NOVEMBER 2005
Mortgage Banking/Consumer Finance Commentary
Regulation AB: Countdown to Disclosure
for Loan Sellers
As the transition period to mandatory compliance with Regulation AB rapidly comes to a close, asset-backed
securities (ABS) issuers (including issuers of mortgage-backed securities, or MBS) and other market participants are still struggling with the new and revised disclosure regime that Regulation AB creates. In fact, loan
sellers are just now learning that “transparency and improved quality of disclosure” means that they are going
to face a tough adjustment period as sponsors of MBS offerings look to hedge their bets as to which way the
market will go on a number of disclosure issues. Indeed, the lack of clear guidance from the Securities and
Exchange Commission (“SEC”) has created an anarchy of ambiguity where no one can say with any certainty
what truly is required, leaving loan sellers to confront the inconsistent disclosure demands from different loan
purchasers that are interpreting the same Regulation AB in different ways.
The key issues facing the MBS market include implementation of data collection systems; determining how
far down the origination chain the data collection should go; implementation costs; potential disruptions to the
data collection and reporting systems; and contingency planning for noncompliance. The informational burdens and associated expenses of Regulation AB disclosure requirements may lead to loan sellers being segmented by their ability to provide Regulation AB information, with those who cannot provide Regulation AB
information finding themselves either unable to sell to certain purchasers or being subject to a limitation on
the volume of their sales to certain purchasers. In any event, originators that sell into the capital markets are
confronting a new array of broad representations, warranties, and covenants in the loan purchase agreements
that they are asked to sign, which must be reviewed carefully to appreciate what obligations they are assuming.
BACKGROUND
On December 15, 2004, the SEC approved the final regulations covering the registration, disclosure, communications, and reporting requirements for ABS. The disclosure requirements, which are set forth in a newly
created subpart to Regulation S-K—specifically Items 1100 through 1123, largely codify the existing market
practices and SEC positions. They contain several new disclosure requirements, however, including requirements to provide historical financial data (referred to as “static pool information”) including loss, delinquency,
and prepayment information with respect to either prior securitized pools of the same asset class or prior originations by “vintage” year depending on the securitization experience of the sponsor. In addition, Regulation
AB requires increased disclosure, particularly with respect to the background, experience and roles of the various transaction parties, including those involved in the origination, sale or servicing of the loans in the securitized pool.
Kirkpatrick & Lockhart Nicholson Graham
LLP
The disclosure requirements can be divided into several broad categories. First, there are disclosure requirements concerning the following transaction parties: sponsors, depositors, issuing entities, servicers, trustees,
and originators. The second broad category involves disclosure relevant to assessing the performance of the
assets being securitized: static pool disclosure and pool asset disclosure. Finally, there is a catch-all category
that covers disclosure concerning significant obligors, providers of credit enhancement and other support, certain types of derivatives, and alternative third-party information presentation.
In adopting this new disclosure regime, the SEC opted for a “principles-based” approach, which means that
the new rules provide principles that must be followed rather than specific guidance by asset class or transaction structure. Market participants and their respective counsels are now faced with having to grapple with
judgment calls as they attempt to apply these rules to particular facts and circumstances of their transactions.
As a result, the implementation of Regulation AB will undoubtedly evolve over time. For now, however, loan
sellers are confronting different interpretations of the same Regulation AB by different loan purchasers, which
makes it difficult for sellers to develop a uniform approach to collection of information and disclosure.
WHO IS AN ORIGINATOR?
Regulation AB does not define the term “originator” and the SEC believes that a definition is not necessary,
apparently subscribing to the theory that you will know an “originator” when you see one. The question of
who is an “originator” is important for several reasons. Depending on how “originator” is defined, the sponsor (and by implication each seller below the sponsor) may need to go all of the way down the “supply” chain
to collect the information required to be disclosed about an “originator.” If a sponsor is required to go below
its first tier of sellers, it will need to develop mechanisms to combine and sum loan production by originators
who sell to different first tier sellers. Finally, the determination of who is an originator may be important in
selecting the source or sources of static pool information.
Once an originator is identified, if that entity originated more than 20% of assets in a pool, the following information (in addition to identifying the originator) must be disclosed:
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The originator’s form of organization;
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Size and composition of the originator’s origination program, if material; and
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Information material to an analysis of the performance of the pool assets, such as the originator’s creditgranting or underwriting criteria.
