SEC Tightens Securitization Rules

Terry Flanagan

The Securities and Exchange Commission on Wednesday voted to adopt regulations setting forth data format standards for asset-backed security that facilitate comparison among similar asset classes, and requiring ABS issuers to disclose asset- or loan-level data, if such data are necessary for investors to independently perform due diligence.

Reforms tackling the overreliance on credit ratings and the opacity of asset-backed securities directly address issues that contributed to the financial crisis, SEC commissioner Michael Piwowar said during an open meeting that preceded the vote.

“During the financial crisis, I observed first-hand the difficulties in obtaining reliable data about the quality and performance of assets underlying mortgage-backed securities,” he said. “This opacity contributed to the overreliance on credit rating agencies’ risk assessments of these complex securities by market participants such as large financial firms.”

Asset-backed securities provide a way for institutional investors to participate in a wide range of asset classes, but are legally complex and require extensive due diligence.

For example, the last year has seen an uptick in activity in the peer to peer commercial loan market in the U.S., which includes loans made by non-traditional financing sources to small businesses (“P2P Commercial Loans”), according to a report by law firm Dechert. Although there is no standard definition for what constitutes a P2P Commercial Loan, these loans can be as small as $10,000 but are typically less than $250,000.

More recently, a number of institutional investors (such as hedge funds) have shown an increased interest in purchasing these P2P Commercial Loans directly from the originators on a whole loan basis, according to the report. “These trades are driven by the fact that such investors cannot or will not make these types of loans themselves, but are interested in the attractive yields offered by this asset class,” the report said.

Increasingly, both P2P Commercial Loan originators and institutional investors are looking to securitize these loans. However, securitizations of this asset class pose unique legal risks due to the nature of the assets.

“For those accustomed to investing in or lending against pools of middle-market loans, these downstream cousins present specific challenges not seen in the middle market space,” said the Dechert report. “In this context, for both those contemplating securitization and those contemplating lending to or investing in such securitizations, it is important to understand the legal landscape and the risks that are unique to this asset class.”

P2P Commercial Loans inherently carry more fraud and transparency risk than in the middle market or broadly syndicated space, where the originator entity is often able to escape bearing the risk associated with borrower fraud (typically originators or sponsoring entities will negotiate knowledge qualifiers around such eligibility criteria).

The adopted rules require that asset- and loan-level data be filed in interactive data format. Interactive data facilitates the ability of investors and analysts to conduct their own assessments and reach their own conclusions as to the underlying risks of asset-backed securities.
Interactive data will be indispensable, for instance, when a single automotive securitization contains in excess of 50,000 individual car loans or leases.

“The ability to use interactive data will also permit investors to lessen their reliance on credit ratings,” Piwowar said. “If more market participants are able to cost-efficiently analyze the underlying assets, then it will allow for better price discovery and increased market efficiency.”

Feature image via igor/Dollar Photo Club

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