[Senate Hearing 111-397]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 111-397
 
            SECURITIZATION OF ASSETS: PROBLEMS AND SOLUTIONS 

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

       EXAMINING THE SECURITIZATION OF MORTGAGES AND OTHER ASSETS

                               __________

                            OCTOBER 7, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia             JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

            JIM BUNNING, Kentucky, Ranking Republican Member

TIM JOHNSON, South Dakota            JUDD GREGG, New Hampshire
CHARLES E. SCHUMER, New York         ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              DAVID VITTER, Louisiana
SHERROD BROWN, Ohio                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut

               Kara M. Stein, Subcommittee Staff Director

      William H. Henderson, Republican Subcommittee Staff Director

                      Randy Fasnacht, GAO Detailee

                                  (ii)
















                            C O N T E N T S

                              ----------                              

                       WEDNESDAY, OCTOBER 7, 2009

                                                                   Page

Opening statement of Chairman Reed...............................     1
    Prepared statement...........................................    30

Opening statements, comments, or prepared statements of:
    Senator Bunning..............................................     2

                               WITNESSES

Patricia A. McCoy, George J. and Helen M. England Professor of 
  Law, and Director, Insurance Law Center, University of 
  Connecticut School of Law......................................     3
    Prepared statement...........................................    30
George P. Miller, Executive Director, American Securitization 
  Forum..........................................................     5
    Prepared statement...........................................    41
Andrew Davidson, President, Andrew Davidson and Company..........     7
    Prepared statement...........................................    51
J. Christopher Hoeffel, Executive Committee Member, Commercial 
  Mortgage Securities Association................................     8
    Prepared statement...........................................    62
William W. Irving, Portfolio Manager, Fidelity Investments.......    10
    Prepared statement...........................................    69

              Additional Material Supplied for the Record

Statement submitted by the Mortgage Bankers Association..........    74

                                 (iii)


            SECURITIZATION OF ASSETS: PROBLEMS AND SOLUTIONS

                              ----------                              


                       WEDNESDAY, OCTOBER 7, 2009

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 2:35 p.m. in room SD-538, Dirksen 
Senate Office Building, Senator Jack Reed (Chairman of the 
Subcommittee) presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. The Committee will come to order. I want to 
welcome everyone and particularly thank our witnesses for 
making themselves available today.
    This hearing will examine a key activity within our 
financial markets--the securitization of mortgages and other 
assets--and will build on previous hearings this Subcommittee 
has held to address various aspects of regulatory 
modernization, including hedge funds, derivatives, corporate 
governance, SEC enforcement, and risk management at large 
financial institutions.
    Securitization is the packaging of individual loans or 
other debt instruments into marketable securities to be 
purchased by investors. At its core this process helps free 
lenders to make more loans available for families to purchase 
items like homes and cars and for small businesses to thrive.
    But we have learned from the financial crisis that 
securitization or how it is conducted can also be extremely 
harmful to the financial markets and families without 
appropriate diligence and oversight. Arguably, many of the 
basic requirements needed for effective securitization were not 
met over the course of the last several years.
    Today's panel will discuss how in recent years the 
securitization process created incentives throughout the chain 
of participants to emphasize loan volume over loan quality, 
contributing to the buildup and collapse of the subprime 
mortgage market and the broader economy.
    Today we find ourselves in the opposite position from a few 
years back with hardly any issuances in key markets that could 
help return lending to responsible levels. So this afternoon's 
hearing is about how to strengthen the securitization markets 
and enact any needed changes to ensure that securitization can 
be used in ways that expand credit without harming consumers 
and the capital markets.
    I have asked today's witnesses to address a number of key 
issues, including the role securitization played in the 
financial crisis, the current conditions of these markets, and 
what changes may be needed for Federal oversight of the 
securitization process.
    Unfortunately, a number of the banks who issue these 
securities could not find anyone in their workforce who was 
willing to testify today, but we are lucky to have experts 
here, both academic and business experts. I welcome you all and 
look forward to your testimony.
    Let me now turn it over to Senator Bunning for his remarks.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    All it takes is a short amount of time studying the market 
for asset-backed securities to realize really how complicated 
it is. Right now there is no basic private securitization 
market, especially for mortgages. I hope this hearing will help 
us all get a better understanding of the market and what we can 
do and should be done to make it work better.
    In theory, securitization is a great idea that brings more 
capital to the financial markets, leading to more loans for 
individuals and businesses. Done properly, that is a good 
thing. But as we saw last year, if it is done wrong, it can 
lead to disaster.
    The natural first question is whether the problems we saw 
were a result of a bad theory or bad execution. For several 
reasons, I think what happened was bad execution as a result of 
other bad policies and regulations.
    Probably the biggest factor that led to the problems in the 
securitization market were artificial demand created by bank 
capital rules favoring highly rated securities over whole 
loans. That artificial demand found a home in residential 
mortgage securities thanks to the GSEs' loose underwriting and 
easy money. And the rating agencies enabled it all. We should 
start by fixing those problems.
    Once the bad incentives and artificial demand are taken 
away, real risk analysis can be done, and price can be based on 
real value. The Government will not have to solve all the 
problems because investors will demand more protections from 
the issuers.
    For example, the model where issuers were paid by the 
number of deals closed and loan originators passed on all 
responsibility and collects profits up front will not be 
tolerated by investors in the future. That will lead to a 
solution tailored to a particular asset and flexible enough to 
be changed as the market evolves.
    I hope our witnesses will comment on these ideas and 
provide some of their own, because we really need them.
    Thank you.
    Chairman Reed. Thank you, Senator Bunning, and I would 
welcome any comments by my colleagues Senator Corker or Senator 
Gregg.
    [No response.]
    Chairman Reed. Thank you very much. Now let me introduce 
our witnesses.
    Our first witness is Professor Patricia A. McCoy, the 
Director of the Insurance Law Center and the George J. and 
Helen M. England Professor of Law at the University of 
Connecticut Law School. Professor McCoy specializes in 
financial services law and market conduct regulation. Prior to 
her current role, Professor McCoy was a partner in the law firm 
of Mayer Brown in Washington, DC, and specialized in complex 
financial services and commercial litigation. Thank you, 
Professor McCoy.
    Our next witness is Mr. George P. Miller. Mr. Miller is the 
Executive Director of the American Securitization Forum, an 
association representing securitization market participants 
including insurers, investors, and rating agencies. Mr. Miller 
previously served as Deputy General Counsel of the Bond Market 
Association, now SIFMA, where he was responsible for 
securitization market advocacy initiatives. Prior to that, he 
was an attorney in the corporate department at Sidley, Austin, 
Brown & Wood, where he specialized in structured financial 
transactions, representing both issuers and underwriters of 
mortgage and asset-backed securities. Thank you, Mr. Miller.
    Mr. Andrew Davidson is the President of Andrew Davidson & 
Company, a New York firm which he founded in 1992 to specialize 
in the application of analytical tools to mortgage-backed 
securities. He is also a former managing director in charge of 
mortgage research at Merrill Lynch.
    Mr. Christopher Hoeffel is an Executive Committee member of 
the Commercial Mortgage Securities Association, the trade 
association representing the commercial real estate capital 
market finance industry. Mr. Hoeffel is also the Managing 
Director of the investment management firm Investcorp 
International, responsible for sourcing, structuring, 
financing, underwriting, and closing new debt investments for 
the group. Mr. Hoeffel joined Investcorp from JPMorgan Bear 
Stearns where he was a senior managing director and global 
cohead of commercial mortgages.
    Our final witness is Dr. William Irving, a portfolio 
manager for Fidelity Investments. Dr. Irving manages a number 
of Fidelity's funds, including its mortgage-backed security 
Central Fund, Government Income Fund, and Ginnie Mae Fund. 
Prior to joining Fidelity, Dr. Irving was a senior member of 
the technical staff at Alpha Tech in Burlington, Massachusetts, 
from 1995 to 1999 and was a member of the technical staff at 
MIT Lincoln Laboratory in Lexington, Massachusetts, from 1987 
to 1995.
    Welcome, all of you. Professor McCoy, would you please 
begin?

STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND 
     PROFESSOR OF LAW, AND DIRECTOR, INSURANCE LAW CENTER, 
            UNIVERSITY OF CONNECTICUT SCHOOL OF LAW

    Ms. McCoy. Thank you. Chairman Reed, Ranking Member 
Bunning, and Members of the Subcommittee, thank you for 
inviting me here today.
    In the run-up to the crisis, Wall Street financed over half 
of subprime mortgages through private label securitization. 
When defaults spiked on those loans and housing prices fell, 
securitization collapsed in August 2007. It has been on life 
support ever since. When private label securitization comes 
back, it is critical to put it on sound footing so that it does 
not bring down the financial system again. The private label 
system had basic flaws that fueled the crisis.
    First, under the originate-to-distribute model, lenders 
made loans for immediate sale to investors. In addition, 
lenders made their money on up-front fees. Both features 
encouraged lenders to ``pass the trash.'' Lenders cared less 
about underwriting because they knew that investors would bear 
the brunt if the loans went belly up. In addition, to boost 
volume and fees, lenders made loans to weaker and weaker 
borrowers. In fact, when I have examined the internal records 
of some of the largest nonprime lenders in the United States, I 
have often found two sets of underwriting standards: lower 
standards for securitized loans and higher ones for loans held 
in portfolio.
    Second, securitizations spread contagion by allowing the 
same bad loan to serve as collateral for a mortgage-backed 
security, a collateralized debt obligation, and even the CDO of 
CDOs. It further spread contagion because investors used 
tainted subprime bonds as collateral for other types of credit, 
such as commercial paper and interbank loans. This shook 
confidence in the entire financial system because investors did 
not know where the toxic assets were located.
    Last, securitization resulted in a servicing system that 
creates thorny barriers to constructive workouts of distressed 
loans. We have had too many foreclosures as a result. In this, 
there were three victims: borrowers, who were steered into 
bafflingly risky mortgages, often at inflated interest rates; 
investors, who were forced to rely on ratings because 
securities disclosures were deficient and securitizations were 
so complex; and, finally, the public, who had to pay to clean 
up the mess.
    So how do we fix these problems going forward? There are 
two aspects: lax underwriting and loan workouts.
    First, fixing underwriting. One group of proposals seeks to 
realign incentives indirectly so that mortgage actors do 
careful underwriting. These include requiring securitizers to 
retain risk, higher capital requirements, better compensation 
methods, and stronger representations and warranties along with 
stiff recourse.
    I applaud these measures, but they are not enough to ensure 
good underwriting. I doubt, for example, whether prohibiting 
issuers from hedging their retained risk is really enforceable. 
Banks are adept at evading capital standards, and the Basel II 
standards are badly frayed. And stronger reps and warranties 
are only as good as the issuer's solvency. Consider the fact 
that most nonbank subprime lenders are out of business and 128 
banks and thrifts have failed since the crisis began.
    Another group of proposals focuses on better due diligence 
by investors and rating agency reform. This, too, is badly 
needed. However, memories of this crisis eventually will grow 
dim. When that happens, query whether investors will really 
take the time to do careful due diligence when a high-yield 
investment is dangled out in front of them.
    For these reasons, we need to finish the work the Federal 
Reserve Board began last year and adopt uniform Federal 
underwriting standards for mortgages that apply to all mortgage 
actors across the board. A brand-new study by researchers at 
UNC-Chapel Hill just found that States with similar laws had 
lower foreclosure rates than States without those laws. And a 
2008 study found that State assignee liability laws did not 
reduce access to credit.
    Then one last thought: facilitating loan workouts. Here I 
propose amending Federal tax laws to tax securitized trusts 
unless they provide ironclad incentives to do loan workouts 
when cost effective.
    Thank you, and I welcome any questions.
    Chairman Reed. Thank you very much, Professor.
    Mr. Miller, please.

  STATEMENT OF GEORGE P. MILLER, EXECUTIVE DIRECTOR, AMERICAN 
                      SECURITIZATION FORUM

    Mr. Miller. Chairman Reed, Ranking Member Bunning, Members 
of the Subcommittee, on behalf of the American Securitization 
Forum, I appreciate the opportunity to testify today.
    Securitization plays an essential role in the financial 
system and the broader U.S. economy. It is a mainstream source 
of credit and financing for individuals and businesses and 
finances a substantial portion of all consumer credit. 
Currently there is over $12 trillion of outstanding securitized 
assets, including mortgage-backed securities, asset-backed 
securities, and asset-backed commercial paper.
    The size and scope of securitization activities reflects 
the benefits and value it has historically delivered to the 
financial system and economy. Restoration of greater function 
and confidence to this market is a particularly urgent need 
today, in light of capital and liquidity constraints currently 
confronting financial institutions and markets. With the 
process of bank de-leveraging and balance sheet reduction still 
underway, and with increased bank capital requirements on the 
horizon, it is clear that the credit and funding capacity 
provided by securitization cannot be replaced by deposit-based 
financing or other alternatives.
    Simply put, the recovery and restoration of confidence in 
securitization is a necessary ingredient for economic growth to 
resume and for that growth to continue on a sustained basis 
into the future.
    The U.S. securitization markets experienced substantial 
dislocation during the ongoing financial market turmoil. While 
there are signs of recovery in certain market sectors, others--
most notably, private residential mortgage-backed securities--
remain dormant, with other asset classes remaining 
significantly challenged.
    Although tightened lending standards are one important 
reason for a broader constriction in the supply of credit, the 
impairment and reduction in securitization activity plays an 
equal, if not more important role.
    Certain Government programs, including direct support for 
Government-guaranteed mortgage securitization and the TALF 
program for certain asset-backed securities, have been 
successful in supporting financing and the liquidity needs in 
part of this market. However, these programs are temporary, and 
a larger challenge remains to create a stable and sustainable 
private capital market platform for future securitization 
activity.
    To accomplish this essential goal, a number of weaknesses 
and deficiencies of securitization revealed by the financial 
market crisis must be addressed. ASF and the broader industry 
are working actively to pursue and implement certain critical 
reforms, and we will continue to work constructively with 
policymakers on others. I would like to offer several 
overriding perspectives on these reform measures.
    First, many of the problems that have been identified are 
not inherent in securitization per se. Instead, they relate to 
the manner in which securitization was used. As a general rule, 
the amount of risk inherent in a securitization transaction is 
equal to the risk that is embedded in the securitized assets 
themselves. However, ancillary practices and strategies, such 
as the excessive use of leverage and undue reliance on short-
term funding for long-term liabilities, poor credit 
underwriting, or the absence of effective risk management 
controls, can amplify and concentrate these risks. This does 
not, however, mean that securitization itself is inherently 
flawed.
    Second, any reform measures should be targeted carefully to 
address specific and clearly identified deficiencies. Equal 
care should be taken to consider the individual and combined 
effects of various policy reforms to ensure that they do not 
inadvertently stifle otherwise sound and desirable 
securitization activity. We are very concerned that some reform 
measures currently being pursued or under consideration--most 
particularly, the combined effect of accounting standards 
changes and proposed regulatory capital rules--are 
counterproductive policy responses that are not reasonably 
targeted to address identified problems. Such reforms may 
render it prohibitively expensive to securitize a wide range of 
consumer and business assets. In turn, this could blunt the 
ability of the financial system to originate and fund consumer 
and business credit demand that finances jobs and investments, 
just as the broader economy begins to recover. We believe that 
this is an important matter that would benefit from Congress's 
further attention.
    Finally, from an industry perspective, ASF is focused 
primarily on devising and implementing concrete steps to 
improve the basic securitization market infrastructure in 
response to specific deficiencies identified in preexisting 
practices. Grouped broadly under the heading of ``Project 
Restart,'' these reforms will substantially improve and 
standardize information and data that is captured and reported 
to investors in securitized products, including, in the case of 
residential mortgage-backed securities, extensive and detailed 
loan level data. With these data enhancements broadly in place, 
securitization risks will be more transparent and capable of 
evaluation by investors and other market participants. At the 
same time, these data and standardization improvements will 
support higher-quality rating agency, due diligence, quality 
assurance, valuation, and other processes that depend on 
accurate and reliable underlying data.
    And, finally, and briefly, another important goal of 
Project Restart is to enhance and standardize representations 
and warranties that originators of mortgage loans typically 
provide. Much like a defective product is returned to a store 
from which it was sold, a mortgage loan that does not meet 
specified underwriting criteria should be returned to the 
originator through its removal from a securitization trust for 
cash. We believe that more effective representations and 
warranties will result in a full retention of economic risk by 
originators of defective loans consistent with the policy goal 
of requiring those who originate assets for securitization to 
retain a meaningful and continuing economic stake in the 
quality of those loans.
    I thank the Subcommittee for the opportunity to testify 
today.
    Chairman Reed. Thank you very much.
    Mr. Davidson, please.

 STATEMENT OF ANDREW DAVIDSON, PRESIDENT, ANDREW DAVIDSON AND 
                            COMPANY

    Mr. Davidson. Good afternoon, Chairman Reed, Ranking Member 
Bunning, Members of the Subcommittee.
    More than 2 years since the collapse of the Bear Stearns 
high-grade structured credit enhanced leverage fund, its name a 
virtual litany of woes, we are still in the midst of a 
wrenching economic crisis, brought on at least in part by the 
flawed structure of our securitization markets. I appreciate 
the opportunity to share my views on what regulatory and 
legislative actions could reduce the risk of such a future 
crisis.
    I believe that securitization contributed to the current 
economic crisis in two ways:
    First, poor underwriting led to unsustainably low mortgage 
payments and excessive leverage, especially in the subprime and 
Alt-A markets. This in turn contributed to the bubble and 
subsequent house price drop.
    Second, the complexity and obfuscation of some structured 
products such as collateralized debt obligations caused massive 
losses and created uncertainty about the viability of key 
financial institutions.
    Now to solutions. Boiled down to the essentials, I believe 
that for the securitization market to work effectively, 
bondholders must ensure that there is sufficient capital ahead 
of them to bear the first loss risks of underlying assets; that 
the information provided to them is correct; that the rights 
granted to them in securitization contracts are enforceable; 
that they fully understand the investment structures; and that 
any remaining risks they bear are within acceptable bounds.
    If these conditions are not met, investors should refrain 
from participating in these markets. If bondholders act 
responsibly, leverage will be limited and capital providers 
will be more motivated to manage and monitor risks.
    If this is the obligation of investors, what then should be 
the role of Government?
    First, Government should encourage all investors and 
mandate that regulated investors exercise appropriate caution 
and diligence. To achieve this goal, regulators should reduce 
or eliminate their reliance on ratings. As an alternative to 
ratings, I believe regulators should place greater emphasis or 
reliance on analytical measures of risk, such as computations 
of expected loss and portfolio stress tests.
    Second, Government should promote standardization and 
transparency in securitization markets. While the SEC, the ASF, 
and the rating agencies may all have a role in this process, I 
believe that transforming Fannie Mae and Freddie Mac into 
member-owned securitization utilities would be the best way to 
achieve this goal.
    Third, Government can help eliminate fraud and 
misrepresentation. Licensing and bonding of mortgage brokers 
and lenders, along with establishing a clear mechanism for 
enforcing the rights of borrowers and investors for violations 
of legal and contractual obligations, would be beneficial to 
the securitization market. However, I believe that there are 
superior alternatives to the Administration's recommendation of 
retention of 5 percent of credit risk to achieve this goal.
    I would recommend an origination certificate that provides 
a direct guarantee of the obligations of the originator to the 
investors and the obligation of the originator to the borrowers 
coupled with penalties for violations even in good markets and 
requires evidence of financial backing. This would be a more 
effective solution.
    If the flaws that led to the current crisis are addressed 
by Government and by industry, securitization can once again 
make valuable contributions to our economy.
    I look forward to your questions. Thank you.
    Chairman Reed. Thank you, Mr. Davidson.
    Mr. Hoeffel, please.

   STATEMENT OF J. CHRISTOPHER HOEFFEL, EXECUTIVE COMMITTEE 
       MEMBER, COMMERCIAL MORTGAGE SECURITIES ASSOCIATION

    Mr. Hoeffel. Thank you. I am testifying today on behalf of 
the Commercial Mortgage Securities Association. CMSA represents 
the collective voice of all market participants in the 
commercial real estate capital market finance industry, 
including lenders, issuers, investors, rating agencies, and 
servicers, among others. These participants come together to 
facilitate a transparent primary and secondary market for 
commercial mortgages.
    I am also an investor in CMBS, but I have more than two 
decades of experience as a commercial lender and a CMBS issuer. 
I would like to thank the Committee for the opportunity to 
share our views on securitization, which is crucial to borrower 
access to credit and our overall economy.
    This afternoon, I will focus specifically on securitized 
credit markets for commercial real estate, focusing on three 
issues: first, the enormous challenges facing the $3.5 trillion 
market for commercial real estate finance, of which about $850 
billion is securitized; second, the unique structure of CMBS 
and the need to customized regulatory reforms accordingly to 
support recovery; and, finally, the need to restore the CMBS 
market to meet significant borrower demand.
    Today the commercial real estate market is facing a perfect 
storm based on three interconnected and pressing challenges. 
First, there is no liquidity or lending. In 2007, there were 
approximately $240 billion in CMBS loans made, approximately 
half of the total real estate lending market. CMBS issuance 
fell to only $12 billion in 2008, despite strong credit 
performance at the time and high borrower demand. It has now 
been well over a year since a new CMBS deal has been done.
    Second, there are significant loan maturities through 2010. 
In fact, hundreds of billions of dollars is coming due in the 
next 2 years. Capital refinance these loans is largely 
unavailable, and loan extensions are difficult to achieve.
    Third, the downturn in the U.S. economy persists. 
Commercial real estate is greatly impacted by the macroeconomic 
factors: high unemployment, low consumer confidence, poor 
business performance, and falling property values. This last 
point is especially important to highlight. Remember, 
commercial real estate did not cause the current liquidity 
crisis. It has been negatively affected by it now, 2 years into 
the crisis. Second, even within the commercial real estate 
finance industry, CMBS or securitization did not cause stress. 
In fact, nonsecuritized loans are now underperforming CMBS and 
are experiencing in some cases greater defaults. Ironically, 
securitization may be ultimately an exit strategy for these 
troubled loans.
    As financial policymakers, including the current and 
previous Administration, have rightfully pointed out, no 
recovery plan will be successful unless it helps restart the 
securitization markets. The IMF also asserts that 
securitization will assist withdrawal of Government 
interventions, employing private capital to fuel private 
lending.
    Today many recovery efforts in the commercial real estate 
market, such as TALF and PPIP, have been helpful. But they are 
in a nascent and delicate stage, as discussed in my written 
testimony. So it is important that regulatory reforms, 
including accounting changes, as George mentioned, must work to 
strengthen the securitized markets and to give private 
investors who bring their own capital to the table certainty 
you and confidence.
    Above all, in the commercial real estate context, there is 
a real concern that some of the reform proposals will be 
applied in a one-size-fits-all manner that could actually 
impede recovery. Specifically, there are a number of important 
distinctions between CMBS and other asset-based securities 
markets, and the upshot of these distinctions is that they help 
the CMBS market avoid problems of poor underwriting or 
inadequate transparency. These significant differences are in 
four major areas:
    First, the borrower. In CMBS, the borrower in most cases is 
a sophisticated business within income-producing property and 
contractual revenues from tenants as opposed to some situations 
in the subprime residential mortgage where a loan may have been 
underwritten for a borrower who could not document his income.
    Second, the structure of CMBS. There are only about 100 to 
300 loans in a typical CMBS deal as opposed to thousands of 
loans in residential deals. This enables greater due diligence 
and analysis to be performed on CMBS pools by several different 
parties, including rating agencies and investors.
    Third, the existence of a third-party investor or B-piece 
buyer in the securitization process. Unlike other asset 
classes, CMBS has an investor who purchases a first loss 
position and conducts extensive due diligence as a result, 
which includes sit visits to every property. This investor also 
re-underwrites proposed loans in a potential pool, and they can 
negotiate to kick out any loans in which they do not wish to 
invest.
    Finally, greater transparency. CMBS market participants 
have significant access to loan, property, and bond level 
information at issuance and on an ongoing basis. In fact, the 
CMSA investor reporting package is used as a model for 
transparencies by other types of ABS markets.
    It is from this unique perspective that we approach 
regulatory reform proposals that will undoubtedly change the 
CMBS market. We do not necessarily oppose some of these 
proposals despite the fact that they will address practices 
that were typical in the subprime and residential 
securitization markets, not CMBS. Instead, we ask that 
policymakers ensure that such reforms are tailored to address 
the specific needs of each securitization asset class and to 
recognize the many safeguards that already exist in the CMBS 
market today.
    In this regard, two aspects of regulatory reform are of 
utmost interest to CMSA: a requirement that securitizers--that 
is, bond issuers and underwriters--retain at least 5 percent of 
the credit risk in any securitized loan pool; and a restriction 
of the ability of issuers to protect against or hedge this 5-
percent retained risk.
    As is explained in more detail in my written testimony, the 
basic concern we have about both of these proposals is whether 
they will be applied in a one-size-fits-all manner. While we 
agree that it is important for the appropriate parties to keep 
skin in the game, CMBS deals are already structured to do this 
in a way that has worked well for the market and for the 
overall economy for years and can continue to serve the policy 
objective that is sought here.
    As discussed earlier, first loss buyers conduct their own 
extensive credit analysis on the loans, examining detailed 
information concerning every property before buying the 
highest-risk bonds in the CMBS securitization. If these reforms 
are not applied in a tailored fashion, the danger is that the 
reforms will end up hampering the ability of CMBS lenders to 
originate new loans, thereby limiting capital and the flow of 
credit at a time when our economy desperately needs it.
    Thank you.
    Chairman Reed. Thank you very much.
    Dr. Irving, please.

