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Summer / Fall 2011 Volume 5 Issue 2

I N T R O D U C T I O N F R O M T H E
C H A I R M A N
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e should hope to never again see a period like this in our careers. Te pain wrought by the fnan-
cial crisis should give us all a new appreciation for Benjamin Franklins observation that an ounce
of prevention is worth a pound of cure. In this case, though, the side-efects of the purported
cure may well be immeasurable.
It could take as long as fve years for the more than dozen regulatory agencies to draft and implement some
250 new rules that will afect our market. How we then adapt to them remains, of course, uncertain. Some are
already causing concern, such as the recently proposed rules on risk retention and qualifed residential mort-
gage standards. Tese could in fact crimp the availability of credit and create undesirable consequences for the
broader economy.
In hindsight, one of securitizations greatest weaknesses was its lack of a priori intelligent design. Rather,
it arose from a patchwork of cross-disciplinary private-sector solutions to ac-
counting, bankruptcy, REMIC and securities law challenges. But stitching to-
gether the disjointed components of securitization left us with unavoidable
imperfections that went largely unnoticed until the crisis occurred.
During our 2011 Annual Conference this past February, I uttered the
wish for a single, enabling act of legislation for securitization to harmonize its
mismatched components into a new and improved model. Someone quipped
we already have one: Dodd-Frank.
We do, though, have the opportunity to create a single, enabling act of
legislation for a diferent fnancial instrument. It is my hope that by the time I
write my next message, Congress will have passed the United States Covered
Bond Act of 2011. Every other well-developed economy either has a legislated
covered bond system or is in the process of creating one.
Te arbitrarily infated capital requirements imposed by the frst Basel
Accord in 1988 motivated banks to securitize to reduce regulatory capital re-
quirements to something closer to economic capital requirements. Later itera-
tions of Basel corrected many of the original faws, such that banks require
less capital to support the types of assets intended for covered bonds. Realigning the regulatory and economic
capital requirements has also left banks less motivated to securitize. Meanwhile, Basel III imposes more strin-
gent liquidity and funding requirements.
Covered bonds can go a long way to addressing these new asset-liability requirements for our banks while
creating a new supply of conservative triple-A bonds for investors and a new channel of afordable credit for
consumers and businesses. Covered bonds can coexist alongside securitization which will remain the supe-
rior alternative for capital and risk management and a redefned scope for the GSEs.
A globally competitive U.S. covered bond framework requires legislation to ensure creditors entitlement
to cover pool assets is unquestionable and unfettered by issuer insolvency. By mandate the FDIC is pro-
grammed to resist such legislation. Its primary duty is to protect the deposit insurance fund, not bondholders.
We should admire how well the FDIC advocates its position. But it is just one piece of a much larger picture
and an existing policy bias should not stymie moves to establish a market that would serve the greater good.
While we can state our case, only our elected representatives can make this happen.
Ralph Daloisio
Chairman of the Board
American Securitization Forum
Cover Story
Introduction fromthe Chairman
Editorial
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34 Are U.S. Covered Bonds Heading Out of the Dark?
though doubts remain, not least about the FDICs position on repudiating
covered bonds if a bank fails. American Securitization gathered a panel of experts to debate the issues.
Crossword Penny Wise
by Chri s Scaraf i l e
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36 Covered Bonds by the Numbers
Not sure how big the market is or who the players are? Check out our handy guide to the covered bond market.
18 Can Securitization Survive Risk Retention?
Most now accept the need for lenders to keep a slice of whatever they sell to the asset-backed market. But as the participants in our
second roundtable discuss, the proposed rules issued by the six U.S. regulators look too harsh. The standards for exempting mortgages
from risk retention are overly conservative and dont address second lien loans. The strictures for all other mortgages are likely to
make securitization an uneconomic funding tool. And other assets, including auto loans, multi-seller conduits and CMBS, are in some
instances being tarred unfairly with the same brush as subprime home loans.
31 Canada Crafts Some Well-Fitting ABS Rules
by Mi chael K. Fel dman
The countrys regulators have taken a more measured approach to overhauling securitization than their U.S. neighbors. Theres still
CLOs Get Back in the Flow
by Nei l O Hara
many feared. Now, with fewer but more experienced managers, deal volume is picking up again. The new challenge is to prove that
CLOs can remain viable as tightening spreads put pressure on investors aversion to bubble-era leverage and as regulators consider
subjecting the product to risk retention rules.
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ASF Goes Proactive
Thats not an accurate representation, of course we have often taken the lead in reshaping the market, with Project RESTART
an apt example. Now were helping to promote crucially important topics such as covered bonds legislation.
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Contents
Editor: Antony Currie
Email: acurrie@mpacpublishing.com
Journal design: Carolina Zalles
Sub-editors: PJ Johnson, Julian Marshall
Production director: Carolina Zalles
Production and artwork: Clare Brew
Photography: Kelly Shimoda
Crossword: Chris Scarafle
Writers & Contributors
Neil OHara
Michael K. Feldman Torys LLP
Publisher: Matthew Perks
Tel: 845 440 7800
Email: mperks@mpacpublishing.com
Volume 5 - Issue 2
American Securitization is published twice a year
by the American Securitization Forum, Inc.
in partnership with MPAC Publishing.
Te American Securitization Forum (ASF) is a broadly based professional forum
through which participants in the U.S. securitization market can advocate their
common interests on important legal, regulatory and market practice issues.
ASF also provides substantive and timely informational and educational programs
of value to securitization market professionals, including major industry conferences
and topical, issue-specifc workshops and seminars.
Copyright American Securitization Forum, Inc. 2011. All rights reserved.
Materials contained herein may not be reproduced for general distribution,
advertising or promotional purposes without the express consent of ASF.
Te statements of fact and opinion in signed articles are the sole responsibility
of the authors and do not necessarily refect the positions of the ASF,
nor the employers of the authors.
Members of the Editorial Advisory Board
Tom Deutsch, Executive Director
Tel: 212.412.7107
Email: tdeutsch@americansecuritization.com
For information on ASF membership, please contact:
Janet Brathwaite, Executive Assistant
Tel: 212.412.7114
Email: jbrathwaite@americansecuritization.com
Periodicals postage paid at Easton, PA Postmaster:
Send address changes to:
Jennifer Ferrara at
Email: jferrara@americansecuritization.com
ASF Staf Contacts
American Securitization Staf & Contributors
Gloria Aviotti
Alexander Batchvarov
Moorad Choudhry
Cameron L. Cowan
Ralph Daloisio
Tom Deutsch
Joseph M. Donovan
Ron DVari
Christopher T. Flanagan
Greg Medcraft
Tomas E. Plank
Marty Rosenblatt
Michelle L. Russell-Dowe
Professor Steven Schwarcz
Vernon H.C. Wright
Fitch Solutions
Bank of America Merrill Lynch
Royal Bank of Scotland plc
Orrick, Herrington & Sutclife LLP
Natixis
American Securitization Forum
Cohen & Company
NewOak Capital
Bank of America Merrill Lynch
Australian Securities and Investments Commission
University of Tennessee College of Law/
Bingham McCutchen LLP
Marty Rosenblatt
Hyperion Brookfeld Asset Management, Inc.
Duke University School of Law/
Duke Global Capital Markets Center
Vernon H.C. Wright

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he private-label mortgage market will soon have the chance to show how it has changed since the
crisis. At the end of September the limit on jumbo mortgages that lenders can sell to Fannie Mae and
Freddie Mac drops to $625,000 from $729,750.
Te immediate efect, of course, will be higher costs for borrowers. But its the right move. For
starters, the government needs to step back from guaranteeing 95% of all new mortgages at some point. Second,
interest rates are still near historic lows even a one percentage point increase would still make for a cheap
mortgage. And third, at risk of oversimplifying the matter, as a result of the crisis the only people with a chance
of getting a mortgage of $625,000 or more are those who can aford it and who dont need to lean on Uncle Sam
for help.
Tat makes this segment of borrowers the perfect arena for the mortgage industry to prove they can put into
practice the lessons of the housing crash without the safety net of a government guarantee.
Granted, there wont suddenly be a gushing supply of non-agency mortgages for the market to securitize.
Nationwide, the September drop will afect perhaps just 3 percent of new mortgages that were being sold to
the GSEs. Even letting the conforming loan rate fall back to its pre-crisis level would only add a few percentage
points more although in large cities like New York and Los Angeles its likely to have a far greater impact. Small
though the overall impact might be, it should provide a refresher boot camp of sorts for non-agency mortgage
securitization.
Of course, there are a number of challenges, not least growing
fears about the strength of the economic recovery and a housing dou-
ble dip almost fve years after prices frst started falling. Tats likely to
make already chastened lenders tighten their belts further, crimping
loan supply.
Te longer-term danger, though, stems from the continued lack
of clarity on looming regulatory and capital changes. Many in the
mortgage industry are concerned that the proposed rules for risk re-
tention and qualifed residential mortgages are too conservative. As
panelists in our roundtable on page 18 argue, if implemented these
rules may well make the economics of securitization unfeasible for all
but the most pristine loans that meet the QRM standard.
Its right that Washington impose better standards on the
mortgage market. But it bears remembering that around a ffth of
home loans were the problem behind the crash. At times lawmakers
and regulators seem to act as if most mortgages are suspect. Tats
wrong-headed.

Antony Currie
Editor
American Securitization

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e have scored some notable victories in the frst few
months of 2011 ensuring not only that the collective
views of our broad base of members are heard by
regulators working to carry out Congresss will, but also that they
are acted upon.
Being the vocal, timely and infuential voice of the asset-backed
securities market is at present our most important calling. Tere is
nothing more crucial than doing our utmost to ensure that the le-
gal and regulatory framework for securitization is fair, clear, mind-
ful of unintended consequences and well understood by all.
But lobbying Washington is not all we do, of course. ASF also runs a vibrant program of events throughout the year and we have
chalked up some achievements there, too, in recent months.
Elephants in the Room
Te United States is inching towards dealing with one of the biggest issues that will determine how the nation fnances mortgages:
what role should the government play? Februarys report to Congress from the U.S. Treasury and the Department of Housing and Ur-
ban Development entitled Reforming Americas Housing Finance Market is a good starting point. It outlines several potential approaches
for reducing the governments role in, and thus taxpayers exposure to, mortgage fnance.
Much work remains. One of the biggest challenges will be securing the attention of a politically divided Congress as its members
gear up for the 2012 elections. Te chances are that reform will be postponed until at least 2013.
Another aspect of mortgage reform is already much further ahead in the planning stages. Te Notice of Proposed Rulemaking (NPR)
on risk retention in asset-backed securities and standards for qualifed residential mortgages (QRM) was released in March by the six joint
regulators the Ofce of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp, the Securities and
Exchange Commission, the Federal Housing Finance Agency and the Department of Housing and Urban Development.
It is shaping up to be the busiest year yet for the
American Securitization Forum. Much of that is due
to the responses we are fashioning to the at times
vague legislative designs laid down in last years
Dodd-Frank fnancial reform act.
Tats mortgage reform, right there
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In general, ASF accepts the principle both of issuers retain-
ing a degree of risk in loans they sell into securitizations and of
setting lending standards that would qualify some mortgages for
exemption from the rules.
But ASF and its members have several concerns. Execu-
tive Director Tom Deutsch addressed these in testimony to the
House Financial Services Committee in April. He also partici-
pated in the American Securitization roundtable on risk reten-
tion that starts on page 18 of this magazine.
ASF takes issue with four points. First, that the QRM stan-
dard is too conservative. Sec-
ond, that regulators have made
a mistake by deciding not to
develop a tiered approach
from 0% to 5% risk retention
for those loans that do not fall
under the QRM standard, as
was allowed for under Dodd-
Frank. Tird, that premium
capture plans, if implemented as written, would render non-
QRM securitization uneconomical for issuers. Finally, that regu-
lators want to add servicing rules as part of the NPR. Tis is not
part of their remit under Dodd-Frank, nor is it wise to develop
standards for just one part of the home loan market. All in, ASF
argues, the NPR is too
restrictive and risks
making all but the most
conservative loans ex-
ceptionally difcult to
fnance.
ASF has garnered
strong support for its
views among legislators
and submitted a com-
prehensive comment
letter to the joint regu-
lators in June.
Proactive Agenda
ASF is not just reacting
to legislative and regula-
tory issues, though. We
have also gone on the
ofensive. Perhaps the most obvious example of this is the leading
role that we have taken in advancing plans to develop a legisla-
tive framework for a U.S. covered bond market. We applaud and
support Representative Scott Garrett for his tireless eforts to
keep this matter front and center in Congress, reintroducing in
March the same bill outlining the framework that was eventu-
ally excluded from last years Dodd-Frank Act.
ASF Chairman Ralph Daloisio ofered our support for the
bill and the creation of a covered bond market in testimony be-
fore the House Financial Services Committee in March. He was
also a panelist on our roundtable on covered bonds that starts on
page 35 of this magazine.
ASF still contends that securitization ought to be able to
ofer a better form of all-in fnancing for mortgages: it is, after
all, a tool developed to transfer both credit and interest-rate
risk. But ASFs issuer members need low-cost, efcient ways to
fnance their loans while ASFs investor members need high-
quality investments. Covered bonds ofer a way to achieve both,
if properly devised with a solid legal framework that clarifes,
among other matters, investors
rights in the events of an issu-
ing banks insolvency.
Te other piece of legis-
lation we are supporting is the
Asset-Backed Market Stabiliza-
tion Act of 2011, introduced by
Congressman Steve Stivers in
March. Te aim of this bill is to
reinstate Securities Exchange Act Rule 436(g). Tis was repealed
by last years Dodd-Frank and quickly became the frst obvious
unintended consequence of fnancial reform. Te original act had
excluded Nationally Recognized Statistical Rating Organizations
from being treated as experts when their ratings were included in
a registration statement.
It was an attempt to
hold ratings agencies
more accountable for
their opinions. But it
did not account for how
integrated ratings are
to the process of get-
ting a deal done. As a
consequence, when rat-
ings agencies wouldnt
consent to allow their
ratings into issuing pro-
spectuses last year, the
asset-backed market
faced total shutdown.
ASF was instrumen-
tal in eliciting from the
SEC in a matter of days
a no-action letter granting relief from the repeal. Te SEC ex-
tended the exemption indefnitely last November, allowing issu-
ers to omit credit ratings from registration statements fled under
Regulation AB. But the best long-term solution is a legislative fx
and ASF will continue to promote this.
Te broader question about the role of ratings continues, of
course. And ASF is at the heart of the debate. In March, in a fol-
low-up to an earlier gathering, representatives from the working
group of the ASF Ratings Alternatives Taskforce discussed the
Being the vocal, timely and infuential
voice of the asset-backed securities
market is at present our most
important calling.
One of the major issues ASF has been engaged in
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issue in a meeting with regulators from the FDIC, the Federal
Reserve and the Ofce of the Comptroller of the Currency. ASFs
proposals revolve around the overarching concept of calculating
risk-based capital for securitization exposures.
Small But Important Victory
One important, yet perhaps overlooked, achievement since our
last update in these pages revolves around the FDIC and its
new power granted under
Dodd-Franks orderly liq-
uidation authority (OLA)
provisions. Te concern is
similar to a long-standing
concern ASF and market
participants have had about
FDICs belief that it should
be able to liquidate covered
bonds when a bank fails.
In the case of the OLA,
though, the issue revolves
around the potential for the
FDIC to unwind assets in
securitizations in the event
of the insolvency of non-banks deemed systemically important
enough to require the FDIC to step in to ensure an orderly
liquidation.
ASF has engaged with the FDIC on behalf of its members
to seek clarifcation about inconsistencies between the OLA
provisions and the bankruptcy code dealing with preferential
and fraudulent transfers. In late December last year the FDICs
general counsel issued a letter to ASF acknowledging that the
treatment of the transfers
under OLA is intended to
be consistent with the bank-
ruptcy code. In January 2011,
ASF submitted an additional
request that the FDIC clarify
that its repudiation power
under OLA would be exercised consistent with the bankrupt-
cy code and soon received another letter from the FDICs
general counsel granting ASFs request and allaying our main
concerns. Te FDIC issued new proposed rules in March and
is expected to codify its general counsels interpretation in the
coming months.
Derivative Engagement
ASF is no stranger to derivatives. Until recently, though, we have
not had as much need to engage with regulators on the subject
as we have on other issues. Te derivatives provisions of Dodd-
Frank have changed that.
We have been corresponding with the SEC about the end-
user exception to the mandatory clearing of security-based swaps
and swap participant defnitions, and with the CFTC about swap
participant defnitions and the end-user exception and business
conduct standards for swap dealers and major swap partici-
pants.
We have also taken a leading role responding to proposed rules
various regulators released in April that deal with sections 731
and 764 of the Dodd-Frank Act. Tese mandate capital and mar-
gin requirements for swap dealers and major swap participants in
connection with their non-
cleared swaps. Applying any
of these requirements may
render many structured
fnancings uneconomic as
the special-purpose vehicle
would be required to post
cash and liquid securities
which it does not have. Te
source of repayment for
structured fnancings is gen-
erally the cash fow from the
assets or receivables which is
generated over time.
Continuing battles
Te regulatory issues stemming from the Dodd-Frank Act have
kept us busy. But we have not just focused on these challenges.
Much of our regulatory and legal advocacy stems from other
sources.
At the state level, for example, ASF continues to oppose ef-
forts in the New York State Legislature to pass the Vehicle
Lienholder Accountability Act, which was reintroduced to the
NY State Assembly and Sen-
ate this year after it failed
to pass the Senate in 2010.
Tis year, ASF has submit-
ted a new round of letters of
opposition to the bill as well
as met with the bills lead
sponsors in the Assembly and Senate to explain the bills ad-
verse efects on the auto loan credit market. We will con-
tinue to monitor the progress of this bill in the NY State
Legislature.
And ASF has been involved in the continuing discus-
sions about foreclosure and loan modification practices with
the multi-state group of state attorneys general (AGs) led
by Iowa AG Tom Miller. Last December, ASF investors and
financial guarantors met in Des Moines with AG Miller and
the staff of over a dozen other state AGs. Since that meeting,
ASF has analyzed the state AGs proposed settlement terms
to servicers and produced a one-pager summarizing ASF in-
vestor concerns.
ASF continues to work on other issues of high impor-
ASF welcomes Jim Johnson as managing
director of public policy, based in Washington, DC.
Jim will spearhead the development of ASFs political
action committee and will advance ASF member interests
on securitization-related issues confronting Congress
and federal regulators. Previously, Jim served as senior
counsel to the U.S. Senate Committee on Banking,
Housing & Urban Affairs for the ranking member,
Senator Richard Shelby (R-AL).
ASF is not just reacting to legislative and
regulatory issues, though. We have also
gone on the ofensive.
and sold into the capital markets.
Heading Back and Branching Out
ASF is returning to Las Vegas. ASF 2012 will be held at the
ARIA Hotel in Las Vegas, between January 22-25. Our major
winter conference proves
a success no matter where
we hold it ASF 2010
in Washington, DC gar-
nered plenty of attention,
while the 4,400 registrants
for ASF 2011 in Orlando
made our event the larg-
est securitization confer-
ence in the world for a
seventh straight year. But
there is no facility in the
nation that can equal Las
Vegas for a gathering of
the size the ASF produces
where 5000 hotel rooms
are needed within walking
distance of 300,000 square
feet of meeting space
Its not the only venue
change we have instigated.
We held one of our Sun-
set Seminars in April not
just outside New York, but
outside the country in
London. It was the ideal
location for a panel to
discuss whether global se-
curitization reforms were
converging or diverging.
Wed like to thank SNR
Denton for hosting.
We also moved our
2011 Annual Meeting, to
Washington, DC. We have
expanded it from one day
to two and have brought in
high-level keynote speak-
ers including SEC Chair-
man Mary Shapiro and
Senator Mark Warner.
