6 Big Changes the FDIC Intends for Securitization

Poisonous securities backed by bad mortgages were at the heart of the financial crisis. Although Congress hopes to take some action to reform the asset-backed market, the Federal Deposit Insurance Corporation is using its regulatory power to take some aggressive measures of its own. Yesterday, the government agency released new proposed rules (.pdf) that banks would have to follow when securitizing assets. These sweeping changes will reshape the industry.

First, a little background. The reason that the FDIC can force these rules on the securitization market has to do with its resolution authority. Since it can wind down banks, it can also decide how to distribute bank assets during a failure event. For loans that are securitized to remain beyond the FDIC's grasp in resolution proceedings, these rules must be followed. Otherwise, the FDIC will seize the loans and render asset-backed bonds worthless. Obviously, that prospect would be unacceptable to investors who own these securities, so these rules must be followed.

These FDIC proposals are contained within a "Notice of Proposed Rulemaking." That means there is a 45-day comment period during which comments will be considered before these changes are finalized. But considering the FDIC has already accepted comments during the "Advanced Notice of Proposed Rulemaking" period, it's unlikely any huge changes will be made, unless some very compelling comments cause regulators to change their minds.

Here are six of the most significant new rules.

5% Skin in the Game Required

The FDIC will insist that those selling loans through a securitization retain at least 5% of the risk. This would be in the form of a "vertical slice," which would mean that a 5% portion of asset-backed bonds of all risk profiles are retained. This exposure could not be hedged. The idea is that if banks have to eat some of their own cooking, then they'll originate better loans. The Securities and Exchange Commission has suggested a similar requirement. The financial reform being considered by Congress also has such a provision.

While there is wide consensus in Washington that this is a good idea, some argue that it wouldn't have prevented the crisis, as banks already held plenty of asset-backed securities -- much to their peril. It was precisely their possession of those toxic bonds that led to the financial crisis.

Rating Agency and Servicer Compensation Changes

In a very aggressive move, the FDIC is requiring that rating agencies are paid over the course of at least five years, depending on asset performance. A maximum of 60% of their fees can be paid at deal closing. The rest of their compensation won't depend on how well their rating does -- it will reflect asset performance. That means the agencies will have an incentive to kick out uglier loans, which will lead to more conservative underwriting. Of course, it will also render part of the diversification benefit of securitization useless, since all the loans will need to be pristine.

Additionally, servicers' compensation will be based in part on how well they work out troubled loans. Incentives will be provided based on successfully completing loan modifications that produce a higher net present value than default.

Mortgage Modifications Permitted

Speaking of modifications, mortgage-backed transaction representations and warranties will be required to allow servicers to alter loan terms to maximize net present value. Prior to the financial crisis, many securitization deals did not allow for mortgage modifications, which was part of the reason why there was so much industry pushback on foreclosure prevention through this tactic.

Loan Level Disclosure for Investors

The rule change would also require additional disclosure. The most substantial would require data on every loan in a securitized pool provided to investors. In the past, aggregated pool statistics were provided, but some complained that this information was not sufficient to perform a thorough analysis of the assets. Now investors would have more complete data to work with and analyze. This loan-level data would not be provided for asset-backed deals with smaller ticket assets, like credit cards.

Mortgage Bond Complexity Limited

Another problem the FDIC attempts to tackle is security complexity. In order to do so, it seeks to limit mortgage securitization structures to six tranches, or bond classes. Banks and issuers complain that this will limit their innovation in structuring securities to appeal to more investors, but the FDIC worries that overly complex structures make these products dangerous for investors.

CDOs Require Much More Disclosure

Collateralized Debt Obligations (CDOs) have become infamous thanks to Michael Lewis' book "The Big Short" and the Goldman-SEC case. These are bonds backed by pools of bonds backed by pools of loans. In case regular mortgage-backed securities aren't complex enough for you, a CDO analysis would require you to understand not just how the bonds in the CDO pool perform, but also how all of the assets behind those bonds perform. Now all that disclosure is required -- on a loan-level basis. This could easily mean the data behind hundreds of thousands of loans must be provided to investors for some CDO deals.