  STATEMENT OF WILLIAM W. IRVING, PORTFOLIO MANAGER, FIDELITY 
                          INVESTMENTS

    Mr. Irving. Good afternoon, Chairman Reed, Ranking Member 
Bunning, and Members of the Subcommittee. Thank you for the 
opportunity to participate in today's panel.
    I have a very simple three-part message that I want to 
convey today.
    First, securitization can be a very effective mechanism for 
channeling capital into our economy to benefit the consumer and 
commercial sectors.
    Second, as a result of the financial crisis, the 
residential mortgage-backed security market and the asset-
backed market are sharply bifurcated. As I will describe, some 
are performing well, some less so.
    And then, finally, third, there are four broad areas of 
reform worthy of pursuit to help the securitized markets 
function better. In my remaining time, I will elaborate on 
these three points.
    One of the most important benefits of the securitization 
process is that it provides loan originators an additional 
funding source as an alternative to conventional retail 
deposits. As an example, I manage the Fidelity Ginnie Mae Fund, 
which has doubled in size in the past year to over $7 billion 
in assets. The mortgage-backed security market effectively 
brings together shareholders in this Ginnie Mae Fund with 
individuals all over the country who want to purchase a home or 
refinance a mortgage. In this manner, securitization breaks 
down geographic barriers between lenders and borrowers, thereby 
improving the availability and cost of credit across regions.
    Second, to provide further insight into the value of 
securitization, consider what happened to the consumer ABS 
sector. From 2005 through 2007, auto and credit card ABS 
issuance was roughly $170 billion per year. However, after the 
collapse of Lehman Brothers in September of 2008, new issuance 
came to a virtual halt. As a result, the interest rate on new 
car loans provided by finance companies increased by about 5 
percentage points between July of 2008 and year end. Issuance 
did not resume until March of this year, when the TALF program 
began. Thanks to TALF, between March and September, there was 
$91 billion of card and auto ABS issuance. Coincident with the 
resumption of a functioning auto ABS market, new car financing 
fell back into the 3 percent range.
    I will now turn to the agency mortgage market, which is 
also performing well, thanks to the extraordinary Government 
intervention over the past year. This intervention has had two 
parts. First, in September of 2008, Fannie Mae and Freddie Mac 
were placed into conservatorship, thus reassuring tens of 
thousands of skittish agency MBS investors that the Government 
stood behind their investments.
    Second, the Federal Reserve pledged to purchase $1.25 
trillion of agency MBS by the end of 2009. So far, the Fed has 
purchased just over $900 billion, thus reducing significantly 
the spread between the yields on agency MBS and Treasuries. As 
of this week, the conforming balance 30-year fixed mortgage 
rate is approximately 4.85 percent, which is very close to a 
generational low. Furthermore, the agency MBS market is deep 
and liquid.
    In contrast, the new issued private label mortgage market 
has received no Government support and has effectively shut 
down. From 2001 to 2006, issuance in this market had increased 
almost fourfold, to $1.2 trillion. But when the financial 
crisis hit, the issuance quickly fell to zero. Virtually the 
only source of financing for mortgage above the conforming loan 
limit, so-called ``jumbo loans,'' is a bank loan, and generally 
the available rates are not that attractive.
    At first glance, the higher cost of jumbo financing may not 
seem to be an issue that should concern policymakers. But 
consider the following. If the cost of jumbo financing puts 
downward pressure on the price of homes costing, say, $800,000, 
then quite likely there is going to be downward pressure on the 
homes costing $700,000 and so forth. So in my opinion, at the 
same time that policymakers deliberate the future of Fannie Mae 
and Freddie Mac, they should consider the future of mortgage 
finance in all price and credit quality tiers.
    To help improve the functioning of the securitized markets, 
I recommend that regulatory and legislative efforts be 
concentrated in four key areas. First, promote improved 
disclosure to investors at the initial marketing of 
transactions as well as during the life of a deal. For example, 
there should be ample time before a deal is priced for 
investors to review and analyze a full prospectus, not just a 
term sheet.
    Second, strengthen credit underwriting standards in the 
originating process. One way to support this goal is to 
discourage up-front realization of issuers' profits. This issue 
is complex and likely will require specialized rules tailored 
to each market sector.
    Third, facilitate greater transparency of the methodology 
and assumptions used by the rating agencies to determine credit 
ratings. In particular, there should be a public disclosure of 
the main assumptions behind rating methodologies and models.
    Finally, support simpler, more uniform capital structures 
in securitization deals. This goal may not be readily amenable 
to legislative action, but should be a focus of industry best 
practices.
    Taking such steps to correct the defects of recent 
securitization practices will restore much-needed confidence to 
this critical part of our capital markets, thereby providing 
improved liquidity and capital to foster continued growth in 
the U.S. economy.
    Thank you, and I look forward to answering your questions.
    Chairman Reed. Thank you very much, Dr. Irving.
    In fact, I wanted to thank all the witnesses for their not 
only very insightful, but very concise testimony. I appreciate 
it very much. All of your written statements will be made a 
part of the record and any of the statements that my colleagues 
wish to be submitted will be made part of the record.
    Let me pose a question to all of you, which in some cases 
will allow you to elaborate on your initial comments. We have 
seen a--I am getting to the point now where I can say lifetime, 
and that is a long time--shift from a very small secondary 
market for loans to a well-functioning market, now to one that 
has basically seized up. I think some rough numbers that I have 
seen, that loans on bank balance sheets, roughly $3.5 trillion, 
compared to securitization products, about $7.1 trillion, and 
that market has sort of collapsed.
    So the issue is how do we--or what are the key factors that 
are stalling this market and that have to be addressed by us? 
And again, I think you have alluded to some of them, but let me 
start with Professor McCoy and go down the row.
    Ms. McCoy. Thank you. The problem right now on the investor 
end is lack of investor trust. Investors were not getting 
useful disclosures up front. They simply weren't. They weren't 
given information on the individual loans in the loan package 
so they could figure out whether the underwriting was good or 
bad. The due diligence done on those deals by investment banks 
left a lot to be desired, and in some cases, I fear, was 
tantamount to fraud to the investors.
    When I have looked at securitization prospectuses for 
mortgage-backed securities, often they would say, here are our 
underwriting standards. But many of the loans in the loan pool 
were exceptions to these standards, and there is no further 
description of the exception loans or how many of the loans in 
the loan pools are exception loans. In some cases, it was more 
than half, and I guarantee you they did not exceed the 
underwriting standards. They fell far below. So this is a pig 
in the poke, and for starters, that needs to be fixed.
    My additional concern is that investors' interests are not 
always protective of borrowers. We also need to rebuild 
securitization so that it does not saddle borrowers unknowingly 
with products that they cannot afford to repay, and that is a 
separate issue.
    Chairman Reed. Mr. Miller? Thank you.
    Mr. Miller. Senator, I think the reasons are interrelated. 
There are a number of them. I think I would agree, overall, if 
I had to characterize it, it would be a significant lack of 
confidence in various parts of securitization market activity. 
I think that it certainly relates to withdrawal of confidence 
from investors who are in parts of the market for the kind of 
data and data integrity and reliability to give them comfort 
that they are able to evaluate--make meaningful evaluations of 
securitized instruments. I think it clearly relates to similar 
lack of confidence in certain rating agency methods and 
processes.
    Having said that, I think it is important to note that 
while there are clearly parts of the securitization market that 
are dormant and significantly challenged, there are other parts 
of the market that are functioning to some reasonable degree of 
normalcy, and while I think you can also point to Government 
programs, for example, TALF playing a significant role, TALF 
has also been beneficial in that it has brought back non-TALF 
issuance in investors for products that aren't directly 
supported by Government loans. And I think what that reveals is 
that it is not something that is endemic to securitization as a 
whole, but there are specific and identifiable deficiencies 
that need to be addressed.
    And so that is why, again, from ASF's perspective, things 
that lie more perhaps within the industry's control are areas 
where we are focusing to rebuild the securitization 
infrastructure, improve the quality, comparability, 
standardization, and reliability of data, and then finally to--
and I think this goes to some of Andy's comments, which I agree 
with--to help rebuild confidence in the operational processes 
and controls so that protective measures that are there to 
protect investors and ensure that their rights and entitlements 
as promised are delivered, that those protective measures 
actually work. And I think there is some significant work and 
effort that is needed in that area, but all directed at helping 
to rebuild and restore confidence.
    Chairman Reed. Mr. Davidson.
    Mr. Davidson. Addressing the current illiquidity, I would 
focus sort of on two different areas. One is the area of 
uncertainty. We still have a tremendous amount of economic 
uncertainty and regulatory uncertainty, and that just takes 
some investors out of the market because they need the risks to 
know a little bit better. And the other area is just the lack 
of availability of leverage to certain types of instruments. 
Without leverage, many instruments have to trade at very 
discounted prices, and so the institutions who hold those now 
and do have leverage are not willing to transact at the all 
equity price as opposed to the leveraged price. And I think 
that is why some of the Government programs, like TALF, have 
been so effective is because they have reinstituted leverage 
into these markets.
    In thinking about the solutions, we have to consider what 
is the appropriate amount of leverage and make sure that that 
can be delivered through those markets because that will be an 
important part of their future success.
    Chairman Reed. Thank you.
    Mr. Hoeffel, you can also focus in on the commercial loan--
--
    Mr. Hoeffel. Yes. I will definitely have a bent to that. I 
will look at it from both the investor and the lender point of 
view, or the originator or issuer point of view.
    For investors, one of the issues, as Mr. Davidson mentions, 
is their inability to finance their investments, so that has 
caused spreads to be very volatile and, in general, trend 
toward higher spreads than what we had seen when the market was 
healthier. TALF has certainly helped that from a secondary 
point of view, some of the existing securities, and may help in 
some new issues if we get some deals done, but that is yet to 
be seen.
    There are certainly concerns about the rating agencies and 
the rating process, not that they were necessarily wrong, but 
as I think several people have mentioned, we need greater 
transparency so investors can understand what the rating 
process is and delve in and do their own critical analysis of 
what the ratings mean.
    And third, from an investor point of view, I think there 
are concerns about the continuous changes in accounting and 
regulatory policies. They don't know what the potential 
ramifications of investing in a security might be down the road 
because some of the FASB rules keep changing and there is a 
certain amount of uncertainty there that is unpalatable.
    From a lender point of view, because, again, of the 
volatility of credit spreads, in order to make a loan work, you 
would have to originate it at a pretty high spread today and 
that is not competitive to the few people that are active in 
the markets. Some banks and life companies are making new 
commercial mortgages.
    Second, there is a big challenge in the commercial real 
estate space to aggregate collateral. In a healthy market, it 
takes 3 to 6 months to aggregate sufficient loans to do a 
securitization. Today's market, it would probably be longer. 
Typically, lenders would hedge their positions against movement 
in credit spreads or interest rates during that aggregation 
period through a number of different derivative options that 
don't exist right now, or are so uncorrelated to the market 
that they can't really use them to effectively hedge. So people 
are unwilling to take the balance sheet risk to aggregate loans 
solely for securitization.
    And similarly, lenders or aggregators are concerned about 
ongoing accounting changes in the market and how that might 
affect them while they are aggregating, but before they sell.
    Chairman Reed. Thank you.
    Dr. Irving, finally.
    Mr. Irving. I will make four comments. First of all, I 
think uncertainty about home prices and how borrowers behave 
when they are underwater on their mortgage, when the loan-to-
value ratio is greater than 100, has increased the risk premium 
in the market.
    And the second facet of uncertainty which is causing 
skittishness about these securities is just uncertainty about 
Government policy. The Government in some sense has been in the 
position inadvertently of picking winners and losers in terms 
of which investments do well and which do not. Those that get 
the Government support perform better than those that do not, 
so it becomes less of an intrinsic relative value of the cash-
flows and more an assessment of how the Government policy is 
going to go.
    The third would be the equity-like price volatility that we 
have seen exhibited in many of these marketplaces, again causes 
there to need to be an increased risk premium, that is, prices 
go down.
    And then finally, the complexity. We have sort of a rule of 
thumb on our trading room floor that for every additional 
sentence I need to describe to my boss the structure of the 
security I am buying, the price has to be lower by about a 
point, and----
    Chairman Reed. That would be terrible here.
    [Laughter.]
    Chairman Reed. Thank you, Dr. Irving. And one point, I 
think, emerges, and I am going to turn it over to Senator 
Bunning, is as we proceed forward on financial reform 
legislation, that will provide one way of at least an 
additional degree of certainty and calculation of the market, 
so that might contribute to, in a small way, to expanding this 
market.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    I am going to start on the other side. Without reform of 
bank capital standards, rating agencies, and housing subsidies 
like the GSEs, is there any way the private asset-backed 
security market will ever return?
    Mr. Irving. So first of all, we do have evidence that--from 
the TALF program for a number of----
    Senator Bunning. That is Government-backed, though.
    Mr. Irving. No, but where I am going to go with that is 
that certain high-quality issuers are no longer relying on the 
TALF program. They can do issuance without the benefit of the 
Government subsidy.
    More generally, though, I would say that the past year's 
experience would suggest that in the residential mortgage 
market, some sort of a Government guarantee is probably going 
to be required, and the evidence that I would put forth to that 
would be if you look at the striking difference between the 
performance of the agency market, even before the Fannie Mae-
Freddie Mac conservatorship, and a nonagency market, where in 
the nonagency market, even prime jumbo responsible loans with a 
loan-to-value ratio of 70 were priced at, like, 80 cents on the 
dollar, there was so much furor in the marketplace and so much 
concern, that I think that that evidence suggests to me that in 
times of tremendous stress, at least, there needs to be some 
sort of a Government backstop. That is not to say necessarily 
you need to have organizations with large retained portfolios, 
but some sort of a Government guarantee or credit guarantee, in 
my opinion.
    Senator Bunning. Another question. Which problems that 
surfaced in the asset-backed securities markets can be solved 
by market participants on their own, and which need Government 
action? All of them, or just some of them?
    Mr. Irving. Well, for instance, I think that in terms of 
aligning the interests, one of the key principles is to align 
the interests of the investors and the issuers. For instance, 
there is the proposal of issuers retaining a 5-percent slice of 
the security. I would say that that is far too blunt an 
instrument, and what we need instead is to take a step back and 
set up an overall regulatory environment and then let that 
regulator work with a trade organization like ASF to--and CMSA 
and come up with more detailed rules that are tailored to each 
particular sector of the market.
    So, for instance, in that case of aligning the interests of 
the investors and the issuers, I think that is something that a 
regulator should do by working closely with the organization to 
tailor solutions for each individual marketplace.
    I think maybe one area where legislative could help would 
be in terms of disclosure in the rating agencies, so we have 
fuller transparency on their methods and quicker turnaround 
when there is changing to their methodology or when they 
discover errors in their process.
    Senator Bunning. Mr. Miller, you mentioned that there were 
about $12 trillion worth of assets. How much would you say of 
that is near or under water?
    Mr. Miller. Well, from a, I think--and we can look into 
this and get back to you with specific detail, but the $12 
trillion refers to the amount of securitized assets currently 
outstanding----
    Senator Bunning. That is correct. I understand that.
    Mr. Miller. Right. I think a very small minority of that 
would be in technical default, so that the securitized 
instruments are not paying as promised----
    Senator Bunning. We have approximately five million 
homeowners that are in foreclosure or are--obviously, their 
houses are worth less than their mortgages.
    Mr. Miller. Right. And I am distinguishing here--I am 
speaking at the security level, so the mortgage----
    Senator Bunning. I understand that, but those securitized 
mortgages were the things that were sold as AAA rated, and that 
is where we got into all kind of the devil is in the details. 
And I find that the rating agencies were right in the middle of 
all that. In other words, they were the ones that were selling 
those as AAA quality to not only other banks, but the same 
banks that had sold them the mortgages in the first place, and 
all around the world. And that is why when the bubble burst, it 
didn't just burst here in the United States, it burst in Europe 
and other places.
    Mr. Miller. I would certainly agree with that, and to the 
extent that rating agencies were overly optimistic or 
miscalculated in terms of their assessment of credit----
    Senator Bunning. Do you think they did due diligence in 
finding out exactly what kind of mortgages they were 
securitizing?
    Mr. Miller. I don't think the rating agencies traditionally 
have performed due diligence on the underlying mortgages. I do 
think--I guess the point that I was going to make is that to 
the extent they did get it wrong, I think, number one, it 
emphasizes the critical importance of avoiding undue reliance 
on rating agencies by all parties.
    And then, second, as I indicated in my earlier testimony, I 
think one of the core features of reform that will assist 
issues and problems with the rating agencies and many other 
issues and deficiencies that we have identified is simply 
having access to better data that can then support better due 
diligence, better quality assurance, better rating agency 
processes in a much more transparent way. I think part of the 
problem is that judgments made by rating agencies and others 
were really not easily capable of similar evaluation by others.
    Senator Bunning. Meaning, in other words, being able to 
distinguish the mortgages that were in the portfolio----
    Mr. Miller. Yes.
    Senator Bunning. ----that they were doing.
    Mr. Miller. That is certainly part of it.
    Senator Bunning. Are all of you familiar with the 1994 law 
that the Congress passed giving the Federal Reserve the 
jurisdiction over all banks making mortgages and also the 
mortgage brokers that were making mortgages? They were 
empowered with oversight--the Federal Reserve was--to see that 
they were doing their job. In other words, they were watching 
the store. And it was exactly 14 years from the day that we 
passed that bill that the first regulation was written, and 
that was 2 years into Chairman Bernanke's oversight, the first 
regulations were promulgated on mortgages. So we went 14 years 
without a regulation. Would someone like to comment on that?
    Ms. McCoy. Senator, I am very familiar with that history.
    Senator Bunning. OK.
    Ms. McCoy. I am actually writing a book on it.
    [Laughter.]
    Senator Bunning. I have spoken enough to write a book on 
it, so----
    [Laughter.]
    Ms. McCoy. I was on the Consumer Advisory Council for the 
Federal Reserve from 2002 to 2004. We begged the Federal 
Reserve to exercise that power. We were aware of the burgeoning 
problems with the subprime market at that time, and I was 
privately told by Governor Gramlich that he very much supported 
that rule, but it would never fly with the Board.
    Senator Bunning. Oh, really?
    Ms. McCoy. Yes.
    Senator Bunning. Well, it is funny, but the Congress of the 
United States gave that power to the Federal Reserve and 
expected them to completely fulfill their obligation in 
oversight of the mortgage market, whether it be the bank or 
whether it be the mortgage broker.
    Ms. McCoy. When we would talk to Federal Reserve staff 
during that time period, we were told that we only had 
anecdotes to offer, that we could not produce proof of a 
deleterious effect on the macroeconomy, and that, therefore, 
the Board would not take action.
    Senator Bunning. Well, I can tell you when Chairman 
Greenspan and Chairman Bernanke came before this Banking 
Committee as a whole, they were all warned about it, especially 
early in the early 2000s, that we were getting ourselves into a 
potential bubble situation like we did in the dot-com bubble, 
and we couldn't get action out of the Federal Reserve. I am 
just wondering if anybody here was aware of that. No one here 
was aware that the Fed had that power except the person who was 
in direct contact with the Federal Reserve?
    Ms. McCoy. Yes.
    Senator Bunning. OK. Thank you very much.
    Chairman Reed. Thank you, Senator Bunning.
    Senator Corker.
    Senator Corker. Since I was in another hearing, I am going 
to let Senator Gregg go and I will go after him.
    Chairman Reed. Senator Gregg.
    Senator Gregg. That is very kind of you, Senator.
    First off, I thought your testimony was exceptional and 
very, very helpful and constructive, everyone's, and the fact 
that you were concise and had specific thoughts and ideas as to 
what we should do is extremely useful.
    My opening thought, though, however, as I listened to all 
of you, was does any of this need to be legislated? It sounds 
to me like almost every specific proposal you have suggested 
should fall to a regulatory agency to do, and most of it went 
to underwriting and better underwriting standards, it seemed 
like. So I would ask anybody on the panel, is there anything 
here that needs legislation to accomplish it versus just having 
the proper regulatory agencies noticed that this is the way we 
should approach these issues?
    Ms. McCoy. Senator, if I may, I have jotted down eight 
different things, and we can divide them between the private 
market and Government intervention.
    I think representations and warranties, recourse clauses, 
standardizing products, and having a functioning resale market 
for mortgage-backed securities is probably a private sector 
function, although the Government might convene discussions 
along those lines.
    But for Government action----
    Senator Gregg. I am talking about Congressional action, 
not----
    Ms. McCoy. Yes. Yes. I believe that better disclosures to 
investors can be handled by the SEC directly and Congress does 
not need to intervene there.
    Better underwriting standards, I think, do need 
Congressional action because the Fed is still not sufficiently 
aggressive and there is very strong legislation in both 
chambers along those lines.
    Higher capital standards, I believe banking regulators will 
address.
    Rating agency reform may very well need Congressional 
attention.
    Senator Gregg. I would just note that I think if you are 
going to have a uniform underwriting standard, you don't want 
that written into law if you want to have flexibility on how--
--
    Ms. McCoy. Yes, but I believe----
    Senator Gregg. That is going to require some mutation.
    Ms. McCoy. The authorization needs to come from Congress 
and then delegated, I have proposed, to the new agency.
    Senator Gregg. You don't think that power already exists 
within the Fed or----
    Ms. McCoy. Well, the power may exist within the Fed, but 
the Fed is not exercising it effectively.
    Senator Gregg. OK. So does anybody else have Congressional 
action that is required?
    Mr. Davidson. Senator Gregg, certainly in the area of 
Fannie Mae and Freddie Mac, which is central to the mortgage-
backed securities market----
    Senator Gregg. Yes, I accept that.
    Mr. Davidson. ----Congressional action is necessary. And 
then that would have a number of spillover effects, depending 
on how that process went, that may or may not require further 
Congressional action.
    Senator Gregg. Does anybody else have anything? You know, 
this does come down to underwriting. Everybody used that as an 
example of where the problem lies. Should we move toward a 
system like the Australians have, where you basically have to 
put a certain percent down--in Australia, I think it is 20 
percent--then you have recourse on mortgages. Or should we 
continue with the system of the Congress telling everybody in 
America that they have a right to have a loan to buy a house, 
no matter whether they can pay it back or not, through the CRA? 
Or is there someplace in between?
    Mr. Hoeffel. Senator, I don't think you need to regulate 
underwriting per se. I think you need to make sure that 
potential investors who might be impacted by the underwriting 
are fully aware of what they are investing in, so that if the 
underwriting has been poor, it is not glazed over by a rating 
or a structure. They have all the information they need to make 
the proper assessments.
    Mr. Miller. I would agree. I don't think it is desirable to 
legislate or regulate underwriting standards per se. I do think 
it is important, though, for those involved in credit 
underwriting functions, and I am thinking specifically in the 
residential mortgage market, for those involved in those 
activities--mortgage lenders, brokers, and others--to be 
subject to the same type of regulation so that you have a level 
playing field and consistent standards that apply to all who 
are engaged in those functions.
    Ms. McCoy. I am forced to disagree. We saw a situation in 
which the residential mortgage lending industry was unable to 
organize self-regulation, and, in fact, engaged in a race to 
the bottom in lending standards, which was aided and abetted by 
our fragmented regulatory system which, as Senator Bunning 
noted, refused to impose strong standards. That is how we got 
in this mess, and I think the only way that we prevent that 
from happening is to have some basic common sense standards 
that apply to all lenders in all States from the Federal 
Government.
    To my mind, the most important one is require borrowers to 
produce documentation that they have the ability to repay the 
loan at inception. That is common sense. We don't have to 
obsess about down payment requirements. But that, to me, is 
essential.
    Senator Gregg. I don't want to--doesn't that go to 
recourse? I mean, should there be recourse?
    Ms. McCoy. Against the borrower?
    Senator Gregg. Right. Should that be a standard that we 
subscribe to in this country, which we don't now?
    Ms. McCoy. Well, some States do subscribe to it. It depends 
on the State.
    Senator Gregg. Well, is it a good idea or bad idea?
    Ms. McCoy. I think right now, it is causing people who have 
already lost their houses to be pushed further into crisis and 
it is not helping the situation right now.
    Senator Gregg. And didn't this push to the bottom--wasn't 
the shove given by the Congress with the CRA and the way it set 
up Fannie Mae and Freddie Mac as basically guaranteed entities?
    Ms. McCoy. Actually, CRA loans have turned out to perform 
pretty well, and one of the reasons is that banks held them in 
portfolios so that those higher underwriting standards actually 
applied to CRA loans. They have been a success story among 
different classes of loans.
    Fannie Mae and Freddie Mac, I agree, they cut their 
underwriting standards, but they joined the bandwagon late. The 
private label nonconforming loans created a strong competitive 
threat that they felt necessary to meet, and so they were not 
the cause of the problem, although they did join the bandwagon.
    Senator Gregg. Thank you.
    Chairman Reed. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I am sorry I 
missed part of the end of the testimony going to another 
hearing, but I got the general idea.
    Focusing on commercial real estate right now, I know there 
has been a lot of discussion. We were just in New York, lots of 
people concerned about this huge amount of indebtedness that is 
coming due, huge amounts of loans done 10 years ago. You had 
10-year term, 30-year ARM. In essence, you kind of sold the 
project at that time because it was almost--you almost got full 
value because underwriting was so loose, so you kind of 
wondered, what is the problem? These have got to roll over, and 
the developer kind of sold the deal on the front end.
    But I guess as we--and I know that is not the case in every 
case. But what is the key? Some organization that wants to 
begin originating commercial real estate loans again and 
securitizing them from just doing those things and market needs 
to make those be sold by keeping recourse or doing other kinds 
of things? I just don't get it, really. The real estate values 
are dropping. You are underwriting at lower levels. The bond 
holders today are going to take a haircut to get financed out. 
The developer is going to have a little bit different deal or 
lose his property, but what is to keep the private market from 
just functioning right now? I really don't get it, and I don't 
understand why the focus is on us.
    Mr. Hoeffel. Well, there are a couple of different 
responses. One is that there are loans being made by insurance 
companies and some banks that are holding those loans----
    Senator Corker. Right.
    Mr. Hoeffel. So that business is happening. Unfortunately--
--
    Senator Corker. And it is heating up a little bit, isn't 
it?
    Mr. Hoeffel. It has picked up, but there is just not a 
capacity for banks and insurance companies to fill the void 
that is left by the absence of securitization. They just don't 
have the balance sheet strength or size to write all the loans 
that need to be written. But it can be done.
    For the securitized, and you may have missed these 
comments, there is a mechanical issue in that there are a lot 
of people who would like to go and make loans to securitize, 
but it takes a great deal of time to aggregate a sufficient 
pool to go out and create a pool to securitize. It was 3 to 6 
months. It may be 6 to 12 months today just because the market 
has slowed down.
    Traditionally, issuers would hedge their positions against 
movements in credit spreads or interest rates during that 
aggregation period, but there really aren't any instruments to 
do that now. There is no efficient way for them to warehouse 
their lines while they are--warehouse their portfolios while 
they are aggregating or hedge those specific interest rate 
risks--not credit risk, not credit of the underlying asset, but 
just movements in market spreads. And until that really exists, 
people are not willing to take on the balance sheet strain of 
aggregating a billion dollars' worth of new commercial 
mortgages, even if they are underwritten to lower values and 
better standards.
    Plus, there is so much uncertainty on what the ultimate 
execution might be for those securitizations. It is kind of a 
chicken and the egg. Once a few securitizations get done, an 
index will be able to be created so people can use that to 
hedge their positions. But until that happens----
    Senator Corker. Let me ask you, so I would assume there 
are, like, trillions of dollars of legacy securitizations that 
already are pulled together.
    Mr. Hoeffel. Mm-hmm.
    Senator Corker. People have an operating history on those 
portfolios. So there would be no risk in aggregation. Those 
exist. So why isn't there a market to at least deal with the 
legacy issues? Why aren't people cranking that up and going in 
and writing those assets down? The operating history is there. 
I don't understand why that is not occurring and why somebody 
isn't willing just to put up some recourse liability to make 
that get done and move on.
    Mr. Hoeffel. There is a market for both legacy loans and 
legacy securities. The securities market has been helped by 
TALF as an ability to finance those acquisitions, but there has 
been both TALF-financed and non-TALF-financed trading of 
mortgage securities.
    For whole loans, there is a market, as well, but those 
loans are being purchased based on new values and that requires 
the seller to recognize a loss, and many times sellers don't 
want to recognize that loss if they don't have to. So if a loan 
is written to $100 and the market value based on what you think 
the property is worth is $70, to sell the loan, you would sell 
it for $70 or less and then the owner of the loan would have to 
recognize a $30 loss.
    Well, if the mortgage is performing, it is a 10-year loan 
and there is sufficient cash-flow today to service that loan, 
the seller is going to forestall that sale until they 
ultimately have to, and hopefully between now and the time that 
loan matures, the value of the underlying asset may improve. So 
there hasn't been a lot of impetus for holders of whole loans 
to sell.
    Senator Corker. So back to the securitization--is it OK if 
I continue?
    Chairman Reed. Go ahead.
    Senator Corker. Back to the securitization piece, I assume 
that what is happening on that side is the loans are just being 
extended, and if you happen to own some of those securities, 
you are just in them longer than you anticipated being in those 
securities.
    Mr. Hoeffel. That decision is being made by the servicers 
alone on a case-by-case basis. In some cases, they are being 
extended. In some cases, they are being foreclosed or otherwise 
worked out. So there has been resolution, but there is just 
such a wave of requests for work-outs and modifications, it is 
going to take time to get through that.
    Senator Corker. What role should--you know, there is a lot 
of discussion here about covered bonds, and I realize that at 
the volume levels we are talking about, it is not going to 
certainly supplant the need for securitizations down the road, 
but what level of faith should we as policymakers have in the 
cover loan process here in our country as it relates to 
commercial real estate?
    Mr. Hoeffel. I think we want to not do anything that 
precludes commercial mortgages from being eligible to be in a 
covered bond issue. I don't think it is going to be the 
solution. It can be another tool to provide liquidity to the 
commercial real estate market, but because banks or the issuer 
has to keep those assets on their balance sheet and there will 
be regulatory capital requirements against those assets, it is 
a tool, but it is not going to be a sufficient tool to fill the 
void.
    Senator Corker. Let me just ask one more question.
    Chairman Reed. Take your time.
    Senator Corker. Do you think there is a sense among a lot 
of the larger players that we are going to do something here? I 
am hearing that from some of the larger players, and so instead 
of going ahead and taking some of these write-downs and moving 
on and sort of taking the pain, they are waiting, thinking that 
either through TARP or some other mechanism here, we are going 
to create a solution.
    Mr. Hoeffel. There is hope that something will happen, and 
some players are--may be waiting. I think it would be difficult 
to justify to sit around and wait for something to happen if 
you don't know it is going to happen, but that may be, in fact, 
the case.
    Senator Corker. Would it be a good signal to the market to 
let everybody know that TARP is over at the end of the year, 
that the circumstances that created the need for it are 
different and not there today, and would that help the market 
sort of move along versus this hope that there is a possibility 
that there won't be as great a loss and, therefore, let us hold 
on and not do the write-downs now?
    Mr. Hoeffel. I think TARP and the TALF financing for 
commercial real estate has been a help. It has created 
liquidity and it has created trading volumes. Certainty, I 
think, is always beneficial. If people know absolutely when 
something is going to start and when it is going to stop, the 
market can react to it, and the market may not always react 
favorably, but it will react one way or the other. And I think 
part of the problem with some of these programs is they have 
had fits and starts, and people think it is going to go one way 
and then it goes another or dates aren't certain. So the market 
will react one way or another to certainty and I think 
certainty is beneficial for everybody.
    Senator Corker. Would anybody like to respond to the 
certainty of people knowing that this is a private sector 
issue? We may do some regulatory reform down the road, and I 
know Mr. Miller had some concerns about what some of those 
might be, and I guess in another setting we will probe those, 
but does anybody else want to respond to the people who are 
involved in commercial real estate financing knowing that 
nothing else is going to occur? Would that alone not help move 
along the process to some degree?
    Mr. Davidson. You know, the Government had become, through 
various programs, both the Fed, Treasury, TARP, TALF, PPIP, 
very involved in the financing of a wide variety of financial 
instruments, and I think rapidly removing all of those at once 
will certainly be detrimental to the market because there are 
no other mechanisms in place now. So I agree with the idea that 
certainty is important, but I also believe that there needs to 
be a transition period, given how extensive Government's 
involvement currently is in financing.
    Mr. Hoeffel. One clarification. It is not only certainty 
what Congressional action will be, but certainty of what the 
regulators are going to do and what the accountants are going 
to do, because all of those things have been interplaying and 
some of the good work that is done here is undermined by work 
that is done elsewhere in Washington or in Connecticut. So I 
think you need certainty on all fronts.
    Senator Corker. And I would just close by saying that in 
the event we did end TALF as, I think, everybody had hoped 
might happen at the end of the year, the programs that are 
funded right now, TALF and others, they would continue on until 
they ran out. So it wouldn't be like all the Government 
assistance that is occurring today would end at the same time. 
It is just there would be no more commitments.
    Thank you all for your testimony.
    Chairman Reed. Thank you, Senator Corker.
    Let me begin a second round with a question that Mr. 
Hoeffel and others have raised, which is the FASB's role in the 
securitization process, particularly Statements 166 and 167, 
but all of the FASB rules affect this. Let us start with Mr. 
Hoeffel. Can you comment about how that might be inhibiting and 
what might be due to help FASB?
    Mr. Hoeffel. OK. Well, FAS 166 and 167 get rid of the QSP, 
the qualified special purpose entity, that was the vehicle 
through which many securitizations were done. On a going-
forward basis, I think we can work with that, but one of the 
key issues is that it is retroactive, so that people who have 
invested a small part of a securitization pool, maybe the 
bottom five to 10 percent, will be forced to consolidate all of 
the assets and all of the liabilities for that transaction onto 
their balance sheet, which could give them rate cap issues or 
low covenance, if they are a private company, on their 
financing. So it is a real challenge.
    It is almost impossible for these companies to get audited 
after the fact because they would have to consolidate 
everything down to the individual loan level, which may or may 
not be feasible given the terms of the loans themselves. So it 
is a significant challenge to the market.
    And further, given that there is some weakness in property 
markets, if a certain class got wiped out through recognized 
losses or realized losses, you could have the next bond holder 
have to consolidate. So you could theoretically have a BBB or a 
single-A investor suddenly have to consolidate, and that is not 
something they had envisioned at all when they bought those 
bonds.
    That will be specific to certain issues, but it is a 
challenge, both the lack of QSP for new issue and the 
consolidation that would happen for existing debt that is out 
there.
    Chairman Reed. Any other comments? Mr. Miller.
    Mr. Miller. Thank you, Mr. Chairman. Just extending those 
comments a little bit to other parts of the securitization 
market, at a macro level, the outcome of the 166 and 167 
accounting standards changes will be to require a large volume 
of securitized assets in many different product sectors to be 
put back onto balance sheets or to prevent them from moving off 
balance sheet.
    And our position--I want to be clear about this--is we are 
not for or against on- or off-balance sheet accounting. We 
simply think the accounting should be appropriate in light of 
exposure to risks or entitlement to assets. We think FASB's 
outcome in these standards is to--will result in an over-
consolidation of many of these vehicles where the consolidating 
party really does not have meaningful entitlements to the 
benefits of those assets or exposure to the risks.
    Having said that, the standards have been--will be adopted. 
They will generally take effect in January. I think our bigger 
concern at this point, as I mentioned earlier, is the ripple 
effects of those accounting standards changes. If you picture a 
very large volume of assets coming back onto bank balance 
sheets exactly at a time when those balance sheets are already 
very constrained, the larger asset side of the balance sheets 
will attract higher regulatory capital charges. They will 
factor into leverage ratio calculations. They will attract loan 
loss reserves.
    And our concern, and we have heard this very forcefully 
from our members across a wide range of markets, is that that, 
coupled with other steps being considered, may constrict the 
ability of financial institutions to use their capital base to 
support new lending. And so we are very concerned, both about 
the accounting standards changes, but even more so now about 
the downstream impacts that those may have.
    Chairman Reed. Any other comments on this issue?
    Mr. Hoeffel. One other thought is that the 5-percent 
retention that is being discussed in the regulatory reform 
proposals will--this sort of flies in the fact of that, because 
if you are required to retain 5 percent, now you are going to 
have to consolidate. So it exacerbates some of the issues that 
Mr. Miller mentioned.
    Chairman Reed. Let me raise another issue with Mr. Hoeffel, 
and anyone else, and that is, there seems to be one distinction 
between residential mortgage-backed securitization and remedies 
and commercial, which is commercial bankruptcy code is 
available to the individual mortgages if they default. Is that 
a difference that makes a difference in terms of the commercial 
market versus the residential market?
    Mr. Hoeffel. I think it will impact the resolution of 
workouts, and we have seen that forestall some of the workouts 
that have happened in some very large securitizations to date. 
We are still waiting to hear what the outcome of some of those 
cases are.
    So, again, I think that process, because commercial 
borrowers can file for bankruptcy--we have tried to avoid that 
through recourse carveouts for bankruptcy, but even that seems 
to be not as enforceable as maybe some people had thought. So 
it does create, again, more uncertainty, which is a challenge 
for investors going forward.
    Chairman Reed. But at least in the commercial context, the 
access to bankruptcy was clearly understood before the 
securitization process took place. And I guess the question 
would be if someone has the ability to work it out, it is 
understood beforehand. That is anticipated by the investors. 
Does that facilitate the process at all or is it sort of 
neutral?
    Mr. Hoeffel. Well, investors always knew that bankruptcy 
was an option and always has been. We tried structurally to 
limit a borrower's ability to file for a bankruptcy by putting 
most securitized loans into special purpose entities where you 
needed unanimity of all the directors to file for bankruptcy, 
and there you had independent directors that would not file for 
bankruptcy on a solvent entity. Again, there have been some 
court challenges to that, and many of us are waiting to find 
out what will happen.
    Nobody thought that commercial real estate, even in an SPE, 
was completely bankruptcy proof, but we did think that there 
were enough hurdles to that to provide protections for 
investors.
    Chairman Reed. Thank you.
    Professor McCoy, you have suggested that borrowers be given 
an affirmative claim against assignees, a violation of Federal 
lending standards. Can you elaborate on that? Then I would ask 
others to comment on that proposal.
    Ms. McCoy. Yes, I would be glad to. We are in a situation 
right now where in the majority of States, if a borrower's loan 
is sold, generally through securitization, they lose, without 
their consent, their defenses to collection and their ability 
to sue the holder of the loan for consumer protection 
violations and fraud. And where the rubber really hits the road 
is when that borrower is sued for foreclosure.
    If the loan has been securitized, let us say the borrower 
was defrauded originally, the loan later goes into foreclosure, 
under State law the borrower cannot raise the fraud as a 
defense to foreclosure. They lost that, and they lost that 
through a process over which they had no say.
    In addition, because the borrowers can really only sue 
their lender, or their mortgage broker, it means that we do not 
have the threat of making the borrower whole that investment 
banks have to care about; that investors have to care about 
when they think about will we do due diligence or just rely on 
the rating agency.
    And I feel in order to bring rationality and consistency to 
the entire mortgage process, we need to allow borrowers to 
bring claims of fraud and consumer protection violations 
against whoever holds their loan.
    Now, there are ways you can structure this liability that 
rating agencies can rate and that securitization can function 
with. Economists and I and other coauthors studied the effect 
of similar laws in nine States, and what we found is in six of 
those States, access to subprime credit actually increased, 
holding everyone else constant, despite assignee liability.
    In three of the States, depending on the indicator, the 
results were mixed, but in no State was there an affirmative 
drop in access to credit.
    Chairman Reed. And I am going to ask others to comment on 
this, obviously, but to follow up, would this be a way to 
complement or displace the requirement of the Administration to 
hold 5 percent of a mortgage or 5 percent to give the 
originator sort of some skin in the game or----
    Ms. McCoy. I view it as a complement. I am supportive of 
the Administration's 5-percent retention measure, but my 
concern is even though the Administration would prohibit 
hedging it, I do not think that that prohibition is enforceable 
because often hedges are taken on a broad variety of positions. 
And there is a lot of devil in the details with respect to that 
proposal, so I would have assignee liability as well.
    Chairman Reed. Mr. Miller, and anyone else who wants to 
jump in on this issue.
    Mr. Miller. Certainly borrowers should have remedies and 
defenses against fraud that may relate proximately to a 
foreclosure action against them. The details, though, of any 
assignee liability mechanisms are very, very important and 
should be addressed at that level of detail. But, broadly 
speaking, the securitization industry would have very 
significant concerns about broad-based assignee liability. 
While, again, the interests of the borrowers here are primary, 
at the same time those borrower interests are also served by 
having investors who are willing to commit capital to the 
mortgage-backed securities markets. And if those investors are 
potentially subject to downstream claims by borrowers for 
origination defects over which they have absolutely no ability 
to perform diligence upon or to verify, they are not sitting at 
the loan closing table, my fear is that and I think the 
industry's fear is that if those types of assignee liability 
provisions are broadly introduced, it will significantly 
curtail, if not dry up completely, the willingness of investors 
to take that risk. If it is not a risk that they can manage, I 
do not believe that it is a risk that they are broadly going to 
undertake. So there are some very significant competing 
considerations that would weigh against broad-based assignee 
liability.
    Chairman Reed. Just a follow-up. Would one of aspect of 
this might be that those investors would be much more careful 
about what they are buying and what they are investing in? 
Because they would like to make sure that the originator was 
doing their job in underwriting and that would be a market 
solution to this problem.
    Mr. Miller. I think they certainly want to be and will be 
more careful. I think the issue, though, is whether they really 
are in a position even with the extreme time and effort and due 
diligence to be able to know whether, in fact, fraud was 
committed. I do not think they can be in that position, and so 
there, I do not think that at least it is a universal solution 
or market-based response that could work.
    Chairman Reed. Thank you.
    Mr. Davidson, do you have a comment?
    Mr. Davidson. Sure. In both my written statement and oral 
statement, I mentioned this idea of an origination certificate.
    Chairman Reed. Right.
    Mr. Davidson. And the idea of that is an alternative to 
both the assignee liability and the current way that 
representations and warranties travel through the system. And 
the idea there is to say that these are the obligations of the 
originator and that that tracks along with the loan, or whoever 
the investor is, and stays as an obligation back to the 
borrower, and that we also track through a bonding system or 
other capital system capital of that originator or lender so 
that in the case there are violations of representations and 
warranties or there is fraud against the borrower, there is 
money to go after. And so this puts the responsibility in the 
hands of the person who created the problem rather than other 
parties who really, as Mr. Miller has said, cannot really know 
exactly what happened.
    Chairman Reed. All right. And, Mr. Miller, you have also 
suggested a unique identification number for loans. How would 
that work? And would it work in conjunction with Mr. Davidson's 
proposal? Or what other aspects would it help?
    Mr. Miller. I think that it would, and just building on 
what Mr. Davidson just indicated, I think also the 
representations and warranties and enhancements there are 
really, I think, very consistent with what he was stating in 
terms of creating an ongoing economic responsibility. His 
proposal is a bit of a variation on that theme.
    I think the unique loan identifier, which ASF has recently 
announced, will broadly assist the process of being able to 
drill down to the individual level of the mortgage loan as that 
makes its way into the secondary and debt capital market so 
that no matter what type of securities structure--it could be a 
whole loan sale, it could be a mortgage-backed securitization, 
it could be another type of instrument down the road--investors 
and other parties would be able to identify the specific loans 
underlying that instrument and coupled with the other data, 
standardization enhancements through Project Restart, be able 
to perform analytics at a very deep level of detail, providing 
investors and other market participants with a much better 
window into the performance characteristics and risk profiles 
of those loans and, thus, the securities that they are a part 
of.
    Chairman Reed. Thank you. One final area of questioning, 
and that is, many of these securitizations depend on REMIC, the 
real estate conduit tax treatment. And there has been some 
discussion that because of the structure of these vehicles, it 
is very difficult to modify mortgages held in them because in 
some cases it requires unanimous consent, which is hard to get 
if you are at the lowest tranche. And I am wondering as we go 
forward, should we consider conditioning this favorable 
treatment on an agreement to modify loans that are financially 
appropriate? I mean, you know, not subsidized loans, but if the 
modification will have a value more than a foreclosure, then 
that should be done? Professor McCoy, and then anyone else who 
wants to comment.
    Ms. McCoy. Yes, I think this is essential. There seem to be 
three impediments right now. One is that perhaps the REMIC 
rules themselves discourage workouts, although the IRS has been 
trying to soften that.
    The second problem is servicer compensation often is more 
lucrative if you go to foreclosure. That is a separate problem 
that needs to be fixed.
    But, last, servicers do have some justifiable fear that 
they will be sued by one set of tranche holders if they benefit 
another in the process of doing a good-faith workout. And I 
think we can use the REMIC rules to say the trust will not 
receive Federal tax favored treatment unless these problems are 
solved, so that when workouts are cost effective, that they go 
forward, and the servicer has the incentive to do it and is not 
worried about lawsuits.
    If I could work in one other thing?
    Chairman Reed. Yes, please.
    Ms. McCoy. Which is with respect to assignee liability, 
again and again we hear this claim that investors will not come 
to the table if there is carefully crafted assignee liability 
that does not expect investors to do the impossible. In fact, 
in States that had carefully crafted standards, investors did 
fund those loans.
    What drove them away was the failure of securitization. So 
it is ironic to talk about assignee liability driving them away 
when securitization was able to do that just fine on its own.
    Chairman Reed. Any other comments, particularly on this 
REMIC question? Mr. Miller.
    Mr. Miller. Yes, I do not think that the REMIC regulations 
are themselves an impediment at all to loan modifications that 
are otherwise contractually permitted. I think it is really 
quite well established that under the REMIC regulations, if a 
mortgage loan is in default or that default is reasonably 
foreseeable, which covers, I think, a lot of territory, that a 
loan modification can be pursued-- again, subject to any 
contractual requirements in the securitization itself.
    Having said that, I do not believe that it would be 
advisable public policy to condition REMIC qualification or 
continuing REMIC qualification on requirements to perform 
modifications or to do that in a certain way. Again, I think 
that would threaten the tax treatment that is provided through 
the REMIC regulations in a way that would, again, chill or 
inhibit participation and create distortions in the 
marketplace.
    To the extent that there are solutions or improvements to 
the loan modification process, I think we should address those 
frontally and head on. Part of Project Restart looking forward 
prospectively is to support changes and develop standardized 
provisions governing loan modifications and loss mitigation for 
future securitization transactions to address uncertainties or 
ambiguities in the way that that language is currently 
constructed in those transactions. So I think the better way 
would be to address it directly and not indirectly through the 
Tax Code.
    Chairman Reed. Just a follow-up question. The point that 
Professor McCoy makes about the incentives for services 
financially, in some cases--not all, obviously--that 
foreclosure provides them more income than a modification, 
which takes time, et cetera, and that seems to be a classic 
case of the obvious benefit to one person but socially a cost 
to all of us because as more and more mortgages go into default 
and foreclosure, it is hurting the economy grievously.
    So is that something that we can correct or should correct?
    Mr. Miller. Well, I think the answer that I would give to 
that is, regardless of incentives of any of the parties who are 
involved in that circumstance, again, at least in the 
securitization context, the duties and obligations and 
responsibilities of servicers are laid out in the contracts, 
they are and should be held to those standards by investors and 
others. So regardless of any potential incentive that they may 
have--and I personally think that some of the arguments about 
servicing incentives to foreclose as opposed to, you know, 
taking reasonable workout strategies, especially where that can 
yield a greater net present value, I think some of those 
statements are overstated or exaggerated. But, again, you know, 
I think that really is something that is determined and 
dictated by contract and the parties should be held to their 
contractual obligations.
    Chairman Reed. Just a final point. You are talking about 
prospectively fixing this system. But currently we are looking 
at estimates range from 4 million to 6 million foreclosures 
next year, which is a huge drag on the economy and which may, 
in fact, be sufficient drag to cutoff or at least to deflect 
the growth and the prosperity we are all hoping for.
    So I think we are confronting--I applaud your efforts to go 
forward prospectively, but we have a huge problem with what we 
have to deal with right now.
    Anyone else who has a comment on this topic?
    [No response.]
    Chairman Reed. If not, let me thank you all again for 
excellent testimony. I think Senator Gregg said it very well: 
great insights together with very specific suggestions and done 
in a very concise and understandable way. So thank you all for 
your wonderful testimony.
    The hearing is adjourned.
    [Whereupon, at 4:11 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
                PREPARED STATEMENT OF CHAIRMAN JACK REED
    I want to welcome everyone and thank our witnesses for appearing 
today.
    This hearing will examine a key activity within our financial 
markets--the securitization of mortgages and other assets--and will 
build on previous hearings this Subcommittee has held to address 
various aspects of regulatory modernization, including hedge funds, 
derivatives, corporate governance, SEC enforcement, and risk management 
at large financial institutions.
    Securitization is the packaging of individual loans or other debt 
instruments into marketable securities to be purchased by investors. At 
its core, this process helps free lenders to make more loans available 
for families to purchase items like homes and cars and for small 
businesses to thrive.
    But we have learned from the financial crisis that securitization, 
or how it is conducted, can also be extremely harmful to financial 
markets and families without appropriate diligence and oversight. 
Arguably, many of the basic requirements needed for effective 
securitization were not met. Today's panel will discuss how in recent 
years the securitization process created incentives throughout the 
chain of participants to emphasize loan volume over loan quality, 
contributing to the build-up and collapse of the subprime mortgage 
market and the broader economy.
    Today we find ourselves in the opposite position from a few years 
back, with hardly any issuances in key markets that could help return 
lending to responsible levels. So this afternoon's hearing is about how 
to strengthen the securitization markets and enact any needed changes 
to ensure that securitization can be used in ways that expand credit 
without harming consumers and the capital markets.
    I have asked today's witnesses to address a number of key issues, 
including the role securitization played in the financial crisis, the 
current conditions of these markets, and what changes may be needed to 
Federal oversight of the securitization process.
    Unfortunately, a number of the banks who issue these securities 
could not find anyone in their workforce who was willing to testify 
today.
    I welcome you all and look forward to your testimony.
                                 ______
                                 
