[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
Available at: http: //www.fdsys.gov /
_____
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70-772 PDF WASHINGTON : 2011
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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
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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\
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\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.
---------------------------------------------------------------------------
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\
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\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.
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\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
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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\
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\3\ 2011 Mortgage Market Statistical Annual, Volume II, p. 31.
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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.
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\4\ S&P/Case-Shiller Home Price Index press release dated April
26, 2011.
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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\
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\1\ The Dodd-Frank NPR: Implications for CMBS, April 12, 2011,
Morgan Stanley at 1.
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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\
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\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.).
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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.
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\4\ Pub. L. No. 111-203.
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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\
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\5\ A copy of the March 25, 2010, letter is attached.
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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\
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\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\
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\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
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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.
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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.
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\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.
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\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\
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\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.
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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.
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\2\ The exceptions are two recent securitizations by Redwood
Trust.
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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\
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\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\
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\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\
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\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.
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\1\ ``Private Ordering of Public Markets: The Rating Agency
Paradox'', 2002 U. Illinois L. Rev. 1, 7-8.
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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.
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\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.
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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\
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\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.
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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\
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\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\
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\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.
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------
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.
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\1\ http://www.rooseveltinstitute.org/policy-and-ideas/ideas-
database/securitization-taming-wild-west
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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:
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\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
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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\
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\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.