[Senate Hearing 112-150]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-150


                  THE STATE OF SECURITIZATION MARKETS

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

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

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

             EXAMINING THE STATE OF SECURITIZATION MARKETS

                               __________

                              MAY 18, 2011

                               __________

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








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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         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                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                      Brett Hewitt, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

         Gregg Richard, Republican Subcommittee Staff Director

                                  (ii)









                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, MAY 18, 2011

                                                                   Page

Opening statement of Chairman Reed...............................     1

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

                               WITNESSES

Steven L. Schwarcz, Stanley A. Star Professor of Law and 
  Business, Duke University School of Law........................     4
    Prepared statement...........................................    33
    Responses to written questions of:
        Chairman Reed............................................   230
Tom Deutsch, Executive Director, American Securitization Forum...     6
    Prepared statement...........................................    39
    Responses to written questions of:
        Chairman Reed............................................   232
Martin S. Hughes, President and Chief Executive Officer, Redwood 
  Trust, Inc.....................................................     7
    Prepared statement...........................................   196
    Responses to written questions of:
        Chairman Reed............................................   232
Lisa Pendergast, President, Commercial Real Estate Finance 
  Council........................................................     9
    Prepared statement...........................................   200
    Responses to written questions of:
        Chairman Reed............................................   232
Ann Elaine Rutledge, Founding Principal, R&R Consulting..........    11
    Prepared statement...........................................   215
    Responses to written questions of:
        Chairman Reed............................................   235
Chris J. Katopis, Executive Director, Association of Mortgage 
  Investors......................................................    12
    Prepared statement...........................................   219
    Responses to written questions of:
        Chairman Reed............................................   246

                                 (iii)

 
                  THE STATE OF SECURITIZATION MARKETS

                              ----------                              


                        WEDNESDAY, MAY 18, 2011

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:35 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. Good morning. Let me call the hearing to 
order and welcome all of our witnesses. This is an opportunity 
to talk about the state of the securitization markets, which is 
a critical issue to our economy and to the Nation.
    Securitization is the bundling of individual loans or other 
debt instruments into marketable securities to be purchased by 
investors. Securitizations have touched nearly every American. 
These financial products operate behind the scenes in our 
economy. They provide lower-cost loans for homes and 
automobiles. They provide students with low-rate loans. They 
provide businesses with capital to purchase equipment. They are 
used to finance apartments and neighborhood malls. And because 
they are so prevalent in our economy, they can also cause a lot 
of trouble when they do not function properly.
    Securitization has been a powerful tool providing 
significant economic benefits, including lowering the cost of 
credit to households and businesses and helping investors 
better match their return to their appetite for risk. 
Securitization has also allowed lenders to transfer credit risk 
and free up capital for additional lending. This in turn 
provides greater availability and lower-cost loans to consumers 
and businesses.
    Securitization, when executed correctly, can be an 
important part of our financial system, helping to create jobs 
by providing the financing and liquidity necessary to build our 
infrastructure and help our businesses grow and innovate. 
However, most market participants and policy makers agree that 
the financial crisis revealed a troubling aspect to an 
increasingly Byzantine and opaque securitization process which 
has had a devastating effect on our economy.
    The way securitization was implemented in the years leading 
up to the financial crisis created perverse incentives, often 
emphasizing volume over quality, easy fees over the long-term 
viability of the loans, and speed over diligence. We only need 
to look at the residential mortgage market to see how badly 
things can go if securitization is not executed carefully.
    Indeed, the mad rush to cut corners led to an eventual 
freezing of the securitization markets as investors lost 
confidence and drastic Government intervention was necessary to 
prevent the evaporation of liquidity and allow access to credit 
to continue for many consumers and businesses.
    In short, securitization is not just a fancy Wall Street 
process. Securitization structures can and have a profound 
impact on our economy and a unique ability to allocate capital 
at low cost.
    As we examine the state of the securitization markets 
today, we need to go back to fundamentals. We need to assess 
the role of securitization on our economy. Should it continue 
to have a role as it is playing today? Or should that role be 
different? What is the balance between liquidity and investor 
confidence? How can we help create a more robust, transparent, 
liquid, and competitive marketplace?
    At the same time, how do we discourage reckless lending, 
excessive risk taking, and excessive leverage? And, ultimately, 
how do we sufficiently protect investors? And how do we protect 
the American economy and public when these processes go wrong?
    We do have to ensure that securitization is used properly 
and effectively for the benefit of all Americans. The answers 
to these questions have huge implications for our economy and 
also as we look forward to reforming and changing the 
Government-sponsored enterprises under the control of the 
Government today.
    I look forward to hearing from all of our witnesses, and at 
this point I would like to recognize my Ranking Member, Senator 
Crapo. Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Senator Reed, and I 
appreciate you holding this hearing. You are right, the 
implications of how we resolve this issue are going to have 
huge consequences for our economy, and we have got to get it 
right. I appreciate our witnesses being here today and the 
thoughtful assistance that they are giving us in evaluating 
this.
    If we are going to encourage private money that is still 
sitting on the sidelines to return to security markets, we need 
to provide the appropriate balance between the strong standards 
that will align the interests of lenders, issuers, and 
investors with the ability of the securitization process to 
work.
    Section 941 of the Dodd-Frank Act legislation mandates that 
our financial regulators craft rules requiring entities 
involved in the securitization process to retain a certain 
level of risk of the assets being securitized. The intent is to 
better align the incentives among the chain of originators, 
securitizers, and investors. It is important to note that the 
Federal Reserve's October 2010 study cautioned that risk 
retention is not a panacea and that if rules are not 
implemented carefully by asset class, credit availability could 
be disrupted at a time when it is desperately needed.
    This was also the same reason that the Senate made two key 
changes to the section when deliberating on the Dodd-Frank 
legislation.
    The first that I refer to is the Landrieu-Izakson-Hagan 
amendment that required regulators to establish a category of 
well-underwritten single-family loans that would be exempt from 
the bill's risk retention requirements.
    The second was my amendment, which directed regulators to 
consider risk retention forms and requirements in order to 
ensure that regulators considered the unique nature of the 
commercial mortgage-backed securities market.
    After months of sometimes very heated interagency debate, 
the joint risk retention rule proposal was put out for comment 
on March 31st this year. The proposal is 367 pages and seeks 
comments on more than 150 different questions. While many 
experts are still trying to understand all the consequences of 
the proposed rule to the impact of capital formation in these 
markets, the early feedback and comments suggest that more work 
needs to be done in this area, and several of our witnesses 
argue that a reproposal is warranted.
    This rule will have a broad impact, and I am interested in 
learning from our witnesses today how it is going to impact the 
securitization market and our economy. If necessary, what 
changes should regulators consider that will provide the flow 
of credit and strengthen the underwriting and align the 
interests of lenders, issuers, and investors?
    Ultimately we need rules that are strong enough to protect 
our economy but that can adapt to changing market conditions 
and promote credit availability which will spur job growth for 
millions of Americans.
    Thank you, Mr. Chairman, and, again, I appreciate your 
holding this hearing.
    Chairman Reed. Thank you very much, Senator Crapo.
    I will now introduce all of the panelists and then ask 
Professor Schwarcz to begin, but let me begin with the 
introduction of all the panelists.
    Steven Schwarcz is the Stanley A. Star Professor of Law and 
Business at Duke University. Prior to joining the Duke faculty 
in 1996, he was a partner at the law firm of Shearman & 
Sterling and then a partner and practice group chairman at Kaye 
Scholer LLP. Professor Schwarcz's book, ``Structured Finance: A 
Guide to the Principles of Asset Securitization'', is one of 
the most widely used texts in this field. Thank you, Professor.
    Tom Deutsch is the executive director of the American 
Standardized Forum. Mr. Deutsch previously served as an 
associate in the Capital Markets Department at Cadwalader, 
Wickersham & Taft, and he represented issuers and underwriters 
in various structured finance offerings.
    Martin Hughes has served as president of Redwood Trust 
since 2009 and chief executive officer since May 2010. Mr. 
Hughes has over 18 years of senior management experience in the 
financial services industry. Thank you.
    Lisa Pendergast is president of the CRE Finance Council. 
She is also a managing director in Jefferies' Fixed Income 
Division and is responsible for strategy and risk for CMBS and 
other structured commercial and multifamily real estate 
products. Thank you.
    Ann Rutledge is the founding principal of R&R Consulting. 
In addition, Ms. Rutledge is an adjunct assistant professor of 
asset securitization at the Hong Kong University of Science and 
Technology and visiting lecturer at the University of 
California at Irvine.
    Chris Katopis serves as the executive director of the 
Association of Mortgage Investors, AMI. Mr. Katopis has years 
of experience in Washington in a variety of public policy 
positions in the private sector and Government.
    Thank you all for being here. Professor Schwarcz, would you 
begin? Turn on your microphone. Two, your statements are all 
part of the record, so feel free, very free, to summarize your 
very thoughtful and analytical presentations. And we have got 
about 5 minutes. Go ahead, Professor.

 STATEMENT OF STEVEN L. SCHWARCZ, STANLEY A. STAR PROFESSOR OF 
        LAW AND BUSINESS, DUKE UNIVERSITY SCHOOL OF LAW

    Mr. Schwarcz. Thank you. My written testimony discusses in 
more detail securitization's role in the financial crisis. The 
problem was not securitization per se, but a correlation of 
factors, some of which were not completely foreseeable, 
including the unprecedented collapse of the housing markets.
    The resulting mortgage defaults had localized consequences 
in traditional securitization transactions. But they had 
larger, systemic consequences in nontraditional transactions 
that involved complex and highly leveraged securitizations of 
asset-backed securities that were already issued in 
securitizations--effectively ``securitizations of 
securitizations.''
    I believe that the important question is: Why did the 
markets believe in these nontraditional securitization 
transactions? And answering this question helps us to 
understand how to protect against potential abuses.
    Now, in trying to answer this, in addition to the 
widespread inconceivability of the extent of the housing price 
collapse, part of the answer may be that securitization's focus 
on mathematical modeling to simplify complexity fostered an 
abandonment of common sense. Another part of the answer may be 
that investors, who seemed as anxious to buy these 
superficially attractive securities as underwriters were to 
sell them, were overly complacent and eager to follow the herd 
of other investors. Other parts of the answer may touch on 
intra-firm conflicts, which I will discuss, and the failure to 
internalize costs.
    Dodd-Frank addresses at least one of securitization's 
flaws, and that is the originate-to-distribute model of 
securitization, which is said to have fostered an undisciplined 
lending industry, and Dodd-Frank does this by requiring 
securitizers to keep skin in the game, effectively retaining a 
minimum risk of loss, in order to help align the incentives of 
securitizers and investors.
    There does remain a question, however, of the extent to 
which this originate-to-distribute model actually caused 
mortgage underwriting standards to fall. There are other 
reasons set forth in my testimony that at least give 
suggestions as to why it may have occurred, and one of the more 
important questions is: Why did the ultimate beneficial owners 
of the mortgage loans--the investors in the asset-backed 
securities--not govern their own investments by the same credit 
standards that they would observe if they were making the loans 
in the first place?
    Now, Dodd-Frank does not directly address the problem of 
overreliance on mathematical modeling or complexity. To some 
extent, this should be self-correcting in the short term. But 
in the long term, I fear that investors will really forget that 
lesson; they tend to, as Business Week once said it, ``Go for 
the gold, look to the yield.''
    Dodd-Frank does not address the broader complacency 
question, although I am not sure how regulation can really 
change human behavior. For example, market participants will 
probably always engage in herd behavior, there being safety in 
numbers.
    Dodd-Frank focuses on disclosure besides the skin in the 
game, and among other things, it requires more standardized 
disclosure of information. In principle, that makes sense. In 
my experience, though, investors often already get this type of 
standardized information. And I think the larger problem is not 
disclosure itself, that it is inadequate in terms of what is 
provided, but the fact that investors do not always read it, 
and if they do read it, they do not always understand the 
information that is already disclosed.
    There are several reasons for this. One is complacency. 
Another reason which I think is very important is a conflict of 
interest within investing firms themselves. As investments 
become more complex, conflicts are increasingly driven by 
short-term management compensation schemes. And this is 
critical, especially for the technically sophisticated 
secondary managers who do not always worry about long-term 
risks because their compensation is on a short-term bonus 
basis.
    Now, this is an intra-firm conflict, very much unlike the 
traditional focus of scholars and politicians who focus on 
conflicts between the senior managers and the shareholders. I 
think that regulation needs to address this intra-firm 
conflict.
    Another reason for disclosure's failure is that financial 
products, including some securitization products, are becoming 
so complex that disclosure can never lead to a complete 
understanding.
    Now, let us just briefly look at the larger perspective. 
Securitization has existed for decades, has worked very well 
for the most part. Even during the recent crisis, almost all 
traditional securitization structures protected investors from 
major losses. But certain of securitization's problems, 
especially for the nontraditional structures, are typical of 
problems we must face in any innovative financial market: that 
increasing complexity, coupled with human complacency, among 
other factors, will make failures virtually inevitable. And 
regulation must respond to this reality. It must mitigate the 
impact of failures when they occur.
    And, finally, it is important to provide incentives for 
financial institutions to try to minimize the impact of 
failures and to absorb them. This could be done, for example, 
by requiring at least systemically important market 
participants to contribute to a risk fund, which could be used 
as a source of stabilization. Fund contributors then would be 
motivated not only to better monitor their own behavior, but 
also to monitor the behavior of other financial institutions 
whose failures could deplete the fund.
    Thank you.
    Chairman Reed. Thank you very much Mr. Schwarcz.
    Mr. Deutsch.

    STATEMENT OF TOM DEUTSCH, EXECUTIVE DIRECTOR, AMERICAN 
                      SECURITIZATION FORUM

    Mr. Deutsch. Chairman Reed, Senator Corker, thank you very 
much for the opportunity to testify here today. My name is Tom 
Deutsch, and on behalf of the 330 member institutions of the 
ASF, I appreciate this opportunity to represent the issuer, 
dealer, and investor interest in the securitization 
marketplace.
    In our 157-page written statement, which I will not try to 
get into 5 minutes of oral statements, we seek to identify and 
describe in detail the panoply of key legislative and 
regulatory initiatives that are currently confronting the 
securitization markets. The purpose of this deep and critical 
review of the outstanding legislative and regulatory 
initiatives is to demonstrate not just the individual aspects 
that are of concern to the securitization markets but 
ultimately the cumulative effects of all of these regulatory 
initiatives occurring simultaneously. And in effect the 
securitization markets' greatest fear is not to be damaged by 
one slice of the sword but, in fact, to be destroyed by a death 
by a thousand cuts.
    Many of the industry's current issues arise from 
regulations prescribed by the Dodd-Frank Act. Some of the key 
areas of Dodd-Frank that we discuss in our detailed written 
statement are: one, risk retention; two, rating agency reform; 
three, orderly liquidation authority for nonbanks; four, 
derivatives; five, the Volcker rule; and, finally, conflicts of 
interest.
    But the massive regulatory changes in the securitization 
market are not solely deriving from the Dodd-Frank Act. And, in 
fact, they come from a number of other areas, including: one, 
the SEC's Regulation AB proposals that would completely 
overhaul the registration, disclosure, and reporting 
requirements for the entire asset-backed securities market; 
two, the FDIC's securitization safe harbor, which was developed 
in a unilateral fashion by the FDIC, effectively front-running 
much of the Dodd-Frank securitization mandate, and has 
currently sidelined most bank issuers from securitization 
issuance; and, three, finally, the capital adequacy changes 
coming in Basel 2.5 and Basel III, as well as the accounting 
and regulatory capital charges created by FAS 166 and 167, the 
effects of which are still being absorbed by the market.
    Ultimately, these proposals confront the market during a 
time when certain sectors, such as auto and equipment ABS, are 
at or near normal levels, and other sectors, such as the 
commercial mortgage-backed securities market, that are 
beginning to see signs of life. Particularly a significant 
number of commercial loans are coming due for refinance.
    But, clearly, the future of residential mortgage funding 
hangs in the balance as the Administration and Members of 
Congress seek to wind down the GSEs and wean Americans' 
addiction off of cheap or Government-subsidized mortgage 
credit. But to reduce Government's role in the residential 
mortgage sector, private sector capital has to return to this 
market to allow the residential mortgage market to live on its 
own.
    Ultimately, few would dispute that industry and policy 
changes do not need to occur in the subprime and Alt-A 
residential mortgage securities marketplace, and the ASF fully 
supports appropriate changes in that marketplace. But making 
changes to the entire engine of the securitization machine 
while at the same time doing it across all asset classes, while 
driving up a steep economic hill in a down market, is 
ultimately a recipe for a sputtering car, if not a complete 
breakdown on the side of the road.
    In particular, in the risk retention proposals recently 
released by the Federal regulators, we are seeing rules drafted 
precisely for the residential mortgage market, but being 
applied, somewhat bluntly, to other types of securitizations, 
like auto loans. As an example, the regulators included an auto 
ABS exemption from the risk retention rules for certain 
qualified auto loans. But few, if any, auto loans made in 
America over the past 30 years would ever actually qualify for 
such an exemption because the exemption was developed with 
mortgage underwriting criteria, such as the requirement for a 
20-percent down payment. I do not know about you, but I do not 
know many people who have put 20 percent down on a car loan. It 
just simply does not happen.
    Also, but even within the mortgage sector, there are new 
concepts, such as the premium cash reserve account, that 
ultimately is beyond the scope effectively of Dodd-Frank that 
would ultimately make the securitization business a not-for-
profit business, effectively shutting down large swaths of the 
RMBS and CMBS markets if those rules were to go into effect as 
written.
    The ASF requests ultimately the regulators should 
specifically articulate that the proposed risk retention rules 
not apply to certain sections of the highly functioning 
securitization market, such as the auto loan sector and the 
asset-backed commercial paper sector that shows no signs of 
misalignment of incentives during one of the worst economic 
crises in American history.
    Moreover, given the extremely complicated set of rules that 
are being proposed, over 300 pages and 150-plus questions, 
ultimately we believe that given the thousands of pages of 
comments that the regulators are going to receive on June 10th, 
the regulators should ultimately repropose the rules to ensure 
that they get it right and make sure that availability of 
credit is ensured to Americans through the securitization 
process.
    Thank you very much for your time today, and I look forward 
to answering questions.
    Chairman Reed. Thank you very much.
    Mr. Hughes, please.

 STATEMENT OF MARTIN S. HUGHES, PRESIDENT AND CHIEF EXECUTIVE 
                  OFFICER, REDWOOD TRUST, INC.

    Mr. Hughes. Good morning, Chairman Reed, Ranking Member 
Crapo, and Members of the Committee. My name is Marty Hughes. I 
am the CEO of Redwood Trust, and I sincerely appreciate the 
opportunity to testify here today.
    My testimony is focused on restoring private sector 
financing for prime residential mortgages. Redwood has a long 
history in the business of issuing and investing in private 
label jumbo mortgage-backed securities, or MBS. Since the 
market freeze 3 years ago, we have completed the only two 
issuances of fully private MBS of newly originated mortgage 
loans. We are planning to complete another two transactions by 
year end.
    Based on the success of these transactions and our ongoing 
conversations with investors and lenders, we believe private 
capital is ready to step back in and invest in safe, well-
structured prime securitizations backed by good mortgages. The 
speed at which the private market returns will depend on 
several factors.
    Through Fannie Mae, Freddie Mac, and the FHA, the 
Government currently supports the credit risk in 90 percent of 
the mortgages in the U.S. without passing on the full cost of 
the credit risk assumed. Government subsidies must be scaled 
back on a safe and measured basis to permit the private market 
to flourish. We note that post-crisis, the asset-backed 
securities markets for autos, credit cards loans, and now 
commercial loans are up and running while the private label MBS 
market remains virtually dormant. The difference is the 
pervasive below-market Government financing in the mortgage 
sector that is crowding out traditional private market players.
    We can only securitize the small volume of prime quality 
loans outside the Government's reach. We are ready to purchase 
and securitize any prime loan and can do it at an affordable 
rate once the Government creates a level playing field.
    I strongly advocate beginning, again, a safe and measured 
process of testing the private market's ability to replace 
Government-dependent mortgage financing.
    The Administration should follow through on its plan to 
reduce conforming limits and increase guarantee fees to market 
rates over time so the Government gradually withdraws from a 
majority of the market over 5 years. That time frame will 
enable the private label market to gain standardized practices 
and procedures and confidence.
    In the wake of the Dodd-Frank Act, there are many 
regulatory requirements and market standards currently out for 
comment. The resulting uncertainty keeps many participants out 
of the market. Once the final rules of the road are known, 
market participants can adjust their policies, practices, and 
operations.
    Another issue to restoring investor confidence and 
increasing the velocity of private label issuance is the 
standardization of sponsor and servicer best practices. In 
recently issuing two private label MBS transactions, we worked 
closely with those who invest in high-quality AAA securities--
insurance companies, banks, and money managers, and with 
lenders, borrowers, and industry groups. Each transaction was 
well oversubscribed. This did not happen by accident. Sponsors 
need to meet the new requirements of AAA investors. These 
include enhanced disclosures, strong and enforceable 
representations and warranties, safer and simpler structures, 
and meaningful sponsor skin in the game.
    It is also critical that servicers regain the confidence of 
investors. Uniform standards need to be established governing 
servicer responsibilities, performance, and conflicts of 
interest.
    In my opinion, the one gaping hole to restoring private 
investor confidence is the unresolved threat from second 
mortgages--a significant factor that contributed to the 
mortgage and housing crisis. The first and most important level 
of skin in the game is at the borrower level. If a borrower can 
effectively withdraw his or her skin out of the game through a 
second mortgage, the likelihood of default on the first 
significantly increases. Left unchecked, this would be a very, 
very disappointing result for private investors.
    Regarding mortgage rates, it is reasonable to expect rates 
to rise somewhat when the Government withdraws. We believe 
rates will only rise modestly, perhaps by 50 basis points. And 
we note that in our most recent deal, the average mortgage 
interest rate for 30-year fixed rate loans underlying that 
securitization was 46 basis points above the Government-
guaranteed rate.
    Done correctly, we believe a gradual wind-down of the 
Government's role in the mortgage market can be replaced by a 
smarter, less risky private label MBS market. Thank you for the 
opportunity to allow me to testify. I would be happy to answer 
your questions when the time comes up.
    Chairman Reed. Thank you very much, Mr. Hughes.
    Ms. Pendergast.

STATEMENT OF LISA PENDERGAST, PRESIDENT, COMMERCIAL REAL ESTATE 
                        FINANCE COUNCIL

    Ms. Pendergast. Good morning, Chairman Reed, Ranking Member 
Crapo, and Members of the Subcommittee. My name is Lisa 
Pendergast, and I am a managing director at Jefferies & 
Company. I am testifying today a president of the CRE Finance 
Council, or CREFC. CREFC is a trade association that represents 
all constituents of CRE real estate finance, including bank, 
life company, private equity, and CMBS lenders, as well as 
investors in CRE debt, loan servicers, and other third-party 
providers.
    First, I would like to frame the critical role that the 
securitized debt occupies in commercial real estate and the 
economy at large. There is approximately $7 trillion in 
commercial real estate outstanding in the United States today, 
and between now and 2014, more than $1 trillion of CRE loans 
will mature and will require refinancing.
    Prior to the economic crisis, the commercial mortgage-
backed securities, the CMBS market, provided as much as 50 
percent of debt capital for commercial real estate annually. In 
2007, CMBS issuance peaked at $240 billion. In 2009, that 
number plummeted to just over $1 billion, including the help 
provided by TALF.
    As the markets begin to stabilize and recover, so do CMBS. 
In 2010, CMBS issuance rose to about $12 billion, and in 2011, 
it is projected that we will issue some $35 to $40 billion in 
new issue supply.
    This is a good start, but it is not nearly enough to 
address the upcoming refinancing wave. Without a fully 
functional CMBS market, there simply is not enough capital to 
address this refinancing wave.
    It is for that reason that Treasury Secretary Geithner and 
other policy makers agree that no economic recovery will be 
successful unless the securitization markets are revived and 
healthy. And make no mistake. Getting the Dodd-Frank mandated 
securitization retention rules right is essential to healthy 
securitization markets. There are lenders who are withholding 
judgment today on whether they will reenter the market until 
they can be sure that the final rules will work. The proposed 
rules are complicated, controversial, and they create as much 
uncertainty as they provide answers.
    CREFC supports the basic framework for CMBS within the 
proposed rules. However, there are fundamental aspects within 
the rules that have the potential to render the CRE 
securitization market unviable. Given the complexity, the 
rulemaking process must be an iterative one rather than a one-
and-done proposition. For this reason, we are asking that you 
provide the regulators with the latitude they need to get the 
rules right.
    Specifically, our request today is twofold: first, extend 
the current June 10, 2011, rulemaking response date to allow 
for additional debate and clarification via roundtable 
discussions with regulators; second, encourage a reproposal of 
the draft rule that incorporates a response to the extensive 
industry feedback and dialog that will occur between regulators 
and the markets.
    Let me provide you with a sense of some of the issues that 
we are grappling with as it relates to the rules.
    First, the proposal includes a new concept called the 
premium capture cash reserve account that was not contemplated 
in the statute. Based on our reading, the reserve account 
substantially reduces the economic incentive for issuers to 
undertake securitization transactions. At a minimum, the 
reserve account will dramatically change CMBS transactions 
economics and likely result in fewer loans originated by CMBS 
lenders. Ultimately, this is likely to drive up the cost of CRE 
debt.
    Second, and specifically for CMBS, we appreciate that 
regulators created a special B-piece buyer retention option, as 
directed by Dodd-Frank and championed by Senator Crapo. The B-
piece of the first loss position buyer is often also the 
special servicer charged with working out troubled loans, and 
that raises conflict-of-interest concerns for some of our 
constituents.
    To address that, the proposed rules incorporate a market-
developed operating adviser construct that would require an 
independent ombudsman to participate in any transaction in 
which the B-piece buyer had special servicing rights. This 
provision in the rules, however, creates a broad set of its own 
potential problems as it goes well beyond the market-created 
operating adviser provisions in recent CMBS transactions.
    Third, the proposal requires permanent retention buyer 
sponsor or B-piece buyer. Such a permanent investment 
constraint is unprecedented in the financial markets and could 
severely limit the universe of institutions that would be 
willing to function as retainers.
    Fourth, the proposed regulations include a CRE specific 
retention exemption for loan pools compromised exclusively of 
low-risk qualifying CRE loans. It does not appear that any CRE 
loans would satisfy these requirements, and we are also 
concerned that the rules do not properly consider entire 
segments of the commercial real estate market and the CMBS 
market, such as large floating-rate loans and single borrower 
transactions.
    The Dodd-Frank risk retention framework is the most 
significant threat to sustaining a commercial real estate 
recovery. This statutorily imposed Dodd-Frank rulemaking 
schedule creates needless time pressure on regulators, 
especially given that the rules will not go into effect until 
sometime in 2013. We are concerned that this will result in the 
issuance of poorly designed final rules. It is critical that 
you make clear to the six agencies charged with implementing 
the CMBS components of the retention framework that they take 
the time necessary to get the rules right. A one-and-done 
approach for discussion of this high-stakes issue benefits no 
one.
    Thank you for your time, and I look forward to questions.
    Chairman Reed. Thank you very much.
    Ms. Rutledge.

   STATEMENT OF ANN ELAINE RUTLEDGE, FOUNDING PRINCIPAL, R&R 
                           CONSULTING

    Ms. Rutledge. Chairman Reed, Ranking Member Crapo, Senators 
Corker and Hagan, my name is Ann Rutledge, and I am very 
grateful for the opportunity to testify this morning.
    I have a very simple point to make. As was mentioned, I do 
lecture and I talk for 8 hours on end and it is impossible for 
me to read from a speech, so let me tell you what I do when I 
do not lecture. My business partner, Sylvain Raynes, and I 
started R&R Consulting 11 years ago. We left Moody's Investors 
Service because we believed that there was a fatal flaw in the 
rating product and process. The business model that we created 
was intended to address that fatal flaw, and let me tell you 
what that flaw is because it has a lot of relevance today.
    The flaw is that it created a market that was too good to 
be true. That is because the valuation and credit analysis that 
was done at closing was only related to the conditions at 
closing. What happens with ABS and RMBS, in particular, but all 
securitizations in theory, is they may actually improve over 
time, like good wine. But there is not a rating agency around 
to take a second look or a periodic look. There is never an 
apples to apples comparison between the analysis done initially 
and after the fact.
    Now, that was a great situation for investors for 20 or 25 
years because it meant that they were holding securities that, 
on average, were better than the ratings suggested. That was a 
good situation for investors; but the sellers were happy as 
well, because securitization is much more flexible and offers a 
sort of corporate rating arbitrage. But unfortunately the 
sellers could have done even better.
    And so we had a situation in the beginning--at least after 
1998, we had a situation where there was an opportunity to 
repackage securities in CDOs, in particular, RMBS CDOs. And now 
we have just said that the rating is not a valid credit measure 
after origination. It either understates or it overstates 
credit quality. Now we have created a perverse incentive to put 
securities into the market that are not well structured, that 
will not improve, that will actually deteriorate, and we can 
repackage them in CDOs without the ultimate investors realizing 
what is happening until it is too late because the rating 
system does not reflect current credit quality.
    What is the source of the flaw? Because ABS and RMBS are 
measured--the credit quality is measured based upon empirical 
data. For CDOs, ABCP, and SIVs, the credit measure is a rating. 
It is not empirical data. And if the rating is stale, then the 
assessment is wrong.
    So my point of view, my recommendation today is the same as 
11 years ago, but as Benjamin Franklin said, ``Tell me and I 
forget. Teach me and I learn. Involve me and I understand.'' We 
are all involved in this now, so I hope that the next 
recommendations that I make will have some resonance.
    The most important things that we need to have to motivate 
better behavior is not to regulate behavior, but to create 
clear standards and enforce them. The standards that need to be 
set are particularly with respect to disclosure on the 
securities and with respect to the standard at which the 
securities are rated. What is the rating scale that allows a 
AAA security to go out as a AAA or allows a CCC security to go 
out as a AAA? We all need to know this.
    The rating scale issue has not aired publicly. I know from 
working at Moody's Investors Service that we all benchmarked 
our ratings according to a fixed-point scale; and in 1994 
Moody's analysts actually showed the investor public how it 
worked. The scale needs to be taken out of the hands of rating 
agencies, because with it, they have created a discount window 
for corporations to go to the market with their collateral and 
get cash, and that is a great idea, but it is something that 
affects the economy as a whole. The rating scale needs to be 
determined by the regulators and probably the Administration 
and Congress, and then it needs to be published so that the 
whole market can actually monitor credit quality, so that the 
determination of current credit quality is not in the hands of 
a few people.
    Chairman Reed. Thank you very much.
    Sir?