                PREPARED STATEMENT OF PATRICIA A. McCOY
    George J. and Helen M. England Professor of Law, and Director, 
     Insurance Law Center, University of Connecticut School of Law
                            October 7, 2009
    During the housing bubble, private-label securitization financed 
the majority of subprime and nontraditional mortgages. \1\ This system 
proceeded on the assumption that housing prices would keep going up. 
When housing prices fell and people could not refinance out of 
unaffordable loans, investors lost confidence in private-label mortgage 
securitization and the system collapsed in August 2007.
---------------------------------------------------------------------------
     \1\ I use the term ``nonprime'' to refer to subprime loans plus 
other nontraditional mortgages. Subprime mortgages carry higher 
interest rates and fees and are designed for borrowers with impaired 
credit. Nontraditional mortgages encompass a variety of risky mortgage 
products, including option payment ARMs, interest-only mortgages, and 
reduced documentation loans. Originally, these nontraditional products 
were offered primarily in the ``Alt-A'' market to people with near-
prime credit scores but intermittent or undocumented income sources. 
Eventually, interest-only ARMs and reduced documentation loans 
penetrated the subprime market as well.
---------------------------------------------------------------------------
    This statement begins with a thumbnail sketch of securitization. 
Then I describe the role played by securitization in the financial 
crisis. Following that, I analyze the inherent flaws in private-label 
mortgage securitization. The statement goes on to describe current 
conditions in that market. I close by describing needed reforms.
I. An Introduction to Securitization
    Back in the 1970s, banks had to hold home mortgages in portfolio 
until those loans were paid off. This destabilized banks that made 
mortgages because they got their financing from demand deposits, but 
invested those deposits in illiquid mortgages. This ``term mismatch'' 
between assets and liabilities was a direct cause of the 1980s savings 
and loan crisis.
    Starting in the late 1970s, securitization burst on the scene and 
eliminated the need for lenders to hold their mortgages in portfolio. 
The idea behind securitization is ingenious: bundle a lender's loans, 
sell them to a bankruptcy-remote trust, repackage the monthly loan 
payments into bonds rated by rating agencies, back the bonds with the 
underlying mortgages as collateral, and sell those bonds to investors.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Investment banks ``structured'' these securitization deals by 
dividing the bonds into ``tranches'' (French for ``slice''). The best 
tranche, with the lowest expected default rate, carried an AAA rating, 
was paid off first, and offered the lowest rate of return. The lower 
tranches were rated AA, A, etc., on down to the junior-most tranche, 
known as the equity tranche. The equity tranche was paid off last and 
was the first to absorb any losses from the loans.
    Securitization was prized for accomplishing four things. First, 
lenders were able to get their mortgages off their books. Second, 
securitization appeared to manage the risks of mortgages by slicing and 
dicing those risks and spreading them among millions of investors with 
assorted tolerances for risk. Third, securitization opened up huge new 
pools of capital to finance home mortgages. Finally, securitization 
freed lenders from relying principally on insured deposits in order to 
make loans. Instead, in a continuous cycle, lenders could make loans, 
sell those loans through securitization, and then plow the proceeds 
into a new batch of loans, which in turn would be securitized. This 
paved the way for a new breed of nonbank subprime lenders, who had 
little in the way of capital reserves, were free from Federal banking 
regulation, and were inured to the reputational constraints of banks 
and thrifts.
    At first, securitization was limited to prime loans, which were 
mostly securitized through the two Government-sponsored entities (GSEs) 
Fannie Mae and Freddie Mac. Once the market gained confidence about its 
ability to price subprime mortgages, securitization expanded to the 
subprime market in the early 1990s. Although the GSEs made limited 
forays into the subprime market and later expanded those forays around 
2005, most subprime securitizations did not take place through the 
GSEs, but rather through the ``private-label'' securitization market. 
The private-label market lacked the same degree of public 
accountability that was expected of Fannie Mae and Freddie Mac as GSEs. 
By 2006, two-thirds or more of subprime mortgages were being 
securitized through the private-label market.
II. The Role of Securitization in the Financial Crisis
A. How Private-Label Securitization Increased the Risk of Mortgage 
        Lending
    Before securitization, lenders usually did it all: they solicited 
loan applicants, underwrote and funded the loans, serviced the loans, 
and held the loans in portfolio. Lenders earned profits on loans from 
interest payments as well as from upfront fees. If the loans went into 
default, the lenders bore the losses. Default was such a serious 
financial event that lenders took care when underwriting loans.
    All that changed with private-label securitization. Securitization 
allowed lenders to offload most of the default risk associated with 
nonprime loans. Under the ``originate-to-distribute'' model, lenders 
could make loans intending to sell them to investors, knowing that 
investors would bear the financial brunt if the loans went belly-up. 
Similarly, securitization altered the compensation structure of 
nonprime lenders. Lenders made their money on upfront fees collected 
from borrowers and the cash proceeds from securitization offerings, not 
on the interest payments on loans.
    Lenders liked the security of being paid in advance, instead of 
having to wait for uncertain monthly payments over the life of loans. 
And, because they could pass the lion's share of the default risk onto 
faceless investors, lenders had less reason to care about how well 
their loans performed. In my examinations of internal records of major 
nonprime lenders, including Federal thrift institutions and national 
banks, too often I found two sets of underwriting standards: high 
standards for the loans they kept on their books and lax standards for 
the loans that they securitized.
    At their peak, investment grade, \2\ nonprime residential mortgage-
backed securities (RMBS) were considered excellent investments because 
they supposedly posed minimal default risk while offering high returns. 
Investors clamored for these bonds, creating demand for ever-riskier 
loans.
---------------------------------------------------------------------------
     \2\ The top four ratings issued by a rating agency are 
``investment grade'' ratings. For Standard & Poor's, these are ratings 
of AAA, AA, A, and BBB; for Moody's, Aaa, Aa, A, and Baa. Any rating 
below investment grade is considered junk bond status.
---------------------------------------------------------------------------
    Lenders were not the only players in the chain between borrowers 
and investors. Investment banks played significant roles as 
underwriters of nonprime securitizations. Lehman Brothers, Bear 
Stearns, Merrill Lynch, JPMorgan, Morgan Stanley, Citigroup, and 
Goldman Sachs underwrote numerous private-label nonprime 
securitizations. From 2000 through 2002, when IPO offerings dried up 
during the 3-year bear market, RMBS and CDO deals stepped into the 
breach and became one of the hottest profit centers for investment 
banks.
    Investment banks profited from nonprime underwriting by collecting 
a percentage of the sales proceeds, either in the form of discounts, 
concessions, or commissions. Once an offering was fully distributed, 
the underwriter collected its fee in full. This compensation system for 
the underwriters of subprime offerings caused Donna Tanoue, the former 
Chairman of the Federal Deposit Insurance Corporation, to warn: ``[T]he 
underwriter's motivation appears to be to receive the highest price . . 
. on behalf of the issuer--not to help curb predatory loans.''
    Tanoue's warning proved prophetic. In February 2008, Fitch Ratings 
projected that fully 48 percent of the subprime loans securitized by 
Wall Street in 2006 would go into default. Despite that dismal 
performance, 2006 produced record net earnings for Goldman Sachs, 
Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. That 
year, manager pay reflected the bottom-line importance that investment 
banks placed on private-label RMBS, with managing directors in the 
mortgage divisions of investment banks earning more on average in 2006 
than their counterparts in other divisions.
B. How Securitization Fueled Contagion
    Ultimately, private-label mortgage securitization turned out to be 
an edifice built on a rotting foundation. Once that foundation gave 
way, rising nonprime delinquencies mushroomed into international 
contagion for a number of reasons. For example, the same loan often 
served as collateral for multiple bonds, including an RMBS, a CDO, and 
a CDO of CDOs. If the loan went into default, it would jeopardize 
repayment for all three bonds. In addition, if defaults led to 
downgrades on those bonds, those assets were highly correlated. If 
rating agencies downgraded one issue, other issues came into question 
as well.
    Collateral is another reason why nonprime loans infected other 
markets. Many large institutional investors bought nonprime bonds that 
they later pledged as security for other types of loans. Banks, for 
instance, pledged their nonprime bonds as security for short-term loans 
from other banks on the market for interbank credit. Major corporations 
borrowed money from other corporations on the short-term commercial 
paper market by issuing paper backed by nonprime bonds. As the value of 
nonprime bonds fell, lenders began calling loans and ultimately the 
interbank lending and asset-backed commercial paper markets slowed to a 
crawl.
    Banks also reinfected themselves with subprime risks by buying 
private-label RMBS and CDOs and effectively taking those risks back on 
their books. When they sustained major losses on those bonds, they 
reined in their lending, adding fuel to the recession.
    General investor panic is the final reason for contagion. Even in 
transactions involving no nonprime collateral, concerns about the 
nonprime crisis had a ripple effect, making it hard for companies and 
cities across-the-board to secure financing. Banks did not want to lend 
to other banks out of fear that undisclosed nonprime losses might be 
lurking on their books. Investors did not want to buy other types of 
securitized bonds, such as those backed by student loans or car loans, 
because they lost faith in ratings and could not assess the quality of 
the underlying collateral. Stocks in commercial banks, insurance 
companies, and Wall Street firms took a beating because investors did 
not know where nonprime assets were hidden and feared more nonprime 
write-downs. Because they did not know exactly who was tainted by 
nonprime, investors stopped trusting practically everyone.
III. Inherent Flaws in Private-Label Mortgage Securitization
A. The Lemons Problem
    In hindsight, private-label mortgage securitization turned out to 
resemble the used car business in one respect. Both businesses have 
motivations to sell ``lemons.'' In other words, they have structural 
incentives to sell products carrying hidden defects and a heightened 
risk of failure.
    There are two main reasons for this lemons problem. First, 
securitization resulted in a misalignment of compensation and risk. 
Each company in the securitization process was able to collect upfront 
fees, while shifting default risk to downstream purchasers. Although 
investors tried to protect themselves through recourse clauses and 
structures making lenders retain the equity tranches, those contractual 
safeguards often broke down. Lenders were able to hedge their equity 
tranches or shed them by resecuritizing them as CDOs. Similarly, too 
many originators lacked the capital to honor their recourse obligations 
in full.
    Second, securitization fueled a relentless demand for volume and 
volume-based commissions. In the process, the quest for volume pushed 
lending standards steadily downward in order to maintain market share. 
This became a challenge in 2003, when interest rates began rising 
again, ending the refinancing boom. Securitizers needed another source 
of mortgages in order to increase the rate of securitization and the 
fees it generated. The ``solution'' was to expand the market through 
nontraditional mortgages, especially interest-only loans and option 
payment ARMs offering negative amortization. Lenders also relaxed their 
underwriting standards on traditional products to qualify more 
borrowers. This expansion of credit swept a larger portion of the 
population into the potential homeowner pool, driving up housing demand 
and prices, and consumer indebtedness. Many big investment banks, 
including Lehman Brothers and Bear Stearns, went so far as to buy 
subprime lenders in order to have an assured pipeline of mortgages to 
securitize.
    In short, the incentive structure of securitization caused the 
lemons problem to grow worse over time. Not only did private-label 
securitization sell lemons, those lemons grew more rotten as the 
housing bubble grew. In the process, securitization actors played the 
ends against the middle, injuring borrowers and investors alike.
B. Harm to Borrowers
    Private-label securitization hurt numerous borrowers. First, 
investor appetite for high-yield RMBS caused originators to peddle 
risky mortgages, to the exclusion of safer loans. Second, compensation 
methods such as yield spread premiums saddled many borrowers with 
costlier mortgages than they qualified for. Third, borrowers whose 
loans were securitized lost important legal rights without their 
consent.
    On the first point: As mentioned above, in order to maintain volume 
while satisfying investor demand for high-yield bonds, investment banks 
and lenders had to continually tap new groups of borrowers with lower 
credit scores and less disposable income. For many of these cash-
strapped borrowers, low monthly payments were a primary consideration. 
In order to offer the lure of lower initial payments, lenders concocted 
bafflingly complex loans combining a host of risky features, including 
adjustable-rate terms, teaser rates, high margins, stiff prepayment 
penalties, and no amortization or even negative amortization. Evidence 
is now coming to light that investment banks or large investors in many 
cases dictated those underwriting guidelines to originators.
    The front-end payments of these hazardous mortgages were attractive 
to unsuspecting borrowers and usually lower than the payments on a 
plain vanilla fixed-rate mortgage. But the back-end risks of those 
mortgages were daunting, yet difficult or impossible for borrowers to 
discern. Worse yet, to qualify individual borrowers, lenders often 
threw full income verification out the window.
    There was a second way in which investor demand for higher yield 
hurt many borrowers. Because investors paid more for higher yields, 
lenders offered mortgage brokers higher compensation in the form of 
yield spread premiums to convince borrowers who probably qualified for 
cheaper loans to unwittingly pay higher interest rates. The Wall Street 
Journal estimated that by year-end 2006, 61 percent of subprime 
mortgages went to borrowers with high enough credit scores to qualify 
for cheaper prime loans. \3\ Yield spread premiums artificially 
inflated the interest rates that borrowers had to pay, substantially 
increasing the likelihood that nonprime loans would default and go into 
foreclosure. Economists have estimated the size of this risk. For every 
1 percent increase in the initial interest rate of a home mortgage, the 
chance that a household will lose its home rises by 16 percent a year.
---------------------------------------------------------------------------
     \3\ Rick Brooks and Ruth Simon, ``Subprime Debacle Traps Even Very 
Creditworthy'', Wall St. J., Dec. 3, 2007, at A1.
---------------------------------------------------------------------------
    Finally, under the Uniform Commercial Code in many States, 
borrowers whose loans are securitized lose valuable legal rights 
without their consent or financial compensation. This doctrine, known 
as the ``holder-in-due-course rule,'' prohibits borrowers whose loans 
are securitized from raising common types of fraud or other misconduct 
in the making of their loans against all subsequent purchasers of their 
loan notes. In many case, this shields investment banks, rating 
agencies, and investors from borrower suits for fraud. Although 
borrowers can still raise fraud as a claim or defense against their 
mortgage brokers and lenders, many of those entities are bankrupt today 
and thus judgment-proof. More importantly, once a loan is securitized, 
any suit for foreclosure will be brought by the investor or securitized 
trust, not the mortgage broker or lender. In those cases, the holder-
in-due course rule prevents borrowers who were defrauded from even 
raising the fraud as a defense to foreclosure.
C. Harm to Investors
    The lack of transparency in securitization also hurt investors. The 
securities disclosures for private-label RMBS lacked crucial 
information to investors. In addition, product complexity made it 
difficult or impossible for investors to grasp the risks associated 
with many offerings. Finally, both problems caused investors to place 
undue reliance on credit ratings, which proved to be badly inflated.
    1. Inadequate Securities Disclosures--For most of the housing 
bubble, the Securities and Exchange Commission (SEC) had no rule 
requiring disclosures specifically tailored to RMBS or CDOs. The SEC 
adopted Regulation AB in an attempt to redress that gap, but the rule 
did not go into effect until January 1, 2006, too late to cover earlier 
private-label offerings.
    Once the rule went into effect, it was riddled with holes. First, 
Reg AB only applies to public offerings of asset-backed securities. An 
investment bank could simply bypass Reg AB by structuring the offering 
as a private offering limited to big institutional investors. In 
private offerings, SEC disclosures are lighter or left to private 
negotiation, based on the idea that institutional investors have clout 
to demand the information they need. Wall Street took full advantage of 
this loophole, meaning that CDOs were almost always sold through 
private offerings with seriously deficient disclosures.
    Even when Reg AB did apply--i.e., in public offerings of asset-
backed securities--the disclosures were too skimpy to be of use. The 
SEC modeled many of Reg AB's disclosures on the reporting requirements 
for corporate issuers. Corporations usually have track records to speak 
of, so securities disclosures for those issuers focus on recent past 
performance. But past performance was irrelevant for most offerings of 
RMBS and CDOs, which involved relatively new mortgages. In essence, Reg 
AB puts the wrong information under the microscope.
    Instead, investors in nonprime bonds needed standardized 
information on the risk characteristics of the individual loans in the 
loan pool. But Reg AB does not require that level of detail. While the 
rule encouraged investment banks to make tapes with loan level data 
available to investors online, it did not force them to do so. Instead, 
Reg AB simply mandates a summary of the aggregate characteristics of 
the loan pool. That made it difficult to discern whether the riskiest 
loans were going to the strongest borrowers or to the worst borrowers 
in the loan pool.
    Similarly, too many prospectuses and offering memoranda for 
private-label offerings stated that the lenders reserved the right to 
make exceptions to their underwriting standards in individual cases. In 
2006 and 2007, there were offerings in which the exceptions--in other 
words, loans that flunked the lender's underwriting standards--
outweighed the number of loans that conformed to the lender's stated 
standards. The exact (and often high) percentage of exceptions was not 
disclosed to investors.
    Nor does Reg AB make investment banks disclose the due diligence 
reports they commissioned from outside firms, even when those reports 
contained evidence of deteriorating lending standards. Too often, 
investment banks withheld those reports from investors and ratings 
agencies.
    Reg AB is also deficient regarding the performance of individual 
loans. While Reg AB requires some reporting on loan performance, it is 
only for the first year following the offering, not for the life of the 
loans.
    All told, there was a dearth of useful publicly available 
information on the loan pools underlying private-label RMBS and CDOs. 
The SEC disclosure scheme for nonprime RMBS and CDOs was so misbegotten 
and riddled with exceptions that those securities operated in a fact-
free zone. Investors and analysts who wanted to do serious due 
diligence could not get the facts they needed to figure out the true 
risk presented by the loans. Without those facts, investors often 
overpaid for those securities. Furthermore, the dearth of key public 
information also impeded the development of a healthy resale market in 
those bonds, which became a big problem later on when banks tried to 
unload toxic subprime assets off their books.
    2. Complex Products--Many private-label RMBS and CDOs were so 
complex that due diligence was too costly or impossible for investors. 
CDOs are a good example. Typically, a CDO consisted of junior tranches 
of RMBS from different offerings, sometimes paired with other types of 
asset-backed securities involving receivables from things like credit 
cards or auto loans. At best, the investor received data on the quality 
of the underlying bonds. But it was impossible for the investor to x-
ray the offering in order to analyze the underlying home mortgages, 
credit card borrowers, or auto loans themselves. That was even more 
impossible when the CDO was a ``synthetic CDO'' made up of credit 
default swaps on RMBS and asset-backed securities.
    Even in regular RMBS, complexity was a big problem. One issue was 
the sheer number of tranches. Another was the fact that many private-
label RMBS offerings featured complex credit enhancement rules about 
who would receive cash flows from the mortgages in what amounts, 
depending on changes in the amount of subordination or 
overcollateralization. This meant that investors could not just stop 
with estimating expected losses from the mortgages. They also had to 
analyze who would get what cash flows when, based on a changing 
kaleidoscope of scenarios. \4\ In addition, too many offerings were 
made on a ``to be announced'' or ``TBA'' basis, which meant that 
investors could not scrutinize the underlying loans because the loans 
had not yet been put in the loan pool. Finally, many securitization 
deals involved custom features that undermined standardization.
---------------------------------------------------------------------------
     \4\ Ingo Fender and Janet Mitchell, ``The Future of 
Securitization: How To Align Incentives?'', Bis. Quarterly Review 27, 
30, 32 (Sept. 2009).
---------------------------------------------------------------------------
    Of course, this discussion begs the question whether investors 
would have done adequate investigation in any case when the housing 
bubble was at its height and euphoria prevailed. But back then, even 
investors who wanted to do serious due diligence would have met 
insuperable obstacles. More recently, lack of transparency and 
complexity have blocked the formation of an active, liquid resale 
market that would enable banks to remove impaired RMBS and CDOs from 
their books.
    3. Overreliance on Credit Ratings--Poor disclosures and overly 
complex deals caused investors to over rely on credit ratings. 
Meanwhile, the rating agencies had financial incentives to understate 
the risks of nonprime RMBS and CDOs. The investment banks that 
underwrote nonprime securitizations paid the rating agencies to provide 
them with investment-grade ratings. The rating agencies touted the top-
rated nonprime bonds--ranging from AAA down to A--as hardly ever 
defaulting.
    Under banking and insurance laws, banks and insurance companies can 
only invest in types of bonds permitted by law. Private-label RMBS and 
CDOs carrying investment grade ratings are on the permissible list, so 
long as those ratings are rendered by rating agencies designated 
Nationally Recognized Statistical Rating Organizations (NRSROs) by the 
SEC. These regulatory rules encouraged institutional investors in 
search of higher yields to buy the top-rated nonprime RMBS and CDOs.
    During the housing bubble, rating fees on private-label RMBS and 
CDOs were the fastest-growing sector of the rating agency business. 
Issuers paid the rating agencies handsome fees from these deals, 
spurring the rating agencies to rate offerings for which there was 
scant historical default data. Similarly, the rating agencies used 
flawed models which assumed never-ending housing price appreciation and 
were not updated with new default data. Nor did most investors realize 
that an AAA rating for an RMBS offering was different than, and 
inferior to, an AAA rating for a corporate bond. \5\
---------------------------------------------------------------------------
     \5\ In large part, and in contrast with corporate bonds, this is 
because downgrades of a tranched RMBS tend to make downgrades of other 
RMBS tranches more likely. Fender and Mitchell, supra note 4, at 33.
---------------------------------------------------------------------------
D. Impediments to Loan Modifications
    Deal provisions in private-label securitizations have also 
paralyzed constructive workouts of many distressed home loans. Today, 
securitized trusts, not lenders, hold the vast majority of those loans. 
The complexity of the securitized deals often pits servicers against 
investors and investors against each other. Too often, the servicers 
opt for foreclosing on property, instead of arranging workouts that 
would allow homeowners to stay in their homes. The irony of this 
approach is that, in many cases, workouts in the form of loan 
forbearance or loan modifications would result in a higher recovery.
    There are several explanations for this seemingly irrational 
behavior, including inadequate staffing levels and compensation clauses 
that cause servicers to earn more money from foreclosures than 
workouts. But the main reason why more workouts do not occur is that 
many pooling and servicing agreements place constraints on servicers' 
ability to negotiate loan workouts. Some limit the percent of the loan 
pool that can be modified. Others have vague prohibitions allowing 
modifications only to the extent they are in the best interests of the 
investors. Even when those agreements give servicers latitude to modify 
loans, servicers are reluctant to modify loans because they fear 
lawsuits by warring trancheholders for breach of fiduciary duty.
    This hold-up problem has stymied Federal regulators' attempts to 
speed up loan modifications and halt the vicious cycle of falling home 
prices. With no Federal legislation to force modifications, regulators 
have only had limited success. Meanwhile, loan workouts are crawling at 
a snail's pace, leading foreclosed homes to be dumped on the market in 
record numbers and pushing home prices further down in the process.
IV. Current Conditions in the Private-Label Securitization Markets
    Due to the problems just described, the markets for private-label 
RMBS and CDOs are essentially dead. The securitization markets for auto 
loans, credit cards, and student loans are open, but their volume has 
dropped sharply due to general concerns about the soundness of the 
securitization process.
    For all intents and purposes, the Federal Government has become the 
financier of first resort for residential mortgages. In 2008, agency 
mortgage-backed securities--in other words, RMBS issued by Fannie Mae, 
Freddie Mac, and Ginnie Mae (FHA loans)--accounted for over 96 percent 
of the U.S. RMBS market. Private-label mortgage-backed securitization 
accounted for less than 4 percent of the market that year.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    This disparity widened in the first 6 months of 2009, when the 
relative market shares of agency and private-label mortgage-backed 
securitization were 99 percent and 1 percent. \6\ In second quarter 
2009, moreover, 38.4 percent of private-label RMBS transactions were 
re-REMICs of old loans that were repackaged into tranches of good and 
bad loans. According to the Securities Industry and Financial Markets 
Association (SIFMA), the ``private label market remains dormant due to 
reduced lending, lack of investor demand, low liquidity,'' and rising 
delinquencies and foreclosures. \7\
---------------------------------------------------------------------------
     \6\ I use the term ``agency'' to refer to GNMA, Fannie Mae and 
Freddie Mac mortgage-backed securities and collateralized mortgage 
obligations. The term ``private-label'' includes RMBS and CMOs.
     \7\ Securities Industry and Financial Markets Association, 
Research Report 2009 Q2 (August 2009), at 2, 9.
---------------------------------------------------------------------------
    As these numbers suggest, private investors are largely shunning 
the private-label mortgage securitization market in favor of other 
investments, including agency RMBS. In the meantime, the Federal 
Reserve has become a major investor in agency RMBS, having begun 
purchases in this market in December 2008. The Fed has pledged to 
buying up to $1.25 trillion in agency RMBS before the end of this year, 
in an effort to help lower home mortgage interest rates.
    Other securitization markets associated by investors with mortgages 
are also dormant. SIFMA reports that the private-label commercial MBS 
primary market ``remains closed.'' \8\ Similarly, global issuance of 
CDOs has essentially come to a halt.
---------------------------------------------------------------------------
     \8\ Id. at 9.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
    Outside of the mortgage sector, auto loan, credit card, and student 
loan securitizations have fallen by over half since 2007. All three 
sectors became paralyzed in mid-2008, prompting the Federal Reserve to 
revive these markets with the Term Asset-Backed Securities Lending 
Facility (TALF). Spreads soared in 2008 and have since fallen, although 
have not completely recovered. This suggests that investor concerns 
about the general integrity of the securitization process spilled over 
to other sectors.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Although TALF has helped to revive these markets, particularly in 
the auto and credit card areas, delinquencies and charge-offs continue 
to climb.
V. Needed Reforms
    Private-label mortgage securitization will undoubtedly return in 
one form or another. And just as certainly, investors will eventually 
forget the lessons from this crisis. To avoid repeating the mistakes of 
the past, it is essential to put private-label mortgage securitization 
on sound footing going forward.
A. Proposals To Realign Incentives
    Discussions about reforming private-label securitization often 
revolve around proposals to realign the incentives of originators and 
investment banks. The idea is to give them sufficient ``skin in the 
game'' to care about soundly underwritten loans. Thus, the Obama 
Administration has proposed \9\ requiring securitizers to retain at 
least 5 percent of the credit risk on each asset in the asset-backed 
securities that they issue. \10\ Securitizers would also be barred from 
resecuritizing or hedging that retained risk. Section 213 of the 
Mortgage Reform and Anti-Predatory Lending Act, H.R. 1728, passed by 
the House of Representatives on May 7, 2009, contains a similar 
proposal.
---------------------------------------------------------------------------
     \9\ Financial Regulatory Reform Proposal, Title IX, 951, 
www.treas.gov/initiatives/regulatoryreform/.
     \10\ The implementing agencies would also have to adopt provisions 
allocating the risk retention obligation between the securitizer and 
the originator.
---------------------------------------------------------------------------
    There are other incentive-based proposals to improve loan 
underwriting. One involves increased capital: in other words, requiring 
commercial and investment banks --especially too-big-to-fail banks--to 
hold more capital, both against the tranches they retain and against 
other aspects of securitization that could come back to haunt them, 
such as recourse clauses and structured investment vehicles.
    Another proposal is to realign originators' compensation with loan 
performance. Accounting standards could be changed to eliminate 
immediate recognition of gain on sale by originators at the time of 
securitization. And there are two promising proposals to curb reckless 
originations by independent mortgage brokers. One would prohibit pay 
incentives such as yield spread premiums for steering customers to 
costlier or riskier loans. H.R. 1728, 103. Another proposal would make 
full payout of compensation to mortgage brokers contingent on good 
performance of the loan.
    A final idea along these lines is to require lenders and 
securitizers to make stronger representations and warranties to 
investors, accompanied by stiffer recourse provisions for loans that 
violate those reps and warranties. The American Securitization Forum 
has advanced this reform.
    All of these proposals are good ideas. However, they are not 
enough, together or alone, to ensure sound underwriting. Take the risk 
retention requirement, for example. It is doubtful whether the ban on 
hedging is even enforceable, since ``sometimes firms pool their risk 
and set hedges against several positions at once.'' \11\ More 
importantly, requiring risk retention does not solve the fact that 
banks, once they got loans off of their books through securitization, 
assumed that risk again by investing in toxic subprime RMBS and CDOs.
---------------------------------------------------------------------------
     \11\ Fender and Mitchell, supra note 4, at 41.
---------------------------------------------------------------------------
    As for capital requirements, more capital is essential for 
depository institutions and investment banks. But capital is no 
panacea. Banks have proven adept at evading minimum capital 
requirements. Furthermore, the credit crisis raised serious concerns 
about the newly adopted Basel II capital standards, which were designed 
to lower capital and allow large internationally active banks--i.e., 
too-big-to-fail banks--to set their own minimum capital.
    Stronger reps and warranties, backed by stiffer recourse, are 
likewise advisable. But the crisis has shown that recourse provisions 
are only as good as a lender's solvency. Since the credit crisis began, 
most nonbank subprime lenders have gone out of business. In addition, 
126 banks and thrifts have failed since 2007. Some institutions failed 
precisely due to their inability to meet investor demands for recourse. 
\12\
---------------------------------------------------------------------------
     \12\ See, e.g., Office of Inspector General, Department of the 
Treasury, ``Safety and Soundness: Material Loss Review of NetBank, 
FSB'' (OIG-08-032, April 23, 2008), www.ustreas.gov/inspector-general/
audit-reports/2008/OIG08032.pdf.
---------------------------------------------------------------------------
    Even when recourse can be had, negotiations can be long and drawn-
out. Moreover, if a recourse provision is not ironclad, a solvent 
lender may be able to escape it. For example, any provisions that would 
condition recourse on the lender's knowledge that the reps and 
warranties were violated--creating a Sergeant Schultz ``I know 
nothing'' defense--usually would be meaningless if the misconduct in 
question was committed by an independent mortgage broker. That would 
include situations where the lender failed to adequately supervise the 
broker, which often was the case.
    For all of these reasons, having ``skin in the game'' is not enough 
to ensure sound loan underwriting. As discussed below, more is needed 
in the form of minimum underwriting standards.
B. Improved Due Diligence by Investors
    Meanwhile, investors need the ability to do better due diligence. 
Three major reforms are needed to provide investors with the 
information that they need to make sound investment decisions about 
private-label mortgage-related bonds. First is improved transparency, 
second is product simplification and standardization, and third is 
rating agency reform.
    Transparency--The SEC should require securitizers to provide 
investors with all of the loan-level data they need to assess the risks 
involved. See Obama Administration Proposal, Title IX, 952. In 
addition, the SEC should require securitizers and servicers to provide 
loan-level information on a monthly basis on the performance of each 
loan and the incidence of loan modifications and recourse. These 
disclosures should be made in public offerings and private placements 
alike. In addition, TBA offerings should be prohibited because it is 
impossible for investors to do due diligence on those loan pools.
    Product Simplification and Standardization--The Government should 
encourage simpler, standardized securitization products, whether 
through the REMIC tax rules or rules governing permissible investments 
by insured banks and thrifts. Similarly, the Government should explore 
ways to build a liquid secondary trading market in private-label RMBS 
and other bonds.
    Rating Agency Reform--The most critical rating agency reform is 
banning the ``issuer pays'' system, in which issuers pay for ratings. 
That would help ensure that rating agencies serve the interests of 
investors, not issuers. In addition, it is necessary to require the 
rating agencies to create a new, different ratings scale for mortgage 
structured finance to distinguish it from the ratings for corporate 
bonds. Finally, NRSRO designations need to be abolished.
    The Obama Administration's proposal takes a different approach. The 
proposal would subject NRSROs to enhanced SEC oversight, including 
expanded public disclosures. In addition, the Administration would 
require rating agencies to have systems to ``manage, and disclose'' 
their conflicts of interest. Title IX, subtitle C.
    While better investor due diligence is necessary to improve 
private-label mortgage securitization, it is not enough. At the height 
of every business cycle, memories grow dim and euphoria takes hold. 
During bubbles, when default rates are low, investors are apt to cast 
aside basic due diligence precautions to grab the chance of a high-
yield investment. This temptation is particularly great for 
institutional money managers, who have cash they need to put to work 
and face pressure to report the same high returns as their competitors. 
For all of these reasons, minimum Federal underwriting standards are a 
needed supplement to investor due diligence.
C. Protecting Borrowers and the Financial System
    We cannot assume that investors will monitor adequately or that 
standardization will be achieved. Furthermore, none of the measures 
outlined above addresses the obstacles to loan modifications. Two 
additional measures are needed to protect borrowers and the larger 
economic system from reckless loans and unnecessary foreclosures.
    1. Uniform Minimum Underwriting Standards Enforceable by 
Borrowers--The downward spiral in underwriting standards drove home the 
need for uniform consumer protection standards that apply to all 
financial services providers. In fact, a new study by the Center for 
Community Capital at the University of North Carolina (Chapel Hill) 
finds that States that mandated strong loan underwriting standards had 
lower foreclosure rates than States without those laws. \13\
---------------------------------------------------------------------------
     \13\ Center for Community Capital, State Anti-Predatory Lending 
Laws (October 5, 2009), http://www.ccc.unc.edu/news/
AG_study_release_5[2].10.2009.pdf.
---------------------------------------------------------------------------
    The Federal Reserve's 2008 rule for higher-cost loans accomplished 
part of this goal, \14\ but all loans need protection, not just 
subprime loans. The Obama Administration proposal, H.R. 1728, and H.R. 
3126 would solve this problem by creating one set of uniform Federal 
laws that apply to all financial services providers across the country, 
regardless of entity, charter, or geographic location. To prevent a 
race to the bottom in which regulators compete to relax lending 
standards, the Administration proposal and H.R. 3126 would consolidate 
the authority to administer those laws in a new Consumer Financial 
Protection Agency. Under both, the standards would constitute a floor, 
in which weaker State laws are federally preempted. States would remain 
free to enact stricter consumer protections so long as those 
protections were consistent with Federal law.
---------------------------------------------------------------------------
     \14\ Federal Reserve System, Truth in Lending: Final rule; 
official staff commentary, 73 FED. REG. 44522, 44536 (July 30, 2008). 
The Board intended to cover the subprime market, but not the prime 
market. See, id. at 44536-37.
---------------------------------------------------------------------------
    These Federal standards do three things. First, the standards would 
ensure proper loan underwriting based on the consumer's ability to 
repay. Second, the standards would prohibit unfair or deceptive 
practices in consumer credit products and transactions. Finally, the 
standards would promote transparency through improved consumer 
disclosures. Bottom-line, the proposed standards would help make it 
possible for consumers to engage in meaningful comparison shopping, 
with no hidden surprises.
    In the event these standards are violated, injured borrowers need 
an affirmative claim for relief as well as a defense to foreclosure. 
Both the claim and the defense should be available against loan 
originators. Limiting relief to loan originators does not help 
borrowers with securitized loans, however, if their loans later go into 
foreclosure or their originators become judgment-proof. When a 
securitized loan is foreclosed on, for example, the lender is not the 
plaintiff; rather, foreclosure is instituted by the servicer, the owner 
of the loan, or its designee (generally the Mortgage Electronic 
Registration Systems or MERS). Consequently, fairness requires allowing 
injured borrowers to raise violations as a defense to foreclosure 
against those entities. Similarly, giving borrowers an affirmative 
claim against assignees for violations of Federal lending standards by 
originators will spur investors and investment banks to insist on 
proper underwriting of loans and afford injured borrowers relief when 
their originators are judgment-proof or a securitized trust sues for 
foreclosure. The Administration's proposal and H.R. 1728, 204, both 
contain assignee liability provisions designed to accomplish these 
objectives.
    Some fear that a borrower right of action against securitized 
trusts and investment banks would reduce access to credit. A 2008 study 
by Dr. Raphael Bostic et al. examined that question by looking at the 
effect of assignee liability provisions in nine State antipredatory 
lending laws on the availability of subprime credit. The study found 
``no definitive effect of assignee liability on the likelihood of 
subprime originations, even when the [assignee] liability provisions 
are in their strongest form.'' Subprime originations rose in six of the 
nine States studied that had assignee liability, relative to the 
control State. Results were mixed in the other three States, depending 
on how subprime lending was defined. No State reported a consistent 
drop in subprime originations. \15\
---------------------------------------------------------------------------
     \15\ Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony 
Pennington-Cross, and Susan Wachter, ``The Impact of Predatory Lending 
Laws: Policy Implications and Insights'', In Borrowing To Live: 
Consumer and Mortgage Credit Revisited 138 (Nicolas P. Retsinas and 
Eric S. Belsky eds., Joint Center for Housing Studies of Harvard 
University and Brookings Institution Press, 2008), working paper 
version at http://www.jchs.harvard.edu/publications/finance/
understanding_consumer_credit/papers/ucc08-9_bostic_et_al.pdf.
---------------------------------------------------------------------------
    In short, assignee liability is not likely to impede access to 
credit. To the contrary, borrower relief will provide needed incentives 
for originators, Wall Street, and investors to only securitize loans 
that borrowers can repay. Providing that relief would go a long way 
toward avoiding the biggest threat to access to credit, which is a 
repeat collapse of private-label securitization.
    2. Remove Artificial Barriers to Cost-Effective Loan 
Modifications--Right now, too many distressed loans are needlessly 
going to foreclosure despite the availability of cost-effective loan 
modifications. Not only do these foreclosures oust homeowners from 
their homes, they needlessly depress home values for everyone else. It 
is time to cut this Gordian knot.
    Most securitized loan pools are created as ``Real Estate Mortgage 
Investment Conduits,'' or REMICs, under the Federal tax code. Any 
securitization vehicle that qualifies for REMIC treatment is exempt 
from Federal income taxes. Congress or the Internal Revenue Service 
should amend the REMIC rules to disqualify future mortgage pools from 
favored REMIC tax treatment unless pooling and servicing agreements and 
related deal documents are drafted to give servicers ironclad 
incentives to participate in large-scale loan modifications when 
specific triggers are hit. \16\
---------------------------------------------------------------------------
     \16\ See, Michael S. Barr and James A. Feldman, Issue Brief: 
Overcoming Legal Barriers to the Bulk Sale of At-Risk Mortgages (Center 
for American Progress April 2008).
---------------------------------------------------------------------------
                                 ______
                                 
