U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

70–772 PDF 2011

S. HRG. 112–150 

THE STATE OF SECURITIZATION MARKETS 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING THE STATE OF SECURITIZATION MARKETS 

MAY 18, 2011 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

BRETT HEWITT, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

JACK REED, Rhode Island, Chairman 

MIKE CRAPO, Idaho, Ranking Republican Member 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

TIM JOHNSON, South Dakota 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

KARA STEIN, Subcommittee Staff Director 

GREGG RICHARD, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

WEDNESDAY, MAY 18, 2011 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Crapo ................................................................................................... 2 

WITNESSES 

Steven L. Schwarcz, Stanley A. Star Professor of Law and Business, Duke 

University School of Law ..................................................................................... 4 

Prepared statement .......................................................................................... 33 

Responses to written questions of: 

Chairman Reed .......................................................................................... 230 

Tom Deutsch, Executive Director, American Securitization Forum .................... 6 

Prepared statement .......................................................................................... 39 

Responses to written questions of: 

Chairman Reed .......................................................................................... 232 

Martin S. Hughes, President and Chief Executive Officer, Redwood Trust, 

Inc. ......................................................................................................................... 7

Prepared statement .......................................................................................... 196 

Responses to written questions of: 

Chairman Reed .......................................................................................... 232 

Lisa Pendergast, President, Commercial Real Estate Finance Council .............. 9 

Prepared statement .......................................................................................... 200 

Responses to written questions of: 

Chairman Reed .......................................................................................... 232 

Ann Elaine Rutledge, Founding Principal, R&R Consulting ............................... 11 

Prepared statement .......................................................................................... 215 

Responses to written questions of: 

Chairman Reed .......................................................................................... 235 

Chris J. Katopis, Executive Director, Association of Mortgage Investors ........... 12 

Prepared statement .......................................................................................... 219 

Responses to written questions of: 

Chairman Reed .......................................................................................... 246 

(III)

(1) 

THE STATE OF SECURITIZATION MARKETS 

WEDNESDAY, MAY 18, 2011 

U.S. SENATE, SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 9:35 a.m., in room SD–538, Dirksen 

Senate Office Building, Hon. Jack Reed, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. Good morning. Let me call the hearing to order 

and welcome all of our witnesses. This is an opportunity to talk 

about the state of the securitization markets, which is a critical 

issue to our economy and to the Nation. 

Securitization is the bundling of individual loans or other debt 

instruments into marketable securities to be purchased by investors. Securitizations have touched nearly every American. These financial products operate behind the scenes in our economy. They 

provide lower-cost loans for homes and automobiles. They provide 

students with low-rate loans. They provide businesses with capital 

to purchase equipment. They are used to finance apartments and 

neighborhood malls. And because they are so prevalent in our economy, they can also cause a lot of trouble when they do not function 

properly. 

Securitization has been a powerful tool providing significant economic benefits, including lowering the cost of credit to households 

and businesses and helping investors better match their return to 

their appetite for risk. Securitization has also allowed lenders to 

transfer credit risk and free up capital for additional lending. This 

in turn provides greater availability and lower-cost loans to consumers and businesses. 

Securitization, when executed correctly, can be an important part 

of our financial system, helping to create jobs by providing the financing and liquidity necessary to build our infrastructure and 

help our businesses grow and innovate. However, most market participants and policy makers agree that the financial crisis revealed 

a troubling aspect to an increasingly Byzantine and opaque 

securitization process which has had a devastating effect on our 

economy. 

The way securitization was implemented in the years leading up 

to the financial crisis created perverse incentives, often emphasizing volume over quality, easy fees over the long-term viability of 

2 

the loans, and speed over diligence. We only need to look at the 

residential mortgage market to see how badly things can go if 

securitization is not executed carefully. 

Indeed, the mad rush to cut corners led to an eventual freezing 

of the securitization markets as investors lost confidence and drastic Government intervention was necessary to prevent the evaporation of liquidity and allow access to credit to continue for many 

consumers and businesses. 

In short, securitization is not just a fancy Wall Street process. 

Securitization structures can and have a profound impact on our 

economy and a unique ability to allocate capital at low cost. 

As we examine the state of the securitization markets today, we 

need to go back to fundamentals. We need to assess the role of 

securitization on our economy. Should it continue to have a role as 

it is playing today? Or should that role be different? What is the 

balance between liquidity and investor confidence? How can we 

help create a more robust, transparent, liquid, and competitive 

marketplace? 

At the same time, how do we discourage reckless lending, excessive risk taking, and excessive leverage? And, ultimately, how do 

we sufficiently protect investors? And how do we protect the American economy and public when these processes go wrong? 

We do have to ensure that securitization is used properly and effectively for the benefit of all Americans. The answers to these 

questions have huge implications for our economy and also as we 

look forward to reforming and changing the Government-sponsored 

enterprises under the control of the Government today. 

I look forward to hearing from all of our witnesses, and at this 

point I would like to recognize my Ranking Member, Senator 

Crapo. Senator Crapo. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Thank you very much, Senator Reed, and I appreciate you holding this hearing. You are right, the implications 

of how we resolve this issue are going to have huge consequences 

for our economy, and we have got to get it right. I appreciate our 

witnesses being here today and the thoughtful assistance that they 

are giving us in evaluating this. 

If we are going to encourage private money that is still sitting 

on the sidelines to return to security markets, we need to provide 

the appropriate balance between the strong standards that will 

align the interests of lenders, issuers, and investors with the ability 

of the securitization process to work. 

Section 941 of the Dodd-Frank Act legislation mandates that our 

financial regulators craft rules requiring entities involved in the 

securitization process to retain a certain level of risk of the assets 

being securitized. The intent is to better align the incentives among 

the chain of originators, securitizers, and investors. It is important 

to note that the Federal Reserve’s October 2010 study cautioned 

that risk retention is not a panacea and that if rules are not implemented carefully by asset class, credit availability could be disrupted at a time when it is desperately needed. 

3 

This was also the same reason that the Senate made two key 

changes to the section when deliberating on the Dodd-Frank legislation. 

The first that I refer to is the Landrieu-Izakson-Hagan amendment that required regulators to establish a category of well-underwritten single-family loans that would be exempt from the bill’s 

risk retention requirements. 

The second was my amendment, which directed regulators to 

consider risk retention forms and requirements in order to ensure 

that regulators considered the unique nature of the commercial 

mortgage-backed securities market. 

After months of sometimes very heated interagency debate, the 

joint risk retention rule proposal was put out for comment on 

March 31st this year. The proposal is 367 pages and seeks comments on more than 150 different questions. While many experts 

are still trying to understand all the consequences of the proposed 

rule to the impact of capital formation in these markets, the early 

feedback and comments suggest that more work needs to be done 

in this area, and several of our witnesses argue that a reproposal 

is warranted. 

This rule will have a broad impact, and I am interested in learning from our witnesses today how it is going to impact the 

securitization market and our economy. If necessary, what changes 

should regulators consider that will provide the flow of credit and 

strengthen the underwriting and align the interests of lenders, 

issuers, and investors? 

Ultimately we need rules that are strong enough to protect our 

economy but that can adapt to changing market conditions and 

promote credit availability which will spur job growth for millions 

of Americans. 

Thank you, Mr. Chairman, and, again, I appreciate your holding 

this hearing. 

Chairman REED. Thank you very much, Senator Crapo. 

I will now introduce all of the panelists and then ask Professor 

Schwarcz to begin, but let me begin with the introduction of all the 

panelists. 

Steven Schwarcz is the Stanley A. Star Professor of Law and 

Business at Duke University. Prior to joining the Duke faculty in 

1996, he was a partner at the law firm of Shearman & Sterling and 

then a partner and practice group chairman at Kaye Scholer LLP. 

Professor Schwarcz’s book, ‘‘Structured Finance: A Guide to the 

Principles of Asset Securitization’’, is one of the most widely used 

texts in this field. Thank you, Professor. 

Tom Deutsch is the executive director of the American Standardized Forum. Mr. Deutsch previously served as an associate in the 

Capital Markets Department at Cadwalader, Wickersham & Taft, 

and he represented issuers and underwriters in various structured 

finance offerings. 

Martin Hughes has served as president of Redwood Trust since 

2009 and chief executive officer since May 2010. Mr. Hughes has 

over 18 years of senior management experience in the financial 

services industry. Thank you. 

Lisa Pendergast is president of the CRE Finance Council. She is 

also a managing director in Jefferies’ Fixed Income Division and is 

4 

responsible for strategy and risk for CMBS and other structured 

commercial and multifamily real estate products. Thank you. 

Ann Rutledge is the founding principal of R&R Consulting. In 

addition, Ms. Rutledge is an adjunct assistant professor of asset 

securitization at the Hong Kong University of Science and Technology and visiting lecturer at the University of California at 

Irvine. 

Chris Katopis serves as the executive director of the Association 

of Mortgage Investors, AMI. Mr. Katopis has years of experience in 

Washington in a variety of public policy positions in the private 

sector and Government. 

Thank you all for being here. Professor Schwarcz, would you 

begin? Turn on your microphone. Two, your statements are all part 

of the record, so feel free, very free, to summarize your very 

thoughtful and analytical presentations. And we have got about 5 

minutes. Go ahead, Professor. 

STATEMENT OF STEVEN L. SCHWARCZ, STANLEY A. STAR PROFESSOR OF LAW AND BUSINESS, DUKE UNIVERSITY SCHOOL 

OF LAW 

Mr. SCHWARCZ. Thank you. My written testimony discusses in 

more detail securitization’s role in the financial crisis. The problem 

was not securitization per se, but a correlation of factors, some of 

which were not completely foreseeable, including the unprecedented collapse of the housing markets. 

The resulting mortgage defaults had localized consequences in 

traditional securitization transactions. But they had larger, systemic consequences in nontraditional transactions that involved 

complex and highly leveraged securitizations of asset-backed securities that were already issued in securitizations—effectively 

‘‘securitizations of securitizations.’’ 

I believe that the important question is: Why did the markets believe in these nontraditional securitization transactions? And answering this question helps us to understand how to protect 

against potential abuses. 

Now, in trying to answer this, in addition to the widespread inconceivability of the extent of the housing price collapse, part of the 

answer may be that securitization’s focus on mathematical modeling to simplify complexity fostered an abandonment of common 

sense. Another part of the answer may be that investors, who 

seemed as anxious to buy these superficially attractive securities as 

underwriters were to sell them, were overly complacent and eager 

to follow the herd of other investors. Other parts of the answer 

may touch on intra-firm conflicts, which I will discuss, and the failure to internalize costs. 

Dodd-Frank addresses at least one of securitization’s flaws, and 

that is the originate-to-distribute model of securitization, which is 

said to have fostered an undisciplined lending industry, and DoddFrank does this by requiring securitizers to keep skin in the game, 

effectively retaining a minimum risk of loss, in order to help align 

the incentives of securitizers and investors. 

There does remain a question, however, of the extent to which 

this originate-to-distribute model actually caused mortgage underwriting standards to fall. There are other reasons set forth in my 

5 

testimony that at least give suggestions as to why it may have occurred, and one of the more important questions is: Why did the 

ultimate beneficial owners of the mortgage loans—the investors in 

the asset-backed securities—not govern their own investments by 

the same credit standards that they would observe if they were 

making the loans in the first place? 

Now, Dodd-Frank does not directly address the problem of overreliance on mathematical modeling or complexity. To some extent, 

this should be self-correcting in the short term. But in the long 

term, I fear that investors will really forget that lesson; they tend 

to, as Business Week once said it, ‘‘Go for the gold, look to the 

yield.’’ 

Dodd-Frank does not address the broader complacency question, 

although I am not sure how regulation can really change human 

behavior. For example, market participants will probably always 

engage in herd behavior, there being safety in numbers. 

Dodd-Frank focuses on disclosure besides the skin in the game, 

and among other things, it requires more standardized disclosure 

of information. In principle, that makes sense. In my experience, 

though, investors often already get this type of standardized information. And I think the larger problem is not disclosure itself, that 

it is inadequate in terms of what is provided, but the fact that investors do not always read it, and if they do read it, they do not 

always understand the information that is already disclosed. 

There are several reasons for this. One is complacency. Another 

reason which I think is very important is a conflict of interest within investing firms themselves. As investments become more complex, conflicts are increasingly driven by short-term management 

compensation schemes. And this is critical, especially for the technically sophisticated secondary managers who do not always worry 

about long-term risks because their compensation is on a shortterm bonus basis. 

Now, this is an intra-firm conflict, very much unlike the traditional focus of scholars and politicians who focus on conflicts between the senior managers and the shareholders. I think that regulation needs to address this intra-firm conflict. 

Another reason for disclosure’s failure is that financial products, 

including some securitization products, are becoming so complex 

that disclosure can never lead to a complete understanding. 

Now, let us just briefly look at the larger perspective. 

Securitization has existed for decades, has worked very well for the 

most part. Even during the recent crisis, almost all traditional 

securitization structures protected investors from major losses. But 

certain of securitization’s problems, especially for the nontraditional structures, are typical of problems we must face in any innovative financial market: that increasing complexity, coupled with 

human complacency, among other factors, will make failures virtually inevitable. And regulation must respond to this reality. It 

must mitigate the impact of failures when they occur. 

And, finally, it is important to provide incentives for financial institutions to try to minimize the impact of failures and to absorb 

them. This could be done, for example, by requiring at least systemically important market participants to contribute to a risk 

fund, which could be used as a source of stabilization. Fund conVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
6 

tributors then would be motivated not only to better monitor their 

own behavior, but also to monitor the behavior of other financial 

institutions whose failures could deplete the fund. 

Thank you. 

Chairman REED. Thank you very much Mr. Schwarcz. 

Mr. Deutsch. 

STATEMENT OF TOM DEUTSCH, EXECUTIVE DIRECTOR, 

AMERICAN SECURITIZATION FORUM 

Mr. DEUTSCH. Chairman Reed, Senator Corker, thank you very 

much for the opportunity to testify here today. My name is Tom 

Deutsch, and on behalf of the 330 member institutions of the ASF, 

I appreciate this opportunity to represent the issuer, dealer, and 

investor interest in the securitization marketplace. 

In our 157-page written statement, which I will not try to get 

into 5 minutes of oral statements, we seek to identify and describe 

in detail the panoply of key legislative and regulatory initiatives 

that are currently confronting the securitization markets. The purpose of this deep and critical review of the outstanding legislative 

and regulatory initiatives is to demonstrate not just the individual 

aspects that are of concern to the securitization markets but ultimately the cumulative effects of all of these regulatory initiatives 

occurring simultaneously. And in effect the securitization markets’ 

greatest fear is not to be damaged by one slice of the sword but, 

in fact, to be destroyed by a death by a thousand cuts. 

Many of the industry’s current issues arise from regulations prescribed by the Dodd-Frank Act. Some of the key areas of DoddFrank that we discuss in our detailed written statement are: one, 

risk retention; two, rating agency reform; three, orderly liquidation 

authority for nonbanks; four, derivatives; five, the Volcker rule; 

and, finally, conflicts of interest. 

But the massive regulatory changes in the securitization market 

are not solely deriving from the Dodd-Frank Act. And, in fact, they 

come from a number of other areas, including: one, the SEC’s Regulation AB proposals that would completely overhaul the registration, disclosure, and reporting requirements for the entire assetbacked securities market; two, the FDIC’s securitization safe harbor, which was developed in a unilateral fashion by the FDIC, effectively front-running much of the Dodd-Frank securitization mandate, and has currently sidelined most bank issuers from 

securitization issuance; and, three, finally, the capital adequacy 

changes coming in Basel 2.5 and Basel III, as well as the accounting and regulatory capital charges created by FAS 166 and 167, the 

effects of which are still being absorbed by the market. 

Ultimately, these proposals confront the market during a time 

when certain sectors, such as auto and equipment ABS, are at or 

near normal levels, and other sectors, such as the commercial mortgage-backed securities market, that are beginning to see signs of 

life. Particularly a significant number of commercial loans are coming due for refinance. 

But, clearly, the future of residential mortgage funding hangs in 

the balance as the Administration and Members of Congress seek 

to wind down the GSEs and wean Americans’ addiction off of cheap 

or Government-subsidized mortgage credit. But to reduce GovernVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
7 

ment’s role in the residential mortgage sector, private sector capital 

has to return to this market to allow the residential mortgage market to live on its own. 

Ultimately, few would dispute that industry and policy changes 

do not need to occur in the subprime and Alt-A residential mortgage securities marketplace, and the ASF fully supports appropriate changes in that marketplace. But making changes to the entire engine of the securitization machine while at the same time 

doing it across all asset classes, while driving up a steep economic 

hill in a down market, is ultimately a recipe for a sputtering car, 

if not a complete breakdown on the side of the road. 

In particular, in the risk retention proposals recently released by 

the Federal regulators, we are seeing rules drafted precisely for the 

residential mortgage market, but being applied, somewhat bluntly, 

to other types of securitizations, like auto loans. As an example, 

the regulators included an auto ABS exemption from the risk retention rules for certain qualified auto loans. But few, if any, auto 

loans made in America over the past 30 years would ever actually 

qualify for such an exemption because the exemption was developed with mortgage underwriting criteria, such as the requirement 

for a 20-percent down payment. I do not know about you, but I do 

not know many people who have put 20 percent down on a car 

loan. It just simply does not happen. 

Also, but even within the mortgage sector, there are new concepts, such as the premium cash reserve account, that ultimately 

is beyond the scope effectively of Dodd-Frank that would ultimately 

make the securitization business a not-for-profit business, effectively shutting down large swaths of the RMBS and CMBS markets if those rules were to go into effect as written. 

The ASF requests ultimately the regulators should specifically 

articulate that the proposed risk retention rules not apply to certain sections of the highly functioning securitization market, such 

as the auto loan sector and the asset-backed commercial paper sector that shows no signs of misalignment of incentives during one 

of the worst economic crises in American history. 

Moreover, given the extremely complicated set of rules that are 

being proposed, over 300 pages and 150-plus questions, ultimately 

we believe that given the thousands of pages of comments that the 

regulators are going to receive on June 10th, the regulators should 

ultimately repropose the rules to ensure that they get it right and 

make sure that availability of credit is ensured to Americans 

through the securitization process. 

Thank you very much for your time today, and I look forward to 

answering questions. 

Chairman REED. Thank you very much. 

Mr. Hughes, please. 

STATEMENT OF MARTIN S. HUGHES, PRESIDENT AND CHIEF 

EXECUTIVE OFFICER, REDWOOD TRUST, INC. 

Mr. HUGHES. Good morning, Chairman Reed, Ranking Member 

Crapo, and Members of the Committee. My name is Marty Hughes. 

I am the CEO of Redwood Trust, and I sincerely appreciate the opportunity to testify here today. 

8 

My testimony is focused on restoring private sector financing for 

prime residential mortgages. Redwood has a long history in the 

business of issuing and investing in private label jumbo mortgagebacked securities, or MBS. Since the market freeze 3 years ago, we 

have completed the only two issuances of fully private MBS of 

newly originated mortgage loans. We are planning to complete another two transactions by year end. 

Based on the success of these transactions and our ongoing conversations with investors and lenders, we believe private capital is 

ready to step back in and invest in safe, well-structured prime 

securitizations backed by good mortgages. The speed at which the 

private market returns will depend on several factors. 

Through Fannie Mae, Freddie Mac, and the FHA, the Government currently supports the credit risk in 90 percent of the mortgages in the U.S. without passing on the full cost of the credit risk 

assumed. Government subsidies must be scaled back on a safe and 

measured basis to permit the private market to flourish. We note 

that post-crisis, the asset-backed securities markets for autos, credit cards loans, and now commercial loans are up and running while 

the private label MBS market remains virtually dormant. The difference is the pervasive below-market Government financing in the 

mortgage sector that is crowding out traditional private market 

players. 

We can only securitize the small volume of prime quality loans 

outside the Government’s reach. We are ready to purchase and 

securitize any prime loan and can do it at an affordable rate once 

the Government creates a level playing field. 

I strongly advocate beginning, again, a safe and measured process of testing the private market’s ability to replace Governmentdependent mortgage financing. 

The Administration should follow through on its plan to reduce 

conforming limits and increase guarantee fees to market rates over 

time so the Government gradually withdraws from a majority of 

the market over 5 years. That time frame will enable the private 

label market to gain standardized practices and procedures and 

confidence. 

In the wake of the Dodd-Frank Act, there are many regulatory 

requirements and market standards currently out for comment. 

The resulting uncertainty keeps many participants out of the market. Once the final rules of the road are known, market participants can adjust their policies, practices, and operations. 

Another issue to restoring investor confidence and increasing the 

velocity of private label issuance is the standardization of sponsor 

and servicer best practices. In recently issuing two private label 

MBS transactions, we worked closely with those who invest in 

high-quality AAA securities—insurance companies, banks, and 

money managers, and with lenders, borrowers, and industry 

groups. Each transaction was well oversubscribed. This did not 

happen by accident. Sponsors need to meet the new requirements 

of AAA investors. These include enhanced disclosures, strong and 

enforceable representations and warranties, safer and simpler 

structures, and meaningful sponsor skin in the game. 

9 

It is also critical that servicers regain the confidence of investors. 

Uniform standards need to be established governing servicer responsibilities, performance, and conflicts of interest. 

In my opinion, the one gaping hole to restoring private investor 

confidence is the unresolved threat from second mortgages—a significant factor that contributed to the mortgage and housing crisis. 

The first and most important level of skin in the game is at the 

borrower level. If a borrower can effectively withdraw his or her 

skin out of the game through a second mortgage, the likelihood of 

default on the first significantly increases. Left unchecked, this 

would be a very, very disappointing result for private investors. 

Regarding mortgage rates, it is reasonable to expect rates to rise 

somewhat when the Government withdraws. We believe rates will 

only rise modestly, perhaps by 50 basis points. And we note that 

in our most recent deal, the average mortgage interest rate for 30- 

year fixed rate loans underlying that securitization was 46 basis 

points above the Government-guaranteed rate. 

Done correctly, we believe a gradual wind-down of the Government’s role in the mortgage market can be replaced by a smarter, 

less risky private label MBS market. Thank you for the opportunity 

to allow me to testify. I would be happy to answer your questions 

when the time comes up. 

Chairman REED. Thank you very much, Mr. Hughes. 

Ms. Pendergast. 

STATEMENT OF LISA PENDERGAST, PRESIDENT, 

COMMERCIAL REAL ESTATE FINANCE COUNCIL 

Ms. PENDERGAST. Good morning, Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee. My name is Lisa 

Pendergast, and I am a managing director at Jefferies & Company. 

I am testifying today a president of the CRE Finance Council, or 

CREFC. CREFC is a trade association that represents all constituents of CRE real estate finance, including bank, life company, private equity, and CMBS lenders, as well as investors in CRE debt, 

loan servicers, and other third-party providers. 

First, I would like to frame the critical role that the securitized 

debt occupies in commercial real estate and the economy at large. 

There is approximately $7 trillion in commercial real estate outstanding in the United States today, and between now and 2014, 

more than $1 trillion of CRE loans will mature and will require refinancing. 

Prior to the economic crisis, the commercial mortgage-backed securities, the CMBS market, provided as much as 50 percent of debt 

capital for commercial real estate annually. In 2007, CMBS 

issuance peaked at $240 billion. In 2009, that number plummeted 

to just over $1 billion, including the help provided by TALF. 

As the markets begin to stabilize and recover, so do CMBS. In 

2010, CMBS issuance rose to about $12 billion, and in 2011, it is 

projected that we will issue some $35 to $40 billion in new issue 

supply. 

This is a good start, but it is not nearly enough to address the 

upcoming refinancing wave. Without a fully functional CMBS market, there simply is not enough capital to address this refinancing 

wave. 

10 

It is for that reason that Treasury Secretary Geithner and other 

policy makers agree that no economic recovery will be successful 

unless the securitization markets are revived and healthy. And 

make no mistake. Getting the Dodd-Frank mandated securitization 

retention rules right is essential to healthy securitization markets. 

There are lenders who are withholding judgment today on whether 

they will reenter the market until they can be sure that the final 

rules will work. The proposed rules are complicated, controversial, 

and they create as much uncertainty as they provide answers. 

CREFC supports the basic framework for CMBS within the proposed rules. However, there are fundamental aspects within the 

rules that have the potential to render the CRE securitization market unviable. Given the complexity, the rulemaking process must 

be an iterative one rather than a one-and-done proposition. For this 

reason, we are asking that you provide the regulators with the latitude they need to get the rules right. 

Specifically, our request today is twofold: first, extend the current June 10, 2011, rulemaking response date to allow for additional debate and clarification via roundtable discussions with regulators; second, encourage a reproposal of the draft rule that incorporates a response to the extensive industry feedback and dialog 

that will occur between regulators and the markets. 

Let me provide you with a sense of some of the issues that we 

are grappling with as it relates to the rules. 

First, the proposal includes a new concept called the premium 

capture cash reserve account that was not contemplated in the 

statute. Based on our reading, the reserve account substantially reduces the economic incentive for issuers to undertake securitization 

transactions. At a minimum, the reserve account will dramatically 

change CMBS transactions economics and likely result in fewer 

loans originated by CMBS lenders. Ultimately, this is likely to 

drive up the cost of CRE debt. 

Second, and specifically for CMBS, we appreciate that regulators 

created a special B-piece buyer retention option, as directed by 

Dodd-Frank and championed by Senator Crapo. The B-piece of the 

first loss position buyer is often also the special servicer charged 

with working out troubled loans, and that raises conflict-of-interest 

concerns for some of our constituents. 

To address that, the proposed rules incorporate a market-developed operating adviser construct that would require an independent ombudsman to participate in any transaction in which the 

B-piece buyer had special servicing rights. This provision in the 

rules, however, creates a broad set of its own potential problems 

as it goes well beyond the market-created operating adviser provisions in recent CMBS transactions. 