STATEMENT OF CHRIS J. KATOPIS, EXECUTIVE DIRECTOR, ASSOCIATION 
                     OF MORTGAGE INVESTORS

    Mr. Katopis. Good morning, Chairman Reed, Ranking Member 
Crapo, distinguished members of the panel. Thank you for the 
opportunity for the Association of Mortgage Investors to 
testify on the state of securitization markets and housing 
finance in general.
    The U.S. mortgage market is awesome, $11 trillion in 
outstanding mortgages derived from three sources: Bank balance 
sheets, and critics argue that the bank balance sheets are full 
and stressed; the GSEs, and there is a vigorous debate about 
the potential liability on the taxpayers and Uncle Sam 
resulting from the enterprises; and securitization. Mortgage 
investors bring private capital to the market. At the height, 
we have financed $1 trillion in first lien mortgages, and at 
the height, 60 percent of all first lien mortgages were 
financed through securitization, not the banks.
    But today, securitization is shut down. Senator Corker goes 
around Tennessee saying mortgage investors are on strike. This 
is not our choice. We have private capital to invest in the 
markets. Capital craves yield. But unfortunately, the current 
legal and regulatory environment is not conducive to those 
yields.
    So this has two sets of consequences. First is a 
macroconsequence on the U.S. economy, our capital markets, U.S. 
global competitiveness. But the second set of consequences 
squarely impact Main Street, because it impacts the ability to 
get housing, the price of credit, as well, the pension funds, 
retirement systems, and unions that have traditionally invested 
in RMBS because for decades it was the safest, most secure form 
of investment for long-term returns.
    So who is AMI? AMI are a number of private investors that 
came together to identify obstacles and hurdles to 
securitization in the market and identify public policy 
solutions. We, along with the insurance industry, public 
institutions such as State pension funds, retirement systems, 
universities, charitable endowments, are trying to identify 
ways that the Government can develop better systems, 
structures, and standards to, one, restart securitization in 
this country, as well as deal with issues surrounding the 
legacy of investments that impact all stakeholders.
    So with my testimony, my oral statement today, I would like 
to briefly summarize six broad-brush areas of concern, 
obstacles to RMBS securitization, and also try to touch on 10 
public policy recommendations which we outline in our written 
statement and we outlined in our March 2010 white paper about 
restarting securitization.
    First, the market suffers because of opacity, asymmetries 
of information, and a thorough lack of transparency. Our 
investors are very good at pricing risk, but they cannot price 
the unknown. When have you ever heard of an investor wanting 
less information? They have fiduciary responsibilities. They 
want as much information as they can obtain.
    Second, there is a lack of standardization and uniformity 
surrounding very basic transaction documents and papers. 
Certainly, we strive for a model pooling and servicing 
agreement. And to give you a flavor of some of the problems 
that exist in this space, very basic contractual terms, such as 
delinquency and default, have no standardized industry meaning. 
So you can imagine the vagueness and ambiguity that flow from 
these contracts and some of the problems that exist in the 
space.
    Mortgage investors are very concerned about poor 
underwriting standards. Further, we have a number of concerns 
about conflicts of interest among servicers and their 
affiliates. Many services are conflicted. Hence, they are not 
servicing mortgages properly. Accordingly, AMI finds it aligns 
with consumers in many instances concerning these issues.
    Originators and issuers are not honoring their contractual 
obligations through representations and warranties. Contracts 
have these representation and warranty clauses. And to give you 
an analogy, you buy anything in America, you buy a car, you buy 
an iPod, you get a warranty. And if you bring it home and it is 
a four-cylinder car, not an eight-cylinder car, you can have a 
cure. Maybe the cure is you swap it for what you intended. We 
find that in a number of instances, these representations and 
warranties are not being honored and our members are left 
without recourse.
    In general, the market lacks sufficient tools for first 
lien mortgage holders. And then, again, the effect of 
enforcement.
    So in closing, I would say that we would like to work with 
the Committee on its continued oversight and legislation 
regarding this area. There are a number of people that are 
working on solutions. There seems to be a sense of having a 
global, elegant, universal solution affecting securitization 
and all asset classes. We would argue that RMBS is very 
important for the housing sector, a very basic need, shelter. 
And if you can just fix MBS this year, that would be a great 
start. The enemy should not be the perfect of the good. I mean, 
sorry, the perfect should not be the enemy of the necessary.
    So we thank you for your oversight and we would like to be 
a resource for the Committee.
    Chairman Reed. Well, thank you very much. I want to thank 
all the panelists for very detailed and very thoughtful and 
insightful testimony about very difficult issues that the 
agencies are confronting today. They have not yet published a 
final rule, so there is still opportunity. I am sure they are 
reflecting on everything you have said. I hope they are and 
expect they will.
    Let me begin with Mr. Hughes, because you have just 
successfully brought issues to the market and many of the 
points you have made, I think, echo a lot of what has been said 
before. But let me begin with a point which I think several 
people have reflected.
    If we had good underwriting, we would not have a lot of 
these problems. In some respects, a lot of what, from my view, 
Dodd-Frank is trying to do with ``skin in the game,'' et 
cetera, is just forcing good underwriting. So if you could just 
address from your perspective that issue, and anyone else who 
has a point about that. You know, there is one view that 
perhaps we are creating this elaborate structure to force good 
underwriting where we could do something more specific, more 
direct, or the market eventually with other sanctions would be 
doing better underwriting. But, Mr. Hughes, please.
    Mr. Hughes. Yes. I believe everything starts with the 
borrower and obviously walks through the chain. I think, not to 
oversimplify, I think, actually, the problem is not as 
complicated as all the regulations and everything we are going 
through. If we start with a process where the borrower has a 
down payment, the borrower can clearly afford the loan from day 
one, we do not create mortgage products, neg-ams and stuff that 
would extend the reach of that borrower. There is 
responsibility in communicating with that borrower between the 
lender, and then to the extent the next step is when the 
lender, if it does go to securitize, there is total 
transparency. They have skin in the game.
    I think you can go back--we went 20 years at ten, 15 basis 
points, a loss in the prime. It is just to reflect on what 
changed, and to me, the one thing that changed all the way up 
from borrower down payments, no terrible underwriting, you 
know, and all the things that have been well documented. From 
our standpoint, the one thing that is missing here is seconds, 
and we have been talking about it. I do not know how it--I have 
heard about St. Germain and this law and why it cannot get 
changed, but that is a big thing from a borrower standpoint 
that is still out there.
    Chairman Reed. Let me just follow up with one question. I 
read your testimony that you basically--you insist on sort of 
skin in the game, taking it yourself as a way, I guess, to 
assure your fellow investors. So you have no problem with at 
least the concept under Dodd-Frank of making----
    Mr. Hughes. Correct.
    Chairman Reed. --of the person taking skin in the game.
    Mr. Hughes. Yes. As part of our business model, and again, 
we are on the prime jumbo space, we think the most significant 
and best way to provide skin in the game is to hold the 
horizontal slice. I know there is a lot of confusion between 
subprime structures and prime. But what our sales pitch says to 
you is that we put this deal together. We are selling you 
securities. And then we will hold 5 percent of the securities 
underneath you, and to the extent that something goes wrong, 
100 percent of that is on our checkbook, our buying. It is not 
vertical where we get 5 percent.
    I think that, along with the disclosures in the 
transactions we did, it was not--you know, the first one was 
six times oversubscribed. So to me, it goes to show it cannot 
be subprime, but if you meet what investors are looking for, 
the borrower has skin in the game and throughout the chain, I 
do not think it is as difficult as all this, at least on the 
prime side.
    Chairman Reed. Thank you.
    Professor Schwarcz, in your testimony, you talked about 
many different factors and some which are intra-company, which 
are not being dealt with directly today by us, obviously. But 
one issue, I think, that comes--again, it resonates throughout 
all the testimony--is the complexity. The market went from 
pretty simple stuff to CDO-squared and CDO-cubed, where you 
would take the lowest tranches of a mortgage-backed security 
and then combine it into something else or actually come up 
with another security that had at least a component that was 
AAA rated.
    I guess, and I think what Mr. Katopis said, too, if it is 
standardized, if it is simple, it will work. Should we be 
spending more time--will the market--let me put it this way. 
Will the market permanently reject this complexity? Has it 
learned the lesson that, you know, keep it simple, stupid? That 
is what I learned at Fort Benning. Or are we going to see, if 
we do not have some of these very elaborate rules promulgated 
by the agencies, a quick return to super-complex and issues 
that cannot be understood?
    Mr. Schwarcz. That is a very good question, and I think 
that certainly in the short term, the market is going to reject 
the complexity. I fear that in the long term, as yields go 
higher in very complex products, the market may find them very 
attractive. In my written testimony, I talk about how the 
intra-firm conflicts, like issues of VaR, can facilitate this.
    One thing that--just a couple of thoughts here quickly. One 
thing is that because complexity will be inevitable, I think 
that failures will be inevitable. I have a paper that is cited 
in these materials, ``Regulating Complexity in Financial 
Markets'', where I develop this at great length and I compare 
it to chaos theory in complex engineering systems, where 
failures are also inevitable.
    So the question is how to address this. You address this, 
in part, by trying to prevent the failures, but also you 
address it, in part, by trying to mitigate the consequences of 
the failures when they occur. This is something I think we need 
to do.
    A couple of other thoughts. In a perfect market, the 
investors themselves would be understanding what they are 
buying, would be insisting, in fact, that the originators, the 
underwriters, really retain skin in the game. In my experience, 
for example, in many loan sale markets, you could not sell a 
bank participation in a loan unless the seller of the 
participation retained at least 5, 10 percent interest in that 
loan.
    And so one of the questions I think we need to fully 
understand is why did the system break down here, and I think 
part of the answer is that things, again, have gotten too 
complex and that disclosure is an insufficient solution. 
Another part of the answer is that risk has been almost 
marginalized. This is interesting. Most of the investors are 
the hugest investors. Many of them are QIBs, Qualified 
Institutional Buyers, who are freely allowed to buy and sell 
securities under the SEC rules. And so it is something we need 
to look at.
    A final thing is that I have thought a lot about whether we 
should try to standardize these complex deals. And, in fact, 
one of the speakers talked about standardizing in the RMBS 
field issues of the pooling and servicing agreement and so 
forth. Standardization certainly can help in the very short 
term, but I fear that in the long term, requiring 
standardization would really stymie the ability of our 
financial markets to innovate and grow. Thank you.
    Chairman Reed. Thank you very much.
    I am going to recognize Senator Crapo and my colleagues, 
but we will have a second round if you want it, also. So 
Senator Crapo?
    Senator Crapo. Thank you, Mr. Chairman.
    I want to start out on commercial real estate, so Ms. 
Pendergast, I will direct my first question to you. As you 
indicated and as I indicated, frankly, in my statement, during 
the deliberation on Dodd-Frank, I was successful in getting an 
amendment adopted that would focus on commercial real estate to 
give the rule makers more flexibility, frankly, to recognize 
the unique nature of commercial real estate and help us to deal 
with the risk retention issue in a more flexible way.
    From your written testimony and your testimony here today, 
it is my understanding that you feel that that flexibility was 
not effectively achieved, or that much more could be done to 
more effectively create a rule that helps to facilitate 
commercial real estate mortgage activity and still aligning the 
interests of lenders, issuers, and investors. Could you 
elaborate on that a little bit?
    Ms. Pendergast. Sure. First, I would like to thank you and 
the regulators for incorporating that B-piece buyer retention 
option into the rules. It is extremely beneficial and suits the 
structure of the CMBS market.
    As to the second issue, in terms of other forms of risk 
retention, you know, first and foremost, I am a research 
analyst by trade and one of the things that you look to is the 
performance of bank portfolios, those portfolio lenders who 
kept these loans on their balance sheets. If you look at the 
data currently via the FDIC, you will find that they have some 
of the highest commercial real estate default delinquency rates 
out there.
    So certainly, I do not necessarily view risk retention as a 
panacea. I do think the market has embraced it and that is to 
the good. But having said that, there are other options for 
risk alignment, and that would include things like the best 
practices reps and warranties package that was issued by the 
Commercial Real Estate Finance Council. Those certainly will go 
a long way toward better risk alignment if incorporated into 
current documents and required by the regulators.
    In addition to that, there are transparency and disclosure 
issues that I think permeate the entire securitization market. 
I like to think that the CMBS market, by very nature of the 
asset class, such that we have 200 or 300 loans in a deal as 
opposed to the RMBS market where there are 3,000 to 5,000 loans 
in the deal, the smaller number of loans allows us to do far 
more due diligence and provide that information to investors, 
not only at issuance, but on an ongoing basis.
    So one thing we would like to see is the incorporation of 
some of these best practices that have been put forth by CREFC 
into the regulations such that perhaps there is a combination 
of risk retention and the employment of some of these best 
practices that are out there.
    Senator Crapo. And I assume from that that you believe that 
a reproposal is warranted.
    Ms. Pendergast. No question. One of the key things that we 
saw with the SEC is they held some roundtables when they were 
doing their Reg AB rulemaking, and it was vital, I think, and 
it is vital today for we to better understand what some of 
these proposals are. There is still a lack of clarity regarding 
the premium capture cash reserves account and many other rules 
that are out there. So a give and take between the industry and 
the regulators as to what their intent is and how we can best 
meet those goals, I think, would be important, and that really 
would require that we prolong the comment period and then 
incorporate the results of these roundtables into a reproposal 
of the regulations.
    Senator Crapo. If we do not take another look at this and 
get the kind of flexibility that you are talking about, do you 
believe that we will see an unnecessary restriction of consumer 
activity and lending in the market?
    Ms. Pendergast. No question. I have spoken to a lot of the 
nonlarge bank lenders out there and they are quite concerned 
and, in fact, have started to pull back some of their activity 
already because they are not comfortable with how these rules 
will eventually affect them.
    One example would be that we have investors in the B-piece 
security, also, who will not be able to sell this investment at 
any time during the life of the security. That is really 
unheard of in the market, and the lack of liquidity could be 
extremely troublesome, causing many of these B-piece investors 
to either, one, leave the market entirely, or two, decide that 
they need higher yields on those securities that they buy. 
Ultimately, what that does is that it causes the cost of 
capital to rise for those CRE borrowers that are out in the 
market.
    Senator Crapo. Thank you. Would any of the other panelists 
like to comment on this issue? Mr. Deutsch?
    Mr. Deutsch. I am happy to talk about the reproposal aspect 
in detail because one of the key concerns about the proposed 
rules is they affect not just the mortgage market. I think 
everybody is very much focused on commercial and residential 
mortgages. But securitization affects, and is included as part 
of the asset classes, auto ABS, equipment loan ABS, whole 
business securitizations, asset-backed commercial paper, which 
is a $300 billion market. These are all areas that have massive 
impacts on sort of the middle market funding and consumer 
market funding in the U.S. Without getting a reproposal that 
makes the exemptions for these other asset classes work and be 
functional, I think could be pretty devastating to the consumer 
credit markets.
    Senator Crapo. And I would like to follow up on that with 
you, Mr. Deutsch, and again, any other member of the panel that 
would like to respond to this, but it seems to me that what I 
am hearing from many of you, if not all of you, is that as 
currently drafted, the rule will ultimately cause a, well, I 
guess a contraction in consumer activity and commercial lending 
that is not justified by increased safety and soundness. Mr. 
Deutsch, could you comment on that, and any other panelist, if 
you would like to.
    Mr. Deutsch. Sure. I will take a fresh shot in thinking 
about, again, outside of the mortgage context. We can talk 
about subprime and Alt-A mortgages. It is its own separate 
bailiwick. But take the example of prime auto loans. Those 
securitizations worked perfectly throughout the crisis. There 
were very little, if any, losses in those securitizations in 
the worst economic downturn.
    So to me, to have auto finance companies, which are not in 
the business of holding capital--they do not just have money 
sort of sitting around, they are in the business of selling 
cars and then financing the sale of those cars and motorcycles 
and equipment loans--to create a lot of capital burdens, to 
make them hold capital just to sit around pulls that credit out 
of the system and ultimately lowers the availability of credit 
and makes it at a higher price, and I think that is a pretty 
critical component, that we have to get these exemptions right, 
and right now, they clearly are not.
    Senator Crapo. Ms. Rutledge.
    Ms. Rutledge. I guess the main point that I would like to 
say with respect to risk retention and some of the other 
structural fixes on the market is that the whole reason for the 
market initially, which came out of this S&L crisis was 
recognition that receivable asset quality can be better than 
the firm's own credit quality, and it can finance itself more 
cheaply by financing itself off-balance sheet, given how our 
bankruptcy system works.
    The whole idea is an economy of capital utilization: 
capital efficiency. In fact, when Congress decides to do 
something like mandate risk retention, or any other structural 
piece, you are in fact structuring these deals.
    A simpler way to address systemic risk is to go back to the 
original definition of credit quality. What are we doing when 
we securitize? We are finding the boundary between debt and 
equity, using a judicious amount of leverage that gives buyers 
and sellers the best possible deal. ``Judicious'' is determined 
primarily with reference to the rating scale, and that is why I 
advocate transparency around the rating scale.
    Senator Crapo. Thank you. Mr. Hughes and then Mr. Schwarcz, 
and I am probably going to be out of time. I am already out of 
time. I apologize.
    Mr. Hughes. I am going to try to talk a little bit about 
the Premium Capture Account and what is it, and I am going to 
try and oversimplify what we believed happened and particularly 
on the residential side.
    On the residential side, there was basically two different 
types of structures that were used. On the prime side, 
basically, your credit protection, you issued $500,000 in 
mortgages--$500,000 in mortgages went in the pool, $500,000 
securities went out. The protection to the top securities were 
a series of bonds that were underneath that security. In those 
deals, there was a time where the AAA--the mortgage may be 5 
percent and AAA says, if I have all the subordination, all I 
need is 4 percent. So that different security there was called 
an IO. That IO is a senior security in the structure, has 
nothing to do with subordination.
    We move over to a subprime structure. Subprime structures, 
you could have a mortgage rate of seven and you could have the 
same pass through as four. The structures were designed, well, 
why do we not capture some of that excess spread and use that 
to pay down AAA mortgages, and actually what it is, it is 
subordination. So what happened in some of the subprime deals 
during the crisis, that subordination left really early. People 
pulled out the IO. And by the IO leaving early, you pulled the 
bottom out of the structure. So that was one thing.
    What happened was the rules are written that if you have 
any IO in a deal, and this includes on the commercial side, 
even though it is not used for credit support, you have to put 
it down on the bottom of the structure and use it as credit 
support. It is very, very inefficient in that spot.
    Securitization is about maximizing proceeds. You are going 
to maximize the proceeds for that IO for a buyer that just 
wants a senior security, that has to worry about prepayment, if 
asked to work credit, it is worth a lot less. That was one that 
gets recaptured.
    The second one really relates to a concept of, hey, at the 
time of securitization, the proceeds were 102. The two must be 
profit. The profit goes down at the bottom and that has to be 
recaptured. And the basic theory was it was a measurement 
against the fair value of the securities. What it failed to do, 
and the conceptual thing is if we bought loans at 100 and 
spreads tighten, interest rate move, and they are worth 102, 
all that matters at the time of exchange of the securitization 
entry, that the fair value of everything is even and we hold 5 
percent of 102. If we want to say, you cannot make any profits, 
you know, it is the American way. If there is no profit 
incentive for this, there is not going to be an opportunity to 
securitize.
    What is really, really, really important is at the time we 
securitize, what I would say, the pot is right. We brought over 
loans worth 102. Securities went out that was 102. We held 5 
percent. I think if you did it on that basis and said, for a 
prime side, take out premium recapture for the IO, did it on a 
fair value basis, I think on the prime side, the problems go 
away.
    Senator Crapo. Thank you.
    And Professor, I am way over time, so maybe----
    Mr. Schwarcz. Ten seconds, if I may?
    Chairman Reed. Ten seconds.
    Mr. Schwarcz. OK. I just wanted to point out very briefly 
that even if we had perfect levels of risk retention, it would 
not be a panacea. There would still be a mutual misinformation 
potential. For example, in the recent crisis, firms like Citi, 
Merrill, took huge amounts of the lowest rated securities on 
their books in underwriting because they felt these would be 
very profitable. This can potentially mislead senior investors 
into investing. So we just need to have that caution. Thank 
you.
    Senator Crapo. Thank you.
    Chairman Reed. Thank you.
    Let me recognize Senator Hagan.
    Senator Hagan. Thank you, Mr. Chairman.
    Mr. Hughes, I wanted to follow up on Senator Reed's earlier 
question having to do with the good underwriting question. Can 
you explain in more detail what you mean when you say seconds 
and why are these such a big problem?
    Mr. Hughes. Yes. So when a--in a securitization entity, you 
will buy the underlying loans based on the information that you 
have at that point in time. So you will evaluate, there is 20 
percent down. That goes into your modeling. And from that, you 
can evaluate a risk of loss.
    To the extent that after the fact a borrower can go out the 
next day and get a second from a different lender and take out 
15 percent or 20 percent, which is what happened in the crisis, 
and basically day two, you have no money in the deal, the risk 
to me as the initial acquirer when I thought it was 80, the 
risk profile of that borrower has changed.
    So what we think is there should be something to check to--
we have a couple different ways it could happen--so that the 
borrower retains whatever the level is, their skin in the game.
    Senator Hagan. Thank you. Mr. Schwarcz, setting aside the 
question of the extent to which the originate to distribute 
model caused mortgage underwriting standards to fall, I wanted 
to ask you about the incentives in portfolio lending versus 
securitization. It is my understanding that across-the-board 
risk retention requirement, one where the securitizers retain a 
fixed percentage of all pools, may encourage originators who 
are also portfolio lenders to adversely select loans for 
securitization.
    My question is, if an originator makes a marginal loan and 
has a choice to put it into a securitization with a 5-percent 
risk retention or hold it with a 100-percent risk retention, 
what is the lender likely to do? It would seem to me that the 
loan would go into the securitization.
    Mr. Schwarcz. On those facts, I would agree with you 
entirely, and I think that, you know, that is another potential 
reason that risk retention is not a panacea. We need to really 
better enable the investors to understand what it is they are 
buying and to resist the impulse to buy because others are 
buying, and I am not sure that the answers to do that are easy. 
And at the end of the day, I think it is going to be imperfect.
    We are never going to be able to set up a precise system, 
and that, I think, is part of the reason why I would argue that 
in addition to trying to regulate on an ex ante basis, that is, 
to prevent failures from happening, which is very important, we 
need to also be aware that there will be failures and we need 
to try to understand how to address them.
    Senator Hagan. Well, in the case of across-the-board risk 
retention standard, would you expect participants to originate 
to one standard for their portfolio loans and then another 
standard for the securitization?
    Mr. Schwarcz. If you have across-the-board, you mean 
across-the-board in securitization?
    Senator Hagan. Mm-hmm.
    Mr. Schwarcz. I think that depends on what the market will 
require. It is hard to say. I think it depends on the facts. I 
could not answer that in the vacuum.
    Senator Hagan. Does the QRM standard create incentives to 
originate to a higher standard, and if a loan could be 
securitized with a 5-percent risk retention or a zero-percent 
risk retention, it seems that the exempt loan would be the 
preference.
    Mr. Schwarcz. Well, yes, I agree with that. The Qualified 
Residential Mortgage standard, of course, is not yet worked out 
as to exactly what it would be, so I am not sure I--I am not 
sure I could fully answer that question. I would maybe defer 
that to some of my other colleagues on the panel.
    Ms. Pendergast. If I may answer the question regarding 
portfolio lending versus securitization lending, for example, 
in the commercial real estate market, traditionally, the 
components are life companies, banks, and CMBS lenders. 
Traditionally, the portfolio lenders would take, particularly 
the life companies would focus on the larger assets and the 
larger markets, leaving the smaller loans, smaller markets to 
the securitization business.
    Just because you have a market that is not sort of the top 
ten in the country, you still can underwrite a loan that makes 
sense, and I think that has always been the way in which the 
CMBS market has worked initially. The average loan size for 
CMBS is $8 million, whereas I think if you were to look at a 
life company portfolio, that average loan size is somewhere, 
you know, $50, $60, $75 million and upward. So there is a 
distinction between the two.
    The one thing, also, I would say about the qualifying 
mortgage, within CRE, it seems to me there are 33 criteria for 
becoming a qualified mortgage, and, frankly, some of the 
criteria are things that have never been seen in the commercial 
real estate lending world. So we calculate at about a half of 1 
percent of the loans that are outstanding currently in the CRE 
universe would qualify for an exemption. And what is ironic to 
me is that I hear from my colleagues that in the residential 
space, that that number is closer to 10 to 20 percent. And when 
you look at the delinquency rates between the two markets, that 
is just nonsensical.
    Mr. Deutsch. Senator Hagan, if I could come back to your 
question about the QRM and its current definition, the way it 
is proposed right now is--and the regulators were very clear 
about this in their proposal--is that, currently, only 
approximately 19 percent of the loans that Fannie and Freddie 
guarantee right now would be eligible for the QRM. So if you 
are a portfolio lender and you originate, or if you are a bank 
and you originate a loan right now that would be eligible for 
the proposed QRM standard, you would sell that immediately to 
the GSEs. So the QRM standard, an exemption, right now would 
never, ever be used because those loans will be passed along to 
Fannie and Freddie.
    So a core question as part of this debate is as long as we 
have this QRM that is much, much smaller than the definition of 
a conforming loan that you can sell to the GSEs, we are not 
going to use this exemption. All those loans will just go to 
Fannie and Freddie and it will continue, I think, as Marty 
indicated, an inability for the private sector to get into the 
market and to be able to securitize these loans and bring 
credit back because the GSEs effectively hog the space.
    Senator Hagan. I was up with Senator Isakson and Senator 
Landrieu to try to craft the QRM so that it was available to 
more, to be sure that we did not subject so many people not to 
have the opportunity to go out and get that first home.
    Thank you, Mr. Chairman.
    Chairman Reed. Thank you.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman. It has been a 
great hearing and great witnesses, and I thank all of you for 
being here.
    Mr. Hughes, on the second mortgage issue, it has been a 
fascinating issue, I think, throughout this whole process. And 
I guess in many cases a second mortgage holder is actually the 
servicer of the loan, too. Is that correct?
    Mr. Hughes. Certainly over the last few years they have 
been the primary----
    Senator Corker. And so what you have is you have the 
primary lender and you have the investors out there, and then 
you have the servicer who is benefiting from servicing the loan 
who makes this second mortgage, and so there is a conflict that 
is created there. Is that correct?
    Mr. Hughes. Correct.
    Senator Corker. And then I guess the way our laws are now 
written on bankruptcy and that type of thing, they have the 
ability to continue to have their second mortgage, which is of 
lower priority, continue to be paid while the first mortgage is 
not being paid. Is that correct?
    Mr. Hughes. Correct.
    Senator Corker. Would it be reasonable to say that we ought 
to revisit that whole priority situation and have that 
corrected?
    Mr. Hughes. I think revisiting seconds and priorities needs 
work.
    Senator Corker. And you would actually advocate changing 
bankruptcy laws to allow for a different type of seniority. Is 
that correct?
    Mr. Hughes. What we would recommend is just putting 
controls up front from--allowing borrowers to take them out but 
have the amount that you go out set to a limit. You could 
either have--in other forms of lending, two things happen when 
you take out a second, if you are in corporate, if you are in 
commercial, whatever, that basically the first says I feel OK, 
you can take out a second. That is probably unreasonable in a 
residential situation.
    A second thing--we will go back to our example. We started 
out with an 80-percent loan to value that potentially you can 
get to a point in time where, based on a new appraisal, 80 has 
come down to 70, that you can go back to 80 percent.
    Senator Corker. Let me ask you this. You know, during the 
risk retention debate, there was a lot of concern about the 
fact that with risk retention at 5 percent, or whatever the 
number was going to be, it was basically going to shut the 
market down, that there were not people out there that had the 
ability to reserve or keep that risk, and in essence 
securitization, which is, you know, to efficiently allocate 
capital and to spread it around, was going to shut down. And 
yet you found a way for that not to be the case.
    What do you do as it relates to your balance sheet and 
reserving that 5-percent risk?
    Mr. Hughes. Basically, we are agnostic to consolidating, so 
we are not a bank, so we are not subject to capital 
requirements, so we just put it on the balance sheet and show 
the assets and liabilities.
    Furthermore, I mean, we are----
    Senator Corker. So you do not really--you just keep it----
    Mr. Hughes. We just keep it.
    Senator Corker. But you do not really have to reserve.
    Mr. Hughes. No.
    Senator Corker. So really----
    Mr. Hughes. So what we would have to do is reserve for the 
loans over time since we have both--the reserve.
    Senator Corker. So when an investor is buying these bonds 
and you have kept 5 percent, what are they really getting from 
you?
    Mr. Hughes. From us in the way we hold it, which is 
horizontal, if----
    Senator Corker. And walk through the horizontal versus 
vertical. I think that would be enlightening for everybody.
    Mr. Hughes. OK. And I am going to make a--just to make the 
math easy, if you had 100 million of loans and the 
subordination level below AAA was 10 percent, 90 percent was 
AAA. To the extent that you held vertical, and let us say on 
that pool, what you would be holding, you would be holding--of 
your skin in the game, 1 percent effectively would be in that 
bottom tier, and the top would be--the balance would be sitting 
in the top, such that if there was, you know, in that pool 
there was 5 percent of losses or $5 million, you would only 
share in 5 percent of the $5 million. So there is very little 
teeth when you hold it in terms of actual loss that you would 
sustain.
    To the extent that you held it horizontally, 5 percent on 
the bottom, and that same pool had $5 million of losses, all $5 
million losses would be borne by someone like Redwood Trust or 
a sponsor on the bottom holding horizontal.
    Senator Corker. And you are holding horizontal.
    Mr. Hughes. We are holding horizontal. It is part of our--
--
    Senator Corker. You are really keeping the risk.
    Mr. Hughes. We are keeping the risk because it is part of 
our business model to sell to you on the top so that you 
would--the reason you should feel comfortable about buying our 
deal is because we are down below you. Right on the bleeding 
edge is where we are going to have it.
    Senator Corker. And so, but the person who is buying the 
bonds does not really know that you have reserved against it. I 
mean, they are just hoping Redwood has the ability to step up 
in the event that occurs. Is that correct?
    Mr. Hughes. Well, what we are doing, remember, at closing, 
you know, in our deals, we are essentially completely funding 
those deals day one, so there is no insurance, there is nothing 
to come later on. So we will, again, back to that $100 million, 
we will buy those bonds on the bottom, so they will be 
completely funded--we contributed by putting $100 million of 
loans in the deal.
    Senator Corker. Interesting.
    Mr. Hughes. And we are going to leave 5 percent----
    Senator Corker. Interesting. Yes, that is good.
    So let me ask you this--that actually is very interesting. 
Walk me through how we get from where we are with the GSEs and, 
you know, you transition over from them to the private market. 
I mean, there are several--there is, you know, three different 
models we have heard about. One is, you know, basically you 
start tranching down the upper limit of loans to get down to a 
level where basically the private sector is coming back on the 
jumbo side in the beginning and then walking down. The other 
piece is basically going from 100-percent guarantee to 90, to 
80, to 70. And another piece is basically letting the very best 
loans today go out into the private market and start working it 
that way.
    What is the best way to transition, in your opinion, from 
where we are today at 90 percent Government-guarantees loans to 
100-percent private sector loans? How do we do that?
    Mr. Hughes. I think probably the best first step is to 
allow the loan limits to come down and to test to see what 
happens, because I think if we wait--I think one of the things 
they are waiting for----
    Senator Corker. So the guys like you would come in behind 
as those loan limits come down.
    Mr. Hughes. We will come--I think the gap will get filled. 
I know many think it is going to be if you go down to 625, 
there is going to be this breach, and it is going to go way 
down. Who is going to step in that breach? It is going to be 
the same people that are doing 729. The banks. They are just 
going to move down, and pricing today, you know, in that sector 
is probably 30 to 40 basis points higher than it is. So I would 
think the first logical test would be to bring that down.
    The second logical test would be why don't we bring up 
guarantee fees to more of a market rate to allow the private 
sector to do it. Then you can slowly and gradually measure to 
figure out is it there. But, I mean, we keep running into this 
scare-mongering, it cannot happen. This thing, it is going to 
be 300 basis points. Test it on a safe basis to see where we 
come out.
    I would think waiting until we have co-ops together and all 
other stuff is years off in trying to do that. So find ways 
through private capital to begin the process of bringing 
private capital in and moving back, you know, the Government to 
more of a reinsurance position. And I believe private capital 
will come in to take that position.
    Senator Corker. Ms. Pendergast, as the CMBS market is kind 
of is where it is and you have got all these rulemakings that 
are taking place, what do you do today when you are actually 
doing a CMBS? I mean, how do you know what the rules are going 
to be? Do you do it based on the rules as they exist today? How 
does one go out and actually do a securitization today when the 
rules are changing?
    Ms. Pendergast. Carefully. It is a time when those who are 
lending, I think to the good, the CMBS secondary market has 
stabilized, so you have a sense of where bonds will clear in 
the market, and that is important, and that is testament to the 
fact that there has been some significant recovery in our 
sector.
    As far as, though, the large banks I think are out there 
lending, and that is a good thing. However, this is a market 
that is going to need more than just the five or six largest 
banks in the country focused on CMBS lending. So the smaller 
banks, those that are nonbank institutions that are lending, I 
think are quite concerned about how you originate a loan today, 
not knowing exactly how that execution is going to take place, 
you know, between now and 2013 when the rules actually take 
effect.
    That is certainly a concern that I have, this sort of lag 
period between we are now, you know, formulating the rules but, 
in fact, they do not take effect until 2013. How do you 
originate during that time period? So it is important that as 
soon as possible we get--you know, there is clarity as to how 
these rules are going to work for the CMBS market and for other 
securitization markets as well.
    Mr. Deutsch. Senator Corker, if I could add, I think one of 
the key concerns of the market right now is they are looking 
toward complying with these future rules. The banks right now, 
insured depository institutions, are being asked to comply with 
a different set of rules from the FDIC's securitization safe 
harbor. So areas around risk retention, they now have to comply 
with those FDIC safe harbor rules, which those rules right now 
that the FDIC just implemented last year, are very different 
than what the current proposals are right now. And I think that 
is creating a real challenge for banks to try to have to create 
one system now, but then have to totally overhaul that system 
once they know what these new final rules are.
    Senator Corker. I would like to keep going, but I know I am 
overstepping, so I will let you go ahead and then I will come 
back.
    Chairman Reed. Thank you very much.
    One of the issues that Senator Corker's line of questioning 
raised was we have seen the asset-backed securities markets in 
automobiles and other areas come back rather--if not robustly, 
at least come back. We have not seen that in housing, and the 
implication, at least--and I think it should be made explicit--
is that a lot of this is not--some of it is related to the 
uncertainty with respect to these rules, but a lot of it is 
related to the role the GSEs are playing in terms of their 
guaranteeing fees, below market rate, as you suggest, the fact 
that they can insure or guarantee to a significant amount now 
that is going to come down. And I wondered, Mr. Hughes, your 
estimate of--is that really what is holding back the private 
market now? Or is it more this issue of what will the rules be 
in 2013?
    Mr. Hughes. Yes. So if you were to look at the market in 
2010 in terms of, you know, the pieces of it, and actually the 
amount of loans under 417, the old GSE rate, is 90 percent. So 
if you went down to--rolled it back to 417, it would be 90 
percent. So they are financing now--the additional amount 
between 417 and 729 is another 5 percent. So the amount that is 
really only available for people like Redwood is the top 5, and 
it is even less than that. And the reason it is even less than 
that for an outside securitizer is if you look at the 
executions, you know, for a bank today, if you are awash in 
liquidity you can sell 90 percent into a Government bid. You 
are sitting on excess cash. You know, a 4- or 5-percent 
mortgage sounds pretty good, then trading it over for, you 
know, 25 basis points or something else, so they are retaining 
it.
    So there really is not any financial incentive in the 
system to get it going. So that, you know, investors, there is 
really nothing to kind of put together.
    Chairman Reed. But let me follow--when we begin this 
process--you suggested, I think, the first step obviously is 
lowering the maximum amount that can be guaranteed. When we 
start doing that, you expect the private market to come in. And 
I guess the question that is before us today, we have got to 
get these rules right. But the biggest thing at the moment, 
macroissue, is just the sheer presence of GSEs in the 
marketplace.
    Mr. Hughes. Correct. And even if it did come back to 629, I 
think the amount that it would probably add out there, about 3 
percent is all I think it would come down to, when you come 
down, because 5 percent was 417 to 729, so for all the--again, 
the fear if we go down you are going to take away what is 
outside the GSEs' reach, about 2 percent.
    Chairman Reed. Ms. Pendergast, the issue of reproposal 
presumes that very little of your--you do not feel that your 
comments will be adhered to, because I presume you have made 
numerous comments in this process. Not you personally but the 
industry. But can you just give me an idea of why a reproposal 
in your view is necessary since the final rules have not been 
proposed, as I presume, that you will also have a situation 
where the implementation will not be until 2013, so that seems 
to suggest that there will be a time even to adjust the rules 
