Bankruptcy

SEC Proposes Tighter Regulation of Asset-Backed Securities

By Chris Kramer

The Securities and Exchange Commission (SEC) announced that it has proposed new rules to govern the field of bonds backed by consumer loans, perhaps best known in its incarnation of mortgage-backed securities sold during the subprime housing boom.

Background: What They Are, How They Work

So, what might this mean for borrowers and investors? Here?s a little background on asset-backed securities and what they do.

• Consumer loans: When you and other ordinary Americans take out mortgages and other loans, you go through a bank or other lender. When the loan is originated, that lender "holds your debt."
• Loan bundling: It has become common practice to "bundle" consumer loans (especially mortgages), which means to lump them together to sell off to investors. But, rather than selling off easy-to-trace sections of the bundle, many banks sell off sections composed of various loans. These sections are the securities.
• Asset backed securities: Because the securities theoretically earn money when consumers make payments on their loans, they?re known as "asset-backed securities."
• Bond ratings: During the subprime boom, credit agencies gave various asset-backed securities risk evaluations to help guide investors: high-risk securities had the potential to yield more money, but with a greater risk of consumers not paying. Lower-risk securities offered a lower earning potential, but with more security for investors.

Naturally, the system works well assuming everyone does what they?re supposed to: banks issue loans consumers can afford, credit agencies give honest ratings, consumers make regular payments, etc.

But, as we know from the collapse of the subprime market, that?s not necessarily how the system works in practice.

The Proposed Rules

The SEC?s proposed changes would essentially take out the role of the credit agencies. Rather than have credit agencies rate loans, bond issuers themselves would be required to:

• Keep larger portions of loans on their books, thus giving them an increased stake
• Provide regular reports on the exact loans that compose a bond
• Guarantee the risk level of their products

If these changes pass, it?s expected that they?ll help prevent a repeat of many of the problems that caused the subprime bubble to expand and burst.

Additional Resources

SEC Proposal on Asset-Backed Securities (PDF)

Full post as published by The Bankruptcy Blog on April 15, 2010 (boomark / email).