Unintended Consequences of Reform Hinder ABS Issuance
July 21, 2010
The repeal of Section 436(G) of the Securities Act of 1933 --- what the Wall Street Journal in an article this morning called an “unintended consequence” of the Dodd-Frank Wall Street Reform and Consumer Protection Act --- is likely to open rating agencies to unprecedented liability for the quality of their ratings on ABS transactions, according to Barclays Capital analysts.
With difficulty assessing this new liability, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings have already pulled back from the new -issue securitization market. Barclays analysts expect this to impact consumer ABS more than residential credit ABS, where issuance volumes have been generally lower and issuance that has come to the market has generally been privately placed as 144A deals .
In light of the support previously shown by Congress and the Obama administration for consumer ABS, Barclays analysts doubt that the intent was to hinder securitization. They believe that the repeal is an unintended consequence of the larger legislation and will be solved in a “mutually beneficial way” by the industry and the Securities and Exchange Commission (SEC).
According to Barclays, Rule 436(G) currently provides a carve-out for rating agencies from the consent requirements with respect to the provision and use of expert information in offering materials.
This protects rating agencies from liability for their ratings, which are considered opinions rather than expert advice. To close an ABS transaction, it must have a rating from one or more nationally recognized statistical rating organizations (NRSROs). When ratings are mandated, SEC regulations require the ratings to be disclosed and released by the agency in the public offering documents. Analysts said that failure to disclose this information could be considered a material omission and would potentially subject the issuer and underwriter to further liability.
“Thus, disclosure of ratings in offering documents of publicly registered securitizations is required, but consent of the agencies to include them is not,” said Barclays analysts in the report released today.
As a result of the appeal, which will be effective one day after the legislation is signed into law by President Obama, rating agencies will need to consent to the use of their ratings in public offering materials. If provided, this will likely open the agencies to liability under Section 11 of the 1933 Act under which they were previously not exposed.
Moody’s, Fitch, and S&P have each suggested that they are not likely to provide such consent at this time. Their hesitation has put the brakes on new publicly registered ABS issuance, Barclays analysts said .
“While we will continue to publish credit ratings, given the potential legal consequences, we cannot consent to the inclusion of ratings in prospectuses and registration statements without further study. Issuers should discuss this change for the use of credit ratings in public offerings registered under the ’33 Act with their legal advisors,” Moody’s reported in a press release this week.
A statement by S&P highlighted some of the steps taken to provide transparency in light of the reform.
“We are currently examining the proposed legislation and expect to provide additional information to you in the future about any related new procedures or changes to our processes,” the agency stated.
Fitch issued a similar statement, indicating that the potential liabilities would prohibit them from providing consent.
“While Fitch will continue to publish credit ratings and research, given the potential consequences, Fitch cannot consent to including Fitch credit ratings in prospectuses and registration statements at this time,” the credit rating agency reported.
DBRS, too, commented on the rule’s repeal, adding: “In view of the unprecedented treatment of credit ratings resulting from the repeal of Rule 436(g), DBRS is not willing to consent to the inclusion of its ratings in registration statements or prospectuses at this time. Of course, DBRS will continue to make its credit ratings and research available to the public through its normal distribution channels.”
The intent of the repeal was to make rating agencies more accountable for the quality of their ratings. It appears, however, that the issuance of public securitization is likely to “come to a halt” in the near term as a result of their hesitation, analysts said.
Consumer ABS has generated new- issue activity in the securitization market for the past 18 months. Analysts do not believe that Congress was trying to reverse those gains. They view the repeal of Section 436(G) as a “temporary speedbump” that will likely cause a temporary decline in issuance volume.
Meanwhile, solutions include a move by issuers to the private/144A market, where public filings with the SEC are not required, Barclays analysts said.
However, Bank of America Merrill Lynch analysts said in a report this week that limiting ABS issuers to the 144A market could reduce the options available to many investors. With a substantial portion of consumer and commercial ABS issuance stemming from the public market, many investors can not participate in the 144A market and it would therefore not be a long-term solution, analysts noted.
Additionally, a shift to the 144A market could also have the potential of increasing funding costs to issuers — which would eventually be passed on to consumers. Some issuers may choose to reduce origination volumes if faced with rising funding costs, BofA analysts observed.
Alternatively, said Barclays analysts, the SEC could also collaborate with the industry to alleviate the unintended results of the repeal. Analysts expect the former to take place initially, but the latter to be the eventual long-term result.