Securitization had a significant negative role based on its distorted motivation system in the subprime crisis of 2007–2009. This paper examines the legal system after the crisis in terms of how regulators and supervisory bodies drew the conclusions of a faulty securitization system. It is also the scope of the study to examine the efficiency of this new regulation and its implementation in terms of avoiding the same problems caused by securitization in the crisis under jurisdiction of the United States and the European Union.
Although the negative role of securitization was significant during the crisis of 2007–2009, this structured financial product has its macroeconomic advantages, which surpasses its negative role. The securitization in Hungarian economy can support this idea, since securitization of claims can induce economic recovery during recessionary periods in the economy. This Janus-face of securitization can be well illustrated by the case of regulations’ main goals in both jurisdictions (in the United States and in the European Union), the focus of which was on creating leveled playing fields for all actors of securitization, as well as sustaining a transparent environment without conflicts of interests.
The author applied as a benchmark of the research the results of Steven L. Schwarcz, professor of Duke University, concerning the negative role of securitization during the financial crisis of 2007–2009. The distorted motivations was summarized by professor Schwarcz in five points: not proportional use (relative to their risk) of mortgage loans and their low quality, misuse of the originate to distribute model, conflict of interests in the activities of loan administration institutions, excess use of mathematical models, the role of credit rating agency instead of investors’ due diligence.
Credit rating agencies have played a crucial role in the United States in the securitization process in comparison to the European Union. This role has become so deep-rooted in the practices of securitizations under US law, that its legal regulation could only define as its objective to limit such activities to a lower level (by eliminating or significantly reducing macro prudential risk). The legislator almost over accomplished this goal by extending prospectus liability to credit rating agencies in their activities within securitization, but this motion was not successful, so it was not enacted because of the credit rating agencies’ high lobby power. Instead of that, the law only ordered credit rating agencies to disclose all relevant information for investors. As part of this ruling, credit rating agencies must disclose not only their respective rating, but also the model under which these decisions are based and all relevant information used as well as deviations from methods during ratings of similar securities. This regulation contains disclosure requirements concerning the sampling methods and results of examining credit contracts of claims, from the perspective of whether these contracts adhere to loan underwriting rules. This latter promulgation of Dodd-Frank Act of 2002 reduces the risk of adverse selection during loan underwriting processes.
The lawmaking process was very fast in the United States. This hurry was quite obvious not only because of the public outcry, but also because of an urgent need to avoid a similar crisis caused by securitization. This new regulation concentrated on four major areas: significantly stricter disclosure rules, compulsory risk taking of securitization originators, stricter rules for credit rating agencies (NRSRO) and raising capital requirements.
Before analyzing the regulatory changes in detail, it is important to emphasize the special role of Credit Default Swaps (CDS) in the securitization process in the United States during the first decade of the 2000’s. Credit default swap was very much a misunderstood financial tool by lots of investors. Its original role was to make securitization less risky, but it played out just the opposite, as it has similarities to insurance products. As long as a CDS does not reach its default event it works like an insurance contract paying premiums to its issuer. However, when a default risk event happens, the seller of the CDS has to fulfill its obligation and pay up to the difference of the security’s face value and the market price of a defaulted asset. These insurance product characteristics worked without capital pledged against potential future obligations arising from CDS. This credit default risk was a very low risk event, which made its user irresponsible by only concentrating on positive cash-flows from premium payment and its short-term profits, but not calculating its potential losses in case of an obligation to be fulfilled. An efficient capital market regulation could have helped to avoid this situation in the subprime crisis of 2007–2009. Alan Greenspan, Chair of the Federal Reserve, and Secretary of Treasury Robert Rubin were responsible for preventing the debate concerning the necessary regulation. However, Brooksley Born, Commodity Futures Trading Commission chairperson submitted a proposal in which she would include OTC swaps under the same regulation as exchange traded derivatives: under the control of a central-counter party. By overruling the proposal, Rubin and Greenspan caused indirectly a USD 85 billion loss for AIG (American Insurance Group), which had to be capitalized by the Treasury of the United States as all obligations from CDS at AIG added up to this sum. At the time, AIG operated as a licensed public insurance company, but did not pledge any capital against possible losses for fulfilling obligations stemming from selling CDSs. In the case of operating under the control of a central counter-party, a contract instantly results in the stepping of the central counter-party as part of a novation process, eliminating counterparty risk by operating a multi-level collateral system for its partners.
