Rebirth of the securitization market

Although traditional asset-backed securitization, or ABS, transactions were successfully completed through mid-2008, access to the capital markets for esoteric assets or innovative structures has been functionally closed since August 2007.

Two primary asset classes -- subprime residential mortgage-backed securities, or RMBS, and collateralized debt obligations, or CDOs -- cast a dark cloud of distrust over the ABS market, which is now only beginning to lighten. Unfortunately, the financial press, even the sophisticated financial press, has consistently lumped all securitizations together -- castigating the tool rather than the application -- thereby creating further confusion and negativism, eroding investor confidence and creating a difficult political environment for such securities.

These factors, combined with the continued economic downturn, have limited ABS investors' appetite.

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The negative psychological pall generated by the RMBS and CDO debacle helped create a massive repricing of all ABS -- whether warranted or not -- which was further re-enforced once structured investment vehicles, or SIVs, and other levered vehicles, which had created an unnatural source of capital for the purchase of seven- to 10-year average life ABS, were required to sell their ABS collateral into the market at fire sale prices -- actions which further depressed ABS market values and the perception of ABS generally.

It is debatable whether capital has truly flowed to the ABS market in recent months. Capital has been readily available for unsecured high-yield paper recently, but it has not yet flowed to all tranches of the ABS market. The main regulatory tool driving at least a portion of the recent volume in the ABS primary market has been the Term Loan Asset Backed Securities Loan Facility, or TALF, established by the Federal Reserve Bank of New York (about 45% of investors have financed their investments with TALF loans of the roughly $72 billion of total primary issuance value from March through July). In the event TALF's scheduled expiration of Dec. 31 is not extended, we expect that TALF's impact on primary issuance will be lessened. Although eligible TALF asset classes include traditional consumer-related ABS issued after Jan. 1 and AAA-rated CMBS issued both before and after Jan. 1. (but not RMBS of any vintage), the U.S. Treasury recently announced the selection of nine money managers to form Public-Private Investment Funds, or PPIFs, to purchase RMBS and CMBS issued before Jan. 1 that were originally rated AAA.

The Treasury will invest up to $30 billion in debt and equity on a pro-rata basis among the nine PPIFs and a like amount will be raised by the managers by the end of September (although if ready, a fund can initiate business any time after Aug. 5). PPIFs are allowed to access TALF to the extent they have TALF-eligible securities, and given the three-year investment period of the PPIFs, this may be an indication that TALF may be extended.

Although TALF has improved liquidity and pricing for TALF eligible asset classes, in order for traditional ABS investors to allocate capital to the primary market in a normalized manner, inclusive of purchasing subordinated tranches, secondary pricing must normalize. However, traditional buyers of subordinated tranches have not allowed this to occur through their unwillingness to sell existing ABS at current pricing levels, which have been driven down not only by credit deterioration but also the market's lack of liquidity created, at some level, by the reputational risks associated with ABS. We would suggest sales with a retained split of the upside of the sold ABS may trigger the start of a macro sales process that will ultimately make capital available to purchase subordinated classes of primary issuances.

Unfortunately, even if capital becomes available, it is our view that normalcy to the ABS market will not be restored until there is improved access to information relating to the underlying obligors/assets as well as a better understanding of transaction structures and risks through improved legal disclosure; ultimately trust must be restored through greater transparency.

Investors must demand more from the "sell" side of the market. One potential baby step is the rebirth of the private placement market (i.e. the true 4(2) market), a market that has traditionally provided greater negotiating leverage to the investor vis-à-vis the issuer. The private investor can re-enter the market demanding greater access to data, do its own independent modeling as well as demand a more complete and "user friendly" disclosure document.

Although private placement market transactions often do not provide disclosure documentation, we feel such disclosure is a fair request and an appropriate deliverable by an ABS issuer that will heighten the transaction parties' due diligence efforts and, if properly formulated, will provide greater transparency.

For example, reliance solely on FICO scores as a generalized and accurate predictor of an obligor's ability to pay is at best incomplete, so we suggest access to obligor payment history and other demographic data (i.e. income levels as well as origination channels that may vary by asset types). For larger transactions, we would propose something akin to a central clearing house where data can be aggregated, analyzed and modeled with much greater detail than exists on current shared analytical systems. Consistent with this suggestion, a unit of Standard & Poor's recently announced a program to bring loan-level transparency to the mortgage and ABS markets by creating a loan-numbering system and a central loan data repository aimed at providing investors with a method to understand the risk, collateral and credit of an underlying loan put into a securitization. This is intended to allow investors to track a loan throughout its duration and provide a chain of accountability between loan originators and investors.