                 PREPARED STATEMENT OF GEORGE P. MILLER
           Executive Director, American Securitization Forum
                            October 7, 2009
    On behalf of the American Securitization Forum, I appreciate the 
opportunity to testify before this Subcommittee as it explores problems 
and solutions associated with the securitization process.
    The American Securitization Forum (ASF) is a broad-based 
professional forum through which participants in the U.S. 
securitization market advocate their common interests on important 
legal, regulatory and market practice issues. ASF members include over 
350 firms, including investors, mortgage and consumer credit lenders 
and securitization issuers, financial intermediaries, legal and 
accounting firms, and other professional organizations involved in the 
securitization markets. The ASF also provides information, education, 
and training on a range of securitization market issues and topics 
through industry conferences, seminars and similar initiatives. ASF is 
an affiliate of the Securities Industry and Financial Markets 
Association. \1\
---------------------------------------------------------------------------
     \1\ For more information on ASF, please visit our Web site: http:/
/www.americansecuritization.com. For more information on the Securities 
Industry and Financial Markets Association, please see: http://
www.sifma.org.
---------------------------------------------------------------------------
    My testimony today will address the following topics:

  1.  The role and importance of securitization to the financial system 
        and U.S. economy;

  2.  Current conditions in the securitization market;

  3.  Limitations and deficiencies in securitization revealed by the 
        recent financial market crisis; and

  4.  Views on certain securitization policy and market reform 
        initiatives now underway or under consideration.
I. The Role and Importance of Securitization to the Financial System 
        and U.S. Economy
    Securitization--generally speaking, the process of pooling and 
financing consumer and business assets in the capital markets by 
issuing securities, the payment on which depends primarily on the 
performance of those underlying assets--plays an essential role in the 
financial system and the broader U.S. economy. Over the past 25 years, 
securitization has grown from a relatively small and unknown segment of 
the financial markets to a mainstream source of credit and financing 
for individuals and businesses alike.
    In recent years, the role that securitization has assumed in 
providing both consumers and businesses with credit is striking: 
currently, there is over $12 trillion of outstanding securitized 
assets, \2\ including mortgage-backed securities (MBS), asset-backed 
securities (ABS), and asset-backed commercial paper. This represents a 
market nearly double the size of all outstanding marketable U.S. 
Treasury securities--bonds, bills, notes, and TIPS combined. \3\ 
Between 1990 and 2006, issuance of mortgage-backed securities grew at 
an annually compounded rate of 13 percent, from $259 billion to $2 
trillion a year. \4\ In the same time period, issuance of asset-backed 
securities secured by auto loans, credit cards, home equity loans, 
equipment loans, student loans and other assets, grew from $43 billion 
to $753 billion. \5\ In 2006, just before the downturn, nearly $2.9 
trillion in mortgage- and asset-backed securities were issued. As these 
data demonstrate, securitization is clearly an important sector of 
today's financial markets.
---------------------------------------------------------------------------
     \2\ SIFMA, ``Asset-Backed Securities Outstanding'', http://
www.sifma.org/uploadedFiles/Research/Statistics/
SIFMA_USABSOutstanding.pdf .
     \3\ U.S. Department of the Treasury, ``Monthly Statement of the 
Public Debt of the United States: August 31, 2009'', (August 2009).  
http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds082009.pdf.
     \4\ National Economic Research Associates, Inc. (NERA), ``Study of 
the Impact of Securitization on Consumers, Investors, Financial 
Institutions and the Capital Markets'', p. 16 (June 2009). http://
www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf .
     \5\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/
uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.
---------------------------------------------------------------------------
    The importance of securitization becomes more evident by observing 
the significant proportion of consumer credit it has financed in the 
U.S. It is estimated that securitization has funded between 30 and 75 
percent of lending in various markets, including an estimated 59 
percent of outstanding home mortgages. \6\ Securitization plays a 
critical role in nonmortgage consumer credit as well. Historically, 
most banks have securitized 50-60 percent of their credit card assets. 
\7\ Meanwhile, in the auto industry, a substantial portion of 
automobile sales are financed through auto ABS. \8\ Overall, recent 
data collected by the Federal Reserve Board show that securitization 
has provided over 25 percent of outstanding U.S. consumer credit. \9\ 
In the first half of 2009 alone, securitization financed over $9.5 
billion in student loans. \10\ Securitization also provides an 
important source of commercial mortgage loan financing throughout the 
U.S., through the issuance of commercial mortgage-backed securities.
---------------------------------------------------------------------------
     \6\ Citigroup, ``Does the World Need Securitization?'' pp. 10-11 
(Dec. 2008).http://www.americansecuritization.com/uploadedFiles/
Citi121208_restart_securitization.pdf.
     \7\ Ibid., p. 10.
     \8\ Ibid., p. 10.
     \9\ Federal Reserve Board of Governors, ``G19: Consumer Credit'', 
(September 2009). http://www.federalreserve.gov/releases/g19/current/
g19.htm.
     \10\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/
uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.
---------------------------------------------------------------------------
    Over the years, securitization has grown in large measure because 
of the benefits and value it delivers to transaction participants and 
to the financial system. Among these benefits and value are the 
following:

  1.  Efficiency and Cost of Financing. By linking financing terms to 
        the performance of a discrete asset or pool of assets, rather 
        than to the future profitability or claims-paying potential of 
        an operating company, securitization often provides a cheaper 
        and more efficient form of financing than other types of equity 
        or debt financing.

  2.  Incremental Credit Creation. By enabling capital to be recycled 
        via securitization, lenders can obtain additional funding from 
        the capital markets that can be used to support incremental 
        credit creation. In contrast, loans that are made and held in a 
        financial institution's portfolio occupy that capital until the 
        loans are repaid.

  3.  Credit Cost Reduction. The economic efficiencies and increased 
        liquidity available from securitization can serve to lower the 
        cost of credit to consumers. Several academic studies have 
        demonstrated this result. A recent study by National Economic 
        Research Associates, Inc., concluded that securitization lowers 
        the cost of consumer credit, reducing yield spreads across a 
        range of products including residential mortgages, credit card 
        receivables and automobile loans. \11\

     \11\ National Economic Research Associates, Inc. (NERA), ``Study 
of the Impact of Securitization on Consumers, Investors, Financial 
Institutions and the Capital Markets'', (June 2009), p. 16. http://
www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf.
---------------------------------------------------------------------------
  4.  Liquidity Creation. Securitization often offers issuers an 
        alternative and cheaper form of financing than is available 
        from traditional bank lending, or debt or equity financing. As 
        a result, securitization serves as an alternative and 
        complementary form of liquidity creation within the capital 
        markets and primary lending markets.

  5.  Risk Transfer. Securitization allows entities that originate 
        credit risk to transfer that risk to other parties throughout 
        the financial markets, thereby allocating that risk to parties 
        willing to assume it.

  6.  Customized Financing and Investment Products. Securitization 
        technology allows for precise and customized creation of 
        financing and investment products tailored to the specific 
        needs of issuers and investors. For example, issuers can tailor 
        securitization structures to meet their capital needs and 
        preferences and diversify their sources of financing and 
        liquidity. Investors can tailor securitized products to meet 
        their specific credit, duration, diversification and other 
        investment objectives. \12\
---------------------------------------------------------------------------
     \12\ The vast majority of investors in the securitization market 
are institutional investors, including banks, insurance companies, 
mutual funds, money market funds, pension funds, hedge funds and other 
large pools of capital. Although these direct market participants are 
institutions, many of them--pension funds, mutual funds and insurance 
companies, in particular--invest on behalf of individuals, in addition 
to other account holders.