if they are proposed.
    Ms. Pendergast. Yes, I think----
    Chairman Reed. Could you put it on, please?
    Ms. Pendergast. I think the concern is that there is a lack 
of clarity as to what some of the proposed rules are 
suggesting, and I think that is one of the things that, yes, we 
can comment on the rules as they stand today, but we are not 
sure exactly what we are commenting on.
    For example, the premium capture cash reserve account, the 
reserve account, is something that we have been discussing with 
regulators, and yet it is still not clear specifically what the 
intent was of that particular provision. What we do know is 
that, as written, it does take substantially all of the 
economic incentives to be involved in this sector out of the 
market. But in conversations what we have learned is that we 
think that it is much more akin to wanting 5 percent of the 
proceeds, not 5 percent of par value. So real 5 percent skin in 
the game.
    Chairman Reed. But you have made that point--as you are 
making it today very well, that is why I think this hearing is 
very useful and very important. You have made that point as 
clear as you can to the bill writers.
    Ms. Pendergast. Correct, but it is not 100 percent clear to 
us that that is the only component of the premium capture cash 
reserve account.
    Chairman Reed. Thank you.
    Mr. Katopis, you have made some interesting comments with 
respect to the investors about standardization, transparency, 
and also the need for servicers--and I think Mr. Hughes made 
similar comments--to be much more flexible in terms of dealing 
with mortgages. Can you elaborate on that? Because, frankly, 
from our different perspectives, that is, trying to get a 
bottom under this foreclosure problem, we have been at least 
figuratively banging our heads against the issue of services, 
their incentives, their relationships, as you alluded to, to 
some of their affiliates, et cetera. So I would benefit from 
your comments.
    Mr. Katopis. Thank you, Senator. I could go on for a long 
time about this, but in brief----
    Chairman Reed. You have 1.2 minutes.
    [Laughter.]
    Mr. Katopis. I will do my best to explain again and refer 
you to the written statement that we share the frustration that 
many consumers have regarding servicers, improper servicing 
standards. The servicing model was not designed for the default 
rates we have today. We urge you to take a look at the 
potential conflicts of interest. When servicers own seconds, 
stand in the way of modifications, and one of the things I do 
is try to debunk the urban myth that mortgage investors, as 
first lien holders, try to block modifications, just go on the 
record again, we would like to see responsible although 
distressed homeowners stay in their homes. We would like to 
work with them on the modification process. We think there are 
benefits for the homeowners, for investors, and communities 
through that. And I refer you again to our written statement 
and our ten points in the white paper.
    Chairman Reed. Have you communicated these concerns 
particularly about servicers to the Federal Reserve and the OCC 
who regulate most of the servicers?
    Mr. Katopis. In December, we reached out to regulators in 
support of national servicing standards, and we have also 
communicated our concerns to the CFPB and the State Attorneys 
General.
    Chairman Reed. And have you gotten any feedback or any 
sense of your getting traction or not?
    Mr. Katopis. I think there is widespread acknowledgment of 
some of the defects of the current servicing model and the 
abuses that are going on. We await further action on that.
    Chairman Reed. I am similarly positioned.
    Senator Corker, do you want to----
    Senator Corker. Thank you, Mr. Chairman. We happen to be 
crafting some legislation to deal with much of what Chris just 
talked about, and maybe we could join together to do that. Talk 
to us a little bit, Chris, about what the HAMP program actually 
did as it relates to mortgage investors and their levels of 
trust, if you will.
    Mr. Katopis. Well, thank you, Senator, for your question. I 
will say that we believe that HAMP was very well intentioned as 
a remedial tool. Certainly it is the view of mortgage investors 
that if there is a way to properly construct a modification and 
keep people in their home, paying a mortgage on a monthly 
basis, where they had the ability and the willingness, this 
would be a good thing.
    We have commented and shared our comments with the 
Administration that we think there were some defects to some of 
the structures regarding HAMP, and, therefore, it was not as 
successful as originally intended, and the evidence bears this 
out.
    I think the most important thing to remember about this or 
any other proprietary modification program is what is in the 
borrower's best interest. And certainly the prompt resolution 
of their distressed situation is very important. If you keep 
someone in the home for 400 or 500 more days, their situation 
will deteriorate, their credit will deteriorate. There are a 
lot of problems. So we think there were concrete observations 
we had about the defects of the HAMP program. They were not 
necessarily acted upon, and we hope that remedial programs will 
try to speed a distressed homeowner to a better solution, 
whether it is a rental situation or a modification, as quickly 
as possible.
    Senator Corker. Mr. Hughes, on the risk retention piece, 
you talked about how you all are handling that. Are there 
stipulations right now by regulators as to whether that risk 
has to be vertical or horizontal? Or is that just something you 
have chosen to do?
    Mr. Hughes. There are actually four options right now, and 
it is just the risk--the way we have chosen it as part of our 
business model, and we have been trying to convince--and what 
we have been battling against has been in a subprime structure 
where we talked before, there was--down the bottom there was 
interest, principal, and other than as opposed to prime you had 
straight bonds. You cannot make more than the face amount of 
bonds. On the subprime you could make a lot of money.
    So in addition, when they wrote risk retention--so we have 
been pounding the table to at least have the option for 
horizontal and let others decide what they want to do--is when 
it was written for horizontal is we cannot get any of our money 
out until the end of the deal, so 10 years down the road. So 
even if tests are made, even if your cash is flowing, even 
those the bonds are paying down, they want to totally block it 
out. So, unfortunately, what we would do today, if the rules 
were adopted, because it is to penal for doing that, and it is 
really not penal to all that hold vertical, we would hold 
vertical to check the box and say, OK, we did it, and then we 
will just hold the bottom and not have the restrictions against 
allowing us to cash-flow in a proper way on the bottom of the 
structure.
    So I am hopeful that maybe, you know, our conversations as 
well with regulators, that when it gets out, if it is the best 
forum, is that it is not as penal as it is laid out today.
    Mr. Deutsch. Senator Corker, if I could add about a bank 
structure versus a REIT structure, I think Marty's structure 
has a certain--the corporate structure has a certain 
availability to be able to withstand that risk, but not have 
the accounting and regulatory capital implications associated 
with it.
    One challenge with the horizontal risk retention proposal--
and certainly I think for an institution like Redwood Trust, it 
makes a lot of sense and there is a lot of strong arguments why 
that can better align retention and incentives. One of the core 
issues, though, is that for a bank that would also service 
these loans, if they hold a horizontal risk retention and they 
service the loans, they will have to consolidate that 
transaction under FAS 166 and 167. The regulatory capital----
    Senator Corker. The entire face value of----
    Mr. Deutsch. The entire face value. So they are only 
holding 5 percent of the----
    Senator Corker. That cannot last very long, can it?
    Mr. Deutsch. It will mean no bank will securitize, because 
you cannot hold 5 percent of the risk but then hold regulatory 
capital for 100 percent of the transaction. It is a quixotic 
outcome of the new FAS 166 and 167 rules and the regulatory 
capital rules. We have long been very concerned about how those 
regulatory capital rules were developed. But that is--unless 
you can get the regulators or FASB to change those rules, we 
have to take that as a given. And if the regulators would only 
require a horizontal risk retention, banks would not have an 
ability to securitize because of those rules.
    Senator Corker. And is there a sense that that issue is 
being resolved?
    Mr. Deutsch. I think the proposals that allow both--either 
a vertical or horizontal or even a L-shaped form would allow 
banks to hold a vertical slice and also service. The 
complicating factor, though, now is this premium cash capture 
reserve account that effectively is additional risk retention, 
which could also trigger--even if you are holding a vertical 
slice, could also trigger a consolidation. And there was no 
accounting or discussion within the proposed rules about what 
the accounting considerations would be.
    So that is, again, another reason to make sure that we get 
these rules right in a reproposal to know and fully understand 
the accounting implications.
    Senator Corker. On the residential mortgage end, you know, 
we talked--I think all of us were shocked, really, when the 
crisis hit to find out that recourse loans almost did not exist 
anymore. I foolishly, when they used to have those kind of 
things, had recourse loans and I did not realize that was not 
the standard. How much does the borrower being recourse against 
the debt matter anymore in America? Is that something that 
people care about anymore? I will ask you, Mr. Hughes, since 
you securitize them.
    Mr. Hughes. It matters to investors, so from our 
standpoint--and we put a whole book together on what we think 
best practices are. You know, we think borrowers should 
absolutely, positively be protected, but they also need--we 
need to be protected from actions that they would do. I mean--
--
    Senator Corker. So in the loans that you make, the 
borrowers are, in fact, fully recourse?
    Mr. Hughes. In the loans that we have here?
    Senator Corker. Yes.
    Mr. Hughes. Well, it depends State by State on what actual 
actions you can do and where it goes back to. But, yes, I think 
one of the things that we had recommended at some point in 
time, to the extent that strategic defaults need to be 
addressed, and one way to address strategic defaults is through 
deficiency judgments after the fact, as well as looking at 
seconds. So we are not looking to do anything harmful to 
borrowers. All we want to do is just get to a point where you 
cannot just either change--significantly change your risk 
profile from when a securitizer--from when an investor bought 
your loan, or you cannot just throw the keys on the table and 
say, you know, I signed something, I am not happy with what I 
signed.
    Senator Corker. Chris.
    Mr. Katopis. Just very briefly, I would point out that 
whereas there has not been an RMBS securitization with the 
exception of the Redwood Trust's over the last few years, the 
Redwood Trust loans, from what I understand, are immaculate. 
And, you know, in the absence of having these immaculate loans, 
we would point out the things that we identify in our 
testimony. You need certainty, transparency, recourse, removing 
conflicts of interest. Those are the things that will bring 
private capital back into the market. It is not simply pulling 
a switch on the GSEs, but the things that we enumerate in our 
testimony.
    Senator Corker. Mr. Chairman, it has been a good hearing. I 
do not want to sour grape--yes, I am sorry. Thank you.
    Ms. Rutledge. After listening to the complexity of your 
world----
    Chairman Reed. Can you turn on your microphone? [dropped.]
    Ms. Rutledge. Sorry. After listening to the complexity of 
your world, I think our quantitative world is rather simple, 
and I would like to just comment a little bit on what Mr. 
Hughes said about the vertical slice versus the horizontal 
slice.
    In the 1980s, the way that we looked at securitization was, 
simplistically, if an investor in the senior tranche has five 
times coverage over the expected loss, that defines AAA. We 
have moved on from that standard, but let us use it for the 
moment. Suppose that the vertical slice--sorry, the horizontal 
slide is 5 percent, which Redwood Trust is holding at the 
bottom of the capital structure, and the expected loss is 50 
basis points, that is ten times coverage.
    Now, what happens is as those 50 basis points of expected 
loss materialize (if loss is indeed 50 bps) and the loss 
amortizes: Redwood takes the loss. And as that extra is applied 
against the loss, the rating factor goes from 10 to 20 times, 
100 times, an infinite number of times. The securities at the 
top of the capital structure become so safe, they are 
bulletproof.
    What I have just described is the model that worked for 20 
years. I am not advocating a five times coverage scale but 
pointing out two things. First, a vertical slice does not 
absorb risk. A horizontal slice does. That is risk retention. 
The second thing is that if you mandate a 5-percent risk 
retention, you are inviting the industry to originate loans 
with a 5-percent loss because that is economically efficient.
    The market risk solution cannot be structural solutions per 
se. There has to be an ability to monitor how the losses are 
performing and how the securities are performing. And if you 
have that transparency, you will motivate proper behavior. That 
is a much simpler model.
    Senator Corker. I would like to follow up. IF I could say 
just one thing, when this bill was passed, about a week later 
the Financial Times had an analysis, and basically it said so 
many pages, so little content. And I think there is something 
for us to learn. You know, basically we punted to regulators at 
a time when we wanted clarity in the markets. We kept saying we 
needed to pass a bill for clarity in the markets, and from what 
I can tell, we have created years of lack of clarity, and 
basically all of us up here which create laws hoping--hoping 
the regulators will do the right thing under time frames that 
are unrealistic. I think everybody who has been in here in the 
industry believes that rulemaking time frames are unrealistic, 
and a lot of rules are being made that are inappropriate.
    Anyway, I have learned a lot from this, and I appreciate 
very much you having the hearing, and certainly all the 
witnesses being here.
    Chairman Reed. Well, thank you, Senator Corker, and I think 
we have all learned a great deal from this, and I think it is 
an ongoing education. So I will just make everyone aware that 
some of my colleagues might have questions which they will 
formally submit to you, and I would ask that all those 
questions be in by Friday, and that you would respond as 
quickly as possible, hopefully within 2 weeks or less.
    But thank you. It has been a very thoughtful, insightful 
hearing on a very complicated topic. I was thinking, as Senator 
Corker talked, about the process of making legislation. I do 
not think I would have wanted to be at 4 o'clock in the morning 
trying to figure out the retained risk premium issue to the 
specificity that the Federal Reserve must--hopefully they will 
do it at least in the middle of the day with a much more sort 
of tranquil environment.
    Senator Corker. Yes, I think we could have given, though, a 
lot more direction, and I do not think we delved into the 
issues of horizontal versus vertical.
    Chairman Reed. You are absolutely right.
    Senator Corker. Risk retention sounded like it as an idea 
that kind of, oh, boy, let us have risk retention, that will 
make it all work. And it was more of an idea than a well 
thought through concept, and I think that is why we are having 
these problems.
    Chairman Reed. Well, in addition to that, it was an idea 
which, you know, had many fathers and mothers. I know there 
were amendments made, et cetera, the nature of the process. 
Some of them have been improvements, I think Senator Crapo's 
amendment. I think what Senator Hagan did was very, very 
helpful in terms of qualifying it. But now we are at the point 
the reality is that this is something that the regulators have 
to address thoughtfully, thoroughly, and the point I hope is 
that they have listened carefully to what you have said, as we 
have, because you have made some excellent points about how we 
create a better system that is more transparent, more 
predictable, and less prone to collapse.
    So thank you all very much. Thank you, Senator Corker. The 
hearing is adjourned.
    [Whereupon, at 11:16 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                PREPARED STATEMENT OF STEVEN L. SCHWARCZ
 Stanley A. Star Professor of Law and Business, Duke University School 
                               of Law\1\
                              May 18, 2011
Introduction
    The securitization markets are very weak, as I'm sure the others 
testifying will report. This is unfortunate because securitization can 
be a major source of capital formation, yielding critical economic 
benefits.
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     \1\ E-mail: [email protected]; tel. 1-919-613-7060.
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    For example, securitization can significantly decrease the cost of 
corporate credit. By raising funds without having to borrow from a bank 
or other financial intermediary, companies avoid the intermediary's 
profit mark-up. Furthermore, the interest rate paid by the company is 
ordinarily lower than the interest rate payable on corporate securities 
issued directly by the company. This interest-rate savings reflects 
that the mortgage loans and other ``financial assets'' being 
securitized are usually more creditworthy, and almost always easier to 
understand and value, than the company itself. For these reasons, 
securitization has become an important way for companies of all types 
to raise low-cost financing.
    Securitization is also the principal means by which banks and other 
lenders turn their loans into cash, thereby enabling them to continue 
making new loans. Securitization of residential mortgage loans, for 
example, has facilitated the expansion of home ownership by enabling 
banks to continue to lend money to homeowners. Many other forms of 
consumer and business credit are also securitized, including automobile 
loans, student loans, credit card balances, and equipment loans.
    Securitization can also reduce consumer costs. By expanding the 
``secondary'' (i.e., trading) market in consumer loans, securitization 
lowers the interest rate that lenders charge on those loans. \2\
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     \2\ Cf. Patric H. Hendershott and James D. Shilling, ``The Impact 
of the Agencies on Conventional Fixed-Rate Mortgage Yields'', 2 J. Real 
Estate Fin. & Econ. 101 (1989) (finding that securitization of 
conforming fixed-rate mortgage loans significantly lowered interest 
rates on mortgage loans relative to what they would otherwise have 
been); C.F. Sirmans and John D. Benjamin, ``Pricing Fixed Rate 
Mortgages: Some Empirical Evidence'', 4 J. Fin. Services Research 191 
(1990) (finding significantly lower interest rates on fixed rate 
mortgages that can be sold in the secondary market versus those that 
cannot).
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    By 1992, securitization had become so important to the American 
economy that the Securities and Exchange Commission observed that it 
was ``becoming one of the dominant means of capital formation in the 
United States.'' \3\ Securitization continued its strong growth until 
the recent financial crisis, rising from $2.9 trillion in 1996 to $11.8 
trillion in 2008. \4\ Even during the crisis, the Federal Reserve 
implemented a $200 billion Term Asset-Backed Securities Loan Facility 
(known as ``TALF'') in order to keep the securitization markets 
running. This helped to assure ``the availability of credit to 
households and businesses of all sizes.'' \5\
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     \3\ Investment Company Act, Release No. 19105, [1992 Transfer 
Binder] Fed. Sec. L. Rep. (CCH) P 85,062, at 83,500 (Nov. 19, 1992) 
(provided in connection with the issuance of Rule 3a-7 under the 
Investment Company Act of 1940).
     \4\ These figures are drawn from http://www.sifma.org/.
     \5\ See, e.g., http://www.ny.frb.org/markets/talf_faq.html; http:/
/www.federalreserve.gov/newsevents/monetary20081125a1.pdf.
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Securitization's Role in the Recent Financial Crisis
    The securitization of subprime mortgage loans--essentially mortgage 
loans made to risky borrowers--is widely viewed as a root cause of the 
financial crisis. The evil, however, was not securitization per se but 
a correlation of factors, some of which were not completely 
foreseeable.
    Securitization transactions were sometimes backed, at least in 
part, by subprime loans. Because home prices had generally been 
increasing in the United States since the Great Depression, the 
expectation was that continuing home-price appreciation would enable 
even risky borrowers to repay their loans by refinancing their houses. 
At the worst, many thought, the steep rise in housing prices might 
level out for some period of time, although at least one rating 
agency's model assumed that prices could drop as much as 10 percent. 
Few predicted the complete collapse of housing prices.
    Many argue that the ``originate-to-distribute'' model of 
securitization, enabling mortgage lenders to sell off loans as they're 
made, led to overreliance on the expectation of repayment through home-
price appreciation. According to this argument, the originate-to-
distribute model created moral hazard because lenders did not have to 
live with the credit consequences of their loans. Loan origination 
standards therefore fell.
    There are other possible explanations of why subprime loans were 
made and securitized. \6\ But whatever the explanation, the fall in 
home prices meant that subprime borrowers, who were relying on 
refinancing for loan repayment, could not refinance and began 
defaulting. The defaults had mostly localized consequences in 
traditional securitization transactions. But they had larger, systemic 
consequences in nontraditional transactions that involved complex and 
highly leveraged securitizations of asset-backed securities already 
issued in prior securitizations--effectively ``securitizations of 
securitizations.'' The resulting leverage caused relatively small 
errors in cash flow projections--due to the unexpectedly high default 
rates on underlying subprime loans--to create defaults on substantial 
amounts of ``investment grade'' rated subordinated classes of these 
securities, and to cause even the most highly rated classes of these 
securities to be downgraded.
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     \6\ These other explanations are bound up with the more important 
question, discussed in the next paragraph, of why nontraditional 
securitization transactions were structured in a way that even 
relatively small errors in cash flow projections could cause defaults 
and downgradings.
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    The important question is why those nontraditional securitization 
transactions were structured in a way that even relatively small errors 
in cash flow projections could cause defaults and downgradings. 
Although one answer is the widespread inconceivability of a housing-
price collapse that could cause those errors, the full answer goes 
beyond that. Part of the answer may be that securitization's focus on 
mathematical modeling to statistically predict the payments on 
financial assets underlying these complex securities fostered an 
overreliance on modeling and an abandonment of common sense. Yet 
another part of the answer may be that investors, who seemed as anxious 
to buy these superficially attractive securities as underwriters were 
to sell them, were overly complacent and eager to follow the herd of 
other investors.
    Whatever the reasons, these defaults and downgradings panicked 
investors, who believed that a ``AAA'' rating meant iron-clad safety 
and that an ``investment grade'' rating meant relative freedom from 
default. Investors started losing confidence in ratings and avoiding 
the debt markets. Fewer investors meant that the price of debt 
securities began falling. Falling prices meant that firms using debt 
securities as collateral had to mark them to market and put up cash, 
requiring the sale of more securities, which caused market prices to 
plummet further downward in a death spiral. With the failure of Lehman 
Brothers, investors lost all confidence in the debt markets. The lack 
of debt financing meant that companies could no longer grow and, in 
some cases, even survive. That affected the real economy and, at least 
in part, contributed to the financial crisis.
    The crisis was also arguably exacerbated by the fact that 
securitization made it difficult to work out problems with securitized 
mortgage loans. The beneficial owners of the loans were no longer the 
mortgage lenders, but a broad universe of investors in securities 
backed by these loans. Although servicers were tasked with the 
responsibility to restructure the underlying loans ``in the best 
interests'' of those investors, they were often reluctant to engage in 
restructurings when there was uncertainty that their costs would be 
reimbursed. Foreclosure costs, in contrast, were relatively minimal. 
Servicers also preferred foreclosure over restructuring because 
foreclosure was more ministerial and thus had lower litigation risk. As 
a result, foreclosure was artificially favored, forcing many homeowners 
from their homes and further driving down property values.
Dodd-Frank's Response
    The Dodd-Frank Act addresses securitization by focusing, 
essentially, on three issues: (i) adequacy of disclosure, (ii) 
conflicts between ``securitizers'' \7\ and investors, and (iii) rating 
agency information.
---------------------------------------------------------------------------
     \7\ In most cases, the ``securitizer'' is the company itself or a 
financial institution that pools financial assets for eventual issuance 
of asset-backed securities.
---------------------------------------------------------------------------
    (i) Adequacy of Disclosure: The Dodd-Frank Act directs the SEC to 
require more standardized disclosure of information regarding the 
underlying financial assets, including information on the assets 
underlying each class of asset-backed securities. This disclosure 
requirement is intended to facilitate an easier comparison of classes. 
The Act also directs the SEC to require securitizers to engage in a 
due-diligence review of the underlying financial assets and to disclose 
to investors the nature of the review.
    (ii) Conflicts between Securitizers and Investors: The Act attempts 
to limit conflicts of interest between securitizers and investors by 
requiring securitizers, in transactions that are not backed entirely by 
``qualified residential mortgage'' loans, \8\ to retain an unhedged 
economic interest in the credit risk of each class of asset-backed 
securities. \9\ This is colloquially known as keeping ``skin in the 
game.'' The minimum retained interest is generally five percent, 
although it may be less if the financial assets meet quality standards 
to be announced by Government agencies.
---------------------------------------------------------------------------
     \8\ The SEC and other governmental agencies are directed to 
collectively define what constitutes qualified residential mortgage 
loans, taking into account mortgage risk factors. Dodd-Frank Act 
941(b).
     \9\ Dodd-Frank Act 941.
---------------------------------------------------------------------------
    (iii) Rating Agency Information: Dodd-Frank also mandates the SEC 
to adopt regulations requiring rating agencies to explain, in any 
report accompanying an asset-backed securities credit rating, the 
representations, warranties, and other enforcement rights available to 
investors, including a comparison of how these rights differ from 
rights in similar transactions.
Dodd-Frank Inadequately Addresses Securitization's Flaws
    I believe that Dodd-Frank inadequately addresses securitization's 
flaws. Although it addresses one of the flaws (or, at least, alleged 
flaws), it underregulates or fails to regulate other flaws and it 
overregulates by addressing aspects of securitization that are not 
flawed.
A. Dodd-Frank Addresses One of Securitization's Flaws
    Dodd-Frank addresses one of securitization's flaws--or at least one 
of its alleged flaws. I mentioned that the originate-to-distribute 
model of securitization is believed to have fostered an undisciplined 
mortgage lending industry, including the making of subprime loans. The 
Dodd-Frank Act, as discussed, addresses the originate-to-distribute 
model by requiring securitizers to retain skin in the game, i.e., 
retaining a minimum risk of loss. The theory is that by aligning the 
incentives of securitizers and investors, the lending industry will 
become more disciplined.
    There remains a question, though, of the extent to which the 
originate-to-distribute model actually caused mortgage underwriting 
standards to fall. Some argue that standards fell because of Federal 
governmental pressure on banks and other mortgage lenders to make and 
securitize subprime mortgage loans to expand homeownership. \10\ The 
fall in standards also may reflect distortions caused by the liquidity 
glut of that time, in which lenders competed aggressively for business; 
or it may also reflect conflicts of interest between lending firms and 
their employees in charge of setting lending standards, such as 
employees being paid for booking loans regardless of the loans' long-
term performance. Blaming the originate-to-distribute model for lower 
mortgage underwriting standards also does not explain why standards 
were not similarly lowered for originating nonmortgage financial assets 
used in other types of securitization transactions. Nor does it explain 
why the ultimate beneficial owners of the mortgage loans--the investors 
in the asset-backed securities--did not govern their investments by the 
same strict credit standards that they would observe but for the 
separation of origination and ownership. \11\
---------------------------------------------------------------------------
     \10\ Cf. Peter J. Wallison, ``The Lost Cause: The Failure of the 
Financial Crisis Inquiry Commission'' (2011) (making that argument), 
http://www.aei.org/docLib/FSO-2011-02-g.pdf.
     \11\ For one explanation of why the ultimate beneficial owners did 
not observe those standards, see Steven L. Schwarcz, ``Marginalizing 
Risk'', 89 Washington University Law Review, forthcoming issue no. 3 
(2012), available at http://ssrn.com/abstract=1721606.
---------------------------------------------------------------------------
    The extent to which the originate-to-distribute model actually 
contributed to the financial crisis may never be known. If that model 
was not a significant causal factor, Dodd-Frank's skin-in-the-game 
requirement may well constitute overregulation. This requirement also 
might, ironically, lull some investors into a false sense of security. 
In the financial crisis, for example, there is some evidence that 
investors purchased senior classes of asset-backed securities because 
underwriters retained the most subordinated interests--effectively 
creating a ``mutual misinformation'' problem. \12\
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     \12\ Dodd-Frank does mandate the Financial Services Oversight 
Council, however, to study and submit a report to Congress on the 
macroeconomic effects of the skin-in-the-game requirements, including 
possibly proactively regulating mortgage origination as an alternative 
or supplement. Dodd-Frank Act 946.
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B. Dodd-Frank Underregulates and Fails To Regulate Other Flaws
    Dodd-Frank underregulates, and in some cases fails to regulate, 
other flaws of securitization. The Act does not, for example, directly 
address the problem of overreliance on mathematical modeling. 
Mathematical models are not inherently problematic. If the model is 
realistic and the inputted data are reliable, models can yield accurate 
predictions of real events. But if the model is unrealistic or the 
inputted data are unreliable--as occurred when unexpectedly high 
default rates due to the housing collapse undermined the value of some 
asset-backed securities--models can be misleading.
    To some extent this overreliance on mathematical models should be 
self-correcting because the financial crisis has shaken faith in the 
market's ability to analyze and measure risk through models. In the 
long term, however, I fear that--as market experience has often shown--
investor memories will shorten.
    Dodd-Frank also fails to address the complacency problem. I'm not 
sure, though, how effective regulation can be in changing human 
behavior. Market participants will probably always engage in herd 
behavior, for example, there being safety in numbers. And people will 
probably always invest in high-yielding securities they can't 
understand if others are doing it.
    Dodd-Frank also does not address the servicing problem, but I find 
that less troublesome. Parties can--and in light of recent experience, 
should have incentives to--write underlying deal documentation that 
sets clearer and more flexible guidelines and more certain 
reimbursement procedures for loan restructuring, especially when 
restructuring appears to be superior to foreclosure. Parties can also 
minimize allocating cash flows to investors in ways that create 
conflicts. Furthermore, parties can agree, when appropriate, to subject 
servicers to--and regulation could also require--more realistic 
performance standards, perhaps akin to a business judgment rule that 
allows them to restructure loans in good faith without being exposed to 
liability. \13\
---------------------------------------------------------------------------
     \13\ Cf. Steven L. Schwarcz and Gregory M. Sergi, ``Bond Defaults 
and the Dilemma of the Indenture Trustee'', 59 Alabama Law Review 1037 
(2008) (arguing that this standard should apply to indenture trustee 
duties after default).
---------------------------------------------------------------------------
C. Dodd-Frank Overregulates by Addressing Aspects of Securitization 
        That Are Not Flawed
    Dodd-Frank overregulates by addressing some aspects of 
securitization that are not flawed. I have already indicated that the 
skin-in-the-game requirement might constitute overregulation. Dodd-
Frank also requires securitizers to engage in a due-diligence review of 
the underlying financial assets; but in my experience, that is already 
routinely done.
    Dodd-Frank also may overregulate in its requirements for more 
standardized disclosure of information. In principle it should be 
helpful for investors to get this information. My experience, however, 
is that prospectuses usually already provide much of this information, 
and that the larger problem is not absence of disclosure but the fact 
that investors don't always read and understand the information already 
disclosed.
    There are at least two reasons for this failure. One reason is 
complacency, discussed above. The second reason is a conflict of 
interest within investing firms themselves. As investments become more 
complex, conflicts of interest are increasingly driven by short-term 
management compensation schemes, especially for technically 
sophisticated secondary managers. \14\
---------------------------------------------------------------------------
     \14\ See, Steven L. Schwarcz, ``Conflicts and Financial Collapse: 
The Problem of Secondary-Management Agency Costs'', 26 Yale Journal on 
Regulation 457 (2009), available at http://ssrn.com/
abstract_id=1322536; Steven L. Schwarcz, ``Regulating Complexity in 
Financial Markets'', 87 Washington University Law Review 211, 261-262 
(2009/2010), available at http://ssrn.com/abstract-id=1240863.
---------------------------------------------------------------------------
    For example, as the VaR, or value-at-risk, model for measuring 
investment-portfolio risk became more accepted, financial firms began 
compensating secondary managers not only for generating profits but 
also for generating profits with low risks, as measured by VaR. 
Secondary managers therefore turned to investment products with low VaR 
risk profile, like credit-defaults swaps that generate small gains but 
only rarely have losses. The managers knew, but did not always explain 
to their seniors, that any losses that might eventually occur could be 
huge.
    This is an intra-firm conflict, quite unlike the traditional focus 
of scholars and politicians on conflicts between managers and 
shareholders. Dodd-Frank attempts to fix the traditional type of 
conflict but completely ignores the problem of secondary-management 
conflicts. Regulation should also require that managers, including 
secondary managers, of financial institutions be compensated based more 
on long-term firm performance. \15\
---------------------------------------------------------------------------
     \15\ See ``Conflicts and Financial Collapse'', supra note 14, at 
468-469 (observing that regulation is needed because there is a 
collective-action problem).
---------------------------------------------------------------------------
    Dodd-Frank's focus on disclosure may also be inherently 
insufficient. I have mentioned that investors don't always read and 
understand the disclosure. Financial products, including some 
securitization products, are becoming so complex, however, that 
disclosure can never lead to complete understanding. \16\ On the other 
hand, it may well be counterproductive to try to limit complexity, such 
as requiring more standardization of financial products. 
Standardization can interfere with the ability of parties to achieve 
the efficiencies that arise when firms issue securities tailored to 
particular needs of investors. \17\
---------------------------------------------------------------------------
     \16\ See, e.g., Steven L. Schwarcz, ``Disclosure's Failure in the 
Subprime Mortgage Crisis'', 2008 Utah Law Review 1109 (arguing that 
disclosure is a necessary but insufficient response to complexity); 
Steven L. Schwarcz, ``Rethinking the Disclosure Paradigm in a World of 
Complexity, 2004'', University of Illinois Law Review 1 (2004) (same).
     \17\ See Iman Anabtawi and Steven L. Schwarcz, ``Regulating 
Systemic Risk'', 86, Notre Dame Law Review, forthcoming issue no. 4 
(Spring 2011), available at http://ssrn.com/abstract=1670017. Dodd-
Frank's focus on standardizing more derivatives transactions is a 
special case because the goal is less standardization per se (in order 
to minimize investor due diligence) than to enable more derivatives to 
be cleared through clearinghouses, which generally require a high 
degree of standardization in the derivatives they clear.
---------------------------------------------------------------------------
Conclusions
    I have suggested certain regulatory responses to improve 
securitization, including the need to fix the intra-firm problem of 
secondary-management conflicts. Overall, however, there are no perfect 
regulatory solutions to the problems of securitization; and indeed 
those problems are not atypical of problems we will face in any 
innovative financial market--that increasing complexity coupled with 
human complacency, among other factors, will make failures virtually 
inevitable. Regulation must respond to this reality.
    To that end, it is important to put into place, before these 
failures occur, regulatory responses to failures that supplement 
regulatory restrictions intended to prevent failures. \18\ The 
financial crisis has shown the increasing importance, for example, of 
financial (e.g., securities) markets and the need to protect them 
against the potential that investor panic artificially drives down 
market prices, becoming a self-fulfilling prophecy. A possible 
regulatory response would be to create financial market stabilizers, 
such as a market liquidity provider of last resort that could act at 
the outset of a panic, profitably investing in securities at a deep 
discount from the market price and still providing a ``floor'' to how 
low the market will drop. \19\
---------------------------------------------------------------------------
     \18\ See generally Steven L. Schwarcz, ``Ex Ante Versus Ex Post 
Approaches to Financial Regulation: The Chapman Dialogue Series and The 
Chapman Law Review Symposium Keynote Address'', forthcoming in Chapman 
Law Review 2011 symposium issue on ``The Future of Financial 
Regulation'', available at http://ssrn.com/abstract=1748007.
     \19\ See Anabtawi & Schwarcz, supra note 17 (showing how buying 
securities at a deep discount will mitigate moral hazard and also make 
it likely that the market liquidity provider will be repaid).
---------------------------------------------------------------------------
    It also is important to provide incentives for financial 
institutions to try to minimize the impact of failures (externalities), 
and to absorb (i.e., ``internalize'') the cost when failures occur. 
This could be done, for example, by regulation requiring at least 
systemically important market participants to contribute to a risk 
fund, which could be used as a source of stabilization (such as by 
funding the financial market stabilizers referenced above). \20\ Fund 
contributors would then be motivated not only to better monitor their 
own behavior but also to monitor the behavior of other financial 
institutions whose failures could deplete the fund (requiring 
contributors to pay in more). \21\
---------------------------------------------------------------------------
     \20\ See id.; see also Marginalizing Risk, supra note 11. Ideally, 
any such fund should be international to avoid anticompetitively 
``taxing'' financial institutions in any given jurisdiction.
     \21\ Id.
---------------------------------------------------------------------------
    The bill that would become the Dodd-Frank Act originally included 
the concept of a systemic risk resolution fund, to be sourced by large 
banks and other systemically important financial institutions and used 
as a possible bailout mechanism in lieu of taxpayer funds. The concept 
was dropped after some alleged it would increase moral hazard by 
institutionalizing bailouts. \22\ Ironically, if structured properly, a 
systemic risk fund should actually have the opposite effect, minimizing 
moral hazard.
---------------------------------------------------------------------------
     \22\ Dodd-Frank includes a provision for possible ex post funding 
of a systemic risk fund, but it is doubtful that any such fund could be 
created quickly enough to be effective. Financial institutions might 
even have difficulty providing such funding at the time of a systemic 
crisis.
---------------------------------------------------------------------------
    We also need to see the big picture. Securitization has existed for 
decades and has generally worked well. Even during the recent crisis, 
almost all traditional securitization structures protected investors 
from major losses. Additionally, we need to keep in mind what investor 
protection--one focus of this hearing--means in the securitization 
context. Investors in securitization transactions are generally large 
and sophisticated financial institutions. One might question whether 
regulation should have the goal of protecting these types of investors, 
except in cases when their failures can harm others, such as by 
triggering systemic consequences, \23\ or when market failures can 
discourage these types of investors from adequately protecting 
themselves. \24\
---------------------------------------------------------------------------
     \23\ See generally Steven L. Schwarcz, ``Systemic Risk'', 97 
Georgetown Law Journal 193 (2008).
     \24\ See supra note 15 and accompanying text (observing that in 
order to resolve the problem of secondary-management conflicts, 
regulation will be needed to fix a collective-action problem).
---------------------------------------------------------------------------
    My comments focus primarily on creating an appropriate regulatory 
framework to help ensure long-term integrity of the securitization 
markets. I do not address how to quickly return depth and liquidity to 
securitization markets but trust that others testifying today, who are 
more intimately connected with the industry, will have proposals to 
that effect. Whatever the proposals, however, there may be relatively 
little need for securitization or other means of capital formation so 
long as lenders and companies sit on mounds of cash, reluctant to make 
loans and to invest in operations.
    Thank you.