STATIC POOL DISCLOSURE
Included Information
One of the most important changes from the current disclosure practice can be found in Item 1105 of
Regulation AB, which requires the disclosure of the sponsor’s static pool information. Static pool information
tracks the performance of a specific pool of loans or assets over time. While the SEC declined to prescribe
specific disclosure by asset class or to offer guidance as to when static pool information is material, Item 1105
provides general guidance on the “starting point” for disclosure based on the sponsor’s seasoning and whether
the asset pool is amortizing or a revolving asset master trust. For amortizing asset pools (which covers mortgage loans), the sponsor must provide the following information to the extent it determines such information
to be material:
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Static pool information regarding delinquencies, cumulative losses and prepayments drawn from the
sponsor’s prior securitized pools for that asset type.
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KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
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If the sponsor has fewer than three years of securitization experience with the asset type, the sponsor must
consider providing the data from purchases or originations by year—so-called “vintage year”—in lieu of
information of the sponsor’s prior securitized pools.
Summary information regarding the original characteristics of the securitized pools (such as those characteristics which are commonly found in the “strat” tables of current MBS offering documents) from which the data
is drawn should also be disclosed.
The sponsor must provide five years of historical data, or, if shorter, the period for which the sponsor has been
securitizing, originating, or purchasing assets of the same type. The data must be presented in monthly or
quarterly increments, with the most recent increment of data as of a date no later than 135 days before the date
the prospectus used in the MBS offering is first used.
Interpretive Issues
Several interpretative issues arise almost immediately upon trying to apply these principles to the particular
facts and circumstances of a securitization transaction. First, what is meant by “asset type”? For example, is
“residential mortgage loans” an asset type, which appears to be the direction the SEC staff is leaning, or is that
designation simply too broad to be meaningful in the context of a materiality standard? Perhaps “asset type”
should be sliced more finely into home equity loans, prime loans, subprime loans, Alt-A loans, and so on.
Second, once you have decided where to draw definitional boundaries for “asset type” and assuming you do not
have three years of securitization experience, do you have to produce vintage year data for every loan originated in a particular year or only a subset? If a subset, how large does the subset have to be? Also, as discussed
above, how do you determine if you were the originator especially if you re-underwrote loans you purchased
from a third party? What if you did not re-underwrite every loan you purchased but only a statistical sample?
Third, who is the “sponsor”? Regulation AB defines a “sponsor” as a person who organizes and initiates the
ABS transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to
the issuing entity. While at first blush the identity of the sponsor appears obvious, especially when the originator of the loans executes the securitization through its affiliates, many securitizations now involve the purchase of loans from a variety of unaffiliated originators. As a result, the SEC distinguished in the commentary
to Regulation AB between “rent-a-shelf” and an “aggregator” transaction. In a “rent-a-shelf” transaction, a
holder of assets securitizes those assets by selling them to an unaffiliated party who has an effective shelf registrations statement and effectuates the securitization on the seller’s behalf. In such a transaction, the SEC
indicates that it would expect the seller to be the sponsor and thus the seller’s static pool information should be
disclosed. Such a result makes sense as prior performance of the seller’s securitized pools is more material in
gauging the potential performance of the pool being securitized than that of the unaffiliated provider of the
“rent-a-shelf.”
In an “aggregator” transaction where an entity acquires loans from a variety of unaffiliated sellers before securitizing the loans, the SEC indicates that the “aggregator” is the sponsor. While in many cases that result may
be correct, there is potentially a very broad grey area between “rent-a-shelf” and “aggregator” transactions.
That grey area is inhabited by transactions in which the so-called “sponsor” is an investment bank that is
either without underwriting guidelines of its own other than general marketability indicators or does not have
the ability to rigorously underwrite each loan it acquires or a particular seller’s loans constitute a large (e.g.,
60-70 percent) or significant percentage of the pool. The grey area is further widened by the SEC’s own commentary that there may be “more than one unaffiliated sponsor” in a single transaction and by language in
Regulation AB providing that static pool information from a party “other than the sponsor may be provided in
addition to or in lieu of” sponsor static pool information “if appropriate to provide material disclosure.” The
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KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
Regulation AB language goes even further and states if static pool information of the sponsor is not material,
but “alternative static pool information would provide material disclosure,” such alternative static pool information must be disclosed.