Were sorry if you
could not attend. But we
look forward to seeing you all in Vegas next January if
not before.
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tance to the industry, such as our advocacy concerning the
FDIC securitization safe harbor, Rule 17g-5, loan modifi-
cation and loss mitigation, tax concerns for securitizations,
and chain-of-title issues. We look forward to continued par-
ticipation from our membership as we tackle these and other
key issues facing the
industry.
ASF Proj ect RE-
START
In January, ASF launched
the ASF Project RE-
START Model RMBS
Repurchase Working
Group to help restore
confdence in the RMBS
market through the de-
velopment of an indus-
try Model Repurchase
Framework comprising a
set of principles that can
be used for future RMBS
transactions. Te Model
Repurchase Working
Group will follow in the
mold of the successful
ASF Project RESTART
Model Representations
and Warranties Working
Group, which released
fnal representations and
warranties guidelines in
2009, and will contin-
ue to meet throughout
2011.
ASF and Standard &
Poors Valuation and Risk
Strategies have continued
development of the new
standardized global code
for identifying critical
information about indi-
vidual loans that are se-
curitized in the MBS and
ABS markets. Te new
global ASF Loan Identif-
cation Number Code is a
fundamental component
of Project RESTART. ASF LINC is a 16 digit identifcation
code which captures the loan type, origination date and country
of origin in addition to randomized alphanumeric data to
create a unique ID for a wide range of assets that may be pooled
The core objectives of the American Securitization Forum
Consensus: To build consensus within the U.S. securitization
industry on issues of broad importance to the industry;
Advocacy: To mount principled and focused efforts to advance
ASFs substantive positions, chiefy by interacting with appropriate
governmental, regulatory, accounting, legislative and other
policy-making bodies; and
Education: To inform and educate not only the securitization
community and related constituencies but also the public at
large, and to sponsor substantive, high quality conferences
and educational programs.
ASF is heading back out west for 2012
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By Neil OHara
A
dd corporate loans to the list of assets that may become
harder to securitize despite proving their resilience
through the fnancial crisis. Credit card and auto-loan
securitizations both fared far better than expected, for example.
But regulatory and accounting changes threatened their useful-
ness. Now its the turn of collateralized loan obligations (CLOs)
to go through the wringer.
New proposed rules are part of the problem: the six
U.S. regulators involved in drawing up the Notice of Pro-
posed Rule-making on risk retention have included CLOs in
the mix. But thats not the only issue hanging over the CLO
markets tepid return to form. While corporate loan-backed
securities performed well over the past few years, many in-
vestors fed the market, or were themselves destroyed. And
the structure has yet to demonstrate, in the wake of the cri-
sis, that it can retain the lower leverage and higher over-
collateralization levels that both managers and investors
currently feel comfortable with and still remain a viable invest-
ment once spreads tighten further.
Te fnancial crisis took its toll on the market
for repackaging senior secured corporate
loans into securities. Investors fed or were
themselves destroyed. But CLOs have proven
to be made of tougher stuf than their CDO
cousins. Te food of defaults many expected
never appeared. Leveraged loan collateral
has performed well, those who stuck with the
market have reaped outstanding returns and
new issues have started to trickle out again.
But to thrive in the future, the CLO market
needs new investors, must demonstrate that
the economics can still work on lower leverage
as spreads tighten and it must stave of
regulatory attempts to impose risk retention
requirements that could stife the market.
Investing in CLOs in the crisis was like sifting gold from dirt
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TesinglebiggestissueCLOshad,though,wasbeingtarred
by the same brush as asset-backed collateralized debt obliga-
tions when the housing market tanked in 2007. It should be
obvious that a diversifed pool of corporate loans has a difer-
ent risk profle from a homogeneous pool of residential mort-
gages.Byearly2009,however,investorswerenotmakingsuch
distinctions: they dumped bonds issued by anything labeled a
collateralizedobligation,nomatterwhattheunderlyingassets
were. But people who sold CLOs were like unfortunate pros-
pectorspanningwithacolander,tossingoutthegoldalongwith
thedirt.
Ofcourse,itdidnotfeellikethatformanyatthetime,given
fearsabouttheparlousstateoftheoveralleconomy.CLOs,af-
ter all, had displayed a large appetite for loans tied to private
equity deals. Buyout frms
took advantage of access to
easycredittodeployhigher
and higher leverage multi-
plesforthecompaniesthey
targetedwhileoferingfew-
er and fewer protections to
lendersandbondholders.
But many such loans
were secured against more
resilient company assets
than home loans proved to be. So while many CDOs tied to
mortgage-backed securities remain deeply troubled, the CLO
structure has proven robust. Te credit support mechanisms
designed to replenish impaired collateral kicked in, default
ratesontheunderlyingloansneverreachedtheextremelevels
impliedbymarketpricesatthelowsandvehiclesthatstopped
distributionstoequityholdershavebouncedbackandresumed
payment.(See box)
TeleveragedloancollateralthatsupportsCLOsperformed
sowellthatthenewissuemarketforCLOsreopenedinMarch
2010, when WCAS/Fraser Sullivan launched the frst U.S.
dealsince2008.CLOsponsorsraised$4.3billionin2010,and
marketobserversexpectanother$10billionto$15billiondur-
ing2011.Tatwouldbecomparabletothesizeofthemarketin
2003,butfarlessthanthe$90billionorsoissuedatthemarket
peakin2007.
Rocketing Spreads
OneofthestructuralfeaturesofCLOsactuallypresentedstal-
wartswithanopportunity.ACLOisnotastaticpool.Itbuys
bankloanstocompaniesthathavespeculativegradecreditrat-
ings(nohigherthandouble-B+byStandard&PoorsorBa1
by Moodys), but borrowers frequently repay these loans well
beforethetypicalfve-orseven-yearmaturitydate.Intheearly
yearsofitslife,aCLOcanreinvestpaymentsofprincipalrather
than return the capital to investors, which creates a need for
CLOmanagers.Whenthereinvestmentperiodends,theassets
become a static pool that amortizes as loans are paid of, after
whichthestructureiswoundupatitslegalfnalmaturity.
Soasspreadsonleveragedloansshotupduringthefnancial
crisis,CLOsthatwerestillinthereinvestmentperiodalmost
all the 20052007 vintages were able to replace maturing
loanswithnewonesthatgeneratehighercashfow.Teliabili-
tiespayafxedspreadoverLibor,soseasonedCLOsmorphed
intogiantATMsfortheequityslice.
Tecashgenerationisasstrongasithaseverbeenforthe
past 18 months, says Greg Stoeckle, head of senior secured
bankloansatInvescoFixedIncome,whichmanages$9.5billion
in CLOs.Tat helped replenish collateral at funds that were
stilltrappingcashandallowedthemtoresumedistributionsto
equityholders.Equityreturnshavebeenatnearrecordlevelsfor
thepast12months.
Ownership of CLO pa-
perhaschanged,ofcourse.
In the 2006-07 heyday,
banks were big buyers, ei-
ther parking them on their
own balance sheets to take
advantageofthelowercap-
ital requirements triple-A
assetsenjoyedcomparedto
loans,orstufngthebonds
into of-balance-sheet structured investment vehicles and con-
duitsthathavesincevanishedfromthefnanciallandscape.To-
day, Ratul Roy, head of structured credit strategy at Citi, says
largeinsurancecompaniesdominatethemarket,luredintothe
triple-A tranches by juicy spreads.It is a new segment, says
Roy.Whatinsurancecompaniesperceivedasapoorassetat25
basispointsoverLibor,theynowseeasanattractivelowcredit
riskproductat120overLibor.Andthatnumberhasshrunk30
basispointssinceJanuary.
Wider spreads mean that CLO economics work at lower
leverage than in 2007. Tats crucial to deal economics because
investors are still showing more caution than at the height of
thebubbleeventhoughtheCLOmarketweatheredtheensuing
stormsowell.Hence,saysRoy,thetriple-Atrancheindealsnow
coming to market has around a ffth more credit support than
beforeat30%-32%comparedwith25%-26%.Teextracushion
is spread over the junior capital but weighted toward the lower
end.
Power Shift
Tats part of a broader shift in the balance of power between
diferentclassesofcapital,leadingtoamoreconservativestruc-
ture all round than the 2006-2007 vintage CLOs. Last years
dealsinitiallyfeaturedaroundeighttimesleverage.Tathasris-
entoaround10timessince,butisstilllowerthanthe12times
leverage reached at the height of the boom. Investors are also
demanding higher-quality collateral focused on frst lien bank
Te buying base will be diminished.
Te amount of new issue CLOs coming on
line is not going to be enough to ofset that
in any signifcant way.
Russell Morrison, Babson Capital
loans, paring back second lien loans to just 5% of the total and
excluding structured debt from the pool entirely.
On top of that, holders of triple-A bonds prefer shorter re-
investment periods to protect against potential deterioration in
collateral quality and provide greater certainty about the fnal
maturity date. Tey also like longer non-call periods to prevent
equity holders from refnancing at lower spreads. Meanwhile,
the equity holders prefer extended reinvestment periods to keep
the leverage high and provide more time to earn excess spread;
they also prefer short non-call periods so that they can refnance
at the earliest opportunity if spreads on CLO paper narrow. For
now, though, the senior noteholders have the whip hand: rein-
vestment periods are typically two or three years instead of fve
or more, with three year call protection. Te triple-A investors
have never had it so good, says Roy.
To seasoned CLO managers like Greg Stoeckle, head of
senior secured bank loans at Invesco Fixed Income, which
manages $9.5 billion in CLOs, the strong performance of
pre-crisis CLOs came as no surprise. A typical CLO has 100-
150 bank loans in its portfolio, the majority of which are to
public companies that must fle fnancial reports with the
SEC. Investors can dig down to analyze the underlying data.
That level of transparency eluded buyers of CDOs which
were often linked to thousands of small home loans, forc-
ing investors to rely on analyzing the credit of the pool as a
whole rather than digging down to individual loan data.
We have the opportunity to conduct due diligence,
which leads to a high level of research going into the individ-
ual asset selection, says Stoeckle. The investment thesis
isnt based on FICO scores or the statistical modeling that
drove a large part of the CDO and mortgage-backed securi-
ties world.
The CLO structure has triggers that suspend distribu-
tions to the various tranches from the bottom up if collateral
quality deteriorates. For example, if the proportion of bonds
rated triple-C exceeds a certain threshold, overcollateraliza-
tion tests impose a haircut on valuations of those bonds
which often curtails payments to equity holders. Cash in
excess of debt service requirements then accumulates in
the CLO to protect bondholders against losses if loans in the
portfolio do default. Payments to equity holders only resume
after a collateral cushion has been rebuilt, the credit quality
of the portfolio exceeds the threshold again, or both.
The haircuts are based on the lower of either market
value as determined by an independent pricing agency or
the assumed recovery value upon default. In late 2008, the
average bid price for the S&P/LSTA U.S. Leveraged Loan
100 Index hit 59 cents on the dollar and the triple-C paper
traded far below the average. It put tremendous pressure
on the haircuts, says Stoeckle. They were much more pu-
nitive than anyone had envisaged.
Figures compiled by Well Fargo Securities show that
the proportion of CLOs failing the minimum overcollateral-
ization test soared from near zero to more than 50% in just
six months, from October 2008 through April 2009. The ra-
tio peaked in June 2009 and then began a long retreat. By
September 2010 it had fallen below 10% and has contin-
ued to decline since then.
Bank loans trading in the low 60s made little sense
to Stoeckle given the historical recovery rate for defaulted
loans in the high 70s or low 80s as a percentage of par.
The mispricing brought new buyers into the CLO market, in-
cluding hedge funds and private equity investors. The infux
became a food after the default rate peaked at 11% well
below pessimists expectations and then began to drop as
fast as it had risen.
Fresh money, and the performance of the issuers, led
to the recovery we have seen in the last 18 months, says
Stoeckle. Prices have rebounded and credit performance
has been very strong. The default rate is now less than 2%,
which is below historical norms.
CLO ratings held up much better than other structured
fnancial assets through the downturn. Credit Suisse esti-
mates that 45.3% of the triple-A bonds were never down-
graded, another 40.9% of triple-A bonds were cut one notch
to double-A and only 1.1% of bonds originally rated triple-A
fell to below investment grade. In contrast, a staggering 77%
of triple-A-rated asset-backed CDO bonds were downgraded
to triple-C or below.
The robust credit performance eventually fowed
through to secondary market prices. Triple-A CLO bonds that
traded at 70 cents in March 2009 were back in the high
80s by the end of that year and at 95 last December. Equity
was the star performer, however, rebounding from pennies
on the dollar to 70 cents or better, a home run for investors
brave enough to scoop up that paper near the bottom.
When the CLO market frst reopened, the sponsor tended
to sell only triple-A and double-A bonds, retaining the rest
of the capital on its own book, but a market for junior capital
soon re-emerged.
We are seeing more multi-tranche deals, where triple-A
and even double-B bonds are getting placed, says Roy. Te
deals still have more subordination and cleaner collateral, and
it is customary for the sponsor to take a large portion of the
equity.
Investors are insisting sponsors have skin in the game, a
feature the regulators will require when the new risk retention
rules are fnalized. On March 29, the six U.S regulators pub-
lished proposals for comment that contemplated a more fex-
ible interpretation of risk retention than a simple 5% vertical
slice, including a horizontal frst-loss slice and L-shaped com-
How CLOs Beat the Crisis Blues
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binations of horizontal and vertical slices. Te likely efect of a
vertical mandate is already clear: in Europe, where a 5% verti-
cal slice is the only option, no new CLOs have come to market
since 2008, in sharp contrast to the U.S. revival.
Back in the United States, the Loan Syndication and Trad-
ing Association (LSTA)
has been leading the charge
against CLOs being caught
up in the risk retention
rules. In testimony before
Congress in April, LSTA
executive director Bram
Smith argued, for example,
that CLOs are managed
by registered investment
advisors and thus should
not be regarded as origi-
nate-to-distribute struc-
tures that some regula-
tors had in mind when
drafting risk retention rules. He also stressed that regula-
tors dubbed CLO managers sponsors in Marchs propos-
als even though they do not ft the literal defnition of se-
curitizer or originator as the Dodd-Frank Act envisioned.
Furthermore, Smith pointed out that CLO managers already
have their incentives aligned with investors as they generally
are remunerated using a three-tier structure that only pays
out most of the fees once noteholders have received all
interest payments.
Historically, most spon-
sors have retained only an
equity interest in CLOs, so
the ability to meet the reten-
tion requirement through a
first-loss slice is critical to
sustaining new issue activ-
ity. An equity interest gives
sponsors a strong incentive
to buy creditworthy loans:
not only are they first in
line to take losses, but they
also forgo any cash flow
if portfolio credit quality
deteriorates, long before
the CLO itself goes into default which has hardly ever
happened.
Tat is why Brian Colgan, senior managing director at MJX,
which manages $4.2 billion in CLO assets and ofers advice
CoreLogicASFad2011finalOL.indd 1 4/26/11 7:25 PM
Te buying base will be diminished, says Russell Morri-
son, head of high-yield investments at Babson Capital, which
hasmorethan$10billionofCLOassetsundermanagement.
TeamountofnewissueCLOscomingonlineisnotgoingto
beenoughtoofsetthatinanysignifcantway.
Backin2007,CLOsowned60%ofallleveragedbankloans,
which at the time was a market in excess of $500 billion. But
theavailablebuyingpowerfromreinvestmentwilltumblefrom
$192billionin2010to$111billionin2012andvirtuallyzero
two years later, according to Wells Fargo Securities. In prin-
ciple,theshrinkageshouldkeeploanspreadsatlevelsthatwill
support the arbitrage trade that underpins CLOs, but wide
spreadsmayalsodetersomeborrowers.
Morrison says:Te market has to identify new investors
who will have to choose the asset class for its characteristics:
foating rate, senior in the capital structure, and an attractive
creditspreadbyhistoricalstandards.
Abigincreaseinfundfowsintobankloanfundscouldtake
uptheslack,however.Investorsanticipatinganendtotheeasy
monetary policy the Federal Reserve has pursued since 2008
have been pouring money into foating-rate funds, supporting
thesecondarymarketpricesoftheleveragedloansCLOsbuy.
SpreadsarestillwideenoughtosupportnewCLOs,however
andbuyerswilllikelybefound.
People are beginning to understand the merits of the as-
set class in protecting their portfolios against interest rate
andcreditrisk,saysMorrison.CLOperformancehaslargely
playedoutasexpected.
to holders of another $14 billion, argues that risk retention
is not needed at all. Te senior-subordinated fee structure
of a CLO aligns the interest of the manager with that of the
investors,hesays.
Conflicts of Interest
Nevertheless, conficts of interest between diferent classes of
capital can occur, and Colgan acknowledges that bondholders
tookexceptiontothewaycertainCLOmanagersactedduring
thecreditcrisis.Forexample,buyingbackbondsatadiscount
boosted overcollateralization for the remaining bondholders,
butinsomecasesthemanagersprimarymotivationmayhave
beentopreservecashdistributionstoequityholdersinclud-
ing themselves. Investors criticized managers for questionable
interpretations of what collateral was eligible for the CLO
pool,too.Investorswilldomuchmoreduediligenceonman-
agers and be more selective for the foreseeable future, says
Colgan.
Teslumpinnewissuesalsopromptedconsolidationamong
CLO managers. Foreign banks in particular have been sellers
Nomura, for example, sold a $5 billion portfolio to Ares
AssetManagementinAprilbecauseCLOsnolongerrepre-
sentaninexpensivesourceoffundingandnewregulatorycapi-
tal requirements have undermined the economics of owning a
CLO manager. Te most active buyers have been traditional
credit managers, including MJX. Others have been getting
involved, too: Carlyle snapped up Mizuhos $1.2 billion CLO
platformaswellasa$5billionportfoliofromStanfeldCapital.
AndBlackstonehasbeenactive,takingBrightwaterCapital,for
example,ofWestLBshandsin2008.
But while CLO assets are concentrating into the hands of
fewermanagers,thetotalassetbaseisshrinking.Pre-crisisvehi-
cleswillsoonoutlivetheirreinvestmentperiods,andmustthen
useprincipalrepaymentstopayofthetriple-Abondholders. C
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Neil OHara is a freelance writer based in Lincoln, Mass.
He is a contributing editor to FTSE Global Markets and
writes for a variety of other publications including On Wall
Street, Wealth Manager and Alpha.
Te views expressed are those of the author and do not necessarily represent the
views of ASF.
Risk Retention
Rules
Leave Much up
in
the Air
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The six U.S. fnancial markets regulators need to rethink
their proposed rules on risk retention. That, at least, is the
consensus of the panel of experts American Securitization
convened in May to discuss this contentious topic. All accept
that mortgage lenders, at least, should have to keep some skin
in the game for riskier-looking home loans though some note
that would not necessarily have prevented the fnancial crisis.
But, say our participants, the rules as proposed are too harsh.
The standard for exempting loans from risk retention the
so-called qualifed residential mortgage, or QRM is too high.

from the regulators and the broader strategic


issues Dodd-Frank tackles. As weve started
to peel back the NPR onion a bit more, were
seeing more analysis come out that identi-
fes some signifcant issues to the extent
that it may be as bad as, and perhaps even
more unfavorable than, expected for certain
potential issuers such as banks, and maybe
even more favorable to others such as REITs.
The initial relief I certainly wouldnt call it
euphoria when it frst came isnt particularly
appropriate at this point.
Kishore Yalamanchili: The regulators were
aiming to align interests between issuers and
investors and the different forms of risk reten-
tion proposed probably achieve much of that.
But we as investors were looking for other
things from the NPR such as clarifying the po-
sition of frst lien holders, overall transparency
and also servicing standards.
