SEC Proposes New Securitization Rules

The Securities and Exchange Commission voted 5-0 today to propose sweeping new rules for the securitization market. With mortgage-backed securities (MBS) playing a prominent role in the financial crisis, the market for packaging loans and selling the resulting bonds has come under intense regulator scrutiny. Both versions of financial reform in Congress include new securitization rules, some of which are echoed in the SEC proposal. Though today's vote just started the process, after receiving public comment the regulator will determine which rules to adopt.

The precise details of the upcoming proposal are not yet known, but some highlights were provided by a fact sheet from the SEC. In contains some good ideas and some not-so-good ideas.

Good Ideas

Income Verification Clarity

A failure to sufficiently verify a borrower's income plagued some ultimately toxic subprime mortgage-backed securities. In these cases, the borrower's income was sometimes stated, but unverified or verified through flawed means. Today's proposal would require new securitization deals to disclose how borrowers' incomes were confirmed for the loans being sold.

Standardized Loan-Level Data Provided

Another problem during the bubble was that MBS investors often didn't always have detailed data to analyze. Aggregated statistics were offered, but this could sometimes mask deeper problems with the loans in the pool sold. The new proposal would require computerized loan-level data provided initially and on an on-going basis.

Additional Time for Analysis

During the height of the mortgage market, MBS deals sometimes sold just hours after hitting the market -- there was incredibly strong investor demand. So anyone who wanted to invest in the stuff didn't have time to think very deeply about what they were buying. The SEC seeks to change that by allowing investors more time to ponder the information about the loans in the securitization pool before purchase.

Not-So-Good Ideas

Issuer CEO Certification

It might sound like a smart idea to have the originator's chief executive officer certify that it's reasonable to expect that the assets in question will perform as expected. While that does put some responsibility on the shoulders of the CEO to ensure the loan quality is as advertized, it's hard to see how this standard would have made much difference if in place during the bubble. These mortgage companies actually believed that the losses would be roughly what they indicated. They were simply wrong.

5% Skin in the Game

The idea that whoever securitizes loans retain a portion of the risk associated with those assets is a pretty popular concept. The assertion is that if the bank creating these assets had some skin in the game, then they would care more about the quality of the bonds they sell to investors. But as the financial crisis has proven, these banks already held plenty of these toxic securities in their own portfolios -- so many that they needed to be bailed out due to fears about the associated losses. Forcing securitizers who have some skin in the game sounds great in theory, but actual experience has shown that poor assumptions -- not trying to trick investors -- led banks to the creation of bad securities.

SEC Computer Model for Analyzing Securities

The SEC wishes to force whoever issues an asset-backed security to provide a computer program (a model) that investors can use to analyze the deal. The utility of this is questionable. Part of being an investor is developing such models on your own. Different basic assumptions could result in the creation of different models. Reliance on a one-size-fits-all model isn't really feasible. Investors should determine what assumptions to use and the amount of time spent developing analytical methods. Standardizing models would just result in the same sort of lazy investor problem that led to too much demand for bad securities in the first place. The burden of analysis should be placed on the investor, not on the securitizer.