    My testimony is based in part on the following sources, in addition 
to those already cited:

The 2011 Diane Sanger Memorial Lecture--Protecting Investors in 
    Securitization Transactions: Does Dodd-Frank Help, or Hurt?, 
    available at Securities and Exchange Commission Historical Society 
    virtual museum and archive, www.sechistorical.org.

Identifying and Managing Systemic Risk: An Assessment of Our Progress, 
    1 Harvard Business Law Review Online (2011), forthcoming at http://
    hblr.org, also available at http://ssrn.com/abstract=1788336 (in 
    its original form as the Keynote Speech at the George Mason 
    University 2011 AGEP Advanced Policy Institute on Financial 
    Services Regulation).

The Conundrum of Covered Bonds, 66 The Business Lawyer (forthcoming 
    issue no. 3, May 2011), available at http://ssrn.com/
    abstract=1661018.

The Future of Securitization, 41 Connecticut Law Review 1313 (2009) 
    (symposium issue on the subprime crisis), available at http://
    ssrn.com/abstract_id=1300928.

                   PREPARED STATEMENT OF TOM DEUTSCH
           Executive Director, American Securitization Forum
                              May 18, 2011








                 PREPARED STATEMENT OF MARTIN S. HUGHES
       President and Chief Executive Officer, Redwood Trust, Inc.
                              May 18, 2011
Introduction
    Good Morning, Chairman Reed, Ranking Member Crapo, and Members of 
the Committee. My name is Marty Hughes, and I am the CEO of Redwood 
Trust, Inc., a publicly traded company listed on the New York Stock 
Exchange. I appreciate the opportunity to testify on the state of the 
residential mortgage securitization market and look forward to 
responding to your questions.
Overview
    My testimony is focused on restoring a fully functioning private-
sector residential mortgage finance market. Currently, about 90 percent 
of all new mortgage originations rely on Government support. \1\ Given 
the fact that there is $9.6 trillion of outstanding first lien mortgage 
debt, \2\ this level of public subsidization is simply not sustainable. 
That being said, reducing the current level of governmental support, 
whether immediately or gradually over time, will have severe 
consequences for the housing market if the private sector is not 
prepared to step in with investment capital to replace a diminished 
level of Government backing.
---------------------------------------------------------------------------
     \1\ 2011 Mortgage Market Statistical Annual, Volume I , p. 19.
     \2\ Federal Reserve Flow of Funds of the United States, Fourth 
Quarter, Tables L.217 and L.218
---------------------------------------------------------------------------
    The consequences of failing to attract sufficient private-sector 
capital to this market include a contraction in the availability of 
credit to home buyers, an increase in mortgage rates, and continued 
decreases in home prices. Furthermore, these problems in the housing 
market may have broader negative effects on the overall economy.
    The main sources of private-sector capital that previously financed 
residential mortgages include banks, mutual funds, pension funds, and 
insurance companies. For the nonbanks, the transmission mechanism for 
providing this financing was through their investments in triple-A 
rated residential mortgage-backed securities (RMBS). My testimony will 
recommend how to bring these ``triple-A investors'' back to this 
securitization market, thereby enabling the Government to reduce its 
role in the mortgage market without negative consequences.
Background on Redwood
    Redwood commenced operations in 1994 as an investor in residential 
mortgage credit risk. We are not a direct lender or mortgage servicer. 
Our primary focus has been on the prime jumbo mortgage market, or that 
portion of the mortgage market where the loan balances exceed the 
limits imposed by Fannie Mae and Freddie Mac (the ``GSEs'') for 
participation in their programs. Similar to the GSEs, Redwood also 
provides credit enhancement, but our focus is on the prime jumbo 
mortgage market. We provide credit enhancement by investing in the 
subordinated securities of private-label residential mortgage 
securitizations, which enables the senior securities to obtain triple-A 
ratings. From 1997 through 2007, Redwood securitized over $35 billion 
of mortgage loans through 52 securitizations.
Recent Securitization Activity
    In April 2010, Redwood was the first company, and is so far the 
only company, to sponsor a securitization of newly originated 
residential mortgage loans without any Government support since the 
market froze in 2008. The size of that first transaction was $238 
million. In March 2011, we completed a second securitization of $295 
million, and we hope to complete two more securitizations this year.
    Completing these transactions required that we address the concerns 
and interests of triple-A investors who, in the wake of the financial 
crisis, had lost confidence that their rights and interests would be 
respected and, consequently, that their investments would be safe and 
secure. We worked hard to regain their trust by putting together 
transactions that included even more comprehensive disclosure, better 
structure, and a new enforcement mechanism for representation and 
warranty breaches. In addition, Redwood retained meaningful exposure to 
the transaction's future performance--i.e., through risk retention or 
``skin-in-the-game''--and, in doing so, aligned our interests with 
those of investors. Investors responded with significant demand to 
acquire the triple-A rated securities, as evidenced by the fact that 
the first offering of those securities was oversubscribed by a factor 
of six to one. The second securitization was also quickly and fully 
subscribed.
    To be clear, Redwood Trust has a financial interest in the return 
of private sector securitization for residential mortgages. We hoped 
that our decision to securitize loans in 2010 would demonstrate to 
policy makers that private capital would support well-structured 
securitizations that also have a proper alignment of interests between 
the sponsor and the triple-A investors. Based in part on the success of 
our two recent mortgage securitizations and ongoing discussions with 
triple-A investors, we have confidence that the private market will 
continue to invest in safe, well-structured, prime securitizations that 
are backed by ``good'' mortgage loans. We consider ``good'' loans as 
loans on properties where the borrowers have real down payments, 
capacity to repay, and good credit. We are proud of our history of 
sponsoring residential mortgage securitizations and our more recent 
role in helping to restart the private securitization market, and are 
pleased to have the opportunity to share our insights and observations 
with the Committee.
The Private Mortgage Securitization Outlook for 2011
    The outlook for nongovernment or private-label residential mortgage 
securitization volume backed by newly originated mortgage loans (new 
securitizations) in 2011 remains very weak by historical standards. 
Year-to-date through April 30, 2011, only one new securitization 
totaling $295 million has been completed, and that was our deal. We 
hope to complete two more securitizations in 2011 and securitize 
between $800 million and $1.0 billion for the year, and to build upon 
that volume in 2012. There are no good industry estimates for new 
private securitization volume in 2011, as the market is still thawing 
from its deep freeze. While we would welcome other securitizations in 
2011 to provide additional third-party validation of the viability of 
securitization, the yearly volume will almost certainly be a small 
fraction of the $180 billion average annual issuance completed from 
2002 through 2007, when the market began to shut down. \3\
---------------------------------------------------------------------------
     \3\ 2011 Mortgage Market Statistical Annual, Volume II, p. 31.
---------------------------------------------------------------------------
Major Hurdles to Private Mortgage Securitization Activity
1. Crowding out of private sector
    Through the GSEs and the Federal Housing Administration (FHA), the 
Government has stepped in and taken the credit risk on about 90 percent 
of the mortgages originated in the U.S., without passing on the full 
cost of the risk assumed. Government subsidies must be scaled back to 
permit a private market to flourish. We note that post-crisis, the 
private asset-backed securities markets for auto loans, credit cards 
loans, and now commercial real estate loans are up and functioning, 
while the private-label RMBS market barely has a pulse. The difference 
is the pervasive below-market Government financing in the residential 
mortgage sector that is crowding out traditional private market 
players.
    Critics will argue that Redwood's transactions were backed by 
unusually high quality jumbo mortgage loans and are therefore not 
representative of the market. In fact, that argument proves the point 
that the Government is crowding out private label securitizations, by 
maintaining an abnormally high conforming loan limit and by subsidizing 
the guarantee fees that the GSEs charge issuers. No private sector 
securitizer can compete with that--we can only securitize the small 
volume of prime quality loans beyond the Government's reach. We are 
ready to purchase and securitize prime mortgage loans of any loan 
amount, and can do so at an affordable rate once the Government creates 
a level playing field.
    We strongly advocate testing the private market's ability to 
replace Government-dependent mortgage financing on a safe and measured 
basis. A first step would be to allow the scheduled reduction in the 
conforming loan limit in high cost areas from $729,750 to $625,500 to 
occur as scheduled in September 2011. We believe there is ample 
liquidity in the banking system to allow banks to step into the breach, 
while financing through private residential mortgage securitization 
regains its footing.
    Additionally, the Administration should follow through on its plan 
to increase guarantee fees to market levels over time to eventually 
level the field between the private market and the GSEs. A gradual 
Government withdrawal from the mortgage market over a 5-year period 
will enable time for a safe, attractive, robust private label market to 
develop.
    As the housing market begins to recover, we support further 
measured reductions on a periodic basis in the conforming loan limit as 
a means to increase the share of the mortgage market available to the 
private sector. We note that with housing prices now down in excess of 
30 percent from their peak in mid-2006, \4\ it would seem logical to 
consider reducing the conforming loan limit by a similar amount over 
time.
---------------------------------------------------------------------------
     \4\ S&P/Case-Shiller Home Price Index press release dated April 
26, 2011.
---------------------------------------------------------------------------
2. Balance Sheet Capacity of Commercial Banks
    The second hurdle to increased private securitization activity is 
the unprecedented amount of liquidity in the banking system. With $1.5 
trillion in excess liquidity and historically low funding costs, there 
is no financial incentive for bank originators to securitize loans. 
Instead, banks are eager to retain their non-GSE eligible mortgage loan 
originations for their balance sheet loan portfolio in order to earn 
the attractive spread between their low cost of funds and the rate on 
the loans. To the extent that banks are selling nonagency loans, they 
are generally selling longer duration mortgages to reduce their 
interest rate risk. We expect this issue to resolve itself when the Fed 
eventually withdraws the excess liquidity from the banking system.
3. Regulatory
    In the wake of the Dodd Frank Act, there are many new regulatory 
requirements and market standards out for comment, but they are not yet 
finalized. The resulting uncertainty keeps many market participants out 
of the market. Once the rules of the road are known, market 
participants can begin to adjust their policies, practices, and 
operations.
            A. Dodd-Frank Act Implementation Overview
    We recognize joint regulators had a very difficult task in 
establishing, writing, and implementing the new rules as required by 
the Dodd-Frank Act. Before I go through specifics, we offer some high 
level observations on the joint regulators' notice of proposed 
rulemaking on risk retention (NPR).
    The NPR as written has some technical definitional and mechanical 
issues that need to be fixed. In particular, how the premium capture 
account works. This issue has been the source of much debate and ire by 
market participants. We are hopeful that appropriate corrections will 
be made after all comment letters are received.
    We would also note that regulators took a well-intentioned approach 
to craft a new set of risk retention rules to cover the entire mortgage 
securitization market which, in theory, should be a more expedient 
method for restarting securitization. However, there are complex 
differences between the prime and subprime markets and their unique 
securitization structures that make it very difficult to apply a one-
size-fits-all set of new rules.
    The details are far too complex for this testimony, but to 
oversimplify, the proposed rules are effectively subprime-centric. 
While the rules do a good job of addressing and deterring abuses of 
subprime securitization structures, they are overly and unnecessarily 
harsh when applied to prime securitization structures. This is 
meaningful since prime loans are likely near 90 percent of the overall 
market. If the proposed rules are adopted as written, prime borrowers 
whose loans are financed through private securitization will face 
unnecessarily higher mortgage rates.
    In Redwood's comment letter to the NPR, we intend to offer a more 
refined approach that would keep intact the necessary safety 
protections, but eliminate the unnecessary structural inefficiencies 
that would lead to higher prime mortgage rates.
    We believe that restoring the prime segment of the market in a safe 
yet efficient manner would bring the greatest benefit to the largest 
number of stakeholders (borrowers, lenders, investors, and taxpayers) 
and would become more effective and productive than attempting to craft 
one all encompassing regulatory solution.
            B. Form of Risk Retention
    We are strong advocates of requiring securitization sponsors to 
retain risk in order to properly align their interests with those of 
investors. We support the intent of the joint regulators' NPR on this 
issue. In fact, it has always been Redwood's operating model to retain 
the first-loss risk in our securitizations.
    The NPR proposes four forms of risk retention: (1) a horizontal 
slice consisting of the most subordinate class or classes; (2) a 
vertical slice with pro-rata exposure to each class; (3) a combination 
of horizontal and vertical slices; and (4) a randomly selected sample 
of loans.
    Redwood believes the most effective form of risk retention is the 
horizontal slice and that other forms are much less effective. The 
horizontal slice requires the sponsor to retain all of the first-loss 
securities and places the sponsor's entire investment at risk. Only 
that approach will provide the required incentive for a sponsor to 
ensure that the senior securities are backed by safe and sound loans, 
which will benefit borrowers as well as investors.
    The other forms of risk retention result in substantially less of 
the sponsor's investment in the first risk position, which reduces the 
incentive to sponsor quality securitizations. Over time, we believe 
investors will vote on the best form of risk retention and reward 
sponsors that retain horizontal ``skin in the game.''
            C. Qualified Residential Mortgages
    We support the intention of the proposed definition of a qualified 
residential mortgage (QRM), but we believe it is a bit too restrictive. 
We support the concept of ``common sense'' underwriting, similar to the 
standards used by the GSEs for so many years prior to the period 
leading up to the credit bubble that resulted in low credit losses for 
many years. We note there is nothing in the NPR that prohibits lenders 
from making loans that do not meet the QRM standards.
            D. Servicer Functions and Responsibilities
    We believe that the well-publicized mortgage servicing issues are 
an impediment to broadly restarting private residential mortgage 
securitization. Beyond the issue of lost documents and foreclosure 
practices, servicers have been on the front lines throughout the recent 
crisis. Focusing more narrowly on their role in the securitization 
structure, they have sometimes been placed in the position of having to 
interpret vague contractual language, ambiguous requirements, and 
conflicting direction. In their role, they are required to operate in 
the best interest of the securitization and not in the interest of any 
particular bond holder. In practice, without any clear guidance or 
requirements, they invariably anger one party or another when there are 
disagreements over what is and is not allowed--with the result of 
discouraging some triple-A investors from further investment in RMBS. 
We propose that uniform standards governing servicer responsibilities 
and conflicts of interest be established and that a credit risk manager 
be established to monitor servicer performance and actions. We have 
discussed this servicing issue in greater detail and have proposed 
recommendations in our ``Guide to Restoring the Private-Sector 
Residential Mortgage Securitization'', which is available on our Web 
site.
Other Hurdles to Private Mortgage Securitization
    While the focus of this hearing is on the state of the 
securitization markets and we believe we are moving in the right 
direction and addressing the securitization issues we need to address, 
we also need to broaden the focus beyond lenders and Wall Street. If we 
really want to restore a safe securitization market, we should also 
address second liens. One of the significant factors that contributed 
to the mortgage and housing crisis was the easy availability of home 
equity loans. Plain and simple, the more equity that a borrower has in 
his or her home, the more likely that borrower will continue to make 
mortgage payments.
    Although the proposed QRM standard will encourage lenders to 
originate loans to borrowers who have a minimum 20 percent down 
payment, there is no prohibition against the borrower immediately 
obtaining a second lien to borrow back the full amount of that down 
payment. The addition of a second lien mortgage that substantially 
erodes the borrower's equity and/or substantially increases a 
borrower's monthly debt payments increases the likelihood of default on 
the first mortgage. Many of the current regulatory reform efforts are 
centered on creating an alignment of interests between sponsors and 
investors through risk retention or ``skin-in-the-game.'' However, the 
first and most important line of defense is at the borrower level. If 
the borrower can take his or her own ``skin'' out of the game through a 
second mortgage, what have we really accomplished? The answer is very 
little. We believe this result will be very discouraging to private-
label RMBS investors.
    To prevent the layering of additional leverage and risk, it is 
common in other forms of secured lending (including commercial and 
corporate lending) to require either the consent of the first lien 
holder to any additional leverage or to limit the new borrowing based 
on a prescribed formula approved by the first lien holder. We recommend 
extending this concept to residential mortgages.
    Specifically, we recommend enactment of a Federal law that would 
prohibit any second lien mortgage on a residential property, unless the 
first lien mortgage holder gives its consent. Alternatively, a second 
mortgage could be subject to a formula whereby the new combined loan-
to-value (based on a new appraisal) does not exceed 80 percent.
Impact on Mortgage Rates
    Some market participants have been very vocal about the potential 
negative impact on mortgage rates as a result of the proposed 
definition of a QRM and/or the phase out of the GSEs. Recent news 
articles have speculated that mortgage rates will rise dramatically, by 
as much as 300 basis points. We don't agree.
    We do believe residential mortgage rates could rise modestly--by 
perhaps 50 basis points--as the Government withdraws from the market. 
The Government support effectively subsidizes borrowing rates and it is 
reasonable to expect these rates to rise somewhat as the subsidy is 
withdrawn. We nevertheless expect borrowing rates to remain attractive.
    For context, in our most recent deal, the average mortgage interest 
rate for 30-year fixed rate loans backing the securitization was 0.46 
percent above the Government-guaranteed rate. As the number and 
diversity of loans available for private label securitization 
increases, thereby lowering risk, it is possible that residential 
mortgage rates could rise by less than 50 basis points relative to 
Government rates.
    Another reason we do not believe that mortgage interest rates will 
increase substantially is the sheer amount of global investment capital 
looking for ways to generate returns, from bank balance sheets, 
insurance companies, and mutual funds to non-U.S. financial 
institutions, hedge funds, and even residential investment trusts. The 
competition for returns is too great to allow such a rise in mortgage 
rates, assuming well underwritten loans with proper disclosure and 
alignment of interests.
Conclusion
    When I look ahead--and admittedly you need to jump pretty high--I 
see a number of positives emerging: safer mortgages that borrowers can 
afford, the return of loan loss rates to historically low norms for 
newly originated prime loans, and private capital willing to fund 
residential mortgages at affordable rate for borrowers through 
responsible, safe securitization. The first step is to give the private 
sector a chance by following through on the Administration's plan to 
reduce the conforming loan limits and increase the GSE's guarantee fees 
to market rates at a safe and measured pace.
    Thank you for the opportunity to testify before the Subcommittee 
today. I would be happy to answer your questions.
                                 ______
                                 
                 PREPARED STATEMENT OF LISA PENDERGAST
           President, Commercial Real Estate Finance Council
                              May 18, 2011
    The Commercial Real Estate (CRE) Finance Council is grateful to 
Chairman Reed, Ranking Member Crapo, and the Members of the 
Subcommittee for holding this hearing to examine the state of the 
securitization market. Commercial real estate is the backbone of the 
American economy. Commercial real estate houses the space where 
everyone in your States goes to work and, in the case of multifamily, 
live. Specifically, commercial real estate comprises the office 
buildings where employees work; the strip malls, grocery stores and 
other retail establishments where goods are sold and food purchased; 
the small business spaces on main street that drive local economies; 
the industrial complexes that produce steel, build cars, and create 
jobs; the hospitals where doctors tend to the sick; and the hotels 
where relatives, vacationers and business executives stay.
    The CRE Finance Council represents all constituencies in the 
broader CRE finance market that provides the money to finance these 
businesses, and we appreciate the opportunity to share our views on the 
current state of the Commercial Mortgage-Backed Securities (CMBS) 
sector of the securitization markets. As explained in detail below, the 
CMBS market is in the early stages of what we hope will be a robust 
recovery. At this moment, the securitization risk retention framework 
mandated by Dodd-Frank is the biggest threat to sustaining that 
recovery. While we are thankful to both Senator Crapo for his amendment 
to Dodd-Frank that created specific a CMBS retention framework, and to 
the regulators for considering that framework in their deliberations, 
we have serious concerns with the proposed rules. Specifically, there 
are three areas under the rules that could negatively affect the 
industry if implemented as proposed, including the: (1) Premium Cash 
Capture Reserve Account; (2) Conditions for a third party to purchase 
the risk; and (3) the exemption for qualified commercial loans. Under 
the terms of the statute, those rules will not go into effect until 
2013. It is critical that the six agencies that are charged with 
implementing the CMBS components of that securitization risk retention 
framework take whatever time they need now to get the rules right. We 
therefore ask you to communicate with the regulators and urge them to 
take their time finalizing this important set of rules by extending the 
current June 10th rulemaking response date and by then reproposing the 
draft rule which--hopefully--will incorporate and respond to the 
extensive industry feedback that they will receive.
Introduction and Overview
    The $7 trillion commercial real estate market in the United States 
is just emerging from a period of serious duress brought on by the 
severe economic downturn, and significant hurdles remain to recovery in 
the near term. The challenges posed by the distress the CRE market has 
experienced will continue to have an impact on U.S. businesses that 
provide jobs and services, as well as on millions of Americans who live 
in multifamily housing. Since 2009, the CRE problem shifted from a 
crisis of confidence and liquidity to a crisis of deteriorating 
commercial property fundamentals, plummeting property values and rising 
defaults. Through 2017, approximately $600 million of CMBS loans and 
over $1.2 trillion in outstanding commercial mortgages will mature, 
many of which are secured by smaller CRE properties; borrower demand to 
refinance those obligations will be at an all-time high. \1\
---------------------------------------------------------------------------
     \1\ The Dodd-Frank NPR: Implications for CMBS, April 12, 2011, 
Morgan Stanley at 1.
---------------------------------------------------------------------------
    Prior to the onset of the economic crisis, commercial mortgage-
backed securities (CMBS) were the source of approximately half of all 
CRE lending, providing approximately $240 billion in capital to the CRE 
finance market in 2007 alone. After plummeting to a mere $2 billion in 
2009 at the height of the crisis, the CMBS market began to see signs of 
life in 2010 with $12.3 billion in issuance. Thus far in 2011, just 
under $10 billion CMBS have been issued, with projections for full-year 
volume ranging from $30 to $50 billion. Furthermore, the total CMBS 
issuance for 2011 is expected to range from $30 to $50B, depending on a 
number of factors including economic conditions and the manner in which 
regulatory and accounting changes are implemented.
    One of the overarching questions faced at this juncture is whether 
CMBS will be able to satisfy the impending capital needs posed by the 
refinancing obligations that are coming due. Without CMBS, there simply 
is not enough balance sheet capacity available through traditional 
portfolio lenders such as banks and life insurers to satisfy these 
demands. It is for this reason that Treasury Secretary Geithner noted 2 
years ago that ``no financial recovery plan will be successful unless 
it helps restart securitization markets for sound loans made to 
businesses--large and small.'' \2\ Similarly, then-Comptroller of the 
Currency John C. Dugan noted that, ``[i]f we do not appropriately 
calibrate and coordinate our actions, rather than reviving a healthy 
securitization market, we risk perpetuating its decline--with 
significant and long-lasting effects on credit availability.'' \3\
---------------------------------------------------------------------------
     \2\ Remarks by Treasury Secretary Timothy Geithner Introducing the 
Financial Stability Plan (Feb. 10, 2009) available at http://
www.ustreas.gov/press/releases/tg18.htm.
     \3\ Remarks by John C. Dugan, Comptroller of the Currency, before 
the American Securitization Forum (Feb. 2, 2010), at 2 (available at 
http://www.crefc.org/uploadFiles/CMSA_Site_Home/Government_Relations/
CMBS_Issues/TALF_Treasury_Plans/DuganRemarksatASF201.pdf.).
---------------------------------------------------------------------------
    Against this backdrop, Congress adopted a credit risk retention 
framework for asset-backed securities in the Dodd-Frank Wall Street 
Reform and Consumer Protection Act (Dodd-Frank). \4\ At the same time, 
the CRE finance industry has taken direct steps to strengthen the CMBS 
market and to foster investor confidence through the completion of 
``market standards'' in the areas of representations and warranties; 
underwriting principles; and initial disclosures. Scores of members of 
the CRE Finance Council across all of the CMBS constituencies worked 
diligently on these market reforms for over a year. We anticipate that 
new market standards, coupled with the unparalleled disclosure regime 
already in place in the CMBS market, will create increased transparency 
and disclosure in underwriting and improved and enforceable industry 
representations and warranties, all of which we believe will go a long 
way toward meeting both investor demands and the Dodd-Frank risk 
retention objectives.
---------------------------------------------------------------------------
     \4\ Pub. L. No. 111-203.
---------------------------------------------------------------------------
    We are thankful to Senator Crapo, who added a provision to Dodd-
Frank requiring the regulators to specifically address some of the 
unique issues and opportunities posed by the CMBS asset class in 
crafting the risk retention rules for CMBS. And we are grateful to the 
regulators who have abided by this mandate in issuing their initial set 
of proposed risk retention rules for comment.
    That said, the proposed rule is long and complicated, containing 
over 300 pages of analysis and roughly 170 questions open for comment. 
As explained in detail below, several facets of the proposal are 
controversial. Indeed, as the regulatory process moves forward, many 
will argue that implementing certain requirements--or the failure to 
implement certain requirements--will be a death knell for the market. 
The more likely outcome is that the failure to get the details right 
will restrict the overall amount of capital that is available through 
the securitization finance markets. The proposed rules impose 
additional costs on and will--in some cases--disincentivize issuers and 
disrupt the efficient execution of capital structures that 
securitization provides.
    If not properly constructed, the risk retention rules could 
potentially result in a significantly smaller secondary market, less 
credit availability, and increased cost of capital for CRE borrowers. 
This may result in balance sheet lending (i.e., portfolio lending) at 
more competitive rates (which would be counter to historical 
experience), thus attracting the safest risks to the portfolio space 
and leaving the smaller and/or riskier loans for the CMBS where 
borrowers will have to pay higher rates. Further, small borrowers--
those that are not concentrated in the major urban areas and that need 
loans in the sub-$10 million space--would be the primary victims of 
these changes. For these reasons, 23 separate trade organizations, 
representing many different types of borrower constituencies, as well 
as lenders and investors in different asset classes, jointly signed a 
letter last year urging careful consideration of the entirety of the 
reforms to ensure that there is no disruption or shrinkage of the 
securitization markets. \5\
---------------------------------------------------------------------------
     \5\ A copy of the March 25, 2010, letter is attached.
---------------------------------------------------------------------------
    As our members continue to work through the proposed rule to better 
crystallize our views, we cannot overstate the stakes, given that this 
rule will directly impact credit availability and the overall economic 
recovery. The agencies need to satisfy the somewhat arbitrarily imposed 
Congressionally mandated rule promulgation schedule, and we are 
concerned that the ultimate judgments they reach may not be as soundly 
thought through as a more generous schedule would allow. We therefore 
ask that you consider extending those deadlines; this may be especially 
appropriate given the fact that under the Dodd-Frank provisions the 
rules for nonresidential asset-backed securities would not go into 
effect for an additional 2 years and our industry could still abide by 
that final effective date even if more time were allotted prior to 
finalizing the actual rules.
    We also ask that you urge the regulators to take advantage of such 
an extended rule promulgation schedule by both (a) holding public 
roundtables to ensure that the public understands the intent behind 
each proposed provision, and (b) reproposes the rules for further 
comment after initial comments are received on June 10th. As one 
prominent commentator has noted:

        Still, that there appeared to be such a wide gap between 
        regulators' intentions and the market's interpretation for the 
        proposal's language suggests that a single round of formal 
        market feedback, after which the regulators finalize the rules, 
        may not be enough. This would especially be the case if the 
        final rules indeed contained substantial revisions to key 
        provisions, such as the premium capture account. Such revisions 
        could introduce fresh confusion or misrepresentation of the 
        regulators' intentions. \6\
---------------------------------------------------------------------------
     \6\ Citigroup Global Markets CMBS Weekly at 10 (April 29, 2011).