Tejal Wadhwani: The number of options to
meet the retention requirement was a pleas-
ant surprise. Once we address some of the
tweaks, we ought to end up in a better position
Antony Currie: Risk retention rather faded into
the background as an issue for a while. Now
weve got the NPR from the regulators and in
some respects it seems its not as bad as peo-
ple feared. Is that a fair representation?
Steve Kudenholdt: People are certainly used
to the idea of 5% risk retention. And on a posi-
tive note, there are a variety of options in the
NPR by which to do that, whether by vertical,
horizontal or representative sample. So its
possible to optimize the retention to account-
ing objectives and to a particular structure.
But there are a couple of very big issues with
the NPR. In some ways it goes beyond the
statutory mandate and in some ways its not
as favorable for certain types of assets.
Brendan Keane: I would suggest that prob-
ably it wasnt as bad as we initially thought
only because its been buried among so many
other initiatives. Weve had, for example, the
policy thats been brought forth and discussed
about the GSEs and how to wind them down.
On top of that, we have more tactical issues
such as the Attorneys Generals settlement
with servicers and enforcement proceedings
than initially expected.
Doug MacInnes: The NPR does provide some
alliance. Its obviously trying to foster account-
ability through risk retention. But the investors
we talked to defnitely are looking for reliability
and transparency too.
Debbie Toennies: Having options was a good
thing. But the regulators went too far in terms
of the box that they built being too small. Its
unclear how much the regulators appreciate
that this is going to have unintended conse-
quences. But I am cautiously optimistic that
with some education and some discussion
about the long-term effects of what they have
done that well get to a more reasonable
place. Given the legislative and the regula-
tory environment, we all understand that the
rules were coming and as long as they dont
go so far that they limit consumers access to
credit or impede the ability of securitization to
service this market, then the mission will be
accomplished.
Antony Currie: But is it the case that the
Regulators missed a trick in not developing a sliding scale of
retention for the vast majority of mortgages that wont ft
the QRM box. And the premium capture rules may well make
securitizing non-QRM loans uneconomic anyway. Meanwhile,
the GSEs remain free from any of these restraints. All in, our
panelists argue that far from solving the housing crisis, the
regulators risk making mortgages even harder to fnance.
And other asset classes are being tarred with the same brush.
But the good news is that Washington also seems willing to
listen to Wall Streets concerns.
The Investor
Kishore Yalamanchili BlackRock
The Lawyer
Steve Kudenholdt SNR Denton
The Moderator
Antony Currie American Securitization
American Securitization Forum
Tom Deutsch
The Advisors
Brendan Keane CoreLogic
Doug MacInnes Bank of New York Mellon
Peter Sack Credit Suisse
Debbie Toennies JPMorgan
Tejal Wadhwani Royal Bank of Scotland
general principle of risk retention is now en-
grained enough in everyones mind that no
one is going to dispute that it should form
part of the markets in the future?
Doug MacInnes: Thats correct. And we had
to start somewhere and get something on pa-
per. One of the positives is that the agencies
worked together on this to get the proposed
rules out in a very short time frame. The ques-
tion is whether they merely took the Qualifed
Residential Mortgage (QRM) criteria and ap-
plied those same principles across other as-
set classes.
Tejal Wadhwani: There are defnitely some
positives within the risk retention rules. But
if adopted as currently drafted, they really do
have the potential to prevent securitization
continuing to be a viable fnancing
option. Its imperative that we take the fve or
six big issues and try and use our unifed effort
to make changes to those provisions. If were
successful, the risk retention rules will not be
as damaging.
Steve Kudenholdt: I have always thought
risk retention is really primarily an optical is-
sue. Other matters are much more important,
such as asset quality and access to informa-
tion about the assets so investors can deter-
mine the asset quality and so on. But in this
environment clearly its become extremely im-
portant optically for there to be risk retention
to present an appearance of an alignment of
incentives. The basic rule will achieve that.
But it needs the right add-ons. To start with, it
should address transparency, disclosure and
asset quality without making the standards
unduly tight. We need to make sure that these
rules in the aggregate do not obstruct the pri-
vate markets from engaging in securitization.
Antony Currie: What are the biggest bug-
bears?
Steve Kudenholdt: The section on represen-
tative sample is a problem. Random repre-
sentative sample is an oxymoron, if you really
pay attention to the language. Its very diffcult
to apply for a pool of larger balance assets
with a smaller number of assets, such as resi-
dential mortgages. But the biggest example is
the premium capture rule.
Antony Currie: Give us some more color on
that.
Steve Kudenholdt: It is designed to capture the
proceeds of the sale of a pool of assets over
95% par or face amount. There is some uncer-
tainty, though, as to whether it was intended to
capture only the excess over 95% of the market
value of the assets that the lender sells. Lack
of clarity aside, certainly as drafted its very
harsh for assets that have premium value.
Peter Sack: I would agree that the premium cap-
ture provision is
probably the big-
gest issue in the
proposed rules.
That may make
it impossible to
economically se-
curitize any resi-
dential mortgage
that does not ft
the defnition of
QRM.
Brendan Keane:
Would that ap-
ply across and
among the dif-
ferent profles of
what have been
historical securi-
tizers whether they
be banks, REITs or
broker dealers?
Peter Sack: Its an impediment for different
reasons depending on the nature of the en-
tity. Certainly, its going to be challenging for
banks to comply with the premium capture
requirement, which effectively is that you cant
monetize any proft at the time that you secu-
ritize. The purpose of that provision was prob-
ably to address the perception that there were
RMBS structures in which excess interest was
allowed to leak to subordinate bonds in securi-
tizations in which senior bonds ultimately took
losses. The rule seems to be written to prevent
that from happening. But it goes a lot further
than that: it effectively prevents the securitizer
from certifcating any IO or capturing any eco-
nomic beneft at the point of securitization by
reserving any premium proceeds from the sale
of the bonds.
Effectively, the rule requires that to the
extent that you sell bonds at a price higher
than par, that excess is reserved in a frst loss
account effectively. Its hard to imagine why
securitizers would do this business when at
best they would have to amortize the income
over a long period of time and own at least the
bottom 5% and never have any cash fow asso-
ciated with that for seven years, or whatever
is the likely duration of all the senior bonds
in the capital structure. Thats clearly an im-
pediment for a bank. The idea that REITs are
going to be the alternative and that the entire
mortgage system is going to move to a REIT-f-
nanced structure may not be realistic. Im not
sure theres enough interest in REIT capital in
the world to fnance the U.S. housing market.
Its a $2 trillion-a-year business.
Brendan Keane: And the vast majority of that
REIT capital, whether its invested in the pri-
mary or secondary capital market, has prob-
ably been for agency collateral, not for non-
agency loans which is what we are trying to
get to through a private enterprise and private
capital perspective.
Peter Sack: Yes, if anything the alternative
sources of capital that have come into the
market recently in the form of REITs, money
managers and others seems to be targeting
the especially pristine part of the market.
Antony Currie: Taking a 36,000-foot view,
Tom, what are the issues that concern ASF
the most?
Tom Deutsch: Lets start with the QRM, be-
cause both the industry and, probably more
importantly, consumer groups have reacted to
the QRM very negatively. Just last week Rank-
ing Member Frank and a number of his demo-
cratic colleagues sent a letter to the bank
regulators saying they were not quite sure
what the regulators were thinking when they
developed the QRM, but that the result was
not what Congress intended. That is, the regu-
lators created something that has too narrow
a credit box that will restrict credit particularly
to low-or moderate-income borrowers.
That will have to resonate with the regula-
tors because its clear evidence of legislative
intent that the Hill meant for this to be a much
bigger box. Having said that, you could widely
expand the QRM, lets say so far as calling
a QRM the same as a performing GSE loan.
Even then, you still will have nobody issuing
QRM securitizations until the GSEs step away
or the guarantee fee goes up signifcantly.
There simply will not be a private label QRM
market until the GSEs are either put on a level
playing feld with the private market or the
GSEs start to wither away somehow through
legislative effort.
Antony Currie: Is the QRM an issue itself
solely because it is so narrow or because of
Freddie and Fannie?
Tom Deutsch: Its both. In the near term, QRM
is going to be irrelevant while the GSEs are still
up and running and operating and potentially
enjoying a guarantee fee that is effectively too
low. MBS issuers simply wont use the QRM.
At some point whether thats two years, fve
years or 10 years down the road, if the rhetoric
in Washington comes to reality and the GSEs
are wound down, or at least trimmed down, T
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Tejal Wadhwani of RBS Credit Suisses Peter Sack looks on
then the QRM will actually be relevant. So we
have to think about the QRM in the medium
or long term.
Whatever QRM we fnally end up with
from the NPR, its going to stay around for a
long time because it takes six regulators to get
together and agree to change it. And that is
going to be almost impossible. All it takes is
one or two of the FDIC, OCC, Fed, SEC, FHFA,
and FHA to say, You know what, I am going to
veto that. Thats always the danger in Ameri-
can politics: it only takes one to stop the train
from moving. So unless they get this right the
frst time, the long-term outlook for the private
label mortgage market is very troubled.
Peter Sack: I agree with Toms comments
with one caveat. QRM may be relevant in the
short term in the context of legacy assets, for
example, sales of large portfolios as compa-
nies restructure, that have historically relied
on securitization for fnancing. Some of those
transactions are very signifcant both for the
companies involved and for the purpose of
producing the price discovery and liquidity
in the market that has contributed to a sig-
nifcant rally in mortgage securities over the
past two years or so. Applying risk retention
to those transactions is hard to justify to the
extent that the purpose of risk retention is
to incentivize prudent lending decisions, be-
cause in the case of loans that have already
been originated, the lending decision has
been made.
But as it stands, because of the narrow-
ness of the defnition of QRM and the prob-
lems associated with the risk retention rules
for non-QRM mortgages, beginning at some
point next year it will be very diffcult or it will
be much more expensive for transactions in-
volving legacy assets to be fnanced. Though
its true as Tom describes, that a large new
origination private label mortgage market is
unlikely until the agency limits come down,
which will likely happen incrementally over the
next few years.
Doug MacInnes: Clearly there should be
skin in the game. Its a question of at what
level and of setting the dials correctly. If they
are set too tightly, that will negatively impact
the economy and its not as if thats on solid
ground at present. So it wont take much to
tip that. Looking at the whole process, in-
cluding qualifed residential mortgages, one
of the areas lacking is technology. And if you
look at the end-to-end lifecycle of a mort-
gage, there is clearly some technology that
could be imported and elements that you can
check electronically. You have program rules
for a mortgage and you can check whats go-
ing into that program and get to it relatively
inexpensively. There are already frms that do
that in the market. So I think there is also that
opportunity to say okay, clearly we had some
things that were broken. We need to get in the
game, but applying the right set of rules and
technology are going to be key.
Steve Kudenholdt: If you look at the Dodd-
Frank language for defning the QRM, it ap-
pears that the whole concept for creating it
was as part of an overall policy of encourag-
ing home ownership and housing fnance by
having a set of loans exempt from risk reten-
tion. It reads as if the concept was to write
rules that identify factors that make loans
risky, and for which there should therefore be
risk retention.
Yet what the regulators came out with
was fundamentally different: the purpose of
the regs as prepared seems instead to iden-
tify QRM as a gold standard, as if it was gold
in Fort Knox as opposed to a consumer loan.
They went way too far and set the bar too high.
Some elements of risk factors that are baked
into the QRM criteria are very appropriate and
should be there, such as income verifcation.
Product terms as defned in the rule are a very
important factor; its right that, for example,
1% start rate teaser ARMs should not be a
QRM. But the rules clearly go off the rails with
the LTV and DTI factors in particular. The NPR
requires, for example, a 28% front-end DTI.
That is part of what is narrowing the to-
tal universe of QRMs to around 20% of the
total universe of loans purchased by the GSEs
over a 15-year period, as they calculated and
showed in the NPR. But that factor in and of
itself does not have an enormous effect on
defaults. In fact, that factor had the least ef-
fect on default risk. I am sure that it can be
demonstrated that a loan with 33% and even
36% DTI, with everything else being done prop-
erly, is a very safe loan. Similarly with LTV, they
capped it at 80%, excluding loans that go over
80% because they are covered by MI. There
they focused on the
risk of default. But the
real risk of default is
how much money are
you going to lose if a
default occurs.
Antony Currie: Surely
by simply coming up
with the concept of
the QRM, Congress
was essentially ask-
ing for the gold stan-
dard. Otherwise what
is the point of having
a QRM?
Steve Kudenholdt: The
point would be to pre-
vent risky underwriting
practices. The big rea-
son in my view for the
credit crisis, to the ex-
tent that it was caused
by residential mortgage lending, was the sud-
den decline in underwriting standards. If any-
thing is going to help prevent a recurrence, it
will be those aspects of the regs that prevent a
future decline in underwriting standards below
a normal baseline. A 28% DTI is not a normal
underwriting standard. T
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SNR Dentons Steve Kudenholdt
Brendan Keane: We all understand the mo-
tivation to improve the creditworthiness of
mortgages given the crisis. The question then
becomes, does it refect the needs of the con-
sumer? Ive seen estimates that only 30%
of current mortgages would qualify for QRM
status. So if you believe in the argument that
securitization helps with liquidity and liquidity
then begets the availability of consumer credit,
then these restrictive guidelines have fallen
short. On the other hand, its good that the
regulators are pointing to specifc data points
on specifc elements within the mortgage con-
struct. It is benefcial that they recognize that
income is an integral function and what the ra-
tio should be. Getting to the appropriate level
is going to be part of the give and take over
the next several weeks and as we go into the
commentary.
Peter Sack: I would suggest that some of these
assumptions are not universally agreed. The
idea, for example, that U.S. residential mort-
gage underwriting standards were the cause of
the fnancial crisis. Thats a complex issue, but
it certainly also involves monetary policy and
macroeconomic conditions. Similarly, the idea
that risk retention equals prudent risk deci-
sions is not at all clear to me. It is possible that
if risk retention had been applied in reverse
fve years ago, such that market participants
had been limited to 5% risk retention, there
would have been fewer fnancial collapses.
In any event, its important to focus on
how we treat assets that are not QRMs be-
cause our role is to provide a capital markets
alternative to ballooning bank balance sheets
to fnance mortgage and other debt markets.
Antony Currie: What
other issues do peo-
ple have with the
NPR?
Kishore Yalamanchili:
There are some inter-
esting issues in the
rules concerning ref-
nancing. These have
stricter LTV require-
ments of 75% or 70%
depending on whether
it is a cash out or a
non-cash out loan. In
a fat housing market,
that could be a prob-
lem. Lets say you take
a loan to buy a house
and then six months
down the road your
house value did not
change but you want
to ref to take advantage of the lower rate. Well,
you are out of luck because you have to put an
additional 10% down to qualify for this 70%
LTV loan, if it is to be a QRM. That needs some
tweaking. In general a matrix approach is far
better than this one line approach that the
regulators have chosen. So instead of having
80% LTV, 28% DTI they should have broader
metrics in those two dimensions and possibly
include other dimensions like FICO scores to
expand the box if we are solving for a bigger
QRM box rather than a smaller QRM box.
In addition, as investors we are very much
concerned about the second lien problem,
which hasnt been addressed to our satisfac-
tion. Basically, even if you have a borrower
with an 80% LTV and 28% DTI loan, under any
rules existing or proposed that borrower is not
prevented from taking out a 20% LTV second
lien loan the week after he takes out his frst
lien loan. From there onwards, its anybodys
guess what the performance of that loan is
going to be. And in the last iteration, the frst
lien investors rights have been violated be-
cause we are the ones that are getting modi-
fed on our loans, whereas the second liens
are not getting modifed. Going by the defni-
tion of the second lien, they should be wiped
out frst before we ever get any adjustment to
our coupons.
So even if you have this narrow QRM def-
nition, the lien issue is going to be paramount
for investors because it has not been satis-
factorily addressed. For capital to be coming
back to fund a $10 trillion mortgage market,
its essential that the issue of lien priorities
and the clarity on investor rights should be ad-
dressed.
Antony Currie: On the LTV for refnancing,
why do you think they have come up with a
bigger margin? There is an argument to be
made that refnancing a mortgage is far too
easy in this country and should be curtailed.
Do you think thats what they are trying to do
or is there another reason?
Kishore Yalamanchili: One reason I could
think of is that they are afraid of infated ap-
praisals in case of refnancing, whereas in a
purchase transaction its clear what the valua-
tion of the house is.
Peter Sack: Compared to rate term ref-
nances, cash-out refs are theoretically risk-
ier loans because the borrower is effectively
withdrawing equity and therefore has reduced
incentive to perform. The property valuation
is historically less clear in the context of re-
fnances generally, because in the case of a
purchase loan, there is not just an appraisal
but there is a transaction. Assuming that its
arms length, that gives you some comfort
about the market value of the property and
that doesnt occur in the context of a refnanc-
ing. So, you can understand the logic for treat-
ing refnance risk differently than purchase.
But as Kishore described, it also creates an
odd circumstance where in theory, assuming
that non-QRMs are going to price differently
than QRMs, which seems inevitable, a bor-
rower could fnd himself paying much more for
a mortgage or being faced with much higher
rates immediately after he purchases even if
rates decline because he is no longer eligible
for a QRM loan. T
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Kishore Yalamanchili of BlackRock
Brendan Keane: Kishore, a com-
ment to your point about what you
call the second lien problem. You
said its anyones guess. But deter-
mining the existence of a second
lien loan is not that hard, to speak
to Dougs comment about tech-
nology. We have seen some tech-
nological advances in that regard.
The question is whether there is
any form of obligation on any par-
ticipants part to do it.
Kishore Yalamanchili: The prob-
lem is once the frst lien is origi-
nated, the borrower can do what-
ever he or she wants. Even if you
fnd that they have taken a second
lien loan, what can you do about
it after you have given the money to the bor-
rower? There should be a way for the frst lien
to have a say in whether a second lien is put
on the house.
Antony Currie: Investors can always ask for
it, of course, and some of the new mortgage
securitization funds that asset managers
are setting up may demand it. The question
is whether the NPR should be addressing it.
Kishore Yalamanchili: The qualifed mortgage
defnition should have some language about
second liens to protect the rights of the frst
lien investor. Otherwise, whats the point of
having a QRM defnition if the borrower meets
all the criteria but then a day after getting his
mortgage takes out a second lien loan worth
20% of the propertys value?
Steve Kudenholdt: You could put a covenant
in the frst mortgage that says that the borrow-
er will not take out a second lien unless the
second lienholder agrees to participate in any
loan modifcation should one be necessary
and design it in accordance with recognized
standards that the second will have to take
a principal write-off before the frst. That, as
Kishore said, would be eminently fair as the
frst lienholder should not get crammed down
before the second lienholder. But the
system doesnt really prevent that
today. Introducing such language
would be a great best practice.
Antony Currie: Would that be an
industry best practice as opposed
to a QRM defnition?
Steve Kudenholdt: I am not saying
lets put it in the QRM. It would be
a good thing to have in all frst lien
loans, not just QRMs.
Doug MacInnes: That raises the
question of how, and even when, to
take these best industry practices
and get them into the rules. Thats
the challenge.
Peter Sack: Much of what ASF has
done so far in drafting best practices has not
only begun to be adopted by the industry but
also seems to have informed some aspects
of the legislative process. The recent rules
with respect to mortgage securitization due
diligence, for example, seem to draw from
the ASF proposal.
Tejal Wadhwani: There is going to have to be
a change in practice at every level of the se-
curitization cycle, from originator to investor,
to ensure that we have a robust securitiza-
tion market that is responsible and diligent.
There is no doubt that investors want secu-
ritized product. Its part of their investment
guidelines. They like the product. They like
the yield. And in the foreseeable future I
dont see any great alternatives for the types
of yields that investors may be looking for.