Third, the proposal requires permanent retention buyer sponsor 

or B-piece buyer. Such a permanent investment constraint is unprecedented in the financial markets and could severely limit the 

universe of institutions that would be willing to function as retainers. 

Fourth, the proposed regulations include a CRE specific retention 

exemption for loan pools compromised exclusively of low-risk qualifying CRE loans. It does not appear that any CRE loans would satisfy these requirements, and we are also concerned that the rules 

11 

do not properly consider entire segments of the commercial real estate market and the CMBS market, such as large floating-rate 

loans and single borrower transactions. 

The Dodd-Frank risk retention framework is the most significant 

threat to sustaining a commercial real estate recovery. This statutorily imposed Dodd-Frank rulemaking schedule creates needless 

time pressure on regulators, especially given that the rules will not 

go into effect until sometime in 2013. We are concerned that this 

will result in the issuance of poorly designed final rules. It is critical that you make clear to the six agencies charged with implementing the CMBS components of the retention framework that 

they take the time necessary to get the rules right. A one-and-done 

approach for discussion of this high-stakes issue benefits no one. 

Thank you for your time, and I look forward to questions. 

Chairman REED. Thank you very much. 

Ms. Rutledge. 

STATEMENT OF ANN ELAINE RUTLEDGE, FOUNDING 

PRINCIPAL, R&R CONSULTING 

Ms. RUTLEDGE. Chairman Reed, Ranking Member Crapo, Senators Corker and Hagan, my name is Ann Rutledge, and I am very 

grateful for the opportunity to testify this morning. 

I have a very simple point to make. As was mentioned, I do lecture and I talk for 8 hours on end and it is impossible for me to 

read from a speech, so let me tell you what I do when I do not lecture. My business partner, Sylvain Raynes, and I started R&R 

Consulting 11 years ago. We left Moody’s Investors Service because 

we believed that there was a fatal flaw in the rating product and 

process. The business model that we created was intended to address that fatal flaw, and let me tell you what that flaw is because 

it has a lot of relevance today. 

The flaw is that it created a market that was too good to be true. 

That is because the valuation and credit analysis that was done at 

closing was only related to the conditions at closing. What happens 

with ABS and RMBS, in particular, but all securitizations in theory, is they may actually improve over time, like good wine. But 

there is not a rating agency around to take a second look or a periodic look. There is never an apples to apples comparison between 

the analysis done initially and after the fact. 

Now, that was a great situation for investors for 20 or 25 years 

because it meant that they were holding securities that, on average, were better than the ratings suggested. That was a good situation for investors; but the sellers were happy as well, because 

securitization is much more flexible and offers a sort of corporate 

rating arbitrage. But unfortunately the sellers could have done 

even better. 

And so we had a situation in the beginning—at least after 1998, 

we had a situation where there was an opportunity to repackage 

securities in CDOs, in particular, RMBS CDOs. And now we have 

just said that the rating is not a valid credit measure after origination. It either understates or it overstates credit quality. Now we 

have created a perverse incentive to put securities into the market 

that are not well structured, that will not improve, that will actually deteriorate, and we can repackage them in CDOs without the 

12 

ultimate investors realizing what is happening until it is too late 

because the rating system does not reflect current credit quality. 

What is the source of the flaw? Because ABS and RMBS are 

measured—the credit quality is measured based upon empirical 

data. For CDOs, ABCP, and SIVs, the credit measure is a rating. 

It is not empirical data. And if the rating is stale, then the assessment is wrong. 

So my point of view, my recommendation today is the same as 

11 years ago, but as Benjamin Franklin said, ‘‘Tell me and I forget. 

Teach me and I learn. Involve me and I understand.’’ We are all 

involved in this now, so I hope that the next recommendations that 

I make will have some resonance. 

The most important things that we need to have to motivate better behavior is not to regulate behavior, but to create clear standards and enforce them. The standards that need to be set are particularly with respect to disclosure on the securities and with respect to the standard at which the securities are rated. What is the 

rating scale that allows a AAA security to go out as a AAA or allows a CCC security to go out as a AAA? We all need to know this. 

The rating scale issue has not aired publicly. I know from working at Moody’s Investors Service that we all benchmarked our ratings according to a fixed-point scale; and in 1994 Moody’s analysts 

actually showed the investor public how it worked. The scale needs 

to be taken out of the hands of rating agencies, because with it, 

they have created a discount window for corporations to go to the 

market with their collateral and get cash, and that is a great idea, 

but it is something that affects the economy as a whole. The rating 

scale needs to be determined by the regulators and probably the 

Administration and Congress, and then it needs to be published so 

that the whole market can actually monitor credit quality, so that 

the determination of current credit quality is not in the hands of 

a few people. 

Chairman REED. Thank you very much. 

Sir? 

STATEMENT OF CHRIS J. KATOPIS, EXECUTIVE DIRECTOR, 

ASSOCIATION OF MORTGAGE INVESTORS 

Mr. KATOPIS. Good morning, Chairman Reed, Ranking Member 

Crapo, distinguished members of the panel. Thank you for the opportunity for the Association of Mortgage Investors to testify on the 

state of securitization markets and housing finance in general. 

The U.S. mortgage market is awesome, $11 trillion in outstanding mortgages derived from three sources: Bank balance 

sheets, and critics argue that the bank balance sheets are full and 

stressed; the GSEs, and there is a vigorous debate about the potential liability on the taxpayers and Uncle Sam resulting from the enterprises; and securitization. Mortgage investors bring private capital to the market. At the height, we have financed $1 trillion in 

first lien mortgages, and at the height, 60 percent of all first lien 

mortgages were financed through securitization, not the banks. 

But today, securitization is shut down. Senator Corker goes 

around Tennessee saying mortgage investors are on strike. This is 

not our choice. We have private capital to invest in the markets. 

13 

Capital craves yield. But unfortunately, the current legal and regulatory environment is not conducive to those yields. 

So this has two sets of consequences. First is a 

macroconsequence on the U.S. economy, our capital markets, U.S. 

global competitiveness. But the second set of consequences squarely 

impact Main Street, because it impacts the ability to get housing, 

the price of credit, as well, the pension funds, retirement systems, 

and unions that have traditionally invested in RMBS because for 

decades it was the safest, most secure form of investment for longterm returns. 

So who is AMI? AMI are a number of private investors that came 

together to identify obstacles and hurdles to securitization in the 

market and identify public policy solutions. We, along with the insurance industry, public institutions such as State pension funds, 

retirement systems, universities, charitable endowments, are trying 

to identify ways that the Government can develop better systems, 

structures, and standards to, one, restart securitization in this 

country, as well as deal with issues surrounding the legacy of investments that impact all stakeholders. 

So with my testimony, my oral statement today, I would like to 

briefly summarize six broad-brush areas of concern, obstacles to 

RMBS securitization, and also try to touch on 10 public policy recommendations which we outline in our written statement and we 

outlined in our March 2010 white paper about restarting 

securitization. 

First, the market suffers because of opacity, asymmetries of information, and a thorough lack of transparency. Our investors are 

very good at pricing risk, but they cannot price the unknown. 

When have you ever heard of an investor wanting less information? 

They have fiduciary responsibilities. They want as much information as they can obtain. 

Second, there is a lack of standardization and uniformity surrounding very basic transaction documents and papers. Certainly, 

we strive for a model pooling and servicing agreement. And to give 

you a flavor of some of the problems that exist in this space, very 

basic contractual terms, such as delinquency and default, have no 

standardized industry meaning. So you can imagine the vagueness 

and ambiguity that flow from these contracts and some of the problems that exist in the space. 

Mortgage investors are very concerned about poor underwriting 

standards. Further, we have a number of concerns about conflicts 

of interest among servicers and their affiliates. Many services are 

conflicted. Hence, they are not servicing mortgages properly. Accordingly, AMI finds it aligns with consumers in many instances 

concerning these issues. 

Originators and issuers are not honoring their contractual obligations through representations and warranties. Contracts have 

these representation and warranty clauses. And to give you an 

analogy, you buy anything in America, you buy a car, you buy an 

iPod, you get a warranty. And if you bring it home and it is a fourcylinder car, not an eight-cylinder car, you can have a cure. Maybe 

the cure is you swap it for what you intended. We find that in a 

number of instances, these representations and warranties are not 

being honored and our members are left without recourse. 

14 

In general, the market lacks sufficient tools for first lien mortgage holders. And then, again, the effect of enforcement. 

So in closing, I would say that we would like to work with the 

Committee on its continued oversight and legislation regarding this 

area. There are a number of people that are working on solutions. 

There seems to be a sense of having a global, elegant, universal solution affecting securitization and all asset classes. We would argue 

that RMBS is very important for the housing sector, a very basic 

need, shelter. And if you can just fix MBS this year, that would be 

a great start. The enemy should not be the perfect of the good. I 

mean, sorry, the perfect should not be the enemy of the necessary. 

So we thank you for your oversight and we would like to be a 

resource for the Committee. 

Chairman REED. Well, thank you very much. I want to thank all 

the panelists for very detailed and very thoughtful and insightful 

testimony about very difficult issues that the agencies are confronting today. They have not yet published a final rule, so there 

is still opportunity. I am sure they are reflecting on everything you 

have said. I hope they are and expect they will. 

Let me begin with Mr. Hughes, because you have just successfully brought issues to the market and many of the points you have 

made, I think, echo a lot of what has been said before. But let me 

begin with a point which I think several people have reflected. 

If we had good underwriting, we would not have a lot of these 

problems. In some respects, a lot of what, from my view, DoddFrank is trying to do with ‘‘skin in the game,’’ et cetera, is just forcing good underwriting. So if you could just address from your perspective that issue, and anyone else who has a point about that. 

You know, there is one view that perhaps we are creating this 

elaborate structure to force good underwriting where we could do 

something more specific, more direct, or the market eventually 

with other sanctions would be doing better underwriting. But, Mr. 

Hughes, please. 

Mr. HUGHES. Yes. I believe everything starts with the borrower 

and obviously walks through the chain. I think, not to oversimplify, 

I think, actually, the problem is not as complicated as all the regulations and everything we are going through. If we start with a 

process where the borrower has a down payment, the borrower can 

clearly afford the loan from day one, we do not create mortgage 

products, neg-ams and stuff that would extend the reach of that 

borrower. There is responsibility in communicating with that borrower between the lender, and then to the extent the next step is 

when the lender, if it does go to securitize, there is total transparency. They have skin in the game. 

I think you can go back—we went 20 years at ten, 15 basis 

points, a loss in the prime. It is just to reflect on what changed, 

and to me, the one thing that changed all the way up from borrower down payments, no terrible underwriting, you know, and all 

the things that have been well documented. From our standpoint, 

the one thing that is missing here is seconds, and we have been 

talking about it. I do not know how it—I have heard about St. Germain and this law and why it cannot get changed, but that is a 

big thing from a borrower standpoint that is still out there. 

15 

Chairman REED. Let me just follow up with one question. I read 

your testimony that you basically—you insist on sort of skin in the 

game, taking it yourself as a way, I guess, to assure your fellow 

investors. So you have no problem with at least the concept under 

Dodd-Frank of making—— 

Mr. HUGHES. Correct. 

Chairman REED. —of the person taking skin in the game. 

Mr. HUGHES. Yes. As part of our business model, and again, we 

are on the prime jumbo space, we think the most significant and 

best way to provide skin in the game is to hold the horizontal slice. 

I know there is a lot of confusion between subprime structures and 

prime. But what our sales pitch says to you is that we put this deal 

together. We are selling you securities. And then we will hold 5 

percent of the securities underneath you, and to the extent that 

something goes wrong, 100 percent of that is on our checkbook, our 

buying. It is not vertical where we get 5 percent. 

I think that, along with the disclosures in the transactions we 

did, it was not—you know, the first one was six times oversubscribed. So to me, it goes to show it cannot be subprime, but if you 

meet what investors are looking for, the borrower has skin in the 

game and throughout the chain, I do not think it is as difficult as 

all this, at least on the prime side. 

Chairman REED. Thank you. 

Professor Schwarcz, in your testimony, you talked about many 

different factors and some which are intra-company, which are not 

being dealt with directly today by us, obviously. But one issue, I 

think, that comes—again, it resonates throughout all the testimony—is the complexity. The market went from pretty simple stuff 

to CDO-squared and CDO-cubed, where you would take the lowest 

tranches of a mortgage-backed security and then combine it into 

something else or actually come up with another security that had 

at least a component that was AAA rated. 

I guess, and I think what Mr. Katopis said, too, if it is standardized, if it is simple, it will work. Should we be spending more 

time—will the market—let me put it this way. Will the market permanently reject this complexity? Has it learned the lesson that, you 

know, keep it simple, stupid? That is what I learned at Fort 

Benning. Or are we going to see, if we do not have some of these 

very elaborate rules promulgated by the agencies, a quick return 

to super-complex and issues that cannot be understood? 

Mr. SCHWARCZ. That is a very good question, and I think that 

certainly in the short term, the market is going to reject the complexity. I fear that in the long term, as yields go higher in very 

complex products, the market may find them very attractive. In my 

written testimony, I talk about how the intra-firm conflicts, like 

issues of VaR, can facilitate this. 

One thing that—just a couple of thoughts here quickly. One 

thing is that because complexity will be inevitable, I think that 

failures will be inevitable. I have a paper that is cited in these materials, ‘‘Regulating Complexity in Financial Markets’’, where I develop this at great length and I compare it to chaos theory in complex engineering systems, where failures are also inevitable. 

So the question is how to address this. You address this, in part, 

by trying to prevent the failures, but also you address it, in part, 

16 

by trying to mitigate the consequences of the failures when they 

occur. This is something I think we need to do. 

A couple of other thoughts. In a perfect market, the investors 

themselves would be understanding what they are buying, would 

be insisting, in fact, that the originators, the underwriters, really 

retain skin in the game. In my experience, for example, in many 

loan sale markets, you could not sell a bank participation in a loan 

unless the seller of the participation retained at least 5, 10 percent 

interest in that loan. 

And so one of the questions I think we need to fully understand 

is why did the system break down here, and I think part of the answer is that things, again, have gotten too complex and that disclosure is an insufficient solution. Another part of the answer is that 

risk has been almost marginalized. This is interesting. Most of the 

investors are the hugest investors. Many of them are QIBs, Qualified Institutional Buyers, who are freely allowed to buy and sell securities under the SEC rules. And so it is something we need to 

look at. 

A final thing is that I have thought a lot about whether we 

should try to standardize these complex deals. And, in fact, one of 

the speakers talked about standardizing in the RMBS field issues 

of the pooling and servicing agreement and so forth. Standardization certainly can help in the very short term, but I fear that in 

the long term, requiring standardization would really stymie the 

ability of our financial markets to innovate and grow. Thank you. 

Chairman REED. Thank you very much. 

I am going to recognize Senator Crapo and my colleagues, but we 

will have a second round if you want it, also. So Senator Crapo? 

Senator CRAPO. Thank you, Mr. Chairman. 

I want to start out on commercial real estate, so Ms. Pendergast, 

I will direct my first question to you. As you indicated and as I indicated, frankly, in my statement, during the deliberation on DoddFrank, I was successful in getting an amendment adopted that 

would focus on commercial real estate to give the rule makers more 

flexibility, frankly, to recognize the unique nature of commercial 

real estate and help us to deal with the risk retention issue in a 

more flexible way. 

From your written testimony and your testimony here today, it 

is my understanding that you feel that that flexibility was not effectively achieved, or that much more could be done to more effectively create a rule that helps to facilitate commercial real estate 

mortgage activity and still aligning the interests of lenders, issuers, 

and investors. Could you elaborate on that a little bit? 

Ms. PENDERGAST. Sure. First, I would like to thank you and the 

regulators for incorporating that B-piece buyer retention option 

into the rules. It is extremely beneficial and suits the structure of 

the CMBS market. 

As to the second issue, in terms of other forms of risk retention, 

you know, first and foremost, I am a research analyst by trade and 

one of the things that you look to is the performance of bank portfolios, those portfolio lenders who kept these loans on their balance 

sheets. If you look at the data currently via the FDIC, you will find 

that they have some of the highest commercial real estate default 

delinquency rates out there. 

17 

So certainly, I do not necessarily view risk retention as a panacea. I do think the market has embraced it and that is to the 

good. But having said that, there are other options for risk alignment, and that would include things like the best practices reps 

and warranties package that was issued by the Commercial Real 

Estate Finance Council. Those certainly will go a long way toward 

better risk alignment if incorporated into current documents and 

required by the regulators. 

In addition to that, there are transparency and disclosure issues 

that I think permeate the entire securitization market. I like to 

think that the CMBS market, by very nature of the asset class, 

such that we have 200 or 300 loans in a deal as opposed to the 

RMBS market where there are 3,000 to 5,000 loans in the deal, the 

smaller number of loans allows us to do far more due diligence and 

provide that information to investors, not only at issuance, but on 

an ongoing basis. 

So one thing we would like to see is the incorporation of some 

of these best practices that have been put forth by CREFC into the 

regulations such that perhaps there is a combination of risk retention and the employment of some of these best practices that are 

out there. 

Senator CRAPO. And I assume from that that you believe that a 

reproposal is warranted. 

Ms. PENDERGAST. No question. One of the key things that we 

saw with the SEC is they held some roundtables when they were 

doing their Reg AB rulemaking, and it was vital, I think, and it 

is vital today for we to better understand what some of these proposals are. There is still a lack of clarity regarding the premium 

capture cash reserves account and many other rules that are out 

there. So a give and take between the industry and the regulators 

as to what their intent is and how we can best meet those goals, 

I think, would be important, and that really would require that we 

prolong the comment period and then incorporate the results of 

these roundtables into a reproposal of the regulations. 

Senator CRAPO. If we do not take another look at this and get 

the kind of flexibility that you are talking about, do you believe 

that we will see an unnecessary restriction of consumer activity 

and lending in the market? 

Ms. PENDERGAST. No question. I have spoken to a lot of the 

nonlarge bank lenders out there and they are quite concerned and, 

in fact, have started to pull back some of their activity already because they are not comfortable with how these rules will eventually 

affect them. 

One example would be that we have investors in the B-piece security, also, who will not be able to sell this investment at any time 

during the life of the security. That is really unheard of in the market, and the lack of liquidity could be extremely troublesome, causing many of these B-piece investors to either, one, leave the market 

entirely, or two, decide that they need higher yields on those securities that they buy. Ultimately, what that does is that it causes 

the cost of capital to rise for those CRE borrowers that are out in 

the market. 

Senator CRAPO. Thank you. Would any of the other panelists like 

to comment on this issue? Mr. Deutsch? 

18 

Mr. DEUTSCH. I am happy to talk about the reproposal aspect in 

detail because one of the key concerns about the proposed rules is 

they affect not just the mortgage market. I think everybody is very 

much focused on commercial and residential mortgages. But 

securitization affects, and is included as part of the asset classes, 

auto ABS, equipment loan ABS, whole business securitizations, 

asset-backed commercial paper, which is a $300 billion market. 

These are all areas that have massive impacts on sort of the middle market funding and consumer market funding in the U.S. 

Without getting a reproposal that makes the exemptions for these 

other asset classes work and be functional, I think could be pretty 

devastating to the consumer credit markets. 

Senator CRAPO. And I would like to follow up on that with you, 

Mr. Deutsch, and again, any other member of the panel that would 

like to respond to this, but it seems to me that what I am hearing 

from many of you, if not all of you, is that as currently drafted, the 

rule will ultimately cause a, well, I guess a contraction in consumer 

activity and commercial lending that is not justified by increased 

safety and soundness. Mr. Deutsch, could you comment on that, 

and any other panelist, if you would like to. 

Mr. DEUTSCH. Sure. I will take a fresh shot in thinking about, 

again, outside of the mortgage context. We can talk about subprime 

and Alt-A mortgages. It is its own separate bailiwick. But take the 

example of prime auto loans. Those securitizations worked perfectly throughout the crisis. There were very little, if any, losses in 

those securitizations in the worst economic downturn. 

So to me, to have auto finance companies, which are not in the 

business of holding capital—they do not just have money sort of sitting around, they are in the business of selling cars and then financing the sale of those cars and motorcycles and equipment 

loans—to create a lot of capital burdens, to make them hold capital 

just to sit around pulls that credit out of the system and ultimately 

lowers the availability of credit and makes it at a higher price, and 

I think that is a pretty critical component, that we have to get 

these exemptions right, and right now, they clearly are not. 

Senator CRAPO. Ms. Rutledge. 

Ms. RUTLEDGE. I guess the main point that I would like to say 

with respect to risk retention and some of the other structural fixes 

on the market is that the whole reason for the market initially, 

which came out of this S&L crisis was recognition that receivable 

asset quality can be better than the firm’s own credit quality, and 

it can finance itself more cheaply by financing itself off-balance 

sheet, given how our bankruptcy system works. 

The whole idea is an economy of capital utilization: capital efficiency. In fact, when Congress decides to do something like mandate risk retention, or any other structural piece, you are in fact 

structuring these deals. 

A simpler way to address systemic risk is to go back to the original definition of credit quality. What are we doing when we 

securitize? We are finding the boundary between debt and equity, 

using a judicious amount of leverage that gives buyers and sellers 

the best possible deal. ‘‘Judicious’’ is determined primarily with reference to the rating scale, and that is why I advocate transparency 

around the rating scale. 

19 

Senator CRAPO. Thank you. Mr. Hughes and then Mr. Schwarcz, 

and I am probably going to be out of time. I am already out of time. 

I apologize. 

Mr. HUGHES. I am going to try to talk a little bit about the Premium Capture Account and what is it, and I am going to try and 

oversimplify what we believed happened and particularly on the 

residential side. 

On the residential side, there was basically two different types 

of structures that were used. On the prime side, basically, your 

credit protection, you issued $500,000 in mortgages—$500,000 in 

mortgages went in the pool, $500,000 securities went out. The protection to the top securities were a series of bonds that were underneath that security. In those deals, there was a time where the 

AAA—the mortgage may be 5 percent and AAA says, if I have all 

the subordination, all I need is 4 percent. So that different security 

there was called an IO. That IO is a senior security in the structure, has nothing to do with subordination. 

We move over to a subprime structure. Subprime structures, you 

could have a mortgage rate of seven and you could have the same 

pass through as four. The structures were designed, well, why do 

we not capture some of that excess spread and use that to pay 

down AAA mortgages, and actually what it is, it is subordination. 

So what happened in some of the subprime deals during the crisis, 

that subordination left really early. People pulled out the IO. And 

by the IO leaving early, you pulled the bottom out of the structure. 

So that was one thing. 

What happened was the rules are written that if you have any 

IO in a deal, and this includes on the commercial side, even though 

it is not used for credit support, you have to put it down on the 

bottom of the structure and use it as credit support. It is very, very 

inefficient in that spot. 

Securitization is about maximizing proceeds. You are going to 

maximize the proceeds for that IO for a buyer that just wants a 

senior security, that has to worry about prepayment, if asked to 

work credit, it is worth a lot less. That was one that gets recaptured. 

The second one really relates to a concept of, hey, at the time of 

securitization, the proceeds were 102. The two must be profit. The 

profit goes down at the bottom and that has to be recaptured. And 

the basic theory was it was a measurement against the fair value 

of the securities. What it failed to do, and the conceptual thing is 

if we bought loans at 100 and spreads tighten, interest rate move, 

and they are worth 102, all that matters at the time of exchange 

of the securitization entry, that the fair value of everything is even 

and we hold 5 percent of 102. If we want to say, you cannot make 

any profits, you know, it is the American way. If there is no profit 

incentive for this, there is not going to be an opportunity to 

securitize. 

What is really, really, really important is at the time we 

securitize, what I would say, the pot is right. We brought over 

loans worth 102. Securities went out that was 102. We held 5 percent. I think if you did it on that basis and said, for a prime side, 

take out premium recapture for the IO, did it on a fair value basis, 

I think on the prime side, the problems go away. 

20 

Senator CRAPO. Thank you. 

And Professor, I am way over time, so maybe—— 

Mr. SCHWARCZ. Ten seconds, if I may? 

Chairman REED. Ten seconds. 

Mr. SCHWARCZ. OK. I just wanted to point out very briefly that 

even if we had perfect levels of risk retention, it would not be a 

panacea. There would still be a mutual misinformation potential. 

For example, in the recent crisis, firms like Citi, Merrill, took huge 

amounts of the lowest rated securities on their books in underwriting because they felt these would be very profitable. This can 

potentially mislead senior investors into investing. So we just need 

to have that caution. Thank you. 

Senator CRAPO. Thank you. 

Chairman REED. Thank you. 

Let me recognize Senator Hagan. 

Senator HAGAN. Thank you, Mr. Chairman. 

Mr. Hughes, I wanted to follow up on Senator Reed’s earlier 

question having to do with the good underwriting question. Can 

you explain in more detail what you mean when you say seconds 

and why are these such a big problem? 

Mr. HUGHES. Yes. So when a—in a securitization entity, you will 

buy the underlying loans based on the information that you have 

at that point in time. So you will evaluate, there is 20 percent 

down. That goes into your modeling. And from that, you can evaluate a risk of loss. 

To the extent that after the fact a borrower can go out the next 

day and get a second from a different lender and take out 15 percent or 20 percent, which is what happened in the crisis, and basically day two, you have no money in the deal, the risk to me as 

the initial acquirer when I thought it was 80, the risk profile of 

that borrower has changed. 

So what we think is there should be something to check to—we 

have a couple different ways it could happen—so that the borrower 

retains whatever the level is, their skin in the game. 

