Attorney General Coakley Provides Testimony to Securities and Exchange Commission Regarding How to Protect Investors in Mortgage Securitizations
AG Coakley asks SEC to close loopholes in its existing proposal for securitization regulation; nationally adopt disclosure regime the Attorney General put in place in Massachusetts' Morgan Stanley settlement
BOSTON - Attorney General Martha Coakley today announced that she has provided testimony to the U.S. Securities and Exchange Commission ("SEC") regarding how to better protect investors relating to the subprime mortgage investment crisis.
The testimony, submitted yesterday in response to a public call for comment by the SEC regarding the federal agency's plan to revamp federal Regulation AB, which governs the offering process and disclosure requirements for asset backed securities. This regulation governs the behavior of investment banks and others when they "securitize" home mortgages and other consumer debt. Securitization is the process of placing large numbers of mortgages or other consumer debt into a pool of assets, and then issuing investment notes based on the income generated collectively by these loans. Money raised from the securitizations essentially funded the rush of unfair subprime lending that led to the market meltdown of 2008. The SEC is currently reviewing the standards of conduct for investment banks and issuers engaged in such securitizations, in order to determine how best to protect investors.
"Our office has worked extensively to hold Wall Street accountable for its actions in the subprime crisis and to help keep people in their homes," AG Coakley said. "It is extremely important that we take what we have learned through these actions and work to fix things moving forward. In our comments to the SEC, we've tried to point out clear, common sense disclosures that need to be made to investors. If investors have better information, they will be able to protect themselves from faulty investment products that are designed from defective loans. If we stop the use of investments to fuel the origination of defective loans, we also can put a brake on the process to help protect homebuyers as well."
Attorney General Coakley has been conducting an industry-wide review of the role of investment banks in the subprime loan crisis in Massachusetts, reviewing allegations that investment banks knowingly funded and facilitated the making of defective unfair loans to Massachusetts consumers. The investment banks then allegedly put many of the defective loans into securitizations which they sold to investors.
In May, 2009, the Attorney General reached a settlement with Goldman Sachs regarding its role in the securitization process in Massachusetts, under which Goldman was required to pay $60 Million in order to reimburse affected homeowners and the Commonwealth. In a follow-up case earlier this summer, the Attorney General completed her investigation of Morgan Stanley's role in the Massachusetts subprime market. Under an Assurance of Discontinuance ("AOD") filed in Suffolk Superior Court, Morgan was required to pay $102 Million, including $58 million in relief to homeowners and nearly $20 million back for Massachusetts taxpayers.
Many of the Attorney General's recommendations to the SEC are modeled on the disclosure requirements in the Morgan AOD. In the Morgan case, the resolution of the case also prospectively required Morgan to make additional disclosures to Massachusetts investors regarding securitization investment products. Morgan will now disclose the results of its own internal due diligence review of securitization loan pools, and provide investors specific data regarding:
- Any Broker Price Opinions it has gathered regarding the value of the properties under the mortgages in the investment pool. Broker Price Opinions are property valuations by real estate professionals hired by an investment bank to assess the likely value of the mortgaged property;
- The Loan to Value (LTV) ratios for the loans in the pool based on these BPOs, rather than just the LTV based on the artificially inflated valuations often used by the loan originator. LTVs are an important metric for investors in evaluating the risk that a loan will default and/or is sufficiently collateralized. If the value of a property is inflated by an originator, it would make the loan appear more solid than it actually is;
- The borrower Debt to Income Ratio (DTI) based on the reset rate of the loans, rather than just the DTI based on the artificially low and temporary "teaser" rate. DTIs are another important metric for investors, which measure the borrower's overall debt compared to their income. DTI measures the likely risk that a borrower will default on a loan. If the "teaser" rate is used to figure out the DTI, it will artificially improve the borrower's DTI. When the real interest rate is applied (the interest rate that will apply after the "teaser" rate- this is called the "Fully Indexed Rate"), the DTI will likely worsen significantly; and
- Unless the SEC puts in place its own disclosure requirements on the issue, whether Morgan placed loans in the investment pool over the objections of its outside diligence consultant.
These disclosure requirements, designed to provide information to help investors evaluate the loans in the loan pools, are among the suggestions the Attorney General is making to the SEC. "We believe it is important to raise the floor substantially on disclosures. We did that in our resolution with Morgan, and we think all investment banks should be held to this higher standard in the future," said AG Coakley.
In addition to these key disclosures, the Attorney General also recommended that the SEC toughen up proposals relating to other important areas including:
- Conflicts of interest- investment banks should disclose fully their relationships with originators, including the role the underwriting investment bank plays as a warehouse lender and/or the provider of other services to the originator,
- Certification requirements- entities making certifications in the prospectus should be responsible for verifying all aspects of the data within their purview, including the data relating to individual pool loans;
- Risk retention- in analyzing the "skin in the game" that investment banks have relating to investment pools, the banks should be required to offset not only direct hedges against their investments, but also surrogates that have a similar effect;
- Disclosures of early repayments- there should be detailed disclosures of the early repayment of loans in the pools, including specific information about the nature of these early repayments. Some types of early repayments may hide early defaults on pool loans; and
- Disclosures regarding breaches of representations and warranties on the loans in the pool- the right to return defective loans to an originator is often part of the agreement created at the start of the investment pool. However, if necessary steps for such actions are left in the hands of the investment bank, it might not have a financial incentive to protect the pool. This is especially true when a failing originator has limited funds and the investment bank has its own loans that it wants to be repaid first.
The comments also respond to a variety of questions posed by the SEC, and provide more insight into the real world mechanics of securitization based on the Attorney General's investigation. The Attorney General's comments are designed to assist the SEC in creating a rule that will help protect Americans from a repeat of the subprime collapse.
The submission of the Regulation AB comments to the SEC, and the AG's Securitization investigation, is being handled by the staff of Attorney General Coakley's Insurance and Financial Services Division.