Given the crisis, the market needs some
structural changes to maintain investor ap-
petite for the product. But how much of that
do we want to have mandated to us by the
statutory authority of the regulators or rule-
making by the SEC? Thats where we have to
be very careful about not asking the govern-
ment to do too much of what we as securiti-
zation market participants should be doing
on our own.
Doug MacInnes: From an end-to-
end solution, I agree a hundred per-
cent that the industry needs to step
back and say how can we make
the mortgage securitization market
better, because wed rather make it
better than be told to make it better
in rules that may not make sense
for everyone collectively. People
talk about the TBA market and how
you could shorten time frames by
digitizing and taking out some expo-
sure. Think of the mortgage market
now, end to end, and compare it to
the securities industry when it was
in paper form. People were running
securities around the street, and
that certain element in the market
believed they could provide better
control through electronic, digitized commu-
nication and data. It took a while though: the
tipping point probably was T+3. Thats when
everyone stepped into line and said okay, this
is going to become an electronic industry. And
look where weve come since then: this is the
age we are in, when you can take a picture
of a check with your iPhone and deposit it
into your account. Then look at the mortgage
process, how a loan is originated and how it
ultimately reaches the investor. Theres a big
divergence in how that processing technology
fows and the potential for what it could look
like.
Peter Sack: The mortgage industry has made
efforts in that direction in recent years, espe-
cially in the middle part of the 2000s when
rates were low, re-fnancings were high and
there were a lot of mortgages being produced.
One example is MERS and that has been
controversial. One of the challenges in the
mortgage business is that its not just con-
sumer credit, its peoples houses. Thats an
appropriate sensitivity which makes it diffcult
to really commoditize these assets and make
for a perfectly effcient market.
Doug MacInnes: Well its funny. I was asked
in Washington about how to implement a
change, whether it would be a leg-
islative change, a regulatory action
or a commercial action thats going
to implement change. The example
I gave was the recordation of mort-
gages. I said well, if its a federal
program, you have fed-based ver-
sus states rights on recordation.
Its federal money, so federal rules
rule, so why not have one record-
ing record for any loan guaranteed
by federal money. Now, if you did
that you could work out the alloca-
tion of funds between the states
as revenue share. Then someone
on the commercial side organizing
a private transaction might notice
and say that looks pretty effcient,
especially compared with say 3,200 T
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ASFs Tom Deutsch
CoreLogics Brendan Keane and BNY Mellons Doug MacInnes
Antony Currie: Lets look at how the NPR treats non-mortgage assets.
Debbie, how would you characterize what it means for the asset-
backed commercial paper market?
Debbie Toennies: The good news was that the regulators recognized
the need to have a separate exclusion or exemption for ABCP subject
to qualifcation criteria. The bad news is much like some of the other
qualifying criteria, they didnt get
it exactly right in terms of what
should be required to qualify as an
eligible ABCP program. Im hope-
ful that with further dialogue they
will get there in terms of providing
for an appropriate exclusion or ex-
emption for ABCP. The other big
issue with the way that the regu-
lators drafted this is that it would
require ABCP sponsors to disclose
to all investors the names of all
sellers into the ABCP program. Its
unclear to me whether this was
due to misunderstanding how the
market works or some thought on
their part that they should change
the way the market works. But
this is a very material issue for the
market. Its not the way the mar-
ket has operated during its more
than 20 years of existence. Its not
a change that has been requested
or desired by investors and is cer-
tainly not one that is desired by
issuers.
Antony Currie: Whether they are right or wrong, can you see any logic
behind why regulators drafted it this way?
Debbie Toennies: If they were thinking about it from a strictly textbook
position, if the risk retention in an eligible ABCP conduit were going to
be held by the sellers of the transactions into the conduits, then there
would be some argument that the investors should know who is holding
that risk retention. The piece they missed in that analysis is that the
banks, or other support providers sponsoring these programs, are tak-
ing the risk in these assets and from the investors perspective thats the
more material risk retention. Investors dont really need to know, nor do
they want to know, the names of those sellers.
Antony Currie: Is there an element of regulators looking at what hap-
pened with vehicles using ABCP-type structures that got into trouble
in the crisis, such as SIVs or the commercial paper-like liquidity puts
that some investment banks used to offoad mortgage and ABS CDO
risk which ultimately cost them billions?
Debbie Toennies: Some of the issues associated with how they drafted
these rules do relate back to some of those other products that were
called ABCP, but that acted very differently, and were structured very
differently than multi-seller CP conduits. Thats where perhaps we need
to engage in some education and discussion with them to help explain
the differences in the structures and why maybe they dont need some
of these more technical issues that they put into the eligible ABCP quali-
fcation criteria. I am optimistic that they will come to a better conclusion
there.
Antony Currie: You said it was a material issue. What are the worst
ramifcations if the NPR went through as it stands and you have to
declare who the sellers are? T
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Debbie Toennies: Well, the good news is that this is not the only option
for ABCP conduits. So the answer would be that no one would select it
and would instead use the other available options outlined in the NPR. I
would expect then that they would go to the horizontal risk retention op-
tion, which would be the closest to the way that these programs are cur-
rently structured. The issue there, though, is that as they are structured
today, these are unfunded letter
of credit exposures that the banks
provide to these conduits. The way
that the NPR is drafted and we
understand that this was inten-
tional unfunded would not work.
So if nothing changes on that dis-
closure issue, banks would utilize
the horizontal risk retention. Those
that could would fund it as a sub
loan. There are some players in the
market that still have expected loss
notes on their conduits. There is
some question whether they would
qualify or whether there would be
accounting repercussions to do-
ing this option as opposed to an
eligible ABCP conduit. So, it is still
unclear on whether it would affect
the size of the overall market if
people had to utilize that option.
Doug MacInnes: Outstanding CP
hit a peak in 2007 and has since
declined considerably. What are
your thoughts on whether the mar-
ket would contract even further if the
NPR goes through as drafted?
Debbie Toennies: The market is far smaller than where we were at
the peak and a large part of that is due to the SIVs no longer being in
the market. CP stands at just under $400 billion and I would expect
there would be further contraction in the market if these rules dont
change.
Doug MacInnes: So the big question is whether that impacts the con-
sumer. From a liquidity perspective and credit perspective, it cant be
good.
Antony Currie: Yes, if the market did shrink even further, where does
the replacement for that credit come from?
Debbie Toennies: Thats unclear. This CP market provides working capi-
tal to the companies using it. Given some of the other changes in regula-
tions that are going on, I dont think bank balance sheets are going to be
able to fully absorb the loss of credit availability in the CP market. So that
is lost capacity in the market for borrowers.
Antony Currie: Moving onto auto ABS, what are the issues there?
Kishore Yalamanchili: The qualifying auto loan criteria are pretty strict.
In fact over the last more than 12 years or so that I have been in this as-
set-backed business, I have not seen loans originated according to such
criteria. That said, I dont think it will have a huge impact on the auto
market because most issuers are already retaining 5% or more except
for a very few high-quality issuers that have lower subordination require-
ments. These rules will have some impact on them. Also, the 20% down
payment is particularly strict. I have never seen an auto loan with a 20%
down payment.
Debbie Toennies of JPMorgan
Its not all about mortgages Its not all about mortgages Its not all abo
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Antony Currie: That, surely, would really impact the consumer. Will
people put that amount of money down?
Kishore Yalamanchili: Correct. On the other hand, even if you dont have
qualifying auto loans, the non-qualifying auto loans are already being
securitized with the subordination levels that exceed the risk retention
requirement. So I doubt it will have a huge impact here even if the rules
are as they are stated in the NPR.
Steve Kudenholdt: I agree that that standard is very strict and it raises
the issue of sweeping in a class of assets that really performed pretty well
into a whole effort around risk retention, which was driven by other types
of assets that are very different, namely subprime mortgage loans.
Tom Deutsch: One aspect of autos, and this probably applies across the
board for other asset classes, is that unlike mortgages you are unlikely
to see a bifurcated issuance on auto ABS. Because mortgage lending is
such a large market, you have different specialty players: you may have
a subprime lender, a prime lender, an Alt-A lender, all with certain niche
markets. But the large auto fnance companies wont have a conforming
platform that would meet the defnition, whatever defnition there is, and
a non-conforming platform. They are going to have one vehicle that they
are going to be issuing product through.
So the regulators will have to make a choice, effectively no exemp-
tion or an exemption that doesnt radically or fundamentally change the
auto lending market. Going back to Steves comment, why do we need
risk retention in the auto market when it performed admirably through
the worst fnancial crisis in U.S. history since the Great Depression? It
doesnt seem to be a good rationale for trying to better align incentives
when incentives already seem to be pretty well aligned. You are playing
with unintended consequences when you start adding new rules for the
sake of adding new rules.
Kishore Yalamanchili: The maturity restrictions on used vehicles are
unusual. The formula that the regulators give punishes used car borrow-
ers. Because of the way the vehicles are manufactured and designed,
we have a lot of vehicles that are bought by people after two, three years
after they go off lease.
Antony Currie: Kishore, has it always been the case that most auto
lenders have kept 5% or more of the risk, or would you say its a re-
sponse to the crisis? So if U.S. auto sales go back up to 15, 16, 17
million units a year, would that number change and is that cause for
concern?
Kishore Yalamanchili: The subordination levels defnitely increased af-
ter the credit crisis. In some cases they doubled from before the crisis.
We are already at the stage where there is tremendous demand for this
paper. So I would not be surprised if issuers start cutting back on subor-
dination levels to see how far they can go.
Brendan Keane: Its ironic: in the regulatory framework the government
recognizes the difference among these securities and the varying credit
performance of the different assets because the regulators have estab-
lished different rules and regulations among those assets. But they have
painted with a very broad brush and maybe thats intentional so that
they might be able to pull that back at a later date. Thats unfortunate,
though, because there are at least two initiatives they are trying to ac-
complish. They are trying to hold institutions accountable and respon-
sible, but also trying to beneft the consumer. Maybe you achieve the
frst with a varying set of regulations. But I dont think weve necessarily
seen how the retail consumer benefts, whether its for borrowing under
a mortgage or an auto loan.
Doug MacInnes: And dont forget the CLO market. The Loan Syndication
and Trade Association has addressed this best, I would say. That mar-
kets history, its performance and its fee structure are all very different
when compared to mortgage securitization. And CLOs are an important
element of small business fnance. So the dials need to be set properly
with all that in mind.
Antony Currie: Tejal, could you elaborate on what the issues are in the
CMBS, market?
Tejal Wadhwani: One of the ways that the CMBS market differs from oth-
er asset classes is the role of the B-piece buyer. The B-piece buyer does
signifcant diligence, is very much involved in the process front to back
and has a say on what can and cannot go into a particular structure,
because of their position in the deal. And so, regulators defnitely got it
right by saying a traditional B-piece buyer can satisfy the risk retention
requirement so long as they meet certain other requirements.
Some of those requirements seem workable with minor tweaks,
such as the B-piece buyer conducting asset level diligence, the type of
retention, the composition of the collateral and the source of funds the
B-piece buyer must pay cash at the closing of the securitization without
fnancing being provided, directly or indirectly, from any other transaction
party.
But some of the other requirements are more problematic. For ex-
ample, the rule requires the sponsor to disclose, among other things, in-
formation regarding the B-piece buyer or its retention that is material to
investors as well as the purchase price. The frst part of this is vague and
it is unclear how it can be met. Disclosure of the purchase price is gener-
ally not made public and raises confdentiality and other concerns.
We are hearing from most CMBS participants that having to dis-
close the retention amount and the price the B-piece buyer pays, like the
point on ABCP, is likely to render this risk retention alternative unviable.
It is something that has traditionally not been disclosed, it puts players at
a competitive disadvantage and its also diffcult to see what signifcant
value a CMBS investor is going to get out of this type of disclosure.
Some of the other risk retention alternatives make this even more
troublesome. In a typical CMBS transaction, you have two or three spon-
sors contributing the collateral. So if you have a $2 billion deal with three
securitization sponsors, one of them has to hold all the risk retention un-
der the current proposed rules, and that can be diffcult. Couple that with
the fact that all of the other sponsors are responsible for making sure
that the sponsor that has agreed to retain that risk is going to continue
to meet all of the requirements of the retention. One of those two pieces
needs some tweaking so that the CMBS market can continue to grow.
Antony Currie: It sounds a bit like getting neighbors to spy on each
other. Can it work?
Tejal Wadhwani: I dont think so. Weve been talking to a lot of constitu-
ents in the CMBS market and we havent come across any sponsors that
have said they would be willing to do something like that.
Debbie Toennies: That third-party policing effort is also true in the ABCP
market. If you are an eligible conduit the requirement in the NPR is that
the sponsor of the conduit then polices all of the individual sellers into
the conduit on their risk retention and they are required in that case to
all hold horizontal risk retention. ABCP sponsors would have a contrac-
tual arrangement with those parties and could include covenants in the
transaction to require the sellers to retain the risk throughout the life of
the transaction to do it. But its interesting that across the NPR, they are
asking the markets to police other participants in the market without this
same privity of contract.
Tejal Wadhwani: And one of the differences is that you have a smaller
set of parties that you have to police in the CMBS market as opposed
to ABCP.
out mortgages Its not all about mortgages Its not all about mortgages
counties that they have to record in 3,200 dif-
ferent ways. So there are some changes that
could take place that would cut a lot of risk
out of the process.
Peter Sack: I would
agree that the mort-
gage business could
be a lot more effcient.
But its often a political
issue take Kishores
earlier point, for exam-
ple, on frst lien rights
versus subordinate
lienholders and other
creditors of the borrow-
er who are not secured
at all.
Why is it, for exam-
ple, that so many of the
loans proved not really
to involve recourse to
the borrower? Thats a
political issue. To the ex-
tent that there are laws
to that effect, mostly
in the western states I
think, those were adopted for consumer pro-
tection. Yet they have the effect of impairing
the availability of credit because they make
it diffcult to realize on the collateral assets
although they were written for the beneft of
consumers.
Such political issues or consumer-related
sensitivities make it very diffcult on a broad
scale to implement changes in the mortgage
business. Clearly, there are many potential
effciencies. But there are probably regula-
tors and lawmakers who would say precisely
that modernization of this asset class was the
problem. The issue that we are faced with is
how to defne a safe mortgage the defnition
of which is not going to overly impair the avail-
ability of credit to a large part of the borrower
population.
Steve Kudenholdt: One thing we are not see-
ing as part of all of this is any kind of trend
towards a larger sense of responsibility on
the part of the borrower. If anything, it seems
to be going the other way; many courts tend
to view borrowers as victims, as people who
were given credit that shouldnt have been
given to them. There seems to be retribution
for that by punishing the lender, which means
punishing the investor. There is no big move-
ment towards making all loans full recourse
for example. They should be, but that doesnt
seem to be in the cards.
All of this underscores that the onus is
on the lender, and therefore on the securi-
tization industry, to make sure that lending
practices are responsible. Its going to be crit-
ically important to make sure that unreason-
ably easy money does not become available
in the form of some of these risky products
or by risky underwriting standards but at
the same time to not throw the baby out with
the bath water by making those credit stan-
dards cause large sections of the borrowing
population to be ineligible for a loan on favor-
able terms. My big problem with the QRMs is
that after the frst 20% of loans that do meet
the QRM standards, why are the next 40%
or more not also very good quality loans and
why should credit be made more expensive to
those borrowers, particularly if its done in a
way that simply preserves the role of the GSEs
during what should be a wind-down period?
Antony Currie: You mentioned the next 40%
after the 20%. There is a mention in the NPR
of fexibility, of requiring more than 0% and
less than 5% risk retention for loans that
meet some of the standards. How useful
would that be and how likely is it?
Steve Kudenholdt: Youre right, there is
something in the law that says the regula-
tors shall include underwriting standards
under which the retention will be reduced
for different loan types, including residential
mortgages, separate from the QRM exemp-
tion. However, the regulators did not include
a proposal for residential mortgages, other
than for QRM. But it would be great to have a
separate middle-ground exemption; we could
call it QRM-lite, or some such. For example,
loans with full income verifcation, no risky
product features but perhaps a higher LTV
and higher DTIs with compensating factors
could ft in a broader category with a reduced
retention level, say 2% instead of 5%. It would
also be helpful to allow blended pools, for ex-
ample mixing loans that have zero retention
and ones with 2% and, say, ones with 5% all
in one pool, with the risk retention require-
ment being based on the weighted average.
These ideas would mitigate some of the cliff
effects for loans that fall slightly outside the
QRM defnition.
Antony Currie: We mentioned the GSEs a
number of times. They are exempt from
risk retention, which given the guarantee
theoretically makes sense. But the fact that
they had these guarantees and lost billions
of dollars anyway implies that risk reten-
tion doesnt necessar-
ily work, as Peter men-
tioned earlier.
Brendan Keane: There
are several legislative
initiatives to eliminate
that perceived beneft.
Its part of what has
been described by some
as the Eight Points of
Light initiatives that
have emerged from
time to time from Con-
gressman Garrett and a
few others. At least one
addresses leveling the
playing feld.
Steve Kudenholdt: I
would say that the risk
retention regs should
be changed to result in
a level playing feld for
GSEs and non-GSEs. That initiative is moving
forward in the House, but its unclear if it will
get through.
Peter Sack: Its unclear what that means, giv-
en that GSEs either own the loans in a portfolio
or guarantee 100% of the risks. They already
have risk retention to the maximum extent.
Steve Kudenholdt: The difference is that
somebody has to hold ownership interest.
Peter Sack: You mean with respect to the
bank itself.
Steve Kudenholdt: Yes.
Peter Sack: From what Ive heard, as long as
the defnition of QRM doesnt change dramati-
cally, and it doesnt seem like its going to get
tighter, the loans that the GSE portfolio will
buy may ultimately ft the box other than, for
example, DTI.
Antony Currie: There is a lot of commentary
about Freddie and Fannie getting in the way
of restarting the private markets. Yet the
two existed side by side before, granted as
subprime became a larger part of the mar-
ket. So, why are the GSEs preventing private
capital getting back in now?
Peter Sack: There are about $10 trillion of
residential mortgages outstanding right now,
about $5.5 trillion of which are owned or
guaranteed by the GSEs. About $1.3 trillion
is outstanding in private label securitizations
and the balance is basically in bank portfolios.
In 2005 or 2006 private label represented
about 50% of the market. That was the peak
of private label relative to the GSEs, with his-
torically low rates, an extraordinary amount of T
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refnancing activity and after signifcant growth
in Alt-A mortgages. Subprime at its peak made
up maybe 20% of the market. The agencies
owned about 65% of all the subprime risk, for
example in the form of senior RMBS. So its not
as if the private capital markets were the sole
repository for subprime.
At that point, the capital markets loan
price was not that far away from agencies,
maybe as little as 25 or even 15 basis points
of difference in price in some circumstances.
That spread between agencies and non-agen-
cies is greater now, and thats a function of
a lot of things, but it certainly includes all of
this uncertainty about foreclosures, liquidation
timelines and so forth. Those issues do exist in
the context of agency securities but they affect
only speeds, not credit.
In most parts of the country, its not clear
that home price decline has stopped, and you
have all of these modifcation, foreclosure and
other legal issues. But to Tejals point earlier,
its not that there are no investors for private
label RMBS. What few deals there are, are
oversubscribed by the traditional investors
who have always been active in this space.
However, its not clear that there is enough pri-
vate capital available to get back to 50%. So
the most likely outcome is that the agency role
will be incrementally reduced over a period
of years as market conditions normalize, and
more importantly as home prices stabilize, and
the private label market will grow to meet that
increase in supply.
Brendan Keane: The far-reaching attempts at
winding down to zero the GSEs is sparking the
polarization that we discussed earlier where
you have political capital and private capital
coming together and you are seeing a poten-
tial overreaction or overreaching as it relates to
the GSEs. If you look at whats happening with
the GSEs in terms of losses and who suffered
the losses, a lot of the political capital attempts
to resonate and gain favor at the consumer
level. So the taxpayer is under the burden of
all those losses. If the GSEs, or whatever they
become, post a proft, or gain traction or mo-
mentum over the next two to three years, we
will see that call to arms signifcantly reduced
and well probably have some type of peaceful
coexistence to some extent. But clearly there
is a need for fresh capital to register again and
its a function of fnding that right level, but its
a polarization we are witnessing.
