SEC Seeks Safer Mortgage Securities

The market for bonds backed by various types of consumer loans is getting healthier every day. So-called asset-backed securities deals are again hitting the market, mostly consisting of packaged auto and credit card loans. Commercial mortgages are also beginning to interest investors once again. But the residential mortgage-backed bond market continues to struggle. The Securities and Exchange Commission offered a new rule last week to help build investors' comfort with these assets. Will it help?

The new rule requires loan issuers to provide a review of the assets underlying an asset-backed securities transactions. Either the issuer itself can perform the due diligence procedures or it can hire a third-party firm to do the work. The rule applies to all assets, but the real value would be provided to mortgages, since investors never became nearly as wary about the other asset classes. Investors should be pretty excited about the new rule.

Here's how it would work. Let's say you're Bank of America and you want to securitize $1 billion worth of mortgages. Now, you would have to either perform detailed due diligence on those assets that supports all of the underwriting requirements and statistics in the deal's offering documents or hire a third-party due diligence expert. And whoever does that due diligence will have expert liability, so must stand behind the results. In other words, investors can be fairly confident that the assets are what they're represented to be according to the deal documents, or else they have someone to sue.

In the past, there was some due diligence provided on assets in these transactions. Obviously, that due diligence wasn't always strong enough to provide enough clarity to investors about what they were actually buying. That's why there was a big toxic asset fiasco. The new SEC rule hopes deepen that due diligence, ensure that the entire offering document is covered, and introduce expert liability.

That last part has the Securities Industry and Financial Markets Association frowning. It has expressed a concern that the expert liability is a bad idea, because due diligence providers don't want to be held to that standard. Perhaps not, but it's pretty clear that they should be. After all, the buck has to stop somewhere.

You might recall last year when rating agencies also objected to an expert liability standard being pushed on them by regulators. They asserted that their ratings were just opinions, and that they shouldn't be held liable if they were wrong. Consequently, they refused to include their ratings in asset-backed security deal documents, which temporarily threw the market into disarray until the SEC nullified the requirement.

Is an expert liability standard too strong for due diligence as well? Let's consider the sort of tasks that would be involved. Imagine that an issuer hires a due diligence firm to check whether its loans satisfy the criteria that it claims to have used to originate the loans. Perhaps one such criterion was for mortgages to have a loan-to-value ratio of 100%. That's possible to determine objectively: the due diligence firm can look at the loan files and see if the original balance shown on the mortgage note and the value shown on a recent appraisal.

This is very different from what the rating agencies do, because these due diligence providers aren't making assumptions or predictions about the future. If they say that a line in a deal prospectus has been verified, then they can back that up through an audit trail. It's far easier to become comfortable standing behind something that concrete than, say an assumption of how housing prices will change over the next five years.

If there is some part of this due diligence requirement that the firms who would do this work are particularly worried about, then they should explain the kind of findings they would be uncomfortable standing behind. And if legitimate, the SEC should listen. But they should, in fact, be due diligence experts, so subjecting them to an expert liability standard makes sense.