    As noted, such a deliberate approach and a reproposal of the rules 
need not alter the effective implementation date for the industry, 
given that the statute does not dictate that the rules be effective 
until 2013 and the CMBS industry does not need 2 years to effectuate 
the new retention requirements.
    The balance of our testimony will focus on six key areas:

  1.  A description of the CRE Finance Council and its unique role;

  2.  The current state of CRE finance, including the challenges that 
        loom for the $3.5 trillion in outstanding CRE loans;

  3.  A framework for a recovery, including the unique structure of the 
        commercial market and the importance of having customized 
        regulatory reforms;

  4.  The CRE Finance Council's market standards initiatives, which 
        have been designed to build on existing safeguards in our 
        industry, to promote certainty and confidence that will support 
        a timely resurgence of the CRE finance market in the short 
        term, and a sound and sustainable market in the long term;

  5.  The CRE Finance Council's general reactions to the recently 
        proposed regulation to implement Dodd-Frank's risk retention 
        requirement; and

  6.  Actions that can be taken to ensure that the CMBS securitization 
        market continues to heal and recover.
Discussion
1. The CRE Finance Council
    The CRE Finance Council is the collective voice of the entire $3.5 
trillion commercial real estate finance market, including portfolio, 
multifamily, and CMBS lenders; issuers of CMBS; loan and bond investors 
such as insurance companies, pension funds, and money managers; 
servicers; rating agencies; accounting firms; law firms; and other 
service providers.
    Our principal missions include setting market standards, 
facilitating market information, and education at all levels, 
particularly related to securitization, which has been a crucial and 
necessary tool for growth and success in commercial real estate 
finance. To this end, we have worked closely with policy makers in an 
effort to ensure that legislative and regulatory actions do not negate 
or counteract economic recovery efforts in the CRE market. We will 
continue to work with policy makers on this effort, as well as our 
ongoing work with market participants and policy makers to build on the 
unparalleled level of disclosure and other safeguards that exist in the 
CMBS market, prime examples of which are our ``Annex A'' initial 
disclosure package, and our Investor Reporting PackageTM 
(IRP) for ongoing disclosures.
    While the CMBS market is very different from other asset classes 
and is already seeing positive developments, the CRE Finance Council is 
committed to building on existing safeguards, to promote certainty and 
confidence that will support a timely resurgence in the short term and 
a sound and sustainable market in the long term. In this regard, we 
have worked with market participants to develop mutually agreed upon 
improvements needed in the CRE finance arena that will provide an 
important foundation for industry standards. Prime examples of our work 
include both the CRE Finance Council's ``Annex A'' initial disclosure 
package and the Investor Reporting PackageTM for ongoing 
disclosures.
    Furthermore, our members across all constituencies have devoted an 
extraordinary amount of time over the past year to working 
collaboratively and diligently on the completion of market standards 
for: (1) Model Representations and Warranties; (2) Underwriting 
Principles; and (3) Annex A revisions, all of which we previously have 
shared with the regulators charged with implementing the Dodd-Frank 
risk retention rules: the Securities and Exchange Commission, Federal 
Reserve Board, Federal Deposit Insurance Corporation, Department of the 
Treasury, and the Office of the Comptroller of the Currency. We 
anticipate that these three new market standards initiatives, along 
with the unparalleled ongoing disclosure offered by our existing IRP, 
will create increased transparency and disclosure in underwriting and 
improved industry representations and warranties and enforcement, which 
we believe will go a long way toward meeting both investor demands and 
Dodd-Frank objectives.
2. The Current State of CRE Finance
    CRE is a lagging indicator that is greatly impacted by 
microeconomic conditions, and as such, began to be affected by the 
prolonged economic recession relatively late in the overall economy's 
downward cycle. What started as a ``housing-driven'' recession due to 
turmoil in the residential/subprime markets (in which credit tightened 
severely) quickly turned into a ``consumer-driven'' recession, 
impacting businesses and the overall economy. Not surprisingly, CRE has 
come under strain in light of the economic fundamentals today and over 
the last three years, including poor consumer confidence and business 
performance, high unemployment and property depreciation. Unlike 
previous downturns, the stress placed on the CRE sector today is 
generated by a ``perfect storm'' of several interconnected challenges 
that compound each other and that, when taken together, has exacerbated 
the capital crisis and will prolong a recovery:

    Severe U.S. Recession--There is not greater effect on CRE 
        than jobs and a healthy economy. With a prolonged recession and 
        an unemployment rate at or above 8.8 percent for the last 24 
        months, commercial and multifamily occupancy rates, rental 
        income, and property values have subsequently been negatively 
        impacted, thus perpetuating the economic downturn. Those 
        impacts persist even as the recession has abated.

    ``Equity Gap''--During the worst of the economic crisis, 
        our industry saw CRE assets depreciate in value by 30 percent 
        to 50 percent from peak 2007 levels, creating an ``equity gap'' 
        between the outstanding loan amount and the current value of 
        the CRE property, thus requiring additional equity to extend or 
        refinance a loan. This dynamic affects even ``performing'' 
        properties that continue to support the payment of monthly 
        principal and interest on the underlying loans. While there has 
        been some lessening of the equity gap in the past year as the 
        slide in property values slowed, the market is at a sensitive 
        point on the climb toward recovery and a shortage of capital at 
        this stage could cause a resurgence of the equity gap problem.

    Significant Loan Maturities--Approximately $1.2 trillion in 
        CRE loans mature over the next several years. Perhaps most 
        significant is that many of those loans will require additional 
        ``equity'' to refinance given the decline in CRE asset values.

    CMBS Restarting--Slowly--Even in normal economic 
        conditions, the primary banking sector lacked the capacity to 
        meet CRE borrower demand. That gap has been filled over the 
        course of the last two decades by securitization (specifically, 
        CMBS) which utilizes sophisticated private investors--pension 
        funds, mutual funds, life insurance companies, and endowments, 
        among others--who bring their own capital to the table and fuel 
        lending. CMBS accounts, on average, for approximately 25 
        percent of all outstanding CRE debt, and as much as 50 percent 
        at the peak, while readily identifiable properties funded by 
        CMBS exist in every State and Congressional district. However, 
        a prolonged liquidity crisis caused the volume of new CRE loan 
        originations and thus new CMBS to plummet from $240 billion in 
        2007 (when CMBS accounted for half of all CRE lending) to $12 
        billion in 2008 and $2 billion in 2009. In 2010, the CMBS 
        market began to see signs of life with $12.3 billion in 
        issuance, while issuance is expected to range between $30 and 
        $50 billion in 2011, depending upon a number of economic 
        conditions and uncertainty related to regulatory and accounting 
        changes. While there is revitalized activity in the CMBS space, 
        there is a mismatch between the types of loans that investors 
        are willing to finance and the refinancing that existing 
        borrowers are looking for to extend their current loans.

    While the market has evolved from the initial liquidity crisis, 
there is still an unfortunate combination of circumstances that leave 
the broader CRE sector and the CMBS market with three primary problems: 
(1) the ``equity gap'' (again, the difference between the current 
market value of commercial properties and the debt owed on them, which 
will be extremely difficult to refinance as current loans mature); (2) 
a hesitancy of lenders and issuers to take the risk of ``originating'' 
or ``aggregating'' loans for securitization, given the uncertainty 
related to investor demand to buy such bonds (this 3-6 month ``pre-
issuance'' phase is known as the ``aggregation'' or ``warehousing'' 
period); and (3) the tremendous uncertainty created by the multitude of 
required financial regulatory changes, which serve as an impediment to 
private lending and investing, as the markets attempt to anticipate the 
impact these developments may have on capital and liquidity. Indeed, 
market analysts have concluded that regulatory uncertainty will likely 
delay recovery of the securitization markets, including one observer 
that recently concluded that the delay would be for at least another 12 
months. \7\
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     \7\ See, ``A Guide to Global Structured Finance Regulatory 
Initiatives and Their Potential Impact'', Fitch Ratings (Apr. 4, 2011), 
at 1 (available at http://www.fitchratings.com/creditdest/reports/
report_frame.cfm?rpt_id=571646).
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    The importance of the securitized credit market to economic 
recovery has been widely recognized. Both the previous and current 
Administrations share the view that ``no financial recovery plan will 
be successful unless it helps restart securitization markets for sound 
loans made to consumers and businesses--large and small.'' \8\ The 
importance of restoring the securitization markets is recognized 
globally as well, with the International Monetary Fund noting in a 
Global Financial Stability Report last year 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.'' \9\
---------------------------------------------------------------------------
     \8\ Remarks by Treasury Secretary Timothy Geithner Introducing the 
Financial Stability Plan (Feb. 10, 2009) available at http://
www.ustreas.gov/press/releases/tg18.htm.
     \9\ International Monetary Fund, ``Restarting Securitization 
Markets: Policy Proposals and Pitfalls,'' Chapter 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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            Current State of Small Business Lending Finance
    Significantly, it is also important to be aware of the importance 
of securitization to smaller businesses that seek real estate 
financing. The average CMBS securitized loan is $8 million. As of July 
2010, there were more than 40,000 CMBS loans less than $10 million in 
size with a combined outstanding balance of $158 billion, which makes 
CMBS a significant source of capital for lending to small businesses. 
Therefore, when evaluating securitization reforms like the proposed 
risk retention rules, policy makers should be mindful that changes that 
could halt or severely restrict securitization of CRE loans will have a 
disparate adverse impact on small businesses, and on capital and 
liquidity in CRE markets in smaller cities where smaller CRE loans are 
more likely to be originated.
    As many independent research analysts have noted, 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 on a relative basis, 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.
3. A Framework for Recovery--Customized Reforms That Take Into Account 
        the Unique Characteristics of the CMBS
    The private investors who purchase CMBS, and thereby provide the 
capital that supports the origination of loans for CMBS, are absolutely 
critical to restarting commercial mortgage lending in the capital 
markets that are critical to a CRE recovery. Accordingly, Government 
initiatives and other reforms must support private investors--who bring 
their own capital to the table--in a way that gives them certainty and 
confidence to return to the capital markets. This type of support can 
and will vary by asset class. The Board of Governors of the Federal 
Reserve issued a ``Report to the Congress on Risk Retention'' as 
required under the Dodd-Frank mandate, concluding just that:

        simple credit risk retention rules, applied uniformly across 
        assets of all types, are unlikely to achieve the stated 
        objective of the Act--namely, to improve the asset-backed 
        securitization process and protect investors from losses 
        associated with poorly underwritten loans . . . the Board 
        recommends that rule makers consider crafting credit risk 
        retention requirements that are tailored to each major class of 
        securitized assets. Such an approach could recognize 
        differences in market practices and conventions, which in many 
        instances exist for sound reasons related to the inherent 
        nature of the type of asset being securitized. Asset class-
        specific requirements could also more directly address 
        differences in the fundamental incentive problems 
        characteristic of securitizations of each asset type, some of 
        which became evident only during the crisis. \10\
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     \10\ Board of Governors of the Federal Reserve System, Report to 
Congress on Risk Retention (October 2010), at 3 (available at http://
federalerserve.gov/boarddocs/rtpcongress/securitization/
riskretention.pdf). See also Daniel Tarullo, Federal Reserve Governor, 
Statement Before The House Committee on Financial Services (Oct. 26, 
2009) (``A credit exposure retention requirement may thus need to be 
implemented somewhat differently across the full spectrum of 
securitizations in order to properly align the interests of 
originators, securitizers, and investors without unduly restricting the 
availability of credit or threatening the safety and soundness of 
financial institutions.''); John C. Dugan, Comptroller of the Currency, 
Statement on the Federal Deposit Insurance Corporation's Advance Notice 
of Proposed Rulemaking on Securitizations (Dec. 15, 2009), at 1-3 
(``[R]ecent studies note that a policy of requiring a rigid minimum 
retention requirement risks closing down parts of securitization 
markets if poorly designed and implemented. Before proposing and 
implementing such a requirement for all securitizations, further 
analysis is needed to ensure an understanding of the potential effects 
of the different ways in which risk could be retained.'').

    Similarly, the International Monetary Fund has 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.'' International Monetary Fund, 
``Restarting Securitization Markets: Policy Proposals and Pitfalls,'' 
Chapter 2, Global Financial Stability Report: Navigating the Financial 
Challenges Ahead (October 2009), at 109 (``Conclusions and Policy 
Recommendations'' section) available at http://www.imf.org/external/
pubs/ft/gfsr/2009/02/pdf/text.pdf.

    CMBS has innate characteristics that minimize the risky 
securitization practices that policy makers sought to address in Dodd-
Frank. More specifically, the unique characteristics that set CMBS 
apart from other types of assets relate not only to the type and 
sophistication of the borrowers, but to the structure of securities, 
the underlying collateral, and the existing level of transparency in 
---------------------------------------------------------------------------
CMBS deals, each of which are briefly described here:

    Commercial Borrowers: Part of the difficulty for 
        securitization as an industry arose from practices in the 
        residential sector, for example, where 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. In contrast, 
        commercial borrowers are highly sophisticated businesses with 
        cash flows based on business operations and/or tenants under 
        leases (i.e., ``income-producing'' properties). Additionally, 
        securitized commercial mortgages have different terms 
        (generally 5-10 year ``balloon'' loans), and they are, in the 
        vast majority of cases, ``nonrecourse'' loans that allow the 
        lender to seize the collateral in the event of default.

    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 far fewer commercial loans in 
        a pool (traditionally, between 100 to 200 loans; while some 
        recent issuances have had between 30 and 40 loans) that support 
        a bond, as opposed, for example, to residential pools, which 
        are typically comprised of between 1,000 and 4,000 loans. The 
        more limited number of loans (and the tangible nature of 
        properties) in the commercial context 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 typically 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. We 
        also note that certain types of securitized structures are 
        written so conservatively that they do not include a 
        traditional ``B-Piece.'' Such structures, for example, include 
        extremely low loan-to-value, high debt-service-coverage-ratio 
        pools that are tranched only to investment grade.

    Greater Transparency: CMBS market participants already have 
        access to a wealth of information through the CRE Finance 
        Council Investor Reporting PackageTM, which 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. Our reporting package has been so 
        successful in the commercial space that it is now serving as a 
        model for the residential mortgage-backed securities market. By 
        way of contrast, in the residential realm, transparency and 
        disclosure are limited not only by servicers, but by privacy 
        laws that limit access to borrowers' identifying information. 
        Importantly, the CRE Finance Council released version ``5.1'' 
        of the IRP in December, 2010 to make even further improvements. 
        The updated IRP was responsive to investor needs, including 
        disclosures for a new ``Loan Modification Template.'' Also, as 
        referenced above and as discussed in greater detail in Section 
        5 below, CREFC working groups--comprised of all CMBS 
        constituencies (issuers, investors, etc.)--have created 
        standard practices that could be used immediately in the market 
        to enhance disclosure, improve underwriting, and strengthen 
        representations and warranties to ensure alignment of interests 
        between issuers and investors. These consensus standards build 
        on existing safeguards in CMBS and go beyond Dodd-Frank 
        requirements for CRE loans.
4. The CRE Finance Industry's Market Standards
    Another way in which the CMBS space is unique is the nature of the 
engagement of the industry participants. In the wake of the onset of 
the economic crisis and with an eye toward addressing issues that 
prompted policy makers to craft risk retention requirements, the CRE 
Finance Council and its members have been independently working on a 
series of market reforms with a view toward strengthening the 
securitization markets and fostering investor confidence. Our members 
across all constituencies have devoted an extraordinary amount of time 
over the past year to working collaboratively and diligently on the 
development of market standards in the areas of representations and 
warranties and their enforcement; underwriting principles; and initial 
disclosures, all of which have similar aims of strengthening our market 
and fostering investor confidence.
    We anticipate that the new industry market standards, coupled with 
the ongoing disclosure regime offered by our existing IRP, will create 
increased transparency and disclosure in underwriting and improved 
industry representations and warranties, which we believe will go a 
long way toward meeting both investor demands and Dodd-Frank 
objectives. We believe that these standards will be used both (1) in 
the marketplace immediately, and (2) by the regulators as they continue 
to contemplate how to properly construct the final risk retention 
rules.
    Having previously shared these projects with the regulators charged 
with implementing the Dodd-Frank risk retention rules, the CRE Finance 
Council also wishes to provide some information to Congress as well 
about the projects.
            Representations and Warranties
    Building upon existing customary representations and warranties for 
CMBS, the CRE Finance Council has created Model Representations and 
Warranties that represent industry consensus viewpoints. 
Representations and warranties relate to assertions that lenders make 
about loan qualities, characteristics, and the lender's due diligence. 
The CRE Finance Council's model was the result of 200-plus hours of 
work by our Representations and Warranties Committee over the last 6 
months, and represents the input of more than 50 market participants 
during negotiations to achieve industry consensus.
    The Model Representations and Warranties were specifically crafted 
to meet the needs of CMBS investors in a way that is also acceptable to 
issuers. Such Model Representations and Warranties for CMBS will be 
made by the loan seller in the mortgage loan purchase agreement. 
Issuers are free to provide the representations and warranties of their 
choosing, and the representations and warranties will necessarily 
differ from one deal to another because representations and warranties 
are fact based. However, issuers will be required to present all 
prospective bond investors with a comparison via black line of the 
actual representations and warranties they make to the newly created 
CRE Finance Council Model Representations and Warranties. Additionally, 
loan-by-loan exceptions to the representations and warranties must be 
disclosed to all prospective bond investors.
    Finally, the CRE Finance Council also has developed market 
standards for addressing and resolving breach claims in an expedited, 
reliable and fair fashion by way of mandatory mediation before any 
lawsuit can be commenced, thereby streamlining resolution and avoiding 
unnecessary costs.
    For many investors, strengthened and new representations and 
warranties coupled with extensive disclosure are considered a form of 
risk retention that is much more valuable than having an issuer hold a 
5 percent vertical or horizontal strip. The CRE Finance Council 
believes that its Model Representations and Warranties are a practical 
and workable point of reference that has been vetted by the industry, 
and we intend to explore whether industry-standard representations and 
warranties such as the CRE Finance Council's model could be adopted by 
regulators to serve as ``adequate'' representations and warranties as 
contemplated by the Dodd-Frank menu of options for risk retention for 
commercial mortgages.
    Moreover, industry-standard representations and warranties could be 
used in at least two other regulatory contexts. First, the conditions 
on third-party retention in the proposed regulation contemplate 
securitizer disclosures regarding representations and warranties, and 
the possible use of blacklines against industry-standard 
representations and warranties. We are exploring the possibility of 
suggesting use of the CRE Finance Council's model for this purpose.
    In addition, Dodd-Frank Section 943(1) directs the SEC to develop 
regulations requiring credit rating agencies (CRAs) to include in 
ratings reports a description of the representations, warranties, and 
enforcement mechanisms available to investors for the issuance in 
question, along with a description of how those representations, 
warranties, and enforcement mechanisms differ from those in ``issuances 
of similar securities.'' CRAs have played an important role in the CRE 
Finance Council's development of Model Representations and Warranties, 
and we believe the Model Representations and Warranties can facilitate 
CRAs' fulfillment of their new reporting requirements under Dodd-Frank 
Section 943(1).
            Loan Underwriting Principles
    Commercial mortgages securitized through CMBS do not easily lend 
themselves to the development of universally applicable objective 
criteria that would be indicative of having lower credit risk as 
envisioned under Dodd-Frank or otherwise. This is because these 
nonrecourse loans are collateralized by income streams from an 
incredibly diverse array of commercial property types that cannot be 
meaningfully categorized in a way that would allow for the practical 
application of such objective ``low credit risk'' criteria. For 
example, it is difficult to meaningfully compare property types such as 
hotels, malls, and office buildings, and credit risk profiles can also 
vary by geographic location, so that it would be even more difficult to 
compare a resort in Hawaii to a shopping mall in Texas or an office 
building in New York. In short, commercial properties are not 
homogeneous and do not lend themselves to a ``one size fits all'' 
underwriting standard that could be deemed ``adequate.''
    The industry accordingly created a framework of principles and 
procedures that are characteristic of a comprehensive underwriting 
process that enables lenders to mitigate the risk of default associated 
with all loans, and a disclosure regime that requires representations 
as to the manner in which that underwriting process was performed. The 
intent of the Underwriting Best Practices is to be responsive to 
investors and market participants; provide for the characteristics of 
low-risk loans; and provide for common definitions and computations for 
the key metrics used by lenders.
    Our membership believes that this principles-based underwriting 
framework can and will generate the underwriting of lower credit risk 
CMBS loans and, when combined with necessary and appropriate 
underwriting transparency, will allow investors to make their own 
independent underwriting evaluation and be in a position to better 
evaluate the risk profiles of the loans included in the CMBS issuances 
in which they are considering investing. It is also critical to note 
that the majority of the underwriting principles and disclosures 
outlined in our best practices are already standard industry practices, 
though they had not previously be formally outlined or presented.
    The Underwriting Principles were developed with a view toward 
reducing risk through use of market analysis; property and cash flow 
analysis; borrower analysis; loan structure and credit enhancements; 
risk factors such as macro- and property-type risks. With respect to 
defining numerical underwriting metrics, our project recognized the 
impossibility of imposing uniform metrics since the characteristics of 
a ``low risk'' CRE loan could vary by property type, area of the 
country, and even by operator, and low risk loan-to-value ratios differ 
by geographic area.
    While we have long maintained that it is not possible or even 
advisable for regulators to attempt to define uniform underwriting 
``standards'' for CRE loans due to the heterogeneous nature of 
commercial mortgages underlying CMBS and the dissimilarity of this 
market to residential, we recognize that regulators have attempted to 
do just that in the qualified commercial loan provisions of the 
proposed risk retention regulations. We wish to point out, in any 
event, that such criteria exclude many low-risk loans from qualifying 
for the exemption, and should not be viewed as the sole framework for 
assessing whether a commercial mortgage is low risk.
            ``Annex A'' Initial Disclosures
    The CRE Finance Council's ``Annex A'' has long been a part of the 
package of materials given to investors as part of CMBS offering 
materials, and provides detailed information on the securitized 
mortgage loans. In conjunction with the SEC's Spring 2010 proposal to 
revise its Regulation AB, our members commenced an initiative to 
review, update, and standardize Annex A, which has resulted in changes 
to Annex A incorporating numerous additional data points concerning the 
assets underlying CMBS. This work was the effort of both issuers and 
investors.
    These changes, together with the information already required by 
Annex A, closely conform Annex A with the Schedule L asset-level 
disclosure framework proposed by the Commission under Regulation AB. 
The CRE Finance Council's newly created standardized Annex A provides 
numerous additional data points concerning the assets underlying CMBS, 
including, but not limited to:

    Changes to the Loan Structure Section with regard to 
        Disclosures on supplemental debt. Examples include, but are not 
        limited to, detail of all rake, B-note, subordinated mortgage, 
        mezzanine debt, and preferred equity as well as information 
        regarding the debt owner, coupon, loan type, term, 
        amortization, debt service calculation, debt yield, cumulative 
        DSCR, and LTV calculations through the capital structure.

    Additionally, issuers will now be providing a breakdown of 
        net operating income into revenue and expenses for historic and 
        underwriting basis.

    Added information on the fourth and fifth largest tenants 
        at a property to the tenant information section--most Annex As 
        in the past would contain information on the three largest 
        tenants at a property, that information being square footage 
        leased, percent of overall net rentable square feet, and lease 
        expiration date.

    In fact, Annex A provides more information than required under 
Schedule L and is available to market participants in more expedited 
fashion. At the same time, the new standardized Annex A is consistent 
with the existing practices that CMBS market issuers and other 
participants have developed to provide CMBS investors with clear, 
timely and useful disclosure and reporting that is specifically 
tailored for CMBS investors. We believe that such consistency will 
avoid unnecessary increases in transaction costs while still delivering 
enhanced clarity and transparency.
    It follows that the CRE Finance Council's Annex A is a practical 
and workable framework that has already been vetted by the industry, 
and we believe it can be adopted by the SEC to implement the asset-
level and loan-level disclosure requirements in Dodd-Frank Section 
942(b), and those in Proposed Schedule L to SEC Regulation AB.
5. Preliminary Views on the Proposed Risk Retention Rule
    The proposed risk retention regulations, released in late March, do 
attempt to fulfill the Congressional mandate embodied in the Crapo 
amendment by offering different options for satisfying the risk 
retention requirements (e.g., vertical, horizontal, or L-shape 
retention structures) and by providing asset-class specific options 
including a set of CMBS-specific provisions to satisfy the retention 
mandate. As a community, our members appreciate the efforts to create 
rules by asset class, given the unique nature of the CMBS market.
    At the same time, the proposed risk retention regulations are 
complex, and we are in the process of studying and discussing them with 
the different CMBS constituencies included under the CRE Finance 
Council umbrella (including lenders, issuers, servicers, and investors, 
among others) in order to fully evaluate their potential impact and to 
provide useful feedback to regulators on their proposal. As the Board 
of Governors of the Federal Reserve Report cited above also noted, the 
totality of the regulatory changes that are being put into motion--
including the various new disclosure and credit rating agency reform 
provisions included in Dodd-Frank, the accounting changes that must be 
effectuated, and the new Basel capital requirements regime--must be 
considered in toto in making this evaluation:

        [R]ulemakings in other areas could affect securitization in a 
        manner that should be considered in the design of credit risk 
        retention requirements. Retention requirements that would, if 
        imposed in isolation, have modest effects on the provision of 
        credit through securitization channels could, in combination 
        with other regulatory initiatives, significantly impede the 
        availability of financing. In other instances, rulemakings 
        under distinct sections of the Act might more efficiently 
        address the same objectives as credit risk retention 
        requirements. \11\
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     \11\ Id. at 84.

    Viewed through this lens, there are elements of the proposed 
retention regime that raise potential concerns in the market and, 
overall, the proposal has prompted more questions than it answers. Our 
preliminary view, however, is that the structural framework of the 
CMBS-specific provisions could provide a workable foundation for 
implementing the risk retention rules as Congress envisioned in Dodd-
Frank. That said, there are areas where the rule could have unintended 
adverse consequences for securitization and the broader CRE finance 
markets. At the same time, the purpose of many important provisions is 
unclear, and they will likely need to be refined to ensure that they 
accomplish their intent in the least disruptive manner. Needless to 
say, the stakes are high with the impact on credit availability 
weighing in the balance and we look forward to working with Congress 
and the regulators to ensure a regulatory framework that supports a 
sound and vibrant securitization market, which is critical to consumers 
in the U.S. economy.
            The Proposed Risk Retention Regulation for Commercial 
                    Mortgages
    By way of background, the proposed risk retention regulation 
contains ``base'' risk retention requirements that generally apply to 
all asset classes. The base requirements include a number of options 
for the securitizer to hold the required 5 percent retained interest, 
such as: a ``vertical slice,'' which involves holding 5 percent of each 
class of ABS interests issued in the securitization; a horizontal 
residual interest, which requires that the securitizer retain a first-
loss exposure equal to at least 5 percent of the par value of all the 
ABS interests issued in the transaction; and an ``L-shaped'' option 
which involves a combination of the vertical and horizontal options. 
The CRE Finance Council believes generally that the menu of options for 
holding the retained interest will be beneficial in that this 
flexibility will foster more efficient and practical structuring of 
securitizations than a one-size-fits-all approach, and we commend 
regulators for the thought and effort they put into developing these 
options.
    The retained risk would be required to be held for the life of the 
securitization. No sale or transfer of the retained interest would be 
permitted, except in limited circumstances.
    Notably, the base retention regime includes a restriction on the 
ability of securitizers to monetize excess spread on underlying assets 
at the inception of the securitization transaction, such as through 
sale of premium or interest-only (IO) tranches. As discussed below in 
greater detail, this provision, which requires securitizers to 
establish a ``premium capture cash reserve account'' where a 
transaction is structured to monetize excess spread, and to hold this 
account in a first-loss position even ahead of the retained interest, 
has generated considerable confusion throughout the market, and the 
purpose of the provision is unclear. It should be noted that this 
particular provision is one that is prompting significant concerns 
about a potential adverse impact on the viability of the CMBS market, 
as well as questions about whether it can be implemented as a practical 
matter without shutting down the market for new CMBS issuance.
    Hedging of the retained interest is generally prohibited, although 
the proposed regulation gives securitizers the ability to use tools, 
such as foreign currency risk hedges, that do not directly involve 
hedging against the specific credit risk associated with the retained 
interest. The continued ability to use market risk hedges is a matter 
the ABS issuer community viewed as critical to the viability of 
securitization, and we believe that the proposed rule is generally 
responsive to market's concerns in that regard.
    With respect to CMBS specifically, the Crapo Dodd-Frank amendment 
mandated that the regulators consider several specific alternatives for 
risk retention to strengthen the CRE market and to support a recovery 
for commercial mortgages, including:

  1.  adequate underwriting standards and controls;

  2.  adequate representations and warranties and related enforcement 
        mechanisms; and/or

  3.  a percent of the total credit risk of the asset held by the 
        securitizer, originators, or a third-party investor.

