The leaked report placed particular emphasis on regulating originators and sponsors of securitisations. "One of the most significant problems in the securitisation markets was the lack of sufficient incentives for lenders and securitisers to consider the performance of the underlying loans after asset-backed securities (ABS) were issued," the report stated. The Treasury also noted that a lack of adequate disclosure in the market served to exacerbate the divergence in incentives between lenders, securitisers and investors.
The US Treasury's proposals are broadly comparable to amendments made by the European Commission to the Capital Requirements Directive (CRD) that passed through the European Parliament on May 6, which also required a 5% retention and greater disclosure from originators. However, in contrast to the US Treasury proposals, the EC's CRD chose to emphasise investor due diligence as the key to regulating securitisation, while the 5% originator retention requirement was to act as a "backstop" mechanism.
"To align the interests of issuers and investors, we simply want to make sure investors do their homework in terms of due diligence when they buy securitisation positions," said Kai Spitzer, a seconded national expert in the Internal Markets Directorate General at the EC, in a speech at Risk Europe 2009 in Frankfurt on June 4.
The EC reinforces this onus on investors, by imposing capital charges of 250%, capped at 1,250%, on investors that cannot prove they have undertaken adequate due diligence on securitised positions.
"The [EC] regulation is not there to change the behaviour of the originators, the regulation is there to constrain the behaviour of the bank investors. What this really is all about is European banks buying US subprime residential mortgage-backed securities (RMBS) and sustaining massive losses. This is what the European regulators want to prevent," explained one European head of ABS research at a European bank.
The US's proposed 5% retention requirement – which could be increased or reduced if necessary – will be applied to all originators and sponsors of securitisations. The US Treasury did not specify what form the retention should take, although examples were given of the originator retaining the first-loss portion of the securitisation or a vertical slice of all tranches. Instead, the report stated US regulators will be given their own mandate to specify how the requirement can be fulfilled. However, the 5% retained portion will not be allowed to be hedged away by originators, although there might be certain exemptions granted.
Some analysts question how effectively a retention requirement aligns the interests of originators and investors. "I'm generally sceptical that this is the way to realign the interests of issuers and investors. If your economy falls off a cliff, even some of the underwritten loans are going to deteriorate," says one international financial strategist at a US bank.
Nonetheless, if the US retention requirement follows the EC's model, analysts say it should not unduly hamper bank originators. For example, the EC's CRD allows originators to satisfy the requirement by retaining 5% of their portfolio on their books unsecuritised, something bank originators already practised, particularly for RMBS.
"Bank originators such as ourselves will probably find it easier to contend with the retention requirement than the non-bank originators," says Gordon Haskins, head of transaction execution for securitisation at Royal Bank of Scotland in London, speaking in reference to the EC's retention requirement.
Instead, it is the originate-to-distribute non-bank originators – so prevalent in the US prior to the subprime crisis – that would struggle the most to meet the 5% retention level, as these institutions typically rely on securitising their entire portfolio to fund a transaction. However, the loss of this securitisation model – which allowed the proliferation of subprime mortgages – is unlikely to be mourned by regulators.
Like the EC's CRD, US regulators will also impose stiffer transparency requirements on originators. Information on underlying assets, including loan-level data, will have to be provided to investors. Moreover, the compensation received by originators and sponsors for the transaction, as well as the risk-retention level, will also have to be made available.
Banks and investors indicate that, in general, much of this type of information was already provided. As such, these requirements will probably serve to standardise existing practices rather than overhaul them. However, Miles Bake, London-based associate at Mayer Brown, believes providing loan-level data could be a challenge in some cases. "If this level of disclosure does lead to loan-by-loan data for massive granular pools like RMBS master trusts, that will pose operational challenges for originators, and also for investors, as to how to deal with this information," he explained.
Elsewhere, the Treasury's proposals mark a change of emphasis from the EC's CRD. First, the report suggests compensation processes for brokers, originators, sponsors and underwriters should be "linked to the longer-term performance of securitised assets", rather than determined at origination. This would first be achieved by changing accounting standards to prevent originators from immediately recognising the gain of selling a securitisation, and instead requiring originators to recognise income over time. Likewise, fees for loan brokers and loan officers should be spread over an appropriate time period.
Second, in contrast to the EC focusing on investor due diligence, the US Treasury proposes that credit rating agencies provide clear and detailed information on the risks of structured credit transactions. Regulators were also urged to "reduce their use of credit ratings in regulations and supervisory practices wherever possible".