I join Chairman Schapiro in thanking the staff of the Division of Corporation Finance, most notably Paula Dubberly, Katherine Hsu, Rolaine Bancroft and, of course, Meredith Cross, and the other contributing offices, for their outstanding work on this release, which addresses a complex and very important subject.
Before I address the specific proposal that we are considering today, I would like to spend a few minutes discussing the importance of the public and private ABS markets, the weaknesses in the ABS market exposed by the financial crisis, the reactions of the market and policymakers to these weaknesses and some of the implications for the regulation of ABS.
As the Release notes, asset-backed securities were an increasingly important driver of economic growth in the United States in the years leading up to the financial crisis that began in 2007. In particular, the securitization of financial assets permitted lenders and other institutions to increase the availability of credit to consumers and businesses by enabling those institutions to transfer financial assets off of their balance sheets, freeing up capital to make new loans while transferring the risks of holding these assets to other investors.
As a result, consumers had greater access to mortgages, auto loans, student loans, and credit cards, and businesses had greater access to commercial mortgages, equipment financing, floorplan financing, and other corporate credit. This expansion of credit was the result of increasing investor demand for both public and private offerings of ABS. In addition to increased access to credit, consumers and businesses benefitted from reduced costs of borrowing and an expanded range of financial products.
Nevertheless, the financial crisis highlighted weaknesses in the ABS market and has called into question the efficiency and operation of this market. Several reports, including President's Working Group's March 2008 Policy Statement on Financial Market Developments and the August 2008 Report of the Counterparty Risk Management Policy Group III, have documented the link between an increase in the default rate for subprime and other mortgages, the decrease in the value of collateralized debt obligations and collateralized loan obligations (which were often collateralized by residential mortgage backed securities), and the resulting decrease in demand for ABS across all asset classes.
These reports and others have noted some of the key weaknesses in the ABS market that contributed to the financial crisis, including:
Underwriting standards for subprime mortgages deteriorated and market discipline by participants in the securitization process — including originators, underwriters, credit rating agencies (CRAs), and global investors — eroded, related in part to failures to provide or obtain adequate risk disclosures;
CRAs failed to assess accurately and to communicate effectively the risks underlying complicated structured securities like RMBS and CDOs;
Increasing complexity and innovation in structured securities was insufficiently accompanied by analysis and understanding by market participants of the attendant risk of loss; and
Investors relied too heavily on ratings of structured securities without conducting sufficient independent analysis and due diligence of those investments.
The market correction that resulted from the loss of confidence in ABS markets was quick and brutal. The effects of this correction remain today. While there has been some return of liquidity in some asset classes, including credit cards, auto loans and "agency" RMBS, there has been virtually no activity in many other asset classes, such as private-label RMBS and complicated structured securities like CDOs.
Although there have been market efforts to address some weaknesses in the ABS market — in particular initiatives, such as the American Securitization Forum's Project RESTART, designed to increase transparency and standardization — there remains a surplus of outstanding ABS to satisfy investor demand for these investments, so the recovery of the ABS market for new ABS in many asset classes will take time.
There has also been a great deal of focus by policymakers on the need to restart, and support sound practices in, the securitization market. The release before us today is proposed in this spirit and with this objective.
It is imperative, however, that policymakers consider improvements to this market holistically and ensure that they appreciate the far-reaching effects of changes they may propose. Furthermore, policymakers must recognize changes, both by private actors in the market and by other U.S. and international policymakers, that have taken place since the inception of the market crisis or that are in progress.