Steve Kudenholdt: Political capital is a great
word for it. Another way to describe it would
be public capital which is deployed in part for
political-economic policy purposes and not
for proft-making purposes. There is no lower
cost of funds than for debt that has a federal
guarantee, as the GSEs do. And the differen-
tial between public and private cost of funds
is getting wider at the same time as more and
more regulations are being imposed on private
securitization markets. That is going to make
the cost of a private securitization even greater
compared to a GSE securitization.
Virtually none of these new requirements
being phased in due diligence, risk reten-
tion, RegAB are being imposed on the GSEs,
ensuring they continue to have a low cost of
funds, including a lower cost of executing a se-
curitization. The gap keeps getting wider, and
then you wonder what goes into the decision-
making about what types of loans should be
bought by the GSEs. At the same time, there
are higher standards being brought in for loans
going into private label securitizations, where-
as the GSEs continue to have a far broader set
of underwriting criteria.
Antony Currie: Do investors share such opin-
ions, Kishore?
Kishore Yalamanchili: From an investors
point of view, there should be some govern-
ment presence in the market to guarantee the
pass through or other types of structure. We
can have private securitization also, but were
talking about funding a $10 trillion market.
At the end of the day that does require some
participation by the government for capital to
come back to this market. We can debate how
thats done, of course.
Antony Currie: The NPR raises the issue
of servicing. It doesnt appear to delve too
deeply into it and it does give a nod to other
initiatives that are out there. But the securi-
tization industry is not happy about it. Can
you explain why?
Doug MacInnes: The problem is that it creates
a servicing standard for a subgroup of loans.
And it doesnt belong in the NPR. If you were
looking to implement a servicing standards
change, you would surely do it for the broader
market. The Federal Housing Finance Author-
cant issues that are raised by proposed regu-
latory changes for the securitization market,
the matter of a banks risk-weighted assets is
the constraining issue. Capital is going to be
increasingly at a premium over the next few
years. Its a complex issue, but crystallizes
why obtaining further clarifcation on how
all the different retention options work is of
paramount importance.
If, for example, a bank is not able to rely
on its existing inventory of loans to satisfy the
risk retention requirements but is actually re-
quired to hold bonds, thats a very expensive
proposition in RWA terms.
Anything that bears on capital is a seri-
ous concern and its all about capital. The
proposed rules could make mortgage lending
more capital intensive. That will increase cost
to the consumers.
Under Basel III, the 5% risk retained at
the unrated horizontal bottom of the capital
structure is going to be charged to Tier I capi-
tal dollar for dollar. In the next few years the
mortgage business will be a $2 trillion-a-year
lending business, give or take. If the non-
agency part of that became again $1 trillion
dollars, well, you can do the math. Thats a lot
of capital. Thats why its so important that the
defnition of QRM be suffciently expansive to
accommodate the bulk of the loans. And the
bulk of the loans are good loans.
American Securitization and ASF would like
to thank all participants, and in particular
our sponsors BNY Mellon, CoreLogic and SNR
Denton for their support of this roundtable.
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ity, for example, recently came out with some
guidelines for Fannie and Freddie, and thats
probably a better way to set some of these ser-
vicing standards. It would probably take hold
in the market far more quickly than it would
via the NPR. Besides the servicing standards
here, as I understand them, point towards the
QRMs, which at the end of day are probably
the least likely candidates to need a change
in servicing standards.
Kishore Yalamanchili: We have seen issues
with the processing of mortgage loans over
the last four years. We have high delinquen-
cy and foreclosure levels, staff shortages,
paperwork issues and a confict of interest
when banks service both frst and second
lien loans, among many other issues. I am
agnostic whether the QRM defnition or some
other rule or regulation should deal with the
servicing standards. But as an investor I want
to have clearly defned servicing standards for
processing loans. What I am afraid of is that
if we dont get it done here, we wont get it
done at all elsewhere. Im not saying the NPR
is the best venue to achieve this, but what is
the alternative?
Steve Kudenholdt: First of all, it should be an
initiative that operates through regulations
that regulate servicer conduct directly as op-
posed to a requirement to embed it within
the terms of the mortgage loan. Thats be-
cause by putting it in terms of the mortgage
loan, the borrower has a private right of ac-
tion or defense to foreclosures saying, Oh,
you didnt have modifcation policies that
conformed to these extremely vague require-
ments in the QRM defnition. And literally it
will just be a defense to foreclosures that will
just further slow the process down.
Second, as Doug said, the risk reten-
tion NPR is not the right place to launch it.
It should not be launched with the top 20%
quality of loans that are not bought by the
GSEs. It should be rolled out to all residential
loans of all types, whether or not they are go-
ing into the GSEs.
Steve Kudenholdt: I am not sure what the
right venue is, but I know this is not it. Its
certainly not the last venue. Its just an open-
ing salvo to the discussion. The last thing we
want is to have these initial thoughts on a
developing regulatory idea be cast in stone
for QRM loans, and then have to deal with
changing that in the future. Its a bit like the
FDIC putting risk retention into the legal iso-
lation Safe Harbor. It appears in a very dif-
ferent format in that rule, which came out
about a year ago, as compared to the NPR.
Now its going to be necessary to effectively
retroft the risk retention version from the
FDIC rule. I dont really see any purpose or
value whatsoever of even having the servic-
ing rules in the NPR other than just to elicit
some commentary. It absolutely should not
be in the fnal rule.
Antony Currie: Heres a speculative question
for you. Assume the QRM and risk retention
aspects of the NPR go through after some
tweaks prompted by industry comment. Will
that prevent housing crises in the future, or
should we still be worried about risk?
Steve Kudenholdt: I have two concerns. First,
I worry the economy will not support frst a
foor in housing and then a gradual rise in
housing values. Second, mortgage credit
standards have a tendency to loosen when
the economy is strong.
Antony Currie: Wouldnt this help it?
Isnt that the intent of the QRM and risk
retention?
Steve Kudenholdt: I dont think that would
stop it. If you look back at what happened,
one thing you might say is that everyones
interests were aligned in the direction of
making more loans, by loosening credit stan-
dards. That was the wrong type of alignment
and happened because there was nothing
in place to prevent credit standards from ex-
panding overly aggressively.
If everybody in the system is going to
make more money by loosening standards
then risk retention doesnt help anything.
Maybe the QRM standards or other types of
standards that limit the amount of risk reten-
tion could have had a benefcial effect. But
they have to be targeted at the right level, not
way to the conservative end of the spectrum.
We should be setting underwriting standards
at a reasonable middle level and keep them
there.
Brendan Keane: The potential for another
crisis is there. So much time has been spent
focused on the institutions involved in the
process. But what are the borrowers respon-
sibilities? You can set up all the institutional
restrictions and governors that you like. But
we need to make sure we are monitoring and
staying in tune with how the borrowers react
and what they will be doing in terms of debt
management.
Debbie Toennies: The defnition of the QRM
is important to the banks ability to fund the
mortgage market. If they have to hold risk re-
tention and cant hedge and cant sell, they
are going to run out of capacity pretty quickly.
The effect on the ultimate consumer of not
being able to get credit would be signifcant.
Banks will continue to have risk limits.
If they cant hedge and they have to buy and
hold for a very long time period, especially
in the mortgage market, its just not hard to
imagine that in very short order, they are go-
ing to run out of capacity.
Antony Currie: Could covered bonds help
bridge the gap?
Peter Sack: Covered bonds dont involve
risk transfer, with respect to either credit or
interest rates. And the loans are on balance
sheet. Notwithstanding all of the very signif-
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By Michael K. Feldman
I
n the childrens story Goldilocks and the Tree Bears Gold-
ilocks struggled to fnd a bed that was neither too soft nor too
hard. Eventually, of course, she settled on one that was just
right. Te Canadian Securities Administrators (CSA) appear to
have largely succeeded in crafting a similar level of comfort with
the comprehensive set of new rules for securitized products that
they unveiled in April after a two-and-a-half-year study.
Te CSA, which represent each of the provincial and territorial securities regulators in Canada, have successfully avoided many
of the mistakes made by the U.S. lawmakers who drafted legislation for publicly distributed asset-backed securities (ABS). But
certain details of Canadas securitization proposals need refnement primarily, as I argue below, the sections dealing with exempt
distributions, where the CSA still need to provide greater fexibility.
One reason why the Canadian securitization proposals are not as cumbersome as those in the United States is because the
2007 credit crisis did not hit Canada as hard. Te countrys fnancial markets calamity was the collapse of the $32 billion third-par-
ty ABCP market. Exploring new rules for the sale of ABCP was thus what the CSA initially decided to focus on when it released
its consultation paper in October 2008.
Tis was the only regulatory initiative undertaken in Canada for asset-backed securities. By comparison, the U.S. government
and regulators have been hyperactive: sections of the far broader Dodd-Frank Act are devoted to securitization and the Securities
and Exchange Commission (SEC) has already issued several rules and released other draft rules as a result. In addition, the SEC
has proposed amendments to Regulation AB, known as RegAB II, though that appears to have taken a back seat of late. And the
Federal Deposit Insurance Corporation has issued its new safe harbor rules for bank-sponsored securitizations.
Te slower pace of rule-making adopted by the CSA has allowed them to refect upon U.S. securitization initiatives and seek
a more balanced approach. Te CSAs prospectus and continuous disclosure proposals are largely based on the requirements of Re-
gAB with very few additional elements adopted from the latest bout of U.S. regulatory initiatives. In general, these provisions can
be fairly summarized as an uncontroversial update of securitization disclosure requirements to meet the standards that have been
in efect in the United States for fve years. Many of the prohibitions or obligatory requirements contained in the U.S. securitization
initiatives are dealt with instead as disclosure items under the CSAs securitization proposals (see box on page 33).
At least Canadas regulators know wholl be sleeping in the bed
theyre making
istock
The credit crisis did not hit Canada as hard as the
United States. As a result, its regulators took their time
before reacting and have now proposed a measured
approach to regulating the securitization industry.
However, their rules still need some fne-tuning.
Te CSAs proposals for exempt distributions of securi-
tized products, however, are less benign. Like the provisions of
RegAB II that would apply to private placements, the exempt
distribution rules under the CSAs proposals would, if left in-
tact, probably inhibit the private placement securitization mar-
ket much more than the CSA apparently intends, according to
the background sections of their proposals.
Te proposals would eliminate all of the existing prospec-
tus exemptions for securitized products, including ABCP, and
replace them with a single securitized product exemption.
Te exemption has three components. First, sales may only
be made to eligible securitized product investors (ESPIs), es-
sentially a slightly more restrictive list than the current accred-
ited investor designation.
Next, the issuer must deliver
an information memoran-
dum to each investor and also
make it available to prospec-
tive investors in the second-
ary market. Finally, the issuer
must prepare and deliver pe-
riodic continuous disclosure
reports essentially as if the
distribution of ABS or ABCP had been executed through the
terms of a prospectus.
Crisis Reaction
Te securitized product exemption is largely a reaction to the
2007 credit crisis where thousands of Canadian retail ABCP
investors found themselves holding illiquid ABCP and unable
to gain access to crucial information concerning the assets back-
ing their ABCP or the conditions surrounding the ability of
ABCP conduits to draw on liquidity lines. Under the Canadian
securitization proposals, information memoranda for short-
term securitized products, including ABCP, would have to be
in a prescribed form.
Te details of the form are outside the scope of this article
but they should be sufcient to address the concerns arising out
of the 2007 credit crisis. Although the requirement for infor-
mation memoranda for short-term securitized products would
be new, much of the information required in the prescribed
form of information memorandum and continuous disclosure
for ABCP is already being provided privately to investors by
bank-sponsored ABCP conduits in their monthly reports.
Tere are a few areas where the form of information mem-
oranda for short-term securitized products arguably goes too
far. For example, it is proposed that sponsors must describe the
material terms of existing program documents and transaction
agreements. Tis could be quite an onerous task for a multi-
seller ABCP conduit. Yet it is unlikely that it would provide
much useful information to investors.
Te most problematic aspect of the exempt distribution
rules, though, appears to be a requirement for the sponsor to
certify that the information memorandum contains no mis-
representation. Since sponsors of ABCP conduits rely on the
servicers of their various programs to provide the information
required for the information memorandum, this will efectively
make the sponsor of an ABCP conduit a guarantor for the ser-
vicers. Te sponsor could, of course, have recourse back to the
servicers. But that would be cumbersome, introduce an addi-
tional layer of unnecessary risk and would probably limit ac-
cessibility to ABCP conduits to only the most creditworthy of
servicers.
Tere is no prescribed form for information memoranda
for other securitized products, but they must disclose suf-
cient information about the securitized product and securitized
product transaction to enable a prospective purchaser to make
an informed investment decision. Tis is a novel and vague
standard for ofering docu-
ment disclosure.
Te securitized product
exemption has a few other
bugs to work out, too. Te
defnition of ESPI does not
include conduits in other
words, trusts adminis-
tered by an ESPI. So under
the current proposals, bank-
sponsored ABCP conduits may only purchase asset-backed se-
curities if they are ofered by prospectus.
Another requirement may well stife the ABS private place-
ment market: the CSA is proposing that the information mem-
oranda for all securitized products must be certifed by at least
one underwriter to contain no misrepresentations, to the best
of the underwriters knowledge. Currently, underwriters and
other agents do not take responsibility for disclosure in private
placement ofering documents. Forcing them to do so may un-
dermine their desire and ability to participate.
Finally, many private placements of ABS are to sophisti-
cated investors who do not require or desire an information
memorandum, particularly where the sale is to a single investor.
At the very least, a subset of ESPIs ought to be able to opt out
of the information memorandum and continuous disclosure re-
quirements of the securitized product exemption and instead
negotiate for whatever disclosure they require.
Market participants have had time to make their views
known: the comment period for the Canadian securitizations
proposals ends on July 1. Revised proposals should come be-
fore the end of 2011, with a further comment period thereafter.
Once that is over, the CSA are likely to promulgate the fnal
rules in the frst half of 2012. Tankfully, most of the rules are
nowhere near as onerous as the restrictions U.S. legislation
seeks to impose. And with a few adjustments, it should be pos-
sible to rejig the proposed Canadian exempt distribution rules
to make them much more accommodating.
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Te slower pace of rulemaking adopted
by the CSA has allowed it to refect upon
U.S. securitization initiatives and seek
a more balanced approach.
Michael K. Feldman is a partner with Torys LLP in Toronto.
Te views expressed are those of the author and do not necessarily represent the
views of ASF.
The bulk of proposals contained in the Canadian Securities Adminis-
trators (CSA) securitization proposals strike the right balance for all
participants. What follows is a guide to the main differences between
proposed rules in the United States and Canada.
Risk Retention
The Canadian securitization proposals contain no requirement that se-
curitizations be structured in a particular manner, such as requiring risk
retention of an arbitrary amount by the sponsor or an originator. Instead,
a prospectus must disclose whether any signifcant party is retaining
a portion or a tranche of the economic interest in a transaction, the
amount retained and whether the retained exposure has been hedged.
Conficts of Interest
Under the CSAs securitization proposals, those who are or have been in
the past engaged in a transaction that would involve a confict of interest
with investors are not prohibited from participating as underwriters in a
securitization. Rather, this becomes a prospectus disclosure issue.
Ratings Agencies
Credit ratings will remain an eligibility criterion for accessing the Cana-
dian shelf prospectus system for issuers of asset-backed securities. No
one seems to have come up with more meaningful criteria yet includ-
ing the drafters of RegAB II so the CSA are sticking with the poison
that they know.
Also, credit rating agencies continue to be exempt from expert
liability when issuing their ratings. As a result, it will not be necessary to
obtain rating agency consent to disclose ratings. In fact, disclosure of
certain credit rating information in a prospectus is required and, unlike
the current situation under RegAB, it is expected that Issuers will be able
to comply with these requirements because consent of the rating agen-
cies will not be required.
Level of Disclosure
The type and level of disclosure required by the Canadian securitiza-
tion proposals is similar to, and is based upon, that required under the
current RegAB. Major departures, such as asset- or loan-level disclosure
and the provision of a computer waterfall payout program, have been
rejected in the current proposals.
Static Pool Data
Notwithstanding the general move towards RegAB-level disclosure, an
issuer need not include static pool data if it would not be material, pro-
vided that the prospectus discloses why such information was omitted. A
recent decision of the Supreme Court of Canada (Sharbern Holding Inc.
vs Vancouver Airport Centre Ltd., et al., 2011 SCC 23) could provide sup-
port under certain circumstances for issuers wanting to take the position
that static pool data may not be material.
Review of Pool Assets
Under the CSAs securitization proposals, there is no mandatory review
of pool assets underlying ABS. However, if the pool assets are reviewed,
the result of this review must be disclosed in the prospectus and, as with
U.S. securitization initiatives, if the review is conducted by a third party,
that third party must be named in the prospectus and must consent to
being named as an expert.
Fulflled and Unfulflled Purchase Requests
The differences here are subtle. The Canadian securitization proposals
require a prospectus to provide historical demand, repurchase and re-
placement information with respect to other securitizations by the spon-
sor for the same class of assets when ABS is distributed by prospectus.
Subsequent demand, repurchase and replacement information must
be provided as part of the continuous disclosure package. However, it is
not necessary for issuers to disclose this information regarding different
asset classes or in connection with privately placed securities.
Canada Structures
ABSolutely Better Rules
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lewtan2011new.pdf 1 5/27/2011 3:56:33 PM
Are
Covered Bonds
Heading
out of the
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Antony Currie: As we were preparing for this
roundtable, a number of people said they were
interested in participating but either didnt
understand quite enough about the product
or their company didnt have a position on cov-
ered bonds. That struck us as odd, considering
how long this product has been touted as a
useful arrow in the mortgage fnance quiver.
So perhaps we should start with some basics.
What is it about covered bonds that is so useful
and why is it that ASF is pushing to establish a
U.S. market?
Ralph Daloisio: There are a number of reasons
why the securitization industry should be back-
ing covered bonds. First,
look at our membership.
ASF represents fxed-in-
come institutional investors
who collectively manage, in
aggregate, trillions of dol-
lars. Many of them need
high-quality investments.
Before the fnancial crisis,
securitization manufactured
the predominant share of
triple-A fxed income instru-
ments purchased by this in-
vestor base. But the supply
of triple-A debt, from the pri-
vate sector at least, fell off
the cliff and has not much
recovered since. Covered
bonds would help restore
that supply.
Covered bonds also offer an opportunity
for issuers. And ASF also represents banks,
non-bank fnancial institutions and other types
of credit institutions who must manage their
asset-liability dynamics by looking for low-cost,
effcient and liquid fnancing alternatives in the
debt capital markets. Our membership would
be very engaged in the development and use
of a U.S. covered bond market, just as they
have been from the early days of the asset-
backed securities market.
Then lets consider the public policy per-
spective. There is widespread consensus that
we need to reengage the private sector in
U.S. mortgage fnance. Creating alternatives
can help facilitate GSE reform. Thats impor-
tant because without those alternatives, well
be trapped in this chicken and egg situation:
how do we reduce and re-scope the role of the
GSEs if there is no suitable alternative for gen-
erating mortgage fnance in the United States.
