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.

Everything "A" is "A" Again

I admit that I am still agog when I look at the residential mortgage-backed securities transactions from right before the crash. I know it sounds like I am, once again, excavating things best left interred, but that is not the case. Last week, Fitch gave a triple A rating to a new security called "JP Morgan Re-securitization Trust 2009-R10." The Fitch news release mentions that among the securities being "re-securitized" is "a 25% interest in Lehman Mortgage Trust 2007-7, class 6-A-4." "And what's that?" I wondered, you know, to myself (I'm a blogger so, I am alone).

Then, I went on Westlaw Business and found the prospectus. LMT 2007-7 was an $800 million pool of about 2,000 residential mortgages. It issued 19 different classes of securities. The securities were narrowly sliced to reflect specific parts of the large pool. First,the big pool was subdivided into three smaller pools based on the quality of the underwriting standards. 77% of the mortgages in Pool 3, composed mostly of mortgages originated by Lehman's banking sub Lehman Brothers Bank, were "no-doc" loans.

The Pools were further subdivided into "collateral groups" by interest rate. Series 6-A4 was paid out of collateral group 6, a collection of 700-or-so mortgages with a weighted average interest rate of 7.5%. The "A" and the "4" indicate payment priority - "A" securities got paid first, but within "A" 1 got paid before 2, or 4. Further confusing the payment priority picture, the 6-A4 securities are also described as "super senior."

LMT 2007-7 paid right on schedule until December of 2007-7 when it filed a form 15 to withdraw its registration on the grounds that it was held by fewer then 40 people.

Virtually all the LMT 2007-7 securities were initially rated triple A by S&P. When I checked their rating last week, they were all rated B+ or lower. When I checked today, the ratings were gone.

Is this what we're going to get instead of PPIP?

Who Shot Mr. Burns?

Please read the gloriously deadpan Death Plays in Barron's about my favorite new securitization. "We admit" says Alan Abelson "to a nagging concern or two."

The Next Really Bad Thing

Standard & Poors has completed a review of securities collateralized by commercial mortgages and, as predicted, has put a whole bunch of them on watch for downgrade. The Wall Street Journal reports that "The watch includes 2,648 classes of commercial mortgage pass-through certificates from 170 conduit and fusion transactions."

TALF to the Wesque!

Yesterday, the Treasury, Federal Reserve Board and the New York Fed announced a new program to revivify the asset-backed securities market. The Term Asset-Backed Securities Loan Facility is faddled wifth the liwsp induffuing acronym "TALF," the new program:

"is designed to catalyze the securitization markets by providing financing to investors to support their purchases of certain AAA-rated asset-backed securities (ABS) [...] the Federal Reserve Bank of New York will lend up to $200 billion to eligible owners of certain AAA-rated ABS backed by newly and recently originated auto loans, credit card loans, student loans, and SBA-guaranteed small business loans."

The TALF Master Loan and Security Agreement are available on the NY Fed's website.

Blog Update

The Harvard Corporate Governance Blog has a post from George Bason of Davis Polk about the Treasury's final implementing regulations for the Foreign Investment National Security Act of 2007 (FINSA). FINSA amended what is known as the Exon-Florio process. Exon-Florio, administered by the Treasury's Committee on Foreign Investment in the United States, gives the President power to examine and even stop acquisitions of certain US businesses by foreign entities.

The Corporate Counsel Blog has this post about how recommendations on executive compensation from the recent meeting of the G20 look a lot like provisions of the Emergency Economic Stabilization Act.

Finally, the Business Law Prof Blog has a post about a lawsuit brought by a hedge fund called Greenwich Financial Services seeking to modify an agreement between Countrywide and 11 state Attorneys General. The agreement modified a bunch of mortgages written by Countrywide. The problem, Greenwich argues, is that Countrywide no longer owns the mortgages it agreed to modify (Greenwich Financial Services v. Countrywide Home Loan Inc., Superior Ct. for NY County, 650474/2008). More from the New York Times here.

CD'oh

Yesterday, I was talking to my father-in-law, a retired corporate lawyer and strong contender for smartest-guy-I-know honors, and I mentioned that I was thinking about writing something about CDOs (collateralized debt obligations). "What's that again?" he asked, "I hate that kind of jargon. It just makes my mind go blank." I made a couple of jokes about the redundancy of CDO - aren't debts obligations?

But the more I thought about it, the more it seemed that this lack of clarity might not be entirely unintentional. Words like "collateralized" gave a gloss of stability to investments that were anything but.