During the subprime crisis the lack of centrally kept records resulted in the uncertainty of settlement and a clear picture for the authorities concerned about the notional value of outstanding CDS obligations. In several cases, CDS contracts were based on the same claim portfolios of mortgage loans. The lack of information about the notional value of obligations resulted in a crisis of trust among actors of the financial markets. It was an especially serious loss of trust among repo market and money market participants which eventually led to loss of confidence in investment banks as well. The FED had to intervene to avoid the collapse of the financial system. The central bank stepped in several money markets, including repo and money market mutual fund markets as a lender of last resort. These activities were the first in history when a central bank acted as a lender of last resort to save a shadow banking actor instead of concentrating such activities on the actors of the traditional banking system like commercial banks and savings and loans.
Before the enactment of the Dodd Frank Act of 2002, the Securities Act of 1933 regulated the rules of disclosure and registration for public offerings. These acts refer to securitized assets as asset-backed securities (ABS). The two acts define private asset backed securities as opposed to asset backed securities which considered publicly issued ABSs. The private ABSs had no registration or disclosure requirement before the enactment of the Dodd-Frank Act of 2002. In this case, the limited scope of investors – qualified investors could participate only in these private securitization – was the guarantee for protection of investors’ interests.
Dodd Frank Act of 2002 promulgated a revision of disclosure requirement to have a stricter one for the Securities and Exchange Commission (SEC) to protect investors and increase market transparency. The SEC – based on its commission by the Dodd Frank Act – issued a Final rule (79 FR 57183) in September 2014 about ABS disclosure and registration rules. SEC, as a legislator and a regulatory authority applying relevant legal regulations, amended the article of the Securities Act of 1933 regulating prospectus with promulgating disclosure of each tranches of a securitization. As part of the amendment the SEC also promulgated the continuous compulsory revision of portfolio of claims. For public offerings the SEC specified no exact deadlines and material conditions, but rather applied a reasonable assurance method, with which the ruling can protect the interests of investors by promulgating for securitization originators to provide sufficient time for investors to analyze complex and large amounts of data.
By promulgating to securitization originators to have compulsory risk taking (skin in the game), the SEC made a significant step towards a stricter regulation to achieve responsible securitization activities. The SEC ruled – according to its duty stipulated by section 941 of the Dodd Frank Act – in accordance with other federal authorities on October 2014, which actually modified article 15 section G of the Securities Exchange Act of 1934. According to the regulation, a securitization originator must hold outstanding during the whole time of securitized assets at least five percent of the assets securitized without any hedge position, except for securitizations made exclusively from Qualified Residential Mortgage (QRM). As a result of this ruling, the motivations of transferring risks merely to achieve increasing profits without responsible business activity were eliminated.
To provide proper information to all participants in the securitization process, credit rating agencies must disclose in full array all expected and preliminary ratings according to the SEC ruling, as it was promulgated in the Securities and Exchange Act of 1934 Article 17 section g-7 (Dodd Frank Act article 943). Furthermore, credit rating agencies must disclose all information of how much difference can be measured relative to their ratings of similar securities issues in terms of sampling and loan underwriting procedures for claims based on these loans.
The tightening of capital requirements eliminated another distorted motivation of securitization, namely the capital release. With the help of the new regulation it is not allowed to generate free cash by buying new claims or underwrite new loans to be securitized later. Another modification in regulation which also aims to eliminate this distorted motivation for securitization is promulgating high capital requirements for asset backed securities and covered bonds as well.
As a conclusion of evaluating the reregulation of securitization in the United States after the Financial Crisis of 2008–2009 in the United States, it is worth going back to professor Schwartz’ s list of distorted motivations. Overviewing the 5-piece list, the author concludes that the 5 percent skin in the game, risk retention rule is the one defending the markets from only for profit-based securitization motivation, and instead it is enforcing responsible market activities during securitization. There was a partial result from the point of view of investors, that credit rating agencies’ role remained intact and their responsibility was not included as it is in the case of IPOs for prospectuses. The Dodd-Frank Act provides ground for investors for due diligence, but the regulation has not made it an exclusive practice as it is now in the European Union. As a conclusion it can be stated that the reregulation of securitization in the United States is the right step towards efficient lawmaking. It is not a complete solution however, as it could not eliminate the role of credit rating agencies and could not enforce them to be held responsible as an investment bank during the IPO process, as it is defined in prospectus liability.