When we look at the experience of the f-
nancial crisis, we reconnect the role of securiti-
zation as a bridge between both sides of Main
Street. On one side are the borrowers and on
the other side the investors. During the fnan-
cial crisis, we saw that the borrowers were los-
ing their homes and the investors were losing
their money. So what we need to do to restore
the service to Main Street is ensure that there
3
Covered bonds have long been touted as the next big thing in U.S. mortgage fnance. They offer low-cost funding for fnancial
institutions and would reinvigorate the supply of triple-A assets that was hard hit by the fnancial crisis. But the market has
never quite managed to fnd a foothold. That might, fnally, be changing. Representative Scott Garrett has reintroduced his
bill to create a legislative framework for covered bonds. Questions still remain not least whether the FDIC will ever modify
its stance on its ability to repudiate covered bonds in the event of a bank failure. Some on our panel are concerned that only a
handful of large banks would be able to tap the market. Others wonder whether covered bonds would be able to survive in the
United States if mortgage securitization found its feet again. The European market may give some comfort it has, after all,
functioned successfully for years. With housing still frmly on the agenda as the 2012 elections draw closer, this may well be
the defning moment for the future of covered bonds in the United States.
is a suitable mix of alternatives for the invest-
ment side of Main Street that is responsible to
the debtor-homeowner side of Main Street.
A separate point is to look at this even
more broadly. At our conference this past
February, I was part of a small group discuss-
ing what our wish list was for securitization.
Mine was to have a single piece of legislation
governing the uniform operation of asset se-
curitization. Someone turned to me and said,
Weve got that, its called Dodd-Frank. Well,
we can debate that point, of course. But when
I roll back the calendar on securitization and
think about how it all came to fruition, it re-
ally was a quilt patching
together individual pieces
solving Remic, accounting,
bankruptcy considerations
and securities consider-
ations almost independent
of one another. There is no
single enabling piece of
legislation that was able to
create what I would call an
a priori intelligent design
around which free market
forces could build a pru-
dentially supervised system
of fnance. We have that op-
portunity now for covered
bonds.
The European experi-
ence has been extremely
favorable, even through
the crisis. Banks were able to create cov-
ered bond instruments that were deliverable
to the European Central Bank as a way to
shore up their liquidity at a time when their
traditional sources of liquidity were drying up.
This helped arrest the liquidity and solvency
stress confronting their banking and fnancial
system.
The Bankers
Ramon Gomez JPMorgan Chase
Kristi Leo Deutsche Bank
The Ratings Agencies
Yehudah Forster Moodys
Karen Naylor Standard and Poors
The Moderator
Antony Currie American Securitization
The Lawyer
Scott Stengel King & Spalding
The Investors
Ralph Daloisio Natixis
Nicolas Steinbach BlackRock
Its no secret that Europe is the home of
covered bonds. But who actually issues
them? Where are they based? Who are their
bankers? And just how much is issued in
euros? We at American Securitization have
gathered all the information together for
you, with the help of Thomson Reuters. The
data is revealing. First, Germanys banks no
longer lead the market. The countrys 242-
year-old Pfandbrief product was the inspira-
tion for many of its neighbors covered bond
programs. Now, Germanys issuers sit third
behind France and Spain.
As for currencies, while euro-denomi-
nated deals still dominate, at 82% last year
they represented the lowest share of the
market since the single currency was
introduced - and as of May this year that
has fallen to 80%. Whats causing the
change? The increase in dollar issuance.
Granted, the issuers are European, but the
numbers show that, if structured correctly,
U.S. investors will buy covered bonds. And
note the almost 50% increase in volume in
the frst fve months of 2011: thats in part
due to unsecured bank debt being more
expensive this year. But its also a sure
sign that, in Europe at least, covered bonds
are an integral and trusted part of bank
funding strategies.
Covered Bonds by the Numbers - A Bluffers Guide
36
All Data Provided by Thomson Reuters
37
38
Securitization will remain a superior al-
ternative.Therejustisnobettertechniquefor
transferring both credit and interest rate risk
while releasing both regulatory and economic
capital. These are not hallmarks of covered
bonds.
Antony Currie: The covered bond legislation
that Representative Scott Garrett has put on
the docket this year was out there last year, and
went nowhere. Why doesnt this product seem
able to get off the ground in Washington?
Scott Stengel: Thats particularly diffcult to
translate for Wall Street, where even those
with different interests in a deal share the
common objective of closing it. In Washing-
ton it is incredibly hard to
enact positive legislation,
by which I mean legisla-
tionthatismeanttocreate
something out of whole
cloth. Its not enough to
convince folks on the Hill
and in the Administration
that a piece of legislation
has sound policy objec-
tives and market benefts.
InWashingtonthepolitical
variabledominates,soyou
have to give both legisla-
tors and members of the
executivebranchareason
todevotetheirtimetoit.
That did start to hap-
pen at the end of 2009
andthenevenmoreduring
the deliberations on Dodd-
Frank.Butafterlosingour
opportunity in Dodd-Frank
last year, we had to begin
again to build momentum especially in the
Senate where only large pieces of legislation
are generally passed. Covered bonds have a
lotofpositiveattributes,butbecausethisisa
fairly discrete bill, getting the attention of the
folksontheHilltogetbehinditandtomoveit
hastakensometime.Thatsnotsurprisingto
thosewholiveinWashington.Itsmoresurpris-
ingtothefolksinNewYorkwhokeepasking,
Whenistheclosingdate?Andthereisnever
aclosingdateforlegislation.
Antony Currie: What are the chances of the
bill going through this time?
Scott Stengel:Iwouldputtheoddsat70-30.
The30%riskoffailurestemslargelyfromwhat
I just described how diffcult it is to get any
kind of comprehensive legislation passed in
Washington.The70%convictioncomesfroma
coupleofthings.First,folksontheHillarebe-
ginningtosensethatthe2012electionscould
beheldinthemidstofaneconomicrecovery
that is still struggling and a housing market
thatisstilldepressed.
Withrule-makingsunderDodd-Frankcon-
tinuing to suffocate securitization and other
parts of the capital markets, there is a grow-
ingrecognitionthattheyneedtodosomething
constructive to facilitate stable and cost-ef-
fective funding for consumers, businesses,
and public-sector entities. Second, the only
substantial opposition to covered bonds has
comefromtheFDIC.Whilewearecontinuing
toworktowardacompromise,legislatorsmay
ultimatelyconcludethattheFDICsinstitution-
albiasagainstsecuredcreditgenerallyisnot
suffcient to deprive the United States of the
benefts of a covered-bond market.
Antony Currie: Why do we need legislation
for covered bonds?
Yehudah Forster: The main reason why we
needlegislationhastodowithwhathappens
in the worst-case scenario of a bank failing
thathasissuedcoveredbonds.Thequestion
thenbecomeswhatdoinvestorsrelyontoget
paid?Currently,legislationhandscertainpow-
erstotheFDICthatmayinterferewithprotec-
tionsthatinvestorsintraditionalcoveredbond
jurisdictionsareusedto.
For example, the FDIC has the power to
repudiatecontracts,whichwouldincludease-
curedloan.Thatmeanstheycouldtakeback
theassetsthatarebackingthesecuredloan
inexchangeforpayingdamagestoinvestors.
The problem is that the amount of the dam-
ageswhichtheFDICwouldlikelypayasalump
sumshortlyafterwouldbethelowerofthepar
amount of the covered bonds or the market
valueoftheassets.Theconcernwiththatfrom
acreditperspectiveisthatifweareinaharsh
environment where the secondary market is
shutdownandtheassetvaluewouldbelow,
investorscouldsufferlossesontheircovered
bonds.
Furthermore, even if the FDIC were to
choosenottorepudiate,itisnotinterestedin
handingovertheassetstothecoveredbond
program until the covered bonds pay off. It
wants to be able to reap the benefts of any
overcollateralization thats backing the cov-
eredbondsquickly.ThisiswhytheFDICwrote
in its policy statement that if it chooses not
to repudiate or continue to pay the covered
bonds,thecoveredbondtrusteeshouldliqui-
datealloftheassetsinashortperiodoftime.
Both of those options produce what
weve termed acute market value risk for U.S.
covered bonds: bank failures could lead to a
verylargeamountofassetshavingtobesold
oratleastvaluedinharshmarketconditions
inashortperiodoftime.Issuerscantchange
these powers through entering into contrac-
tual provisions in their program documents
because the FDIC received the repudiation
powersfromCongress.Soweneedlegislation
tooverridethat.
Antony Currie: Is the abil-
ity to repudiate solely for
covered bonds or does
that affect secured loans
or asset-backed securi-
ties as well?
Yehudah Forster: Its not
specifc to covered bonds.
It applies for any secured
assets that remain the
property of the bank. That
shouldnt be the case for
a true sale securitization
althoughtheFDICsSafe
Harbor did raise some
questionsaboutthis.
Antony Currie: Whats the
appeal of covered bonds
to investors?
Nicolas Steinbach: First
and foremost, as has al-
ready been pointed out,
there is a deep and grow-
ingdemandfortriple-Aassets,especiallygiven
thebackdropofincreasingsovereignriskand
diminishing securitization. The other thing is
that we are losing supply from frequent and
large issuers in the positively convex triple-A
assetclasstheGSEs.Originally,theforecast
wasthatwewouldlosesomethingintheorder
of$60billionto$100billionofGSEissuance
in 2011. We may, in fact, be on track for net
negative issuance of up to $150 billion. So,
the question arises, whats the replacement
asset? Granted, its not a very exciting asset
I often put people to sleep talking about
positively convex triple-A assets. But demand
for this asset class is cyclical and in times of
fnancial distress, it becomes a far more ap-
pealingassetclass.
Losing that issuance is signifcant for
portfolio construction. The aggregate indices,
like the Barclays Aggregate Index for U.S. fxed
incomeinvestors,comprisesbetween9%and
10%ofagencyandsupra/sovereignexposure
combined.Creditindiceswithexposuretothat
typeofassetcompriseabout25%oftheindex.
Theagenciessteppingoutofthepictureorbe-
ingmothballedcreatesaverylargehole.
Unfortunately, the way most agency inves-
torsoperatemeanstheyneedtotakeseveral
King & Spaldings Scott Stengel and Ramon Gomez of JPMorgan
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stepsbeforebeingallowedtobuynewinvest-
ments.Smallandregionalinvestorsaswellas
traditionalplayersinagencyproductsprobably
needtwoorthreeyearstoapprovethesecov-
eredbonds,fromthedatelegislationappears.
So getting full participation out of current
agencyinvestorswillbealongprocess.
As a result, I am not as optimistic as
some about how much supply we are going
to get initially. Thats because we do have
alternatives.BankscanfundusingFHLBad-
vances. They can fund using securitization.
They can fund issuing senior unsecured or
subdebt.Soitsgoingtobeinterestingtosee
how much covered bond supply would ema-
nate from U.S. covered bond legislation. But
intheearlystagesIdontthinktheresgoing
to be that much supply and its going to re-
main largely, from our perspective, a supra/
sovereign Yankee issuer alternative. It would
benicetoseesubstantialissuance,meaning
several hundred billion from U.S. banks. But
aside from the money center banks, I dont
seehowthesecond-andthird-tierbanksget
involvedinameaningfulway.
Antony Currie: Why does it take two to three
years for investors to approve this?
Nicolas Steinbach: The profle of such an
investoristhatofanentitythatprobablyallo-
cates most of their investment balance sheet
totreasuries,andthenagenciestogetanex-
tra 20 or 30 basis points. So covered bonds,
becausetheyinvolvecreditrisk,newstructure
andnewlegislation,arewayoffthatscope.Get-
tingtheselesssophisticatedinvestorsinvolved
is going to take time. Ultimately I would like to
seeacoveredbondmarketthathastwotiers,
similar to France or perhaps Germany. These
countries have issues that fall under legisla-
tionandthenmorestructuredandcontractual
issues that yield a little bit more and may be
moresuitableformoresophisticatedinvestors.
Toaddtothat,thelegislationshouldconsider
the possibility of potentially guaranteed fund-
ingfacilitiesinthewind-downprocess.
Afterall,whatsthetaxpayerspositionin
taking a loss from housing credit? Right now
taxpayers are short an at-the-money put. So
anytimeaborrowerdefaults,theGSEsareon
thehookfortheinterestandprincipal.Buttax-
payersshouldhavearemotelosspositionas
opposed to a frst loss position. Introducing a
guaranteeintheeventofacoveredbondde-
fault removes the taxpayer from that frst loss
positiontoalastlossposition.
Antony Currie: How much should triple-A
investors worry about covered bonds either
losing or not getting triple-A ratings? After
all, covered bond ratings are linked to the
bank rating, arent they?
Karen Naylor: Indeed. Most of the agencies
have linked ratings to the underlying issuing
bankduetothevariousrisksthatareinvolved
in covered bonds, in particular the mismatch
betweenassetsandliabilitiesandbondsbeing
issuedasbulletsecurities,unlikepassthrough
Antony Currie: How should issuers decide whether
covered bonds are suitable for them?
Kristi Leo: They have to assess the benefts and
weaknesses of each of their funding sources.
Theres the FHLB and issuers should calculate the
all-inspreadofwhatitcoststoissueandthenwhat
the OC level is and what the cost is to fund that.
Securitizationallowsissuerstogofurtherdownthe
capitalstructure,althoughclearlywiththenewrules
underDodd-Frank,theywillhavetoretainaportion.
Beingabletofundfurtherdownthecapitalstructure
depends on the rating of the institution. A single-A
bank,forexample,wouldprobablynotissuetriple-B
covered bonds because its single-A unsecured pa-
perprobablytradesinsideofthat.
Antony Currie: Whats an issuers thought process
when it comes to investors?
Kristi Leo: They should determine whether a new
funding tool diversifes their fxed-income investor
base. Just cannibalizing another source of funding
is not the right approach. For example, access to
theconsumerABSmarketisstillrobustandenjoys
stronginvestorsupport,soanissuerwouldntneces-
sarilywanttocannibalizeitunlesstheyplantohave
coveredbondsreplacealloraportionofsecuritiza-
tionfundingforotherreasons.
But issuers always like to diversify to new in-
vestor bases. Thats the great thing about covered
bonds:theyallowissuerstobuildcapacitywithinves-
tors that have previously only purchased agencies
and sovereigns, not securitizations or unsecured
credit. These rates investors would be a welcome
addition.
Issuers must also keep in mind the collateral
availabletoputintoastructure.Theyaremakinga
commitment to investors that they will continue to
fundthecoveredbondprogramandputthecollater-
alnecessaryintothecoveredbondprogramoverthe
lifeofallofthedebtthattheyhaveissued.Youdont
want to set up a covered bond program for a one-
timedeal.Itsnotlikesecuritization,whereyoucan
setupashelfandcometomarketwhenyouneed
fundingforthatparticularasset.Withcoveredbonds
issuersareobligatingthemselvesforalongperiodof
time.Sotheyshouldensurethattheprogramisset
up to be fexible enough for them to continue to meet
theneedsofthatcoveredbond.Butinvestorsneed
somecriteriabuiltintoensurethattheywontturn
aroundonedayanddiscoverthatwhatwasoncea
bondwithveryprimelowdefaultassetsissuddenly
stuffedwithsubprime.
Antony Currie: Are there any issuers in particu-
lar that would beneft from setting up a covered
bonds program? Or Issuers that would fnd it hard
to tap the market?
Kristi Leo: The further down the corporate ratings
scalewego,thelessopportunitythoseissuersare
likely to have to fund effciently using covered bonds.
Grappling with the
Issuers Dilemmas
Thisiswherethelinkageofcoveredbondratingsto
theunderlyingissuerscorporateratingisveryimpor-
tant:thelowerthelatteris,thelesslikelytheissuer
is able to get a triple-A rating on the covered bond
program.Becauseofthelowerlevelofcorporatelink-
ageassociatedwithsecuritizationratingcriteria,you
mightgetbetterall-inexecutionbydoingasecuritiza-
tiontoatriple-Alevelthanissuingcoveredbondsat
asingle-Alevel.
Youre also going to fnd that what works well for
someissuersinitiallywilllikelychangeovertimeas
the investor base develops. For example, we might
evenseeatwo-tiersystem,withsomeinvestorspre-
ferringamortizingpay-downsoftbulletswhileothers
willwanttobuythehardbulletstructure.Thenwed
likelyseedifferentpricingdeveloptomatchthedif-
feringdemands.
Nicolas Steinbach:Itseems,then,liketheresacov-
ered bond club for larger, higher-rated banks only.
So how do we extend it to the banks that are out
there that could beneft from this? Is there going
tobepooling?Ihaverecentlyheardideaslikethis
in Europe. SpareBanken 1 is the perfect example:
thisNorwegianissueriseffectivelyapoolofregional
banksactingasoneissuer.Iwouldliketoseesome
ideas feshed out around that because ultimately we
have 8000 or so banks in the United States, of which
perhapsnomorethan20willbethinkinghardabout
coveredbonds.Sohowdowematchissuersupply
withinvestordemandforthoselower-ratedbanks?
Theratingiscruciallyimportant.Agencyinves-
tors like us are not going to be sympathetic to a
lower-ratedissuer.Havingatriple-Aratingiskeyfor
issuerstobeabletodiversifytheirinvestorbaseand
sources of funding. Unfortunately that may mean
thattherearebankswhichjustcantparticipatein
thepoolingprocess.
Antony Currie: Kristi, could you see pooling hap-
pening for smaller banks?
Kristi Leo:Fromaninvestorstandpoint,becauseno
onereliesonjusttheratingtheyalsowanttodo
theirowncreditworkitpartlydependsuponhow
many issuers are pooling together as well. Having fve
bankspooltheirmortgageloanstogetherforacov-
ered bond means having to know fve banks credit
storiesratherthanjustone.Butif200bankscom-
binetheirloans,asaninvestoryoureholdingpaper
thatisfarmorediverse.
As far as issuers are concerned, community
bankshaveraisedtheconcernthatcovered bonds
willendupbeingafundingsourcejustforlargein-
stitutionsandthattheywonthaveaccesstoit.De-
velopingastructuringandratingsmethodsosmaller
banks can use covered bonds would be fantastic.
Butevenifthatcanbedone,theywillstillcompare
theall-incostofcoveredbondstotheirotherfunding
sources.Soitremainstobeseenhowtheultimate
OC requirements work out for them and whether,
once thats calculated, covered bonds can be a vi-
ablealternativeforthem.
Yehudah Forster: Therearemulti-issuerprogramsin
Europe, in Spain for example. We do have a meth-
odologyforratingthoseprograms.Essentiallyitde-
pendsonthestrengthoftheentitythatisissuingthe
coveredbonds.Soifthatsanentitythatabunchof
bankshaveformedandcontributetoandstandbe-
hind,ultimatelytheratingderivesfromthecombina-
tion of the credit strength of the underlying banks.
Ofcoursethatleadstotheproblemthatcombining
lower-rated banks together doesnt necessarily pro-
duceahighlyratedbank.
Oneotheroptionthatweheardfromsomemar-
ketparticipantsistheideaofahighlyratedbankact-
inglikeaconduitandbuyingloansfromlower-rated
banks and then including those loans in its own
coveredbondprogram.Obviouslytheissuethereis
thatthehigher-ratedbankisgoingtohavegetcom-
pensatedforthat.Butperhapsthatsonewaythat
lower-rated banks could participate in highly rated
coveredbonds.
Karen Naylor:Fromapracticalperspectivethepool-
ing is tricky because the loss sharing among the
contributing members can be diffcult to work out.
Thatstypicallybeenastumblingblock.Themulti-is-
suerstructureswehaveseeninEuropehavebeen
wheretheunderlyingbanksareallpartofthesame
group or organization, or where similar ownership
createsacommoncause.Therehavebeenalotof
discussions about the UK building societies using
thisforaccesstofunding.
Asfortheissueoflimitingcoveredbondsto,for
example, 4% of total assets. That might work fne for
largerbanks,where4%ofalargeportfoliostillgives
youalotofassetstouseassecurityforyourcovered
bonds or provide the overcollateralization. Looking
at smaller banks, though, that sort of percentage
and the amount of overcollateralization needed to
achieve the highest rating means covered bonds
maynotmakesense.