    The proposal does not address the representations/warranties 
alternative at all but we are hopeful that the regulators will consider 
the role of the CRE Finance Council developed market-standards 
discussed above when it considers revisions to the risk retention 
regime. In addition to the base risk retention rules, there are two 
important provisions specific to commercial mortgages that relate to 
the other statutory alternatives. First, there is an option to have a 
third-party purchaser hold a 5 percent horizontal first-loss position. 
The third-party retention option is subject to several conditions, 
which are being closely examined, but market participants have noted a 
lack of clarity with respect to some of the conditions, and there are 
concerns that some of the conditions may create significant 
disincentives for use of this retention option. An unworkable third-
party retention option would render the rule more inflexible, which may 
run counter to the intent of Congress when it outlined third-party risk 
retention as one of the options for the CRE market in Dodd-Frank.
    Second, there is a commercial mortgage loan exemption that would 
subject qualified commercial mortgage loans to a 0 percent retention 
obligation, if several criteria are met. While we understand that 
regulators intended that only a small subset of ``low-risk'' loans 
would qualify for the exemption, our initial examination of the CRE 
exemption provision reflects that the parameters for qualified 
commercial mortgages are so narrow that virtually no CRE mortgage could 
qualify. This stands in contrast to other asset classes, where we 
understand that proposed exemptions could cover an appreciably larger 
percentage of the universe of loans.
    Three components of the proposed rules have generated the most 
internal discussion and debate.
            Premium Capture Cash Reserve Accounts
    First, there is considerable confusion and concern within the CRE 
finance community about the proposed rule's requirement that 
securitizers establish a ``premium capture cash reserve account'' when 
a transaction is structured to monetize excess spread at the inception 
of the securitization transaction, such as through an IO tranche. One 
issue is that the purpose of such a requirement is unclear. The 
narrative to the proposed rule states that the purpose of the premium 
capture is to prevent sponsors of the securitization from ``reduc[ing] 
the impact of any economic interest they may have retained in the 
outcome of the transaction and in the credit quality of the assets they 
securitized,'' \12\ presumably by extracting all of their profit on the 
deal at the outset. However, we were informed through preliminary 
discussions with the regulatory agencies, for example, that the premium 
capture feature was designed to ensure that the retained interest, 
whether held by the sponsor or a third party, represents 5 percent of 
the transaction proceeds.
---------------------------------------------------------------------------
     \12\ Risk Retention NPRM at 89.
---------------------------------------------------------------------------
    The effect of the proposal as drafted would be for all revenue from 
excess spread (which is virtually all revenue) to be retained for the 
life of the transaction. An analogy, for example; would be to consider 
if the rule were applied to your local sandwich shop owner. The owner, 
for example, spends money up front--say $1,000--to purchase bread, 
meat, cheese, mustard, and other sandwich making supplies. He then 
sells all his sandwiches to customers for $3,000, a gross profit of 
$2,000. He uses that profit to pay his workers; buy more sandwich 
supplies and to invest in his business. However, under the PCCRA, he 
can only collect the cost of the sandwich on the day he sells it to his 
customer. The net profit of $2,000 must go into an escrow account, and 
cannot be put to use for 10 years. Under this business strategy, it is 
difficult to imagine that many delis would be left open in the country.
    Such a mechanism will inhibit an issuer's ability to pay operating 
expenses, transaction expenses, and realize profits from the 
securitization until, typically, 10 years from the date of a 
securitization. Thus, while the proposed rule's narrative expressed 
regulators' expectation that the premium capture feature would merely 
prompt securitization sponsors to stop structuring securitizations to 
monetize excess spread at closing, \13\ the broader impact would be to 
make the securitization business very unattractive to sponsors, which 
in turn, would shrink capital availability. For this reason, many in 
our industry have significant concerns about the premium capture 
component having an adverse impact on the viability of the CMBS market.
---------------------------------------------------------------------------
     \13\ See id. at 90.
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            Conditions for Retention by a Third-Party Purchaser
    Second, the third-party retention option that was specifically 
designed for CMBS also has generated substantial discussion. Under the 
proposal, the option is subject to several conditions. Most notable 
among the conditions is a requirement that an independent Operating 
Advisor be appointed where a third-party purchaser retains the risk and 
also has control rights (itself or through an affiliate) that are not 
collectively shared with all other classes of bondholders, such as 
servicing or special servicing rights. The Operating Advisor would have 
to be consulted on all major servicing decisions, such as loan 
modifications or foreclosures, and would have the ability to recommend 
replacement of the servicer or special servicer if it determines that 
the servicer or special servicer is not acting in the best interests of 
the investors as a whole. Only a majority vote of each class of 
bondholder would prevent the servicer or special servicer from being 
replaced in this instance.
    As a preliminary matter, certain aspects of the Operating Advisor 
provision are not sufficiently fleshed out, and our membership believes 
that additional clarity will be necessary for an Operating Advisor 
framework to function efficiently. For example, other than requiring 
the Operating Advisor to be independent, the proposed rule provides no 
specifics on qualifications for an entity to serve as an Operating 
Advisor, such as whether the entity should have expertise in dealing 
with the class of securities that are the subject of the 
securitization. CMBS servicing can be a complex and highly fact-
specific enterprise and CMBS transaction parties, including B-piece 
buyers who might hold the retained interest under the proposed rule and 
who may handle servicing or special servicing, are sophisticated and 
very experienced in these matters. It is unlikely that such a B-piece 
buyer would accept the appointment of an Operating Advisor lacking in 
CMBS expertise to oversee servicing. Nor should this be desirable from 
the regulators' perspective, since an unqualified Operating Advisor is 
unlikely to add value, and would only add to transaction costs.
    B-piece buyers and issuers also have raised concerns that the 
Operating Advisor requirement may create other significant 
disincentives for use of the third party retention option. For example, 
some question whether it is necessary for an Operating Advisor to have 
the authority to oversee servicing and have replacement rights from the 
deal's inception, when a B-piece buyer's capital is at risk in a first-
loss position, which gives a B-piece/servicer incentives that are more 
fully aligned with those of other investors. Moreover, there are 
concerns that the addition of another administrative layer in the 
securitization process may make the servicing and workout of 
securitized loans more difficult from the borrower's perspective.
    Some investment-grade investors have expressed interest in the 
Operating Advisor construct, but there clearly is room to better hone 
the powers of and the limitations on the requisite Operating Advisor. 
For example, one suggestion being discussed to address concerns of B-
piece buyers and investment-grade investors may be to have the 
Operating Advisors' recommendations to replace servicers approved by a 
majority vote of investors, rather than requiring a majority to 
disapprove as the proposed rule currently contemplates.
    We note that there is precedent in the market for use of 
independent Operating Advisors in these circumstances, as the industry 
has developed a fairly standard Operating Advisor framework with input 
from B-piece buyers, investors, and issuers in the past few years. The 
most practical analogue to examine among past transactions are those 
that only involved an independent Operating Advisor once the B-piece 
buyer/servicer is ``out of the money'' and its interests theoretically 
would not align with those of other bondholders. Such a structure might 
solve the alignment of interest concern while also addressing B-piece 
buyers' reluctance to have servicing decisions second-guessed by a 
third-party when the B-piece buyer's investment is first in line should 
there be losses.
            Exempt Commercial Mortgages
    There is a commercial mortgage loan exemption that would subject 
``qualified'' commercial mortgage loan pools to a 0 percent retention 
obligation, if several criteria are met. Regulators have stated that 
they only intended for a relatively small percentage of loans, meeting 
a set of ``low-risk'' characteristics, to qualify for the exemption. 
While the CRE Finance Council understands this objective, our initial 
examination of the CRE exemption provision reflects that the parameters 
for qualified commercial mortgages are so narrow that virtually no CMBS 
mortgages could qualify.
    The exemption's 20-year maximum amortization requirement, for 
instance, presents perhaps the most significant hurdle to 
qualification, since commercial mortgages are amortized on a 30-year 
basis. Rather than utilizing an amortization period as a criterion, a 
better metric for assessing the risk characteristics of a loan may be 
to use the loan-to-value ration at origination and maturity. Also 
problematic is the requirement that borrowers covenant not to use the 
property as collateral for any other indebtedness, which appears to 
effectively prohibit subordinate debt. Currently, borrowers typically 
are permitted to have subordinate debt upon lender approval (e.g., 
loans that have subordinate debt funded concurrent with the first 
mortgage). It follows that an outright prohibition on subordinate debt, 
regardless of lender approval, may be viewed by borrowers as an undue 
restriction of their ability to manage their finances.
    That said, as part of its market standards initiative, the CRE 
Finance Council submitted an underwriting principles framework white 
paper to the regulators during the rulemaking process highlighting the 
difficulty in creating universally objective metrics that would 
indicate that a loan is ``low risk'' in the very heterogeneous 
commercial mortgage space. Given the proposed rule, however, we are 
taking a fresh look at these issues and attempting to evaluate whether 
the ``qualified CRE loan'' construct could be reworked to be of value 
for CRE loans. There are loan segments outside of the typical conduit 
loan structure--like large loan and single borrower securitization 
deals--that may be more suited for the exemption treatment and we are 
evaluating what the appropriate ``low risk'' metrics should be for such 
deals.
    Additionally, a fourth area of concern about the proposed rule that 
should be highlighted relates to the duration of retention, and a 
prohibition on sale or transfer of retained interest. As mentioned, the 
proposed rule contemplates holding the retained interest for the life 
of the bond, and imposes a permanent prohibition on the sale or 
transfer of retained risk. Both of these features would restrict the 
flow of capital into the markets for an unnecessarily long time period, 
a situation that is even less desirable in light of the $1 trillion in 
commercial mortgage maturities that will occur in the next few years, 
at the same time the CMBS market is struggling to recover. We also note 
that in the third-party retention context, a permanent prohibition on 
the sale or transfer of retained risk would not be acceptable to many 
B-piece buyers.
    Our members are evaluating the extent to which the proper alignment 
of risk can be achieved without making the mandated retention 
permanent. We also believe that it is not necessary to completely 
restrict any sale or transfer of retained interest to achieve the risk 
retention regulation's goals. A modification to the proposed rule to, 
for example, allow transfer of a B-piece buyer's or sponsor's retained 
interest to a ``qualified'' transferee, who would have to comply with 
the obligations imposed on the transferor and meet other criteria, 
would address this concern.
    On all of these issues as well as for the more technical issues 
that will emerge during the course of our evaluation, we intend to work 
with regulators on modifications that will facilitate proper alignment 
of risk without unduly restricting market capital and liquidity.
6. Proactive Measures That Would Encourage a Securitization Market 
        Recovery
    Significantly, the many challenges discussed earlier are 
interconnected and mutually compounding. To address the challenges and 
to help to facilitate a revitalized securitization market, we suggest 
the following:
            Take a Deliberate Approach to the Proposed Risk Retention 
                    Rules
    As discussed at length above, with so many questions remaining 
unanswered, the current proposed rule reads like an advance notice of 
proposed rulemaking. We are concerned that the 60-day public comment 
period, which ends June 10, 2011, does not give the industry sufficient 
time to fully analyze the impact of the proposed rules. Furthermore, 
given our expectation that we will be asking for significant changes, 
we believe that it will be appropriate for the regulators to jointly 
repropose the rules to allow industry a sufficient opportunity to 
digest and comment on the revised retention framework. The sheer 
complexity of these markets demands a thoughtful and deliberate 
approach to rulemaking, and a more iterative process helps achieve this 
crucial goal. As part of this process, it is critical to evaluate 
workable counter-proposals that could make the risk retention regime 
work in a way that will minimize adverse unintended consequences to 
credit availability and the overall economy while achieving an 
appropriate alignment of risk as Congress intended.
    Furthermore, our members believe it would be extremely helpful to 
have more interactive discussion between regulators and the public, 
particularly as the industry seeks to ensure that it correctly 
understands both the regulatory goals and intent of certain provisions, 
and to work cooperatively to develop acceptable alternatives. We are 
aware that the staffs of the Commodity Futures Trading Commission and 
the Securities and Exchange Commission have planned a two-day joint 
public roundtable on issues associated with the rules to govern swaps 
under Dodd-Frank. We believe that a similar opportunity to have a 
dialog with the relevant agencies to discuss risk retention rules would 
be beneficial to all, and could even foster a more efficient rulemaking 
process since the aim would be to inform the agencies' understanding of 
industry concerns while the agencies are still in the process 
developing final rules, rather than afterward.
            Create a U.S. Covered Bond Market
    The CRE Finance Council supports ``H.R. 940, the U.S. Covered Bond 
Act of 2011,'' (covered bond) that the House Financial Services Capital 
Markets Subcommittee passed last week by voice vote. The bill, which 
was reintroduced by Capital Markets Subcommittee Raking Member Garrett 
and Congresswoman Maloney, would include high-quality CMBS as eligible 
collateral in a newly created U.S. covered bond market. Covered bonds, 
which were originated in Europe are securities issued by a financial 
institution and backed by a specified pool of loans known as the 
``cover pool.'' Bondholders have a preferential contractual claim to 
the pool in the event of the issuer's insolvency. In the United States, 
a typical covered bond transaction involves an insured depository 
institution (IDI) selling mortgage bonds, secured by the cover pool, to 
a trust or similar entity (known as a ``special purpose vehicle'' or 
``SPV''). The pledged mortgages remain on the IDI's balance sheet 
securing the IDI's promise to make payments on the bond, and the SPV 
sells ``covered bonds,'' secured by the mortgage bonds, to investors. 
In this fashion, the IDI generates more capital that can be used, in 
turn, to make more loans or provide financial institutions with a 
bigger cushion for their regulatory capitalization requirements. In 
sum, covered bonds are an elegant mechanism for generating more 
liquidity in the capital markets.
    A problem arises, however, if the IDI becomes insolvent and the 
FDIC assumes control as a receiver or conservator. Once the FDIC takes 
over, there can be uncertainty about whether the FDIC would continue to 
pay on the bond obligation according to the bond's terms, or whether it 
will repudiate the transaction. If the IDI is also in default on the 
bond, there also can be uncertainty regarding the amount that investors 
would repaid, or at the very least, delay in allowing investors access 
to the bond collateral. The transactions can be hedged to alleviate 
some of these risks, but this increases transaction costs. In the face 
of such risks, investors were reluctant to invest in covered bonds to 
any significant degree; the FDIC reported in July 2008 that only two 
banks had issued covered bonds. The FDIC recognized that covered bonds 
could be a ``useful liquidity tool'' for IDIs and the importance of 
``diversification of sources of liquidity.'' \14\ Therefore, to provide 
a measure of certainty to encourage investment in covered bonds, the 
FDIC issued a Policy Statement in 2008 setting forth directives 
explaining how it would address certain types of covered bond 
obligations in cases in which it has assumed control of an IDI. 
Unfortunately, the FDIC limited the scope of its Policy Statement to 
covered bonds secured by ``eligible assets,'' and limited the 
definition of ``eligible assets'' to residential mortgages. As a 
result, a market for covered bonds in the CRE mortgage sector has not 
developed.
---------------------------------------------------------------------------
     \14\ Covered Bond Policy Statement, Final Statement of Policy, 
FDIC, 73 Fed. Reg. 43754, 43754 (July 28, 2008).
---------------------------------------------------------------------------
    Significantly, however, commercial mortgages and CMBS are already 
permitted in covered bond pools in most European jurisdictions, \15\ 
which also accord the appropriate and necessary regulatory treatment, 
including capital requirements, with respect to covered bonds to 
facilitate the market and to better serve consumers and businesses 
seeking access to credit. It follows that in order to be globally 
competitive, any U.S. covered bond regime should include commercial 
mortgages and CMBS, and that the overall regulatory framework should be 
closely aligned with the approach used by our European counterparts. 
Such a framework will give U.S. consumers and businesses access to the 
same sources of credit availability, supporting our overall recovery 
and we applaud the Committee's passage of the covered bond bill 2 weeks 
ago.
---------------------------------------------------------------------------
     \15\ Legislative frameworks for covered bonds in the following 
countries specifically permit the use of commercial mortgage loans as 
collateral: Austria, Bulgaria, Denmark, Finland, France, Germany, 
Hungary, Iceland, Ireland, Italy, Latvia, Luxembourg, the Netherlands, 
Norway, Poland, Portugal, Romania, Spain, Sweden, and the United 
Kingdom. In addition, all European jurisdictions that permit the use of 
residential mortgage-backed securities (RMBS) in cover pools also 
permit the use of CMBS.
---------------------------------------------------------------------------
    While covered bonds should not and cannot replace CMBS as a capital 
source for the CRE mortgage market, facilitating a commercial covered 
bond market will be additive. Covered bonds can provide yet another 
source of liquidity for financial institutions to help raise much 
needed capital to fund CRE loans, and in turn, ease the current CRE 
credit crisis, which persists despite high borrower demand. Indeed, in 
the current environment, covered bonds could be a helpful means of 
raising capital relative to CMBS, particularly today as the cost of 
capital related to a covered bond deal could be less volatile than for 
CMBS. Such conditions also could assist financial institutions in 
aggregating collateral for a covered bond issuance, in contrast with 
the aggregation difficulties now being experienced in the CMBS market.
            Ensure Credit Rating Transparency
    Dodd-Frank includes extensive credit rating agency reform 
provisions, and the CRE Finance Council and its members generally are 
supportive of any reforms that require CRAs to provide more information 
about individual ratings and their rating methodologies.
    In terms of credit ratings performance, the CRE Finance Council 
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 for structured finance 
products--a concept that has been debated and rejected by the SEC, 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. \16\
---------------------------------------------------------------------------
     \16\ In comments filed with the SEC in July 2008, the CRE Finance 
Council (filing under its former CMSA name) 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.
---------------------------------------------------------------------------
Conclusion
    Today, the CMBS market is showing some positive signs that it is 
slowly moving toward recovery. However, with $1 trillion in commercial 
mortgage loans maturing in the next few years, it will be critically 
important that risk retention regulations be implemented in way that 
does not severely constrict or shut down altogether the securitization 
markets. The CRE Finance Council appreciates the fact that the general 
construct of the proposed risk retention rule attempts to customize and 
provide options for the commercial mortgage asset class. At the same 
time, our members strongly believe that the proposal needs 
clarification in many areas. And we also have concerns about the impact 
of some of the details, including concerns that these aspects could 
make securitization an untenable prospect for issuers and third-party 
investors.
    The CRE Finance Council believes these concerns can, and should, be 
addressed in an extended rulemaking process that we hope you will 
encourage, and we anticipate working with regulators on clarifications 
and refinements that can achieve an appropriate alignment of risk while 
also avoiding undue restriction of capital and liquidity in the CRE 
finance market.
                                 ______
                                 
               PREPARED STATEMENT OF ANN ELAINE RUTLEDGE
                   Founding Principal, R&R Consulting
                              May 18, 2011
    Chairman Reed, Ranking Member Crapo, and distinguished Members of 
the Subcommittee, my name is Ann Rutledge. You have asked about the 
current conditions in the mortgage and asset-backed securities markets. 
You want to hear whether today's impediments to capital formation and 
liquidity are going to resolve themselves based on reforms or best 
practices in use today--or whether other mechanisms or perhaps policy 
initiatives need to be added to the mix, to reignite securitization. As 
an independent consultant and, at times, critic of securitization 
market practices, I am deeply honored that you have asked me to 
testify.
    You may not have heard of R&R Consulting before now. We are a 
seven-person structured finance boutique cofounded by me and my 
partner, Sylvain Raynes. I resigned from Moody's Investors Service's 
Structured Finance Group at the end of 1999, when it was becoming clear 
that Moody's was shedding its franchise-defining commitment to research 
and becoming a ratings factory. It was also clear that this was 
happening at a moment in the market's development when thought 
leadership was becoming more important than ever. I saw the mission of 
R&R as a continuation of the role Moody's was moving away from, thought 
leadership. Our business vision was to serve the market by refining and 
unifying the techniques we learned at Moody's into a single framework 
of analysis that could be used on all asset classes, at all points in 
time, to obtain consistent, reliable, capital-efficient results.
    I believe today that the goal of a unified framework of analysis is 
where the securitization market still must go if we are going to (a) 
restore investor trust in the securitization markets and (b) address, 
head-on, the needs of the real economy for capital. Many people have 
commented on the need to rebuild investor trust. However, I don't hear 
nearly enough discussion about how to channel funds into the real 
economy with securitization.
    The assumption seems to be that all will be well once the market 
comes back. However, as we commented in Elements of Structured Finance, 
\1\ structured finance and securitization marshaled unimaginable 
quantities of money before--but to what end? It is difficult to base a 
persuasive economic case for securitization on what has been achieved 
so far. Moreover, we have been too occupied with making money and 
mourning the loss of the big money machine to acknowledge that the 
microstructure of the securitization market is badly broken. If we want 
it to come back, we must be prepared to accept certain changes in the 
way it works--beginning with the fact that we need to understand how it 
works. We cannot delegate the work of understanding it to others, any 
more than we can delegate the work of understanding the foundation of 
our civil society to others. Once we understand what the market can and 
cannot do, the changes that need to be made will seem very fundamental 
and achievable. I would like to talk to you from my reform-oriented 
perspective about what is precious and worth preserving about this 
market, where the challenges lie, what reforms are working, and what 
still needs to be done.
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     \1\ Rutledge, Ann, and Sylvain Raynes, ``Elements of Structured 
Finance'', Oxford University Press, May 2010.
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The Good News: Bragging Rights; Thought and Financial Leadership and 
        the Economy Restored
    Securitization is a quintessential American innovation, a melding 
together of financial innovations from our 19th Century railroad crisis 
experience and our 20th Century savings and loan crisis experience. So, 
let's pat ourselves on the back before we ask--which innovations? 
First, the discovery that, in insolvency, the railroad company's 
capital structure could be restructured to make both the debt and 
equity investors better off. Second, credit ratings: a key for 
investors to discern relative value in securities issued from complex 
structures like railroad bonds (and securitizations). Third, cash flow 
modeling technologies based on a different set of metrics than those 
used in options markets, developed by engineers and information 
specialists no longer needed for the Cold War effort, and made 
ubiquitous by the affordable (also quintessentially American) PC and 
spreadsheet software.
    Substantively, securitization enables investors to look beyond 
public corporate finance disclosures to find additional evidence of 
value or risk through a close analysis of company financial 
receivables--private data. Where value can be found, it can be 
monetized without adding to company or system risk using standard 
securitization structuring techniques and a feedback loop. Part of the 
value that is discovered can be returned, to reward the producers who 
have created the value and help them continue to grow. America's 
credibility and thought leadership in finance have taken a severe 
beating as a result of the credit crisis. Nowhere is our fall from 
grace more apparent than in China, where I taught a securitization 
course last month. But, an America that can rebuild its economy with 
sustainable securitization markets while building incentives for 
producers in the capital-intensive sectors of the economy will, 
forcibly, continue to lead the world financially too.
    Securitization works where traditional corporate finance does not, 
because it is less stylized and more capable of using a variety of data 
types. What this means in practical terms is that securitization holds 
promise as a means of channeling capital towards our SME sector and our 
social priorities--education, health care and the arts--where 
traditional corporate finance tools are ill-suited. Securitization also 
has a beneficial financial impact because it accelerates the speed and 
accuracy with which capital circulates between lenders and borrowers. 
Let me illustrate this point with reference to the health care 
industry. Beyond the question of delivery of basic health care 
services, there is the funding problem caused by inefficiencies in the 
cash cycle of hospitals. The establishment of a system of registering 
title to health care receivables and discounting them using a uniform 
set of standards could release billions of dollars of much-needed 
capital to hospitals, particularly if the insurance companies were 
given incentives to make early claims payment. R&R estimates that bona 
fide health care securitization is a $1.5 trillion dollar a year 
market.
    This vision for securitization as a funding solution for tough 
sectors may be grand, but in order to carry it out, the market needs to 
sharpen its proverbial pencil. Historically, securitization has 
flourished primarily in consumer sectors, where no particular industry 
or modeling expertise is required for deals to come to market. 
Overdevelopment of consumer markets is a generalized problem in 
securitization. In Russia, during 2007, the mortgage securitization 
markets developed so rapidly that primary mortgage bankers, already in 
scarce supply, became unaffordable to many banks. Ironically, mortgage 
lending activities declined as a result. And yet, Russia's real need 
for capital was in the SME sector, not homes.
    The problems of unbalanced growth and the failure to clone 
securitization to new opportunities have a single, straightforward 
solution: skill development through training. The U.S. has many MBA 
programs and finance departments, but securitization is not taught in 
the vast majority of them--most certainly not by people who have deal 
experience. This shortage of teaching talent would disappear quickly if 
the securitization market made skill development more of a priority.
The Bad News: What Reinventing the Corporate Paradigm Does to Banks
    Before securitization, banks were the supply chain of capital. They 
made money by exploiting market discontinuities: small banks earned 
spread income from borrowers; regional banks earned spread income from 
small banks; and universal banks earned spread income from regional 
banks; etc.
    Securitization knits the funding markets together into a seamless 
credit supply chain, where the cost of capital is no longer a function 
of the risk of the balance sheet it happens to be sitting on, but 
rather a function of the ultimate borrower's payment ability. It makes 
the borrower's payment ability more transparent, and it expands the 
market for the borrower's credit. Securitization did not cause the 
changes--deregulation, financial education, and the Internet caused 
them--but securitization is a solution to the problem of credit market 
inefficiency from which banks have benefited so long--as long as there 
have been banks and corporations. Securitization is an inconvenient 
reality for banks, because it erodes their information monopoly, so 
that they can no longer control the price of credit locally. 
Effectively it turns their core business from dealing to broking, which 
is much less profitable.
    No one, perhaps, saw this paradigm shift for what it was in the 
first phase of the market, from 1976-1997. Those were very good years, 
with new asset types coming on stream, new structures, and so much 
surplus capital being released that had been locked up in the economy, 
everyone involved in securitization prospered. New consumer companies 
got startup capital easily; existing companies lowered their funding 
costs; investors enjoyed unprecedentedly low default rates, far below 
what the ratings implied; and at deal origination, professional 
services firms lined up for a sliver of the expected residual. It was, 
as Buck Henry tells Teri Garr in Steve Martin's The Absent-Minded 
Waiter, ``an incredible experience.'' (In this comedy-short, Steve 
Martin as the absent-minded waiter commits every imaginable faux pas 
but then hands Buck nearly $10,000 in change before the bill is paid--
precisely what Buck came for.)
    In the late 1990s, as the credit risk premium and the surpluses 
disappeared, the strategy of securitizing banks shifted to exploiting 
different loopholes, in particular, those built into different rating 
methods. The endgame of this strategy was the subprime crisis. Although 
recounting what happened in detail is beyond the scope of this paper, 
it is not very hard to depict (see the figure below) or explain. The 
hard part is that once we explain it, we feel compelled to fix it, and 
there are no easy solutions for the banking industry other than to meet 
more the rigorous disclosure requirements that are coming into effect 
now.
    But I would remind the Banking Committee that one of the most 
fertile periods of American financial innovation came in the mid-to-
late 1980s, when regulatory tightening brought the trading of financial 
derivatives into exchanges and the swaps market was born. There is 
still much room for banks in America to innovate in credit engineering 
without operating as if credit were a zero sum game. Credit is not a 
zero sum game. Everybody benefits from responsible lending.
Disclosure Disciplines
    If securitization knits the credit markets together into a supply 
chain, the biggest challenge to securitization is sealing off the leaks 
as capital circulates through it. I believe there are two key places 
where the leakages occur. One is the disclosure problem. I believe 
Regulation AB does an excellent job of addressing the disclosure 
problem. As a former securitization analyst, I worked with Reg AB even 
before it was promulgated; and as a consultant, I have come to rely 
extensively on Reg AB as a workable, well-designed information standard 
for this market. Reg AB speaks the language of securitization. It 
requires disclosure of all the material deal data elements needed for 
valuation.


    Reg AB makes it possible for investors to do for themselves what 
rating agencies do not do: continuous rerating so that a conclusion can 
be drawn about how the deal worked out. Rerating is important because 
the composition of risk and value in these deals can shift, sometimes 
very dramatically. For well-structured transactions, the risk decreases 
over time, but for improperly structured transactions, the 
deterioration can be sudden and shocking if one does not know how to 
continuously monitor and value the exposure.
    Reg AB is currently being revised, and the SEC has said it wants to 
see cash flow model outputs posted as well as raw data elements. I 
believe that this requirement is an important mechanism by which the 
market can organize and communicate its thinking about value. Once a 
deal is structured, there is actually very little flexibility around 
the interpretation of the value proposition. Analysts may disagree on 
the path of future cash flows, but there is no reason to disagree about 
how the deal works, which is what the cash flow model outputs show. 
This requirement therefore reduces the ``mystery of valuation'' by one 
more important dimension.