It could be argued that the SEC’s commentary distinguishing “rent-a-shelf” from “aggregator” transactions,
coupled with the “alternative static pool information” concept, creates a nexus between underwriting guidelines (and thus who is an originator) and whose static pool information needs to be delivered. While such a
linkage may prove to be unworkable, cautious “sponsors” are considering whether they should require the
originators from whom they purchase loans to provide static pool information if reasonably requested. Even if
it is concluded that an originator’s static pool information is relevant, however, the question of when static
pool information of an originator is material remains. When the originator’s loans constitute more than twothirds, or half, or 20% of the pool?
OBTAINING DISCLOSURE INFORMATION
Regulation AB’s disclosure requirements are the obligation of the registrant and not of the other ABS transaction parties. To fulfill that obligation, however, the registrant (who is often the sponsor) may need to obtain
disclosure from unaffiliated third parties ranging from basic entity information about such third parties to static pool information about their originations beyond the loans sold. To obtain this information, purchasers are
inserting provisions in the master loan purchase agreements and servicing agreements with sellers and servicers. As to be expected, the language contained in these new provisions is not uniform as the transaction
parties struggle with disclosure issues discussed above. In addition, under the basic liability provisions of the
Securities Act of 1933, registrants are strictly liable for information contained in the prospectus in connection
with an MBS offering, including the information provided by third parties. While registrants will undoubtedly
require indemnification from third parties, the SEC’s long-standing opposition to indemnification for securities law liability at least raises the question for registrants as to how much risk are they willing to take with
respect to including third-party information in the prospectus. Potential responses to this risk issue will range
from taking a very prudent and go-slow approach, to including third-party information or to requiring auditors
to comfort static pool information from third parties. These additional requirements raise the issue of who
should pay the costs of such enhanced due diligence activities.
NEXT STEPS
While the requirements of Regulation AB are anything but clear, if you are a loan seller, you should focus on
the following issues:
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Are your loans likely to be less than 20% of pools backing MBS offerings? If yes, we expect that the
practical effect of Regulation AB may be minimal. Initially, as the market develops, you may be required
by purchasers to commit to providing Regulation AB disclosure information, but while we cannot be certain, it appears that it is unlikely that you should have to actually provide such information. There is a
risk, however, that the market will not follow this approach, and that originators who are unable to provide Regulation AB information are effectively shut out of the market as a result.
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Even if your loans are likely to be less than 20% of any pools backing MBS offerings, are you planning
to increase your loan production in the future so that you may exceed this threshold in the future? If yes,
you need to become familiar with Regulation AB and its information requirements. While you may have
some preparation time, you need to develop a strategy for dealing with loan purchase agreements and the
related information collection requirements.
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KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
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Are your loans currently expected to comprise more than 20% of any pools backing MBS offerings? If
yes, you can expect to be subject to additional information requirements of Regulation AB through your
loan purchase agreements. You must quickly become familiar with Regulation AB and develop a strategy to deal with loan purchase agreement language your purchasers propose. You will also want to consider changes to any loan purchase agreements with your sellers to ensure you can collect the necessary
information to meet these new requirements.
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Irrespective of your current loan originations, are you planning to securitize your originations in the
future? If yes, you need to develop an information collection strategy and a loan purchase agreement
strategy as soon as possible. It does not matter if you are planning to file your own shelf registration
statement or use a “rent-a-shelf,” because in both cases you will be the sponsor. Also, it does not matter
if you plan on securitizing your loans in a public registered transaction or in a private 144A transaction.
We expect that the 144A market will follow the public market, as it has in the past, and become
Regulation AB compliant.
Even though we have entered the countdown phase to Regulation AB disclosure, there is still
time to address these and other issues as the market evolves toward a consensus. If you
have any questions about Regulation AB or would like assistance in complying with it, please
call Phil Kardis 202.778.9401, Drew Malakoff 202.778.9086, Eric Edwardson 202.778.9387, or
any other member of the Mortgage Banking/Consumer Finance Practice listed on the following page.
5 NOVEMBER 2005
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MORTGAGE BANKING/CONSUMER FINANCE PRACTICE
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For more information, please visit our website at www.klng.com or contact one of the lawyers listed below.
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Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally.
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