Senator HAGAN. Thank you. Mr. Schwarcz, setting aside the 

question of the extent to which the originate to distribute model 

caused mortgage underwriting standards to fall, I wanted to ask 

you about the incentives in portfolio lending versus securitization. 

It is my understanding that across-the-board risk retention requirement, one where the securitizers retain a fixed percentage of 

all pools, may encourage originators who are also portfolio lenders 

to adversely select loans for securitization. 

My question is, if an originator makes a marginal loan and has 

a choice to put it into a securitization with a 5-percent risk retention or hold it with a 100-percent risk retention, what is the lender 

likely to do? It would seem to me that the loan would go into the 

securitization. 

Mr. SCHWARCZ. On those facts, I would agree with you entirely, 

and I think that, you know, that is another potential reason that 

risk retention is not a panacea. We need to really better enable the 

investors to understand what it is they are buying and to resist the 

impulse to buy because others are buying, and I am not sure that 

the answers to do that are easy. And at the end of the day, I think 

it is going to be imperfect. 

21 

We are never going to be able to set up a precise system, and 

that, I think, is part of the reason why I would argue that in addition to trying to regulate on an ex ante basis, that is, to prevent 

failures from happening, which is very important, we need to also 

be aware that there will be failures and we need to try to understand how to address them. 

Senator HAGAN. Well, in the case of across-the-board risk retention standard, would you expect participants to originate to one 

standard for their portfolio loans and then another standard for the 

securitization? 

Mr. SCHWARCZ. If you have across-the-board, you mean acrossthe-board in securitization? 

Senator HAGAN. Mm-hmm. 

Mr. SCHWARCZ. I think that depends on what the market will require. It is hard to say. I think it depends on the facts. I could not 

answer that in the vacuum. 

Senator HAGAN. Does the QRM standard create incentives to 

originate to a higher standard, and if a loan could be securitized 

with a 5-percent risk retention or a zero-percent risk retention, it 

seems that the exempt loan would be the preference. 

Mr. SCHWARCZ. Well, yes, I agree with that. The Qualified Residential Mortgage standard, of course, is not yet worked out as to 

exactly what it would be, so I am not sure I—I am not sure I could 

fully answer that question. I would maybe defer that to some of my 

other colleagues on the panel. 

Ms. PENDERGAST. If I may answer the question regarding portfolio lending versus securitization lending, for example, in the commercial real estate market, traditionally, the components are life 

companies, banks, and CMBS lenders. Traditionally, the portfolio 

lenders would take, particularly the life companies would focus on 

the larger assets and the larger markets, leaving the smaller loans, 

smaller markets to the securitization business. 

Just because you have a market that is not sort of the top ten 

in the country, you still can underwrite a loan that makes sense, 

and I think that has always been the way in which the CMBS market has worked initially. The average loan size for CMBS is $8 million, whereas I think if you were to look at a life company portfolio, 

that average loan size is somewhere, you know, $50, $60, $75 million and upward. So there is a distinction between the two. 

The one thing, also, I would say about the qualifying mortgage, 

within CRE, it seems to me there are 33 criteria for becoming a 

qualified mortgage, and, frankly, some of the criteria are things 

that have never been seen in the commercial real estate lending 

world. So we calculate at about a half of 1 percent of the loans that 

are outstanding currently in the CRE universe would qualify for an 

exemption. And what is ironic to me is that I hear from my colleagues that in the residential space, that that number is closer to 

10 to 20 percent. And when you look at the delinquency rates between the two markets, that is just nonsensical. 

Mr. DEUTSCH. Senator Hagan, if I could come back to your question about the QRM and its current definition, the way it is proposed right now is—and the regulators were very clear about this 

in their proposal—is that, currently, only approximately 19 percent 

of the loans that Fannie and Freddie guarantee right now would 

22 

be eligible for the QRM. So if you are a portfolio lender and you 

originate, or if you are a bank and you originate a loan right now 

that would be eligible for the proposed QRM standard, you would 

sell that immediately to the GSEs. So the QRM standard, an exemption, right now would never, ever be used because those loans 

will be passed along to Fannie and Freddie. 

So a core question as part of this debate is as long as we have 

this QRM that is much, much smaller than the definition of a conforming loan that you can sell to the GSEs, we are not going to use 

this exemption. All those loans will just go to Fannie and Freddie 

and it will continue, I think, as Marty indicated, an inability for 

the private sector to get into the market and to be able to 

securitize these loans and bring credit back because the GSEs effectively hog the space. 

Senator HAGAN. I was up with Senator Isakson and Senator 

Landrieu to try to craft the QRM so that it was available to more, 

to be sure that we did not subject so many people not to have the 

opportunity to go out and get that first home. 

Thank you, Mr. Chairman. 

Chairman REED. Thank you. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman. It has been a great 

hearing and great witnesses, and I thank all of you for being here. 

Mr. Hughes, on the second mortgage issue, it has been a fascinating issue, I think, throughout this whole process. And I guess 

in many cases a second mortgage holder is actually the servicer of 

the loan, too. Is that correct? 

Mr. HUGHES. Certainly over the last few years they have been 

the primary—— 

Senator CORKER. And so what you have is you have the primary 

lender and you have the investors out there, and then you have the 

servicer who is benefiting from servicing the loan who makes this 

second mortgage, and so there is a conflict that is created there. 

Is that correct? 

Mr. HUGHES. Correct. 

Senator CORKER. And then I guess the way our laws are now 

written on bankruptcy and that type of thing, they have the ability 

to continue to have their second mortgage, which is of lower priority, continue to be paid while the first mortgage is not being paid. 

Is that correct? 

Mr. HUGHES. Correct. 

Senator CORKER. Would it be reasonable to say that we ought to 

revisit that whole priority situation and have that corrected? 

Mr. HUGHES. I think revisiting seconds and priorities needs 

work. 

Senator CORKER. And you would actually advocate changing 

bankruptcy laws to allow for a different type of seniority. Is that 

correct? 

Mr. HUGHES. What we would recommend is just putting controls 

up front from—allowing borrowers to take them out but have the 

amount that you go out set to a limit. You could either have—in 

other forms of lending, two things happen when you take out a second, if you are in corporate, if you are in commercial, whatever, 

23 

that basically the first says I feel OK, you can take out a second. 

That is probably unreasonable in a residential situation. 

A second thing—we will go back to our example. We started out 

with an 80-percent loan to value that potentially you can get to a 

point in time where, based on a new appraisal, 80 has come down 

to 70, that you can go back to 80 percent. 

Senator CORKER. Let me ask you this. You know, during the risk 

retention debate, there was a lot of concern about the fact that 

with risk retention at 5 percent, or whatever the number was going 

to be, it was basically going to shut the market down, that there 

were not people out there that had the ability to reserve or keep 

that risk, and in essence securitization, which is, you know, to efficiently allocate capital and to spread it around, was going to shut 

down. And yet you found a way for that not to be the case. 

What do you do as it relates to your balance sheet and reserving 

that 5-percent risk? 

Mr. HUGHES. Basically, we are agnostic to consolidating, so we 

are not a bank, so we are not subject to capital requirements, so 

we just put it on the balance sheet and show the assets and liabilities. 

Furthermore, I mean, we are—— 

Senator CORKER. So you do not really—you just keep it—— 

Mr. HUGHES. We just keep it. 

Senator CORKER. But you do not really have to reserve. 

Mr. HUGHES. No. 

Senator CORKER. So really—— 

Mr. HUGHES. So what we would have to do is reserve for the 

loans over time since we have both—the reserve. 

Senator CORKER. So when an investor is buying these bonds and 

you have kept 5 percent, what are they really getting from you? 

Mr. HUGHES. From us in the way we hold it, which is horizontal, 

if—— 

Senator CORKER. And walk through the horizontal versus 

vertical. I think that would be enlightening for everybody. 

Mr. HUGHES. OK. And I am going to make a—just to make the 

math easy, if you had 100 million of loans and the subordination 

level below AAA was 10 percent, 90 percent was AAA. To the extent that you held vertical, and let us say on that pool, what you 

would be holding, you would be holding—of your skin in the game, 

1 percent effectively would be in that bottom tier, and the top 

would be—the balance would be sitting in the top, such that if 

there was, you know, in that pool there was 5 percent of losses or 

$5 million, you would only share in 5 percent of the $5 million. So 

there is very little teeth when you hold it in terms of actual loss 

that you would sustain. 

To the extent that you held it horizontally, 5 percent on the bot- tom, and that same pool had $5 million of losses, all $5 million 

losses would be borne by someone like Redwood Trust or a sponsor 

on the bottom holding horizontal. 

Senator CORKER. And you are holding horizontal. 

Mr. HUGHES. We are holding horizontal. It is part of our—— 

Senator CORKER. You are really keeping the risk. 

Mr. HUGHES. We are keeping the risk because it is part of our 

business model to sell to you on the top so that you would—the 

24 

reason you should feel comfortable about buying our deal is because we are down below you. Right on the bleeding edge is where 

we are going to have it. 

Senator CORKER. And so, but the person who is buying the bonds 

does not really know that you have reserved against it. I mean, 

they are just hoping Redwood has the ability to step up in the 

event that occurs. Is that correct? 

Mr. HUGHES. Well, what we are doing, remember, at closing, you 

know, in our deals, we are essentially completely funding those 

deals day one, so there is no insurance, there is nothing to come 

later on. So we will, again, back to that $100 million, we will buy 

those bonds on the bottom, so they will be completely funded—we 

contributed by putting $100 million of loans in the deal. 

Senator CORKER. Interesting. 

Mr. HUGHES. And we are going to leave 5 percent—— 

Senator CORKER. Interesting. Yes, that is good. 

So let me ask you this—that actually is very interesting. Walk 

me through how we get from where we are with the GSEs and, you 

know, you transition over from them to the private market. I mean, 

there are several—there is, you know, three different models we 

have heard about. One is, you know, basically you start tranching 

down the upper limit of loans to get down to a level where basically 

the private sector is coming back on the jumbo side in the beginning and then walking down. The other piece is basically going 

from 100-percent guarantee to 90, to 80, to 70. And another piece 

is basically letting the very best loans today go out into the private 

market and start working it that way. 

What is the best way to transition, in your opinion, from where 

we are today at 90 percent Government-guarantees loans to 100- 

percent private sector loans? How do we do that? 

Mr. HUGHES. I think probably the best first step is to allow the 

loan limits to come down and to test to see what happens, because 

I think if we wait—I think one of the things they are waiting 

for—— 

Senator CORKER. So the guys like you would come in behind as 

those loan limits come down. 

Mr. HUGHES. We will come—I think the gap will get filled. I 

know many think it is going to be if you go down to 625, there is 

going to be this breach, and it is going to go way down. Who is 

going to step in that breach? It is going to be the same people that 

are doing 729. The banks. They are just going to move down, and 

pricing today, you know, in that sector is probably 30 to 40 basis 

points higher than it is. So I would think the first logical test 

would be to bring that down. 

The second logical test would be why don’t we bring up guarantee fees to more of a market rate to allow the private sector to 

do it. Then you can slowly and gradually measure to figure out is 

it there. But, I mean, we keep running into this scare-mongering, 

it cannot happen. This thing, it is going to be 300 basis points. Test 

it on a safe basis to see where we come out. 

I would think waiting until we have co-ops together and all other 

stuff is years off in trying to do that. So find ways through private 

capital to begin the process of bringing private capital in and moving back, you know, the Government to more of a reinsurance posiVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
25 

tion. And I believe private capital will come in to take that position. 

Senator CORKER. Ms. Pendergast, as the CMBS market is kind 

of is where it is and you have got all these rulemakings that are 

taking place, what do you do today when you are actually doing a 

CMBS? I mean, how do you know what the rules are going to be? 

Do you do it based on the rules as they exist today? How does one 

go out and actually do a securitization today when the rules are 

changing? 

Ms. PENDERGAST. Carefully. It is a time when those who are 

lending, I think to the good, the CMBS secondary market has stabilized, so you have a sense of where bonds will clear in the market, and that is important, and that is testament to the fact that 

there has been some significant recovery in our sector. 

As far as, though, the large banks I think are out there lending, 

and that is a good thing. However, this is a market that is going 

to need more than just the five or six largest banks in the country 

focused on CMBS lending. So the smaller banks, those that are 

nonbank institutions that are lending, I think are quite concerned 

about how you originate a loan today, not knowing exactly how 

that execution is going to take place, you know, between now and 

2013 when the rules actually take effect. 

That is certainly a concern that I have, this sort of lag period between we are now, you know, formulating the rules but, in fact, 

they do not take effect until 2013. How do you originate during 

that time period? So it is important that as soon as possible we 

get—you know, there is clarity as to how these rules are going to 

work for the CMBS market and for other securitization markets as 

well. 

Mr. DEUTSCH. Senator Corker, if I could add, I think one of the 

key concerns of the market right now is they are looking toward 

complying with these future rules. The banks right now, insured 

depository institutions, are being asked to comply with a different 

set of rules from the FDIC’s securitization safe harbor. So areas 

around risk retention, they now have to comply with those FDIC 

safe harbor rules, which those rules right now that the FDIC just 

implemented last year, are very different than what the current 

proposals are right now. And I think that is creating a real challenge for banks to try to have to create one system now, but then 

have to totally overhaul that system once they know what these 

new final rules are. 

Senator CORKER. I would like to keep going, but I know I am 

overstepping, so I will let you go ahead and then I will come back. 

Chairman REED. Thank you very much. 

One of the issues that Senator Corker’s line of questioning raised 

was we have seen the asset-backed securities markets in automobiles and other areas come back rather—if not robustly, at least 

come back. We have not seen that in housing, and the implication, 

at least—and I think it should be made explicit—is that a lot of 

this is not—some of it is related to the uncertainty with respect to 

these rules, but a lot of it is related to the role the GSEs are playing in terms of their guaranteeing fees, below market rate, as you 

suggest, the fact that they can insure or guarantee to a significant 

amount now that is going to come down. And I wondered, Mr. 

26 

Hughes, your estimate of—is that really what is holding back the 

private market now? Or is it more this issue of what will the rules 

be in 2013? 

Mr. HUGHES. Yes. So if you were to look at the market in 2010 

in terms of, you know, the pieces of it, and actually the amount of 

loans under 417, the old GSE rate, is 90 percent. So if you went 

down to—rolled it back to 417, it would be 90 percent. So they are 

financing now—the additional amount between 417 and 729 is another 5 percent. So the amount that is really only available for people like Redwood is the top 5, and it is even less than that. And 

the reason it is even less than that for an outside securitizer is if 

you look at the executions, you know, for a bank today, if you are 

awash in liquidity you can sell 90 percent into a Government bid. 

You are sitting on excess cash. You know, a 4- or 5-percent mortgage sounds pretty good, then trading it over for, you know, 25 

basis points or something else, so they are retaining it. 

So there really is not any financial incentive in the system to get 

it going. So that, you know, investors, there is really nothing to 

kind of put together. 

Chairman REED. But let me follow—when we begin this process—you suggested, I think, the first step obviously is lowering the 

maximum amount that can be guaranteed. When we start doing 

that, you expect the private market to come in. And I guess the 

question that is before us today, we have got to get these rules 

right. But the biggest thing at the moment, macroissue, is just the 

sheer presence of GSEs in the marketplace. 

Mr. HUGHES. Correct. And even if it did come back to 629, I 

think the amount that it would probably add out there, about 3 

percent is all I think it would come down to, when you come down, 

because 5 percent was 417 to 729, so for all the—again, the fear 

if we go down you are going to take away what is outside the 

GSEs’ reach, about 2 percent. 

Chairman REED. Ms. Pendergast, the issue of reproposal presumes that very little of your—you do not feel that your comments 

will be adhered to, because I presume you have made numerous 

comments in this process. Not you personally but the industry. But 

can you just give me an idea of why a reproposal in your view is 

necessary since the final rules have not been proposed, as I presume, that you will also have a situation where the implementation 

will not be until 2013, so that seems to suggest that there will be 

a time even to adjust the rules if they are proposed. 

Ms. PENDERGAST. Yes, I think—— 

Chairman REED. Could you put it on, please? 

Ms. PENDERGAST. I think the concern is that there is a lack of 

clarity as to what some of the proposed rules are suggesting, and 

I think that is one of the things that, yes, we can comment on the 

rules as they stand today, but we are not sure exactly what we are 

commenting on. 

For example, the premium capture cash reserve account, the reserve account, is something that we have been discussing with regulators, and yet it is still not clear specifically what the intent was 

of that particular provision. What we do know is that, as written, 

it does take substantially all of the economic incentives to be involved in this sector out of the market. But in conversations what 

27 

we have learned is that we think that it is much more akin to 

wanting 5 percent of the proceeds, not 5 percent of par value. So 

real 5 percent skin in the game. 

Chairman REED. But you have made that point—as you are making it today very well, that is why I think this hearing is very useful and very important. You have made that point as clear as you 

can to the bill writers. 

Ms. PENDERGAST. Correct, but it is not 100 percent clear to us 

that that is the only component of the premium capture cash reserve account. 

Chairman REED. Thank you. 

Mr. Katopis, you have made some interesting comments with respect to the investors about standardization, transparency, and 

also the need for servicers—and I think Mr. Hughes made similar 

comments—to be much more flexible in terms of dealing with mortgages. Can you elaborate on that? Because, frankly, from our different perspectives, that is, trying to get a bottom under this foreclosure problem, we have been at least figuratively banging our 

heads against the issue of services, their incentives, their relationships, as you alluded to, to some of their affiliates, et cetera. So I 

would benefit from your comments. 

Mr. KATOPIS. Thank you, Senator. I could go on for a long time 

about this, but in brief—— 

Chairman REED. You have 1.2 minutes. 

[Laughter.] 

Mr. KATOPIS. I will do my best to explain again and refer you to 

the written statement that we share the frustration that many consumers have regarding servicers, improper servicing standards. 

The servicing model was not designed for the default rates we have 

today. We urge you to take a look at the potential conflicts of interest. When servicers own seconds, stand in the way of modifications, 

and one of the things I do is try to debunk the urban myth that 

mortgage investors, as first lien holders, try to block modifications, 

just go on the record again, we would like to see responsible although distressed homeowners stay in their homes. We would like 

to work with them on the modification process. We think there are 

benefits for the homeowners, for investors, and communities 

through that. And I refer you again to our written statement and 

our ten points in the white paper. 

Chairman REED. Have you communicated these concerns particularly about servicers to the Federal Reserve and the OCC who regulate most of the servicers? 

Mr. KATOPIS. In December, we reached out to regulators in support of national servicing standards, and we have also communicated our concerns to the CFPB and the State Attorneys General. 

Chairman REED. And have you gotten any feedback or any sense 

of your getting traction or not? 

Mr. KATOPIS. I think there is widespread acknowledgment of 

some of the defects of the current servicing model and the abuses 

that are going on. We await further action on that. 

Chairman REED. I am similarly positioned. 

Senator Corker, do you want to—— 

Senator CORKER. Thank you, Mr. Chairman. We happen to be 

crafting some legislation to deal with much of what Chris just 

28 

talked about, and maybe we could join together to do that. Talk to 

us a little bit, Chris, about what the HAMP program actually did 

as it relates to mortgage investors and their levels of trust, if you 

will. 

Mr. KATOPIS. Well, thank you, Senator, for your question. I will 

say that we believe that HAMP was very well intentioned as a remedial tool. Certainly it is the view of mortgage investors that if 

there is a way to properly construct a modification and keep people 

in their home, paying a mortgage on a monthly basis, where they 

had the ability and the willingness, this would be a good thing. 

We have commented and shared our comments with the Administration that we think there were some defects to some of the 

structures regarding HAMP, and, therefore, it was not as successful as originally intended, and the evidence bears this out. 

I think the most important thing to remember about this or any 

other proprietary modification program is what is in the borrower’s 

best interest. And certainly the prompt resolution of their distressed situation is very important. If you keep someone in the 

home for 400 or 500 more days, their situation will deteriorate, 

their credit will deteriorate. There are a lot of problems. So we 

think there were concrete observations we had about the defects of 

the HAMP program. They were not necessarily acted upon, and we 

hope that remedial programs will try to speed a distressed homeowner to a better solution, whether it is a rental situation or a 

modification, as quickly as possible. 

Senator CORKER. Mr. Hughes, on the risk retention piece, you 

talked about how you all are handling that. Are there stipulations 

right now by regulators as to whether that risk has to be vertical 

or horizontal? Or is that just something you have chosen to do? 

Mr. HUGHES. There are actually four options right now, and it 

is just the risk—the way we have chosen it as part of our business 

model, and we have been trying to convince—and what we have 

been battling against has been in a subprime structure where we 

talked before, there was—down the bottom there was interest, 

principal, and other than as opposed to prime you had straight 

bonds. You cannot make more than the face amount of bonds. On 

the subprime you could make a lot of money. 

So in addition, when they wrote risk retention—so we have been 

pounding the table to at least have the option for horizontal and 

let others decide what they want to do—is when it was written for 

horizontal is we cannot get any of our money out until the end of 

the deal, so 10 years down the road. So even if tests are made, 

even if your cash is flowing, even those the bonds are paying down, 

they want to totally block it out. So, unfortunately, what we would 

do today, if the rules were adopted, because it is to penal for doing 

that, and it is really not penal to all that hold vertical, we would 

hold vertical to check the box and say, OK, we did it, and then we 

will just hold the bottom and not have the restrictions against allowing us to cash-flow in a proper way on the bottom of the structure. 

So I am hopeful that maybe, you know, our conversations as well 

with regulators, that when it gets out, if it is the best forum, is 

that it is not as penal as it is laid out today. 

29 

Mr. DEUTSCH. Senator Corker, if I could add about a bank structure versus a REIT structure, I think Marty’s structure has a certain—the corporate structure has a certain availability to be able 

to withstand that risk, but not have the accounting and regulatory 

capital implications associated with it. 

One challenge with the horizontal risk retention proposal—and 

certainly I think for an institution like Redwood Trust, it makes a 

lot of sense and there is a lot of strong arguments why that can 

better align retention and incentives. One of the core issues, 

though, is that for a bank that would also service these loans, if 

they hold a horizontal risk retention and they service the loans, 

they will have to consolidate that transaction under FAS 166 and 

167. The regulatory capital—— 

Senator CORKER. The entire face value of—— 

Mr. DEUTSCH. The entire face value. So they are only holding 5 

percent of the—— 

Senator CORKER. That cannot last very long, can it? 

Mr. DEUTSCH. It will mean no bank will securitize, because you 

cannot hold 5 percent of the risk but then hold regulatory capital 

for 100 percent of the transaction. It is a quixotic outcome of the 

new FAS 166 and 167 rules and the regulatory capital rules. We 

have long been very concerned about how those regulatory capital 

rules were developed. But that is—unless you can get the regulators or FASB to change those rules, we have to take that as a 

given. And if the regulators would only require a horizontal risk retention, banks would not have an ability to securitize because of 

those rules. 

Senator CORKER. And is there a sense that that issue is being resolved? 

Mr. DEUTSCH. I think the proposals that allow both—either a 

vertical or horizontal or even a L-shaped form would allow banks 

to hold a vertical slice and also service. The complicating factor, 

though, now is this premium cash capture reserve account that effectively is additional risk retention, which could also trigger—even 

if you are holding a vertical slice, could also trigger a consolidation. 

And there was no accounting or discussion within the proposed 

rules about what the accounting considerations would be. 

So that is, again, another reason to make sure that we get these 

rules right in a reproposal to know and fully understand the accounting implications. 

Senator CORKER. On the residential mortgage end, you know, we 

talked—I think all of us were shocked, really, when the crisis hit 

to find out that recourse loans almost did not exist anymore. I foolishly, when they used to have those kind of things, had recourse 

loans and I did not realize that was not the standard. How much 

does the borrower being recourse against the debt matter anymore 

in America? Is that something that people care about anymore? I 

will ask you, Mr. Hughes, since you securitize them. 

Mr. HUGHES. It matters to investors, so from our standpoint— 

and we put a whole book together on what we think best practices 

are. You know, we think borrowers should absolutely, positively be 

protected, but they also need—we need to be protected from actions 

that they would do. I mean—— 

30 

Senator CORKER. So in the loans that you make, the borrowers 

are, in fact, fully recourse? 

Mr. HUGHES. In the loans that we have here? 

Senator CORKER. Yes. 

Mr. HUGHES. Well, it depends State by State on what actual actions you can do and where it goes back to. But, yes, I think one 

of the things that we had recommended at some point in time, to 

the extent that strategic defaults need to be addressed, and one 

way to address strategic defaults is through deficiency judgments 

after the fact, as well as looking at seconds. So we are not looking 

to do anything harmful to borrowers. All we want to do is just get 

to a point where you cannot just either change—significantly 

change your risk profile from when a securitizer—from when an investor bought your loan, or you cannot just throw the keys on the 

table and say, you know, I signed something, I am not happy with 

what I signed. 

Senator CORKER. Chris. 

Mr. KATOPIS. Just very briefly, I would point out that whereas 

there has not been an RMBS securitization with the exception of 

the Redwood Trust’s over the last few years, the Redwood Trust 

loans, from what I understand, are immaculate. And, you know, in 

the absence of having these immaculate loans, we would point out 

the things that we identify in our testimony. You need certainty, 

transparency, recourse, removing conflicts of interest. Those are 

the things that will bring private capital back into the market. It 

is not simply pulling a switch on the GSEs, but the things that we 

enumerate in our testimony. 

Senator CORKER. Mr. Chairman, it has been a good hearing. I do 

not want to sour grape—yes, I am sorry. Thank you. 

Ms. RUTLEDGE. After listening to the complexity of your 

world—— 

Chairman REED. Can you turn on your microphone? [dropped.] 

Ms. RUTLEDGE. Sorry. After listening to the complexity of your 

world, I think our quantitative world is rather simple, and I would 

like to just comment a little bit on what Mr. Hughes said about the 

vertical slice versus the horizontal slice. 

