Tranche Retention: One Size Doesn't Fit All

The Federal Reserve Board has released, as required by the Dodd-Frank Act, a study titled Report to the Congress on Risk Retention:

The study defines and focuses on eight loan categories and on asset-backed commercial paper (ABCP). ABCP can be backed by a variety of collateral types but represents a sufficiently distinct structure that it warrants separate consideration. These nine categories, which together account for a significant amount of securitization activity, are
1. Nonconforming residential mortgages (RMBS)
2. Commercial mortgages (CMBS)
3. Credit cards
4. Auto loans and leases
5. Student loans (both federally guaranteed and privately issued)
6. Commercial and industrial bank loans (collateralized loan obligations, or CLOs)
7. Equipment loans and leases
8. Dealer floorplan loans

The study also addresses the interaction of credit risk retention and accounting standards, including FAS 166 and 167. Depending on the type and amount of risk retention required, a securitizer could become exposed to potentially significant losses of the issuance entity, which could require accounting consolidation when considered with the securitizer’s decision making power over the issuance entity. Given the earnings and regulatory capital consequences of maintaining assets on–balance sheet, companies may be encouraged to structure securitization to again achieve off-balance-sheet treatment. For example, institutions may cede the power over ABS issuance entities by selling servicing rights or distancing themselves from their customers primarily to avoid consolidating the assets and liabilities of the issuance entities. Alternatively, the potential interaction of accounting treatment, regulatory capital requirements and new credit risk retention standards may make securitization a less attractive form of financing and may result in lower credit availability.

Overall, the study documents considerable heterogeneity across asset classes in securitization chains, deal structure, and incentive alignment mechanisms in place before or after the financial crisis. Thus, this study concludes that simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the Act—namely, to improve the asset-backed securitization process and protect investors from losses associated with poorly underwritten loans.

Moreover, the Board recommends that that the following considerations should be taken into account by the agencies responsible for implementing the credit risk retention requirements of the Act in order to help ensure that the regulations promote the purposes of the Act without unnecessarily reducing the supply of credit. Specifically, the rulemaking agencies should:
1. Consider the specific incentive alignment problems to be addressed by each credit risk retention requirement established under the jointly prescribed rules.

2. Consider the economics of asset classes and securitization structure in designing credit risk retention requirements.

3. Consider the potential effect of credit risk retention requirements on the capacity of smaller market participants to comply and remain active in the securitization market.

4. Consider the potential for other incentive alignment mechanisms to function as either an alternative or a complement to mandated credit risk retention.

5. Consider the interaction of credit risk retention with both accounting treatment and regulatory capital requirements.

6. Consider credit risk retention requirements in the context of all the rulemakings required under the Dodd–Frank Act, some of which might magnify the effect of, or influence, the optimal form of credit risk retention requirements.

7. Consider that investors may appropriately demand that originators and securitizers hold alternate forms of risk retention beyond that required by the credit risk retention regulations.

8. Consider that capital markets are, and should remain, dynamic, and thus periodic adjustments to any credit risk retention requirement may be necessary to ensure that the requirements remain effective over the longer term, and do not provide undue incentives to move intermediation into other venues where such requirements are less stringent or may not apply.

Gee, it sounds like tranche-retention isn’t a magic bullet after all, eh?

Tranche retention is a silly idea. It is, after all,tranche retention that exacerbated the crisis, since the big banks kept a significant portion of their toxic assets on the books anyway; in addition, it seeks to diminish the role of due diligence on the part of the buyers of these things.

Tranche retention was last discussed on PrefBlog in the post SEC Proposes ABS Tranche Retention Requirement

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