    Recognizing these and other benefits, policymakers globally have 
taken steps to help encourage and facilitate the recovery of 
securitization activity. The G-7 finance ministers, representing the 
world's largest economies, declared that ``the current situation calls 
for urgent and exceptional action . . . to restart the secondary 
markets for mortgages and other securitized assets.'' \13\ The 
Department of the Treasury stated in March that ``while the intricacies 
of secondary markets and securitization . . . may be complex, these 
loans account for almost half of the credit going to Main Street,'' 
\14\ underscoring the critical nature of securitization in today's 
economy. The Chairman of the Federal Reserve Board recently noted that 
securitization ``provides originators much wider sources of funding 
than they could obtain through conventional sources, such as retail 
deposits'' and also that ``it substantially reduces the originator's 
exposure to interest rate, credit, prepayment, and other risks.'' \15\ 
Echoing that statement, Federal Reserve Board Governor Elizabeth Duke 
recently stated that the ``financial system has become dependent upon 
securitization as an important intermediation tool,'' \16\ and last 
week the International Monetary Fund (IMF) noted in its Global 
Financial Stability Report that ``restarting private-label 
securitization markets, especially in the United States, is critical to 
limiting the fallout from the credit crisis and to the withdrawal of 
central bank and Government interventions.'' \17\ There is clear 
recognition in the official sector of the importance of the 
securitization process and the access to financing that it provides 
lenders, and of its importance to the availability of credit that 
ultimately flows to consumers, businesses and the real economy.
---------------------------------------------------------------------------
     \13\ G-7 Finance Ministers and Central Bank Governors Plan of 
Action (Oct. 10, 2008). http://www.treas.gov/press/releases/hp1195.htm.
     \14\ U.S. Department of the Treasury, ``Road to Stability: 
Consumer & Business Lending Initiative'', (March 2009). http://
www.financialstability.gov/roadtostability/lendinginitiative.html.
     \15\ Bernanke, Ben S., ``Speech at the UC Berkeley/UCLA Symposium: 
The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, 
California'', Board of Governors of the Federal Reserve System (Oct. 
2008). http://www.federalreserve.gov/newsevents/speech/
bernanke20081031a.htm.
     \16\ Duke, Elizabeth A., ``Speech at the AICPA National Conference 
on Banks and Savings Institutions, Washington, DC'', Board of Governors 
of the Federal Reserve System (Sept. 2009). http://
www.federalreserve.gov/newsevents/speech/duke20090914a.htm.
     \17\ International Monetary Fund, ``Restarting Securitization 
Markets: Policy Proposals and Pitfalls'', Global Financial Stability 
Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 33. 
http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.
---------------------------------------------------------------------------
    Restoration of function and confidence to the securitization 
markets is a particularly urgent need, in light of capital and 
liquidity constraints currently confronting financial institutions and 
markets globally. As mentioned above, at present nearly $12 trillion in 
U.S. assets are funded via securitization. With the process of bank de-
leveraging and balance sheet reduction still underway, and with 
increased bank capital requirements on the horizon, the funding 
capacity provided by securitization cannot be replaced with deposit-
based financing alone in the current or foreseeable economic 
environment. Just last week, the IMF estimated that a financing ``gap'' 
of $440 billion will exist between total U.S. credit capacity available 
for the nonfinancial sector and U.S. total credit demand from that 
sector for the year 2009. \18\ Moreover, nonbank finance companies, who 
have played an important role in providing financing to consumers and 
small businesses, are particularly reliant on securitization to fund 
their lending activities, since they do not have access to deposit-
based funding. Small businesses, who employ approximately 50 percent of 
the Nation's workforce, depend on securitization to supply credit that 
is used to pay employees, finance inventory and investment, and other 
business purposes. Furthermore, many jobs are made possible by 
securitization. For example, a lack of financing for mortgages hampers 
the housing industry; likewise, constriction of trade receivable 
financing can adversely affect employment opportunities in the 
manufacturing sector. To jump start the engine of growth and jobs, 
securitization is needed to help restore credit availability.
---------------------------------------------------------------------------
     \18\ International Monetary Fund, ``The Road to Recovery'', Global 
Financial Stability Report: Navigating the Financial Challenges Ahead 
(Oct. 2009), p. 29. http://www.imf.org/external/pubs/ft/gfsr/2009/02/
pdf/text.pdf.
---------------------------------------------------------------------------
    Simply put, the absence of a properly functioning securitization 
market, and the funding and liquidity this market has historically 
provided, adversely impacts consumers, businesses, financial markets, 
and the broader economy. The recovery and restoration of confidence in 
securitization is therefore a necessary ingredient for economic growth 
to resume, and for that growth to continue on a sustained basis into 
the future.
II. Current Conditions in the Securitization Market
    The U.S. securitization markets experienced substantial dislocation 
during the recent financial market turmoil, with a virtual collapse of 
both supply and demand in the new-issue market, very substantial 
reductions in liquidity, widespread declines in securities prices and 
valuations, and increases in risk premiums throughout the secondary 
market. While there have been signs of recovery in certain parts of the 
securitization market throughout the first three calendar quarters of 
2009, some market segments--most notably, private-label residential 
mortgage backed securities--remain dormant, with other securitization 
asset classes and market sectors remaining significantly challenged.
    In the asset-backed securities market, total issuance volume 
remains at a relatively low level, with 2009 issuance projected to 
reach $130 billion, roughly in line with the $140 billion issued in 
2008 but sharply down from the $750 billion issued in 2006. \19\ 
Although issuance rates in nearly all major asset classes, including 
credit cards, auto and equipment loans, and student loans, picked up in 
the second quarter of 2009, a recent ASF survey showed that market 
participants expect securitization issuance rates to return to only 
half of their predownturn levels over the next 2 to 3 years. For 
residential mortgage-backed securities, 2009 to date has seen over $1.2 
trillion in issuance, compared with a yearlong total of $1.3 trillion 
in 2008 and $2.1 trillion in 2006. However, in 2009, less than 1 
percent of this has been issued without a Government or GSE guarantee 
(i.e., private-label MBS); this is compared with private-label MBS 
comprising over 23 percent of all issuance during the time period from 
1996 to 2006. \20\ Furthermore, private-label MBS transactions that 
have occurred in 2009 involved pools of seasoned, conforming loans--no 
major private-label residential mortgage-backed securities deal of 
which we are aware has directly financed new mortgage loan origination 
this year.
---------------------------------------------------------------------------
     \19\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/
uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.
     \20\ SIFMA, ``U.S. Mortgage-Related Issuance'', http://
www.sifma.org/uploadedFiles/Research/Statistics/
SIFMA_USMortgageRelatedIssuance.pdf.
---------------------------------------------------------------------------
    Part of the reason for this involves a broad retreat from risk by 
many investors. The events of 2007 and 2008, especially in the RMBS 
markets, resulted in significant losses for many investors. While it 
seems unlikely that some types of investors, such as those who 
purchased securitized instruments issued by structured investment 
vehicles (SIVs) or certain types of collateralized debt obligations 
(CDOs), will play a significant role in the future MBS and ABS markets, 
the number of traditional securitization investors has also diminished, 
and along with it, the liquidity they have provided to both senior and 
subordinate parts of the market. Replacing at least a portion of this 
investor base is a significant challenge faced by participants in 
today's market.
    Certain programs sponsored by the Federal Government--in 
particular, the TALF program--have been successful in stimulating parts 
of the new-issue securitization market. President Obama described TALF 
as the Government's ``largest effort ever to help provide auto loans, 
college loans, and small business loans to the consumers and 
entrepreneurs who keep this economy running,'' \21\ and in many ways, 
TALF is among the most successful of the Government's efforts to 
bolster the consumer economy. As of September 2009, TALF has directly 
financed $46 billion \22\ of ABS issuances out of the approximately $80 
billion of ABS eligible for TALF that has been issued since March. \23\ 
Due in significant measure to TALF, credit costs on consumer ABS have, 
across the board, returned to levels more in line with their historical 
trends than the extremely high levels that were seen in late 2008 and 
early 2009. For example, 3-year AAA credit card spreads to benchmark 
rates had ballooned to more than 500 basis points, or 5 percent, above 
LIBOR by January 2009, but have retracted to a level less than 1 
percent above LIBOR. \24\ While this is not quite back to the spread 
levels seen over the years leading up to the crisis, it represents a 
more stable and economical level for issuers that translates into more 
affordable rates for borrowers. In recent months a number of issuers 
have been able to sell, at economical levels, transactions without the 
support of TALF. \25\ Clearly there are other factors at play in this 
recovery, including a generally more benign credit market, but one 
cannot dismiss the considerable and positive impact of TALF.
---------------------------------------------------------------------------
     \21\ Obama, Barack, ``Remarks of President Barack Obama--Address 
to Joint Session of Congress'', (Feb. 24, 2009). http://
www.whitehouse.gov/the_press_office/remarks-of-President-Barack-Obama-
address-to-joint-session-of-congress.
     \22\ SIFMA, ``TALF'', http://www.sifma.org/research/
research.aspx?ID=10256#TALF.
     \23\ Allison, Herbert M., ``Written Testimony: Senate Committee on 
Banking, Housing and Urban Affairs'', (Sept. 2009). http://
www.ustreas.gov/press/releases/tg298.htm.
     \24\ JPMorgan Securitized Products Weekly, September 18, 2009, pp. 
22-23.
     \25\ See, for example: ``AmeriCredit's $725 Million Auto ABS 
transaction'', (July 2009) http://www.reuters.com/article/pressRelease/
idUS140529+31-Aug-2009+BW20090831; JPMorgan's $2.53 billion credit card 
ABS deal, (Sept. 2009) http://online.wsj.com/article/
SB125311472402316179.html.
---------------------------------------------------------------------------
    TALF has helped somewhat to bring investors back to the parts of 
consumer ABS markets that are not directly eligible for the program, 
although the markets for debt rated lower than AAA are still 
struggling. For example, 5-year single-A rated credit card ABS, which 
are not TALF eligible, saw an even more severe spread widening than 
that of AAA during the height of the disruption in late 2008. By 
January 2009 spreads had ballooned to more than 15 percent above LIBOR, 
but have since come back in to lower levels. \26\ The subordinate ABS 
markets are still relatively dormant, and unless banks are able to 
finance a greater portion of the capital structure, credit origination 
via securitization cannot be fully restored.
---------------------------------------------------------------------------
     \26\ ``JPMorgan Securitized Products Weekly'', September 18, 2009, 
pp. 22-23.
---------------------------------------------------------------------------
    Notwithstanding the success of the TALF program and the restoration 
of a modest degree of securitization financing and liquidity in some 
market segments, significant challenges remain, including establishing 
a stable, sustainable, and broad-based platform for future 
securitization market issuance and investment activity that is less 
reliant on direct Government support.
III. Limitations and Deficiencies in Securitization Revealed by the 
        Recent Financial Market Crisis
    The recent financial market crisis revealed several limitations and 
weaknesses in securitization market activity. Among the multiple (and, 
in many cases, interrelated) deficiencies revealed were the following:

  1.  Risk management failures, including the excessive or imprudent 
        use of leverage and mismanagement of liquidity risk. Many 
        market participants--including financial intermediaries, 
        investors, and others--established large, leveraged risk 
        positions in securitized instruments. A significant number of 
        these market positions were, in effect, highly levered triggers 
        which, when tripped by an adverse rating action or downward 
        price movement, caused widespread deleveraging and further 
        price reductions. At the same time, large parts of the 
        securitization market became reliant on cheap, short term 
        liquidity to finance long-term assets. When this liquidity 
        disappeared and financing was either repriced or withdrawn 
        completely, a more systematic deleveraging and unwinding 
        process ensued.

  2.  Credit ratings methodologies and assessments that proved to be 
        overly optimistic, and excessive reliance on credit ratings. 
        Especially in parts of the residential mortgage market, a 
        favorable economic environment and persistent increase in 
        housing prices masked gaps in credit rating agency models and 
        methodologies that did not sufficiently factor in the risk of 
        nationwide housing price declines and a high correlation in the 
        performance of the assets underlying certain mortgage and 
        asset-backed securities. At the same time, market participants 
        became overly reliant on credit ratings, and many failed to 
        perform or to act upon their own assessment of the risks 
        created by certain securitized transaction structures.

  3.  Deteriorating underwriting standards and loan quality. 
        Underwriting standards declined precipitously throughout 
        various segments of the credit markets, including but not 
        limited to subprime mortgages, with housing prices rising 
        steeply and credit and liquidity in plentiful supply. As loan 
        demand and competition among lending institutions intensified, 
        asset quality declined, leaving securitized instruments 
        vulnerable to credit-related performance impairments.

  4.  Gaps in data integrity, reliability and standardization. 
        Especially in parts of the residential mortgage market, a 
        combination of explosive lending growth, operational 
        weaknesses, the absence of standardized and comparable loan-
        level data, an increasing prevalence of fraud and other factors 
        caused investors broadly to question the accuracy and integrity 
        of performance data relating to the assets underlying 
        securitizations. This led to a massive loss of confidence and 
        widespread aversion to securitized risk, including asset 
        classes and transaction structures that were far removed from 
        the direct source of these concerns.

  5.  A breakdown in checks and balances and lack of shared 
        responsibility for the system as a whole. While many within the 
        securitization industry were aware of the general deterioration 
        in credit underwriting standards and the other factors outlined 
        above, no single party or group of market participants enforced 
        sufficient discipline across all parts of the interdependent 
        securitization value chain. Weaknesses and deficiencies in one 
        part of the chain thus impaired the function of the chain in 
        its entirety.

    It is important to note that the weaknesses outlined above are not 
inherent in securitization per se. Instead, they relate to the manner 
in which securitization was used in some settings by some market 
participants. In general, the amount of risk inherent in a 
securitization is equal to the risk that is embedded in the securitized 
assets themselves. However, in retrospect it is clear that 
securitization technology can be used in ways that can reduce and 
distribute risk (i.e., can be beneficial to the financial system), or 
that increase and concentrate that risk (i.e., can be detrimental to 
the financial system). Ancillary practices and strategies employed in 
some securitization transactions by some market participants--for 
example, the use of additional leverage; reliance on short-term funding 
for long-term liabilities; or the absence of effective risk management 
controls--can amplify and concentrate those risks. This is especially 
true when such practices and strategies relate to large dollar volumes 
of transactions and risk positions held by multiple participants 
throughout the financial system.
    It is also important to recognize that many of the deficiencies 
outlined above were prevalent, or at least more heavily concentrated, 
in certain securitization market products and sectors, rather than 
characterizing conditions or practices in the securitization market as 
a whole. In fact, the most consequential deficiencies were concentrated 
in portions of the residential mortgage market--and the subprime 
mortgage market, in particular--and in certain types of CDOs, SIVs and 
similar securities arbitrage structures. These transactions--many of 
which relied on high degrees of leverage--generated significant 
incremental demand for underlying securitization products. However, 
much of that demand was ``artificial,'' in the sense that production of 
underlying securitization products (e.g., subordinated risk tranches of 
subprime RMBS) was driven by demand from CDOs and SIVs, rather than by 
the financing needs of lenders or borrowing needs of consumers. In 
other parts of the securitization market, including prime RMBS, credit 
card, auto and student loan ABS, and asset-backed commercial paper 
conduits, among others, securitization activity largely remained 
focused on its historical role of financing the credit extension 
activities of lenders, and the credit needs of their consumer and 
business customers.
IV. Views on Securitization Policy and Market Reform Initiatives
    Numerous policy and market reforms aimed at the securitization 
market have been advanced in response to the broader financial market 
crisis. Global policymaking bodies have proposed a series of 
securitization reforms as part of their broader response to financial 
market turmoil, and in the United States, both legislative and 
regulatory responses are under active consideration. At the same time, 
industry participants and their representative organizations are moving 
forward with important reforms to securitization market practices and 
to retool key parts of the market's operational infrastructure.
    Overall, we believe that a targeted combination of thoughtful 
policy reforms, coupled with industry initiatives to improve the 
securitization market infrastructure, will help to establish a more 
stable and lasting platform for future securitization market activity. 
In general, we believe that these policy and industry reform measures 
should facilitate the ability to originate and fund of a wide range of 
consumer and business credit via securitization. However, this activity 
must be supported by improved data and transparency that enables 
securitized risk to be evaluated and priced efficiently by market 
participants, and by enhanced operational controls (including but not 
limited to asset origination practices, due diligence and quality 
review practices, standardized and more effective representations and 
warranties, standardization of key documentation provisions and rating 
agency methodologies, among others) that provide necessary assurances 
to investors and other market participants regarding the accuracy, 
integrity and reliability of securitization data and transaction 
structures. At the same time, we believe that it is important, as a 
recent IMF report noted, to consider the individual and combined 
effects of various reform measures under consideration, to ensure that 
they do not inadvertently stifle otherwise sound and desirable 
securitization activity. \27\
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     \27\ The exact language used by the IMF in its Global Financial 
Stability Report states: ``While most of the current proposals are 
unambiguously positive for securitization markets and financial 
stability, some proposals--such as those designed to improve the 
alignment of securitizer and investor interests and accounting changes 
that will result in more securitized assets remaining on balance 
sheets--may be combined in ways that could halt, not restart, 
securitization, by inadvertently making it too costly for 
securitizers.'' See, ``The Road to Recovery'', (Oct. 2009), p. 29. 
http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.
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    In the United States, a primary policy focus is on legislative 
proposals advanced by the Obama Administration, which in turn reflect 
many of the reform themes and initiatives under consideration globally. 
Together with other reforms being pursued by Federal regulatory 
agencies and accounting standards setters, these securitization reform 
initiatives may be broadly categorized as follows:

  1.  Increased Data Transparency, Disclosure, and Standardization; and 
        Improvements to the Securitization Infrastructure. Initiatives 
        designed to increase the type and amount of information and 
        data (including loan-level data) that is captured and disclosed 
        with respect to securitized instruments, and to improve and 
        standardize that information and data as well as key 
        documentation provisions, market practices and procedures 
        employed in securitization transactions.

  2.  Required Risk Retention and Other Incentive Alignment Mechanisms. 
        Mandated requirements for asset originators and/or securitizers 
        to retain an economic interest in securitization transactions, 
        and other mechanisms designed to produce a closer alignment of 
        economic risks and incentives of originators, securitizers, and 
        end investors.

  3.  Increased Regulatory Capital Requirements and Limitations on Off-
        Balance Sheet Accounting. Increases in regulatory capital 
        required to be held against securitized exposures by regulated 
        financial institutions, as a means of creating an additional 
        safety and soundness buffer against potential losses associated 
        with those exposures, and revisions to generally accepted 
        accounting standards that restrict off-balance sheet accounting 
        for securitized transactions and produce more widespread 
        accounting consolidation of the assets and liabilities of 
        securitization special purpose entities.

  4.  Credit Rating Agency Reforms. Various reforms intended to 
        eliminate or minimize conflicts of interest, and to promote the 
        accuracy, integrity and transparency of methodologies and 
        processes that credit rating agencies apply to securitization 
        transactions.

    A summary of ASF's views on each of these reform directions and 
initiatives are set forth below.
A. Increased Transparency, Disclosure, Standardization; and 
        Improvements to the Securitization Market Infrastructure
    ASF supports increased transparency and standardization in the 
securitization markets, and related improvements to the securitization 
market infrastructure. We believe that such efforts should be focused 
on those areas and products where preexisting practices have been 
determined to be deficient, and where improvements can help to restore 
confidence and function to the related market segment(s).
    Our principal focus in this area is ASF's Project on Residential 
Securitization Transparency and Reporting (Project RESTART), which is 
initially directed at addressing transparency and standardization 
deficiencies in the residential mortgage-backed securities (RMBS) 
market. Prior studies and market surveys conducted by ASF have clearly 
identified the RMBS market as most in need of these types of reform.
    Overall, Project RESTART seeks to address transparency and 
standardization needs in the RMBS market via the substantial injection 
of new disclosures and reporting by issuers and servicers on new 
transactions as well as on the trillions of dollars of outstanding 
private-label RMBS. Project RESTART would create a uniform set of data 
standards for such disclosure and reporting, including at the loan 
level. This will create a more level playing field where issuers 
provide the same information at the initiation of a securitization 
transaction and on an ongoing basis throughout the life of that 
transaction. With these standards in place, information provided by 
different issuers will be more comparable and capable of meaningful 
evaluation by investors and other market participants. In addition to 
supporting investment analysis, these data and standardization 
improvements will also support more robust and reliable rating agency, 
due diligence, quality review and valuation processes, and other 
downstream applications that will benefit from more robust, reliable 
and comparable underlying data.
    Project RESTART for RMBS transactions consists of the following 
phases: (i) the Disclosure Package, which will provide substantially 
more loan-level data than is currently available to investors, rating 
agencies and other parties, and standardize the presentation of 
transaction-level and loan-level data to allow for a more ready 
comparison of transactions and loans across issuers; (ii) the Reporting 
Package, which will provide for monthly updating of critical loan-level 
information that will enable improvements in the ability of investors, 
rating agencies and other market participants to analyze the 
performance of outstanding securities; (iii) Model RMBS Representations 
and Warranties, which will provide assurances to investors in RMBS 
transactions regarding the allocation and assumption of risk associated 
with loan origination and underwriting practices; (iv) Model Repurchase 
Procedures, which will be used to enforce the Model Representations and 
Warranties and to clearly delineate the roles and responsibilities of 
transaction parties in the repurchase process; (v) Model Pre-
Securitization Due Diligence Standards, which will buttress due 
diligence and quality review practices relating to mortgage 
underwriting and origination practices and the data supplied to market 
participants through the Disclosure Package; and (vi) Model Servicing 
Provisions for Pooling and Servicing Agreements, which will create more 
standardized documentation provisions and work rules in key areas, such 
as loss mitigation procedures that servicers may employ in dealing with 
delinquent or defaulting loans.
    Final versions of the Disclosure and Reporting Packages were 
released by ASF in July 2009, with industry implementation beginning in 
2010. Work continues on the other Project RESTART workstreams 
identified above, with an immediate focus on the development of Model 
RMBS Representations and Warranties, which are used to act as a 
``return policy'' to guard against the risk of defective mortgage loans 
being sold into a securitization trust. Much like a defective product 
is returned to the store from which it was sold, a defective mortgage 
loan will be ``returned'' to the issuer through its removal from a 
securitization trust for cash. A mortgage loan is ``defective'' if it 
materially breaches one of the representations and warranties. Examples 
of defects range from a general fraud in a loan's origination to a 
failure to properly verify a borrower's income or employ an independent 
appraiser. The ASF supports 100 percent risk retention for defective 
loans that result from an originator's failure to meet specified 
underwriting criteria.
    Although Project RESTART has initially been focused on the RMBS 
market, members of the ASF have begun development of the ASF Credit 
Card ABS Disclosure Package, which seeks to provide increased 
transparency and standardization to the Credit Card ABS market.
    Finally, ASF believes that every mortgage loan should be assigned a 
unique identification number at origination, which would facilitate the 
identification and tracking of individual loans as they are sold or 
financed in the secondary market, including via RMBS securitization. 
ASF recently selected a vendor who will work with us to provide this 
unique Loan ID, which is called the ASF LINCTM. 
Implementation of the ASF LINC will enable market participants to 
access Project RESTART's valuable loan-level information without 
violating privacy laws by removing personal nonpublic information and 
other protected information from the process.
B. Required Risk Retention
    ASF supports initiatives to align the economic interests of asset 
originators and securitization sponsors with investors. As suggested 
above, we believe that the principal goal of these efforts should be to 
establish and reinforce commercial incentives for originators and 
sponsors to create and fund assets that conform to stated underwriting 
standards and securitization eligibility criteria, thereby making those 
parties economically responsible for the stated attributes and 
underwriting quality of securitized loans. The creation and maintenance 
of effective mechanisms of this type will facilitate responsible 
lending, as well as a more disciplined and efficient funding of 
consumer assets via securitization (i.e., where the varying credit and 
performance risks presented by different types of securitized assets 
can be properly evaluated and priced in the capital markets).
    Securitization risk retention proposals currently under 
consideration, including legislation advanced by the Obama 
Administration, call for securitization sponsors and/or asset 
originators to retain an economic interest in a material portion of the 
credit risk that the sponsor and/or asset originator conveys to a third 
party via a securitization transaction.
    As noted above, we support the concept of requiring retention of a 
meaningful economic interest in securitized loans as a means of 
creating a better alignment of incentives among transaction 
participants. Many securitizations already embed this concept through 
various structuring mechanisms, including via the retention of 
subordinated or equity risk in the securitization, holding portfolio 
assets bearing credit exposure that is similar or identical to that of 
securitized assets, and representations and warranties that require 
originators or sponsors to repurchase assets that fail to meet stated 
securitization eligibility requirements, among others. However, we do 
not believe that mandated retention of specific portions of credit 
risk--one such form of economic interest--necessarily constitutes the 
sole or most effective means of achieving this alignment in all cases.
    There are numerous valid and competing policy goals that stand in 
opposition to requiring the retention of credit risk in securitized 
assets and exposures. Among others, these include the proper isolation 
of transferred assets (i.e., meeting legal criteria necessary to effect 
a ``true sale''); reduction and management of risk on financial 
institutions' balance sheets; balance sheet management; and the 
redeployment of capital to enable financial institutions to originate 
more credit than their limited capital resources would otherwise allow. 
Balancing these competing and worthwhile policy goals suggests that 
retention and incentive alignment mechanisms other than universal 
credit risk retention requirements should be considered. This viewpoint 
was echoed by the IMF last week in its Global Financial Stability 
Report, which expressed strong concerns about the potential unintended 
negative consequences of implementing suggested credit risk retention 
requirements and instead indicated that regulatory authorities ``should 
consider other mechanisms that incentivize due diligence and may be 
able to produce results comparable to a retention requirement, 
including, perhaps, representations and warranties.'' \28\
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     \28\ International Monetary Fund, ``Restarting Securitization 
Markets: Policy Proposals and Pitfalls.'' Global Financial Stability 
Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 31. 
http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.
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    We believe that the risk or ``skin in the game'' traditionally 
retained by originators of RMBS is embodied in the representations and 
warranties that issuers provide with respect to the mortgage loans sold 
into the securitization trust. These representations and warranties are 
designed to ensure that the loans are free from undisclosed origination 
risks, leaving the investor primarily with normal risks of loan 
ownership, such as the deterioration of the borrower's credit due to 
loss of employment, disability or other ``life events.'' However, many 
market participants have indicated that the traditional representations 
and warranties and their related remedy provisions have not 
sufficiently provided a means to return defective loans to the 
originator. Because of this, the ASF has sought to enhance and 
standardize these items through the previously discussed Project 
RESTART Model RMBS Representations and Warranties and Model Repurchase 
Provisions.
    We therefore believe that to the extent legislation is adopted to 
require risk retention, regulators should have flexibility to develop 
and apply alternative retention mechanisms. This flexibility should 
include the ability for regulators to specify permissible forms and 
amounts of retention, how retention requirements may be calculated and 
measured, the duration of retention requirements, whether and to what 
extent hedging or risk management of retained positions is permissible, 
and other implementation details.
    Finally, we believe that it is imperative to achieve global 
harmonization and consistency of policy approaches to securitization 
risk retention. Different approaches are being considered and/or have 
been adopted in different jurisdictions. \29\ Given the global nature 
of securitization activity and the mobility of global capital among 
jurisdictions, significant competitive disparities and inefficiencies 
may be produced by introducing substantively different retention 
standards throughout the world's financial markets. We believe that is 
essential for policymakers to coordinate their approaches in this area.
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     \29\ One such approach was adopted by the European Parliament in 
May 2009. Article 122a to the Capital Requirements Directive prohibits 
EU banks from investing in securitizations unless the originator 
retains on an ongoing basis at least 5 percent of the material net 
economic interest of the securities securitized. The article proposes 
four ways the 5 percent retention requirement may be applied. The 
article's requirement is scheduled to go into effect on December 31, 
2010, for new issues, and December 31, 2014, for existing 
securitizations where new underlying exposures are added or subtracted 
after that date. For more information, see: http://
www.europarl.europa.eu/sides/getDoc.do?type=TA&reference=P6-TA-2009-
0367&language=EN˚=A6-2009-0139#BKMD-35.
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C. Increased Regulatory Capital and Limitations on Off-Balance Sheet 
        Financing
    The Obama Administration has advocated that risk-based regulatory 
capital requirements should appropriately reflect the risk of 
structured credit products, including the concentrated risk of senior 
tranches and resecuritizations and the risk of exposures held in highly 
leveraged off-balance sheet vehicles. Global policymakers have also 
advocated for minimizing opportunities for financial institutions to 
use securitization to reduce their regulatory capital requirements 
without a commensurate reduction in risk.
    Consistent with the above views, the Basel Committee on Banking 
Supervision has amended the Basel II risk-based capital framework to 
require additional regulatory capital to be held against certain 
resecuritizations (such as CDOs), on the basis that previous rules 
underestimated the risks inherent in such structures. In the U.S., the 
combined bank regulatory agencies recently issued proposals that would 
continue to link risk-based capital requirements to whether an 
accounting sale has occurred under U.S. GAAP. Given that recent 
accounting changes (which will generally take effect in January 2010) 
will make it very difficult to achieve GAAP sales in many 
securitizations, including both term asset-backed securities and asset-
backed commercial paper vehicles, these proposed rules will likely 
materially increase the capital that financial institutions will be 
required to hold in against securitizations, since many securitized 
assets will remain on or return to those institutions' balance sheets.
    ASF supports efforts to addresses weaknesses in the risk-based 
capital framework that have been revealed in certain securitization 
products by the recent financial market dislocation, and agrees that 
regulatory capital levels should adequately reflect the risks of 
different types of securitization transactions. Furthermore, ASF 
supports efforts to reduce or eliminate opportunities for regulatory 
capital arbitrage that are unrelated to differences in the risk 
profiles of securitization instruments.
    We therefore believe that increases in regulatory capital 
requirements for certain securitizations may be appropriate, based on 
the conclusion that they present more risk than had been previously 
understood (for example, because of their use of leverage or where 
underlying risk positions are more highly correlated than they were 
assumed to be, as in the case of certain CDOs and SIVs). However, a 
broader increase in capital requirements for securitization across the 
board, that is not tied to the differing risk profiles of different 
transactions, may produce very negative consequences for the economic 
viability of securitization. In turn, this outcome could unduly 
constrain the ability of financial institutions to originate and fund 
consumer and business credit demand, particularly as the broader 
economy begins to recover.
    ASF is particularly concerned that linking risk-based capital 
requirements to accounting outcomes--particularly when those outcomes 
are produced by the application of accounting standards that are not 
themselves risk-based--is an inappropriate policy response. We believe 
that the resulting increase in regulatory capital required to be held 
against securitized assets held on financial institutions' balance 
sheets will grossly misrepresent the actual, incremental risk inherent 
in those assets. We believe that a more targeted approach to revising 
the securitization risk-based capital framework is warranted. Last week 
ASF asked the U.S. bank regulatory agencies for a 6-month moratorium 
relating to any changes in bank regulatory capital requirements 
resulting from the implementation of FASB's Statements 166 and 167. We 
believe that this action is necessary to avoid a potentially severe 
capital and credit shock to the financial system as of January 1st, 
when the new accounting rules generally take effect. We will be 
providing detailed input and recommendations to bank regulatory 
agencies and other policymakers on this important topic by the October 
15th deadline.
D. Rating Agency Reforms
    ASF supports credit rating reform in the securitization markets, 
focusing on steps designed to increase the quality, accuracy and 
integrity of credit ratings and the transparency of the ratings 
process. Credit ratings have occupied a central role in the 
securitization markets, providing investors and other market 
participants with expert views on the credit performance and risks 
associated with a wide range of securitization products. As an 
outgrowth of the financial market crisis, confidence in rating agencies 
and the ratings process for securitization have been significantly 
impaired. We believe that a restoration of such confidence is a 
necessary step in restoring broader confidence and function to the 
securitization markets.
    Various credit rating reform measures targeting the securitization 
markets have been advanced by policymakers, and a number of proposals 
have been adopted or remain under consideration by the Securities 
Exchange Commission. Our views on some of the more significant 
proposals affecting the securitization market are summarized below: 
\30\
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     \30\ For more detail on ASF's views on these and other credit 
rating agency reform proposals, see the series of letters submitted to 
the SEC by ASF between May and September of 2008. These letters may be 
found at: http://www.americansecuritization.com/uploadedFiles/
ASFpercent20CRA percent20-percent20ratings percent20scale.pdf (May 
2008); http://www.americansecuritization.com/uploadedFiles/Release_34-
57967_ASF_Comment_Letter_.pdf (July 2008); and http://
www.americansecuritization.com/uploadedFiles/ASF_Final_SEC_CRA--
Letter_9_5_08.pdf  (Sept. 2008).

