SEC Proposes ABS Tranche Retention Requirement

The Securities and Exchange Commission has proposed a new rule, Asset Backed Securities:

We are proposing significant revisions to Regulation AB and other rules regarding the offering process, disclosure and reporting for asset-backed securities. Our proposals would revise filing deadlines for ABS offerings to provide investors with more time to consider transaction-specific information, including information about the pool assets. Our proposals also would repeal the current credit ratings references in shelf eligibility criteria for asset-backed issuers and establish new shelf eligibility criteria that would include, among other things, a requirement that the sponsor retain a portion of each tranche of the securities that are sold and a requirement that the issuer undertake to file Exchange Act reports on an ongoing basis so long as its public securities are outstanding. We also are proposing to require that, with some exceptions, prospectuses for public offerings of asset-backed securities and ongoing Exchange Act reports contain specified asset-level information about each of the assets in the pool. The asset-level information would be provided according to proposed standards and in a tagged data format using eXtensible Markup Language (XML). In addition, we are proposing to require, along with the prospectus filing, the filing of a computer program of the contractual cash flow provisions expressed as downloadable source code in Python, a commonly used open source interpretive programming language. We are proposing new information requirements for the safe harbors for exempt offerings and resales of asset-backed securities and are also proposing a number of other revisions to our rules applicable to asset-backed securities.

Some of this stuff is sort-of good, for example Our proposals would revise filing deadlines for ABS offerings to provide investors with more time to consider transaction-specific information, including information about the pool assets, but appears to intend a more stringent process for ABS than for actual bonds. When an institutional investor is offered a new issue, for example, only bare-bones information is available: generally just the coupon (perhaps expressed as a spread) and term. There might be some mention of special features.

However, for these offerings, documentation is simply not available. You want to read through the pricing supplement or the prospectus? Tough luck, Charlie, ain’t got it. You want some or not? If you wait for the documentation, the issue’s been sold out by the time you get it.

Thus, new issue bond investors are typically entirely reliant on the knowledge and good will of the underwriters’ salesmen or, to put it another way, new issue bond investors are fools.

Of more interest, however, is the tranche retention requirement: Our proposals also would repeal the current credit ratings references in shelf eligibility criteria for asset-backed issuers and establish new shelf eligibility criteria that would include, among other things, a requirement that the sponsor retain a portion of each tranche of the securities that are sold and a requirement that the issuer undertake to file Exchange Act reports on an ongoing basis so long as its public securities are outstanding.

Tranche retention has become the rallying cry throughout the crisis for those who believe that the world would be a much better place if only there were more rules. John Hull supports tranche retention but admits that tranche retention was already in effect throughout the crisis, albeit in different parts of the underwriting firm. The opposite approach, encouraging arm’s length sales to third parties, was urged by Krahen and Wilde in 2005, as cited in the story of the CDO meltdown. Note that a major problem that exacerbated the crisis was collateral substitution in CDOs in which – effectively – investment decisions for a CDO were made primarily for the benefit of the most junior tranche; mandatory tranche retention will exacerbate, not address, this problem; it should be noted in mitigation, however, that the SEC proposes to require that a portion of each tranche be retained.

Ain’t no substitute for forcing long term investors to think! Since the sell-side is congenitally incapable of such a thing, I continue to suggest that the regulatory regime focus on disaggregating the trading part of the street from the investing side; the Volcker Rule is overkill, but allowing financial institutions to choose – one choice per institution! – between regulatory capital regimes intended to penalize aged inventories for traders, and penalize trading activities by investors will go very far to actually accomplishing something.

However, back to the SEC’s proposal. As usual, the SEC (and other American institutions, such as the Fed) the SEC at least pays lip service to the idea that it takes two to make an argument, as opposed to the continuous intellectual dishonesty forthcoming from, for instance, OSFI. Thus – and I trust Assiduous Readers are sitting down – opposing viewpoints are discussed and heavily footnoted:

Risk retention requirements are being considered in the U.S. and internationally. In the U.S., proposals with such requirements have come in several different forms.108 Risk retention requirements have recently garnered support.109 On the other hand, some are concerned that mandatory risk retention will not necessarily result in improved asset quality, may not be calibrated to reflect the risk in any given pool and across different asset classes, and may conflict with various other goals and purposes of securitization.110

(110) See, e.g., comment letter from American Securitization Forum and comment letter from American Bar Association on the FDIC Securitization Proposal.

I believe that the American Securitization Forum’s letter is this one, similarly I believe that this is the ABA letter.

2 Responses to “SEC Proposes ABS Tranche Retention Requirement”

  1. […] … let me see. Did tranche retention work in this instance? Would the SEC’s tranche retention idea have accomplished anything? Um … […]

  2. […] looks like tranche retention will become law, as proposed by the SEC and supported by John Hull, among others: Private lenders will be required to keep at least a 5 […]

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