There is a significant difference between the regulation of securitization in the European Union and the United States – this is especially true in two areas. The first major difference is the pace of introduction of new regulation, while the second one is the legislators’ different motivation. As mentioned above, the specialty of United States’ securitization is the role of credit rating agencies, while in Europe the credit rating agencies had a much lesser role.
The different role of securitization can also be traced between the two jurisdictions. It can be measured by a much lower volume of issues and also a much lower level of default rate during the crisis in the European Union, relative to the one in the United States. In the United States the securitized claims that had the best rating (AAA) had a non-performing rate of 16 % in case of subprime claims, while it was 3 % in case of prime claims. In the European Union securitization based on portfolios of retail mortgage loans had a nonperforming rate of merely 0,1 %. The difference was even more striking in the non-investment category securitized claims (BBB), where the maximum non-performing rate was 62 % during the crisis in the United States and only 0,2 % in the European Union respectively. It can be concluded that securitization has much higher quality and much lesser role in the European Union, since it was accounted to only one fourth of those of the United States in 2017.
Before the European Union’s relevant regulation came into force on January 1st of 2019, Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 regulated securitization. This regulation promulgated rules for securitization in an independent section of the Regulation, but only from the point of view of the prudential operation of financial institutions.
Legislators of the regulation in effect before 2019 concentrated on traditional securitization and approached rulemaking to achieve a prudential regulation for financial institutions. That approach had two basic causes. At first at traditional financial institutions securitization played a different role relative to that of selling loans in case of investment banks. In case of commercial banks, they seek further loan financing opportunities by securitization since they can reduce capital dedicated against possible losses on non-performing loans and at the same time the amount paid for the sold loans can be used as a resource for loan advancement. On the other hand, the use of leverage and the off-balance sheet characteristic of the securitization originator created greatest risk both at the micro – and the macro prudential level, since capital requirement rules can be overridden in this way. That is why traditional securitization has the double risk mentioned above, which made supervisory bodies of European Union member states to focus not only on strict regulation but on its coherent implementation as well.
The lower level of securitization in Europe and the majority share of traditional securitization explain why the European Union did not have special incentive for fast change in regulation and so it had time to make a well-prepared and elaborated regulation for securitization. The EU Regulation on securitization was approved only in December 2017, almost a decade after the crisis of 2007–2009, and entered into force on the 1st of January 2019. The basis for the regulation was the joint recommendation of the Basel Committee on Banking Commission (BCBS) and the International Organization of Securities Commissions – (IOSCO) on July 23, 2015. The two international organizations determined the internationally accepted basic principles and the most important criteria of implementation for simple, transparent and comparable – (STC) securitization. The European Union set the goal to encourage traditional securitization in its lawmaking process starting in 2015. As part of this process it emphasized the regulation of simple transparent and standardized (STS) securitization as it was later on approved in the European Union.
The goal of the European Union’s Regulation is to give a comprehensive legal framework for securitization for all European Union member states. As part of this goal, instead of supporting via the tools of law very complex and opaque securitization which caused the financial crisis, the legislators’ goal was to foster simple, transparent, standardised (STS) securitization with it positive legal tools. The legislator determined the new law’s personal scope covering institutional investors, but did not exclude natural persons – in case of fulfilling certain conditions – from the potential investors to have securitization position.
Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 made a very important change in securitization with the aim to support the spread of STS securitization. This major change was the expansion of the scope of trade repositories involving transactions of securitization. Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories was the law which introduced the trade depositories as predecessor of securitization repositories in the European Union.
This legal entity in the securitization process provides basis to give settlements of OTC derivative transactions execution by the inclusion of a central counter-party. The latter legal entity can always provide exact information about all outstanding transactions to give opportunity to the authorities to early interventions. The CDSs in the subprime crisis of 2007–2009, as part of synthetic securitizations were settled in a bilateral way not including a central counterparty. This fact explains why it could happen that at the outburst of the crisis the authorities had no clues and exact numbers on how many market actors had positions, based on the same portfolio of claims and what could be the total amount of outstanding liabilities based on CDS in securitizations. That could cause the lack of trust among market participants and the fall of CDS market prices, which could lead to liquidity crisis in money and capital markets. This scenario could be avoided only with the intervention of the FED.