In particular:
The market correction that I have just described has been characterized both by changes in the prices investors are willing to pay for structured securities and changes in investors' behavior, as evidenced by the lack of demand for opaque or complex securities,
Accounting standard-setters have adopted or are considering changes relating to the off-balance sheet treatment and the valuation of financial assets,
Prudential regulators have adopted, proposed or are considering various changes to the capital requirements for financial institutions, including changes to the risk-based capital rules jointly adopted by U.S. banking and thrift regulators and proposals by the Basel Committee on Banking Supervision relating to new capital and liquidity standards, and
The Commission has taken significant and comprehensive measures to reform CRAs pursuant to authority granted by the Rating Agency Act. These reforms address the conflicts and incentives that led CRAs to fail investors so badly. The Commission has also adopted extensive rules intended to promote competition among credit rating agencies and that enhance the amount and quality of disclosure by CRAs in order to ensure their accountability. Finally, the Commission continues to remove the references to credit ratings embedded in our rules, which contributed to investors' undue reliance on credit ratings.
Regulations that are based solely on the market as it existed in the period leading up to the financial crisis, and that do not properly consider these and other changes, may be outdated from their inception and risk thwarting a recovery in these markets.
Furthermore, coordination and cooperation among policymakers are vital. While it is appropriate for us to proceed today to propose rules to improve our regime relating to ABS, I fully expect that the Commission will coordinate closely with our fellow regulators, including banking regulators and the Treasury Department.
Indeed, as Congress has already indicated, to the degree that our reforms interrelate with other regulatory initiatives, it may be appropriate for us ultimately to engage in joint rulemaking.
For instance, financial reform legislation under consideration in Congress, an advance notice of proposed rulemaking recently issued by the FDIC, and our proposal today each contemplate some form of a risk retention requirement, albeit to satisfy different regulatory purposes.
Putting to the side for the moment the prudential considerations of risk retention, this issue illustrates the importance of a coordinated, comprehensive approach to regulation by policymakers in order to ensure rational regulation, avoid unintended consequences and promote certainty among market participants.
For the Commission's part, we seek to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation by ensuring that investors receive complete, accurate and timely information necessary to make informed investment decisions.
Where investors can "fend for themselves," however, the Securities laws have provided for the exemption of transactions from the more fulsome requirements of our disclosure regime. As a result, the United States has historically benefitted from a robust private market for securities, including ABS. Revitalizing both the public and private markets remains central to our efforts to improve market efficiency and promote capital formation which is, in turn, vital to broader efforts to support economic recovery, job creation and long-term growth.
All regulation, including a disclosure regime, comes at some cost to market participants — including issuers, sponsors, investors and others — and the Commission, like all regulators, must balance its regulatory objectives against these costs.
In light of the significant market disruption in the ABS market during the financial crisis, and the role that structured securities played in that crisis, our proposal today is far-reaching. Nevertheless, I believe that the release attempts to balance these interests.
The release reflects our preliminary views rather than definitive answers, and should be considered as a request for input about whether the proposals properly identify and appropriately respond to weaknesses in the ABS market.
Turning now to the release itself, I just want to highlight a few proposals and other issues where I believe commenters' views and insights will be particularly helpful.
First, we propose to eliminate the current means of establishing shelf eligibility for an ABS transaction based on the security's credit ratings, and to adopt other criteria that are intended to ensure that the securities possess certain indicia of "quality." One of these proposed criteria is that the ABS sponsor retain 5% of each tranche of the securitization.
Although I wholeheartedly support the proposal to remove credit ratings as a condition to shelf eligibility, I am less confident that the conditions that we have proposed to replace credit ratings are appropriate.
As an initial matter, it is worth noting that the release requests comment as to whether shelf eligibility for ABS should continue to be based upon the quality of the securities at all. The Commission has expertise in disclosure, and its historical approach to regulation is to ensure investors have appropriate disclosure rather than attempting to regulate based on the merits of particular securities.
In particular, I am concerned about conditioning shelf eligibility on risk retention. Although I understand the theory that risk retention aligns the interests of ABS sponsors with the interests of investors, achieving the theoretical merits of risk retention remains a point of continued debate and analysis. Even granting that risk retention has such a beneficial effect, the amount and form of risk retention that would prove most effective also are subject to debate.
The release recognizes these ongoing issues and further queries whether alternatives to such a requirement would be more appropriate.