TheAustraliandraftlegislationlookstotryand
createfundingoptionsforsmallerinstitutions.There
arefourbigbanksintheAustralianmarketthathave
plentyofassetsontheirbalancesheet.Butforthe
smaller ones theres the diffculty of how they share
theriskandwhathappenstothecoveredbondsif
oneofthecontributingbanksfails.
Ramon Gomez:Therehasbeenverylittletalkofthe
multi-originator conduit. One commentator raised
itasapossibilityintestimonybeforeCongressbut
wentnofurther.ButCongressisnotdeaftotheno-
tionthatcoveredbondsmaynotworkforeveryissu-
er.Multi-originatorconduitsmaybesomethingthat
helps community banks and a lot of other mid- to
small-sizeentitiesthatmaybelockedoutofthecov-
ered bond market. Its worth feshing out whether
thereisawayofincludingthem.
Scott Stengel:Thelegislation,asitisdrafted,pro-
videsnotforlosssharingbutforindependentcov-
BlackRocks Steinbach warns covered bonds may only work for a small club of banks
eredbondprogramsforeachcommunitybankand
then a pooling not of the underlying collateral but
of their separately issued covered bonds. And cer-
tainly the reaction from some community banks is
thattheycurrentlyhaveaccesstoafederallysubsi-
dizedGSE,theFederalHomeLoanBanks,andthat
they do not want to do anything to jeopardize that
funding source. But, assuming that the FHLBs are
preserved,Ibelievethatmostcommunitybankswill
beinterestedinwhatcoveredbondsmightholdfor
them.
The recent fnancial crisis should prompt ev-
eryone, including the FHLBs, to take a longer-term
perspectiveonwhatistheappropriatefundingmix
forabank.Perhapswecouldevenenvisionarolefor
FHLBsinthecoveredbondmarket,whetheracting
astheassetmonitororinsomeothercapacity,since
they are already so involved with individual com-
munity banks. There are a number of ideas foating
aroundabouthowthiscouldpossiblyworkmoreef-
fectivelyforthecommunitybanks.
A lot, of course, will depend on what hap-
penswiththeFHLBsduringGSEreform.Theyhave
largely, for both political and practical reasons, fown
under the radar thus far. While a couple of them
havebeguntorattlethecageaboutwhetherornot
competitiondownthestreetfromcoveredbondsis
warranted,theyrecognizethattheywouldbewiseto
holdtheirpowderatthisparticularmomentandnot
getdrawnintotheGSEdebateprematurely.Butthe
role that they should be playing in mortgage fnance,
and the federal subsidy that they beneft from, will
very much affect how pooled issuance will evolve.
Weallrecognizethatlargerinstitutionswillleadand
blazeapath.Bythetimethemarketbecomeses-
tablished,weshouldhaveabetterideaofwhatGSE
reformwilllooklikeandamuchcleanerviewofwhat
pooledissuancewilllooklike.
Intheend,unlesswearegoingtogobackto
atimewhencommunitybanksrelyondepositsand
federally subsidized pass-through borrowings for
their funding needs. it will be hard not to imagine
an important place for covered bonds in their
fundingmix.
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42
securitizationswheretheprincipalcomesfrom
theunderlyingassetsasthebondspaydown.
Europeaninvestorstendtolikethebulletma-
turities.Butthatcreatesamismatchbetween
these underlying assets and the liability of
maturities.Thatiswhathasledmostagencies
to link the rating to the covered bond issuer
insomemanner,whichdoesleadparticularly
todowngradesifthesovereignsorthebanks
areunderpressure.WeveseenthatinPortu-
gal,GreeceandIreland,forexample.Covered
bonds from those countries are now rated
muchlowerthantriple-A.Alotofinvestorsdo
theirownworkandhavetheirownviewsabout
the bank rating and therefore the uplift that
they are comfortable with for covered bonds,
because they have the security. But, from an
S&Pperspectiveforexample,ofalltheratings
wehaveoncoveredbonds,approximately85%
aretriple-A.Investorsarestartingtogetcom-
fortablewithnon-triple-Acoveredbonds.
Asforthelegislation,inEurope,wehave
seen both the original sort of legislation-en-
abled covered bonds as well as contractually
based structured covered bonds developing.
Butmostofthosemarkets,forexampleinthe
UK, the Netherlands and France, have moved
towards having a legislative framework put
on top of them. France, for example, recently
introduced legislation to create so-called ob-
ligations de fnancement de lhabitat. Such a
trendisdrivenbyinvestorswhoseemtoprefer
having a consistency of approach that a law
can provide, for example to understand how
theassetsaresegregatedupontheinsolvency
oftheissuingbank.
From an agency perspective, we
have assigned the highest ratings
based on contractual obligations as
well as legislative frameworks. But
from an investor perspective, they
likethatconsistencyofapproachthat
legislationprovidessothattheydont
needtolookindividuallyateachpro-
gramtodeterminewhethertheassets
willbesegregated.
Butfromalegislativeperspective,
in terms of whether it will kick-start
the market in the United States, there
areotherpartsofthemortgagemar-
ket puzzle that need to ft as well, such
astheroleofFannieandFreddieand
the Federal Home Loan Banks and
whether it makes economic sense
for the banks to be issuing covered
bondsaswell.
Yehudah Forster: Its true that inves-
tors have gotten more comfortable in
Europewithnon-triple-A-ratedcovered
bonds. But if U.S. investors are specif-
callylookingfortriple-Acoveredbonds,
thelinkageontheratingswilllimitthe
universeofcoveredbondissuers.Typi-
callyabankwouldneedaninvestment-
grade rating of a high Baa or single-A
to achieve triple-A on covered bonds
basedonMoodysmethodology.
One way the U.S. market might look dif-
ferenttoEuropesisifbanksstructuredealsto
appealtoFannieandFreddieinvestors.These
are investors who are already taking prepay-
ment risk, so perhaps banks would structure
U.S. covered bonds as pass-through securities
rather than with bullet maturities. That would
certainlyreducethelinkageontheratings,be-
cause the main risk for covered bonds is the
market value risk that comes because of the
mismatch in the assets and liabilities. If you
removethematuritymismatchbyincorporating
apass-throughstructure,youcouldpotentially
have much more delinkage from the issuers
ratings.
Karen Naylor: That would make it more eco-
nomicallyfeasibleforissuersaswell,andfor
smallerissuers,becausethelevelofovercollat-
eralizationtoachievethehighestratingcould
be much lower. The U.S. covered bond market
doesnthavetolookliketheEuropeancovered
bond market. The U.S. market is big enough for
something to develop here thats very specifc
that works for U.S. issuers as well as investors.
Thereisalotmoreinformationanddatahere
aboutprepaymentrisk,forexample,insecuri-
tization to get investors comfortable with the
optionalityofnothavingabullet.InEuropeits
different:thereisverylittledataandverylittle
research on prepayment risk. Investors dont
knowhowtopricethatintothecoveredbond.
They are very much focused on holding until
maturityandnothavingtoworryaboutreceiv-
ingthatprincipalbackbeforehand.
S&Ps Karen Naylor
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Scott Stengel: This is a critically important
issue as we look to develop a covered bond
market in the United States. It begins with that
question of whether triple-A is triple-A across
asset classes. If an issuers promise to an in-
vestor is repayment whenever the issuer has
money,itsrelativelyeasytoachieveatriple-A
ratingthere.Theprobabilityofdefaultiseffec-
tively non-existent because the issuer is only
obligated to pay when money is available. If
we go out to the other extreme and consider
manyofthecoveredbondsthatexistinEurope,
whicharebulletbonds,thethresholdfortriple-
Aisquitehigh.So,ifwearesimplylookingfor
a triple-A rating and nothing more, creating a
pass-throughratherthanabulletcoveredbond
in the United States makes eminent sense. By
itsnature,apass-throughwouldhavealower
probabilityofdefaultandmakethehigherrat-
ingmuchsimplertoachieve.
Thoseofuswhohavebeeninvolvedinthe
legislative process, however, have done some
informal sampling of the investor base. The
credit investors for the most part are fne with
apass-throughstructure.Theywantthetriple-A
ratingandareusedtogettingtheirmoneyback
earlyespeciallyintheeventofthesponsorsin-
solvency.Butthosewhohavetraditionallybeen
agency and rates investors are much more
concernedaboutreinvestmentriskandarenot
interestedinsuchaproduct.Yetitisprecisely
thissegmentoftheinvestorbasethatsbring-
ing the cost-effcient pricing that issuers will de-
mandtoutilizecoveredbonds.
So this informal sampling implies that
were caught betwixt and between. The issu-
ers will only fnd this to be an attractive market
if they are able to issue at spreads that are
moreconsistentwithagencyratherthancredit
buyers;andagencybuyersareonlyinterested
incoveredbondswithhardorsoftbulletma-
turities. Unless that dynamic changes, it be-
comes diffcult to create a U.S. covered bond
thatdifferssomarkedlyfromitscounterpartin
Europe.
Karen Naylor:Itsinterestinghere:becauseof
the U.S. securitization market shutdown, there
ispotentiallyauniverseofinvestorswhocould
belookingtotakesomethingthatlooksquitea
bitdifferenttowhattheyreusedto.Whereas
in the European markets you have covered
bond investors and securitization investors,
withverylittlecrossoverbetweenthetwo.
Ramon Gomez: The discussion about what
the market might look like compared to Eu-
rope is a critical question. Lets assume that
Congressagreesthatweneedanewarrowin
thequiverandpassesthelegislation.Weneed
tothinkaboutwhattheprocessofputtingto-
getherthepool,disclosingitandratingitwill
look like. How much more effort will it entail
compared with traditional securitization or to
new securitization whether under the Project
RestartorthenewstandardsthattheSECwill
issue?Therearegoingtobequestionsabout
exactly how comparatively effcient or burden-
someitisandwhetherinfactcoveredbonds
offer a reasonable substitute to some of the
Dodd-Frank requirements that could be bur-
densome. Then it would take some time to
develop the confdence in the structure, the
disclosure regime, the lookback periods, the
reporting all those things that investors re-
quireandaresoimportanttoensureliquidity
inthemarket.
Antony Currie: Is anything to be learned from
WaMus original euro-denominated covered
bonds in 2006 that may or may not inform
how the market develops.
Ramon Gomez: I am not sure how much we
can learn from that. It was a contractual ar-
rangementundermarketconditionsthatwere
very different. Now there are real investor
concernsabouttheFDICspotentialuseofits
broadrepudiationpowersabouttheabilityof
coveredbondlegislationtoensuresomekind
ofmorerational,predictablescheme.
Nicolas Steinbach: I draw something from it
as an investor. Its not a pleasant topic, but
thereisalottobelearned.Butletsstepaway
fromWaMuforasecondandlookatamuch
moresubstantialissuer,DepfaACS.Thiswas
a prolifc issuer, selling covered bonds at Li-
bor fat in 06 and 07 that have since caused
substantialproblemsforinvestors,BlackRock
included. I am sympathetic to the fact that
therehasneverbeenacoveredbonddefault,I
understandthehistoryofitbeingasafeinvest-
ment,butatriple-Ainvestormanagingmoney
as a fduciary has a very hard time explaining
how a triple-A asset goes from Libor fat, to Li-
borplus400.

The WaMu experience is similar: there


is no technical default, but for the investors
purposes it is a default because the investor
has been fred as a manager, and the portfolio
managerhasprobablylosthisorherjobifthey
made a signifcant investment in Depfa ACS.
There hasnt even been a downgrade. There
have been many efforts underway to repair
andenhancetheunderlyingcollateral.Butas
aninvestor,thatkindofmovementinspread
constitutesthesameexperienceasatechni-
cal default. So I want to make sure that this
time we get it right: if the government is go-
ingtobeinvolvedinlegislatingtheproductit
mayaswellhaveavestedinterestinseeingit
survive.Theimplicitmessagethereissimilar
totheGSEcharter,thatthereshouldbesome
thoughtinvestedinwhathappensintheevent
ofdefaultandhowwestanduptolegislation
andbeproactive.
Wearestillintheveryearlystagesand
not enough ideas are being foated to fesh
out the U.S. covered bond market. Obviously
thereisalwaysthepossibilityoflosingmoney
onaninvestment,letsberealistic.Butthese
are triple-A investments. Taking a very high
altitude view of this, the originate-to-distrib-
utemodelmovedincentivesawayfromgood
origination and good risk management to
letsjustprintdealsandcollectfees.Regula-
tors obviously have identifed this as a prob-
lem. And covered bonds provide a solution
to this by aligning the economic interests of
thebankwiththeperformanceandqualityof
theloans.Investorsshouldbewillingtoalign
themselveswiththoseeconomicforces.But
regulators must have a substantial vested
interest in seeing these things go well, and
sointroducingtheconceptofhowtoprevent
thecoveredbondproblemswesawatDepfa
ACS or WaMu from ever happening again is
imperative.
Ralph Daloisio: Thecommondenominatorof
thediscussionwearehavingrightnowcomes
back down to the legislative framework. The
market can innovate. We can see variation
in the types of contractual frameworks that
come off of a U.S. covered bond market. But it
hastobepredicatedonaverysolidlegislative
foundation.Ifwetryandbuildstrongcontrac-
tualframeworksonaweaklegislativeframe-
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work, U.S. covered bonds will end up being a
veryshorttopicfordiscussion.
WaMuisthecaseinpoint.Thosebonds
traded down to something like 75 a 25%
market-value loss, which is disastrous for a
rates-basedinvestorbeforeWaMuwastak-
enoverbyJPMorgan.EventhoughJPMorgan
is now the obligor on those notes, they still
trade at a signifcant concession to anything
comparable in the European market. WaMu
sold a lot of securities in a short period of
time. They were denominated in euros, sold
in the precrisis era, and bought by Euro-
pean investors many of whom, I speculate,
assumed that the U.S. contractual framework
was somewhat akin to what they were used
toinEurope.Thecrisisfocusedeveryoneon
the weakness in the framework, and then
investors started to realize that this confict
of interest between covered bond investors
andtheFDICwasarealnegativeforcovered
bondholders.
That helps explain why we havent seen
anyissuanceevenaftertheTreasuryandthe
FDICcollaboratedtopassguidelinesin2008,
yet here we are in 2011. All this screams for
a solid legislative foundation. I looked at a
Swedishissuerecently.Thelegislativefounda-
tionthereisveryclear,butitonlysaysthatthe
valueofthecoverpoolassetsneedstoatall
timesexceedthevalueofthecoverpoolliabili-
ties. It doesnt say by how much: the ratings
agencies, the issuer and the investors deter-
mine that. But at least investors know at the
endofthedaytheyhavethislegislativeframe-
work providing rock-solid protection of their
rightstotheassets,includingtheactuallevel
ofovercollateralatthetime.Thelessonisthat
ifwedontgetitrightatthestart,wearegoing
tohavearealtoughtimegettingthismarketto
evenonedollarofissuance.
Antony Currie: Karen, on the theme of get-
ting it right at the start, what can we learn
from looking at the European market in its
early days?
Karen Naylor: There are parallels with what
happened in the early days in the UK market.
HBOS was the frst issuer of a structured cov-
ered bond. There was no legislation in the UK
at that point. From what I understand from
peopleinvolvedintheprogramtheycreateda
structuredcoveredbondinfourtosixmonths
to replicate what other European countries
had created through legislation. After HBOS
sold its deal, other UK banks followed suit
andreplicatedthesamemodelsandprogram
documentation structure. That led to UK legis-
lationacoupleofyearslaterwhenitbecame
obvious to the legislators that the UK banks
wereusingcoveredbondsasausefulsource
of fnancing to complement their securitization
programs.
The sticking point in the U.S. market, of
course, is the specifc issue with the FDIC of
how to ensure in the event of the insolvency
ofissuingbankthattheovercollateralizationis
used for the beneft of the bondholders.
Kristi Leo: The reason the UK was able to
complete its frst issuance in four months is
becausetherewereexpertsinthespacewho
were all working toward the same goal with-
outtheneedforpassinglegislationwhereas
here in the United States we need to educate
the members of Capitol Hill, who are not ex-
perts in covered bonds. As Scott mentioned
earlier,theindustryhascometogethertolay
out very cleanly for Congress that if they leg-
islate covered bonds in the right manner, it
canbeprotectivetoeverybodyincludingthe
FDIC,recognizingitsresponsibilitiestothein-
surancefundandmakingsuretoomuchcol-
lateralisnotpulledawaytootherinvestors.
But the legislation wont cover every-
thing. Being able to clearly state in the cov-
ered bond indenture what happens at de-
fault, how that problem is going to work out
andwhoseresponsibilitiesthosestepsareis
extremelyimportant.WeseethatintheABS
market today. What investors would like to
knowis,ifabonddefaultsanditstartstopay
down early or extends beyond expected ma-
turity, how is that put into practice? Theres
a trustee, but what are their responsibilities
and are they specifcally laid out in the docu-
ments?Sometimesitseemslikethesimplest
decisions take three months for the trustee
toimplementduetothelackofproperdocu-
mentation.
Karen Naylor: And of course once you pass
the frst level of legislation then you start work-
ing on your amendments. The UK is in consul-
tation on updates to its legislation, Sweden
amended its legislation last year. As markets
are not static, legislation often needs to be
updated.
Scott Stengel:Aswehavediscussed,itisvery
diffcult in the United States to have legislation
passed, and it is just as diffcult to have leg-
islation amended. Think, for example, about
the Financial Institutions Reform, Recovery,
andEnforcementActof1989.Therearepro-
visions of that legislation which to this day
remain nonsensical and which would beneft
from clarifcation, but it is all but impossible to
generate momentum for Congress to change
them.
Itsoneofthereasonsthattheindustry
has proposed the approach that Congress-
man Garrett has taken, which is a legislative
framework that really is just the foundation
andthatallowstheregulatorstoframeoutthe
structureontopofit.Itscertainlymucheasier
for the regulators to recognize and adapt to
marketdevelopmentsthanforustogobackto
Congressandhavethelegislationamended.
To be honest, I could never foresee this
legislation being amended in a meaningful
way,atleastintheshortterm.Wecannoteven
get technical corrections through on Dodd-
Frankeventhougheveryoneagreesthatwe
would just be fxing periods and commas.
Karen Naylor: Three are many different ap-
proaches to covered bond legislation in Eu-
rope. The German law runs to many pages
and is very prescriptive and very specifc about
how to value property, for example. Then, at
the other extreme, is the Dutch legislation,
which runs to about three pages the legis-
lationjustsitsontopoftheexistingprogram
documentation, where all the technical and
practicalaspectsarecontained.
Antony Currie: Turning our attention back to
the U.S. market, how do we view the issue
of the FDICs current resistance to covered
bonds?
Yehudah Forster: It seems like thats where
themainoppositiontothelegislationiscom-
ing from. One of its main concerns is that if
thebankdoesdefault,itdoesntwanttohave
togiveawayalargeamountofovercollateral-
ization,oratleastitdoesntwantthevalueof
its interest in the overcollateralization to be
destroyed,suchasifitheldaresidualinterest
initandhadtowaituntilallthecoveredbond-
holders got paid off frst.
MyunderstandingisthattheFDICwould
bewillingtoconcedeinlegislationthatifthe
bank were to default the FDIC would then
have the option to pay off the covered bond
Scott Stengel, Ramon Gomez and Nicolas Steinbach of BlackRock
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ownersinfulltokeeptheassets.Thatmeans
fullprincipalandfullinterestuptothedateof
repudiationpayment,notnecessarilyfullyield
tothematuritydatebutatleastfullprincipal
and interest to the date of payment. From a
creditperspectivethatsnotaproblemforus.
Everybodyisgettingpaidinfull.Obviouslyan
investor has more concerns than just getting
theirprincipalback.
Nicolas Steinbach: Yes. This is going to hap-
pen in a very low rate environment so inves-
torsaregoingtoloseanicecoupon.Thereis
convexitythere.