In the 1980s, the way that we looked at securitization was, simplistically, if an investor in the senior tranche has five times coverage over the expected loss, that defines AAA. We have moved on 

from that standard, but let us use it for the moment. Suppose that 

the vertical slice—sorry, the horizontal slide is 5 percent, which 

Redwood Trust is holding at the bottom of the capital structure, 

and the expected loss is 50 basis points, that is ten times coverage. 

Now, what happens is as those 50 basis points of expected loss 

materialize (if loss is indeed 50 bps) and the loss amortizes: Redwood takes the loss. And as that extra is applied against the loss, 

the rating factor goes from 10 to 20 times, 100 times, an infinite 

number of times. The securities at the top of the capital structure 

become so safe, they are bulletproof. 

What I have just described is the model that worked for 20 years. 

I am not advocating a five times coverage scale but pointing out 

two things. First, a vertical slice does not absorb risk. A horizontal 

slice does. That is risk retention. The second thing is that if you 

mandate a 5-percent risk retention, you are inviting the industry 

31 

to originate loans with a 5-percent loss because that is economically efficient. 

The market risk solution cannot be structural solutions per se. 

There has to be an ability to monitor how the losses are performing 

and how the securities are performing. And if you have that transparency, you will motivate proper behavior. That is a much simpler 

model. 

Senator CORKER. I would like to follow up. IF I could say just one 

thing, when this bill was passed, about a week later the Financial 

Times had an analysis, and basically it said so many pages, so little content. And I think there is something for us to learn. You 

know, basically we punted to regulators at a time when we wanted 

clarity in the markets. We kept saying we needed to pass a bill for 

clarity in the markets, and from what I can tell, we have created 

years of lack of clarity, and basically all of us up here which create 

laws hoping—hoping the regulators will do the right thing under 

time frames that are unrealistic. I think everybody who has been 

in here in the industry believes that rulemaking time frames are 

unrealistic, and a lot of rules are being made that are inappropriate. 

Anyway, I have learned a lot from this, and I appreciate very 

much you having the hearing, and certainly all the witnesses being 

here. 

Chairman REED. Well, thank you, Senator Corker, and I think 

we have all learned a great deal from this, and I think it is an ongoing education. So I will just make everyone aware that some of 

my colleagues might have questions which they will formally submit to you, and I would ask that all those questions be in by Friday, and that you would respond as quickly as possible, hopefully 

within 2 weeks or less. 

But thank you. It has been a very thoughtful, insightful hearing 

on a very complicated topic. I was thinking, as Senator Corker 

talked, about the process of making legislation. I do not think I 

would have wanted to be at 4 o’clock in the morning trying to figure out the retained risk premium issue to the specificity that the 

Federal Reserve must—hopefully they will do it at least in the middle of the day with a much more sort of tranquil environment. 

Senator CORKER. Yes, I think we could have given, though, a lot 

more direction, and I do not think we delved into the issues of horizontal versus vertical. 

Chairman REED. You are absolutely right. 

Senator CORKER. Risk retention sounded like it as an idea that 

kind of, oh, boy, let us have risk retention, that will make it all 

work. And it was more of an idea than a well thought through concept, and I think that is why we are having these problems. 

Chairman REED. Well, in addition to that, it was an idea which, 

you know, had many fathers and mothers. I know there were 

amendments made, et cetera, the nature of the process. Some of 

them have been improvements, I think Senator Crapo’s amendment. I think what Senator Hagan did was very, very helpful in 

terms of qualifying it. But now we are at the point the reality is 

that this is something that the regulators have to address thoughtfully, thoroughly, and the point I hope is that they have listened 

carefully to what you have said, as we have, because you have 

32 

made some excellent points about how we create a better system 

that is more transparent, more predictable, and less prone to collapse. 

So thank you all very much. Thank you, Senator Corker. The 

hearing is adjourned. 

[Whereupon, at 11:16 a.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions supplied for the record follow:] 

33 

1 E-mail: schwarcz@law.duke.edu; tel. 1-919-613-7060. 

2 Cf. Patric H. Hendershott and James D. Shilling, ‘‘The Impact of the Agencies on Conventional Fixed-Rate Mortgage Yields’’, 2 J. Real Estate Fin. & Econ. 101 (1989) (finding that 

securitization of conforming fixed-rate mortgage loans significantly lowered interest rates on 

mortgage loans relative to what they would otherwise have been); C.F. Sirmans and John D. 

Benjamin, ‘‘Pricing Fixed Rate Mortgages: Some Empirical Evidence’’, 4 J. Fin. Services Research 191 (1990) (finding significantly lower interest rates on fixed rate mortgages that can be 

sold in the secondary market versus those that cannot). 3 Investment Company Act, Release No. 19105, [1992 Transfer Binder] Fed. Sec. L. Rep. 

(CCH) P 85,062, at 83,500 (Nov. 19, 1992) (provided in connection with the issuance of Rule 

3a-7 under the Investment Company Act of 1940). 4These figures are drawn from http://www.sifma.org/. 5See, e.g., http://www.ny.frb.org/markets/talflfaq.html; http://www.federalreserve.gov/ 

newsevents/monetary20081125a1.pdf. 

PREPARED STATEMENT OF STEVEN L. SCHWARCZ 

STANLEY A. STAR PROFESSOR OF LAW AND BUSINESS, DUKE UNIVERSITY SCHOOL OF

LAW1

MAY 18, 2011 

Introduction 

The securitization markets are very weak, as I’m sure the others testifying will 

report. This is unfortunate because securitization can be a major source of capital 

formation, yielding critical economic benefits. 

For example, securitization can significantly decrease the cost of corporate credit. 

By raising funds without having to borrow from a bank or other financial intermediary, companies avoid the intermediary’s profit mark-up. Furthermore, the interest rate paid by the company is ordinarily lower than the interest rate payable 

on corporate securities issued directly by the company. This interest-rate savings reflects that the mortgage loans and other ‘‘financial assets’’ being securitized are usually more creditworthy, and almost always easier to understand and value, than the 

company itself. For these reasons, securitization has become an important way for 

companies of all types to raise low-cost financing. 

Securitization is also the principal means by which banks and other lenders turn 

their loans into cash, thereby enabling them to continue making new loans. 

Securitization of residential mortgage loans, for example, has facilitated the expansion of home ownership by enabling banks to continue to lend money to homeowners. Many other forms of consumer and business credit are also securitized, including automobile loans, student loans, credit card balances, and equipment loans. 

Securitization can also reduce consumer costs. By expanding the ‘‘secondary’’ (i.e., 

trading) market in consumer loans, securitization lowers the interest rate that lenders charge on those loans. 2

By 1992, securitization had become so important to the American economy that 

the Securities and Exchange Commission observed that it was ‘‘becoming one of the 

dominant means of capital formation in the United States.’’ 3 Securitization continued its strong growth until the recent financial crisis, rising from $2.9 trillion in 

1996 to $11.8 trillion in 2008. 4 Even during the crisis, the Federal Reserve implemented a $200 billion Term Asset-Backed Securities Loan Facility (known as 

‘‘TALF’’) in order to keep the securitization markets running. This helped to assure 

‘‘the availability of credit to households and businesses of all sizes.’’ 5

Securitization’s Role in the Recent Financial Crisis 

The securitization of subprime mortgage loans—essentially mortgage loans made 

to risky borrowers—is widely viewed as a root cause of the financial crisis. The evil, 

however, was not securitization per se but a correlation of factors, some of which 

were not completely foreseeable. 

Securitization transactions were sometimes backed, at least in part, by subprime 

loans. Because home prices had generally been increasing in the United States since 

the Great Depression, the expectation was that continuing home-price appreciation 

would enable even risky borrowers to repay their loans by refinancing their houses. 

At the worst, many thought, the steep rise in housing prices might level out for 

some period of time, although at least one rating agency’s model assumed that 

prices could drop as much as 10 percent. Few predicted the complete collapse of 

housing prices. 

Many argue that the ‘‘originate-to-distribute’’ model of securitization, enabling 

mortgage lenders to sell off loans as they’re made, led to overreliance on the expectation of repayment through home-price appreciation. According to this argument, 

the originate-to-distribute model created moral hazard because lenders did not have 

34 

6These other explanations are bound up with the more important question, discussed in the 

next paragraph, of why nontraditional securitization transactions were structured in a way that 

even relatively small errors in cash flow projections could cause defaults and downgradings. 7 In most cases, the ‘‘securitizer’’ is the company itself or a financial institution that pools financial assets for eventual issuance of asset-backed securities. 

to live with the credit consequences of their loans. Loan origination standards therefore fell. 

There are other possible explanations of why subprime loans were made and 

securitized. 6 But whatever the explanation, the fall in home prices meant that 

subprime borrowers, who were relying on refinancing for loan repayment, could not 

refinance and began defaulting. The defaults had mostly localized consequences in 

traditional securitization transactions. But they had larger, systemic consequences 

in nontraditional transactions that involved complex and highly leveraged 

securitizations of asset-backed securities already issued in prior securitizations—effectively ‘‘securitizations of securitizations.’’ The resulting leverage caused relatively 

small errors in cash flow projections—due to the unexpectedly high default rates on 

underlying subprime loans—to create defaults on substantial amounts of ‘‘investment grade’’ rated subordinated classes of these securities, and to cause even the 

most highly rated classes of these securities to be downgraded. 

The important question is why those nontraditional securitization transactions 

were structured in a way that even relatively small errors in cash flow projections 

could cause defaults and downgradings. Although one answer is the widespread inconceivability of a housing-price collapse that could cause those errors, the full answer goes beyond that. Part of the answer may be that securitization’s focus on 

mathematical modeling to statistically predict the payments on financial assets underlying these complex securities fostered an overreliance on modeling and an abandonment of common sense. Yet another part of the answer may be that investors, 

who seemed as anxious to buy these superficially attractive securities as underwriters were to sell them, were overly complacent and eager to follow the herd of 

other investors. 

Whatever the reasons, these defaults and downgradings panicked investors, who 

believed that a ‘‘AAA’’ rating meant iron-clad safety and that an ‘‘investment grade’’ 

rating meant relative freedom from default. Investors started losing confidence in 

ratings and avoiding the debt markets. Fewer investors meant that the price of debt 

securities began falling. Falling prices meant that firms using debt securities as collateral had to mark them to market and put up cash, requiring the sale of more 

securities, which caused market prices to plummet further downward in a death spiral. With the failure of Lehman Brothers, investors lost all confidence in the debt 

markets. The lack of debt financing meant that companies could no longer grow and, 

in some cases, even survive. That affected the real economy and, at least in part, 

contributed to the financial crisis. 

The crisis was also arguably exacerbated by the fact that securitization made it 

difficult to work out problems with securitized mortgage loans. The beneficial owners of the loans were no longer the mortgage lenders, but a broad universe of investors in securities backed by these loans. Although servicers were tasked with the 

responsibility to restructure the underlying loans ‘‘in the best interests’’ of those investors, they were often reluctant to engage in restructurings when there was uncertainty that their costs would be reimbursed. Foreclosure costs, in contrast, were 

relatively minimal. Servicers also preferred foreclosure over restructuring because 

foreclosure was more ministerial and thus had lower litigation risk. As a result, 

foreclosure was artificially favored, forcing many homeowners from their homes and 

further driving down property values. 

Dodd-Frank’s Response 

The Dodd-Frank Act addresses securitization by focusing, essentially, on three 

issues: (i) adequacy of disclosure, (ii) conflicts between ‘‘securitizers’’ 7 and investors, 

and (iii) rating agency information. 

(i) Adequacy of Disclosure: The Dodd-Frank Act directs the SEC to require more 

standardized disclosure of information regarding the underlying financial assets, including information on the assets underlying each class of asset-backed securities. 

This disclosure requirement is intended to facilitate an easier comparison of classes. 

The Act also directs the SEC to require securitizers to engage in a due-diligence review of the underlying financial assets and to disclose to investors the nature of the 

review. 

(ii) Conflicts between Securitizers and Investors: The Act attempts to limit conflicts 

of interest between securitizers and investors by requiring securitizers, in transVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00038 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
35 

8The SEC and other governmental agencies are directed to collectively define what constitutes qualified residential mortgage loans, taking into account mortgage risk factors. DoddFrank Act §941(b). 9Dodd-Frank Act §941. 10 Cf. Peter J. Wallison, ‘‘The Lost Cause: The Failure of the Financial Crisis Inquiry Commission’’ (2011) (making that argument), http://www.aei.org/docLib/FSO-2011-02-g.pdf. 11For one explanation of why the ultimate beneficial owners did not observe those standards, 

see Steven L. Schwarcz, ‘‘Marginalizing Risk’’, 89 Washington University Law Review, forthcoming issue no. 3 (2012), available at http://ssrn.com/abstract=1721606. 12Dodd-Frank does mandate the Financial Services Oversight Council, however, to study and 

submit a report to Congress on the macroeconomic effects of the skin-in-the-game requirements, 

including possibly proactively regulating mortgage origination as an alternative or supplement. 

Dodd-Frank Act §946. 

actions that are not backed entirely by ‘‘qualified residential mortgage’’ loans, 8 to 

retain an unhedged economic interest in the credit risk of each class of asset-backed 

securities. 9 This is colloquially known as keeping ‘‘skin in the game.’’ The minimum 

retained interest is generally five percent, although it may be less if the financial 

assets meet quality standards to be announced by Government agencies. 

(iii) Rating Agency Information: Dodd-Frank also mandates the SEC to adopt regulations requiring rating agencies to explain, in any report accompanying an assetbacked securities credit rating, the representations, warranties, and other enforcement rights available to investors, including a comparison of how these rights differ 

from rights in similar transactions. 

Dodd-Frank Inadequately Addresses Securitization’s Flaws 

I believe that Dodd-Frank inadequately addresses securitization’s flaws. Although 

it addresses one of the flaws (or, at least, alleged flaws), it underregulates or fails 

to regulate other flaws and it overregulates by addressing aspects of securitization 

that are not flawed. 

A. Dodd-Frank Addresses One of Securitization’s Flaws 

Dodd-Frank addresses one of securitization’s flaws—or at least one of its alleged 

flaws. I mentioned that the originate-to-distribute model of securitization is believed 

to have fostered an undisciplined mortgage lending industry, including the making 

of subprime loans. The Dodd-Frank Act, as discussed, addresses the originate-to-distribute model by requiring securitizers to retain skin in the game, i.e., retaining a 

minimum risk of loss. The theory is that by aligning the incentives of securitizers 

and investors, the lending industry will become more disciplined. 

There remains a question, though, of the extent to which the originate-to-distribute model actually caused mortgage underwriting standards to fall. Some argue 

that standards fell because of Federal governmental pressure on banks and other 

mortgage lenders to make and securitize subprime mortgage loans to expand homeownership. 10 The fall in standards also may reflect distortions caused by the liquidity glut of that time, in which lenders competed aggressively for business; or it may 

also reflect conflicts of interest between lending firms and their employees in charge 

of setting lending standards, such as employees being paid for booking loans regardless of the loans’ long-term performance. Blaming the originate-to-distribute model 

for lower mortgage underwriting standards also does not explain why standards 

were not similarly lowered for originating nonmortgage financial assets used in 

other types of securitization transactions. Nor does it explain why the ultimate beneficial owners of the mortgage loans—the investors in the asset-backed securities— 

did not govern their investments by the same strict credit standards that they 

would observe but for the separation of origination and ownership. 11

The extent to which the originate-to-distribute model actually contributed to the 

financial crisis may never be known. If that model was not a significant causal factor, Dodd-Frank’s skin-in-the-game requirement may well constitute overregulation. 

This requirement also might, ironically, lull some investors into a false sense of security. In the financial crisis, for example, there is some evidence that investors purchased senior classes of asset-backed securities because underwriters retained the 

most subordinated interests—effectively creating a ‘‘mutual misinformation’’ problem. 12

B. Dodd-Frank Underregulates and Fails To Regulate Other Flaws 

Dodd-Frank underregulates, and in some cases fails to regulate, other flaws of 

securitization. The Act does not, for example, directly address the problem of overreliance on mathematical modeling. Mathematical models are not inherently problematic. If the model is realistic and the inputted data are reliable, models can yield 

accurate predictions of real events. But if the model is unrealistic or the inputted 

data are unreliable—as occurred when unexpectedly high default rates due to the 

36 

13 Cf. Steven L. Schwarcz and Gregory M. Sergi, ‘‘Bond Defaults and the Dilemma of the Indenture Trustee’’, 59 Alabama Law Review 1037 (2008) (arguing that this standard should apply 

to indenture trustee duties after default). 14See, Steven L. Schwarcz, ‘‘Conflicts and Financial Collapse: The Problem of Secondary-Management Agency Costs’’, 26 Yale Journal on Regulation 457 (2009), available at http:// 

ssrn.com/abstractlid=1322536; Steven L. Schwarcz, ‘‘Regulating Complexity in Financial Markets’’, 87 Washington University Law Review 211, 261–262 (2009/2010), available at http:// 

ssrn.com/abstract–id=1240863. 15See ‘‘Conflicts and Financial Collapse’’, supra note 14, at 468–469 (observing that regulation 

is needed because there is a collective-action problem). 

housing collapse undermined the value of some asset-backed securities—models can 

be misleading. 

To some extent this overreliance on mathematical models should be self-correcting 

because the financial crisis has shaken faith in the market’s ability to analyze and 

measure risk through models. In the long term, however, I fear that—as market experience has often shown—investor memories will shorten. 

Dodd-Frank also fails to address the complacency problem. I’m not sure, though, 

how effective regulation can be in changing human behavior. Market participants 

will probably always engage in herd behavior, for example, there being safety in 

numbers. And people will probably always invest in high-yielding securities they 

can’t understand if others are doing it. 

Dodd-Frank also does not address the servicing problem, but I find that less troublesome. Parties can—and in light of recent experience, should have incentives to— 

write underlying deal documentation that sets clearer and more flexible guidelines 

and more certain reimbursement procedures for loan restructuring, especially when 

restructuring appears to be superior to foreclosure. Parties can also minimize allocating cash flows to investors in ways that create conflicts. Furthermore, parties can 

agree, when appropriate, to subject servicers to—and regulation could also require— 

more realistic performance standards, perhaps akin to a business judgment rule 

that allows them to restructure loans in good faith without being exposed to liability. 13

C. Dodd-Frank Overregulates by Addressing Aspects of Securitization That Are Not 

Flawed 

Dodd-Frank overregulates by addressing some aspects of securitization that are 

not flawed. I have already indicated that the skin-in-the-game requirement might 

constitute overregulation. Dodd-Frank also requires securitizers to engage in a duediligence review of the underlying financial assets; but in my experience, that is already routinely done. 

Dodd-Frank also may overregulate in its requirements for more standardized disclosure of information. In principle it should be helpful for investors to get this information. My experience, however, is that prospectuses usually already provide 

much of this information, and that the larger problem is not absence of disclosure 

but the fact that investors don’t always read and understand the information already 

disclosed. 

There are at least two reasons for this failure. One reason is complacency, discussed above. The second reason is a conflict of interest within investing firms 

themselves. As investments become more complex, conflicts of interest are increasingly driven by short-term management compensation schemes, especially for technically sophisticated secondary managers. 14

For example, as the VaR, or value-at-risk, model for measuring investment-portfolio risk became more accepted, financial firms began compensating secondary 

managers not only for generating profits but also for generating profits with low 

risks, as measured by VaR. Secondary managers therefore turned to investment 

products with low VaR risk profile, like credit-defaults swaps that generate small 

gains but only rarely have losses. The managers knew, but did not always explain 

to their seniors, that any losses that might eventually occur could be huge. 

This is an intra-firm conflict, quite unlike the traditional focus of scholars and 

politicians on conflicts between managers and shareholders. Dodd-Frank attempts 

to fix the traditional type of conflict but completely ignores the problem of secondary-management conflicts. Regulation should also require that managers, including secondary managers, of financial institutions be compensated based more on 

long-term firm performance. 15

Dodd-Frank’s focus on disclosure may also be inherently insufficient. I have mentioned that investors don’t always read and understand the disclosure. Financial 

products, including some securitization products, are becoming so complex, however, 

37 

16See, e.g., Steven L. Schwarcz, ‘‘Disclosure’s Failure in the Subprime Mortgage Crisis’’, 2008 

Utah Law Review 1109 (arguing that disclosure is a necessary but insufficient response to complexity); Steven L. Schwarcz, ‘‘Rethinking the Disclosure Paradigm in a World of Complexity, 

2004’’, University of Illinois Law Review 1 (2004) (same). 17See Iman Anabtawi and Steven L. Schwarcz, ‘‘Regulating Systemic Risk’’, 86, Notre Dame 

Law Review, forthcoming issue no. 4 (Spring 2011), available at http://ssrn.com/ 

abstract=1670017. Dodd-Frank’s focus on standardizing more derivatives transactions is a special case because the goal is less standardization per se (in order to minimize investor due diligence) than to enable more derivatives to be cleared through clearinghouses, which generally 

require a high degree of standardization in the derivatives they clear. 18See generally Steven L. Schwarcz, ‘‘Ex Ante Versus Ex Post Approaches to Financial Regulation: The Chapman Dialogue Series and The Chapman Law Review Symposium Keynote Address’’, forthcoming in Chapman Law Review 2011 symposium issue on ‘‘The Future of Financial 

Regulation’’, available at http://ssrn.com/abstract=1748007. 19See Anabtawi & Schwarcz, supra note 17 (showing how buying securities at a deep discount 

will mitigate moral hazard and also make it likely that the market liquidity provider will be 

repaid). 20See id.; see also Marginalizing Risk, supra note 11. Ideally, any such fund should be international to avoid anticompetitively ‘‘taxing’’ financial institutions in any given jurisdiction. 21 Id. 22Dodd-Frank includes a provision for possible ex post funding of a systemic risk fund, but 

it is doubtful that any such fund could be created quickly enough to be effective. Financial institutions might even have difficulty providing such funding at the time of a systemic crisis. 

that disclosure can never lead to complete understanding. 16 On the other hand, it 

may well be counterproductive to try to limit complexity, such as requiring more 

standardization of financial products. Standardization can interfere with the ability 

of parties to achieve the efficiencies that arise when firms issue securities tailored 

to particular needs of investors. 17

Conclusions 

I have suggested certain regulatory responses to improve securitization, including 

the need to fix the intra-firm problem of secondary-management conflicts. Overall, 

however, there are no perfect regulatory solutions to the problems of securitization; 

and indeed those problems are not atypical of problems we will face in any innovative financial market—that increasing complexity coupled with human complacency, 

among other factors, will make failures virtually inevitable. Regulation must respond to this reality. 

To that end, it is important to put into place, before these failures occur, regulatory responses to failures that supplement regulatory restrictions intended to prevent failures. 18 The financial crisis has shown the increasing importance, for example, of financial (e.g., securities) markets and the need to protect them against the 

potential that investor panic artificially drives down market prices, becoming a selffulfilling prophecy. A possible regulatory response would be to create financial market stabilizers, such as a market liquidity provider of last resort that could act at 

the outset of a panic, profitably investing in securities at a deep discount from the 

market price and still providing a ‘‘floor’’ to how low the market will drop. 19

It also is important to provide incentives for financial institutions to try to minimize the impact of failures (externalities), and to absorb (i.e., ‘‘internalize’’) the cost 

when failures occur. This could be done, for example, by regulation requiring at 

least systemically important market participants to contribute to a risk fund, which 

could be used as a source of stabilization (such as by funding the financial market 

stabilizers referenced above). 20 Fund contributors would then be motivated not only 

to better monitor their own behavior but also to monitor the behavior of other financial institutions whose failures could deplete the fund (requiring contributors to pay 

in more). 21

The bill that would become the Dodd-Frank Act originally included the concept 

of a systemic risk resolution fund, to be sourced by large banks and other systemically important financial institutions and used as a possible bailout mechanism in 

lieu of taxpayer funds. The concept was dropped after some alleged it would increase moral hazard by institutionalizing bailouts. 22 Ironically, if structured properly, a systemic risk fund should actually have the opposite effect, minimizing moral 

hazard. 

We also need to see the big picture. Securitization has existed for decades and 

has generally worked well. Even during the recent crisis, almost all traditional 

securitization structures protected investors from major losses. Additionally, we 

need to keep in mind what investor protection—one focus of this hearing—means 

in the securitization context. Investors in securitization transactions are generally 

large and sophisticated financial institutions. One might question whether regulation should have the goal of protecting these types of investors, except in cases when 

38 

23See generally Steven L. Schwarcz, ‘‘Systemic Risk’’, 97 Georgetown Law Journal 193 (2008). 24See supra note 15 and accompanying text (observing that in order to resolve the problem 

of secondary-management conflicts, regulation will be needed to fix a collective-action problem). 

their failures can harm others, such as by triggering systemic consequences, 23 or 

when market failures can discourage these types of investors from adequately protecting themselves. 24

My comments focus primarily on creating an appropriate regulatory framework to 

help ensure long-term integrity of the securitization markets. I do not address how 

to quickly return depth and liquidity to securitization markets but trust that others 

testifying today, who are more intimately connected with the industry, will have 

proposals to that effect. Whatever the proposals, however, there may be relatively 

little need for securitization or other means of capital formation so long as lenders 

and companies sit on mounds of cash, reluctant to make loans and to invest in operations. 

Thank you. 

My testimony is based in part on the following sources, in addition to those already cited: 

The 2011 Diane Sanger Memorial Lecture—Protecting Investors in Securitization 

Transactions: Does Dodd-Frank Help, or Hurt?, available at Securities and Exchange Commission Historical Society virtual museum and archive, 

www.sechistorical.org. 

Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harvard 

Business Law Review Online (2011), forthcoming at http://hblr.org, also available 

at http://ssrn.com/abstract=1788336 (in its original form as the Keynote Speech 

at the George Mason University 2011 AGEP Advanced Policy Institute on Financial Services Regulation). 

The Conundrum of Covered Bonds, 66 The Business Lawyer (forthcoming issue no. 

3, May 2011), available at http://ssrn.com/abstract=1661018. 

The Future of Securitization, 41 Connecticut Law Review 1313 (2009) (symposium 

issue on the subprime crisis), available at http://ssrn.com/abstractlid=1300928. 

39 

PREPARED STATEMENT OF TOM DEUTSCH 

EXECUTIVE DIRECTOR, AMERICAN SECURITIZATION FORUM

MAY 18, 2011 

40 

41 

42 

43 

44 

45 

46 

47 

48 

49 

50 

51 

52 

53 

54 

55 

56 

57 

58 

59 

60 

61 

62 

63 

64 

65 

66 

67 

68 

69 

70 

71 

72 

73 

74 

75 

76 

77 

78 

79 

80 

81 

82 

83 

84 

85 

86 

87 

88 

89 

90 

91 

92 

93 

94 

95 

96 

97 

98 

99 

100 

101 

102 

103 

104 

105 

106 

107 

108 

109 

110 

111 

112 

113 

114 

115 

116 

117 

118 

119 

120 

121 

122 

123 

124 

125 

126 

127 

128 

129 

130 

131 

132 

133 

134 

135 

136 

137 

138 

139 

140 

141 

142 

143 

144 

145 

146 

147 

148 

149 

150 

151 

152 

153 

154 

155 

156 

157 

158 

159 

160 

161 

162 

163 

164 

165 

166 

167 

168 

169 

170 

171 

172 

173 

174 

175 

176 

177 

178 

179 

180 

181 

182 

183 

184 

185 

186 

187 

188 

189 

190 

191 

192 

193 

194 

195 

196 

1 2011 Mortgage Market Statistical Annual, Volume I , p. 19. 2Federal Reserve Flow of Funds of the United States, Fourth Quarter, Tables L.217 and 

L.218 

PREPARED STATEMENT OF MARTIN S. HUGHES 

PRESIDENT AND CHIEF EXECUTIVE OFFICER, REDWOOD TRUST, INC. 

MAY 18, 2011 

Introduction 

Good Morning, Chairman Reed, Ranking Member Crapo, and Members of the 

Committee. My name is Marty Hughes, and I am the CEO of Redwood Trust, Inc., 

a publicly traded company listed on the New York Stock Exchange. I appreciate the 

opportunity to testify on the state of the residential mortgage securitization market 

and look forward to responding to your questions. 

Overview 

My testimony is focused on restoring a fully functioning private-sector residential 

mortgage finance market. Currently, about 90 percent of all new mortgage originations rely on Government support. 1 Given the fact that there is $9.6 trillion of outstanding first lien mortgage debt, 2 this level of public subsidization is simply not 

sustainable. That being said, reducing the current level of governmental support, 

whether immediately or gradually over time, will have severe consequences for the 

housing market if the private sector is not prepared to step in with investment capital to replace a diminished level of Government backing. 

The consequences of failing to attract sufficient private-sector capital to this market include a contraction in the availability of credit to home buyers, an increase 

in mortgage rates, and continued decreases in home prices. Furthermore, these 

problems in the housing market may have broader negative effects on the overall 

economy. 

The main sources of private-sector capital that previously financed residential 

mortgages include banks, mutual funds, pension funds, and insurance companies. 

For the nonbanks, the transmission mechanism for providing this financing was 

through their investments in triple-A rated residential mortgage-backed securities 

(RMBS). My testimony will recommend how to bring these ‘‘triple-A investors’’ back 

to this securitization market, thereby enabling the Government to reduce its role 

in the mortgage market without negative consequences. 

Background on Redwood 

Redwood commenced operations in 1994 as an investor in residential mortgage 

credit risk. We are not a direct lender or mortgage servicer. Our primary focus has 

been on the prime jumbo mortgage market, or that portion of the mortgage market 

where the loan balances exceed the limits imposed by Fannie Mae and Freddie Mac 

(the ‘‘GSEs’’) for participation in their programs. Similar to the GSEs, Redwood also 

provides credit enhancement, but our focus is on the prime jumbo mortgage market. 

We provide credit enhancement by investing in the subordinated securities of private-label residential mortgage securitizations, which enables the senior securities 

to obtain triple-A ratings. From 1997 through 2007, Redwood securitized over $35 

billion of mortgage loans through 52 securitizations. 

Recent Securitization Activity 

In April 2010, Redwood was the first company, and is so far the only company, 

to sponsor a securitization of newly originated residential mortgage loans without 

any Government support since the market froze in 2008. The size of that first transaction was $238 million. In March 2011, we completed a second securitization of 

$295 million, and we hope to complete two more securitizations this year. 

Completing these transactions required that we address the concerns and interests of triple-A investors who, in the wake of the financial crisis, had lost confidence 

that their rights and interests would be respected and, consequently, that their investments would be safe and secure. We worked hard to regain their trust by putting together transactions that included even more comprehensive disclosure, better 

structure, and a new enforcement mechanism for representation and warranty 

breaches. In addition, Redwood retained meaningful exposure to the transaction’s 

future performance—i.e., through risk retention or ‘‘skin-in-the-game’’—and, in 

doing so, aligned our interests with those of investors. Investors responded with significant demand to acquire the triple-A rated securities, as evidenced by the fact 

that the first offering of those securities was oversubscribed by a factor of six to one. 

The second securitization was also quickly and fully subscribed. 

197 

3 2011 Mortgage Market Statistical Annual, Volume II, p. 31. 4S&P/Case-Shiller Home Price Index press release dated April 26, 2011. 

To be clear, Redwood Trust has a financial interest in the return of private sector 

securitization for residential mortgages. We hoped that our decision to securitize 

loans in 2010 would demonstrate to policy makers that private capital would support well-structured securitizations that also have a proper alignment of interests 

between the sponsor and the triple-A investors. Based in part on the success of our 

two recent mortgage securitizations and ongoing discussions with triple-A investors, 

we have confidence that the private market will continue to invest in safe, wellstructured, prime securitizations that are backed by ‘‘good’’ mortgage loans. We consider ‘‘good’’ loans as loans on properties where the borrowers have real down payments, capacity to repay, and good credit. We are proud of our history of sponsoring 

residential mortgage securitizations and our more recent role in helping to restart 

the private securitization market, and are pleased to have the opportunity to share 

our insights and observations with the Committee. 

The Private Mortgage Securitization Outlook for 2011 

The outlook for nongovernment or private-label residential mortgage 

securitization volume backed by newly originated mortgage loans (new 

securitizations) in 2011 remains very weak by historical standards. Year-to-date 

through April 30, 2011, only one new securitization totaling $295 million has been 

completed, and that was our deal. We hope to complete two more securitizations in 

2011 and securitize between $800 million and $1.0 billion for the year, and to build 

upon that volume in 2012. There are no good industry estimates for new private 

securitization volume in 2011, as the market is still thawing from its deep freeze. 

While we would welcome other securitizations in 2011 to provide additional thirdparty validation of the viability of securitization, the yearly volume will almost certainly be a small fraction of the $180 billion average annual issuance completed 

from 2002 through 2007, when the market began to shut down. 3

Major Hurdles to Private Mortgage Securitization Activity 

1. Crowding out of private sector 

Through the GSEs and the Federal Housing Administration (FHA), the Government has stepped in and taken the credit risk on about 90 percent of the mortgages 

originated in the U.S., without passing on the full cost of the risk assumed. Government subsidies must be scaled back to permit a private market to flourish. We note 

that post-crisis, the private asset-backed securities markets for auto loans, credit 

cards loans, and now commercial real estate loans are up and functioning, while the 

private-label RMBS market barely has a pulse. The difference is the pervasive 

below-market Government financing in the residential mortgage sector that is 

crowding out traditional private market players. 

Critics will argue that Redwood’s transactions were backed by unusually high 

quality jumbo mortgage loans and are therefore not representative of the market. 

In fact, that argument proves the point that the Government is crowding out private 

label securitizations, by maintaining an abnormally high conforming loan limit and 

by subsidizing the guarantee fees that the GSEs charge issuers. No private sector 

securitizer can compete with that—we can only securitize the small volume of prime 

quality loans beyond the Government’s reach. We are ready to purchase and 

securitize prime mortgage loans of any loan amount, and can do so at an affordable 

rate once the Government creates a level playing field. 

We strongly advocate testing the private market’s ability to replace Governmentdependent mortgage financing on a safe and measured basis. A first step would be 

to allow the scheduled reduction in the conforming loan limit in high cost areas from 

$729,750 to $625,500 to occur as scheduled in September 2011. We believe there is 

ample liquidity in the banking system to allow banks to step into the breach, while 

financing through private residential mortgage securitization regains its footing. 

Additionally, the Administration should follow through on its plan to increase 

guarantee fees to market levels over time to eventually level the field between the 

private market and the GSEs. A gradual Government withdrawal from the mortgage market over a 5-year period will enable time for a safe, attractive, robust private label market to develop. 

As the housing market begins to recover, we support further measured reductions 

on a periodic basis in the conforming loan limit as a means to increase the share 

of the mortgage market available to the private sector. We note that with housing 

prices now down in excess of 30 percent from their peak in mid-2006, 4 it would 

198 

seem logical to consider reducing the conforming loan limit by a similar amount 

over time. 

2. Balance Sheet Capacity of Commercial Banks 

The second hurdle to increased private securitization activity is the unprecedented amount of liquidity in the banking system. With $1.5 trillion in excess liquidity and 

historically low funding costs, there is no financial incentive for bank originators to 

securitize loans. Instead, banks are eager to retain their non-GSE eligible mortgage 

loan originations for their balance sheet loan portfolio in order to earn the attractive 

spread between their low cost of funds and the rate on the loans. To the extent that 

banks are selling nonagency loans, they are generally selling longer duration mortgages to reduce their interest rate risk. We expect this issue to resolve itself when 

the Fed eventually withdraws the excess liquidity from the banking system. 

3. Regulatory 

In the wake of the Dodd Frank Act, there are many new regulatory requirements 

and market standards out for comment, but they are not yet finalized. The resulting 

uncertainty keeps many market participants out of the market. Once the rules of 

the road are known, market participants can begin to adjust their policies, practices, 

and operations. 

A. Dodd-Frank Act Implementation Overview 

We recognize joint regulators had a very difficult task in establishing, writing, 

and implementing the new rules as required by the Dodd-Frank Act. Before I go 

through specifics, we offer some high level observations on the joint regulators’ notice of proposed rulemaking on risk retention (NPR). 

The NPR as written has some technical definitional and mechanical issues that 

need to be fixed. In particular, how the premium capture account works. This issue 

has been the source of much debate and ire by market participants. We are hopeful 

that appropriate corrections will be made after all comment letters are received. 

We would also note that regulators took a well-intentioned approach to craft a 

new set of risk retention rules to cover the entire mortgage securitization market 

which, in theory, should be a more expedient method for restarting securitization. 

However, there are complex differences between the prime and subprime markets 

and their unique securitization structures that make it very difficult to apply a onesize-fits-all set of new rules. 

The details are far too complex for this testimony, but to oversimplify, the proposed rules are effectively subprime-centric. While the rules do a good job of addressing and deterring abuses of subprime securitization structures, they are overly 

and unnecessarily harsh when applied to prime securitization structures. This is 

meaningful since prime loans are likely near 90 percent of the overall market. If 

the proposed rules are adopted as written, prime borrowers whose loans are financed through private securitization will face unnecessarily higher mortgage rates. 

In Redwood’s comment letter to the NPR, we intend to offer a more refined approach that would keep intact the necessary safety protections, but eliminate the 

unnecessary structural inefficiencies that would lead to higher prime mortgage 

rates. 

We believe that restoring the prime segment of the market in a safe yet efficient 

manner would bring the greatest benefit to the largest number of stakeholders (borrowers, lenders, investors, and taxpayers) and would become more effective and productive than attempting to craft one all encompassing regulatory solution. 

B. Form of Risk Retention 

We are strong advocates of requiring securitization sponsors to retain risk in 

order to properly align their interests with those of investors. We support the intent 

of the joint regulators’ NPR on this issue. In fact, it has always been Redwood’s operating model to retain the first-loss risk in our securitizations. 

The NPR proposes four forms of risk retention: (1) a horizontal slice consisting 

of the most subordinate class or classes; (2) a vertical slice with pro-rata exposure 

to each class; (3) a combination of horizontal and vertical slices; and (4) a randomly 

selected sample of loans. 

Redwood believes the most effective form of risk retention is the horizontal slice 

and that other forms are much less effective. The horizontal slice requires the sponsor to retain all of the first-loss securities and places the sponsor’s entire investment 

at risk. Only that approach will provide the required incentive for a sponsor to ensure that the senior securities are backed by safe and sound loans, which will benefit borrowers as well as investors. 

The other forms of risk retention result in substantially less of the sponsor’s investment in the first risk position, which reduces the incentive to sponsor quality 

199 

securitizations. Over time, we believe investors will vote on the best form of risk 

retention and reward sponsors that retain horizontal ‘‘skin in the game.’’ 

C. Qualified Residential Mortgages 

We support the intention of the proposed definition of a qualified residential mortgage (QRM), but we believe it is a bit too restrictive. We support the concept of 

‘‘common sense’’ underwriting, similar to the standards used by the GSEs for so 

many years prior to the period leading up to the credit bubble that resulted in low 

credit losses for many years. We note there is nothing in the NPR that prohibits 

lenders from making loans that do not meet the QRM standards. 

D. Servicer Functions and Responsibilities 

We believe that the well-publicized mortgage servicing issues are an impediment 

to broadly restarting private residential mortgage securitization. Beyond the issue 

of lost documents and foreclosure practices, servicers have been on the front lines 

throughout the recent crisis. Focusing more narrowly on their role in the 

securitization structure, they have sometimes been placed in the position of having 

to interpret vague contractual language, ambiguous requirements, and conflicting 

direction. In their role, they are required to operate in the best interest of the 

securitization and not in the interest of any particular bond holder. In practice, 

without any clear guidance or requirements, they invariably anger one party or another when there are disagreements over what is and is not allowed—with the result of discouraging some triple-A investors from further investment in RMBS. We 

propose that uniform standards governing servicer responsibilities and conflicts of 

interest be established and that a credit risk manager be established to monitor 

servicer performance and actions. We have discussed this servicing issue in greater 

detail and have proposed recommendations in our ‘‘Guide to Restoring the PrivateSector Residential Mortgage Securitization’’, which is available on our Web site. 

Other Hurdles to Private Mortgage Securitization 

While the focus of this hearing is on the state of the securitization markets and 

we believe we are moving in the right direction and addressing the securitization 

issues we need to address, we also need to broaden the focus beyond lenders and 

Wall Street. If we really want to restore a safe securitization market, we should also 

address second liens. One of the significant factors that contributed to the mortgage 

and housing crisis was the easy availability of home equity loans. Plain and simple, 

the more equity that a borrower has in his or her home, the more likely that borrower will continue to make mortgage payments. 

Although the proposed QRM standard will encourage lenders to originate loans 

to borrowers who have a minimum 20 percent down payment, there is no prohibition against the borrower immediately obtaining a second lien to borrow back the 

full amount of that down payment. The addition of a second lien mortgage that substantially erodes the borrower’s equity and/or substantially increases a borrower’s 

monthly debt payments increases the likelihood of default on the first mortgage. 

Many of the current regulatory reform efforts are centered on creating an alignment 

of interests between sponsors and investors through risk retention or ‘‘skin-in-thegame.’’ However, the first and most important line of defense is at the borrower 

level. If the borrower can take his or her own ‘‘skin’’ out of the game through a second mortgage, what have we really accomplished? The answer is very little. We believe this result will be very discouraging to private-label RMBS investors. 

To prevent the layering of additional leverage and risk, it is common in other 

forms of secured lending (including commercial and corporate lending) to require either the consent of the first lien holder to any additional leverage or to limit the 

new borrowing based on a prescribed formula approved by the first lien holder. We 

recommend extending this concept to residential mortgages. 

Specifically, we recommend enactment of a Federal law that would prohibit any 

second lien mortgage on a residential property, unless the first lien mortgage holder 

gives its consent. Alternatively, a second mortgage could be subject to a formula 

whereby the new combined loan-to-value (based on a new appraisal) does not exceed 

80 percent. 

Impact on Mortgage Rates 

Some market participants have been very vocal about the potential negative impact on mortgage rates as a result of the proposed definition of a QRM and/or the 

phase out of the GSEs. Recent news articles have speculated that mortgage rates 

will rise dramatically, by as much as 300 basis points. We don’t agree. 

We do believe residential mortgage rates could rise modestly—by perhaps 50 basis 

points—as the Government withdraws from the market. The Government support 

effectively subsidizes borrowing rates and it is reasonable to expect these rates to 

200 

rise somewhat as the subsidy is withdrawn. We nevertheless expect borrowing rates 

to remain attractive. 

For context, in our most recent deal, the average mortgage interest rate for 30- 

year fixed rate loans backing the securitization was 0.46 percent above the Government-guaranteed rate. As the number and diversity of loans available for private 

label securitization increases, thereby lowering risk, it is possible that residential 

mortgage rates could rise by less than 50 basis points relative to Government rates. 

Another reason we do not believe that mortgage interest rates will increase substantially is the sheer amount of global investment capital looking for ways to generate returns, from bank balance sheets, insurance companies, and mutual funds to 

non-U.S. financial institutions, hedge funds, and even residential investment trusts. 

The competition for returns is too great to allow such a rise in mortgage rates, assuming well underwritten loans with proper disclosure and alignment of interests. 

Conclusion 

When I look ahead—and admittedly you need to jump pretty high—I see a number of positives emerging: safer mortgages that borrowers can afford, the return of 

loan loss rates to historically low norms for newly originated prime loans, and private capital willing to fund residential mortgages at affordable rate for borrowers 

through responsible, safe securitization. The first step is to give the private sector 

a chance by following through on the Administration’s plan to reduce the conforming 

loan limits and increase the GSE’s guarantee fees to market rates at a safe and 

measured pace. 

Thank you for the opportunity to testify before the Subcommittee today. I would 

be happy to answer your questions. 

PREPARED STATEMENT OF LISA PENDERGAST 

PRESIDENT, COMMERCIAL REAL ESTATE FINANCE COUNCIL

MAY 18, 2011 

The Commercial Real Estate (CRE) Finance Council is grateful to Chairman 

Reed, Ranking Member Crapo, and the Members of the Subcommittee for holding 

this hearing to examine the state of the securitization market. Commercial real estate is the backbone of the American economy. Commercial real estate houses the 

space where everyone in your States goes to work and, in the case of multifamily, 

live. Specifically, commercial real estate comprises the office buildings where employees work; the strip malls, grocery stores and other retail establishments where 

goods are sold and food purchased; the small business spaces on main street that 

drive local economies; the industrial complexes that produce steel, build cars, and 

create jobs; the hospitals where doctors tend to the sick; and the hotels where relatives, vacationers and business executives stay. 

The CRE Finance Council represents all constituencies in the broader CRE finance market that provides the money to finance these businesses, and we appreciate the opportunity to share our views on the current state of the Commercial 

Mortgage-Backed Securities (CMBS) sector of the securitization markets. As explained in detail below, the CMBS market is in the early stages of what we hope 

will be a robust recovery. At this moment, the securitization risk retention framework mandated by Dodd-Frank is the biggest threat to sustaining that recovery. 

While we are thankful to both Senator Crapo for his amendment to Dodd-Frank 

that created specific a CMBS retention framework, and to the regulators for considering that framework in their deliberations, we have serious concerns with the proposed rules. Specifically, there are three areas under the rules that could negatively 

affect the industry if implemented as proposed, including the: (1) Premium Cash 

Capture Reserve Account; (2) Conditions for a third party to purchase the risk; and 

(3) the exemption for qualified commercial loans. Under the terms of the statute, 

those rules will not go into effect until 2013. It is critical that the six agencies that 

are charged with implementing the CMBS components of that securitization risk retention framework take whatever time they need now to get the rules right. We 

therefore ask you to communicate with the regulators and urge them to take their 

time finalizing this important set of rules by extending the current June 10th rulemaking response date and by then reproposing the draft rule which—hopefully—will 

incorporate and respond to the extensive industry feedback that they will receive. 

Introduction and Overview 

The $7 trillion commercial real estate market in the United States is just emerging from a period of serious duress brought on by the severe economic downturn, 

and significant hurdles remain to recovery in the near term. The challenges posed 

201 

1The Dodd-Frank NPR: Implications for CMBS, April 12, 2011, Morgan Stanley at 1. 

2 Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan 

(Feb. 10, 2009) available at http://www.ustreas.gov/press/releases/tg18.htm. 3 Remarks by John C. Dugan, Comptroller of the Currency, before the American 

Securitization Forum (Feb. 2, 2010), at 2 (available at http://www.crefc.org/uploadFiles/ 

CMSAlSitelHome/GovernmentlRelations/CMBSlIssues/TALFlTreasurylPlans/ 

DuganRemarksatASF201.pdf.). 4Pub. L. No. 111-203. 

by the distress the CRE market has experienced will continue to have an impact 

on U.S. businesses that provide jobs and services, as well as on millions of Americans who live in multifamily housing. Since 2009, the CRE problem shifted from a 

crisis of confidence and liquidity to a crisis of deteriorating commercial property fundamentals, plummeting property values and rising defaults. Through 2017, approximately $600 million of CMBS loans and over $1.2 trillion in outstanding commercial 

mortgages will mature, many of which are secured by smaller CRE properties; borrower demand to refinance those obligations will be at an all-time high. 1

Prior to the onset of the economic crisis, commercial mortgage-backed securities 

(CMBS) were the source of approximately half of all CRE lending, providing approximately $240 billion in capital to the CRE finance market in 2007 alone. After 

plummeting to a mere $2 billion in 2009 at the height of the crisis, the CMBS market began to see signs of life in 2010 with $12.3 billion in issuance. Thus far in 

2011, just under $10 billion CMBS have been issued, with projections for full-year 

volume ranging from $30 to $50 billion. Furthermore, the total CMBS issuance for 

2011 is expected to range from $30 to $50B, depending on a number of factors including economic conditions and the manner in which regulatory and accounting 

changes are implemented. 

One of the overarching questions faced at this juncture is whether CMBS will be 

able to satisfy the impending capital needs posed by the refinancing obligations that 

are coming due. Without CMBS, there simply is not enough balance sheet capacity 

available through traditional portfolio lenders such as banks and life insurers to satisfy these demands. It is for this reason that Treasury Secretary Geithner noted 2 

years ago that ‘‘no financial recovery plan will be successful unless it helps restart 

securitization markets for sound loans made to businesses—large and small.’’ 2 Similarly, then-Comptroller of the Currency John C. Dugan noted that, ‘‘[i]f we do not 

appropriately calibrate and coordinate our actions, rather than reviving a healthy 

securitization market, we risk perpetuating its decline—with significant and longlasting effects on credit availability.’’ 3

Against this backdrop, Congress adopted a credit risk retention framework for 

asset-backed securities in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). 4 At the same time, the CRE finance industry has taken 

direct steps to strengthen the CMBS market and to foster investor confidence 

through the completion of ‘‘market standards’’ in the areas of representations and 

warranties; underwriting principles; and initial disclosures. Scores of members of 

the CRE Finance Council across all of the CMBS constituencies worked diligently 

on these market reforms for over a year. We anticipate that new market standards, 

coupled with the unparalleled disclosure regime already in place in the CMBS market, will create increased transparency and disclosure in underwriting and improved 

and enforceable industry representations and warranties, all of which we believe 

will go a long way toward meeting both investor demands and the Dodd-Frank risk 

retention objectives. 

We are thankful to Senator Crapo, who added a provision to Dodd-Frank requiring the regulators to specifically address some of the unique issues and opportunities posed by the CMBS asset class in crafting the risk retention rules for CMBS. 

And we are grateful to the regulators who have abided by this mandate in issuing 

their initial set of proposed risk retention rules for comment. 

That said, the proposed rule is long and complicated, containing over 300 pages 

of analysis and roughly 170 questions open for comment. As explained in detail 

below, several facets of the proposal are controversial. Indeed, as the regulatory 

process moves forward, many will argue that implementing certain requirements— 

or the failure to implement certain requirements—will be a death knell for the market. The more likely outcome is that the failure to get the details right will restrict 

the overall amount of capital that is available through the securitization finance 

markets. The proposed rules impose additional costs on and will—in some cases— 

disincentivize issuers and disrupt the efficient execution of capital structures that 

securitization provides. 

If not properly constructed, the risk retention rules could potentially result in a 

significantly smaller secondary market, less credit availability, and increased cost 

202 

5 A copy of the March 25, 2010, letter is attached. 

6 Citigroup Global Markets CMBS Weekly at 10 (April 29, 2011). 

of capital for CRE borrowers. This may result in balance sheet lending (i.e., portfolio 

lending) at more competitive rates (which would be counter to historical experience), 

thus attracting the safest risks to the portfolio space and leaving the smaller and/ 

or riskier loans for the CMBS where borrowers will have to pay higher rates. Further, small borrowers—those that are not concentrated in the major urban areas 

and that need loans in the sub-$10 million space—would be the primary victims of 

these changes. For these reasons, 23 separate trade organizations, representing 

many different types of borrower constituencies, as well as lenders and investors in 

different asset classes, jointly signed a letter last year urging careful consideration 

of the entirety of the reforms to ensure that there is no disruption or shrinkage of 

the securitization markets. 5

As our members continue to work through the proposed rule to better crystallize 

our views, we cannot overstate the stakes, given that this rule will directly impact 

credit availability and the overall economic recovery. The agencies need to satisfy 

the somewhat arbitrarily imposed Congressionally mandated rule promulgation 

schedule, and we are concerned that the ultimate judgments they reach may not be 

as soundly thought through as a more generous schedule would allow. We therefore 

ask that you consider extending those deadlines; this may be especially appropriate 

given the fact that under the Dodd-Frank provisions the rules for nonresidential 

asset-backed securities would not go into effect for an additional 2 years and our 

industry could still abide by that final effective date even if more time were allotted 

prior to finalizing the actual rules. 