Discounting Disciplines
    There is one more mechanism (or policy item, perhaps) that I 
believe the securitization market needs if it is going to come back in 
a sustainable fashion. The rating scale for structured finance needs to 
be taken away from the rating agencies and it needs to be published, 
perhaps after discussion and consensus among the G20, so that everyone 
can know the technical definition of each notch on the rating scale.
    The structured finance rating scale is fundamentally different than 
that for corporate finance. Perhaps you have not thought about 
securitization this way, but securitization is a kind of ``discount 
window'' for corporations to cash in their receivables at some blended 
rate, which can be expressed as the weighted average interest cost of 
the transaction in which the receivables are being refinanced.
    Each notch on the scale corresponds to a level of asset impairment: 
AAA signifies impairment in only a very slight degree (when we worked 
at Moody's, the numerical meaning was an average 0.06 BP loss of yield 
on the security), whereas AA signifies slightly more, A even more, 
etc., in exponential increments going down the scale to single-C. 
Effectively, the rating agencies are setting the levels of risk and 
leverage of the financial system.
    That is a ridiculous situation. It is analogous to leaving the 
decision of how large an inch or a meter should be to the individual 
tailor. Government policy makers should be making this decision, not 
rating agencies. The structured rating scale is the ultimate tool for 
calibrating the expansion of credit to the rate of economic growth. 
Although it has never been used that way before, this is a very good 
time to begin to learn how to synchronize the microstructure of the 
securitization credit markets with macroeconomic credit policy.
    At the same time, the scale (and its revisions) should be made 
public so that anyone who cares about the health of the securitization 
markets can do their own analysis of outstanding deals. It is 
impossible, finally, for anyone including sophisticated investors to 
form an opinion about whether a structured rating is right without 
access to technical rating definitions. But, since most people do not 
rate securitizations, most people do not even realize they have been 
denied access to this crucial piece of market infrastructure. It is as 
if the City of New York (or Washington) enforced speed limits for 
driving in different districts but refused to disclose what the speed 
limits were. Circulation would not shut down, but considerable road 
efficiency and resilience would be lost as a result of drivers having 
to guess, constantly, whether or not they were driving at the legal 
speed.
                                 ______
                                 
                 PREPARED STATEMENT OF CHRIS J. KATOPIS
         Executive Director, Association of Mortgage Investors
                              May 18, 2011
Introduction
    Chairman Reed and Ranking Member Crapo, and distinguished Members 
of the Subcommittee, thank you for the opportunity for the Association 
of Mortgage Investors (AMI) to testify and comment on this critically 
important topic.
    The Association of Mortgage Investors (AMI) commends you and your 
Senate colleagues for your leadership in pursuing responsible and 
effective oversight and vigilance to enhance the health and 
effectiveness of the U.S. financial markets, and in particular, the 
U.S. housing finance system. In summary, currently, mortgage investors 
suffer from a number of problems in the securitization space including:

    Market opacity, an asymmetry of information, and a thorough 
        a lack of transparency;

    Poor underwriting standards;

    A lack of standardization and uniformity concerning the 
        transaction documents;

    Numerous conflicts-of-interest among servicers and their 
        affiliates;

    Antiquated, defective, and improper mortgage servicing 
        practices; and,

    Investors lack effective legal remedies for violations of 
        RMBS contractual obligations and other rights arising under 
        State and Federal law.
I. Background
    The AMI was formed to become the primary trade association 
representing investors in mortgage-backed securities (MBS), along with 
life insurance companies, State pension and retirement systems, 
university endowments, and pension funds. It has developed a set of 
policy priorities that we believe can contribute to achieving this 
goal. We were founded to play a primary role in the analysis, 
development, and implementation of mortgage and housing policy that 
keep homeowners in their homes and provide a sound framework that 
promotes continued home purchasing. In practice, only three sources of 
residential mortgage capital exist in the United States: (1) the bank 
balance sheets--which are arguably full and stressed; (2) the 
Government (Fannie Mae, Freddie Mac, FHA); and, finally, (3) 
securitization, which is effectively shutdown for the reasons described 
herein.
    Today's U.S. mortgage market consists of approximately $11 trillion 
in outstanding mortgages. Of that $11 trillion, approximately one-
half--$5.4 trillion--are held on the books of the GSEs as agency 
mortgage-backed securities (issued by one of the agencies) or in whole 
loan form. Another $4.0 trillion are on the bank balance sheets as 
whole loans or securities in their portfolios, of which $1 trillion are 
second liens (i.e., home equity loans/lines of credit or closed end 
second mortgages). \1\ Of the $1.1 trillion outstanding second 
mortgages, only 3.7 percent of the total (or $41 billion) is held by 
private investors in securitized form. The remaining $1.2 trillion in 
first lien mortgages reside in private label mortgage-backed securities 
(MBS). AMI's members hold a significant proportion of these 
investments; AMI members have approximately $300 billion of assets 
under management.
---------------------------------------------------------------------------
     \1\ Observers note that while PLS represents approximately 12.8 
percent of the first lien market, they represent 40 percent of the 
loans that are currently 60+ days delinquent.
---------------------------------------------------------------------------
    The development of enhanced structures, standards, and safeguards 
will contribute to improving the functioning of capital markets for all 
investment asset classes, especially those pertaining to a necessity of 
life, namely housing. Your work will contribute to helping to keep 
Americans in their homes, making credit available, and the development 
of effective tools against the foreclosure crisis.
    Mortgage investors share your frustration with the slow restoration 
of the housing market, relief for homeowners, and finally offering the 
capital markets and homeowners that are truly in need meaningful and 
permanent relief. In fact, the markets for Residential Mortgage Backed 
Securities (RMBS) securitization have virtually ground to a halt since 
the financial crisis for reasons that we will enumerate. \2\ We are 
hopeful that meaningful solutions can be implemented more quickly, and 
we believe that our interests are aligned with responsible homeowners. 
As difficult as it may be to believe, many of the most sophisticated 
investors were as victimized and abused by the servicers and their 
affiliates as were many consumers. Investors are essential in order to 
rebuild the private mortgage market. However, investors and their 
private capital will only return to a market which is transparent, has 
nonconflicted stakeholders, and the protection of contract law.
---------------------------------------------------------------------------
     \2\ The exceptions are two recent securitizations by Redwood 
Trust.
---------------------------------------------------------------------------
a. The Role of Mortgage Investors in the Marketplace
    Mortgage investors, through securitization, have for decades 
contributed to the affordability of housing, making credit more 
inexpensive, and making other benefits available to consumers. Today, 
however, mortgage investors face enormous challenges in the capital 
markets due to opacity, an asymmetry of information, poor underwriting, 
conflicts-of-interests by key parties in the securitization process, as 
well as the inability to enforce rights arising under contracts, 
securities, and other laws. This list is by no means intended to be 
exhaustive. Accordingly, investors, average Americans, and the U.S. 
economy at-large are harmed.
b. The History and Rise of MBS Securitization
    It is important to note that securitization as a mortgage finance 
tool has been instrumental in reducing housing costs and helping 
citizens achieve the American dream of homeownership. In the 1970s, the 
mortgage finance industry was in its infancy. In fact, then the market 
consisted solely of two products--those backed by Ginnie Mae and 
Freddie Mac. The advent of the mortgage-backed securities market 
resulted in deregionalizing or nationalizing real estate investment 
risk, increasing liquidity to mortgage originators, and lowering 
barriers to home ownership. Securitization was a key factor in 
improving regional real estate markets. New York State is a case in 
point. In the 1970s, most New York depositories were flush with cash 
but had a hard interest rate limit on mortgages. The result was a flow 
of California mortgages to New York and a flow of dollars to 
California. New York was an unattractive and noncompetitive local 
market. With securitization, the New York market, as well as other 
markets became national markets; and hence, mortgage funds were more 
readily available. Since the 1970s, mortgage-backed securities have 
increased lending levels, with even State housing agencies benefiting 
from the mortgage-backed securities' structuring techniques. The 
benefits of securitization are widely known. \3\
---------------------------------------------------------------------------
     \3\ See, e.g.,``Securitization and Federal Regulation of Mortgages 
for Safety and Soundness'', CRS Report for Congress at 2 (RS-22722, 
Oct. 21, 2008). (``This securitization of mortgages increased the 
supply of funds available for mortgage lending'').
---------------------------------------------------------------------------
II. Mortgage Investors' Interests Align With Responsible Borrowers
    Mortgage investors are aligned with both homeowners and the 
Government in our shared goals of keeping responsible Americans in 
their homes and rebuilding and maintaining a vibrant real estate 
market. In fact, the maintenance of a healthy securitization market is 
a vital source of access to private capital for mortgages as well as 
autos and credit cards. Moreover, an efficient securitization market 
provides more and cheaper capital to originators, which allows them to 
issue more loans to additional qualified borrowers. The use of 
mortgage-backed securities equitably distributes risk in the mortgage 
finance industry, and prevents a build-up of specific geographic risk. 
These features, and many others, are those of a market which makes 
access to capital cheaper and thus spurs more mortgage lending.
    Mortgage investors seek effective, long-term sustainable solutions 
for responsible homeowners seeking to stay in their homes. We are 
pleased to report that mortgage investors, primarily the first lien 
holders, do not object to modifications as part of a solution. 
Unfortunately, mortgage investors are often powerless under the 
operative Pooling and Servicing Agreements (PSA) to offer such support. 
We strive for additional remedies to assist homeowners. Likewise, if a 
borrower speculating in the housing market, engaging in a strategic 
default or paying only their second lien mortgages, then they should 
not be eligible for receiving subsidized first lien interest rates. 
Potential structural changes that should be examined include: full 
recourse, blockage of interest payments on second lien debt if the 
first lien is in default, prohibitions on the second lien debt above a 
specified loan-to-value (LTV).
    Those ``private label'' (non-Federal agency) securities are put 
together by a variety of entities (e.g., investment banks) that pool 
the mortgages into a trust. The trust is built around a document called 
a Pooling and Servicing Agreement (PSA) that provides investors the 
rights and protections relating to the mortgages that make up the 
securitization and the terms and duties that are owed to the investors 
by the trustee of the security and the servicer of the individual 
mortgages. Within this Agreement, numerous representations and 
warranties exist regarding the quality of the mortgages that are 
included in the trust and the lending practices that were followed in 
the mortgage origination process. It is important to note that, 
historically, investment in these mortgage products have been 
attractive, in part, because they are governed by binding contracts 
that lend the stability and to the predictability investors desire. 
Like any purchaser, investors expected the sellers of mortgage 
securities (which were often large banks) to stand behind their 
promises. Similarly, the GSEs, the Federal Reserve Bank of New York, 
and others confront the same challenges. Unfortunately, this critical 
component of mortgage securities market has broken down, harming 
mortgage investors including State pension and retirement systems.
    With a restored, vital, and healthy securities market, we will be 
able to attract more private capital into mortgage investments and, in 
turn, provide more affordable mortgages for potential qualified home 
buyers.
Problems Arising From Improper Servicing
    As Congress reviews this area and considers solutions for enhancing 
securitization, it may wish to review solutions across all asset 
classes. We wish to highlight that the housing space and MBS have been 
devastated by the practices and events of the last few years. 
Accordingly, we urge lawmakers that it is necessary to treat MBS 
separately from other asset classes in an effort to restore the U.S. 
housing sector and help American families pursue home ownership. The 
problems impacting investors by the malfeasance of servicers and their 
affiliates are numerous. We wish to highlight the following points:

    Many Servicers Are Conflicted; They May Not Be Servicing 
        Mortgages Properly. Very often they are harming the interests' 
        of both investors and homeowners' interests. This has a 
        negative impact on private investor demand for mortgages and 
        limits housing opportunities; \4\
---------------------------------------------------------------------------
     \4\ An example of this conflict is as follows. Consider the case 
when the servicer and the master servicer are the same entity. In such 
a case, a lack of effective oversight exists when the enforcement 
entity is owned by the same parent as the servicer. For example, in 
certain deals the Master Servicer has ``default oversight'' over the 
servicer therefore certain loss mitigation cannot be accomplished. 
Hence certain critics observe that when both are owned by the same 
parent entity, with the identical priorities and culture, no effective 
oversight is possible.

    Originators and Issuers May Not Be Honoring Their 
        Contractual Representations about what they sold into 
        securitizations. Additionally, the documents are vague, with 
        basic terminology having no definite meaning (e.g., delinquency 
        or default). The past is prologue and there are no assurances 
---------------------------------------------------------------------------
        that they will not repeat these practices in the future; and,

    The Market in General Lacks Sufficient Tools for First Lien 
        Mortgage Holders, such as: recourse to the homeowner on a 
        uniform, national basis (to avoid strategic defaults) and 
        efficient ways to dismiss the 2nd lien (to allow for more 
        effective workouts with the homeowner on the first lien).
III. Solutions Offered by Mortgage Investors
    The current legal and regulatory landscape presents numerous 
obstacles for the MBS securitization, including a lack of the necessary 
transparency for the effective functioning of capital markets in 
connection with several fundamental aspects of the system. These 
problems are varied and numerous in the RMBS context. For example, 
investors were offered transactions with overly complex legal 
documentation, obscured salient facts about a deal, and take-it-or-
leave-it time frames for acceptances of offers to purchase securities 
in underwritings. The lack of transparency in this context distorted 
markets and ultimately proved to impair the health and stability of our 
housing and mortgage markets. In essence, mortgage investors simply 
seek the salient facts underlying a transaction. In fact, last week, 
Mr. Edward DeMarco, Acting Director, Federal Housing Finance 
Administration (FHFA), testified before a House of Representatives 
Subcommittee and explained the following:

        FHFA views enhanced, loan-level disclosures as necessary for 
        investors to analyze and assess the potential risks associated 
        with the collateral of asset-backed securities, including 
        mortgages. \5\
---------------------------------------------------------------------------
     \5\ Hearing on ``Transparency as an Alternative to the Federal 
Government's Regulation of Risk Retention'', before the House Oversight 
and Government Reform Subcommittee on TARP, Financial Services and 
Bailouts of Public and Private Programs, May 11, 2011 (testimony of 
Acting Director Edward DeMarco).

    Accordingly two sets of consequences have arisen. First, the U.S. 
private mortgage-backed securities market has ground to a halt. 
Observers note that with two exceptions, no new RMBS securitizations 
have occurred since the financial crisis. Second, Americans suffer 
through reduced credit, more expensive mortgage rates, and fewer 
housing opportunities. In an effort to solve the problems facing the 
capital markets and the working class, AMI has offered a number of 
policy solutions which are described in its ``Reforming the Asset-
Backed Securities Market'' white paper (March 2010).
    We believe that the recommendations below, which are detailed in 
depth in the attached white paper, support healthy and efficient 
securitization and mortgage finance markets, with more information made 
more widely available to participants, regulators, and observers; 
incentivize positive economic behavior among market participants; 
reduce information asymmetries that distort markets and are entirely 
consistent with the Government's traditional roles of standard-setting 
in capital markets. In sum, the AMI offers the following 
recommendations to enhance transparency and best securitization 
practices within capital markets:

    Provide loan-level information that investors, ratings 
        agencies, and regulators can use to evaluate collateral and its 
        expected economic performance, both at pool underwriting and 
        continuously over the life of the securitization.

    Require a ``cooling off period'' when asset-backed 
        securities are offered so that investors have sufficient time 
        to review and analyze loan-level information before making 
        investment decisions.

    Make deal documents for all asset-backed securities and 
        structured finance securities publicly available to market 
        participants and regulators sufficiently in advance of investor 
        decisions whether to purchase securities offered.

    Develop, for each asset class, standard pooling and 
        servicing agreements with model representations and warranties 
        as a nonwaivable industry minimum standard.

    Develop clear standard definitions for securitization 
        markets.

    Directly address conflicts of interests of servicers that 
        have economic interests adverse to those of investors, by 
        imposing direct fiduciary duties to investors and/or mandatory 
        separation of those economic interests, and standardize 
        servicer accounting and reporting for restructuring, 
        modification, or work-out of collateral assets.

    Just as the Trust Indenture Act of 1939 requires the 
        appointment of a suitably independent and qualified trustee to 
        act for the benefit of holders of corporate debt securities, 
        model securitization agreements must contain substantive 
        provisions to protect asset-backed security holders.

    Asset-backed securities should be explicitly made subject 
        to private right of action provisions of antifraud statutes in 
        securities law and to appropriate Sarbanes-Oxley disclosures 
        and controls.

    Certain asset-backed securities can be simplified and 
        standardized so as to encourage increased trading in the 
        secondary market on venues, such as exchanges, where trading 
        prices are more visible to investors and regulators.

    Ratings agencies need to use loan-level data on their 
        initial ratings and to update their assumptions and ratings as 
        market conditions evolve and collateral performance is 
        reported.
IV. Conclusion
    Mortgage investors believe that the vibrancy and effectiveness of 
the U.S. capital markets can be restored, in part, by enhancing the 
transparency around fundamental regulatory structures, standards, and 
systems. Toward this goal, the Government has a role--not through the 
heavy-hand of big Government, but rather, the light touch of a prudent 
standard-setter and facilitator. With appropriate standards and rights 
for the holders of asset-backed securities, securitization would 
achieve the goals sought by many--the more efficient funding of capital 
markets, lessening volatility, and the resulting better economic 
activity. In the absence of transparency, the future of the U.S. 
housing finance system will remain dark, hurting America's global 
competitiveness and our domestic health. The results will include less 
home lending, more expensive credit, and fewer housing options and less 
opportunity for working class Americans. These are the reasons that we 
need solutions providing for more transparent systems and restarting 
our capital markets.
    Thank you for the opportunity to share the view of the Association 
of Mortgage Investors with the Subcommittee. Please do not hesitate to 
use the AMI as a resource in your continued oversight concerning the 
many issues under review. We may be reached at 202-327-8100 or by e-
mail at [email protected]. We welcome any questions that you might 
have about securitization, representations and warranties, or other 
mortgage industry topics.



        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                    FROM STEVEN L. SCHWARCZ

Q.1. In your written statement, you make reference to a kind of 
expectation gap of investors, where a triple-A rating equated 
to a certification of ``iron-clad safety'' and ``investment-
grade'' meant ``freedom from default.'' Could you expand upon 
this concept? Is this expectation gap contributing to a lack of 
confidence in ratings? Should rating agencies continue to play 
a role, and if so, how do we deal with this expectation gap?

A.1. Could you expand upon this concept?
    As you know, ratings are an assessment of the safety of 
payment on debt securities, with a triple-A rating being the 
highest and BBB- or higher ratings being historically called 
``investment grade''--meaning securities so rated are generally 
viewed as eligible for investment by banks, insurance 
companies, and savings and loan associations. \1\ Rating 
agencies clearly perform a social good by assessing diverse 
information and issuing ratings based thereon, achieving an 
economy of scale. A problem occurs, however, when investors 
overrely on ratings as a shortcut for their own diligence and 
analysis. Investors are prone to overrely for two reasons.
---------------------------------------------------------------------------
     \1\ ``Private Ordering of Public Markets: The Rating Agency 
Paradox'', 2002 U. Illinois L. Rev. 1, 7-8.
---------------------------------------------------------------------------
    First, there is a secondary-manager conflict, which I 
referenced more generally in my testimony. In the context of 
rating agencies, this conflict occurs when analysts employed by 
investors recommend that their firms invest in securities that 
are highly rated, without the analyst engaging in the analysis 
and diligence his or her job theoretically requires. This type 
of conflict can be mitigated by more closely aligning analyst 
(and other secondary-manager) compensation with the long-term 
interests of their firms. \2\ As my testimony explained, this 
is an intra-firm conflict, quite unlike the traditional focus 
of scholars and politicians on conflicts between managers and 
shareholders. Dodd-Frank attempts to fix the traditional type 
of conflict but completely ignores the problem of secondary-
management conflicts.
---------------------------------------------------------------------------
     \2\ See, ``Conflicts and Financial Collapse: The Problem of 
Secondary-Management Agency Costs'', 26 Yale Journal on Regulation 457 
(2009), available at http://ssrn.com/abstract_id=1322536.
---------------------------------------------------------------------------
    Second, in my experience investors do not always bother--or 
perhaps, because of the conflict referred to above, want--to 
learn the limitations of ratings. For example, ratings do not 
technically cover the risk of fraud but, instead, are based on 
the information received. \3\
---------------------------------------------------------------------------
     \3\ ``Private Ordering of Public Markets'', supra note 1, at 6 and 
6 n. 33. I do not think it would be practical to require rating 
agencies themselves to perform the due diligence needed to discern 
fraud; indeed, no amount of advance due diligence can ever eliminate 
fraud.
---------------------------------------------------------------------------

Is this expectation gap contributing to a lack of confidence in 
        ratings?

    This expectation gap may well be contributing to a lack of 
confidence in ratings. However, I believe the expectation gap 
is not caused by ratings per se or even by the ratings system 
as currently constituted. Rather, the gap is caused, as 
discussed above, by a combination of (i) the secondary-manager 
conflict and (ii) investor misunderstanding of what ratings 
provide. This combination of failures leads to variances 
between what investors ``think'' they're investing in and what 
they're actually investing in.

Should rating agencies continue to play a role, and if so, how do we 
        deal with this expectation gap?

    I believe that rating agencies should continue to play a 
role. As mentioned, they perform a social good by assessing 
diverse information and issuing ratings based thereon, 
achieving an economy of scale.
    We could deal with this expectation gap in two ways:

  1.  Mitigate the secondary-manager conflict by more closely 
        aligning analyst (and other secondary-manager) 
        compensation with the long-term interests of their 
        firms. Volume 26 of the Yale Journal on Regulation 
        examines, at pages 465-469, how to accomplish this.

  2.  Require investors to educate themselves about the 
        limitations of ratings. As discussed above, the 
        secondary-manager conflict itself undermines this 
        education process; therefore mitigating that conflict 
        is likely to mitigate this education failure.

Q.2. One of the problems you note in your written statement is 
the ``overreliance on mathematical modeling.'' The SEC has 
proposed that ABS issuers file a waterfall program that 
demonstrates the flow of funds in a transaction. What do you 
think of this proposal?

A.2. I do not think this proposal is needed. The materiality 
requirement of existing disclosure law already requires an 
explanation of waterfalls. In my experience, these explanations 
are generally clear and (insofar as they can be) 
straightforward.
    I fear this proposal could even backfire. A mathematical 
program demonstrating the flow of funds could aggrandize the 
waterfall model, giving the model (as discussed in the next 
paragraph) greater credence than it deserves.
    Sophisticated investors do not, in my experience, have a 
problem understanding waterfalls and funds flows. Rather, their 
problem is under-appreciation of how easy it can be--especially 
in nontraditional transactions involving complex and highly 
leveraged securitizations of asset-backed securities already 
issued in prior securitizations (what I called in my testimony 
``securitizations of securitizations'')--for relatively small 
errors in cash flow projections to significantly impact 
investor recoveries. To correct this under-appreciation, it 
would be helpful to require some sort of ``sensitivity'' 
analysis explaining how the waterfall cash flows would change 
based on changes in collections on the underlying financial 
assets. \4\
---------------------------------------------------------------------------
     \4\ This might be done, for example, through a ``Monte Carlo 
simulation.''
---------------------------------------------------------------------------
    Even a sensitivity analysis, however, is dependent on 
assessing how likely it is that collections on the underlying 
financial assets will change. No one can know that for sure, ex 
ante; there are simply too many variables and potentially 
unknown correlations. This illustrates a larger point: In 
complex financial markets, disclosure is necessary but almost 
always will be insufficient. \5\ For an analysis of how to 
attempt to respond to this insufficiency, see pages 238-245 of 
``Regulating Complexity in Financial Markets''. \6\
---------------------------------------------------------------------------
     \5\ See, e.g., ``Disclosure's Failure in the Subprime Mortgage 
Crisis'', 2008 Utah L. Rev. 1109, available at http://ssrn.com/
abstract_id=1113034; ``Rethinking the Disclosure Paradigm in a World of 
Complexity'', 2004 U. Illinois L. Rev. 1, available at http://ssrn.com/
abstract=336685. See also, ``Regulating Complexity in Financial 
Markets'', 87 Washington U.L. Rev. 211, 221-225 (2009/2010), available 
at http://ssrn.com/abstract_id=1240863.
     \6\ 87 Washington U.L. Rev. 211, 238-245.
---------------------------------------------------------------------------
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                        FROM TOM DEUTSCH

Q.1. A number of panelists described the development of a new 
model representation and warranties document that would correct 
structural flaws in the current representation and warranties. 
What role should a private-standard setting body play in its 
development and implementation? What role should Government 
play? What would be the best method for determining whether a 
particular transaction deviated from the standards?

A.1. Response not provided.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM MARTIN S. HUGHES

Q.1. In your statement, you advocate for risk retention that 
favors a ``horizontal slice,'' which provides for retaining the 
first-loss securities, rather than a vertical slice. Should 
risk retention rules prescribe a specific form of risk 
retention or provide a choice of options for investors to 
choose from? What are the strengths and weaknesses of such an 
approach? In the wake of the financial crisis and evidence that 
some executives internally disparaged the quality of risky 
loans while publicly exuding confidence, how could investors 
have confidence that horizontal slices were really the rust-
loss securities?

A.1. Response not provided.

Q.2. In your statement, you noted that ``mortgage servicing 
issues are an impediment to broadly restarting private 
residential mortgage securitization.'' How important is it that 
this be corrected quickly? What do you believe are the most 
critical items that should be part of any solution to 
restarting the RMBS market? Should this be a regulatory 
response or should private industry lead the way?

A.2. Response not provided.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM LISA PENDERGRAST

Q.1. A number of panelists described the development of a new 
model representation and warranties document that would correct 
structural flaws in the current representation and warranties. 
What role should a private-standard setting body play in its 
development and implementation? What role should Government 
play? What would be the best method for determining whether a 
particular transaction deviated from the standards?

A.1. The Commercial Real Estate (CRE) Finance Council is an 
association that represents a very broad and diverse 
constituency within the commercial real estate finance market, 
including portfolio, multifamily, and commercial mortgage-
backed securities (CMBS) lenders; issuers of CMBS; loan and 
bond investors such as insurance companies, pension funds, and 
money managers; servicers; rating agencies; accounting firms; 
law firms; and other service providers. Even before the passage 
of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (Dodd-Frank), market participants within our industry were 
aware of a desire within the industry to address concerns that 
began to emerge at the onset of the economic crisis and that 
admittedly prompted policy makers to craft risk retention 
requirements. To address this demand, the CRE Finance Council 
independently developed a series of market reforms to 
strengthen the securitization market and foster greater 
investor confidence. Given our diverse representation and our 
stake in ensuring that the CMBS market is efficient and 
sustainable, we believe our private organization is uniquely 
positioned to create ``best practices'' initiatives for the 
CMBS market. And since regulators have been tasked by Congress 
to consider and implement measures that essentially represent 
``best practices'' for the various classes of asset-backed 
securities (e.g., the consideration of representations and 
warranties and of underwriting standards as part of the risk 
retention framework established in Dodd-Frank Section 941(b)), 
we believe that the Government should look to industry-
developed standards to help form the basis of such regulations, 
and we have urged the regulators to do this.
    One of the CRE Finance Council's initiatives builds upon 
existing customary representations and warranties for CMBS to 
create ``Model Representations and Warranties'' that represent 
industry consensus viewpoints. The CRE Finance Council's model 
was the result of 200-plus hours of work by its Representations 
and Warranties Committee over the course of many months in 
2010, and represents the input of more than 50 market 
participants with diverse views who worked to achieve industry 
consensus.
    The CRE Finance Council Model Representations and 
Warranties were specifically crafted to meet the needs of CMBS 
investors in a way that is also acceptable to issuers, and were 
developed with an emphasis on investor concerns about 
transparency and disclosure. Such Model Representations and 
Warranties for CMBS are designed to be made by the loan seller 
in the Mortgage Loan Purchase Agreements. The CRE Finance 
Council's model will require issuers to present all prospective 
bond investors with a comparison via black line of the actual 
representations and warranties they make to the newly created 
CRE Finance Council Model Representations and Warranties. And 
in addition, loan-by-loan exceptions to the representations and 
warranties must also be disclosed to all prospective bond 
investors. The Model Representations provide a clear benchmark 
for comparison, and the need to black line to the Model 
Representations is a disclosure best-practice that makes any 
variations from the Model Representations easy for investors to 
evaluate. Use of the Model Representations as a reporting 
template is also a disclosure best-practice that helps 
investors understand what underwriting and documentation 
practices were applied, and what was found in the underwriting 
process. This provides investors with a key tool that enables 
them to police the quality and completeness of underwriting 
procedures, and do their part in funding good origination 
practices while defunding bad practices that generate risks 
that can damage market sustainability.
    In this regard, it is important for policy makers to be 
aware that, unlike in the residential loan context, it is the 
normal course for there to be representation and warranty 
exceptions in CMBS transactions. This is the case because the 
facts and circumstances of each loan transaction are unique. 
For example, tenant verifications may vary from loan to loan 
depending upon the number and size of tenants, or certain 
environmental concerns may exist with respect to a property and 
property-specific steps may have been taken by a borrower to 
remediate those conditions. Disclosure of these differences is 
normal course and more broadly, properties that have unique 
features need and should attain financing provided that the 
loans are properly sized and structured. It would not be good 
public policy to render large swaths of commercial real estate 
unfinanceable just because the property has unique elements 
that would give rise to a representations exception. Investors 
understand that any large pool of commercial mortgages will 
generate many representation exceptions. What they seek is a 
clear disclosure of those exceptions, so that they can assess 
the quality of the prospective investment in the related bonds, 
in light of all of the key facts pertaining to the collateral 
pool.
    Finally, as part of the Model Representations and 
Warranties project, the CRE Finance Council also has developed 
a framework for addressing and resolving claims for breach of 
representations and warranties. We believe these enforcement 
standards will satisfy the Dodd-Frank Act's requirement for 
``related enforcement mechanisms'' when coupled with adequate 
representations and warranties. The CRE Finance Council 
resolution standards provide for mandatory mediation before 
litigation, and represent an industry consensus view on how to 
resolve disputes in an expedited, reliable, and fair fashion 
while also avoiding unnecessary costs.

Q.2. In your written testimony, you described the commercial 
real estate industry's work on the model representation and 
warranties agreement that you state: ``coupled with extensive 
disclosure are considered a form of risk retention that is more 
valuable than having an issuer hold a 5 percent vertical or 
horizontal strip.'' This appears to be an innovative approach 
to dealing with risk retention. Would you please expand on this 
concept? How would this approach be more valuable than 
retaining of a percentage of the risks of the underlying 
securities?

A.2. The adoption of the CRE Finance Council Model 
Representations and Warranties is a step that both strengthens 
risk retention and empowers investors with a highly useful 
informational tool that can help them do their part in policing 
CMBS market practices. Some investors believe that the use of 
robust, standardized representations and warranties should be 
the key risk retention feature that regulators endorse because 
it helps investors actively monitor securitization quality 
rather than passively delegating that policing role to issuers, 
B-Piece buyers, rating agencies, or others. Other investors 
prefer a regime where robust and standardized representations 
are a key part of a multifaceted risk retention regime, 
provided that no portion of the risk retention regime is so 
inflexible or ill constructed that it threatens to shut down or 
significantly chill origination and investment activities in 
the CMBS market, given that the vibrancy of this market is 
essential to the ongoing health of our economy. But the 
industry is united behind the need for, and efficacy of, 
adopting the Model Representations and Warranties as a key 
element in the solution.
    The CRE Finance Council appreciates the Committee's 
interest in matters of concern to the commercial real estate 
finance industry, and we stand ready to work with you on these 
issues. If you have any additional questions, please feel free 
to contact Michael Flood, Vice President, Legislative and 
Regulatory Policy, CRE Finance Council, at (202) 429-6739 or 
[email protected].
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                    FROM ANN ELAINE RUTLEDGE

Q.1. You state in your written remarks, ``[A]n America that can 
rebuild its economy with sustainable securitization markets 
while building incentives for producers in the capital-
intensive sectors of the economy will, forcibly, continue to 
lead the world financially . . . '' Could you expand on this? 
What types of incentives should be created? Who should be 
championing them? What policy changes should Congress consider?

A.1. First, the phrase ``sustainable securitization markets'' 
needs unpacking. It has two underlying ideas--

  a.  Securitization markets can be sustainable; and

  b.  This would be desirable, because securitization is a 
        fairer, more sustainable form of finance for rebuilding 
        the economy.

    The latter point only sounds controversial. It isn't. 
Securitization is 35 years old. It was an obscure market until 
the Credit Crisis. The best evidence that securitization is 
inherently stable is its 30-year obscurity.

Securitization is a sustainable market form, if the rules are made 
        transparent and enforced.

    The fall of Long Term Capital (LTCM) in 1998 was a 
watershed in securitization history. The culture of the market 
changed rapidly as derivatives traders, who make profits from 
small pricing inconsistencies and large amounts of leverage, 
moved into credit arbitrage using the tools of structured 
finance. As they poured new capital into the market, its focus 
shifted from corporate finance, an intrinsically static 
activity, to dynamic betting. Before, structuring bankers 
strove to keep up with what rating agency analysts were 
thinking. After the demise of LTCM, structured analysts 
struggled to keep up with what the leaders of the banking pack 
were thinking.
    Securitization was not built to handle credit arbitrage 
trading because the credit rating system, a key input in 
pricing and valuing structured securities, was static. This 
defect stimulated the growth of the market after LTCM. That's 
right: the source of demand for RMBS, CDOs, SIVs, and other 
structured products was not fundamental but generated by flawed 
market machinery and distorted prices. The bank-rush to squeeze 
as many faulty deals as possible through the system before it 
collapsed contributed massively to its ultimate collapse.

Securitization is an information game. To bring it back, the 
        information layer needs transparency.

    The history lesson should be clear:
    Securitization always worked, more or less, when the 
objective was to raise funds for companies. It only ceased to 
work when banks, who make more profit from trading than 
lending, found a way to book underwriting fees and profits from 
securitization, not just fees. The social lessons should also 
be clear:

  i.  We should not delegate the responsibility for enforcing 
        the rules to the banks when self-interest lies in 
        breaking them. ``We are conflicted about what we want 
        our institutions to do; we want them to be ethical, but 
        we also want them to make lots of money.'' http://
        bit.ly/m9k3zx. Banks are natural rent-seekers. If we 
        want them to be profitable, we can't ask them to act 
        like regulators.

  ii.  Individuals in a market-capitalist economy cannot 
        delegate their responsibility for keeping the market 
        healthy, any more than a democracy can delegate the 
        duty of electing its representatives. The 
        responsibility is ours, collectively.

    We can make the securitization market stable again by 
publishing information that is relevant to dealing, ensure that 
the structuring rules are carried out, and see that benchmarks 
of value are enforced. To these ends, Regulation AB is a highly 
effective disclosure framework that enables the securitization 
market to govern itself, with or without rating agencies.
    In my opinion, the original 2005 ruling would have been a 
perfectly adequate standard if the market had been 
sophisticated about securitization. It wasn't, and it isn't, so 
further revisions have been proposed to make the practice 
elements come together to form a firmer, fairer market basis.
    Three action items are required to make Regulation AB a 
complete standard. These are mainly outside the jurisdiction 
and control of the SEC and therefore merit further comment 
below:

  i.  More education about structured finance and 
        securitization is needed. These skills are taught in 
        very few finance departments of business schools. The 
        explanation--that the approach is structural rather 
        than empirical, and therefore unorthodox and 
        unpopular--is a little bit outside the scope of my 
        responses. But, the result is that people learn 
        structured finance and securitization in the 
        workplace--and, as you can imagine after the Crisis, in 
        many cases, some of what was learned is wrong.

  ii.  Numeracy deficits need to be addressed through our 
        educational system. In one of his tweets, Steve Martin 
        says the ``hat'' key (shift+6) is a wasted space on the 
        keyboard. This is oddly true. The hat key is the 
        operator for exponents in Excel. If the average 
        mortgagor knew how to work with exponents, they could 
        do loan math. This would be a massive victory for 
        consumers and knowledge workers in America's 
        information society.

  iii.  The structured finance rating scale should be published 
        (Question ii). To foster a genuine two-way market that 
        can police itself (and legislators and regulators can 
        take a well-deserved break from dealing with 
        securitization issues) the rating scale needs to be a 
        public good, available to everyone and anyone.