Moreover, modeling must be done utilizing the above-disclosed expanded fields independent of the rating agencies' formulaic "stamp" rating. The rating agencies' willingness to change their methodologies (October 2007 relating to CDOs and February 2009 relating to CLOs) brings into question their modeling and assumptions. Obviously, there is a critical mass need for investor-employed modeling professionals that may not be economically feasible for all investors, but at a minimum independent consultants could be utilized to implement investors' own independent assumptions.

The Obama administration's financial regulatory overhaul proposals recommend "robust ongoing reporting by ABS issuers" to enable investors to track a securitization transaction at inception as well as over the life of the transaction. Armed with sufficient information, investors can and should run their own loss analysis relying on this more extensive data, thereby giving investors greater comfort with the underlying assets and transaction structures.

Most importantly, all investors (i.e. private, 144A or public) must demand, expect and receive understandable disclosure. During the 2005-2007 halcyon days for the ABS market (especially the 144A market), disclosure documents were simply restatements of the underlying transaction documents. To regain investor and regulatory confidence in the ABS market, disclosure documents should instead attempt to be fully transparent yet intelligible, synthesizing risk analysis with transaction mechanics. Simply put, an ABS transaction's mechanics and risks should be better synthesized in a well-thought-out document provided in "plain English." In his article "The End" found at Portfolio.com, Michael Lewis quoted Dan Gertner, a chemical engineer with an M.B.A., who after reviewing several CDO disclosure documents stated to his employer, " 'I can't figure this thing out,' " leading Gertner's employer to short the CDO market.

The legal profession must apply even greater transparency standards for the disclosure documents drafted on behalf of the issuer and push back even harder on transaction participants, even in a transaction's time-constrained environment, in order to provide more readable and understandable disclosure. The overheated market created such disclosure errors as unintentional, imbedded market value triggers in cash flow CLOs first disclosed in the last pages of the related offering memorandum. At a minimum, such a market value mechanic should have been disclosed in the transaction summary with an attendant risk factor. A "plain English" application to the private and 144A market is necessarily applied with greater care in that it causes drafters to understand what is being disclosed rather than simply restating technical and complex provisions.

Failure to challenge precedent and accepted notions of adequate disclosure exacerbated defective disclosure. In fact, the Obama administration's proposals urge the industry to standardize and make more transparent the legal documentation to make it easier for investors to make informed investment decisions. One approach may be to bring both an ABS disclosure attorney and securities disclosure generalists to the table for drafting purposes. Ultimately, the increased effort will benefit all market participants by heightening the due diligence processes via further vetting the disclosure document, which will provide more appropriate risk allocation for all involved parties.

Not only must investors and the legal profession hold themselves to these higher and more independent standards, but the market's structuring agents (i.e., Wall Street) must modify the previously utilized ABS business model. The fee-based business model pushed the Street to the warehouse/term out model with insufficient capital cushion provided by the originators/issuers based on the assumption of term availability. Obviously, this model did not provide banks sufficient equity cushion when the term market began to freeze in August 2007; if the fee-based model is modified such that bankers treat the capital at risk similar to how a partner in a partnership would treat its own money, then perhaps a greater equity cushion would have been demanded and available for the Wall Street firms during the "mark down" craze of the last two years. Significantly, the Obama administration's proposal would require loan originators or sponsors to retain an unhedged 5% credit risk position in the securitized product to ensure greater "skin in the game." Moreover, the fee-based model created an environment in which it was unclear which entity was the "sponsor" in certain types of ABS (i.e., CLOs), which muddied the appropriate equity risk allocation.

The ABS capital markets have been chastened and will recover only through baby steps directed at building investor trust. A higher standard must be applied to issuers, investors, lawyers and bankers through access to additional obligor information and collateral, independent modeling, more understandable disclosure and a modified Wall Street business model; a likely starting point is the sale and purchase of subordinated pieces of TALF eligible transactions in the private placement market. While the Obama administration's financial overhaul proposals begin to address many of these concerns, regulation and mandates alone will not bring the industry back. Market participants must embrace some or all of the suggested changes to build trust and, ultimately, increase investor participation.

M. David Galainena and Michael T. Mullins are partners at Winston & Strawn LLP. Marvin J. Miller Jr. of Winston & Strawn and Douglas Lipton of CDK Capital contributed to this article.

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