  1.  Conflicts of Interest. We support measures aimed at developing 
        and enhancing strong conflict of interest policies and rules 
        governing the operations of credit rating agencies. We believe 
        that effective management and disclosure of actual and 
        potential conflicts is a necessary component for ensuring 
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        transparency and integrity in the rating process.

  2.  Differentiation of Structured Finance Ratings. ASF supports full 
        and transparent disclosure of the basis for structured finance 
        ratings, so that the risk of securitizations can be understood 
        and differentiated from risks presented by other types of 
        credit instruments. However, we strongly oppose proposals 
        advocating that a special ratings designation or modifier be 
        required for structured finance ratings. We believe that such a 
        designation or modifier would not convey any meaningful 
        information about the rating, and would require significant 
        revisions to private investment guidelines that incorporate 
        ratings requirements.

  3.  Ratings Performance Disclosure. We support the publication in a 
        format reasonably accessible to investors of a record of all 
        ratings actions for securitization instruments for which 
        ratings are published. We believe that publication of these 
        data will enable investors and other market participants to 
        evaluate and compare the performance, stability, and quality of 
        ratings judgments over time.

  4.  Disclosure of Ratings Methods and Processes. ASF strongly 
        supports enhanced disclosure of securitization ratings methods 
        and processes, including information relating to the use of 
        ratings models and key assumptions utilized by those models.

  5.  Reliance on Ratings. We believe that investors and other market 
        participants, including regulators, should not place an undue 
        reliance on credit ratings, and should employ other mechanisms 
        for performing an independent credit analysis. However, ASF 
        believes that credit ratings are an important part of existing 
        regulatory regimes, and that steps aimed at reducing or 
        eliminating the use of ratings in regulation should be 
        considered carefully, to avoid undue disruption to market 
        function and efficiency.
Conclusion
    The securitization market is an essential mechanism for supporting 
credit creation and capital formation throughout the consumer and 
business economy. Its role is even more important today, when other 
sources of credit and financing are limited, due to balance sheet, 
capital, and liquidity constraints facing financial institutions. 
Securitization activity was significantly impaired as a consequence of 
the financial market crisis. While portions of the securitization 
market have recovered to some extent throughout 2009, other market 
segments remain significantly challenged.
    The financial market crisis revealed weaknesses in several key 
areas of securitization market activity. Targeted reforms are needed, 
and a number are being pursued through both public- and private-sector 
responses. In pursuing market reforms and redressing these weaknesses, 
care should be taken to avoid imposing undue impediments to the 
restoration of securitization activity that could adversely impact 
credit availability and retard economic recovery and growth.
    Thank you for the opportunity to share these views, and I look 
forward to answering any questions that Members of the Subcommittee may 
have.
                                 ______
                                 
                 PREPARED STATEMENT OF ANDREW DAVIDSON
                 President, Andrew Davidson and Company
                            October 7, 2009
    Mr. Chairman and Members of the Subcommittee, I appreciate the 
opportunity to testify before you today about securitization. My 
expertise is primarily in the securitization of residential mortgages 
and my comments will be primarily directed toward those markets.
    Securitization has been a force for both good and bad in our 
economy. A well functioning securitization market expands the 
availability of credit for economic activity and home ownership. It 
allows banks and other financial institutions to access capital and 
reduces risk. On the other hand a poorly functioning securitization 
market may lead to misallocation of capital and exacerbate risk. \1\
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     \1\ Portions of this statement are derived from ``Securitization: 
After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.
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    Before delving into a discussion of the current crisis, I would 
like to distinguish three types of capital markets activities that are 
often discussed together: Securitization, Structuring, and Derivatives. 
\2\
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     \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and 
Anne Ching, ``Securitization'', 2003, for a detailed discussion of 
securitization and valuation of securitized products.
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    Securitization is the process of converting individual loans into 
securities that can be freely transferred. Securitization serves to 
separate origination and investment functions.
    Without securitization investors would need to go through a very 
complex process of transferring the ownership of individual loans. The 
agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, 
and Freddie Mac are one of the most successful financial innovations. 
However, as the last years have taught us, the so-called, ``originate 
to sell'' model, especially as reflected in private-label (nonagency) 
MBS, has serious shortcomings.
    Structuring is the process of segmenting the cash flows of one set 
of financial instruments into several bonds which are often called 
tranches. The collateralized mortgage obligation or CMO is a classic 
example of structuring. The CMO transforms mortgage cash flows into a 
variety of bonds that appeal to investors from short-term stable bonds, 
to long-term investments. Private label MBS use a second form of 
structuring to allocate credit risk. A typical structure uses 
subordination, or over-collateralization, to create bonds with 
different degrees of credit risk. The collateralized debt obligation or 
CDO is a third form of structuring. In this case, bonds, rather than 
loans, are the underlying collateral for the CDO bonds which are 
segmented by credit risk. Structuring allows for the expansion of the 
investor base for mortgage cash flows, by tailoring the bonds 
characteristics to investor requirements. Unfortunately, structuring 
has also been used to design bonds that obfuscate risk and return.
    Derivatives, or indexed contracts, are used to transfer risk from 
one party to another. Derivatives are a zero sum game in that one 
investor's gain is another's loss. While typically people think of 
swaps markets and futures markets when they mention derivatives, the 
TBA (to be announced) market for agency pass-through mortgages is a 
large successful derivative market. The TBA market allows for trading 
in pass-through MBS without the need to specify which pool of mortgages 
will be delivered. More recently a large market in mortgage credit risk 
has developed. The instruments in this market are credit default swaps 
(CDS) and ABX, an over-the-counter index based on subprime mortgage 
CDS. Derivatives allow for risk transfer and can be powerful vehicles 
for risk management. On the other hand, derivatives may lead to the 
creation of more risk in the economy as derivate volume may exceed the 
underlying asset by substantial orders of magnitude.
    For any of these products to be economically useful they should 
address one or more of the underlying investment risks of mortgages: 
funding, interest rate risk, prepayment risk, credit risk, and 
liquidity. More than anything else mortgages represent the funding of 
home purchases. The twelve trillion of mortgages represents funding for 
the residential real estate of the country. Interest rate risk arises 
due to the fixed coupon on mortgages. For adjustable rate mortgages it 
arises from the caps, floors and other coupon limitations present in 
residential mortgage products. Interest rate risk is compounded by 
prepayment risk. Prepayment risk reflects both a systematic component 
that arises from the option to refinance (creating the option features 
of MBS) as well as the additional uncertainty created by the difficulty 
in accurately forecasting the behavior of borrowers. Credit risk 
represents the possibility that borrowers will be unable or unwilling 
to make their contractual payments. Credit risk reflects the borrower's 
financial situation, the terms of the loan and the value of the home. 
Credit risk has systematic components related to the performance of the 
economy, idiosyncratic risks related to individual borrowers and 
operational risks related to underwriting and monitoring. Finally, 
liquidity represents the ability to transfer the funding obligation 
and/or the risks of the mortgages.
    In addition to the financial characteristics of these financial 
tools, they all have tax, regulatory and accounting features that 
affect their viability. In some cases tax, regulatory and accounting 
outcomes rather than financial benefit are the primary purpose of a 
transaction. In developing policy alternatives each of these 
activities: securitization, structuring and derivatives, pose distinct 
but interrelated challenges.
Role of Securitization in the Current Financial Crisis
    The current economic crisis represents a combination of many 
factors and blame can be laid far and wide. Additional analysis may be 
required to truly assess the causes of the crisis. Nevertheless I 
believe that securitization contributed to the crisis in two important 
ways. It contributed to the excessive rise in home prices and it 
created instability once the crisis began.
    First, the process of securitization as implemented during the 
period leading up to the crisis allowed a decline in underwriting 
standards and excessive leverage in home ownership. The excess lending 
likely contributed to the rapid rise in home prices leading up to the 
crisis. In addition to the well documented growth in subprime and Alt-A 
lending, we find that the quality of loans declined during the period 
from 2003 to 2005, even after adjusting for loan to value ratios, FICO 
scores, documentation type, home prices and other factors reflected in 
data available to investors. The results of our analysis are shown in 
Figure 1. It shows that the rate of delinquency for loans originated in 
2006 is more than 50 percent higher than loans originated in 2003. The 
implication is that the quality of underwriting declined significantly 
during this period, and this decline was not reflected in the data 
provided to investors. As such it could reflect fraud, 
misrepresentations and lower standard for verifying borrower and 
collateral data. The net impact of this is that borrowers were granted 
credit at greater leverage and at lower cost than in prior years.

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    In concrete terms, the securitization market during 2005 and 2006 
was pricing mortgage loans to an expected lifetime loss of about 5 
percent. Our view is that even if home prices had remained stable, 
these losses would have been 10 percent or more. Given the structure of 
many of these loans, with a 2-year initial coupon and an expected 
payoff by the borrower at reset, the rate on the loans should have been 
200 or 300 basis points higher. That is, initial coupons should have 
been over 10 percent rather than near 8 percent.
    Our analysis further indicates that this lower cost of credit 
inflated home prices. The combination of relaxed underwriting standards 
and affordability products, such as option-arms, effectively lowered 
the required payment on mortgages. The lower payment served to increase 
the price of homes that borrowers could afford. Figure 2 shows the 
rapid rise in the perceived price that borrowers could afford in the 
Los Angeles area due to these reduced payment requirements. Actual home 
prices then followed this pattern. Generally we find that 
securitization of subprime loans and other affordability products such 
as option arms were more prevalent in the areas with high amounts of 
home price appreciation during 2003 to 2006. To be clear, not all of 
the affordability loans were driven by securitization, as many of the 
option arms remained on the balance sheet of lending institutions.

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    Figure 3 provides an indication of the magnitude of home price 
increases that may have resulted from these products on a national 
basis. Based on our home price model, we estimate that home prices may 
have risen by 15 percent at the national level due to lower effective 
interest rates. In the chart, the gap between the solid blue line and 
the dashed blue line reflects the impact of easy credit on home prices.

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    On the flip side, we believe that the shutting down of these 
markets and the reduced availability of mortgage credit contributed to 
the sharp decline in home prices we have seen since 2006 as shown in 
Figure 4. Without an increase in effective mortgage rates, home prices 
might have sustained their inflated values as shown by the dashed blue 
line. \3\
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     \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/
Valuation_Jun09.pdf for more details.

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    Thus the reduced focus on underwriting quality lead to an 
unsustainable level of excess leverage and reduced borrowing costs 
which helped to inflate home prices. When these ``affordability'' 
products were no longer sustainable in the market, they contributed to 
the deflation of the housing bubble.
    The way securitization was implemented during this period fostered 
high home prices through poor underwriting, and the end of that era may 
have led to the sharp decline in home prices and the sharp decline in 
home prices helped to spread the financial crisis beyond the subprime 
market.
    The second way that securitization contributed to the current 
economic crisis is through the obfuscation of risk. For many structures 
in the securitization market: especially collateralized debt 
obligations, structured investment vehicles and other 
resecuritizations, there is and was insufficient information for 
investors to formulate an independent judgment of the risks and value 
of the investment. As markets began to decline in late 2007, investors 
in all of these instruments and investors in the institutions that held 
or issued these instruments were unable to assess the level of risk 
they bore.
    This lack of information quickly became a lack of confidence and 
led to a massive deleveraging of our financial system. This 
deleveraging further depressed the value of these complex securities 
and led to real declines in economic value as the economy entered a 
severe recession. In addition, regulators lacked the ability to assess 
the level of risk in regulated entities, perhaps delaying corrective 
action or other steps that could have reduced risk levels earlier.
Limitations of Securitization Revealed
    To understand how the current market structure could lead to 
undisciplined lending and obfuscation of risk it is useful to look at a 
simplified schematic of the market. \4\
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     \4\ Adapted from ``Six Degrees of Separation'', August 2007, by 
Andrew Davidson http://www.securitization.net/pdf/content/
ADC_SixDegrees_1Aug07.pdf.

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    In the simplest terms, what went wrong in the subprime mortgage in 
particular and the securitization market in general is that the people 
responsible for making loans had too little financial interest in the 
performance of those loans and the people with financial interest in 
the loans had too little involvement in the how the loans were made.
    The secondary market for nonagency mortgages, including subprime 
mortgages, has many participants and a great separation of the 
origination process from the investment process. Each participant has a 
specialized role. Specialization serves the market well, as it allows 
each function to be performed efficiently. Specialization, however also 
means that risk creation and risk taking are separated.
    In simplified form the process can be described as involving:

    A borrower--who wants a loan for home purchase or refinance

    A broker--who works with the borrower and lenders to 
        arrange a loan

    A mortgage banker--who funds the loan and then sells the 
        loan

    An aggregator--(often a broker-dealer) who buys loans and 
        then packages the loans into a securitization, whose bonds are 
        sold to investors.

    A CDO manager--who buys a portfolio of mortgage-backed 
        securities and issues debt

    An investor--who buys the CDO debt

    Two additional participants are also involved:

    A servicer--who keeps the loan documents and collects the 
        payments from the borrower

    A rating agency--that places a rating on the mortgage 
        securities and on the CDO debt

    This chart is obviously a simplification of a more complex process. 
For example, CDOs were not the only purchasers of risk in the subprime 
market. They were however a dominant player, with some estimating that 
they bought about 70 percent of the lower rated classes of subprime 
mortgage securitizations. What is clear even from this simplified 
process is that contact between the provider of risk capital and the 
borrower was very attenuated.
    A central problem with the securitization market, especially for 
subprime loans was that no one was the gate keeper, shutting the door 
on uneconomic loans. The ultimate CDO bond investor placed his trust in 
the first loss investor, the rating agencies, and the CDO manager, and 
in each case that trust was misplaced.
    Ideally mortgage transactions are generally structured so that 
someone close to the origination process would take the first slice of 
credit risk and thus insure that loans were originated properly. In the 
subprime market, however it was possible to originate loans and sell 
them at such a high price, that even if the mortgage banker or 
aggregator retained a first loss piece (or residual) the transaction 
could be profitable even if the loans did not perform well. 
Furthermore, the terms of the residuals were set so that the owner of 
the residual might receive a substantial portion of their cash flows 
before the full extent of losses were known.
    Rating agencies set criteria to establish credit enhancement levels 
that ultimately led to ratings on bonds. The rating agencies generally 
rely on historical statistical analysis to set ratings. The rating 
agencies also depend on numeric descriptions of loans like loan-to-
value ratios and debt-to-income ratios to make their determinations. 
Rating agencies usually do not review loans files or ``re-underwrite'' 
loans. Rating agencies also do not share in the economic costs of loan 
defaults. The rating agencies methodology allowed for the inclusion of 
loans of dubious quality into subprime and Alt-A mortgage pools, 
including low documentation loans for borrowers with poor payment 
histories, without the offsetting requirement of high down payments.
    To help assure investors of the reliability of information about 
the risks of purchased loans, the mortgage market has developed the 
practice of requiring ``representations and warranties'' on purchased 
loans. These reps and warrants as they are called, are designed to 
insure that the loans sold meet the guidelines of the purchasers. This 
is because mortgage market participants have long recognized that there 
is substantial risk in acquiring loans originated by someone else. An 
essential component in having valuable reps and warrants is that the 
provider of those promises has sufficient capital to back up their 
obligations to repurchase loans subsequently determined to be 
inconsistent with the reps and warrants. A financial guarantee from an 
insolvent provider has no value.
    Representations and warranties are the glue that holds the process 
together; if the glue is weak the system can collapse.
    The rating agencies also established criteria for Collateralized 
Debt Obligations that allowed CDO managers to produce very highly 
leveraged portfolios of subprime mortgage securities. The basic 
mechanism for this was a model that predicted the performance of 
subprime mortgage pools were not likely to be highly correlated. That 
is defaults in one pool were not likely to occur at the same time as 
defaults in another pool. This assumption was at best optimistic and 
most likely just wrong.
    In the CDO market the rating agencies have a unique position. In 
most of their other ratings business, a company or a transaction exists 
or is likely to occur and the rating agency reviews that company or 
transaction and establishes ratings. In the CDO market, the criteria of 
the rating agency determine whether or not the transaction will occur. 
A CDO is like a financial institution. It buys assets and issues debt. 
If the rating agency establishes criteria that allow the institution to 
borrow money at a low enough rate or at high enough leverage, then the 
CDO can purchase assets more competitively than other financial 
institutions. If the CDO has a higher cost of debt or lower leverage, 
then it will be at a disadvantage to other buyers and will not be 
brought into existence. If the CDO is created, the rating agency is 
compensated for its ratings. If the CDO is not created, there is no 
compensation. My view is that there are very few institutions that can 
remain objective given such a compensation scheme.
    CDO bond investors also relied upon the CDO manager to guide them 
in the dangerous waters of mortgage investing. Here again investors 
were not well served by the compensation scheme. In many cases CDO 
managers receive fees that are independent of the performance of the 
deals they manage. While CDO managers sometimes keep an equity interest 
in the transactions they manage, the deals are often structured in such 
a way that that the deal can return the initial equity investment even 
if some of the bonds have losses. Moreover, many of the CDOs were 
managed by start-up firms with little or no capital.
    Nevertheless, much of the responsibility should rest with the 
investors. CDO bond investors were not blind to the additional risks 
posed by CDO investing. CDOs generally provided higher yields than 
similarly rated bonds, and it is an extremely naive, and to my mind, 
rare, investor who thinks they get higher returns without incremental 
risk. It is not unusual, however, for investors not to realize the 
magnitude of additional risk they bear for a modest incremental return. 
Ultimately it is investors who will bear the losses, and investors must 
bear the bulk of the burden in evaluating their investments. There were 
clear warning signs for several years as to the problems and risk of 
investing in subprime mortgages. Nevertheless, investors continued to 
participate in this sector as the risks grew and reward decreased.
    As expressed herein, the primary problem facing securitization is a 
failure of industrial organization. The key risk allocators in the 
market, the CDO managers, were too far from the origination process 
and, at best, they believed the originators and the rating agencies 
were responsible for limiting risk. At the origination end, without the 
discipline of a skeptical buyer, abuses grew. The buyer was not 
sufficiently concerned with the process of loan origination and the 
broker was not subject to sufficient constraints.
Current Conditions of the Mortgage-backed Securities Market
    More than 2 years after the announcement of the collapse of the 
Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the 
mortgage market remains in a distressed state. Little of the mortgage 
market is functioning without the direct involvement of the U.S. 
Government, and access to financing for mortgage originators and 
investors is still limited.
    Fortunately there are the beginning signs of stabilization of home 
prices, but rising unemployment threatens the recovery. In the 
secondary market for mortgage-backed securities there has been 
considerable recovery in price in some sectors, but overall demand is 
being propped up by large purchases of MBS by the Federal Reserve Bank.
    In addition, we find that many of our clients are primarily focused 
on accounting and regulatory concerns related to legacy positions, and 
less effort is focused on the economic analysis of current and future 
opportunities. That situation may be changing as over the past few 
months we have seen some firms begin to focus on longer term goals.
The Effectiveness of Government Action
    I have not performed an independent analysis of the effectiveness 
of Government actions, so by comments are limited to my impressions.
    Government involvement has been beneficial in a number of 
significant respects. Without Government involvement in Fannie Mae, 
Freddie Mac, and FHA lending programs, virtually all mortgage lending 
could have stalled. What lending would have existed would have been for 
only the absolute highest quality borrowers and at restrictive rates. 
In addition Government programs to provide liquidity have also been 
beneficial to the market as private lending was reduced to extremely 
low levels. Government and Federal Reserve purchases of MBS have kept 
mortgage rates low. This has probably helped to bolster home prices.
    On the other hand the start/stop nature of the buying programs 
under TARP and PPIP has probably been a net negative for the market. 
Market participants have held back on investments in anticipation of 
Government programs that either did not materialize or were 
substantially smaller in scope than expected.
    Furthermore Government efforts to influence loan modifications, 
while beneficial for some home owners, and possibly even investors, 
have created confusion and distrust. Investors are more reluctant to 
commit capital when the rules are uncertain. In my opinion there has 
been excessive focus on loan modifications as a solution to the current 
crisis. Loan modifications make sense for a certain portion of 
borrowers whose income has been temporarily disrupted or have 
sufficient income to support a modestly reduce loan amount and the 
willingness to make those payments. However for many borrowers, loan 
modifications cannot produce sustainable outcomes. In addition, loan 
modifications must deal with the complexities of multiple liens and 
complex ownership structures of mortgage loans. Short sales, short 
payoffs, and relocation assistance for borrowers are other alternatives 
that should be given greater weight in policy development.
    The extensive Government involvement in the mortgage market has 
likely produced significant positive benefits to the economy. However 
unwinding the Government role will be quite complex and could be 
disruptive to the recovery. Government programs need to be reduced and 
legislative and regulatory uncertainties need to be addressed to 
attract private capital back into these markets.
Legislative and Regulatory Recommendations
    I believe that the problems in the securitization market were 
essentially due to a failure of industrial organization. Solutions 
should address these industrial organization failures. While some may 
seek to limit the risks in the economy, I believe a better solution is 
to make sure the risks are borne by parties who have the capacity to 
manage the risks or the capital to bear those risks. In practical 
terms, this means that ultimately bond investors, as the creators of 
leverage, must be responsible for limiting leverage to economically 
sustainable levels that do not create excessive risk to their 
stakeholders. Moreover, lenders should not allow equity investors to 
have tremendous upside with little exposure to downside risk. Equity 
investors who have sufficient capital at risk are more likely to act 
prudently. Consequently, all the information needed to assess and 
manage risks must be adequately disclosed and investors should have 
assurances that the information they rely upon is accurate and timely. 
Likewise when the Government acts as a guarantor, whether explicitly or 
implicitly, it must insure that it is not encouraging excessive risk 
taking and must have access to critical information on the risks borne 
by regulated entities.
    In this light, I would like to comment on the Administration 
proposals on Securitization in the white paper: ``Financial Regulatory 
Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar 
ground:
---------------------------------------------------------------------------
     \5\ http://www.financialstability.gov/docs/regs/
FinalReport_web.pdf pp. 44-46.

        1. Federal banking agencies should promulgate regulations that 
        require originators or sponsors to retain an economic interest 
        in a material portion of the credit risk of securitized credit 
---------------------------------------------------------------------------
        exposures.

        The Federal banking agencies should promulgate regulations that 
        require loan originators or sponsors to retain 5 percent of the 
        credit risk of securitized exposures.

        2. Regulators should promulgate additional regulations to align 
        compensation of market participants with longer term 
        performance of the underlying loans.

        Sponsors of securitizations should be required to provide 
        assurances to investors, in the form of strong, standardized 
        representations and warranties, regarding the risk associated 
        with the origination and underwriting practices for the 
        securitized loans underlying ABS.

    Clearly excessive leverage and lack of economic discipline was at 
the heart of the problems with securitization. As described above the 
market failed to adequately protect investors from weakened 
underwriting standards. Additional capital requirements certainly 
should be part of the solution. However, such requirements need to be 
constructed carefully. Too little capital and it will not have any 
effect; too much and it will inhibit lending and lead to higher 
mortgage costs. The current recommendation for retention of 5 percent 
of the credit risk does not seem to strike that balance appropriately.
    When a loan is originated there are several kinds of credit related 
risks that are created. In addition to systematic risks related to 
future events such as changes in home prices and idiosyncratic risks 
such as changes in the income of the borrower, there are also 
operational risks related to the quality of the underwriting and 
servicing. An example of an underwriting risk is whether or not the 
borrower's income and current value of their home were verified 
appropriately. Originators are well positioned to reduce the 
operational risks associated with underwriting and fight fraud, but 
they may be less well positioned to bear the long term systematic and 
idiosyncratic risks associated with mortgage lending. Investors are 
well positioned to bear systemic risks and diversify idiosyncratic 
risks, but are not able to assess the risks of poor underwriting and 
servicing. The securitization process should ensure that there is 
sufficient motivation and capital for originators to manage and bear 
the risks of underwriting and sufficient information made available to 
investors to assess the risks they take on.
    The current form of representations and warranties is flawed in 
that it does not provide a direct obligation from the originator to the 
investor. Instead representations and warranties pass through a chain 
of ownership and are often limited by ``knowledge'' and capital. In 
addition current remedies are tied to damages and in a rising home 
price market calculated damages may be limited. Thus a period of rising 
home prices can mask declining credit quality and rising violations of 
representations and warranties.
    Therefore, incentives and penalties should be established to limit 
unacceptable behavior such as fraud, misrepresentations, predatory 
lending. If the goal is to prevent fraud, abuse and misrepresentations 
rather than to limit risk transfer then there needs to be a better 
system to enforce the rights of borrowers and investors than simply 
requiring a originators to retain a set percentage of credit risk.
    I have proposed \6\ a ``securitization certificate'' which would 
travel with the loan and would be accompanied by appropriate assurances 
of financial responsibility. The certificate would replace 
representations and warranties, which travel through the chain of 
buyers and sellers and are often unenforced or weakened by the 
successive loan transfers. The certificate could also serve to protect 
borrowers from fraudulent origination practices in the place of 
assignee liability. Furthermore the certificate should be structured so 
that there are penalties for violations regardless of whether or not 
the investor or the borrower has experienced financial loss. The record 
of violations of these origination responsibilities should publically 
available.
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     \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf 
and ``Securitization: After the Fall'', Anthony Sanders and Andrew 
Davidson, forthcoming.
---------------------------------------------------------------------------
    I have constructed a simple model of monitoring fraudulent loans. 
\7\ Some preliminary results are shown in Table 1. These simulations 
show the impact of increasing the required capital for a seller and of 
instituting a fine for fraudulent loans beyond the losses incurred. 
These results show that under the model assumptions, without a fine for 
fraud, sellers benefit from originating fraudulent loans. The best 
results are obtained when the seller faces fines for fraud and has 
sufficient capital to pay those fines. The table below shows the 
profitability of the seller and buyer for various levels of fraudulent 
loans. In the example below, the profits of the seller increase from 
.75 with no fraudulent loans to .77 with 10 percent fraudulent loans, 
even when the originator retains 5 percent capital against 5 percent of 
the credit risk. On the other hand, the sellers profit falls from .75 
to .44 with 10 percent fraudulent loans even though the retained 
capital is only 1 percent, but there is a penalty for fraudulent loans. 
Thus the use of appropriate incentives can reduce capital costs, while 
increasing loan quality.
---------------------------------------------------------------------------
     \7\ The IMF has produced a similar analysis and reached similar 
conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/
chap2.pdf.

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    Under this analysis the Treasury proposals would not have a direct 
effect on fraud. In fact, there is substantial risk the recommended 
approach of requiring minimum capital requirements for originators to 
bear credit risk would lead to either higher mortgage rates or 
increased risk taking. A better solution is to create new mechanisms to 
monitor and enforce the representations and warranties of originators. 
With adequate disclosure of risks and a workable mechanism for 
enforcing quality controls the securitization market can more 
effectively price and manage risk.
    Recommendation 3 addresses the information available to investors:

        3. The SEC should continue its efforts to increase the 
        transparency and standardization of securitization markets and 
        be given clear authority to require robust reporting by issuers 
        of asset backed securities (ABS).

    Increased transparency and standardization of securitization 
markets would likely to better functioning markets. In this area, 
Treasury charges the SEC and ``industry'' with these goals. I believe 
there needs to be consideration of a variety of institutional 
structures to achieve these goals. Standardization of the market can 
come from many sources. Possible candidates include the SEC, the 
American Securitization Forum, the Rating Agencies and the GSEs, Fannie 
Mae and Freddie Mac.
    I believe the best institutions to standardize a market are those 
which have an economic interest in standardization and disclosure. Of 
all of these entities the GSEs have the best record of standardizing 
the market; this was especially true before their retained portfolios 
grew to dominate their income. (As I will discuss below, reform of the 
GSEs is essential for restoring securitization.) I believe a revived 
Fannie Mae and Freddie Mac, limited primarily to securitization, 
structured as member-owned cooperatives, could be an important force 
for standardization and disclosure.
    While the other candidates could achieve this goal they each face 
significant obstacles.
    The SEC operates primarily through regulation and therefore may not 
be able to adapt to changing markets. While the ASF has made 
substantial strides in this direction, the ASF lacks enforcement power 
for its recommendations and has conflicting constituencies. The rating 
agencies have not shown the will or the power to force standardization, 
and such a role may be incompatible with their stated independence.
    Recommendations 4 and 5 address the role of rating agencies in 
securitization.

        4. The SEC should continue its efforts to strengthen the 
        regulation of credit rating agencies, including measures to 
        require that firms have robust policies and procedures that 
        manage and disclose conflicts of interest, differentiate 
        between structured and other products, and otherwise promote 
        the integrity of the ratings process.

        5. Regulators should reduce their use of credit ratings in 
        regulations and supervisory practices, wherever possible.