It can be stated that in order to avoid the uncertainty caused by the opaqueness of securitization during the subprime crisis, the legal entity of trade repositories was introduced into the securitization process in the European Union. In these databases there are not only comprehensive information available about the exact amount of outstanding securitization transactions, but also about the amount of claims backing securitization. These databases can also provide sufficient information for market supervisory authorities to ensure timely interventions when it is necessary. The creation of securitization repositories serves the security needs of investors with securitization exposure by giving free access to data collected and comparable to analyze before taking part in a securitization transaction.
The legislator made a step towards transparency by including securitization repositories into the securitization process in the European Union. Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 defines the framework for securitization in its preamble section 11 by stating that this framework is necessary to diminish the information asymmetry. This asymmetry was between securitization originators, sponsors and investors, and by the regulation it is elevated to the level of prudent decision making by the latter one. The supervisory role of securitization depositories is held by a European Union supervisory body, the European Securities and Markets Authority (ESMA), which takes the role of supervisor in case of trade depositories, in which it has gained significant experience in supervising.
The transparency of securitization is further increased by the fact that it is promulgated to securitization originators and sponsors to provide the above mentioned data in a standardized form. This requirement is compulsory not only in the pre-decision process but for all relevant information during the investment period especially for ones which connected to the quality of the portfolio of claims.
The security and transparency of the market of securitized claims was further increased by the fact that the European Regulation forbid resecuritization – giving only some exceptions.
It is important to differentiate the simple, transparent and standardized (STS) securitization from the dangerous, complex, not transparent and not standardized securitization. STS securitization is defined already in Commission Delegated Regulation (EU) 2015/61 of 10 October 2014 to supplement Regulation (EU) No 575/2013 of the European Parliament and the Council with regard to liquidity coverage requirement for Credit Institutions in preamble Par 10.
Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 Article 20. defines the framework of simple, transparent and standardized (STS). In this part of the regulation it is worth mentioning that securitization special purpose entity (SSPE) becomes the owner of the claims and the regulation also gives a detailed definition of complete warranty of title of the claims included into the securitization process.
The Regulation Article 22 contains rules for transparency. The securitization originators and sponsors should provide results for investors about securitization information five years before the pricing of the given securitization, which should be audited by an independent third party. Similarly, securitization originators and sponsors should provide the model of expected future cash-flow of claims and after pricing they have to give an upgraded model of it too.
Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 article 21 defines among standardization conditions a 5 % risk retention requirement (skin in the game) for either sponsor or the original creditor (article 6). The documentation of the securitization should be prepared according to the regulation to contain all contractual liabilities and responsibilities for all participants like loan administrators, fiduciary asset managers and other service providers. By defining these liabilities and responsibilities even lawsuits can be avoided, as certain service providers – in the past -instead of intervention waited for the other to fulfill the contractual obligations e.g. restructuring of claims. The documents should also include clear and consistent definitions and rules for any delay of the obligor of claims and rules of treating conflict of interest among investment classes. The legislator drew another conclusion of the subprime crisis when it promulgates in the law by making rules against the basis of distorted motivation system of securitization the originate to distribute model. This takes the form of an instruction, which promulgates to all original creditors and securitization originators not to implement less strict loan underwriting rules for loans securitized than for the not securitized loans.
Finally, an important conclusion, which is interesting because it is not part of the Regulation: the role of credit rating agencies in the securitization process. The Regulation does not even mention credit rating agencies as independent third party experts as being compulsory part of a securitization. Instead of this, investors must conduct thorough due diligence examination in the European Union before and during the securitization process. The European regulation defines in terms of exclusion for these market participants. Instead of their inclusion into the law it excludes them even as an independent expert in STS securitization during data audit.
Finally, the author concludes that the regulation of the European Union, although it took a significant time period before it entered into force in 2019, it handled well the macroeconomic risks and made rules against distorted motivation in securitization. Similarly to the United States, the Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 put emphasis on transparency in setting a general framework for securitization. The European Union, beside risk taking rules devoted to investor responsibility, also promulgated due diligence examination before and during the securitization, with which it overtook the regulatory attitude of the United States. The legislator in the European Union put positive emphasis on STS securitization, which with good faith can result in that the participants of the European Capital Union can enjoy the advantages of securitization without its distortion and creating macroeconomic risk.
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Dr. Zsolt Bujtár, PhD
Associate professor, University of Pécs Faculty of Law
Department of Financial and Business Law
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