We also ask that you urge the regulators to take advantage of such an extended 

rule promulgation schedule by both (a) holding public roundtables to ensure that the 

public understands the intent behind each proposed provision, and (b) reproposes 

the rules for further comment after initial comments are received on June 10th. As 

one prominent commentator has noted: 

Still, that there appeared to be such a wide gap between regulators’ intentions and the market’s interpretation for the proposal’s language suggests 

that a single round of formal market feedback, after which the regulators 

finalize the rules, may not be enough. This would especially be the case if 

the final rules indeed contained substantial revisions to key provisions, 

such as the premium capture account. Such revisions could introduce fresh 

confusion or misrepresentation of the regulators’ intentions. 6

As noted, such a deliberate approach and a reproposal of the rules need not alter 

the effective implementation date for the industry, given that the statute does not 

dictate that the rules be effective until 2013 and the CMBS industry does not need 

2 years to effectuate the new retention requirements. 

The balance of our testimony will focus on six key areas: 

1. A description of the CRE Finance Council and its unique role; 

2. The current state of CRE finance, including the challenges that loom for the $3.5 trillion in outstanding CRE loans; 

3. A framework for a recovery, including the unique structure of the commercial 

market and the importance of having customized regulatory reforms; 

4. The CRE Finance Council’s market standards initiatives, which have been designed to build on existing safeguards in our industry, to promote certainty and 

confidence that will support a timely resurgence of the CRE finance market in 

the short term, and a sound and sustainable market in the long term; 

5. The CRE Finance Council’s general reactions to the recently proposed regulation to implement Dodd-Frank’s risk retention requirement; and 

6. Actions that can be taken to ensure that the CMBS securitization market continues to heal and recover. 

Discussion 

1. The CRE Finance Council 

The CRE Finance Council is the collective voice of the entire $3.5 trillion commercial real estate finance market, including portfolio, multifamily, and CMBS lenders; 

issuers of CMBS; loan and bond investors such as insurance companies, pension 

funds, and money managers; servicers; rating agencies; accounting firms; law firms; 

and other service providers. 

Our principal missions include setting market standards, facilitating market information, and education at all levels, particularly related to securitization, which 

203 

has been a crucial and necessary tool for growth and success in commercial real estate finance. To this end, we have worked closely with policy makers in an effort 

to ensure that legislative and regulatory actions do not negate or counteract economic recovery efforts in the CRE market. We will continue to work with policy 

makers on this effort, as well as our ongoing work with market participants and 

policy makers to build on the unparalleled level of disclosure and other safeguards 

that exist in the CMBS market, prime examples of which are our ‘‘Annex A’’ initial 

disclosure package, and our Investor Reporting PackageTM (IRP) for ongoing disclo- sures. While the CMBS market is very different from other asset classes and is already 

seeing positive developments, the CRE Finance Council is committed to building on 

existing safeguards, to promote certainty and confidence that will support a timely 

resurgence in the short term and a sound and sustainable market in the long term. 

In this regard, we have worked with market participants to develop mutually 

agreed upon improvements needed in the CRE finance arena that will provide an 

important foundation for industry standards. Prime examples of our work include 

both the CRE Finance Council’s ‘‘Annex A’’ initial disclosure package and the Investor Reporting PackageTM for ongoing disclosures. 

Furthermore, our members across all constituencies have devoted an extraordinary amount of time over the past year to working collaboratively and diligently 

on the completion of market standards for: (1) Model Representations and Warranties; (2) Underwriting Principles; and (3) Annex A revisions, all of which we previously have shared with the regulators charged with implementing the Dodd-Frank 

risk retention rules: the Securities and Exchange Commission, Federal Reserve 

Board, Federal Deposit Insurance Corporation, Department of the Treasury, and the 

Office of the Comptroller of the Currency. We anticipate that these three new market standards initiatives, along with the unparalleled ongoing disclosure offered by 

our existing IRP, will create increased transparency and disclosure in underwriting 

and improved industry representations and warranties and enforcement, which we 

believe will go a long way toward meeting both investor demands and Dodd-Frank 

objectives. 

2. The Current State of CRE Finance 

CRE is a lagging indicator that is greatly impacted by microeconomic conditions, 

and as such, began to be affected by the prolonged economic recession relatively late 

in the overall economy’s downward cycle. What started as a ‘‘housing-driven’’ recession due to turmoil in the residential/subprime markets (in which credit tightened 

severely) quickly turned into a ‘‘consumer-driven’’ recession, impacting businesses 

and the overall economy. Not surprisingly, CRE has come under strain in light of 

the economic fundamentals today and over the last three years, including poor consumer confidence and business performance, high unemployment and property depreciation. Unlike previous downturns, the stress placed on the CRE sector today 

is generated by a ‘‘perfect storm’’ of several interconnected challenges that compound each other and that, when taken together, has exacerbated the capital crisis 

and will prolong a recovery: 

• Severe U.S. Recession—There is not greater effect on CRE than jobs and a 

healthy economy. With a prolonged recession and an unemployment rate at or 

above 8.8 percent for the last 24 months, commercial and multifamily occupancy 

rates, rental income, and property values have subsequently been negatively 

impacted, thus perpetuating the economic downturn. Those impacts persist even 

as the recession has abated. 

• ‘‘Equity Gap’’—During the worst of the economic crisis, our industry saw CRE 

assets depreciate in value by 30 percent to 50 percent from peak 2007 levels, 

creating an ‘‘equity gap’’ between the outstanding loan amount and the current 

value of the CRE property, thus requiring additional equity to extend or refinance a loan. This dynamic affects even ‘‘performing’’ properties that continue 

to support the payment of monthly principal and interest on the underlying 

loans. While there has been some lessening of the equity gap in the past year 

as the slide in property values slowed, the market is at a sensitive point on the 

climb toward recovery and a shortage of capital at this stage could cause a resurgence of the equity gap problem. 

• Significant Loan Maturities—Approximately $1.2 trillion in CRE loans mature 

over the next several years. Perhaps most significant is that many of those 

loans will require additional ‘‘equity’’ to refinance given the decline in CRE 

asset values. 

• CMBS Restarting—Slowly—Even in normal economic conditions, the primary 

banking sector lacked the capacity to meet CRE borrower demand. That gap 

204 

7See, ‘‘A Guide to Global Structured Finance Regulatory Initiatives and Their Potential Impact’’, Fitch Ratings (Apr. 4, 2011), at 1 (available at http://www.fitchratings.com/creditdest/ 

reports/reportlframe.cfm?rptlid=571646). 8 Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan 

(Feb. 10, 2009) available at http://www.ustreas.gov/press/releases/tg18.htm. 9 International Monetary Fund, ‘‘Restarting Securitization Markets: Policy Proposals and Pitfalls,’’ Chapter 2, Global Financial Stability Report: Navigating the Financial Challenges Ahead 

(October 2009), at 33 (‘‘Conclusions and Policy Recommendations’’ section) available at http:// 

www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf. 

has been filled over the course of the last two decades by securitization (specifically, CMBS) which utilizes sophisticated private investors—pension funds, mutual funds, life insurance companies, and endowments, among others—who 

bring their own capital to the table and fuel lending. CMBS accounts, on average, for approximately 25 percent of all outstanding CRE debt, and as much as 

50 percent at the peak, while readily identifiable properties funded by CMBS 

exist in every State and Congressional district. However, a prolonged liquidity 

crisis caused the volume of new CRE loan originations and thus new CMBS to 

plummet from $240 billion in 2007 (when CMBS accounted for half of all CRE 

lending) to $12 billion in 2008 and $2 billion in 2009. In 2010, the CMBS market began to see signs of life with $12.3 billion in issuance, while issuance is 

expected to range between $30 and $50 billion in 2011, depending upon a number of economic conditions and uncertainty related to regulatory and accounting 

changes. While there is revitalized activity in the CMBS space, there is a mismatch between the types of loans that investors are willing to finance and the 

refinancing that existing borrowers are looking for to extend their current loans. 

While the market has evolved from the initial liquidity crisis, there is still an unfortunate combination of circumstances that leave the broader CRE sector and the 

CMBS market with three primary problems: (1) the ‘‘equity gap’’ (again, the difference between the current market value of commercial properties and the debt 

owed on them, which will be extremely difficult to refinance as current loans mature); (2) a hesitancy of lenders and issuers to take the risk of ‘‘originating’’ or ‘‘aggregating’’ loans for securitization, given the uncertainty related to investor demand 

to buy such bonds (this 3–6 month ‘‘pre-issuance’’ phase is known as the ‘‘aggregation’’ or ‘‘warehousing’’ period); and (3) the tremendous uncertainty created by the 

multitude of required financial regulatory changes, which serve as an impediment 

to private lending and investing, as the markets attempt to anticipate the impact 

these developments may have on capital and liquidity. Indeed, market analysts have 

concluded that regulatory uncertainty will likely delay recovery of the securitization 

markets, including one observer that recently concluded that the delay would be for 

at least another 12 months. 7

The importance of the securitized credit market to economic recovery has been 

widely recognized. Both the previous and current Administrations share the view 

that ‘‘no financial recovery plan will be successful unless it helps restart 

securitization markets for sound loans made to consumers and businesses—large 

and small.’’ 8 The importance of restoring the securitization markets is recognized 

globally as well, with the International Monetary Fund noting in a Global Financial 

Stability Report last year that ‘‘restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis 

and to the withdrawal of central bank and Government interventions.’’ 9

Current State of Small Business Lending Finance 

Significantly, it is also important to be aware of the importance of securitization 

to smaller businesses that seek real estate financing. The average CMBS securitized 

loan is $8 million. As of July 2010, there were more than 40,000 CMBS loans less 

than $10 million in size with a combined outstanding balance of $158 billion, which 

makes CMBS a significant source of capital for lending to small businesses. Therefore, when evaluating securitization reforms like the proposed risk retention rules, 

policy makers should be mindful that changes that could halt or severely restrict 

securitization of CRE loans will have a disparate adverse impact on small businesses, and on capital and liquidity in CRE markets in smaller cities where smaller 

CRE loans are more likely to be originated. 

As many independent research analysts have noted, while the overall CRE market will experience serious strain (driven by poor consumer confidence and business 

performance, high unemployment and property depreciation), it is the 

nonsecuritized debt on the books of small and regional banks that will be most problematic on a relative basis, as the projected default rates for such unsecuritized comVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00208 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
205 

10 Board of Governors of the Federal Reserve System, Report to Congress on Risk Retention 

(October 2010), at 3 (available at http://federalerserve.gov/boarddocs/rtpcongress/ 

securitization/riskretention.pdf). See also Daniel Tarullo, Federal Reserve Governor, Statement 

Before The House Committee on Financial Services (Oct. 26, 2009) (‘‘A credit exposure retention 

requirement may thus need to be implemented somewhat differently across the full spectrum 

of securitizations in order to properly align the interests of originators, securitizers, and investors without unduly restricting the availability of credit or threatening the safety and soundness 

of financial institutions.’’); John C. Dugan, Comptroller of the Currency, Statement on the Federal Deposit Insurance Corporation’s Advance Notice of Proposed Rulemaking on Securitizations 

(Dec. 15, 2009), at 1-3 (‘‘[R]ecent studies note that a policy of requiring a rigid minimum retention requirement risks closing down parts of securitization markets if poorly designed and implemented. Before proposing and implementing such a requirement for all securitizations, further analysis is needed to ensure an understanding of the potential effects of the different ways 

in which risk could be retained.’’). 

Similarly, the International Monetary Fund has warned that ‘‘[p]roposals for retention requirements should not be imposed uniformly across-the-board, but tailored to the type of 

securitization and underlying assets to ensure that those forms of securitization that already 

benefit from skin in the game and operate well are not weakened. The effects induced by interaction with other regulations will require careful consideration.’’ International Monetary Fund, 

‘‘Restarting Securitization Markets: Policy Proposals and Pitfalls,’’ Chapter 2, Global Financial 

Stability Report: Navigating the Financial Challenges Ahead (October 2009), at 109 (‘‘Conclusions and Policy Recommendations’’ section) available at http://www.imf.org/external/pubs/ft/ 

gfsr/2009/02/pdf/text.pdf. 

mercial debt have been, and are expected to continue to be, significantly higher than 

CMBS loan default rates. 

3. A Framework for Recovery—Customized Reforms That Take Into Account the 

Unique Characteristics of the CMBS 

The private investors who purchase CMBS, and thereby provide the capital that 

supports the origination of loans for CMBS, are absolutely critical to restarting commercial mortgage lending in the capital markets that are critical to a CRE recovery. 

Accordingly, Government initiatives and other reforms must support private investors—who bring their own capital to the table—in a way that gives them certainty 

and confidence to return to the capital markets. This type of support can and will 

vary by asset class. The Board of Governors of the Federal Reserve issued a ‘‘Report 

to the Congress on Risk Retention’’ as required under the Dodd-Frank mandate, 

concluding just that: 

simple credit risk retention rules, applied uniformly across assets of all 

types, are unlikely to achieve the stated objective of the Act—namely, to improve the asset-backed securitization process and protect investors from 

losses associated with poorly underwritten loans . . . the Board recommends that rule makers consider crafting credit risk retention requirements that are tailored to each major class of securitized assets. Such an 

approach could recognize differences in market practices and conventions, 

which in many instances exist for sound reasons related to the inherent nature of the type of asset being securitized. Asset class-specific requirements 

could also more directly address differences in the fundamental incentive 

problems characteristic of securitizations of each asset type, some of which 

became evident only during the crisis. 10

CMBS has innate characteristics that minimize the risky securitization practices 

that policy makers sought to address in Dodd-Frank. More specifically, the unique 

characteristics that set CMBS apart from other types of assets relate not only to 

the type and sophistication of the borrowers, but to the structure of securities, the 

underlying collateral, and the existing level of transparency in CMBS deals, each 

of which are briefly described here: 

• Commercial Borrowers: Part of the difficulty for securitization as an industry 

arose from practices in the residential sector, for example, where loans were underwritten in the subprime category for borrowers who may not have been able 

to document their income, or who may not have understood the effects of factors 

like floating interest rates and balloon payments on their mortgage’s affordability. In contrast, commercial borrowers are highly sophisticated businesses 

with cash flows based on business operations and/or tenants under leases (i.e., 

‘‘income-producing’’ properties). Additionally, securitized commercial mortgages 

have different terms (generally 5–10 year ‘‘balloon’’ loans), and they are, in the 

vast majority of cases, ‘‘nonrecourse’’ loans that allow the lender to seize the collateral in the event of default. 

• Structure of CMBS: There are multiple levels of review and diligence concerning 

the collateral underlying CMBS, which help ensure that investors have a well 

206 

informed, thorough understanding of the risks involved. Specifically, in-depth 

property-level disclosure and review are done by credit rating agencies as part 

of the process of rating CMBS bonds. Moreover, nonstatistical analysis is performed on CMBS pools. This review is possible given that there are far fewer 

commercial loans in a pool (traditionally, between 100 to 200 loans; while some 

recent issuances have had between 30 and 40 loans) that support a bond, as 

opposed, for example, to residential pools, which are typically comprised of between 1,000 and 4,000 loans. The more limited number of loans (and the tangible nature of properties) in the commercial context allows market participants 

(investors, rating agencies, etc.) to gather detailed information about income 

producing properties and the integrity of their cash flows, the credit quality of 

tenants, and the experience and integrity of the borrower and its sponsors, and 

thus conduct independent and extensive due diligence on the underlying collateral supporting their CMBS investments. 

• First-Loss Investor (B-Piece Buyer) Re-Underwrites Risk: CMBS bond issuances 

typically include a first-loss, noninvestment grade bond component. The thirdparty investors that purchase these lowest-rated securities (referred to as ‘‘Bpiece’’ or ‘‘first-loss’’ investors) conduct their own extensive due diligence (usually including, for example, site visits to every property that collateralizes a 

loan in the loan pool) and essentially re-underwrite all of the loans in the proposed pool. Because of this, the B-piece buyers often negotiate the removal of 

any loans they consider to be unsatisfactory from a credit perspective, and specifically negotiate with bond sponsors or originators to purchase this noninvestment-grade risk component of the bond offering. This third-party investor due 

diligence and negotiation occurs on every deal before the investment-grade 

bonds are issued. We also note that certain types of securitized structures are 

written so conservatively that they do not include a traditional ‘‘B-Piece.’’ Such 

structures, for example, include extremely low loan-to-value, high debt-servicecoverage-ratio pools that are tranched only to investment grade. 

• Greater Transparency: CMBS market participants already have access to a 

wealth of information through the CRE Finance Council Investor Reporting 

PackageTM, which provides access to loan-, property-, and bond-level information at issuance and while securities are outstanding, including updated bond 

balances, amount of interest and principal received, and bond ratings. Our reporting package has been so successful in the commercial space that it is now 

serving as a model for the residential mortgage-backed securities market. By 

way of contrast, in the residential realm, transparency and disclosure are limited not only by servicers, but by privacy laws that limit access to borrowers’ 

identifying information. Importantly, the CRE Finance Council released version 

‘‘5.1’’ of the IRP in December, 2010 to make even further improvements. The 

updated IRP was responsive to investor needs, including disclosures for a new 

‘‘Loan Modification Template.’’ Also, as referenced above and as discussed in 

greater detail in Section 5 below, CREFC working groups—comprised of all 

CMBS constituencies (issuers, investors, etc.)—have created standard practices 

that could be used immediately in the market to enhance disclosure, improve 

underwriting, and strengthen representations and warranties to ensure alignment of interests between issuers and investors. These consensus standards 

build on existing safeguards in CMBS and go beyond Dodd-Frank requirements 

for CRE loans. 

4. The CRE Finance Industry’s Market Standards 

Another way in which the CMBS space is unique is the nature of the engagement 

of the industry participants. In the wake of the onset of the economic crisis and with 

an eye toward addressing issues that prompted policy makers to craft risk retention 

requirements, the CRE Finance Council and its members have been independently 

working on a series of market reforms with a view toward strengthening the 

securitization markets and fostering investor confidence. Our members across all 

constituencies have devoted an extraordinary amount of time over the past year to 

working collaboratively and diligently on the development of market standards in 

the areas of representations and warranties and their enforcement; underwriting 

principles; and initial disclosures, all of which have similar aims of strengthening 

our market and fostering investor confidence. 

We anticipate that the new industry market standards, coupled with the ongoing 

disclosure regime offered by our existing IRP, will create increased transparency 

and disclosure in underwriting and improved industry representations and warranties, which we believe will go a long way toward meeting both investor demands and 

Dodd-Frank objectives. We believe that these standards will be used both (1) in the 

207 

marketplace immediately, and (2) by the regulators as they continue to contemplate 

how to properly construct the final risk retention rules. 

Having previously shared these projects with the regulators charged with implementing the Dodd-Frank risk retention rules, the CRE Finance Council also wishes 

to provide some information to Congress as well about the projects. 

Representations and Warranties 

Building upon existing customary representations and warranties for CMBS, the 

CRE Finance Council has created Model Representations and Warranties that represent industry consensus viewpoints. Representations and warranties relate to assertions that lenders make about loan qualities, characteristics, and the lender’s due 

diligence. The CRE Finance Council’s model was the result of 200-plus hours of 

work by our Representations and Warranties Committee over the last 6 months, 

and represents the input of more than 50 market participants during negotiations 

to achieve industry consensus. 

The Model Representations and Warranties were specifically crafted to meet the 

needs of CMBS investors in a way that is also acceptable to issuers. Such Model 

Representations and Warranties for CMBS will be made by the loan seller in the 

mortgage loan purchase agreement. Issuers are free to provide the representations 

and warranties of their choosing, and the representations and warranties will necessarily differ from one deal to another because representations and warranties are 

fact based. However, issuers will be required to present all prospective bond investors with a comparison via black line of the actual representations and warranties 

they make to the newly created CRE Finance Council Model Representations and 

Warranties. Additionally, loan-by-loan exceptions to the representations and warranties must be disclosed to all prospective bond investors. 

Finally, the CRE Finance Council also has developed market standards for addressing and resolving breach claims in an expedited, reliable and fair fashion by 

way of mandatory mediation before any lawsuit can be commenced, thereby streamlining resolution and avoiding unnecessary costs. 

For many investors, strengthened and new representations and warranties coupled with extensive disclosure are considered a form of risk retention that is much 

more valuable than having an issuer hold a 5 percent vertical or horizontal strip. 

The CRE Finance Council believes that its Model Representations and Warranties 

are a practical and workable point of reference that has been vetted by the industry, 

and we intend to explore whether industry-standard representations and warranties 

such as the CRE Finance Council’s model could be adopted by regulators to serve 

as ‘‘adequate’’ representations and warranties as contemplated by the Dodd-Frank 

menu of options for risk retention for commercial mortgages. 

Moreover, industry-standard representations and warranties could be used in at 

least two other regulatory contexts. First, the conditions on third-party retention in 

the proposed regulation contemplate securitizer disclosures regarding representations and warranties, and the possible use of blacklines against industry-standard 

representations and warranties. We are exploring the possibility of suggesting use 

of the CRE Finance Council’s model for this purpose. 

In addition, Dodd-Frank Section 943(1) directs the SEC to develop regulations requiring credit rating agencies (CRAs) to include in ratings reports a description of 

the representations, warranties, and enforcement mechanisms available to investors 

for the issuance in question, along with a description of how those representations, 

warranties, and enforcement mechanisms differ from those in ‘‘issuances of similar 

securities.’’ CRAs have played an important role in the CRE Finance Council’s development of Model Representations and Warranties, and we believe the Model Representations and Warranties can facilitate CRAs’ fulfillment of their new reporting 

requirements under Dodd-Frank Section 943(1). 

Loan Underwriting Principles 

Commercial mortgages securitized through CMBS do not easily lend themselves 

to the development of universally applicable objective criteria that would be indicative of having lower credit risk as envisioned under Dodd-Frank or otherwise. This 

is because these nonrecourse loans are collateralized by income streams from an incredibly diverse array of commercial property types that cannot be meaningfully categorized in a way that would allow for the practical application of such objective 

‘‘low credit risk’’ criteria. For example, it is difficult to meaningfully compare property types such as hotels, malls, and office buildings, and credit risk profiles can 

also vary by geographic location, so that it would be even more difficult to compare 

a resort in Hawaii to a shopping mall in Texas or an office building in New York. 

In short, commercial properties are not homogeneous and do not lend themselves 

to a ‘‘one size fits all’’ underwriting standard that could be deemed ‘‘adequate.’’ 

208 

The industry accordingly created a framework of principles and procedures that 

are characteristic of a comprehensive underwriting process that enables lenders to 

mitigate the risk of default associated with all loans, and a disclosure regime that 

requires representations as to the manner in which that underwriting process was 

performed. The intent of the Underwriting Best Practices is to be responsive to investors and market participants; provide for the characteristics of low-risk loans; 

and provide for common definitions and computations for the key metrics used by 

lenders. 

Our membership believes that this principles-based underwriting framework can 

and will generate the underwriting of lower credit risk CMBS loans and, when combined with necessary and appropriate underwriting transparency, will allow investors to make their own independent underwriting evaluation and be in a position 

to better evaluate the risk profiles of the loans included in the CMBS issuances in 

which they are considering investing. It is also critical to note that the majority of 

the underwriting principles and disclosures outlined in our best practices are already standard industry practices, though they had not previously be formally outlined or presented. 

The Underwriting Principles were developed with a view toward reducing risk 

through use of market analysis; property and cash flow analysis; borrower analysis; 

loan structure and credit enhancements; risk factors such as macro- and propertytype risks. With respect to defining numerical underwriting metrics, our project recognized the impossibility of imposing uniform metrics since the characteristics of a 

‘‘low risk’’ CRE loan could vary by property type, area of the country, and even by 

operator, and low risk loan-to-value ratios differ by geographic area. 

While we have long maintained that it is not possible or even advisable for regulators to attempt to define uniform underwriting ‘‘standards’’ for CRE loans due to 

the heterogeneous nature of commercial mortgages underlying CMBS and the dissimilarity of this market to residential, we recognize that regulators have attempted 

to do just that in the qualified commercial loan provisions of the proposed risk retention regulations. We wish to point out, in any event, that such criteria exclude 

many low-risk loans from qualifying for the exemption, and should not be viewed 

as the sole framework for assessing whether a commercial mortgage is low risk. 

‘‘Annex A’’ Initial Disclosures 

The CRE Finance Council’s ‘‘Annex A’’ has long been a part of the package of materials given to investors as part of CMBS offering materials, and provides detailed 

information on the securitized mortgage loans. In conjunction with the SEC’s Spring 

2010 proposal to revise its Regulation AB, our members commenced an initiative to 

review, update, and standardize Annex A, which has resulted in changes to Annex 

A incorporating numerous additional data points concerning the assets underlying 

CMBS. This work was the effort of both issuers and investors. 

These changes, together with the information already required by Annex A, closely conform Annex A with the Schedule L asset-level disclosure framework proposed 

by the Commission under Regulation AB. The CRE Finance Council’s newly created 

standardized Annex A provides numerous additional data points concerning the assets underlying CMBS, including, but not limited to: 

• Changes to the Loan Structure Section with regard to Disclosures on supplemental debt. Examples include, but are not limited to, detail of all rake, B-note, 

subordinated mortgage, mezzanine debt, and preferred equity as well as information regarding the debt owner, coupon, loan type, term, amortization, debt 

service calculation, debt yield, cumulative DSCR, and LTV calculations through 

the capital structure. 

