and servicing agreement), or for issuers to need to consult with counsel when trying to retrospectively convert the waterfall into actual cash disbursements. Since it is always much more difficult to fix issues after the deal is issued, focusing attention on this aspect prior to the transaction’s closing could alleviate much discussion later.
Notwithstanding that outcome, however, does this proposed requirement increase the operational hurdle in getting a transaction closed? Yes, it does. Many commentators would argue that between the expanded collateral data requirements and the waterfall programming, inherently the SEC has asked issuers to post the equivalent of an investor reporting system prior to deal issuance. Moreover, the proposal is silent as to how the deal participants would know if the Python programming is accurate; we anticipate that requests for the deal accountants to somehow validate the Python output will become commonplace.
We are all familiar with the rapid pace of technological advancement, so by specifying a particular programming language, what happens if that language becomes outmoded? (Remember Fortran, anyone?) Who would be responsible for converting this information to accommodate either more advanced programming languages or upgraded operating systems requirements? What happens if investors encounter difficulties in downloading this program: who do they call? Will such inquiries be directed to the issuer? It will be interesting to see the comments to this part of the proposal in particular, since it is sure to be controversial.
Most of the requirements are proposed to expand to any issuer involved in a Rule 144A transaction – also known as a private placement. What are the possible ramifications to that market? Will it eliminate any preference between doing a public offering of a securitization or a privately placed transaction?
While the integrity of the securitization offering process for all asset classes has been questioned in the wake of the recent fiscal crisis, no form of asset backed securitization has been criticized as much as collateralized debt obligations, or CDOs. Since most, if not all, CDOs were not issued as public offerings but as private placements, the SEC has proposed to extend all its requirements with respect to securitization to any offering made pursuant to reliance on Rule 144A or Topic D of the Exchange Act of 1933.
It is certainly true that most CDOs were privately placed, but many other securitizers issued private placements as well. Typically, some of these issuers doing private placements were ―infrequent‖ securitizers, since often the economics of doing such a deal were facilitated; the size of the asset pool did not have to be as large, and a registration statement and the ensuing SEC review and comment process could be avoided. Additionally, issuers who securitized exotic asset types relied on this market, since the smaller investor pool meant that the education process around the nuances of newer or less familiar assets and their projected performance was easier. Consequently, these issuers would now have to comply with all these same disclosures.
While most securitizers who traditionally issued public securitizations are grappling with the proposal’s implications, remember that this market has already digested and operationalized the first steps for increased disclosure and transparency: Regulation AB. Since its adoption in 2006, the market has routinized many of the processes needed to be completed both pre-closing and post issuance. For example, issuers of public securitizations are familiar with the assembly of the static pool data and its posting (Note: the proposals now shift the posting site for this data to EDGAR and issuers will no longer have the option to post on their own websites). Additionally, issuers, trustees and servicers have become accustomed to the annual requirement for assertions of compliance with the SEC’s minimum servicing criteria, and the need for independent accountants to opine on that assertion. While there has been some voluntary embrace of these requirements by issuers into the private placement market, it has not been universal, and thus many of these private securitizers will face an even steeper hurdle in the data accumulation necessary for a transaction should the proposals be adopted as currently written.
Will this eliminate any advantage of doing a private transaction versus a public offering? It’s difficult to say. Clearly, while infrequent issuers may find the additional data accumulation and disclosure requirements prohibitive, especially for smaller sized transactions, there is still some advantage for those with unusual asset classes of ease of investor education with a privately placed transaction. Theoretically, at least, having investors with an appropriate level of understanding of the collateral characteristics might translate into more beneficial terms, including pricing. Certainly, any issuer who used the private placement market as a substitute for a public offering solely due to the lower level of disclosure required would now be somewhat indifferent between transactions offered in either setting.
The SEC seems to be reacting to investor concerns, yet we are seeing increased investor appetite for transactions. How to reconcile the views?
The proposed requirements are significant and place daunting challenges to issuers looking to complete transactions. Yet, most industry participants have long accepted that, especially in the wake of the recent financial tumult, increased reporting and disclosures were necessary in order to regain investor confidence. Consequently, many participants in the securitization industry have articulated the need for both groups, issuers and investors, to work through the proposals together in order to understand the areas of most importance to each other. Arguably, such collaboration would result in comments to the SEC that would highlight the requirements that the investors regard as most beneficial and useful; balanced against that would be the issuers’ desire to provide data that their investors find meaningful, yet having the wherewithal to do so in a manner that would minimize the impact on a transaction’s timing and be achievable in an operationally efficient manner.
When will these proposals be adopted?
As it stands, the proposals are subjected to a 90 day comment period that commences when the proposal is published in the Federal Register, an event that happened on May 3, 2010. Once the SEC receives comments, it intends to work through them as quickly as possible; it will then issue the final requirements. At this point, the SEC is considering an extended transition period or perhaps some phased in approach, but this is not yet final. As a practical matter, we think that any adoption would fall late into calendar 2011 or early 2012 at the earliest.
There are many other aspects of the proposal that are not discussed above, primarily because the proposed requirements might fall within the purview of other professionals. For example, the SEC’s proposed requirement with respect to repurchase obligations for breaches of representations and warranties centers more on a legal analysis; thus, we are leaving it to our friends in that profession to provide context. As the industry and the SEC work through the issues raised by these proposals, though, we will continue to provide periodic updates. Stay tuned!
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