    In general I believe that the conflicts of interest facing rating 
agencies and their rating criteria were well known and easily 
discovered prior to the financial crisis. Thus I do not believe that 
greater regulatory authority over rating agencies will offer 
substantial benefits. In fact, increasing competition in ratings or 
altering the compensation structure of rating agencies may not serve to 
increase the accuracy of ratings, since most users of ratings issuers 
as well as investors are generally motivated to seek higher ratings. 
(Only if the regulatory reliance on rating agencies is reduced will 
these structural changes be effective.) To the extent there is reliance 
on rating agencies in the determination of the capital requirement for 
financial institutions, a safety and soundness regulators for financial 
institutions, such the FFIEC or its successor, should have regulatory 
authority over the rating agencies.
    Rather than focus on better regulation, I support the second aspect 
of Treasury's recommendations on rating agencies (recommendation 5) and 
believe it would be better for safety and soundness regulators to 
reduce their reliance on ratings and allow the rating agencies to 
continue their role of providing credit opinions that can be used to 
supplement credit analysis performed by investors. To reduce reliance 
on ratings, regulators, and others will need alternative measures of 
credit and other risks. I believe that the appropriate alternative to 
ratings is analytical measures of risk. Analytical measures can be 
adopted, refined, and reviewed by regulators. In addition regulators 
should insist that regulated entities have sufficient internal capacity 
to assess the credit and other risks of their investments. In this way 
regulators would have greater focus on model assumptions and model 
validation and reduced dependence on the judgment of rating agencies. 
The use of quantitative risk measures also requires that investors and 
regulators have access to sufficient information about investments to 
perform the necessary computations. Opaque investments that depend 
entirely upon rating agency opinions would be clearly identified. 
Quantitative measures can also be used to address the concerns raised 
in the report about concentrations of risk and differentiate structured 
products and direct corporate obligations.
    I recently filed a letter with the National Association of 
Insurance Commissioners on the American Council of Life Insurers' 
proposal to use an expected loss measure as an alternative to ratings 
for nonagency MBS in determining risk based capital. Here I would like 
to present some of the key points in that letter:

        An analytical measure may be defined as a number, or a value, 
        that is computed based on characteristics of a specific bond, 
        its collateral and a variety of economic factors both 
        historical and prospective. One such analytical measure is the 
        probability of default and another measure is the expected loss 
        of that bond. While an analytical measure is a numeric value 
        that is the result of computations, it should be noted that 
        there may still be some judgmental factors that go into its 
        production. In contrast, a rating is a letter grade, or other 
        scale, assigned to a bond by a rating agency. While ratings 
        have various attributes, generally having both objective and 
        subjective inputs, there is not a particular mathematical 
        definition of a rating.

    Analytical measures may be useful for use by regulators because 
they have several characteristics not present in ratings.

  1.  An analytical measure can be designed for a specific purpose. 
        Specific analytical measures can be designed with particular 
        policy or risk management goals in mind. Ratings may reflect a 
        variety of considerations. For example, there is some 
        uncertainty as to whether ratings represent the first dollar of 
        loss or the expected loss, or how expected loss is reflected in 
        ratings.

  2.  Analytical measures can be updated at any frequency. Ratings are 
        updated only when the rating agencies believe there has been 
        sufficient change to justify an upgrade, downgrade or watch. 
        Analytical measures can be computed any time new information is 
        available and will show the drift in credit quality even if a 
        bond remains within the same rating range.

  3.  Analytical measures can take into account price or other investor 
        specific information. Ratings are computed for a bond and 
        generally reflect the risk of nonpayment of contractual cash 
        flows. However, the risk to a particular investor of owning a 
        bond will at least partially depend on the price that the bond 
        is carried in the portfolio or the composition of the 
        portfolio.

  4.  Regulators may contract directly with vendors to produce 
        analytical results and may choose the timing of the 
        calculations. On the other hand, ratings are generally 
        purchased by the issuer at the time of issuance. Not only may 
        this introduce conflicts of interest, but it also creates a 
        greater focus on initial ratings than on surveillance and 
        updating of ratings. In addition, once a regulator allows the 
        use of a particular rating agency it has no further involvement 
        in the ratings process.

  5.  Analytical measures based on fundamental data may also be 
        advantageous over purely market-based measures. As market 
        conditions evolve values of bonds may change. These changes 
        reflect economic fundamentals, but may also reflect supply/
        demand dynamics, liquidity and risk preferences. Measures fully 
        dependent on market prices may create excessive volatility in 
        regulatory measures, especially for companies with the ability 
        to hold bonds to maturity.

    Even if regulators use analytical measures of risk, ratings from 
rating agencies as independent opinions would still be valuable to 
investors and regulators due to the multifaceted nature of ratings and 
rating agency analysis can be used to validate the approaches and 
assumptions used to compute particular analytical measures.
    Additional measures beyond the credit risk of individual securities 
such as stress tests, market value sensitivity and measures of 
illiquidity may also be appropriate in the regulatory structure. The 
use of analytical measures rather than ratings does not eliminate the 
potential for mistakes. In general, any rigid system can be gamed as 
financial innovation can often stay ahead of regulation. To reduce this 
problem regulation should be based on principles and evolve with the 
market. Regulators should always seek to build an a margin of safety as 
there is always a risk that the theory underlying the regulatory regime 
falls short and that some participants will find mechanisms to take 
advantage of the regulatory structure.
    Finally, as discussed by the Administration in the white paper, the 
future of securitization for mortgages requires the resolution of the 
status of Fannie/Freddie and role of FHA/GNMA. As stated above, I 
believe that continuation of Fannie Mae and Freddie Mac as member owned 
cooperatives would serve to establish standards, and provide a vehicle 
for the delivery of Government guarantees if so desired. The TBA, or to 
be announced, market has been an important component in the success of 
the fixed rate mortgage market in the United States. Careful 
consideration should be given to the desirability of fixed rate 
mortgages and the mechanisms for maintaining that market in discussions 
of the future of the GSEs.
                                 ______
                                 
              PREPARED STATEMENT OF J. CHRISTOPHER HOEFFEL
 Executive Committee Member, Commercial Mortgage Securities Association
                            October 7, 2009
    The Commercial Mortgage Securities Association (CMSA) is grateful 
to Chairman Reed, Ranking Member Bunning, and the Members of the 
Subcommittee for giving CMSA the opportunity to share its perspective 
concerning the securitized credit markets for commercial real estate. 
In responding to the specific questions the Subcommittee has asked 
witnesses to address, we will focus on securitization in the commercial 
real estate (CRE) mortgage context and address the following issues: 
(1) the challenges facing the $3.5 trillion market for commercial real 
estate finance; (2) the unique structure of the commercial market and 
the need to customize regulatory reforms accordingly to support, and 
not undermine, our Nation's economic recovery; and, (3) efforts to 
restore the availability of credit by promoting and enhancing the 
viability of commercial mortgage-backed securities (CMBS).
CMSA and the Current State of the Market
    CMSA represents the full range of CMBS market participants, 
including investment and commercial banks; rating agencies; accounting 
firms, servicers; other service providers; and investors such as 
insurance companies, pension funds, and money managers. CMSA is a 
leader in the development of standardized practices and in ensuring 
transparency in the commercial real estate capital market finance 
industry.
    Because our membership consists of all constituencies across the 
entire market, CMSA has been able to develop comprehensive responses to 
policy questions to promote increased market efficiency and investor 
confidence. For example, our members continue to work closely with 
policymakers in Congress, the Administration, and financial regulators, 
providing practical advice on measures designed to restore liquidity 
and facilitate lending in the commercial mortgage market (such as the 
Term Asset-Backed Securities Loan Facility (TALF) and the Public-
Private Investment Program (PPIP)). CMSA also actively participates in 
the public policy debates that impact the commercial real estate 
capital markets.
    The CMBS market is a responsible and key contributor to the overall 
economy that historically has provided a tremendous source of capital 
and liquidity to meet the needs of commercial real estate borrowers. 
CMBS helps support the commercial real estate markets that fuel our 
country's economic growth. The loans that are financed through those 
markets help provide jobs and services to local communities, as well as 
housing for millions of Americans in multifamily dwellings.
    Unfortunately, the recent turmoil in the financial markets coupled 
with the overall downturn in the U.S. economy have brought the CMBS 
market to a standstill and created many pressing challenges, 
specifically:

    No liquidity or lending--While the CMBS market provided 
        approximately $240 billion in commercial real estate financing 
        in 2007 (nearly 50 percent of all commercial lending), CMBS 
        issuance fell to $12 billion in 2008, despite strong credit 
        performance and high borrower demand. There has been no new 
        private label CMBS issuance year-to-date in 2009, as the 
        lending markets remain frozen;

    Significant loan maturities through 2010--At the same time, 
        there are significant commercial real estate loan maturities 
        this year and next--amounting to hundreds of billions of 
        dollars--but the capital necessary to refinance these loans 
        remains largely unavailable and loan extensions are difficult 
        to achieve; and

    The U.S. economic downturn persists--The U.S. recession 
        continues to negatively affect both consumer and business 
        confidence, which impacts commercial and multifamily occupancy 
        rates and rental income, as well as business performance and 
        property values.

    Significantly, it is important to note that the difficulties faced 
by the overall CRE market are not attributable solely to the current 
trouble in the CMBS market, but also stem from problems with unsecured 
CRE debt, such as construction loans. As described by Richard Parkus, 
an independent research analyst with Deutsche Bank who has testified 
before both the Joint Economic Committee and the TARP Oversight Panel, 
while the overall CRE market will experience serious strain (driven by 
poor consumer confidence and business performance, high unemployment 
and property depreciation), it is the nonsecuritized debt on the books 
of small and regional banks that will be most problematic, as the 
projected default rates for such unsecuritized commercial debt have 
been, and are expected to continue to be, significantly higher than 
CMBS loan default rates.
    As recently as early this year, default rates in the CMBS market, 
which have historically been low (less than .50 percent for several 
years) still hovered around a mere 1.25 percent. Unfortunately, the 
economic recession that began as a crisis of liquidity in some sectors 
transformed into a crisis in confidence that affected all sectors, and 
it was only a matter of time before CMBS was affected. No matter the 
strength of our fundamentals and loan performance, once investors lost 
confidence and began to shy away from mortgaged-backed securities, CMBS 
could not avoid the contagion.
    This unfortunate combination of circumstances leaves the broader 
CRE sector and the CMBS market with several overarching problems: (1) a 
liquidity gap, i.e., the difference between borrowers' demand for 
credit and the nearly nonexistent supply of credit; (2) an equity gap 
(the difference between the current market value of commercial 
properties and what is owed on them, which will be extremely difficult 
to refinance as current loans mature); and (3) the fact that potential 
CMBS sponsors are very reluctant to take the risk of trying to 
aggregate loans for securitization, since there is no assurance that 
private sector investors will buy the securities, all of which serves 
to simply perpetuate the cycle of frozen credit markets.
Unique Characteristics of the CMBS Market
    There are a number of important distinctions between CMBS and other 
asset-backed securities (ABS) markets, and those distinctions should be 
considered in fashioning any broad securitization-related regulatory 
reforms. These differences relate not only to the structure of 
securities, but also to the underlying collateral, the type and 
sophistication of the borrowers, as well as to the level of 
transparency in CMBS deals.
Commercial Borrowers
    Commercial borrowers are highly sophisticated businesses with cash 
flows based on business operations and/or tenants under leases. This 
characteristic stands in stark contrast to the residential market 
where, for example, loans were underwritten in the subprime category 
for borrowers who may not have been able to document their income, or 
who may not have understood the effects of factors like floating 
interest rates and balloon payments on their mortgage's affordability.
    Additionally, securitized commercial mortgages have different terms 
(generally 5-10 year ``balloon'' loans), and they are, in the vast 
majority of cases, nonrecourse loans. This means that if the borrower 
defaults, the lender can seize the collateral, although it may not 
pursue a claim against the borrower for any deficiency in recovery. 
This dramatically decreases the cost of default because the loan work-
out recoveries in the CMBS context tend to be significantly more 
efficient than, for example, the residential loan foreclosure process.
Structure of CMBS
    There are multiple levels of review and diligence concerning the 
collateral underlying CMBS, which help ensure that investors have a 
well informed, thorough understanding of the risks involved. 
Specifically, in-depth property-level disclosure and review are done by 
credit rating agencies as part of the process of rating CMBS bonds.
    Moreover, nonstatistical analysis is performed on CMBS pools. This 
review is possible given that there are only 100-300 commercial loans 
in a pool that support a bond, as opposed, for example, to tens of 
thousands of loans in residential mortgage-backed securities pools. 
This limited number of loans allows market participants (investors, 
rating agencies, etc.) to gather detailed information about income 
producing properties and the integrity of their cash flows, the credit 
quality of tenants, and the experience and integrity of the borrower 
and its sponsors, and thus conduct independent and extensive due 
diligence on the underlying collateral supporting their CMBS 
investments.
First-Loss Investor (``B-Piece Buyer'') Re-Underwrites Risk
    CMBS bond issuances include a first-loss, noninvestment grade bond 
component. The third-party investors that purchase these lowest-rated 
securities (referred to as ``B-piece'' or ``first-loss'' investors) 
conduct their own extensive due diligence (usually including, for 
example, site visits to every property that collateralizes a loan in 
the loan pool) and essentially re-underwrite all of the loans in the 
proposed pool. Because of this, the B-piece buyers often negotiate the 
removal of any loans they consider to be unsatisfactory from a credit 
perspective, and specifically negotiate with bond sponsors or 
originators to purchase this noninvestment-grade risk component of the 
bond offering. This third-party investor due diligence and negotiation 
occurs on every deal before the investment-grade bonds are issued.
Greater Transparency
    A wealth of transparency currently is provided to CMBS market 
participants via the CMSA Investor Reporting Package (CMSA IRP). The 
CMSA IRP provides access to loan, property and bond-level information 
at issuance and while securities are outstanding, including updated 
bond balances, amount of interest and principal received, and bond 
ratings, as well as loan-level and property-level information on an 
ongoing basis. The ``CMSA IRP'' has been so successful in the 
commercial space that it is now serving as a model for the residential 
mortgage-backed securities market.
Current Efforts To Restore Liquidity
    Private investors are absolutely critical to restoring credit 
availability in the capital finance markets. Accordingly, Government 
initiatives and reforms must work to encourage private investors--who 
bring their own capital to the table--to come back to the capital 
markets.
    Treasury Secretary Geithner emphasized this need when he stressed 
during the introduction of the Administration's Financial Stability 
Plan that ``[b]ecause this vital source of lending has frozen up, no 
financial recovery plan will be successful unless it helps restart 
securitization markets for sound loans made to consumers and 
businesses--large and small.'' The importance of restoring the 
securitization markets is recognized globally as well, with the 
International Monetary Fund noting in its most recent Global Financial 
Stability Report that ``restarting private-label securitization 
markets, especially in the United States, is critical to limiting the 
fallout from the credit crisis and to the withdrawal of central bank 
and Government interventions.'' \1\
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     \1\ International Monetary Fund, ``Restarting Securitization 
Markets: Policy Proposals and Pitfalls'', Ch. 2, Global Financial 
Stability Report: Navigating the Financial Challenges Ahead (October 
2009), at 33 (``Conclusions and Policy Recommendations'' section) 
available at http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/
text.pdf. 
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    As a centerpiece of the Financial Stability Plan, policymakers hope 
to restart the CMBS and other securitization markets through innovative 
initiatives (such TALF and the PPIP), and CMSA welcomes efforts to 
utilize private investors to help fuel private lending. In this regard, 
the TALF program for new CMBS issuance has been particularly helpful in 
our space, as evidenced in triple-A CMBS cash spreads tightening almost 
immediately after the program was announced, as one example.
    To this end, CMSA continues to engage in an ongoing dialogue with 
many members of the relevant Congressional committees, as well as with 
key policymakers at the Treasury Department, Federal Reserve and other 
agencies, and with participants in various sectors of the commercial 
real estate market. The focus of our efforts has been on creative 
solutions to help bring liquidity back to the commercial real estate 
finance markets. We appreciate policymakers' recognition, as evidenced 
by programs like TALF and PPIP, that a major part of the solution will 
be to bring private investors back to the market through 
securitization. We also appreciate the willingness of Congress and 
other policymakers to listen to our recommendations on how to make 
these programs as effective as possible.
    However, there is still a long way to go toward recovery in the CRE 
market, despite the early success of the TALF program. The market faces 
the overarching problems of the liquidity and equity gaps. This is 
driven in part by the absence of any aggregation mechanism--
securitizers are unwilling to bear all of the noncredit risks (like 
interest rate changes) they must currently take on between the time a 
loan is made and when it can be securitized (a process that takes 
months across a pool of loans). This is especially true now when there 
still is uncertainty as to whether there will be willing investors at 
the end of the process.
    CMSA also is committed to working on additional long-term solutions 
to ensure the market is able to meet ongoing commercial borrowing 
demands. For example, CMSA supports efforts to facilitate a U.S. 
commercial covered bond market in order to provide an additional source 
of liquidity through new and diverse funding sources. We will continue 
to work with Congress on the introduction of comprehensive legislation 
that would include high quality commercial mortgage loans and CMBS as 
eligible collateral in the emerging covered bond marketplace.
Financial Regulatory Reform and Commercial Real Estate
    The Administration has proposed new and unprecedented financial 
regulatory reform proposals that will change the nature of the 
securitized credit markets which are at the heart of recovery efforts. 
The securitization reform proposals appear to be prompted by some of 
the practices that were typical in the subprime and residential 
securitization markets. At the outset, we must note that CMSA does not 
oppose efforts to address such issues, as we have long been an advocate 
within the industry for enhanced transparency and sound practices.
    As a general matter, however, policymakers must ensure that any 
regulatory reforms are tailored to address the specific needs of each 
securitization asset class. As discussed above, the structure of the 
CMBS market has incorporated safeguards that minimize the risky 
securitization practices that policymakers hope to address. Thus, the 
securitization reform initiatives should be tailored to take these 
differences into account. In doing so, policymakers can protect the 
viability of the markets that already are functioning in a way that 
does not pose a threat to overall economic stability, and ensure that 
such markets can continue to be a vital component of the economic 
recovery solution.
    CMSA and its members are concerned that certain aspects of the 
Administration's securitization reform proposals could undermine rather 
than support the Administration's many innovative efforts to restart 
the securitization markets, effectively stalling recovery efforts by 
making lenders less willing or able to extend loans and investors less 
willing or able to buy CMBS bonds--two critical components to the flow 
of credit in the commercial market.
    The two aspects of the securitization reform proposal that are of 
utmost concern to CMSA are a plan to require bond issuers or 
underwriters (referred to as ``securitizers'' in the Administration's 
draft securitization reform bill) to retain at least 5 percent of the 
credit risk in any securitized asset they sell, and an associated 
restriction on the ability of issuers to hedge the 5 percent retained 
risk. Again, CMSA does not oppose these measures per se, but emphasizes 
that they should be tailored to reflect key differences between the 
different asset-backed securities markets.
    Significantly, we are not alone in advocating a tailored approach. 
The IMF, which recently expressed concern that U.S. and European 
retained risk proposals may be too simplistic, warned that 
``[p]roposals for retention requirements should not be imposed 
uniformly across the board, but tailored to the type of securitization 
and underlying assets to ensure that those forms of securitization that 
already benefit from skin in the game and operate well are not 
weakened. The effects induced by interaction with other regulations 
will require careful consideration.''
Five Percent Risk Retention for Securitizers
    The retention of risk is an important component regardless of who 
ultimately retains it: the originator, the issuer, or the first-loss 
buyer. As explained above, the CMBS structure has always had a third-
party in the first-loss position that specifically negotiates to 
purchase this risk. Most significantly, these third-party investors are 
able to, and do, protect their own interests in the long-term 
performance of the bonds rather than relying merely on the underwriting 
and representations of securitizers or originators. First-loss buyers 
conduct their own extensive credit analysis on the loans, examining 
detailed information concerning every property--before buying the 
highest risk bonds in a CMBS securitization. In many cases, the holder 
of the first-loss bonds is also related to the special servicer who is 
responsible on behalf of all bondholders as a collective group for 
managing and resolving defaulted loans through workouts or foreclosure.
    Thus, the policy rationale for imposing a risk retention 
requirement on issuers or underwriters as ``securitizers'' that could 
preclude them from transferring the first-loss position to third 
parties is unnecessary in this context, because, although the risk is 
transferred, it is transferred to a party that is acting as a 
``securitizer'' and that is fully cognizant, through its own diligence, 
of the scope and magnitude of the risk it is taking on. In effect, when 
it comes to risk, the first-loss buyer is aware of everything the 
issuer or underwriter is aware of.
    Because the CMBS market is structured differently than other 
securitization markets, policymakers' focus in this market should be on 
the proper transfer of risk (e.g., sufficient collateral disclosure, 
adequate due diligence and/or risk assessment procedures on the part of 
the risk purchaser), analogous to what takes place in CMBS 
transactions. Therefore, CMBS securitizers should be permitted to 
transfer risk to B-piece buyers who--in the CMBS context at least--act 
as ``securitizers.'' To require otherwise would hamper the ability of 
CMBS lenders to originate new bond issuances, by needlessly tying up 
their capital and resources in the retained risk, which in turn, would 
squelch the flow of credit at a time when our economy desperately needs 
it.
    CMSA therefore suggests that securitization legislation include a 
broader definition of ``securitizer'' than is presently in the 
Administration's draft bill, to include third parties akin to the CMBS 
first-loss investors. Such an approach will provide explicit 
recognition of the ability to transfer retained risk to third parties 
under circumstances in which the third party agrees to retain the risk 
and is capable of adequately protecting its own interests.
Prohibition on Hedging of Retained Risk
    In conjunction with the retained risk requirement, there also is a 
proposal to prohibit ``securitizers'' from hedging that risk. Rather 
than adopting an outright ban on hedging the retained risk, however, 
the measure needs to be designed to strike a balance between fulfilling 
the legislation's objective of ensuring that securitizers maintain an 
appropriate stake in the risks they underwrite. Such tailoring is 
necessary to avoid imposing undue constraints on ``protective'' 
mechanisms that are legitimately used by securitizers to maintain their 
financial stability.
    Several risks inherent in any mortgage or security exposure arise 
not from imprudent loan origination and underwriting practices, but 
from outside factors such as changes in interest rates, a sharp 
downturn in economic activity, or regional/geographic events such as a 
terrorist attack or weather-related disaster. Securitizers attempt to 
hedge against these market-oriented factors in keeping with current 
safety and soundness practices, and some examples in this category of 
hedges are interest rate hedges using Treasury securities, relative 
spread hedges (using generic interest-rate swaps), and macroeconomic 
hedges (that, for example, are correlated with changes in GDP or other 
macroeconomic factors). The hallmark of this category is that these 
hedges seek protection from factors the securitizer does not control, 
and the hedging has neither the purpose nor the effect of shielding the 
originators or sponsors from credit exposures on individual loans.
    As such, hedges relate to generally uncontrollable market forces 
that cannot be controlled independently. There is no way to ensure that 
any such hedge protects 100 percent of an investment from loss--
particularly as it pertains to a CMBS transaction that, for example, is 
secured by a diverse pool of loans with exposure to different 
geographic locations, industries and property types. Therefore, loan 
securitizers that must satisfy a retention requirement continue to 
carry significant credit risk exposure that reinforces the economic tie 
between the securitizer and the issued CMBS even in the absence of any 
hedging constraints.
    For these reasons, securitization reform legislation should not 
seek to prohibit securitizers from using market-oriented hedging 
vehicles. Instead, if a limitation is to be placed on the ability to 
hedge, it should be targeted to prohibit hedging any individual credit 
risks within the pool of risks underlying the securitization. Because 
these types of vehicles effectively allow the originator or issuer to 
completely shift the risk of default with respect to a particular loan 
or security, their use could provide a disincentive to engage in 
prudent underwriting practices--the specific type of disincentive 
policymakers want to address.
Retroactive Changes to Securitization Accounting
    Beyond the specific securitization reform proposals that have been 
circulated by the Administration in draft legislation, there are two 
other policy initiatives that greatly concern CMSA because of the 
adverse effect these initiatives can have on the securitization market: 
retroactive changes to the rules for securitization accounting, and 
differentiated credit rating symbols for structured finance products.
    Retroactive changes to securitization accounting rules known as FAS 
166 and 167, which were recently adopted by the Financial Accounting 
Standards Board (FASB), throw into question the future of securitized 
credit markets. \2\ The new rules eliminate Qualified Special Purposes 
Entities (QSPEs), which are the primary securitization accounting 
vehicle for all asset-backed securities including CMBS, as well as 
change the criteria for the sales treatment and consolidation of 
financial assets. These accounting standards are important to issuers 
and investors, and for the liquidity of capital markets as a whole, 
because they free up balance sheet capacity to enable issuers to make 
more loans and do more securitizations, and they enable investors to 
invest more of their capital into the market. Under the new rules, 
however, issuers may not receive sales accounting treatment, while 
investors may be forced to consolidate an entire pool of loans on their 
balance sheet, despite owning only a small fraction of the loans pool.
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     \2\ More specifically, these two standards provide accounting 
guidance on when a sale of a financial instrument has occurred and how 
to account for the sale, and guidance on when a securities issuer, B-
piece buyer or servicer needs to consolidate the securities and 
liabilities on its balance sheet. The current rules facilitate 
securitization by allowing issuers to receive ``sales treatment'' for 
the assets they securitize, such that these assets are reflected on the 
balance sheet of the investors that purchase the bonds, rather than the 
issuers' balance sheet. Moreover, under present rules, investors 
reflect only the fraction of the securitization deal that they actually 
own on their balance sheet.
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    The implementation date of FAS 166 and 167 is January 1, 2010, and 
it will be applied retroactively. The elimination of QSPEs therefore 
will impact trillions of dollars of outstanding asset-backed 
securities, including investors in these assets. These significant and 
retroactive changes will pose a serious threat to unlocking the frozen 
credit markets and another impediment to the Administration's wide-
ranging efforts to restart the securitized credit markets. CMSA and a 
diverse coalition of 15 trade groups have raised concerns about the 
timing and scope of FAS 166 and 167 given the impact these rule changes 
could have on credit availability. These concerns have been echoed by 
the Federal Reserve and other banking regulators, which wrote to FASB 
in December 2008 to highlight the adverse impact these rule changes 
could have on the credit markets.
    More recently, Federal Reserve Board Member Elizabeth Duke 
capsulized the concerns shared by the industry when she cautioned that:

        [i]f the risk retention requirements, combined with accounting 
        standards governing the treatment of off-balance-sheet 
        entities, make it impossible for firms to reduce the balance 
        sheet through securitization and if, at the same time, leverage 
        ratios limit balance sheet growth, we could be faced with 
        substantially less credit availability. I'm not arguing with 
        the accounting standards or the regulatory direction. I am just 
        saying they must be coordinated to avoid potentially limiting 
        the free flow of credit . . . . As policymakers and others work 
        to create a new framework for securitization, we need to be 
        mindful of falling into the trap of letting either the 
        accounting or regulatory capital drive us to the wrong model. 
        This may mean we have to revisit the accounting or regulatory 
        capital in order to achieve our objectives for a viable 
        securitization market. \3\
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     \3\ ``Regulatory Perspectives on the Changing Accounting 
Landscape'', Speech by Governor Elizabeth A. Duke at the AICPA National 
Conference on Banks and Savings Institutions, Washington, DC, September 
14, 2009, available at http://www.federalreserve.gov/newsevents/speech/
duke20090914a.htm.