• Additionally, issuers will now be providing a breakdown of net operating income 

into revenue and expenses for historic and underwriting basis. 

• Added information on the fourth and fifth largest tenants at a property to the 

tenant information section—most Annex As in the past would contain information on the three largest tenants at a property, that information being square 

footage leased, percent of overall net rentable square feet, and lease expiration 

date. 

In fact, Annex A provides more information than required under Schedule L and 

is available to market participants in more expedited fashion. At the same time, the 

new standardized Annex A is consistent with the existing practices that CMBS market issuers and other participants have developed to provide CMBS investors with 

clear, timely and useful disclosure and reporting that is specifically tailored for 

CMBS investors. We believe that such consistency will avoid unnecessary increases 

in transaction costs while still delivering enhanced clarity and transparency. 

209 

11 Id. at 84. 

It follows that the CRE Finance Council’s Annex A is a practical and workable 

framework that has already been vetted by the industry, and we believe it can be 

adopted by the SEC to implement the asset-level and loan-level disclosure requirements in Dodd-Frank Section 942(b), and those in Proposed Schedule L to SEC Regulation AB. 

5. Preliminary Views on the Proposed Risk Retention Rule 

The proposed risk retention regulations, released in late March, do attempt to fulfill the Congressional mandate embodied in the Crapo amendment by offering different options for satisfying the risk retention requirements (e.g., vertical, horizontal, or L-shape retention structures) and by providing asset-class specific options 

including a set of CMBS-specific provisions to satisfy the retention mandate. As a 

community, our members appreciate the efforts to create rules by asset class, given 

the unique nature of the CMBS market. 

At the same time, the proposed risk retention regulations are complex, and we 

are in the process of studying and discussing them with the different CMBS constituencies included under the CRE Finance Council umbrella (including lenders, 

issuers, servicers, and investors, among others) in order to fully evaluate their potential impact and to provide useful feedback to regulators on their proposal. As the 

Board of Governors of the Federal Reserve Report cited above also noted, the totality of the regulatory changes that are being put into motion—including the various 

new disclosure and credit rating agency reform provisions included in Dodd-Frank, 

the accounting changes that must be effectuated, and the new Basel capital requirements regime—must be considered in toto in making this evaluation: 

[R]ulemakings in other areas could affect securitization in a manner that 

should be considered in the design of credit risk retention requirements. Retention requirements that would, if imposed in isolation, have modest effects on the provision of credit through securitization channels could, in 

combination with other regulatory initiatives, significantly impede the 

availability of financing. In other instances, rulemakings under distinct sections of the Act might more efficiently address the same objectives as credit 

risk retention requirements. 11

Viewed through this lens, there are elements of the proposed retention regime 

that raise potential concerns in the market and, overall, the proposal has prompted 

more questions than it answers. Our preliminary view, however, is that the structural framework of the CMBS-specific provisions could provide a workable foundation for implementing the risk retention rules as Congress envisioned in DoddFrank. That said, there are areas where the rule could have unintended adverse 

consequences for securitization and the broader CRE finance markets. At the same 

time, the purpose of many important provisions is unclear, and they will likely need 

to be refined to ensure that they accomplish their intent in the least disruptive 

manner. Needless to say, the stakes are high with the impact on credit availability 

weighing in the balance and we look forward to working with Congress and the regulators to ensure a regulatory framework that supports a sound and vibrant 

securitization market, which is critical to consumers in the U.S. economy. 

The Proposed Risk Retention Regulation for Commercial Mortgages 

By way of background, the proposed risk retention regulation contains ‘‘base’’ risk 

retention requirements that generally apply to all asset classes. The base requirements include a number of options for the securitizer to hold the required 5 percent 

retained interest, such as: a ‘‘vertical slice,’’ which involves holding 5 percent of each 

class of ABS interests issued in the securitization; a horizontal residual interest, 

which requires that the securitizer retain a first-loss exposure equal to at least 5 

percent of the par value of all the ABS interests issued in the transaction; and an 

‘‘L-shaped’’ option which involves a combination of the vertical and horizontal options. The CRE Finance Council believes generally that the menu of options for 

holding the retained interest will be beneficial in that this flexibility will foster more 

efficient and practical structuring of securitizations than a one-size-fits-all approach, 

and we commend regulators for the thought and effort they put into developing 

these options. 

The retained risk would be required to be held for the life of the securitization. 

No sale or transfer of the retained interest would be permitted, except in limited 

circumstances. 

Notably, the base retention regime includes a restriction on the ability of 

securitizers to monetize excess spread on underlying assets at the inception of the 

210 

12 Risk Retention NPRM at 89. 

securitization transaction, such as through sale of premium or interest-only (IO) 

tranches. As discussed below in greater detail, this provision, which requires 

securitizers to establish a ‘‘premium capture cash reserve account’’ where a transaction is structured to monetize excess spread, and to hold this account in a firstloss position even ahead of the retained interest, has generated considerable confusion throughout the market, and the purpose of the provision is unclear. It should 

be noted that this particular provision is one that is prompting significant concerns 

about a potential adverse impact on the viability of the CMBS market, as well as 

questions about whether it can be implemented as a practical matter without shutting down the market for new CMBS issuance. 

Hedging of the retained interest is generally prohibited, although the proposed 

regulation gives securitizers the ability to use tools, such as foreign currency risk 

hedges, that do not directly involve hedging against the specific credit risk associated with the retained interest. The continued ability to use market risk hedges is 

a matter the ABS issuer community viewed as critical to the viability of 

securitization, and we believe that the proposed rule is generally responsive to market’s concerns in that regard. 

With respect to CMBS specifically, the Crapo Dodd-Frank amendment mandated 

that the regulators consider several specific alternatives for risk retention to 

strengthen the CRE market and to support a recovery for commercial mortgages, 

including: 

1. adequate underwriting standards and controls; 

2. adequate representations and warranties and related enforcement mechanisms; 

and/or 

3. a percent of the total credit risk of the asset held by the securitizer, originators, or a third-party investor. 

The proposal does not address the representations/warranties alternative at all 

but we are hopeful that the regulators will consider the role of the CRE Finance 

Council developed market-standards discussed above when it considers revisions to 

the risk retention regime. In addition to the base risk retention rules, there are two 

important provisions specific to commercial mortgages that relate to the other statutory alternatives. First, there is an option to have a third-party purchaser hold a 

5 percent horizontal first-loss position. The third-party retention option is subject 

to several conditions, which are being closely examined, but market participants 

have noted a lack of clarity with respect to some of the conditions, and there are 

concerns that some of the conditions may create significant disincentives for use of 

this retention option. An unworkable third-party retention option would render the 

rule more inflexible, which may run counter to the intent of Congress when it outlined third-party risk retention as one of the options for the CRE market in DoddFrank. 

Second, there is a commercial mortgage loan exemption that would subject qualified commercial mortgage loans to a 0 percent retention obligation, if several criteria 

are met. While we understand that regulators intended that only a small subset of 

‘‘low-risk’’ loans would qualify for the exemption, our initial examination of the CRE 

exemption provision reflects that the parameters for qualified commercial mortgages 

are so narrow that virtually no CRE mortgage could qualify. This stands in contrast 

to other asset classes, where we understand that proposed exemptions could cover 

an appreciably larger percentage of the universe of loans. 

Three components of the proposed rules have generated the most internal discussion and debate. 

Premium Capture Cash Reserve Accounts 

First, there is considerable confusion and concern within the CRE finance community about the proposed rule’s requirement that securitizers establish a ‘‘premium 

capture cash reserve account’’ when a transaction is structured to monetize excess 

spread at the inception of the securitization transaction, such as through an IO 

tranche. One issue is that the purpose of such a requirement is unclear. The narrative to the proposed rule states that the purpose of the premium capture is to prevent sponsors of the securitization from ‘‘reduc[ing] the impact of any economic interest they may have retained in the outcome of the transaction and in the credit 

quality of the assets they securitized,’’ 12 presumably by extracting all of their profit 

on the deal at the outset. However, we were informed through preliminary discussions with the regulatory agencies, for example, that the premium capture feature 

211 

13See id. at 90. 

was designed to ensure that the retained interest, whether held by the sponsor or 

a third party, represents 5 percent of the transaction proceeds. 

The effect of the proposal as drafted would be for all revenue from excess spread 

(which is virtually all revenue) to be retained for the life of the transaction. An analogy, for example; would be to consider if the rule were applied to your local sandwich shop owner. The owner, for example, spends money up front—say $1,000—to 

purchase bread, meat, cheese, mustard, and other sandwich making supplies. He 

then sells all his sandwiches to customers for $3,000, a gross profit of $2,000. He 

uses that profit to pay his workers; buy more sandwich supplies and to invest in 

his business. However, under the PCCRA, he can only collect the cost of the sandwich on the day he sells it to his customer. The net profit of $2,000 must go into 

an escrow account, and cannot be put to use for 10 years. Under this business strategy, it is difficult to imagine that many delis would be left open in the country. 

Such a mechanism will inhibit an issuer’s ability to pay operating expenses, transaction expenses, and realize profits from the securitization until, typically, 10 years 

from the date of a securitization. Thus, while the proposed rule’s narrative expressed regulators’ expectation that the premium capture feature would merely 

prompt securitization sponsors to stop structuring securitizations to monetize excess 

spread at closing, 13 the broader impact would be to make the securitization business very unattractive to sponsors, which in turn, would shrink capital availability. 

For this reason, many in our industry have significant concerns about the premium 

capture component having an adverse impact on the viability of the CMBS market. 

Conditions for Retention by a Third-Party Purchaser 

Second, the third-party retention option that was specifically designed for CMBS 

also has generated substantial discussion. Under the proposal, the option is subject 

to several conditions. Most notable among the conditions is a requirement that an 

independent Operating Advisor be appointed where a third-party purchaser retains 

the risk and also has control rights (itself or through an affiliate) that are not collectively shared with all other classes of bondholders, such as servicing or special servicing rights. The Operating Advisor would have to be consulted on all major servicing decisions, such as loan modifications or foreclosures, and would have the ability to recommend replacement of the servicer or special servicer if it determines that 

the servicer or special servicer is not acting in the best interests of the investors 

as a whole. Only a majority vote of each class of bondholder would prevent the 

servicer or special servicer from being replaced in this instance. 

As a preliminary matter, certain aspects of the Operating Advisor provision are 

not sufficiently fleshed out, and our membership believes that additional clarity will 

be necessary for an Operating Advisor framework to function efficiently. For example, other than requiring the Operating Advisor to be independent, the proposed 

rule provides no specifics on qualifications for an entity to serve as an Operating 

Advisor, such as whether the entity should have expertise in dealing with the class 

of securities that are the subject of the securitization. CMBS servicing can be a complex and highly fact-specific enterprise and CMBS transaction parties, including Bpiece buyers who might hold the retained interest under the proposed rule and who 

may handle servicing or special servicing, are sophisticated and very experienced in 

these matters. It is unlikely that such a B-piece buyer would accept the appointment of an Operating Advisor lacking in CMBS expertise to oversee servicing. Nor 

should this be desirable from the regulators’ perspective, since an unqualified Operating Advisor is unlikely to add value, and would only add to transaction costs. 

B-piece buyers and issuers also have raised concerns that the Operating Advisor 

requirement may create other significant disincentives for use of the third party retention option. For example, some question whether it is necessary for an Operating 

Advisor to have the authority to oversee servicing and have replacement rights from 

the deal’s inception, when a B-piece buyer’s capital is at risk in a first-loss position, 

which gives a B-piece/servicer incentives that are more fully aligned with those of 

other investors. Moreover, there are concerns that the addition of another administrative layer in the securitization process may make the servicing and workout of 

securitized loans more difficult from the borrower’s perspective. 

Some investment-grade investors have expressed interest in the Operating Advisor construct, but there clearly is room to better hone the powers of and the limitations on the requisite Operating Advisor. For example, one suggestion being discussed to address concerns of B-piece buyers and investment-grade investors may 

be to have the Operating Advisors’ recommendations to replace servicers approved 

by a majority vote of investors, rather than requiring a majority to disapprove as 

the proposed rule currently contemplates. 

212 

We note that there is precedent in the market for use of independent Operating 

Advisors in these circumstances, as the industry has developed a fairly standard 

Operating Advisor framework with input from B-piece buyers, investors, and issuers 

in the past few years. The most practical analogue to examine among past transactions are those that only involved an independent Operating Advisor once the Bpiece buyer/servicer is ‘‘out of the money’’ and its interests theoretically would not 

align with those of other bondholders. Such a structure might solve the alignment 

of interest concern while also addressing B-piece buyers’ reluctance to have servicing decisions second-guessed by a third-party when the B-piece buyer’s investment 

is first in line should there be losses. 

Exempt Commercial Mortgages 

There is a commercial mortgage loan exemption that would subject ‘‘qualified’’ 

commercial mortgage loan pools to a 0 percent retention obligation, if several criteria are met. Regulators have stated that they only intended for a relatively small 

percentage of loans, meeting a set of ‘‘low-risk’’ characteristics, to qualify for the exemption. While the CRE Finance Council understands this objective, our initial examination of the CRE exemption provision reflects that the parameters for qualified 

commercial mortgages are so narrow that virtually no CMBS mortgages could qualify. 

The exemption’s 20-year maximum amortization requirement, for instance, presents perhaps the most significant hurdle to qualification, since commercial mortgages are amortized on a 30-year basis. Rather than utilizing an amortization period as a criterion, a better metric for assessing the risk characteristics of a loan 

may be to use the loan-to-value ration at origination and maturity. Also problematic 

is the requirement that borrowers covenant not to use the property as collateral for 

any other indebtedness, which appears to effectively prohibit subordinate debt. Currently, borrowers typically are permitted to have subordinate debt upon lender approval (e.g., loans that have subordinate debt funded concurrent with the first mortgage). It follows that an outright prohibition on subordinate debt, regardless of lender approval, may be viewed by borrowers as an undue restriction of their ability to 

manage their finances. 

That said, as part of its market standards initiative, the CRE Finance Council 

submitted an underwriting principles framework white paper to the regulators during the rulemaking process highlighting the difficulty in creating universally objective metrics that would indicate that a loan is ‘‘low risk’’ in the very heterogeneous 

commercial mortgage space. Given the proposed rule, however, we are taking a 

fresh look at these issues and attempting to evaluate whether the ‘‘qualified CRE 

loan’’ construct could be reworked to be of value for CRE loans. There are loan segments outside of the typical conduit loan structure—like large loan and single borrower securitization deals—that may be more suited for the exemption treatment 

and we are evaluating what the appropriate ‘‘low risk’’ metrics should be for such 

deals. 

Additionally, a fourth area of concern about the proposed rule that should be 

highlighted relates to the duration of retention, and a prohibition on sale or transfer 

of retained interest. As mentioned, the proposed rule contemplates holding the retained interest for the life of the bond, and imposes a permanent prohibition on the 

sale or transfer of retained risk. Both of these features would restrict the flow of 

capital into the markets for an unnecessarily long time period, a situation that is 

even less desirable in light of the $1 trillion in commercial mortgage maturities that 

will occur in the next few years, at the same time the CMBS market is struggling 

to recover. We also note that in the third-party retention context, a permanent prohibition on the sale or transfer of retained risk would not be acceptable to many 

B-piece buyers. 

Our members are evaluating the extent to which the proper alignment of risk can 

be achieved without making the mandated retention permanent. We also believe 

that it is not necessary to completely restrict any sale or transfer of retained interest to achieve the risk retention regulation’s goals. A modification to the proposed 

rule to, for example, allow transfer of a B-piece buyer’s or sponsor’s retained interest 

to a ‘‘qualified’’ transferee, who would have to comply with the obligations imposed 

on the transferor and meet other criteria, would address this concern. 

On all of these issues as well as for the more technical issues that will emerge 

during the course of our evaluation, we intend to work with regulators on modifications that will facilitate proper alignment of risk without unduly restricting market 

capital and liquidity. 

213 

14 Covered Bond Policy Statement, Final Statement of Policy, FDIC, 73 Fed. Reg. 43754, 

43754 (July 28, 2008). 

6. Proactive Measures That Would Encourage a Securitization Market Recovery 

Significantly, the many challenges discussed earlier are interconnected and mutually compounding. To address the challenges and to help to facilitate a revitalized 

securitization market, we suggest the following: 

Take a Deliberate Approach to the Proposed Risk Retention Rules 

As discussed at length above, with so many questions remaining unanswered, the 

current proposed rule reads like an advance notice of proposed rulemaking. We are 

concerned that the 60-day public comment period, which ends June 10, 2011, does 

not give the industry sufficient time to fully analyze the impact of the proposed 

rules. Furthermore, given our expectation that we will be asking for significant 

changes, we believe that it will be appropriate for the regulators to jointly repropose 

the rules to allow industry a sufficient opportunity to digest and comment on the 

revised retention framework. The sheer complexity of these markets demands a 

thoughtful and deliberate approach to rulemaking, and a more iterative process 

helps achieve this crucial goal. As part of this process, it is critical to evaluate workable counter-proposals that could make the risk retention regime work in a way that 

will minimize adverse unintended consequences to credit availability and the overall 

economy while achieving an appropriate alignment of risk as Congress intended. 

Furthermore, our members believe it would be extremely helpful to have more 

interactive discussion between regulators and the public, particularly as the industry seeks to ensure that it correctly understands both the regulatory goals and intent of certain provisions, and to work cooperatively to develop acceptable alternatives. We are aware that the staffs of the Commodity Futures Trading Commission and the Securities and Exchange Commission have planned a two-day joint 

public roundtable on issues associated with the rules to govern swaps under DoddFrank. We believe that a similar opportunity to have a dialog with the relevant 

agencies to discuss risk retention rules would be beneficial to all, and could even 

foster a more efficient rulemaking process since the aim would be to inform the 

agencies’ understanding of industry concerns while the agencies are still in the process developing final rules, rather than afterward. 

Create a U.S. Covered Bond Market 

The CRE Finance Council supports ‘‘H.R. 940, the U.S. Covered Bond Act of 

2011,’’ (covered bond) that the House Financial Services Capital Markets Subcommittee passed last week by voice vote. The bill, which was reintroduced by Capital Markets Subcommittee Raking Member Garrett and Congresswoman Maloney, 

would include high-quality CMBS as eligible collateral in a newly created U.S. covered bond market. Covered bonds, which were originated in Europe are securities 

issued by a financial institution and backed by a specified pool of loans known as 

the ‘‘cover pool.’’ Bondholders have a preferential contractual claim to the pool in 

the event of the issuer’s insolvency. In the United States, a typical covered bond 

transaction involves an insured depository institution (IDI) selling mortgage bonds, 

secured by the cover pool, to a trust or similar entity (known as a ‘‘special purpose 

vehicle’’ or ‘‘SPV’’). The pledged mortgages remain on the IDI’s balance sheet securing the IDI’s promise to make payments on the bond, and the SPV sells ‘‘covered 

bonds,’’ secured by the mortgage bonds, to investors. In this fashion, the IDI generates more capital that can be used, in turn, to make more loans or provide financial institutions with a bigger cushion for their regulatory capitalization requirements. In sum, covered bonds are an elegant mechanism for generating more liquidity in the capital markets. 

A problem arises, however, if the IDI becomes insolvent and the FDIC assumes 

control as a receiver or conservator. Once the FDIC takes over, there can be uncertainty about whether the FDIC would continue to pay on the bond obligation according to the bond’s terms, or whether it will repudiate the transaction. If the IDI is 

also in default on the bond, there also can be uncertainty regarding the amount that 

investors would repaid, or at the very least, delay in allowing investors access to 

the bond collateral. The transactions can be hedged to alleviate some of these risks, 

but this increases transaction costs. In the face of such risks, investors were reluctant to invest in covered bonds to any significant degree; the FDIC reported in July 

2008 that only two banks had issued covered bonds. The FDIC recognized that covered bonds could be a ‘‘useful liquidity tool’’ for IDIs and the importance of ‘‘diversification of sources of liquidity.’’ 14 Therefore, to provide a measure of certainty to 

encourage investment in covered bonds, the FDIC issued a Policy Statement in 2008 

setting forth directives explaining how it would address certain types of covered 

214 

15Legislative frameworks for covered bonds in the following countries specifically permit the 

use of commercial mortgage loans as collateral: Austria, Bulgaria, Denmark, Finland, France, 

Germany, Hungary, Iceland, Ireland, Italy, Latvia, Luxembourg, the Netherlands, Norway, Poland, Portugal, Romania, Spain, Sweden, and the United Kingdom. In addition, all European 

jurisdictions that permit the use of residential mortgage-backed securities (RMBS) in cover pools 

also permit the use of CMBS. 16 In comments filed with the SEC in July 2008, the CRE Finance Council (filing under its 

former CMSA name) listed a number of recommendations for enhancements that would serve 

the investor community, such as publication of more specific information regarding NRSRO policies and procedures related to CMBS valuations; adoption of a standard presale report template 

with specified information regarding methodology and underwriting assumptions; and adoption 

of a standard surveillance press release with specified information regarding the ratings. Such 

information would allow investors to better understand the rating methodology and make their 

own investment determinations. 

bond obligations in cases in which it has assumed control of an IDI. Unfortunately, 

the FDIC limited the scope of its Policy Statement to covered bonds secured by ‘‘eligible assets,’’ and limited the definition of ‘‘eligible assets’’ to residential mortgages. 

As a result, a market for covered bonds in the CRE mortgage sector has not developed. 

Significantly, however, commercial mortgages and CMBS are already permitted in 

covered bond pools in most European jurisdictions, 15 which also accord the appropriate and necessary regulatory treatment, including capital requirements, with respect to covered bonds to facilitate the market and to better serve consumers and 

businesses seeking access to credit. It follows that in order to be globally competitive, any U.S. covered bond regime should include commercial mortgages and 

CMBS, and that the overall regulatory framework should be closely aligned with the 

approach used by our European counterparts. Such a framework will give U.S. consumers and businesses access to the same sources of credit availability, supporting 

our overall recovery and we applaud the Committee’s passage of the covered bond 

bill 2 weeks ago. 

While covered bonds should not and cannot replace CMBS as a capital source for 

the CRE mortgage market, facilitating a commercial covered bond market will be 

additive. Covered bonds can provide yet another source of liquidity for financial institutions to help raise much needed capital to fund CRE loans, and in turn, ease 

the current CRE credit crisis, which persists despite high borrower demand. Indeed, 

in the current environment, covered bonds could be a helpful means of raising capital relative to CMBS, particularly today as the cost of capital related to a covered 

bond deal could be less volatile than for CMBS. Such conditions also could assist 

financial institutions in aggregating collateral for a covered bond issuance, in contrast with the aggregation difficulties now being experienced in the CMBS market. 

Ensure Credit Rating Transparency 

Dodd-Frank includes extensive credit rating agency reform provisions, and the 

CRE Finance Council and its members generally are supportive of any reforms that 

require CRAs to provide more information about individual ratings and their rating 

methodologies. 

In terms of credit ratings performance, the CRE Finance Council devoted significant resources over the last few years to affirmatively enhance transparency in credit ratings. Such enhancements will be far more effective in providing investors with 

the information they need to make the most informed decisions than a differentiated 

ratings structure. Instead of differentiated ratings for structured finance products— 

a concept that has been debated and rejected by the SEC, what CMBS investors 

have consistently sought is new, targeted transparency and disclosures about the 

ratings of structured products, to build on the already robust information CRAs provide in their published methodology, presale reports, and surveillance press releases. 16

Conclusion 

Today, the CMBS market is showing some positive signs that it is slowly moving toward recovery. However, with $1 trillion in commercial mortgage loans maturing 

in the next few years, it will be critically important that risk retention regulations 

be implemented in way that does not severely constrict or shut down altogether the 

securitization markets. The CRE Finance Council appreciates the fact that the general construct of the proposed risk retention rule attempts to customize and provide 

options for the commercial mortgage asset class. At the same time, our members 

strongly believe that the proposal needs clarification in many areas. And we also 

have concerns about the impact of some of the details, including concerns that these 

aspects could make securitization an untenable prospect for issuers and third-party 

investors. 

215 

1 Rutledge, Ann, and Sylvain Raynes, ‘‘Elements of Structured Finance’’, Oxford University 

Press, May 2010. 

The CRE Finance Council believes these concerns can, and should, be addressed 

in an extended rulemaking process that we hope you will encourage, and we anticipate working with regulators on clarifications and refinements that can achieve an 

appropriate alignment of risk while also avoiding undue restriction of capital and 

liquidity in the CRE finance market. 

PREPARED STATEMENT OF ANN ELAINE RUTLEDGE 

FOUNDING PRINCIPAL, R&R CONSULTING

MAY 18, 2011 

Chairman Reed, Ranking Member Crapo, and distinguished Members of the Subcommittee, my name is Ann Rutledge. You have asked about the current conditions 

in the mortgage and asset-backed securities markets. You want to hear whether today’s impediments to capital formation and liquidity are going to resolve themselves 

based on reforms or best practices in use today—or whether other mechanisms or 

perhaps policy initiatives need to be added to the mix, to reignite securitization. As 

an independent consultant and, at times, critic of securitization market practices, 

I am deeply honored that you have asked me to testify. 