The entities that issued CDOs were special purpose vehicles like those discussed in this post, except instead of buying mortgages, they bought mortgage-backed securities issued by other SPVs. At the big housing-bubble banquet, the CDOs were the dog under the table. By the time the people at the table started to feel hungry, the dog was dead.

Crask Explainer 4: The Market for Risk

Can we talk about the old days? Back in the old days, when a bank wrote a mortgage, the bank took a risk. If you didn't make your payments, the bank had to contend with the expensive process of taking your house and reselling it at auction. To avoid that result, the bank did its best to determine your ability and willingness to pay it back.

No longer. Our new world, created by Fannie Mae and apotheosized by Lehman Brothers and Bear Stearns, is a place where consequences become wholly untethered from actions. The risk formerly carried by your mortgage bank is titrated into a kind of default-risk toxic sludge and sold to AIG.

This then, is a brief explanation of how the geniuses on Wall Street unglued the risk from mortgage banking. First, investment banks bought the mortgage portfolios of mortgage banks. Then, the investment banks organized special-purpose corporations (SPVs) and sold the mortgages to them. With the mortgages, the SPVs also acquired the associated default risk.

The SPVs were created as mortgage-backed security conduits (for more on mortgage-backed securities see this post). The SPV-issued securities were multi-tiered, with some tiers backed by riskier mortgages than others. The securities backed by the most stable mortgages were sold to the public. The worst went back to the investment bank; the default risk that started with the mortgage bank was distilled and acquired by the investment bank.

To protect itself from these risky securities, the investment bank bought default insurance. Because this insurance swapped default risk for insurance premiums, it was called a credit default swap. Who was the largest insurer? AIG. Thus, the default risk that originated when you borrowed money to buy a house was shifted onto the policyholders of AIG, and finally, to the taxpayers.

Crash Explainer 3: Asset Securitization

In yesterday's SEC Currents there was a story about the role played by the Resolution Trust Corporation in developing the asset securitization methods that investment banks have recently used to blow themselves up.

I thought this as good an opening as any to talk about asset securitization and about the Resolution Trust Corporation.

WHAT IS ASSET SECURITIZATION?

Asset securitization allows a business (called the "originator") to turn a steady trickle of cash into a great, huge whack of cash. The steady trickle is generally some kind of loan receivable like credit card or mortgage payments.

Let's imagine our originator is a bank with a portfolio of residential mortgages.

1. The bank organizes a new company called a special purpose vehicle (SPV).
2. The SPV buys all the bank's residential mortgages.
3. Then, the SPV sells securities (called asset-backed securities - ABS) on the public market.

The bank gets cash and relieves itself of the burden of policing mortgages or getting clobbered if borrowers default. The risk associated with the mortgages shifts to the SPV's shareholders.

Stop, I hear you cry - who in their right mind would buy these ABS? Good question! Not so many people it turns out, so originators developed ways to enhance the appeal of ABS. Some of the methods included:

* A guaranty by the originator
* Third party letters of credit
* Several tranches

The tranches enhancement segregates risk from gain - some tranches bear all potential losses and some get all the gain. Thus, the risk is shifted from the bank to the holders of only one tranche. And what poor unfortunates buy these all-risk securities? The originators, of course.

For a very nice treatment of the origin of ABS see: Culver, The Dawning of Securitization, Probate & Property, March/April 1994 (8-APR PROBPROP 34).

WHAT WAS THE RTC's ROLE?

Mortgage-back securities were invented by Ginny Mae and Fannie Mae in the 1970's. Ginny and Fannie pooled and sold only residential mortgages (in the example above, imagine the bank selling its mortgages to Fannie and Fannie organzing the SPV).

The Resolution Trust Corporation (RTC) came on the scene in 1989 to clean up after the collapse of many savings and loan banks in the late 1980's. RTC, created by the Financial Institutions Reform and Recovery Enforcement Act of 1989 (FIRREA, PL 101-54), was supposed to buy the assets of the failed S&Ls and resell them in hopes of making a little money for taxpayers.

RTC ended up owning a large portfolio of commerical mortgages. Because of the complexity involved, no one had attempted to package commerical mortgages as ABS. Realzing that the alternative of disposing of the mortgages individually would be even more difficult, RTC developed methods for packaging commercial mortgages as ABS.

To see an example of an RTC ABS deal see the S-11 filed by Lehman Structured Securities on 8/12/1996. The securties being sold are called Commerical Mortgage Pass-Through Certificates Series 1996-1. For something more recent, try Bear Stearns Alt-A Trust, 424B5, 2/01/06.

NEXT: Risk