Yehudah Forster: Exactly. So my question is,
ifthedraftersweretoconcedetotheFDICon
thisissue,woulditpreventthemarketfromde-
velopingorcouldthisstillbeaviablemarket?
Scott Stengel: It goes back to the point that
wetalkedaboutearlier:ifcoveredbondsinthe
United States are being directed to credit in-
vestors,thenthatcertainlywouldbethepath
ofleastresistance.Theproblemwiththatap-
proach is that, for credit investors, its much
moreeconomicalforissuerstousesecuritiza-
tion. The capital relief and other effciencies
associated with securitization make it, as
Ralphdescribedearlier,asuperioralternative
for an issuer. So, if we were to go that route,
you may see some covered bond issuance
to credit investors for a period of time, but it
would quickly be replaced by securitization
andwewouldseethecoveredbondmarketin
the United States wither.
This market will only work that is, it
will only fll the niche between securitization,
FHLB advances and unsecured debt if it
is attractive to the agency investors. Issuers
wont realize the benefts of building a program
otherwise.
Ralph Daloisio: Thats right. Ultimately even
if we were to concede to the FDICs view of
theworldasitseemstostandbasedontheir
testimonybeforetheSenateBankingCommit-
teelastfall,weareleftwithaparadigmwhere
the FDIC captures the beneft of the transac-
tion thats taking place between an issuer
and an investor. That reduces the motivation
for issuers and investors to participate in the
market, because they lose that beneft. You
areright,Yehudah,whenyouimplythatazero
LGD solves the credit model problem. When
you plug that into the credit models, it looks
very attractive. But I dont think it satisfes the
market model, which is sensitive to reinvest-
mentrisk.Asaresult,wewouldnotbeableto
generateenoughofadeepandliquidmarket
forcoveredbonds.Ashallowmarketjustwont
exist.
Ramon Gomez:Issuerswouldneedtomakea
signifcant investment in the technology for dis-
closureindevelopingtheentireinfrastructure
forissuingcoveredbonds.Allforloansthatwe
thenkeeponthebalancesheet.Butifcovered
bonds are just a bridge that we are going to
dismantle because securitization will recover,
become once again the most effcient capital
marketstoolandbeabletosatisfymostfund-
ing needs, then it becomes very diffcult to
justifytheexpenseofdevelopingadedicated
coveredbondsinfrastructure.Therehastobe
acompellingvaluetodevelopsomethingthat
might only fll the need for the short term.
Wewanttoencouragethelegislationand
highlight the benefts for the market in having
covered bonds as a new funding technique
with more certainty around issuance. But
thereisstillgoingtobeacost.
Wedontwantthefactthatmarketsnatu-
rallydevelop,andthefactthatpeoplemaynot
beabletopredictexactlyhowthemarketmay
evolve,todetractfromthevalueofpassingleg-
islation.IspendsometimeinWashingtonand
hear a lot about housing, and housing is the
driverinWashingtonthesedays.Theconnec-
tionofcoveredbondstohousingandtheabil-
itytosaythatthereisaproductthatcouldhelp
restart the market is an important argument
that should not get lost. And then for those
people who say you cannot predict how the
marketmightdevelop,well,thatsthemarket.
Antony Currie: How would you characterize
the European market today?
Karen Naylor:NewissuanceintheEuropean
covered bond market has been very buoy-
antsofarthisyearandthereareacoupleof
reasons driving that which could be reasons
whichmayalsocontributetothedevelopment
of a U.S. covered bond market. First, the ability
to tender covered bonds with the ECB, Bank
ofEnglandornationalcentralbankstocreate
liquidity and get funding when other parts of
themarketareclosedtoissuersisimportant.
ThatsbeenveryusefulforEuropeanbanksin
the past few years since the ECB is now the
biggestholderofcoveredbonds.Thehaircuts
the central banks apply are also more favor-
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ableforcoveredbondsthanMBS.
Matchingassetsandliabilitiesbecomes
muchmoreunderfocusforabankunderBa-
selIIIcapitalrules.Coveredbondsgiveissuers
theabilitytoextendmaturities,henceprovide
better matching. A number of UK issuers have
been tapping into UK insurance companies
andissuingmuchlonger-datedcoveredbonds
of15-andeven19-yearmaturities.Also,cov-
eredbondscanbeusedaspartofliquiditycov-
erageratiosunderBaselIII.
Coveredbondsalsogiveissuerstheabil-
ity to go into different currencies that
theywouldntnecessarilybeabletotap
onanunsecuredbasistheAustralian
market, for example because inves-
torsfurtherawayfromanissuershome
country feel a bit more confdent taking
thatriskifthereisthecollateralandse-
curityofacoveredbond.

Ralph Daloisio: Its ironic, we have ex-


actly the opposite problem in the U.S.
For the U.S. its how do we get a covered
bondmarketstartedwhereasinEurope
people are wondering whether its get-
tingtoobig.
Yehudah Forster: One signifcant differ-
ence is that the primary asset in the U.S.
market is the 30-year fxed-rate mort-
gage, whereas most European mort-
gages are ARM loans. The 30-year fxed
is a diffcult product for a bank to hedge.
Ourbankanalyststellmethattheidea
ofhavingacoveredbondthatsgoingto
fund 30-year fxed mortgages may not
reallyinspireneworiginations.Itmaybe
a way to utilize whats currently on the
balance sheet more effciently and pro-
videmorediversityoffunding.
Ratherthanfundingthosethrough
the FHLB solely they would have an al-
ternativesourceoffunding.Currently,theabil-
ity to sell to Fannie and Freddie encourages
banks to originate larger volumes of 30-year
fxed mortgages since by doing so the banks
removetheprepaymentriskfromtheirbalance
sheet. Would having a covered bond where
the prepayment risk remains on the balance
sheet really encourage a lot more origination
ofloans?
Ramon Gomez: Thats an interesting point
becausethemarketisevolving.Weknowthat
conformingloan limitsaregoingtodecrease.
WeknowthatthecapacityoftheFHAandthe
GSEsisgoingtodecrease.Andweknowthat
thereisgoingtobeaclassofmortgageprod-
uct that will have no risk retention and one
that will. So as the market shifts and the pri-
vatemarketopensup,itmaywellbethatthose
threatsandadvantagesstartshifting.Andthen
havingadiversityoffundingtoolswillbecome
animportantpartofamosaicthatissuerswill
have and they will decide whether covered
bonds can be a good tool for those products
andrisksthatneedtoberetained,whichmay
not all be 30-year fxed-rate mortgages.
Thats where the beneft of the legisla-
tion comes in because its really about en-
hancing the ability of issuers to fnd a slot to
help deal with that transition in the market.
Perhaps thats the argument for covered
bondsnotbeingjustthetransitionaltoolinto
full securitization but more part of a repre-
sentative set of tools to deal with the new
mortgage landscape which will be much
morechallengingfromacapitalandriskre-
tentionperspective.
Antony Currie: What other factors do we
need to consider as we look at the poten-
tial evolution of a covered bonds markets in
the U.S.?
Scott Stengel:BaselIII,morethanevenGSE
reform,hasthepotentialtoradicallyalterthe
fnancial markets. The liquidity coverage ratio
alone could destroy the mortgage repo mar-
ket. It could turn the money markets into a
shadow of their existing selves. And it could
drive commercial banks to compete for retail
deposits in ways that we have not seen in
decades. Basel III is the joker card that is so
enormousthatyoucantseeanyoftheother
cardsinthedeck.
Ralph Daloisio: I totally agree. At the core of
the sequels to the frst Basel Accord is an ef-
fort to realign capital requirements closer to
true economic capital requirements. Securiti-
zation was born out of an ability to arbitrage
the regulatory capital requirement because
the regulatory capital requirement was too
highandtheeconomiccapitalpartasseenby
the market was much lower. With regulatory
capitalrequirementscomingmoreinlinewith
economic capital requirements, part of Basel
IIIisaimedatthetraditionalliquiditymismatch
thatbankshaverun.So,asBaselIIIraisesthe
requirements for better liquidity matching it
absolutely could be a landscape changer, as
Scott said at least for the six to eight U.S.
banksthatwillcomeunderit.Thatwouldpoint
infavorofcoveredbondtechnology.
Scott Stengel: My only concern there is how
far down the list of banks the regulators will
push Basel III and whether opt-in and
opt-out elections will be available for
thoseoutsidethetopsixoreight.Ifyou
mark$50billionasourthresholdforSI-
FIs,thatcouldmeanthatBaselIIIgets
applied to more than 30 banks al-
thoughinthatcase,hopefully,someof
the more onerous requirements of Ba-
selIIIwouldbelimited.
Nicolas Steinbach:Theotherjokercard
thatweshouldkeepinmindhereisthe
macroeconomic landscape and whats
happening to the average household.
Home prices continue to decline. As it
standsnow,wearevisitingthelowsof
2009 seen right after the crisis in09
anditdoesntlooklikeitsgoingtostop
there.WhenIlookoutsidetheimmedi-
ate metropolitan area to the outskirts
and see whats happening in foreclo-
suresandREO,Idontseethehousing
market rebounding signifcantly, partic-
ularlybeforethe2012elections.Idont
spend much time in Washington and
perhaps I should, given the AMT sur-
priseIgotthisyear.Butifthispersists,
you have shrinking bank capital from
Basel III and new bank regulation via
Dodd-Frank, a declining employment
environment and declining household
balancesheetsduetodeclininghomeprices.
Housing fnance could become a hugely impor-
tantpoliticalissue.
So,yes,asenatorhasahundredthingsto
look at. But I would say that housing fnance
and the future of it, especially in the context
of mothballing the GSEs has the potential to
become hugely important. So the big ques-
tiontheyhavetoaskishowtoproducemore
fnancing for the housing sector at market in-
terestrateswithoutkillingthehousingmarket.
Rightnow,onewouldarguethattheprevailing
30-year fxed mortgage rate is probably one
to one-and-a-half points too low and that
comes from the taxpayer subsidy. So how do
wegettosomethingthatsclosertoafree,un-
subsidizedratebutnotsoonerousthatitcom-
pletelystuntsthehousingmarkets?
Covered bonds could have a very im-
portant role in enabling a transition from the
artifcially low, subsidized rate. Treasury has
been very clear about this and addressed
coveredbondsaspartofGSEreformandalso
talkedabouttheFHLBsinthewhitepaperthat
came out earlier this year. Ultimately, Treasury
Yehudah Forster and Kristi Leo
est lost on the day a homeowner defaults is
thewrongplaceforthatguarantee.Insteadit
maybelongasabackstopforfundinginwind-
ingdownacoveredbond,providingfundingto
substitute good collateral until that covered
bond matures. Legislators, regulators, the
Treasury and investors all care about where
thisguaranteelives.
AsfortheissueswiththeFDIC,although
itisimportant,theFDICgetstoomuchairtime
on the issue of covered bonds. I say that be-
cause,dontforget,thelegislationtalksabout
capping covered bonds at 4% or 5% of total
liabilities.TheFDICiscruciallyconcernedwith
the 60% of bank liabilities that constitute
depositor receipts. So, I dont see how those
overlap.Obviouslytheycaninawind-downpro-
cess,butwearetalkingaboutvastlydifferent
numbers.Ifwekeepcoveredbondsbelow4%
or5%oftotalliabilitiesthatseemslikesome-
thing thats easy enough to segregate away
from depositor liabilities. If, fve years from
now,wegetto30%ofliabilities,thenIseethat
itcanposearealproblem.Butitwouldntbe
attheoutset.
Antony Currie: Ralph, Ill hand over to you for
a fnal comment.
Ralph Daloisio: Id like to acknowledge Con-
gressman Garretts effort in all of this. Its
hard for a politician to champion something
that doesnt play to the mainstream of their
constituency.Iliveinhisdistrict,whichisthe
ffth district in New Jersey, and he is defnitely
aveterancongressman.Hehasbeenarguing
coveredbondscasenowfortwotothreeyears
andhopefullythisthirdtimewillbethecharm.
Hesreallychampionedthecauseforthisand
hopefully we will pick up some broad biparti-
san support out of the Senate, and then the
odds look good. Regardless, his persistence
onthetaskhascertainlybeenadmirableand
worthyofspecialmention.
American Securitization and ASF would like
to thank all participants, and in particular
our sponsors Deutsche Bank, King & Spald-
ing, Moodys Investors Service and Standard
& Poors for their support of this roundtable.
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doesntknowwhattheprecisesolutionisbut
recognizescoveredbondsasapotentialcon-
tributing solution. If the macroeconomic envi-
ronmentcontinuestodeterioratethisisgoing
tobecomeanincreasinglyimportanttopic.So
wehavetheopportunitytopresentsomesolu-
tionsthroughcoveredbondlegislation.
Ralph Daloisio: The U.S. government cant
continue to backstop the U.S. fnance system,
its just too big. As our own sovereign credit
quality becomes more of a focal point in the
globalcapitalmarkets,thoseparticipantsstart
to look at the aggregate amount of on- and
off-balance sheet commitments that the U.S.
governmenthas.IthinkitwasBillGrosswho
may have pegged the number at something
like $44 trillion. I dont know where he got it
from, but thats a very large number. Fannie
andFreddieaccountfor$5trillionofthatand
theFHLBanother$1trillion.Sohowdoweget
the government out of backstopping a mar-
ketthatstoobigforthemtobebackstopping
when we also need a system where people
can own a home? Well, we have to right-size
the borrowers to the houses. That fell out of
balanceleadinguptothecrisisandwehada
fnancial system where if you wanted to buy a
homewellinexcessofwhatyoucouldafford,
thatwasokay,wevegotanappforthat.
Butwecanmovetoasystemthatdoesnt
have nearly as much governmental support
wherethecostofcreditprobablyisabithigher,
butnotsohighthatitkillsthemarket.Itallows
people to buy homes that are probably right-
sized to their fnances as it should be. Thats a
challengethepolicymakersandthelegislators
are wrestling with. Covered bonds can be an
appforthat.
Ramon Gomez: Thats exactly what Dodd-
Franktriedtodoandthatiswhattheregulators
havebeenstrugglingwithformonths.Between
themtheyhaveissuedcollectivelyaround800
pagesofproposedregulationsonabilitytopay
underTILAandriskretention.Thatssixregu-
lators spending an incredible amount of time
sounding out the industry and trying to get
their arms around it. Its a very diffcult set of
choices from a macro point of view because
thereisadesiretojump-startthehousingmar-
ketwhileatthesametimetryingtoimplement
measurestopreventthedislocationsandthe
irrationallendingthatthemarkethasshownit
canproduce.
Thats why I see covered bonds as one
importanttoolintheevolutionofthatmarket.
Regulatorsarelikelytogetalotofcommentary
about how diffcult it is to fund a 30-year mort-
gage.Peoplebelievethatthisisaproductthat
hastobethecornerstoneofourhousingmar-
ket, yet at the same time there will be layers
ofriskretentionandlayersofotherrisksthat
could prevent effcient funding through secu-
ritization.Thecompellingargumentshouldbe
thatinanyyear,butparticularlyinanelection
year,jobsandhousingarethekeyissuesand
coveredbondsofferawayofgivingthemarket
ashotinthearm.
Ralph Daloisio: I totally agree. Unfortunately
thebiggestimpedimenttoregeneratingapri-
vate sector mortgage fnance system is the
amount of the governmental policy interven-
tion thats already taken place. Investors in
privatelabelmortgage-backedsecuritieshave
seen their economics modifed to the advan-
tageofborrowereconomicsthroughamecha-
nism that creates greater uncertainty down
the road namely that these modifcations
canreducetheinterestrateonloansdownto
2%, but in fve years they are supposed to step
up and reset. So the government created a
rateshockproductthatcanstartbitingintothe
market fve years from now. That creates a tre-
mendous amount of anxiety about hitting yet
anotherlevelintheshadowhousinginventory
in addition to the current level that we have,
whichbysomeestimatescouldtakeacouple
ofyearstoworkitswaythough.
Sountilthatallgetsclearedwecantsee
what the economic bottom is nationwide in
U.S. housing. That doesnt inspire a lot of in-
vestor confdence. That takes me back again
totheneedforlegislation,asinvestorsarego-
ingtobeveryreluctanttorelyonpolicy-based
maneuvers for a U.S. covered bond market
becausetheFDICwasakeydriverforalotof
the interventionist policy in the securitization
systemtoday.SoIdontthinkanyinvestorfeels
that the FDIC through its operational and in-
stitutional bias, which is tied to its mandate,
is really going to look after the covered bond
stakeholderperspective.InEurope,alotofthe
regulation is there for the beneft of covered
bond investors to give them additional conf-
denceinwhattheyhold.
Ramon Gomez: That goes back to Scotts
point, which is important: legislation is hard.
It takes time. And once in place, it is hard to
change. Policy and regulation are relatively
easiertochange,soweareconstantlyatrisk
oftheruleschanging.Theadvantageoflegis-
lationforcoveredbondsisillustratedbywhat
wehavebeensayingabouthowharditistoget
through even the technical changes to Dodd-
Frankorgetsometractiononcoveredbonds:
onceyoudogettherightframework,youend
upwithafairlypredictableandstablefounda-
tion.
Antony Currie: Nicolas, as an investor, are
there any additional issues you believe we
need to focus on?
Nicolas Steinbach: Some interesting consid-
erations are how dealers are incentivized to
provideliquidityandIthinktheanswerisobvi-
ous: through syndication fees. But in Europe,
there are market-making agreements to kick-
startmarketliquiditysoIminterestedinhow
thatsgoingtoplayouthere.
Then theres the issue of the taxpayers
involvement in backstopping housing fnance.
Thequestionis,wheredoweputthatguaran-
tee? Maybe guaranteeing principal and inter-
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48
DOWN
1 Israeli border town
2 'I don`t care
3 Will of Arrested Development`
4 Alarm clock switch
5 Suspect, in police slang
6 Famed fyer ___ Gay
7 It often ends in -ly
8 Speedy Italian
9 Root Beer pioneers A ___
10 Say farewell
12 Actor / civil rights activist Davis
15 Buzz, as a tower
20 Where to fnd one k-i-s-s-i-n-g
21 ___ Spot run
25 Cabinet dept.
27 Bank dep.
28 Osaka affrmative
30 1982 war site
31 Pontiac`s 64-`74 muscle car
33 QB`s goals
35 'Are ___ to understand? (get it?)
36 Remote
37 Battleship prefx
38 Patriotic uncle
39 A long, long time ___
40 Ad ___
43 Chick ___
44 Brothers in 2008 news
46 Poe, to friends
47 ___ the Dragon`
48 BusinessWeek.com rival
49 Alcestis` author Robin
52 Kind of farm
55 Coast to coast abbr.
56 Approximately
57 Tanks
58 'Got it
ACROSS
1 It`s All About Me` singer
4 ___ in the pod
8 Super duper
11 Streamlined prefx
13 Heal
14 Roger Whittaker`s I Don`t
Believe ___ Anymore`
16 Catches some rays
17 Canadian terr.
18 More, briefy
19 Part one of fnancial proverb
22 Goonie Sean
23 We ___ Family`
24 Printer stat
26 Part two of proverb
29 Like some waffes
32 Not this
34 Online class fnal
35 Part three of proverb
40 Monopoly purchase
41 Star Wars,` for one
42 Peddle better
45 Part four of proverb
50 Slugger Ripkin
51 Roadside bomb letters
53 ___ Joy`
54 End of proverb
59 When doubled, 1997 Jim Carrey
hit
60 Lost soldiers, in mil. jargon
61 Basic geometry fgure
62 Tolkien`s trees
63 What to fnd in a museo
64 Theater seat arrangements
65 Day-___
66 Nasdaq alt.
67 National anthem monogram
Penny Wise
Chris Scarafle
Crossword solution is on the Journal section of the ASF website