            Rebuilding the American economy with securitization.
    New companies and small companies are not well served by 
the financial system as it is currently constituted. Moreover, 
for structural reasons, we can expect things to get worse. In 
this section, I justify my assertions and explain how 
securitization is an answer--even though we have rarely seen it 
used that way in the past.
    In corporate finance 101, we learn that growing firms need 
working capital because sales alone are not enough to finance 
and build a sustainable scale of operations. The decision to 
borrow does not signify ``living beyond one's means'' (as it 
may for consumers) but rather pride of ownership and an 
enterprising spirit. Finance theory teaches that equity capital 
involves loss of some ownership and control and costs more than 
company debt. But, in the trenches of finance, we discover a 
paradox: affordable debt is extended mainly to large, mature, 
well-capitalized firms that don't need the funding.
    Moreover, middle market lending today has become a casualty 
of the capital management system. To get working capital, small 
and medium sized businesses (SMEs) turn to personal credit 
cards or unlicensed lenders, or leverage their homes. This 
condition describes a large set of 27 million firms (96 percent 
of the American businesses community), which have fewer than 
500 employees yet employ 50 percent of the American labor force 
according to the 2008 U.S. Census. www.census.gov/econ/
smallbusiness.html. Moreover, the ``nonemployer'' firms who 
represent 74 percent of the businesses in America may never 
build up enough equity to be able to reach equilibrium and do 
the normal things most business owners long to do--hire 
employees, provide health care, pay their lenders and 
suppliers, and give to charities. Debt financing for innovative 
startups that produce jobs is also scarce. Wind River Systems, 
founded in 1983, is the prototype of a startup in the 
engineering/information space that is too sophisticated for the 
average lender to understand. They make embedded operating 
systems, employ 1,500 people, and generate over $350 MM in 
annual revenues. But their business is too sophisticated for 
the debt market, and in the early days, the working capital 
amounts they required would have been too small to merit a 
wholesale lender's attention.
    The stark reality is, a small business owner or 
entrepreneur in America today may never be bankable--no matter 
how much we trust or like them personally, how much their 
business enhances our lives or how lifesaving their inventions 
may turn out to be.
    Our economy is severely afflicted by an invisible 
structural funding gap, and unless the incentives of the 
financial system are redirected towards putting capital back 
into the real economy, things are going to get worse. Financial 
system trends towards deregulation, disintermediation, Basel, 
consolidation, etc., have created incentives for the large 
banks to deal in ever-larger, ever more levered packets of 
capital at razor-thin margins. The efficiency gains are not 
being redistributed to players in the real economy--the gains 
are feeding the financial economy.
    It does not have to be this way.

Securitization is a fairer, more sustainable form of finance for 
        rebuilding the economy.

    Any firm that knows its clients and its business, and runs 
it professionally, becomes bankable with securitization. That 
is because the lending decision is based, not on how big the 
company brand is, but how reliably the receivables perform. 
With securitization, the more professional, targeted, and 
responsive to market the firm is, and the better its 
collections, the greater its access to affordable working 
capital--if the conditions for market sustainability are met.
    Securitization is about putting the value of the capital 
created by firms back to work faster, so that the firm can 
realize its economic potential. Sustainable securitization also 
realigns the incentives along the supply chain of credit so 
that other institutions in the same sector use their capital 
efficiently and appropriately. This is due to the influence of 
informational feedback: firms that securitize and repay 
according to plan receive lower-cost funding and those that 
violate expectations must pay more for their capital. Below, 
three illustrations of how securitization has been or could be 
used, to revive the American dream:

Practical examples of how securitization can put certain sectors on a 
        more sustainable financing basis.

    #1, Live Example: A securitization of stallion stud fees 
and associated syndicate shares in 2007 allowed a small but 
skilled thoroughbred farm to raise five times the amount of its 
equity capital to invest in new stallion syndicate shares. In 
one go, this breeder farm went from a small player to a 
substantial player, and at the same time, halved the interest 
cost of an on-balance sheet loan.
    This transaction was shadow-rated and funded in a bank 
conduit. As the senior creditor, the conduit provided a more 
affordable cost of capital (instead of the lending specialist's 
cost) because

  i.  The investor was not collateralized by individual horses 
        but a senior slice of pooled cash flows from the 
        pledged studding fees and protected by a pledge of 
        syndicate shares;

  ii.  The structure was well-crafted to defend investors 
        against the biggest risks in the deal (mortality, 
        infertility, sterility leading to declines in cash flow 
        and share value); and

  iii.  Investors were provided ample high quality information 
        about the risks and sources of value in the investment.

    The transaction has performed extremely well through the 
worst of the Crisis.
    #2, extending the Live Example to businesses in your State: 
There is nothing special about a securitization of stallion 
stud fees; this financing solution could be applied to other 
industries in your State--for example, to energize solar 
energy, film, music, digital media, information technology, 
aircraft, health care, and companies with commercially viable 
process patents ranging from toys and games to defense 
industries, to life sciences.
    Start with 2,500 financially viable SMEs that have been 
around a few years. Suppose that they could each borrow 
$400,000 at 15 percent per annum. Or, $1 BN pool of their 
receivables could be securitized off-balance sheet and funded 
by issuing two tranches (slices) of securities: senior debt and 
equity. On a blended (weighted average) basis, the funding 
would be cheaper.
    How much capital could be conserved? The blended rate is 
market-determined, and this is a hypothetical example. But, 
suppose it turns out to be 7.5 percent. Over 10 years, the 
amount of interest expense reduction would exceed 50 percent of 
the initial borrowing, or about $514.8 MM. If a rating agency 
determined that the senior debt can be investment grade with 
4:1 leverage in the capital structure, $5 billion of new 
working capital could be raised for the businesses. \1\ The 
footnote goes through the numbers.
---------------------------------------------------------------------------
     \1\ Here is where the numbers come from: a 4:1 leverage ratio 
implies a debt layer of 80 percent, equity of 20 percent. Therefore, $1 
BN/20 percent= $5 BN. If the equity investors demand 17 percent returns 
and the debt investors require 5.625 percent returns, the weighted 
average interest cost would be 7.5 percent.
---------------------------------------------------------------------------

What about the new capital flows--where does this money go?

    Borrowing firms could redeploy the interest savings as 
additional working capital, reinvestment in the business, or 
dividends.
    As a condition of participating in this SME fund, the firms 
could be required to earmark a portion of the proceeds to hire 
and retain the best IT and engineering talent for their 
businesses. This is one way to reinforce their responsibility 
to keep their value proposition alive. Their success would be 
measured by the performance of their receivables. If they 
underperformed expectations, they would have to exit the fund. 
Conversely, as the firms grew in size and reputation, like our 
Wind River Systems example, they could come off the SME Fund 
and securitize as standalone firms.
    Knowledge of structure allows States to help industries 
design and plan for the future. To illustrate, a small equity 
slice could be carved out of the capital structure--a ``genius 
tranche''--for reinvestment in numeracy, structured finance 
education, engineering sciences, policy projects, with 
conditions attached to bring the value back into the fund, 
ultimately. Success could be measured in the fund's financial 
gains.

Using securitization to put our Federal dollars to work more 
        efficiently.

    Two months ago, an article came out about the House Small 
Business Committee cutting $100 MM from a $985 MM Small 
Business Administration budget. Another way to think about 
achieving more capital efficiency from the SBA would be through 
targeted securitizations where the structuring would be goal-
directed and results-oriented; administration costs would be 
reduced by tying program performance measures to the 
performance of the transactions; and new money would flow back 
into the markets. \2\
---------------------------------------------------------------------------
     \2\ ``Tough Choices on SBA Budget'', Portfolio.com, March 15, 
2011.
---------------------------------------------------------------------------
    That is not to say the SBA has not used securitization--
they have. But, to reignite the economy, it must be used more 
effectively, with continuous measurement and reinvestment in 
what works.
    #3, making Health Care Finance sustainable: Another example 
of how securitization could add value at a national and 
systemic level is by using ``true sale'' securitizations backed 
by individual receivables (not blanket liens) to reform health 
care finance. Wherever health care is treated as a cost center 
(Germany or Taiwan, for example) the public bears less than a 
quarter of the expense where health care is considered a 
revenue center (the U.S.). But a cost-based system does not 
offer the same range of choice, and the budget for reinvestment 
in new techniques is not there.
    Health care finance securitizations are a sustainable 
compromise between patient autonomy and system affordability. 
``True sale'' securitization, where the receivables are 
discounted at their face value (not bundled and blindly 
pledged) accelerates the turnover of capital inside hospitals. 
Insurance companies also love it, because health care 
receivables securitization solves their only real financial 
challenge: Asset-Liability Management. They do not need capital 
for this type of securitization; the returns will be very high 
yet stable. When health care receivables are put to work by 
using securitization, our communities will be able to have the 
quality of care they are willing to pay for, affordably.

Only America has the financial know-how to lead economic growth through 
        sustainable securitization.

    America may be the land of plenty but it does not hold an 
infinite reservoir of cash. We must learn how to use the 
resources we have more efficiently without unthinkable 
sacrifices. To put our financial assets to work for us, we need 
securitization. We can create a model for economies to follow, 
to develop their economies and distribute the benefits of hard 
work more equitably. This is how America will reestablish its 
position as a global financial leader.
            What types of incentives should be created? Who should be 
                    championing them? What policy changes should 
                    Congress consider?
    I believe we do not need new incentives. We need to 
redirect the incentives already there in the financial system, 
to make capital work harder for us. This will require carrots 
and sticks.

Carrots first: incentives to recognize and reward the value created by 
        knowledge workers outside finance.

    Harold Evans' book on American innovation, They Made 
America \3\ and the companion PBS series, talk about how 
promoters and financiers harvest the value built created by 
inventors, who remain wage slaves.
---------------------------------------------------------------------------
     \3\ Evans, Harold, ``They Made America'', New York: Little, Brown 
& Company, 2004.
---------------------------------------------------------------------------
    This is a social problem to match the funding problem 
already discussed. Just as most of the value made in the real 
economy feeds the financial economy and does not flow back to 
the real economy, so do knowledge workers follow the money into 
finance, to partake in rewards and recognitions as bankers. Few 
ever return to the real economy.
    Incentives are needed to reverse this direction and 
encourage highly trained people in the sciences and engineering 
to stay there. For this to happen, some of the value created in 
the real economy has to flow back to the real economy. I have 
already suggested how securitization does this through example 
#2. For engineers that prefer to work in finance, they still 
have a role: putting their deep knowledge of processes and 
mathematics to work in monetizing value in IP-intensive 
businesses. The value will circulate much faster with 
securitization. The lift to the economy, and the job creation 
flowing from it, would be swift and self-propelling.
    As I see it, securitization in its sustainable form may be 
the only way to systematically realign the incentives to put 
the economy on a more equitable footing. It cannot be done 
piecemeal.

We also need sticks. Better enforcement will not stifle borrowing and 
        lending. It will revive it.

    If you know how securitization works, fraud is shockingly 
easy to commit and get away with. Cheaters should be punished. 
We already have clear set of rules that facilitate a bright-
line determination of material misstatement, but not enough 
people know how they work. This has to change.

Embracing and enforcing Regulation AB is the key to market 
        sustainability.

    The latest version of Reg AB boils down to two styles of 
regulation: disclosure and risk retention.
    I have nothing against risk-retention--in fact, I am in 
favor of it for shelf-registrations, at least until the Crisis 
is firmly behind us. But risk retention takes capital out of 
the system so we have less to work with; and the jury is out on 
whether it really stops the cheating. There was plenty of risk 
retention before the Crisis--it just was not disclosed. And the 
problem with undisclosed risk is just that. No one knows how 
big the risk actually is. That is why disclosure is a much more 
effective deterrent. Reference the figure below: if originators 
are required to hold a 10 percent ``horizontal slice'' (O/C) 
then one originator may decide to get around risk-retention by 
originating and securitizing loans with expected cumulative 
losses greater than 10 percent while the other follows the 
rules. Note the differences:


    Senior investors in SPE1 are collateralized by a pool where 
the cumulative loss is 11 percent. They will lose 1 percent of 
principal (the red sliver above the O/C slice). Senior 
investors in SPE2 are protected by the additional asset 
coverage exceeding the 2 percent cumulative loss.
    If all we have to rely on is risk-retention, the quality 
differences between SPEs l and 2 remain invisible. Between 
tougher disclosure requirements and risk retention, cheaters 
prefer the latter because they can go on cheating until the 
deal collapses. Disclosure shines a bright light on cheating 
for all to see before the deal collapses.

Competition among NRSROs or surrogates is also key.

    The prescription for using securitization to finance 
emerging enterprises and projects only works if a rating agency 
or other neutral institution is around to vet the financial 
viability of these transactions in the primary market.
    New rating agencies that are not paralyzed with fear of 
litigation, that can rate securitizations confidently and 
without fear of liability, are much needed. This is why 
fostering competition among NRSROs by opening up the field to 
new entrants, as was proposed under credit rating agency reform 
initiatives, continues to be so important. \4\
---------------------------------------------------------------------------
     \4\ SEC Commissioner Kathleen Casey makes a strong argument for 
competition in her speech, ``In Search of Transparency, Accountability, 
and Competition: The Regulation of Credit Rating Agencies'', February 
2009.
---------------------------------------------------------------------------

Who else should be championing the[se incentives]?

    A financial market is a remarkably agile, resilient source 
of incentives all by itself. Once we commit to better 
regulation by information make the ratings industry more 
competitive, the market should resurrect itself in due course.
    But this could happen a lot faster if President Obama, the 
Council of Economic Advisors, and certain key OMB staffers were 
willing to take a fresh look at how securitization can be used 
to manage the Federal deficit more effectively. Demonstrating 
that our debt is being used productively to generate future 
growth and earnings through targeted, well-structured 
securitizations would not only be good for the dollar, it would 
be a compelling template for the global financial markets to 
manage their assets more effectively and democratically.

Q.2. You also describe the need for a structured rating scale 
for transactions. Would you expand on this concept? How would 
the rating scale be administered? Should the rules be 
promulgated by a private standard-setting body, such as the 
International Organization for Standardization (ISO)? Who would 
provide the assessments? Where do rating agencies fall short?

A.2. The structured finance rating scale (or structured rating 
scale) is the set of performance benchmarks against which 
structured securities are rated. The structured finance scale 
does not just permit qualitative comparison, like the corporate 
rating scale, for instance \5\:
---------------------------------------------------------------------------
     \5\ Rutledge, Ann, ``Study Manual for Paper 10 Credit Rating 
Services of the Licensing Examination for Securities and Futures 
Intermediaries'', Hong Kong Securities Institute. May 2011, p. 2-11.


    The structured finance scale is a numerical scale where the 
output can be a direct factor in valuation and pricing. The 
output of a corporate finance scale can only be linked to a 
price through the intermediation of the market. Already, it is 
something special and powerful, because the intervals are said 
to have an objective meaning--similar to a temperature scale.
    Moreover, each rating agency has its own characterization 
of the meaning of the rating but all definitions relate to 
payment certainty and are similar in nature. In structured 
finance, each rating agency also has its own rating definition, 
but the differences are anchored on measures: projected 
portfolio default rate, expected loss of principal or average 
reduction of yield. (My testimony referred to average reduction 
of yield scales, so I will stick with it for my numerical 
illustration in the next section.) Unlike temperature scales, 
where Fahrenheit can be converted directly to Centigrade, and 
vice versa, the units are not always convertible. This is an 
incentive for ``rating shopping.''

The macroeconomic significance of the structured finance rating scale.

    The design of the scale (choice of measure, length of 
intervals) determines how consistently structured securities 
are rated. Fundamentally, it also determines the credit quality 
of the securities that bear the rating, not individually but on 
average across the entire market. In a macroperspective, the 
structured scale becomes a tool for calibrating the amount of 
leverage in the economy. During a bona fide economic expansion, 
when good quality receivables are being generated, more bona 
fide AAA/Aaa-rated structured securities can come to market 
when the financing is needed. During economic contraction, 
fewer will be produced. This is exactly as it should be.
    The rigor of the scale sets the overall tone. One with lax 
benchmarks increases leverage and lowers credit quality. One 
with high hurdles contracts leverage and raises credit quality. 
Rating agencies will always face pressures from issuers to 
lower their standards and investors will always prefer that the 
standards be as strict as possible. Giving in will make things 
worse, since the pressure to lower the standards when credit 
quality is deteriorating will sink the market further, and vice 
versa. That is exactly what we don't want to happen to the 
economy.
    That is the rationale for my appeal to separate the roles 
of setting the structured scale and enforcing the structured 
scale. Enforcing the scale means reverse-engineering the deal 
and rerating it. This can be done by rating agencies, as well 
as by any other skilled person who bothers to get data from the 
Reg AB Web site. The more opinions, the better! By catching 
improperly rated or mispriced deals early on, the market can 
prevent a crisis like the one we just went through--but only if 
the structured scale is public. Presently no one knows what the 
structured rating scale is, and this makes arm's-length 
assessments of ratings impossible, like driving without knowing 
the speed limit, as I said in my testimony.

Who should set the structured rating scale?

    Originally I had thought that President Obama and the head 
of the Council of Economic Advisors and the Comptroller General 
of the United States should jointly promulgate the structured 
scale for the U.S. market, as a matter of national economic 
priority. They might wish to consult and coordinate with the 
Federal Reserve and the Treasury--but it should not be decided 
by the Fed or Treasury due to potential conflicts of interest 
involving the financial sector.
    Since securitization is a global market, it would be 
advisable for the U.S. to share its rationale for setting the 
levels of the structured rating scale with the G20. The likely 
outcome would be for other economies to adopt the same scale--
otherwise, rating shopping would occur between countries until 
the public officials decided to impose uniform standards. You 
make a good suggestion that the final determination of 
structured scale could be delivered by the ISO, after a pilot 
period of review and analysis.

What properties should the scale embody?

    The structured rating scale should be designed to be 
unambiguous. It should be linked to the Average Reduction of 
Yield scale because it is the only measure that makes sense for 
structured finance. Public use of the scale will ensure proper 
calibration between the amount of leverage and certainty of 
structured debt in the system. The scale I would propose based 
on 30 years of structuring experience, and the underlying 
concepts, are explained below:


  1.  The left column represents the rating. The right column 
        represents the benchmark.

  2.  To rate a structured transaction, the analyst runs a 
        large series of Monte Carlo scenarios and obtains 
        performance measures on each scenario.

  3.  In most scenarios, investors receive all the interest and 
        principal they are promised. But under severely 
        stressed scenarios, they will experience yield 
        shortfalls. The arithmetically averaged yield shortfall 
        across all the iterations, or Average Reduction of 
        Yield, is mapped to a rating.

  4.  So if, through a Monte Carlo simulation, the security 
        loses an average of 0.05 basis points (bps) of yield, 
        other things being equal, the security should merit a 
        Aaa (triple-A) rating because the benchmark is 0.05 
        bps. A loss of 0.05 bps of yield on a security with 
        (hypothetically) a nominal yield of 4.25 percent at par 
        and an average life of 5 years will have an expected 
        yield of 4.2495 percent. The 4.25 percent yield comes 
        from looking at the market and finding where Aaa-rated 
        securities with an average life of 5 years are pricing 
        and what they are yielding.

  5.  But, if the security loses 25 bps of yield, it merits a 
        Baa2 (triple-B flat) rating. A loss of 25 bps of yield 
        on a security with a nominal yield of 6.25 percent will 
        have an expected yield of 6.00 percent, by the same 
        logic as in (4).

  6.  If, several months later, the same ``Baa2'' security is 
        reanalyzed in a responsible manner and, on an apples-
        to-apples basis, produces an average reduction of yield 
        of 5 bps, it is no longer a Baa2 but an A1. If 
        reanalysis produces an average reduction of yield of 
        200 bps, it is now a B1.

Where do rating agencies fall short?

    The rating agencies fall short in two ways: first, 
competition between the agencies based on the rating scale is 
likely to exacerbate credit rating arbitrage, or ``rating 
shopping.'' But, the agencies will not give up their power to 
make the scale voluntarily. This means a uniform measure is 
unlikely to emerge, unless the scale is imposed from outside 
the system--preferably by a body that is independent, unbiased 
and interested in solving the ages-old dilemmas of calibrating 
credit extension/curtailment to economic growth/contraction.
    The other way credit rating agencies fall short is by 
failing to rerate structured securities using the original 
benchmarks for the primary market. As mentioned previously, 
securitization was not built to handle credit arbitrage trading 
because the credit rating system, a key input in pricing and 
valuing structured securities, was static. When all is said and 
done, lagging ratings in structured finance is the underlying 
cause of the credit crisis.

Who would provide the assessments?

    If the market is held to a consistent set of benchmarks so 
that AAA always signifies the same risk-return proposition over 
the life of a structured security--in the same way that a 25-
mile an hour speed limit always means the same thing, or a foot 
is always 12 inches--then it does not matter who provides the 
assessments. Rating agencies will . . . but others with 
investments on the line, or ambitions to be recognized for 
their analytical excellence, will set up to the plate. That is 
financial democracy in action.
    Senator Reed, thank you again for your questions and the 
opportunity to respond to them.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                     FROM CHRIS J. KATOPIS

Q.1. In your written statement, you stated: ``Mortgage 
investors seek effective, long-term sustainable solutions for 
responsible homeowners seeking to stay in their homes . . . 
[and] mortgage investors, primarily first lien holders, do not 
object to modifications as part of the solution. Unfortunately, 
mortgage investors are powerless under the [servicing 
agreements] to offer such support.''

    Why are investors powerless?

    Are there ways to empower investors to ensure that 
        decisions that make financial sense are actually made? 
        In other words, is there a reasonable way to help both 
        homeowners and investors?

    Could you please explain why, from an investor's 
        perspective, a loan modification in some cases can make 
        more financial sense than pursuing foreclosure?

A.1. The business environment and dominant mortgage 
securitization practices preceding the financial crisis are 
well-documented. Economist Joshua Rosner has likened this 
period to a ``wild, west'' which ultimately proved harmful for 
consumer, investors, and the Nation-at-large. \1\ The legal 
structure that underlies and controls the residential mortgage-
backed securities (RMBS) pools and servicing are governed 
largely by contracts, such as Pooling and Servicing Agreements 
(PSAs). These contracts govern the rights and remedies for 
first-lien holders (e.g., mortgage investors) and consumers.
---------------------------------------------------------------------------
     \1\ http://www.rooseveltinstitute.org/policy-and-ideas/ideas-
database/securitization-taming-wild-west
---------------------------------------------------------------------------
    Investors comprise the ``buy-side'' of the securities 
industry, i.e., they purchase and hold securities like RMBS; 
whereas, bank servicers and their affiliates comprise what is 
known as the ``sell-side,'' i.e., they create and sell 
securities like RMBS. The mortgage securitization business has 
evolved over the past several decades in a manner strongly 
influenced through the sell-side's control over the structuring 
and documentation of RMBS and on the ad hoc collection of State 
law that governs real estate ownership, financing and 
foreclosure. \2\ Accordingly, the terms of RMBS securitization 
are one-sided in favor of the sell-side and against investors 
in many important respects due to the investors' lack of 
bargaining power relative to underwriters, including:
---------------------------------------------------------------------------
     \2\ It is estimated that the five largest servicers control 59 
percent of the Nation's residential mortgage servicing.

    The entities offering RMBS securities have enormous 
---------------------------------------------------------------------------
        market power and concentration;

    Securities were offered on a take-it-or-leave it 
        basis, providing investors only hours to make a deal 
        decision normally requiring enormous diligence and 
        review;

    The PSAs were very complicated legal documents that 
        varied widely from deal-to-deal (we believe that more 
        than 300 variations of PSAs were in use), written by 
        the sell-side and with little to no input from 
        investors; and,

    The PSAs contained a variety of contractual clauses 
        which favored the rights of originators, servicers, and 
        their affiliates over investors and consumers. One 
        example is that these contracts provide a very high bar 
        for parties to enforce their legal rights and pursue 
        remedies; if RMBS servicers and trustees do not honor 
        their obligations to service mortgages properly and to 
        enforce representations and warranties against the 
        parties that originated the mortgages in the first 
        place, there is little that investors can do. 
        Accordingly, it is extremely difficult for investors to 
        push for changes in mortgage servicing even if such 
        changes would increase the economic value available to 
        investors while keeping people in their homes through 
        NPV-positive loan modifications.

    We believe that it is reasonable for the RMBS securities 
comprising more than one trillion dollars of U.S. mortgage 
financing to be governed by documents that are fair to both 
investors and the sell-side, not the one-sided documents 
putting the sell-side at the center of every conflict of 
interest, adverse to investors and consumers, as they were 
prior to the financial crisis. The Association of Mortgage 
Investors calls on policy makers to help develop the necessary 
standards, structures, and systems to ensure a sound 
securitization system and robust capital markets. These 
solutions range from enacting legislation analogous to the 
Trust Indenture Act (which solved problems for corporate bonds 
revealed by the 1929 financial markets crash similar to the 
problems that exist for RMBS today), to developing a uniform 
and standardized Pooling and Servicing Agreement for all widely 
offered and traded RMBS securities. A properly developed 
capital market infrastructure will assist both investors (and 
our affiliated public institutions such as pensions and 
retirement systems) and consumers enforce their rights and 
remedies, such getting effective remedies to breaches of 
representations and warranties in securitizations. 
Additionally, such reforms, including nationwide servicing 
standards, would serve to facilitate remedies for distressed 
borrowers.
    The basis for mortgage investors preferring mortgage 
modifications in many circumstances is founded on a sound 
business case. First, we believe that a population of 
distressed borrowers have both the willingness to pay a certain 
monthly mortgage payment, local taxes, and related expenses and 
the ability to pay after a modification. In contrast, we 
concede that not every distressed borrower is an eligible 
candidate for a mortgage modification, inter alia, some may 
have too much aggregate household debt or may be a victim of 
long-term unemployment. We believe that a reallocation of one's 
cash flows, assets, and liabilities is exemplary of sound 
business judgment. Accordingly, we favor a modification under 
certain conditions (e.g., the NPV-positive calculation) because 
a percentage modification is a far superior (business) 
proposition for investors and our affiliates, such as State 
pension funds and retirement systems, over a default (a loss 
arising from a foreclosure).

Q.2. In your written statement, your advocate for the creation 
of an independent trustee, similar to that created under the 
Trust Indenture Act of 1939. What benefits would such a 
proposal provide? What are the weaknesses? Could this same 
result be achieved under a national pooling and servicing 
standard? Why or why not?

A.2. AMI raises this point to illustrate a serious problem 
facing investors, public institutions, and consumers. The 
current RMBS system is not functioning properly. With no 
properly independent and incentivized third party looking after 
the interests of investors in securitizations, there are strong 
incentives to put bad mortgages into RMBS securitizations and 
to mismanage them to maximize income to servicers after the 
mortgages are no longer the economic concern of the 
originators. As previously explained, the documents controlling 
a RMBS securitization, such as Pooling and Servicing Agreement 
(PSA), provide for a trustee to oversee the pool of collateral 
underlying the trust (i.e., residential mortgages).
    Neither the current servicing model nor trustee model is 
well-designed for today's economic climate and its default 
rates. The RMBS pool trustee cannot adequately serve the role 
of a fiduciary as envisioned for a variety of reasons, 
including,

  1.  Being inherently conflicted, as they are employees of the 
        servicer and its affiliates;

  2.  Failing to provide the necessary financial resources to 
        adequately oversee the trust; and,

  3.  Insisting on being indemnified by the trust and/or 
        investors for anything short of the basic ministerial 
        functions that the originator and servicer want them to 
        do.

    As a consequence, as a general matter trustees have been 
unresponsive to their investors and reluctant to address 
problems that have emerged in the mortgage pools which they are 
nominally charged with overseeing. This may be addressed in 
several possible manners, including legislation analogous to 
the Trust Indenture Act of 1939 or the adoption of a national 
uniform, standardized Pooling and Servicing Agreement that 
provides for a true third party fiduciary to act on behalf of 
investors.
    The Trust Indenture Act of 1939 (the ``TIA'') is very 
instructive on a number of levels. It was enacted following the 
Great Depression and the 1929 stock market crash. As a result, 
the corporate bond market and the related legal environment 
have functioned positively for decades. However, it was enacted 
against a background where the Nation's bond markets were not 
functioning effectively and investors lacked sufficient 
safeguards.
    In developing this legislation, the U.S. Senate Banking 
Committee tasked the Securities and Exchange Commission to 
study the issue and develop a report. The effort was 
spearheaded by Abe Fortas and William O. Douglas (both future 
U.S. Supreme Court justices). The text of the resulting TIA 
directly speaks to these points of that era, which are equally 
applicable today:

        Upon the basis of facts disclosed by the reports of the 
        Securities and Exchange Commission made to the Congress 
        . . . it is hereby declared that the national public 
        interest and the interest of investors in notes, bonds, 
        debentures . . . which are offered to the public, are 
        adversely affected--

        (1) When the obligor fails to provide a trustee to 
        protect and enforce the rights and to represent the 
        interests of such investors . . .

        (2) When the trustee does not have adequate rights and 
        powers, or adequate duties and responsibilities, in 
        connection with matters relating to the protection and 
        enforcement of the rights of such investors . . .

        (3) When the trustee does not have resources 
        commensurate with its responsibilities . . .

        (4) When the obligor is not obligated to furnish to the 
        trustee under the indenture and to such investors 
        adequate current information as to its financial 
        condition, and as to the performance of its obligations 
        with respect to the securities outstanding under such 
        indenture . . .

        (5) When the indenture contains provisions which are 
        misleading or deceptive, or when full and fair 
        disclosure is not made to prospective investors of the 
        effect of important indenture provisions . . .

        Practices of the character above enumerated have 
        existed to such an extent that, unless regulated, the 
        public offering of notes, bond, debentures [etc.] is 
        injurious to the capital markets, to investors, and to 
        the general public . . . \3\
---------------------------------------------------------------------------
     \3\ Trust Indenture Act of 1939, 302, as added Aug. 3, 1939, ch. 
411, 53 Stat. 1150.

    The Trust Indenture Act has proven an effective reform for 
establishing an effective corporate bond structure. It brought 
reluctant investors back into the bond market, just as the U.S. 
Government needs to bring reluctant investors back into the 
private RMBS market. The backdrop for the enactment of the Act 
is very similar to the circumstances witnessed today. In theory 
and in the absence of any specific draft legislation, we are 
not aware of any weaknesses arising from such a legislative 
remedy. As an alternative to legislation, these defects could 
also be addressed through regulation or an enhanced set of 
provisions in a national, standardized, mandatory PSA.
    In response to the SEC's 2010 notice and comments for 
Regulation AB II, the AMI, along with other financial services 
associations, called for the establishment of a true, 
independent third-party to review the matters arising 
pertaining to the rights and remedies of investors. A qualified 
credit risk manager (CRM) would be independent from other 
parties to the Asset-Backed Securities (ABS) trust, represent 
the interests of all certificate-holders in investigations, 
and, if warranted, pursue claims for breaches of contractual 
obligations against responsible parties. A CRM should have the 
independent authority and independent discretion to pursue 
claims as a fiduciary of the certificate holders or act on 
behalf of individual certificate holders under special, limited 
circumstances. Finally, we agree that in discharging its 
obligations as a compensated third party to the PSA, the CRM, 
or any equivalent, must have complete access to loan and 
servicing files in order to conduct a proper examination and 
effectively pursue resulting claims.
    Again, we greatly appreciate the opportunity to respond on 
the record to the Committee's questions as part of the ongoing 
inquiry. Please do not hesitate to use us as resource as you 
continue your review of the state of the U.S.'s securitization 
markets.
