Subtitle E: Improvements to the Asset-Backed Securitization Process

Today, I'm going to start looking at a neglected piece of the administration's reform proposal: title IX, the vast Investor Protection Act of 2009. The IPA is a grabbag of regulatory off-cuts ranging from asset-backed securitization reform to credit rating agency reform.

The centerpiece of Subtitle E, called "Improvements to the Asset-Backed Securitization Process," is the so-called "skin-in-the-game" regulatory fix. The idea is that the present securitization process provides no incentive for deal sponsors to create good-quality securities. The way sponsors make money is by getting fees. They pay themselves a fee for putting together the pool, for underwriting, and even for servicing the underlying debt. They don't invest. The sponsor is like a chef who won't eat at his own restaurant. The thinking is that if he has to eat what he peddles, his restaurant will improve.

So, section 952 of the IPA would require "securitizers" of ABS deals to retain 5% of the "risk." Securitizers would not be allowed to hedge this retained risk and the SEC would establish standards for the risk's "permissable forms" and "minimum duration."

The new law defines "securitizer" as an issuer or an underwriter. It cleverly hops right over the amorphous matter of trying to define "sponsor" and lands right where the sponsor gets its money - underwriting.

Of course, the ABS packagers, especially the residential mortgage monsters like Lehman and Bear Stearns *were* eating in their own restaurant. In fact, they were eating the leftovers (in the form of the lowest tranches of their offerings), and so, there's a funny sort of conversation that's been going on about whether the ABS sponsors were really avoiding the securities they created. What this argument boils down to is a disagreement about how stupid they were. Were they smart enough to know their ABS deals were crappy, but too stupid to get out in time, or were they completely oblivious to how risky these deals were? Skin-in-the-Game is only an effective deterrent if the ABS packagers are just a little stupid.

Subtitle E also gives the SEC power to create a disclosure obligation for ABS issuers that could not be extinguished by de-registering under section 15 and presumably would continue until the breaking of the world.

For a complete overview, see this Cadwalader memo and wonder along with them (and me) about why the law repeals s. 4(5) of the '33 Act.