    Policymakers and standard setters, including FASB and the SEC, need 
to proceed cautiously and deliberately in this regard, so that 
accounting rule changes do not hamper the recovery of the 
securitization markets.
Credit Rating Agency Reform
    One aspect of the reforms currently being considered for credit 
rating agencies is a previously rejected proposal to require credit 
ratings to be differentiated for certain types of structured financial 
products (requiring the use of ``symbology,'' such as ``AAA.SF''). 
Generally speaking, ``differentiation'' is an overly simplistic and 
broad proposal that provides little value or information about credit 
ratings. Thus, CMSA's members, and specifically the investors the 
symbology is geared to inform, continue to have serious concerns about 
differentiation, although we are strong supporters of more effective 
means of strengthening the credit ratings system in order to provide 
investors with the information they need to make sound investment 
decisions.
    In fact, a broad coalition of market participants--including 
issuers, investors, and borrowers seeking access to credit--remain 
overwhelming opposed to differentiation because it will serve only to 
increase confusion and implementation costs, while decreasing 
confidence and certainty regarding ratings. Such effects would, in 
turn, create market volatility and undermine investor confidence and 
liquidity, which could exacerbate the current constraints on borrowers' 
access to capital, at a time when other policymakers are employing 
every reasonable means to get credit flowing again.
    In this regard, it is worth noting that the concept of 
differentiation has been examined extensively and rejected in recent 
years by the House Committee on Financial Services, as well as by the 
SEC and the ratings agencies themselves, \4\ for most (if not all) of 
the foregoing reasons. Nothing has changed in the interim.
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     \4\ In early 2008, the CRAs sought feedback on various 
differentiation proposals, which elicited overwhelming opposition from 
investors. For example, see the results of Moody's Request for Comment: 
``Should Moody's Consider Differentiating Structured Finance and 
Corporate Ratings?'' (May 2008). Moody's received more than 200 
responses, including ones from investors that together held in excess 
of $9 trillion in fixed income securities.
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    Accordingly, Congress should not include a differentiation 
requirement as part of any credit rating agency reform bill, but 
instead should include language consistent with that already passed 
last year by the House Committee on Financial Services in the Municipal 
Bond Fairness Act. That legislation would require CRAs to use ratings 
symbols that are consistent for all types of securities, recognizing 
the fact that a single and consistent ratings structure is critical to 
bond investors who want the ability to compare a multitude of 
investment options across asset classes. Ultimately, investors (who are 
critical to the Nation's economic recovery) expect and demand a common 
rating structure to provide a meaningful foundation for our markets and 
ratings system. Such consistency will promote certainty and confidence 
among investors and all market participants.
    In terms of credit ratings performance CMSA devoted significant 
resources over the last few years to affirmatively enhance transparency 
in credit ratings. Such enhancements will be far more effective in 
providing investors with the information they need to make the most 
informed decisions than a differentiated ratings structure. Instead of 
differentiated ratings, what CMBS investors have consistently sought is 
new, targeted transparency and disclosures about the ratings of 
structured products, to build on the already robust information CRAs 
provide in their published methodology, presale reports, and 
surveillance press releases.
    In comments filed with the SEC in July 2008, CMSA listed a number 
of recommendations for enhancements that would serve the investor 
community, such as publication of more specific information regarding 
NRSRO policies and procedures related to CMBS valuations; adoption of a 
standard presale report template with specified information regarding 
methodology and underwriting assumptions; and adoption of a standard 
surveillance press release with specified information regarding the 
ratings. Such information would allow investors to better understand 
the rating methodology and make their own investment determinations.
    Fundamentally, CMSA believes that one of the keys to long term 
viability is market transparency. As previously mentioned transparency 
is one of the hallmarks of our market, as exemplified by the 
unqualified success of our Investor Reporting Package. As we endeavor 
to continually update our reporting package and provide additional 
standardized information to market participants, one of our most 
important proactive initiatives is the ongoing process of creating 
model offering documents and providing additional disclosure fields 
with regard to additional subordinate debt that may exist outside the 
CMBS trust. To this end, CMSA is working with the Federal Reserve Board 
to ensure the expanded disclosure meets their information needs under 
TALF.
Conclusion
    There are enormous challenges facing the commercial real estate 
sector. While regulatory reforms are important and warranted, these 
proposals should not detract from or undermine efforts to get credit 
flowing, which is critical to economic recovery. Moreover, any policies 
that make debt or equity interests in commercial real estate less 
liquid will have a further negative effect on property values and the 
cost of capital. Accordingly, we urge Congress to ensure that 
regulatory reform measures are tailored to account for key differences 
in the various securitization markets.
                                 ______
                                 
                PREPARED STATEMENT OF WILLIAM W. IRVING
                Portfolio Manager, Fidelity Investments
                            October 7, 2009
    Good afternoon Chairman Reed, Ranking Member Bunning, and Members 
of the Subcommittee. I am Bill Irving, an employee of Fidelity 
Investments, \1\ where I manage a number of fixed-income portfolios and 
play a leading role in our investment process in residential mortgage-
backed securities (RMBS). This experience has certainly shaped my 
perspective on the role of securitization in the financial crisis, the 
condition of the securitization markets today, and policy changes 
needed going forward. I thank you for the opportunity to share that 
perspective with you in this hearing. At the outset, I want to 
emphasize that the views I will be expressing are my own, and do not 
necessarily represent the views of my employer, Fidelity Investments.
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     \1\ Fidelity Investments is one of the world's largest providers 
of financial services, with assets under Administration of $3.0 
trillion, including assets under management of more than $1.4 trillion 
as of August 31, 2009. Fidelity offers investment management, 
retirement planning, brokerage, and human resources and benefits 
outsourcing services to over 20 million individuals and institutions as 
well as through 5,000 financial intermediary firms. The firm is the 
largest mutual fund company in the United States, the number one 
provider of workplace retirement savings plans, the largest mutual fund 
supermarket and a leading online brokerage firm. For more information 
about Fidelity Investments, visit Fidelity.com.
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Summary
    I will make three main points. First, the securitized markets 
provide an important mechanism for bringing together investors and 
borrowers to provide credit to the American people for the financing of 
residential property, automobiles, and retail purchases. Securitization 
also provides a major source of funding for American businesses for 
commercial property, agricultural equipment, and small-business 
investment. My second point is that the rapid growth of the markets led 
to some poor securitization practices. For example, loan underwriting 
standards got too loose as the interests of issuers and investors 
became misaligned. Furthermore, liquidity was hindered by a 
proliferation of securities that were excessively complex and 
customized. My third and final point is that in spite of these 
demonstrated problems, the concept of asset securitization is not 
inherently flawed; with proper reforms to prevent weak practices, we 
can harness the full potential of the securitization markets to benefit 
the U.S. economy.
Brief Review of the Financial Crisis
    To set context, I will begin with a brief review of the financial 
crisis. This view is necessarily retrospective; I do not mean to imply 
that investors, financial institutions or regulators understood all 
these dynamics at the time. In the middle of 2007, the end of the U.S. 
housing boom revealed serious deficiencies in the underwriting of many 
recently originated mortgages, including subprime loans, limited-
documentation loans, and loans with exotic features like negative 
amortization. Many of these loans had been packaged into complex and 
opaque mortgage-backed securities (MBS) that were distributed around 
the world to investors, some of whom relied heavily on the opinion of 
the rating agencies and did not sufficiently appreciate the risks to 
which they were exposed. \2\
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     \2\ At Fidelity, we consider the opinions of the rating agencies, 
but we also do independent credit research on each issuer or security 
we purchase.
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    The problems of poorly understood risks in these complex securities 
were amplified by the leverage in the financial system. For example, in 
2007, large U.S. investment banks had about $16 of net assets for each 
dollar of capital. \3\ Thus, a seemingly innocuous hiccup in the 
mortgage market in August 2007 had ripple effects that quickly led to a 
radical reassessment of what is an acceptable amount of leverage. What 
investors once deemed safe levels of capital and liquidity were 
suddenly considered far too thin. As a result, assets had to be sold to 
reduce leverage. This selling shrank the supply of new credit and 
raised borrowing costs. In fact, the selling of complex securities was 
more than the market could bear, resulting in joint problems of 
liquidity and solvency. Suddenly, a problem that had started on Wall 
Street spread to Main Street. Companies that were shut off from credit 
had to cancel investments, lay off employees and/or hoard cash. Many 
individuals who were delinquent on their mortgage could no longer sell 
their property at a gain or refinance; instead, they had to seek loan 
modifications or default.
---------------------------------------------------------------------------
     \3\ Source: SNL Financial, and company financials.
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    This de-leveraging process created a vicious cycle. Inability to 
borrow created more defaults, which led to lower asset values, which 
caused more insolvency, which caused more de-leveraging, and so forth. 
Home foreclosures and credit-card delinquencies rose, and job layoffs 
increased, helping to create the worst recession since the Great 
Depression.
Role Played by Asset Securitization in the Crisis
    Without a doubt, securitization played a role in this crisis. Most 
importantly, the ``originate-to-distribute'' model of credit provision 
seemed to spiral out of control. Under this model, intermediaries found 
a way to lend money profitably without worrying if the loans were paid 
back. The loan originator, the warehouse facilitator, the security 
designer, the credit rater, and the marketing and product-placement 
professionals all received a fee for their part in helping to create 
and distribute the securities. These fees were generally linked to the 
size of the transaction and most of them were paid up front. So long as 
there were willing buyers, this situation created enormous incentive to 
originate mortgage loans solely for the purpose of realizing that up-
front intermediation profit.
    Common sense would suggest that securitized assets will perform 
better when originators, such as mortgage brokers and bankers, have an 
incentive to undertake careful underwriting. A recent study by the 
Federal Reserve Bank of Philadelphia supports this conjecture. \4\ The 
study found evidence that for prime mortgages, private-label 
securitized loans have worse credit performance than loans retained in 
bank portfolios. Specifically, the study found that for loans 
originated in 2006, the 2-year default rate on the securitized loans 
was on average 15 percent higher than on loans retained in bank 
portfolios. This observation does not necessarily mean that issuers 
should be required to retain a portion of their securities, but in some 
fashion, the interests of the issuers and the investors have to be kept 
aligned.
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     \4\ Elul, Ronel, ``Working Paper No. 09-21 Securitization and 
Mortgage Default: Reputation vs. Adverse Selection'', Federal Reserve 
Bank of Philadelphia. September 22, 2009.
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    Flawed security design also played a role in the crisis. In its 
simplest form, securitization involves two basic steps. First, many 
individual loans are bundled together into a reference pool. Second, 
the pool is cut up into a collection of securities, each having a 
distinct bundle of risks, including interest-rate risk, prepayment 
risk, and credit risk. For example, in a simple sequential structure, 
the most senior bond receives all available principal payments until it 
is retired; only then does the second most senior bond begin to receive 
principal; and so on. In the early days of securitization, the process 
was kept simple, and there were fewer problems. But over time, cash-
flow rules grew increasingly complex and additional structuring was 
employed. For example, the securities from many simple structures were 
rebundled into a new reference pool, which could then be cut into a new 
set of securities. In theory, there is no limit to the amount of 
customization that is possible. The result was excessive complexity and 
customization. The complexity increased the challenge of determining 
relative value among securities, and the nonuniformity hurt liquidity 
when the financial system was stressed.
    One example of poor RMBS design is the proliferation of securities 
with complex rules on the allocation of principal between the senior 
and subordinate bonds. Such rules can lead to counter-intuitive 
outcomes in which senior bonds take write-downs while certain 
subordinate bonds are paid off in full. A second example of poor design 
is borrower ability to take out a second-lien mortgage without 
notifying the first-lien holder. This ability leads to a variety of 
thorny issues, one of which is simply the credit analysis of the 
borrower. If a corporation levered further, the senior unsecured debt 
holder would surely be notified, but that is not so in RMBS.
Other Factors Contributing to the Crisis
    Securitization of assets played a role in the crisis, but there 
were several additional drivers. Low interest rates and a bubble 
mentality in the real estate market also contributed to the problem. 
Furthermore, in the case of securitized assets, there were plenty of 
willing buyers, many of them highly levered. In hindsight, this high 
demand put investors in the position of competing with each other, 
making it difficult for any of them to demand better underwriting, more 
disclosure, simpler product structures, or other favorable terms. 
Under-estimation of risk is always a possibility in capital markets, as 
the history of the stock market amply demonstrates. That possibility 
does not mean that capital markets, or asset securitization, should be 
discarded.
Benefits of Asset Securitization
    When executed properly, there are many potential benefits of 
allowing financial intermediaries to sell the loans they originate into 
the broader capital markets via the securitization process. For one, 
this process provides loan originators much wider sources of funding 
than they could obtain through conventional sources like retail 
deposits. For example, I manage the Fidelity Ginnie Mae Fund, which has 
doubled in size in the past year to over $7 billion in assets; the MBS 
market effectively brings together shareholders in this Ginnie Mae Fund 
with individuals all over the country who want to purchase a home or 
refinance a mortgage. In this manner, securitization breaks down 
geographic barriers between lenders and borrowers, thereby improving 
the availability and cost of credit across regions.
    A second benefit of securitization is it generally provides term 
financing which matches assets against liabilities; this stands in 
contrast to the bank model, a substantial mismatch can exist between 
short-term retail deposits and long-term loans. Third, it expands the 
availability of credit across the country's socio-economic spectrum, 
and provides a mechanism through which higher credit risks can be 
mitigated with structural enhancements. Finally, it fosters competition 
among capital providers to ensure more efficient pricing of credit to 
borrowers.
Current Conditions of Consumer ABS and Residential MBS Markets
    At present, the RMBS and ABS markets are sharply bifurcated. On one 
side are the sectors that have received Government support, including 
consumer ABS and Agency MBS (i.e., MBS guaranteed by Fannie Mae, 
Freddie Mac, and Ginnie Mae); these sectors are, for the most part, 
functioning well. On the other side are the sectors that have received 
little or no such support, such as the new-issue private-label RMBS 
market, which remains stressed, resulting in a lack of fresh mortgage 
capital for a large segment of the housing market.
Consumer ABS
    The overall size of the consumer debt market is approximately $2.5 
trillion; \5\ this total includes both revolving debt (i.e., credit-
card loans) and nonrevolving debt (e.g., auto and student loans). 
Approximately 75 percent takes the form of loans on balance sheets of 
financial institutions, while the other 25 percent has been 
securitized. \6\
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     \5\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/
current/g19.htm.
     \6\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/
current/g19.htm.
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    From 2005 through the third quarter of 2008, auto and credit card 
ABS issuance ranged between $160 billion and $180 billion per year. \7\ 
However, after the collapse of Lehman Brothers in September 2008, new 
issuance came to a virtual halt. With the ABS market effectively shut 
down, lenders tightened credit standards to where only the most credit 
worthy borrowers had access to credit. As a result, the average 
interest rate on new-car loans provided by finance companies increased 
from 3.28 percent at end of July 2008 to 8.42 percent by the end of 
2008. \8\
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     \7\ Source: Bloomberg.
     \8\ Federal Reserve, www.federalreserve.gov/releases/g19/hist/
cc_hist_tc.html.
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    Issuance did not resume until March 2009 when the Term Asset-Backed 
Securities Loan Facility (TALF) program began. Thanks to TALF, between 
March and September of this year, there has been $91 billion of card 
and auto ABS issuance. \9\ Coincident with the resumption of a 
functioning auto ABS market, the new-car financing rate fell back into 
the 3 percent range and consumer access to auto credit has improved, 
although credit conditions are still more restrictive than prior to the 
crisis. While TALF successfully encouraged the funding of substantial 
volumes of credit card receivables in the ABS market, it is worth 
noting that credit card ABS issuance has recently been suspended due to 
market uncertainty regarding the future regulatory treatment of the 
sector.
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     \9\ Source: Bloomberg.
---------------------------------------------------------------------------
    While interest rates on top tier New Issue ABS are no longer 
attractive for investors to utilize the TALF program, TALF is still 
serving a constructive role by allowing more difficult asset types to 
be financed through securitization. Examples include auto dealer 
floorplans, equipment loans to small businesses, retail credit cards, 
nonprime auto loans, and so forth.
Residential MBS
    The overall size of the residential mortgage market is 
approximately $10.5 trillion, which can be decomposed into three main 
categories:

  1.  Loans on bank balance sheets: \10\ $3.5 trillion.
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     \10\ Source: Federal Reserve, www.federalreserve.gov/econresdata/
releases/mortoutstand/current.htm.

  2.  Agency MBS: \11\ $5.2 trillion.
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     \11\ Source: eMBS, www.embs.com.

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    a.  Fannie Mae: $2.7 trillion.

    b.  Freddie Mac: $1.8 trillion.

    c.  Ginnie Mae: $0.7 trillion.

  3.  Private-Label MBS: \12\ $1.9 trillion.
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     \12\ Source: Loan Performance.

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    a.  Prime: $0.6 trillion.

    b.  Alt-A: $0.8 trillion.

    c.  Subprime: $0.5 trillion.

    Thanks to the extraordinary Government intervention over the past 
year, the Agency MBS market is performing very well. This intervention 
had two crucial components. First, on September 7, 2008, the director 
of the Federal Housing Finance Agency (FHFA) placed Fannie Mae and 
Freddie Mac into conservatorship. This action helped reassure tens of 
thousands of investors in Agency unsecured debt and mortgage-backed 
securities that their investments were supported by the Federal 
Government, in spite of the sharp declines in home prices across the 
country. The second component of the Government intervention was the 
Federal Reserve's pledge to purchase $1.25 trillion of Agency MBS by 
the end of 2009.
    Year to date, as of the end of September 2009, the Fed had 
purchased $905 billion Agency MBS, while net supply was only $448 
billion. \13\ Thus, the Fed has purchased roughly 200 percent of the 
year-to-date net supply. Naturally, this purchase program has reduced 
the spread between the yields on Agency MBS and Treasuries; we estimate 
the reduction to be roughly 50 basis points. As of this week, the 
conforming-balance \14\ 30-year fixed mortgage rate is approximately 
4.85 percent, which is very close to a generational low. \15\
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     \13\ Source: JPMorgan, ``Fact Sheet: Federal Reserve Agency 
Mortgage-Backed Securities Purchase Program''.
     \14\ As of 2009, for the contiguous States, the District of 
Columbia and Puerto Rico, the general conforming limit is $417,000; for 
high-cost areas, it can be as high as $729,500.
     \15\ Source: HSH Associates, Financial Publishers.
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    In contrast, the new-issue private-label MBS market has received no 
Government support and is effectively shut down. From 2001 to 2006, 
issuance in this market had increased almost four-fold from $269 
billion to $1,206 billion. \16\ But when the financial crisis hit, the 
issuance quickly fell to zero. Issuance in 2007, 2008 and 2009 has been 
$759 billion, $44 billion and $0, respectively. \17\ Virtually the only 
source of financing for mortgage above the conforming-loan limit (so-
called ``Jumbo loans'') is a bank loan. As a result, for borrowers with 
high-credit quality, the Jumbo mortgage rate is about 1 percentage 
point higher than its conforming counterpart. \18\
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     \16\ Source: Loan Performance.
     \17\ Source: Loan Performance.
     \18\ Source: HSH Associates, Financial Publishers.
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    At first glance, the higher cost of Jumbo financing may not seem to 
be an issue that should concern policymakers, but what is bad for this 
part of the mortgage market may have implications for other sectors. If 
the cost of Jumbo financing puts downward pressure on the price of 
homes costing (say) $800,000, then quite likely there will be downward 
pressure on the price of homes costing $700,000, and so forth. Pretty 
soon, there is downward pressure on homes priced below the conforming 
limit. In my opinion, at the same time that policymakers deliberate the 
future of the Fannie Mae and Freddie Mac, they should consider the 
future of the mortgage financing in all price and credit-quality tiers.
Recommended Legislative and Regulatory Changes
    The breakdown in the securitization process can be traced to four 
root causes: aggressive underwriting, overly complex securities, 
excessive leverage, and an over-reliance on the rating agencies by some 
investors. Such flaws in the process have contributed to the current 
financial crisis. However, when executed properly, securitization can 
be a very effective mechanism to channel capital into our economy to 
benefit the consumer and commercial sectors. Keep in mind that 
securitization began with the agency mortgage market, which has 
successfully provided affordable mortgage financing to millions of U.S. 
citizens for over 35 years. \19\ To ensure that the lapses of the 
recent past are not repeated, I recommend that regulatory and 
legislative efforts be concentrated in four key areas.
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     \19\ Fannie Mae, Freddie Mac, and Ginnie Mae issued their first 
MBS in 1981, 1971, and 1970, respectively. Source: ``Fannie Mae and 
Freddie Mac: Analysis of Options for Revising the Housing Enterprises 
Long-term Structures'', GAO Report to Congressional Committees, 
September, 2009.
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    First, promote improved disclosure to investors at the initial 
marketing of transactions as well as during the life of the deal. For 
example, originators should provide detailed disclosure on the 
collateral characteristics and on exceptions to stated underwriting 
procedures. Furthermore, there should be ample time before a deal is 
priced for investors to review and analyze a full prospectus, not just 
a term sheet.
    Second, strong credit underwriting standards are needed in the 
origination process. One way to support this goal is to discourage the 
up-front realization of issuers' profits. Instead, issuers' 
compensation should be aligned with the performance of the security 
over its full life. This issue is complex, and will likely require 
specialized rules, tailored to each market sector.
    Third, facilitate greater transparency of the methodology and 
assumptions used by the rating agencies to determine credit ratings. In 
particular, there should be public disclosure of the main assumptions 
behind rating methodologies and models. Furthermore, when those models 
change or errors are discovered, the market should be notified.
    Fourth, support simpler, more uniform capital structures in 
securitization deals. This goal may not readily be amenable to 
legislative action, but should be a focus of industry best practices.
    Taking such steps to correct the defects of recent securitization 
practices will restore much-needed confidence to this critical part of 
our capital markets, thereby providing improved liquidity and capital 
to foster continued growth in the U.S. economy.
              Additional Material Supplied for the Record
         Prepared Statement of the Mortgage Bankers Association
    The Mortgage Bankers Association (MBA) \1\ appreciates the 
opportunity to provide this statement for the record of the Senate 
Banking Securities, Insurance, and Investment Subcommittee hearing on 
the securitization of assets.
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     \1\ The Mortgage Bankers Association (MBA) is the national 
association representing the real estate finance industry, an industry 
that employs more than 280,000 people in virtually every community in 
the country. Headquartered in Washington, DC, the association works to 
ensure the continued strength of the Nation's residential and 
commercial real estate markets; to expand homeownership and extend 
access to affordable housing to all Americans. MBA promotes fair and 
ethical lending practices and fosters professional excellence among 
real estate finance employees through a wide range of educational 
programs and a variety of publications. Its membership of over 2,400 
companies includes all elements of real estate finance: mortgage 
companies, mortgage brokers, commercial banks, thrifts, Wall Street 
conduits, life insurance companies and others in the mortgage lending 
field. For additional information, visit MBA's Web site: 
www.mortgagebankers.org.
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    Asset-backed securities are a fundamental component of the 
financial services system because they enable consumers and businesses 
to access funding, organize capital for new investment opportunities, 
and protect and hedge against risks. As policymakers evaluate 
securitization's role in the recent housing finance system's 
disruptions, MBA believes it is important to keep in mind the benefits 
associated with securitization when it is used prudently by market 
participants.
    Securitization describes the process in which relatively illiquid 
assets are packaged in a way that removes them from the institution's 
balance sheet and sold as more liquid securities. Securities backed by 
residential or commercial mortgages are an example of asset 
securitization.
    Securitization is an effective means of risk management for many 
institutions. For example, the accumulation of many loans in a single 
asset sector creates concentration risk on a financial institution's 
balance sheet. If that sector becomes distressed, these large 
concentrations could place the solvency of the financial institution at 
risk. However, securitization provides a remedy to avoid concentration 
risk by disbursing the exposure more widely across the portfolios of 
many investors. In this way, the exposure of any one investor is 
minimized. As demonstrated by the current business cycle however, if 
the entire system is hit by a significant systemic shock, all investors 
will face losses from these exposures, as diversification does not 
protect investors from systemic events.
    Securitization also enables various market sectors to create 
synergies by combining their particular areas of expertise. For 
example, community-based financial institutions are known for their 
proficiency in originating loans because of their relationships with 
local businesses and consumers, and their knowledge of local economic 
conditions. Securitization links these financial institutions to others 
that may be more adept at matching asset risks with investor appetites.
    As the last 2 or 3 years have demonstrated, when it is not 
understood, or poorly underwritten, securitization can cause meaningful 
harm to investors, lenders, borrowers and other segments of the 
financial services system. Since the economic and housing finance 
crisis began, investors have shunned securitization products, including 
mortgage-backed securities (MBS), particularly those issued by private 
entities. As a result, central banks and governments have taken up the 
slack with various programs to support securitization markets. MBA 
believes this has been an important, yet ultimately unsustainable, 
course of action.
    One key to the process is to create an environment where investors 
can accurately evaluate the risks in the various investment 
opportunities available to them, and have confidence that their 
analysis of the risk is consistent with what the underlying risk will 
turn out to be. No investments are risk-free. But reliable instruments 
allow responsible investors to evaluate whether the instrument's risk 
profile is within the boundaries of an investor's risk tolerance.
    When considering how to reestablish a safe and sound environment 
for securitization of real estate-related assets, MBA believes the 
following components must be addressed:

    Risk Assessment: Risk assessment is an imperfect science, 
        but it is crucial for securitization to enable accurate, 
        effective, and stable risk assessment. Equally important, 
        third-party assessments of risk must be highly credible to be 
        widely used or adopted.

    Aligning Risks, Rewards, and Penalties: A key consideration 
        for the market going forward will be ensuring the alignment of 
        risks with rewards and penalties. Loan attributes, such as 
        whether a loan is adjustable-rate or fixed rate, or does or 
        does not have a prepayment restriction, shift risks between the 
        borrower and the investors. If investors or other market 
        participants are not accountable for the risks they take on, 
        they are prone to act irresponsibly by taking on greater risks 
        than they otherwise would.

    Aligning Rewards With Long-Term Performance: Given the 
        long-term nature of a mortgage contract, as well as the 
        imperfect state of risk assessment, some risks inherent in a 
        mortgage asset may not appear for some time after the asset has 
        changed hands. It is important to consider the degree to which 
        participants in the mortgage process can be held accountable 
        for the long-term performance of an asset.

    Ensuring Capital Adequacy of Participants: Participants 
        throughout the market need adequate levels of capital to 
        protect against losses. Capital adequacy is keenly dependent on 
        the assessment of risks outlined above. The greater the risks, 
        as assessed, the greater the capital needed. In times of rapid 
        market deterioration, when model and risk assumptions change 
        dramatically, capital needs may change dramatically as well. If 
        market participants that have taken on certain risks become 
        undercapitalized, they may not be able to absorb those risks 
        when necessary--forcing others to take on unanticipated risks 
        and losses.

    Controlling Fraud Between Parties in the System: A key 
        consideration for effective securitization is the degree to 
        which fraud can be minimized. Key considerations include the 
        ability to identify and prosecute fraud, and the degree to 
        which fraud is deterred.

    Transparency: In order to attract investors, another key 
        consideration for securitization is transparency. The less 
        transparent a market is, the more poorly understood it will be 
        by investors, and the higher will be the yield those investors 
        demand to compensate for the uncertainty.

    The task of improving transparency and accountability involves both 
policy and operational issues. Public debate typically focuses on the 
policy issues--what general types of information should be disclosed, 
and who should share and receive this information. However, the 
operational issues are equally important to establishing and 
implementing a functional system that promotes and supports the goals 
of transparency and accountability. We are submitting testimony today 
to stress the importance to market transparency and investor confidence 
of better loan tracking and more accessible, complete, and reliable 
loan and security data across the primary and secondary mortgage 
markets.
Loan and Security Tracking
    Improving transparency in the real estate finance system is 
considered essential to restoring investor confidence in the 
securitization market. Because the real estate finance system embraces 
multiple parties--loan originators, loan aggregators (servicers) and 
securitizers--we need transparency solutions that flow from and span 
the complete mortgage value chain.
    The goal, we think, is relatively easy to state: key information 
about mortgages, the securities built upon those mortgages, and the 
people and companies that create them, should all be linked and tracked 
over time, so our financial system is more transparent and the 
strengths and risks of various products can be properly assessed and 
appreciated. Loans need to be tracked, for example, to help identify 
fraud and distinguish the performance of various mortgage products and 
securities types.
    Just as the vehicle identification number, or ``VIN,'' has evolved 
from a simple serial number into a valuable tool for consumers, 
enabling a potential purchaser to research the history of any car or 
truck, a comprehensive mortgage/security numbering system would be the 
key to tracking MBS history and performance.
    Achieving such a goal is very doable because the essential 
components are already in place. With relatively minor modifications 
these existing systems can evolve into the tools necessary to meet the 
challenge of transparency and accountability.
    On the mortgage end of the value chain there is MERS. \2\ This 
national loan registry is already used by virtually all mortgage 
originators, aggregators, and securitizers to track individual 
mortgages by means of a unique, 18-digit Mortgage Identification 
Number, or ``MIN.'' For each registered mortgage, the MIN and the MERS 
database tracks information regarding the originator, the borrower, the 
property, the loan servicer, the investors, and any changes of 
ownership for the life of the loan. MERS currently tracks more than 60 
million loans and is embedded in every major loan origination system, 
servicing system, and delivery system in the United States, so total 
adoption would be swift and inexpensive.
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     \2\ ``MERS'' is formally known as MERSCORP, Inc., and is the owner 
and operator of the MERS System. MBA, along with Fannie Mae, Freddie 
Mac, and other industry participants, is a shareholder in MERS.
---------------------------------------------------------------------------
    On the securitization end of the value chain, the American Bankers 
Association has a product called CUSIP that generates a 9-digit 
identification number for most types of securities, including MBS. The 
CUSIP number uniquely identifies the company or issuer and the type of 
security instrument.
    Together, these two identifiers solve the loan and security 
tracking problem, with the MIN tracking millions of individual mortgage 
loans and the CUSIP tracking thousands of unique financial instruments 
created each year in the United States. Loan-level information for 
every mortgage and mortgage-backed security would be available at the 
touch of a button, for example, the credit rating agencies would have 
needed information to assess more accurately the risk of a given 
security and track its performance relative to other securities over 
time.
    As the Congress looks to reform the capital markets, it should 
require that these two complementary identification systems be linked 
and that they be expanded in scope to track the decisions of all market 
participants--originators, aggregators and securitizers. In this way, 
throughout the value chain, participants that contributed to the 
creation of high-risk mortgages and selling of high-risk securities may 
be identified and held accountable.
    With a system like this in place, the Congress, regulators and the 
market as a whole would have a means of distinguishing with much more 
precision the quality of financial products and could enforce the 
discipline that has not been previously possible.
Data Standards
    The Mortgage Industry Standards Maintenance Organization, Inc. 
(``MISMO'') \3\ has been engaged for the past 8 years in developing 
electronic data standards for the commercial and residential real 
estate finance industries. These standards, which have been developed 
through a structured consensus-building process, are grounded in the 
following principles that we believe characterize a robust, transparent 
system of data reporting:
---------------------------------------------------------------------------
     \3\ MISMO is a wholly owned subsidiary of the Mortgage Bankers 
Association.

    First, there must be concrete definitions of the data 
        elements that are going to be collected, and these definitions 
        must be common across all the related products in the market. 
        Different products (such as conforming and nonconforming loans) 
        may require different data elements, but any data elements that 
        are required for both products should have the same 
---------------------------------------------------------------------------
        definitions.

    Second, there should be a standardized electronic reporting 
        format by which these data elements are shared across the 
        mortgage and security value chain and with investors. The 
        standards should be designed so that information can freely 
        flow across operating systems and programs with a minimum of 
        reformatting or rekeying of data to facilitate desired 
        analytics. Rekeying results in errors, undermining the 
        reliability of data. MISMO's standards are written in the XML 
        (Web based) computer language. This is the language used in the 
        relaunch earlier this week of the Federal Register's Web site. 
        As reported in The Washington Post on October 5, 2009, this Web 
        site has been received with great praise for allowing 
        researchers and other users to extract information readily from 
        the Register for further analysis and reuse without rekeying. 
        Mortgage and securities data transmitted using MISMO's data 
        standards can similarly be extracted and used by investors and 
        regulators for customized analytics. XML is also related to and 
        compatible with the XBRL web language that the Securities and 
        Exchange Commission (SEC) is implementing for financial 
        reporting.

    Third, the definitions and the standards should be 
        nonproprietary and available on a royalty-free basis, so that 
        third-parties can easily access and incorporate those standards 
        into their work, whether it be in the form of a new loan 
        origination software package or an improved analytical tool for 
        assessing loan and security performance or fraud detection.

    Fourth, to the extent that the data includes nonpublic 
        personal information, the system must maintain the highest 
        degree of confidentiality and protect the privacy of that 
        information.

    True transparency requires that information is not only available, 
but also understandable and usable. The incorporation of these four 
principles into any new data reporting regime will help ensure that the 
goal of transparency and accountability is realized.
    We believe that the standards of MISMO and MERS satisfy these 
elements for the conforming mortgage market. Their relative positions 
in the real estate finance process provide them with unique insight and 
an objective perspective that we believe could be very useful to 
improving transparency and accountability in the nonconforming market.
    Increasing the quality and transparency of loan-level mortgage and 
MBS-related data is an essential step so that investor confidence may 
be restored and the risk of a similar securitization crisis of the kind 
we are experiencing in the future can be minimized. This objective is 
paramount to all market participants, and as such all participants have 
an interest in achieving a solution. However, because it is so 
critical, the ultimate solution must also be able to withstand the 
scrutiny of investors, Government regulators, and academics. It must be 
widely perceived as a fair, appropriate, and comprehensive response to 
the challenges at hand.
    In conclusion, MBA reiterates its request for Congress and other 
policymakers to be mindful of the important role of securitization to 
housing finance and the entire financial services system. As the 
Congress looks to reform the capital markets, we look forward to 
working with you to developing a framework with a solid foundation 
based on the key considerations outlined above.