Given full information about risk retention arrangements, it is possible that investors would be capable of placing the value that they deem appropriate on those arrangements, and effectively achieve the same screening incentive or incentive alignment that a hard retention requirement is intended to achieve. Thus, the proposal requests comment on whether a "disclosure only" approach to risk retention would be more appropriate than requiring a certain level of risk retention as a condition to shelf eligibility.
To the extent that commenters do not believe that "quality" generally, or risk retention in particular, are appropriate conditions to shelf eligibility, the release requests comment on a more appropriate substitute for credit ratings as a condition to shelf eligibility.
Next, we propose to significantly expand the disclosure required in ABS transactions. Among other changes, we propose to require the disclosure of asset-level data (or grouped account data in the case of a securitization of credit card receivables) in a machine-readable, standardized format.
These proposed disclosure requirements build, where possible, on private sector initiatives, such as the ASF's Project RESTART, but I expect that commenter input into the specific data points in each asset class that market participants believe would be helpful to an analysis of ABS will help us to tailor the disclosure requirements that we ultimately adopt.
I commend the staff on its sensitivity to real and legitimate privacy concerns that the disclosure of asset-level data raises. While I certainly understand that these data are important to investors' analysis of ABS, I have some concerns as to whether data-miners could "reverse engineer" these data to obtain sensitive or confidential information about individual consumers and businesses, so I look forward to reviewing comments on this issue.
Finally, in private placements of structured finance products to sophisticated investors pursuant to the safeharbors provided by Rule 144A or Regulation D, we are proposing to condition these safeharbors on the issuer's commitment to provide to investors, upfront and on an ongoing basis, the same information that would be required in a registered transaction.
These new disclosure requirements are intended to address concerns relating to the amount and quality of information available to sophisticated investors about structured products — especially complex products like CDOs — sold in these private transactions.
To the degree that sophisticated investors have been unable to obtain necessary and timely access to information in order to make investment decisions, considering ways to facilitate such access is absolutely appropriate. However, it also remains important to recognize that many of these sophisticated investors are institutional investors who are bound by fiduciary duties to conduct appropriate due diligence before investing in these securities. Changes to our rules that enhance access to investment-critical information, while well-intended, should not disincentivize or relieve these investors of their existing fiduciary duties.
More fundamentally, I do not believe that the answer to a failure by sophisticated investors to appropriately consider and understand the risks of their investment decisions in private transactions is to necessarily regulate to the "lowest common denominator," and thus to eviscerate the private placement market for ABS.
Separate from any particular proposal, the release notes that one likely result of our proposals, if adopted, is that Fannie Mae, Freddie Mac and Ginnie Mae, whose RMBS are exempt from SEC registration under the Securities Act, and the originators who are able to securitize mortgage loans through these "GSEs," will gain a further competitive advantage over sponsors and issuers of private-label RMBS and originators of non-conforming loans as a result of the GSEs' exemption from registration.
The financial crisis has underscored, in my view, that investors are poorly served by the maintenance of such an exemption from the protection of the Securities Act. Over the course of the past decade, proposals to remove this exemption have been considered and debated by policymakers. While there may be particular practical issues unique to the existing GSEs that need to be addressed in any such effort, the benefit to investors remains clear.
It is my hope that Congress, as it contemplates financial regulatory reform, will consider the important investor benefits and protections that registration under the Securities Act would bring to GSE RMBS issuances.
In the absence of such action, however, I am deeply concerned that our actions may serve to further subsidize the GSEs and reenforce their dominance, both of which may actually increase longer term systemic risk and risk to taxpayers. Accordingly, I look forward to reviewing comments regarding the impact of our proposals, if adopted, on the residential mortgage market.
In addition to the specific proposals and issues that I have just discussed, I look forward to reviewing comments on the overall effects of our proposals. In particular:
Have we struck the right balance between regulatory objectives and the costs to issuers, sponsors, investors and others?
What will be the impact of these proposals, if adopted, on the availability and costs of all forms of credit to businesses and consumers?
Thanks once again to Meredith, Paula, and the rest of the staff for your excellent work on this release.