You may not have heard of R&R Consulting before now. We are a seven-person 

structured finance boutique cofounded by me and my partner, Sylvain Raynes. I resigned from Moody’s Investors Service’s Structured Finance Group at the end of 

1999, when it was becoming clear that Moody’s was shedding its franchise-defining 

commitment to research and becoming a ratings factory. It was also clear that this 

was happening at a moment in the market’s development when thought leadership 

was becoming more important than ever. I saw the mission of R&R as a continuation of the role Moody’s was moving away from, thought leadership. Our business 

vision was to serve the market by refining and unifying the techniques we learned 

at Moody’s into a single framework of analysis that could be used on all asset classes, at all points in time, to obtain consistent, reliable, capital-efficient results. 

I believe today that the goal of a unified framework of analysis is where the 

securitization market still must go if we are going to (a) restore investor trust in 

the securitization markets and (b) address, head-on, the needs of the real economy 

for capital. Many people have commented on the need to rebuild investor trust. 

However, I don’t hear nearly enough discussion about how to channel funds into the 

real economy with securitization. 

The assumption seems to be that all will be well once the market comes back. 

However, as we commented in Elements of Structured Finance, 1 structured finance 

and securitization marshaled unimaginable quantities of money before—but to what 

end? It is difficult to base a persuasive economic case for securitization on what has 

been achieved so far. Moreover, we have been too occupied with making money and 

mourning the loss of the big money machine to acknowledge that the microstructure 

of the securitization market is badly broken. If we want it to come back, we must 

be prepared to accept certain changes in the way it works—beginning with the fact 

that we need to understand how it works. We cannot delegate the work of understanding it to others, any more than we can delegate the work of understanding the 

foundation of our civil society to others. Once we understand what the market can 

and cannot do, the changes that need to be made will seem very fundamental and 

achievable. I would like to talk to you from my reform-oriented perspective about 

what is precious and worth preserving about this market, where the challenges lie, 

what reforms are working, and what still needs to be done. 

The Good News: Bragging Rights; Thought and Financial Leadership and 

the Economy Restored 

Securitization is a quintessential American innovation, a melding together of financial innovations from our 19th Century railroad crisis experience and our 20th 

Century savings and loan crisis experience. So, let’s pat ourselves on the back before 

we ask—which innovations? First, the discovery that, in insolvency, the railroad 

company’s capital structure could be restructured to make both the debt and equity 

investors better off. Second, credit ratings: a key for investors to discern relative 

value in securities issued from complex structures like railroad bonds (and 

securitizations). Third, cash flow modeling technologies based on a different set of 

metrics than those used in options markets, developed by engineers and information 

216 

specialists no longer needed for the Cold War effort, and made ubiquitous by the 

affordable (also quintessentially American) PC and spreadsheet software. 

Substantively, securitization enables investors to look beyond public corporate finance disclosures to find additional evidence of value or risk through a close analysis of company financial receivables—private data. Where value can be found, it 

can be monetized without adding to company or system risk using standard 

securitization structuring techniques and a feedback loop. Part of the value that is 

discovered can be returned, to reward the producers who have created the value and 

help them continue to grow. America’s credibility and thought leadership in finance 

have taken a severe beating as a result of the credit crisis. Nowhere is our fall from 

grace more apparent than in China, where I taught a securitization course last 

month. But, an America that can rebuild its economy with sustainable securitization 

markets while building incentives for producers in the capital-intensive sectors of 

the economy will, forcibly, continue to lead the world financially too. 

Securitization works where traditional corporate finance does not, because it is 

less stylized and more capable of using a variety of data types. What this means 

in practical terms is that securitization holds promise as a means of channeling capital towards our SME sector and our social priorities—education, health care and 

the arts—where traditional corporate finance tools are ill-suited. Securitization also 

has a beneficial financial impact because it accelerates the speed and accuracy with 

which capital circulates between lenders and borrowers. Let me illustrate this point 

with reference to the health care industry. Beyond the question of delivery of basic 

health care services, there is the funding problem caused by inefficiencies in the 

cash cycle of hospitals. The establishment of a system of registering title to health 

care receivables and discounting them using a uniform set of standards could release billions of dollars of much-needed capital to hospitals, particularly if the insurance companies were given incentives to make early claims payment. R&R estimates that bona fide health care securitization is a $1.5 trillion dollar a year market. 

This vision for securitization as a funding solution for tough sectors may be grand, 

but in order to carry it out, the market needs to sharpen its proverbial pencil. Historically, securitization has flourished primarily in consumer sectors, where no particular industry or modeling expertise is required for deals to come to market. Overdevelopment of consumer markets is a generalized problem in securitization. In 

Russia, during 2007, the mortgage securitization markets developed so rapidly that 

primary mortgage bankers, already in scarce supply, became unaffordable to many 

banks. Ironically, mortgage lending activities declined as a result. And yet, Russia’s 

real need for capital was in the SME sector, not homes. 

The problems of unbalanced growth and the failure to clone securitization to new 

opportunities have a single, straightforward solution: skill development through 

training. The U.S. has many MBA programs and finance departments, but 

securitization is not taught in the vast majority of them—most certainly not by people who have deal experience. This shortage of teaching talent would disappear 

quickly if the securitization market made skill development more of a priority. 

The Bad News: What Reinventing the Corporate Paradigm Does to Banks 

Before securitization, banks were the supply chain of capital. They made money 

by exploiting market discontinuities: small banks earned spread income from borrowers; regional banks earned spread income from small banks; and universal 

banks earned spread income from regional banks; etc. 

Securitization knits the funding markets together into a seamless credit supply 

chain, where the cost of capital is no longer a function of the risk of the balance 

sheet it happens to be sitting on, but rather a function of the ultimate borrower’s 

payment ability. It makes the borrower’s payment ability more transparent, and it 

expands the market for the borrower’s credit. Securitization did not cause the 

changes—deregulation, financial education, and the Internet caused them—but 

securitization is a solution to the problem of credit market inefficiency from which 

banks have benefited so long—as long as there have been banks and corporations. 

Securitization is an inconvenient reality for banks, because it erodes their information monopoly, so that they can no longer control the price of credit locally. Effectively it turns their core business from dealing to broking, which is much less profitable. 

No one, perhaps, saw this paradigm shift for what it was in the first phase of 

the market, from 1976–1997. Those were very good years, with new asset types coming on stream, new structures, and so much surplus capital being released that had 

been locked up in the economy, everyone involved in securitization prospered. New 

consumer companies got startup capital easily; existing companies lowered their 

funding costs; investors enjoyed unprecedentedly low default rates, far below what 

217 

the ratings implied; and at deal origination, professional services firms lined up for 

a sliver of the expected residual. It was, as Buck Henry tells Teri Garr in Steve 

Martin’s The Absent-Minded Waiter, ‘‘an incredible experience.’’ (In this comedyshort, Steve Martin as the absent-minded waiter commits every imaginable faux pas 

but then hands Buck nearly $10,000 in change before the bill is paid—precisely 

what Buck came for.) 

In the late 1990s, as the credit risk premium and the surpluses disappeared, the 

strategy of securitizing banks shifted to exploiting different loopholes, in particular, 

those built into different rating methods. The endgame of this strategy was the 

subprime crisis. Although recounting what happened in detail is beyond the scope 

of this paper, it is not very hard to depict (see the figure below) or explain. The hard 

part is that once we explain it, we feel compelled to fix it, and there are no easy 

solutions for the banking industry other than to meet more the rigorous disclosure 

requirements that are coming into effect now. 

But I would remind the Banking Committee that one of the most fertile periods 

of American financial innovation came in the mid-to-late 1980s, when regulatory 

tightening brought the trading of financial derivatives into exchanges and the swaps 

market was born. There is still much room for banks in America to innovate in credit engineering without operating as if credit were a zero sum game. Credit is not 

a zero sum game. Everybody benefits from responsible lending. 

Disclosure Disciplines 

If securitization knits the credit markets together into a supply chain, the biggest 

challenge to securitization is sealing off the leaks as capital circulates through it. 

I believe there are two key places where the leakages occur. One is the disclosure 

problem. I believe Regulation AB does an excellent job of addressing the disclosure 

problem. As a former securitization analyst, I worked with Reg AB even before it 

was promulgated; and as a consultant, I have come to rely extensively on Reg AB 

as a workable, well-designed information standard for this market. Reg AB speaks 

the language of securitization. It requires disclosure of all the material deal data 

elements needed for valuation. 

Reg AB makes it possible for investors to do for themselves what rating agencies 

do not do: continuous rerating so that a conclusion can be drawn about how the deal 

worked out. Rerating is important because the composition of risk and value in 

these deals can shift, sometimes very dramatically. For well-structured transactions, 

the risk decreases over time, but for improperly structured transactions, the deterioration can be sudden and shocking if one does not know how to continuously monitor and value the exposure. 

Reg AB is currently being revised, and the SEC has said it wants to see cash flow 

model outputs posted as well as raw data elements. I believe that this requirement 

is an important mechanism by which the market can organize and communicate its 

thinking about value. Once a deal is structured, there is actually very little flexiVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00221 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51 51811158.eps
218 

bility around the interpretation of the value proposition. Analysts may disagree on 

the path of future cash flows, but there is no reason to disagree about how the deal 

works, which is what the cash flow model outputs show. This requirement therefore 

reduces the ‘‘mystery of valuation’’ by one more important dimension. 

Discounting Disciplines 

There is one more mechanism (or policy item, perhaps) that I believe the 

securitization market needs if it is going to come back in a sustainable fashion. The 

rating scale for structured finance needs to be taken away from the rating agencies 

and it needs to be published, perhaps after discussion and consensus among the 

G20, so that everyone can know the technical definition of each notch on the rating 

scale. 

The structured finance rating scale is fundamentally different than that for corporate finance. Perhaps you have not thought about securitization this way, but 

securitization is a kind of ‘‘discount window’’ for corporations to cash in their receivables at some blended rate, which can be expressed as the weighted average interest 

cost of the transaction in which the receivables are being refinanced. 

Each notch on the scale corresponds to a level of asset impairment: AAA signifies 

impairment in only a very slight degree (when we worked at Moody’s, the numerical 

meaning was an average 0.06 BP loss of yield on the security), whereas AA signifies 

slightly more, A even more, etc., in exponential increments going down the scale to 

single-C. Effectively, the rating agencies are setting the levels of risk and leverage 

of the financial system. 

That is a ridiculous situation. It is analogous to leaving the decision of how large 

an inch or a meter should be to the individual tailor. Government policy makers 

should be making this decision, not rating agencies. The structured rating scale is 

the ultimate tool for calibrating the expansion of credit to the rate of economic 

growth. Although it has never been used that way before, this is a very good time 

to begin to learn how to synchronize the microstructure of the securitization credit 

markets with macroeconomic credit policy. 

At the same time, the scale (and its revisions) should be made public so that anyone who cares about the health of the securitization markets can do their own analysis of outstanding deals. It is impossible, finally, for anyone including sophisticated 

investors to form an opinion about whether a structured rating is right without access to technical rating definitions. But, since most people do not rate 

securitizations, most people do not even realize they have been denied access to this 

crucial piece of market infrastructure. It is as if the City of New York (or Washington) enforced speed limits for driving in different districts but refused to disclose 

what the speed limits were. Circulation would not shut down, but considerable road 

efficiency and resilience would be lost as a result of drivers having to guess, constantly, whether or not they were driving at the legal speed. 

219 

1Observers note that while PLS represents approximately 12.8 percent of the first lien market, they represent 40 percent of the loans that are currently 60+ days delinquent. 2The exceptions are two recent securitizations by Redwood Trust. 

PREPARED STATEMENT OF CHRIS J. KATOPIS 

EXECUTIVE DIRECTOR, ASSOCIATION OF MORTGAGE INVESTORS

MAY 18, 2011 

Introduction 

Chairman Reed and Ranking Member Crapo, and distinguished Members of the 

Subcommittee, thank you for the opportunity for the Association of Mortgage Investors (AMI) to testify and comment on this critically important topic. 

The Association of Mortgage Investors (AMI) commends you and your Senate colleagues for your leadership in pursuing responsible and effective oversight and vigilance to enhance the health and effectiveness of the U.S. financial markets, and in 

particular, the U.S. housing finance system. In summary, currently, mortgage investors suffer from a number of problems in the securitization space including: 

• Market opacity, an asymmetry of information, and a thorough a lack of transparency; 

• Poor underwriting standards; 

• A lack of standardization and uniformity concerning the transaction documents; 

• Numerous conflicts-of-interest among servicers and their affiliates; 

• Antiquated, defective, and improper mortgage servicing practices; and, 

• Investors lack effective legal remedies for violations of RMBS contractual obligations and other rights arising under State and Federal law. 

I. Background 

The AMI was formed to become the primary trade association representing investors in mortgage-backed securities (MBS), along with life insurance companies, 

State pension and retirement systems, university endowments, and pension funds. 

It has developed a set of policy priorities that we believe can contribute to achieving 

this goal. We were founded to play a primary role in the analysis, development, and 

implementation of mortgage and housing policy that keep homeowners in their 

homes and provide a sound framework that promotes continued home purchasing. 

In practice, only three sources of residential mortgage capital exist in the United 

States: (1) the bank balance sheets—which are arguably full and stressed; (2) the 

Government (Fannie Mae, Freddie Mac, FHA); and, finally, (3) securitization, which 

is effectively shutdown for the reasons described herein. 

Today’s U.S. mortgage market consists of approximately $11 trillion in outstanding mortgages. Of that $11 trillion, approximately one-half—$5.4 trillion—are 

held on the books of the GSEs as agency mortgage-backed securities (issued by one 

of the agencies) or in whole loan form. Another $4.0 trillion are on the bank balance 

sheets as whole loans or securities in their portfolios, of which $1 trillion are second 

liens (i.e., home equity loans/lines of credit or closed end second mortgages). 1 Of the 

$1.1 trillion outstanding second mortgages, only 3.7 percent of the total (or $41 billion) is held by private investors in securitized form. The remaining $1.2 trillion in 

first lien mortgages reside in private label mortgage-backed securities (MBS). AMI’s 

members hold a significant proportion of these investments; AMI members have approximately $300 billion of assets under management. 

The development of enhanced structures, standards, and safeguards will contribute to improving the functioning of capital markets for all investment asset 

classes, especially those pertaining to a necessity of life, namely housing. Your work 

will contribute to helping to keep Americans in their homes, making credit available, and the development of effective tools against the foreclosure crisis. 

Mortgage investors share your frustration with the slow restoration of the housing 

market, relief for homeowners, and finally offering the capital markets and homeowners that are truly in need meaningful and permanent relief. In fact, the markets 

for Residential Mortgage Backed Securities (RMBS) securitization have virtually 

ground to a halt since the financial crisis for reasons that we will enumerate. 2 We 

are hopeful that meaningful solutions can be implemented more quickly, and we believe that our interests are aligned with responsible homeowners. As difficult as it 

may be to believe, many of the most sophisticated investors were as victimized and 

abused by the servicers and their affiliates as were many consumers. Investors are 

essential in order to rebuild the private mortgage market. However, investors and 

220 

3See, e.g.,‘‘Securitization and Federal Regulation of Mortgages for Safety and Soundness’’, 

CRS Report for Congress at 2 (RS-22722, Oct. 21, 2008). (‘‘This securitization of mortgages increased the supply of funds available for mortgage lending’’). 

their private capital will only return to a market which is transparent, has nonconflicted stakeholders, and the protection of contract law. 

a. The Role of Mortgage Investors in the Marketplace 

Mortgage investors, through securitization, have for decades contributed to the affordability of housing, making credit more inexpensive, and making other benefits 

available to consumers. Today, however, mortgage investors face enormous challenges in the capital markets due to opacity, an asymmetry of information, poor underwriting, conflicts-of-interests by key parties in the securitization process, as well 

as the inability to enforce rights arising under contracts, securities, and other laws. 

This list is by no means intended to be exhaustive. Accordingly, investors, average 

Americans, and the U.S. economy at-large are harmed. 

b. The History and Rise of MBS Securitization 

It is important to note that securitization as a mortgage finance tool has been instrumental in reducing housing costs and helping citizens achieve the American 

dream of homeownership. In the 1970s, the mortgage finance industry was in its 

infancy. In fact, then the market consisted solely of two products—those backed by 

Ginnie Mae and Freddie Mac. The advent of the mortgage-backed securities market 

resulted in deregionalizing or nationalizing real estate investment risk, increasing 

liquidity to mortgage originators, and lowering barriers to home ownership. 

Securitization was a key factor in improving regional real estate markets. New York 

State is a case in point. In the 1970s, most New York depositories were flush with 

cash but had a hard interest rate limit on mortgages. The result was a flow of California mortgages to New York and a flow of dollars to California. New York was 

an unattractive and noncompetitive local market. With securitization, the New York 

market, as well as other markets became national markets; and hence, mortgage 

funds were more readily available. Since the 1970s, mortgage-backed securities have 

increased lending levels, with even State housing agencies benefiting from the mortgage-backed securities’ structuring techniques. The benefits of securitization are 

widely known. 3

II. Mortgage Investors’ Interests Align With Responsible Borrowers 

Mortgage investors are aligned with both homeowners and the Government in our 

shared goals of keeping responsible Americans in their homes and rebuilding and 

maintaining a vibrant real estate market. In fact, the maintenance of a healthy 

securitization market is a vital source of access to private capital for mortgages as 

well as autos and credit cards. Moreover, an efficient securitization market provides 

more and cheaper capital to originators, which allows them to issue more loans to 

additional qualified borrowers. The use of mortgage-backed securities equitably distributes risk in the mortgage finance industry, and prevents a build-up of specific 

geographic risk. These features, and many others, are those of a market which 

makes access to capital cheaper and thus spurs more mortgage lending. 

Mortgage investors seek effective, long-term sustainable solutions for responsible 

homeowners seeking to stay in their homes. We are pleased to report that mortgage 

investors, primarily the first lien holders, do not object to modifications as part of 

a solution. Unfortunately, mortgage investors are often powerless under the operative Pooling and Servicing Agreements (PSA) to offer such support. We strive for 

additional remedies to assist homeowners. Likewise, if a borrower speculating in the 

housing market, engaging in a strategic default or paying only their second lien 

mortgages, then they should not be eligible for receiving subsidized first lien interest rates. Potential structural changes that should be examined include: full recourse, blockage of interest payments on second lien debt if the first lien is in default, prohibitions on the second lien debt above a specified loan-to-value (LTV). 

Those ‘‘private label’’ (non-Federal agency) securities are put together by a variety 

of entities (e.g., investment banks) that pool the mortgages into a trust. The trust 

is built around a document called a Pooling and Servicing Agreement (PSA) that 

provides investors the rights and protections relating to the mortgages that make 

up the securitization and the terms and duties that are owed to the investors by 

the trustee of the security and the servicer of the individual mortgages. Within this 

Agreement, numerous representations and warranties exist regarding the quality of 

the mortgages that are included in the trust and the lending practices that were 

followed in the mortgage origination process. It is important to note that, historically, investment in these mortgage products have been attractive, in part, because 

221 

4 An example of this conflict is as follows. Consider the case when the servicer and the master 

servicer are the same entity. In such a case, a lack of effective oversight exists when the enforcement entity is owned by the same parent as the servicer. For example, in certain deals the Master Servicer has ‘‘default oversight’’ over the servicer therefore certain loss mitigation cannot be 

accomplished. Hence certain critics observe that when both are owned by the same parent entity, with the identical priorities and culture, no effective oversight is possible. 5 Hearing on ‘‘Transparency as an Alternative to the Federal Government’s Regulation of Risk 

Retention’’, before the House Oversight and Government Reform Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, May 11, 2011 (testimony of Acting 

Director Edward DeMarco). 

they are governed by binding contracts that lend the stability and to the predictability investors desire. Like any purchaser, investors expected the sellers of mortgage securities (which were often large banks) to stand behind their promises. Similarly, the GSEs, the Federal Reserve Bank of New York, and others confront the 

same challenges. Unfortunately, this critical component of mortgage securities market has broken down, harming mortgage investors including State pension and retirement systems. 

With a restored, vital, and healthy securities market, we will be able to attract 

more private capital into mortgage investments and, in turn, provide more affordable mortgages for potential qualified home buyers. 

Problems Arising From Improper Servicing 

As Congress reviews this area and considers solutions for enhancing 

securitization, it may wish to review solutions across all asset classes. We wish to 

highlight that the housing space and MBS have been devastated by the practices 

and events of the last few years. Accordingly, we urge lawmakers that it is necessary to treat MBS separately from other asset classes in an effort to restore the 

U.S. housing sector and help American families pursue home ownership. The problems impacting investors by the malfeasance of servicers and their affiliates are numerous. We wish to highlight the following points: 

• Many Servicers Are Conflicted; They May Not Be Servicing Mortgages Properly. 

Very often they are harming the interests’ of both investors and homeowners’ 

interests. This has a negative impact on private investor demand for mortgages 

and limits housing opportunities; 4

• Originators and Issuers May Not Be Honoring Their Contractual Representations about what they sold into securitizations. Additionally, the documents are 

vague, with basic terminology having no definite meaning (e.g., delinquency or 

default). The past is prologue and there are no assurances that they will not 

repeat these practices in the future; and, 

• The Market in General Lacks Sufficient Tools for First Lien Mortgage Holders, 

such as: recourse to the homeowner on a uniform, national basis (to avoid strategic defaults) and efficient ways to dismiss the 2nd lien (to allow for more effective workouts with the homeowner on the first lien). 

III. Solutions Offered by Mortgage Investors 

The current legal and regulatory landscape presents numerous obstacles for the 

MBS securitization, including a lack of the necessary transparency for the effective 

functioning of capital markets in connection with several fundamental aspects of the 

system. These problems are varied and numerous in the RMBS context. For example, investors were offered transactions with overly complex legal documentation, 

obscured salient facts about a deal, and take-it-or-leave-it time frames for acceptances of offers to purchase securities in underwritings. The lack of transparency in 

this context distorted markets and ultimately proved to impair the health and stability of our housing and mortgage markets. In essence, mortgage investors simply 

seek the salient facts underlying a transaction. In fact, last week, Mr. Edward 

DeMarco, Acting Director, Federal Housing Finance Administration (FHFA), testified before a House of Representatives Subcommittee and explained the following: 

FHFA views enhanced, loan-level disclosures as necessary for investors to 

analyze and assess the potential risks associated with the collateral of 

asset-backed securities, including mortgages. 5

Accordingly two sets of consequences have arisen. First, the U.S. private mortgage-backed securities market has ground to a halt. Observers note that with two 

exceptions, no new RMBS securitizations have occurred since the financial crisis. 

Second, Americans suffer through reduced credit, more expensive mortgage rates, 

and fewer housing opportunities. In an effort to solve the problems facing the capital markets and the working class, AMI has offered a number of policy solutions 

222 

which are described in its ‘‘Reforming the Asset-Backed Securities Market’’ white 

paper (March 2010). 

We believe that the recommendations below, which are detailed in depth in the 

attached white paper, support healthy and efficient securitization and mortgage finance markets, with more information made more widely available to participants, 

regulators, and observers; incentivize positive economic behavior among market participants; reduce information asymmetries that distort markets and are entirely consistent with the Government’s traditional roles of standard-setting in capital markets. In sum, the AMI offers the following recommendations to enhance transparency and best securitization practices within capital markets: 

• Provide loan-level information that investors, ratings agencies, and regulators 

can use to evaluate collateral and its expected economic performance, both at 

pool underwriting and continuously over the life of the securitization. 

• Require a ‘‘cooling off period’’ when asset-backed securities are offered so that 

investors have sufficient time to review and analyze loan-level information before making investment decisions. 

• Make deal documents for all asset-backed securities and structured finance securities publicly available to market participants and regulators sufficiently in 

advance of investor decisions whether to purchase securities offered. 

• Develop, for each asset class, standard pooling and servicing agreements with 

model representations and warranties as a nonwaivable industry minimum 

standard. 

• Develop clear standard definitions for securitization markets. 

• Directly address conflicts of interests of servicers that have economic interests 

adverse to those of investors, by imposing direct fiduciary duties to investors 

and/or mandatory separation of those economic interests, and standardize 

servicer accounting and reporting for restructuring, modification, or work-out of 

collateral assets. 

• Just as the Trust Indenture Act of 1939 requires the appointment of a suitably 

independent and qualified trustee to act for the benefit of holders of corporate 

debt securities, model securitization agreements must contain substantive provisions to protect asset-backed security holders. 

• Asset-backed securities should be explicitly made subject to private right of action provisions of antifraud statutes in securities law and to appropriate Sarbanes-Oxley disclosures and controls. 

• Certain asset-backed securities can be simplified and standardized so as to encourage increased trading in the secondary market on venues, such as exchanges, where trading prices are more visible to investors and regulators. 

• Ratings agencies need to use loan-level data on their initial ratings and to update their assumptions and ratings as market conditions evolve and collateral 

performance is reported. 

IV. Conclusion 

Mortgage investors believe that the vibrancy and effectiveness of the U.S. capital 

markets can be restored, in part, by enhancing the transparency around fundamental regulatory structures, standards, and systems. Toward this goal, the Government has a role—not through the heavy-hand of big Government, but rather, the 

light touch of a prudent standard-setter and facilitator. With appropriate standards 

and rights for the holders of asset-backed securities, securitization would achieve 

the goals sought by many—the more efficient funding of capital markets, lessening 

volatility, and the resulting better economic activity. In the absence of transparency, 

the future of the U.S. housing finance system will remain dark, hurting America’s 

global competitiveness and our domestic health. The results will include less home 

lending, more expensive credit, and fewer housing options and less opportunity for 

working class Americans. These are the reasons that we need solutions providing 

for more transparent systems and restarting our capital markets. 

Thank you for the opportunity to share the view of the Association of Mortgage 

Investors with the Subcommittee. Please do not hesitate to use the AMI as a resource in your continued oversight concerning the many issues under review. We 

may be reached at 202-327-8100 or by e-mail at katopis@the-ami.org. We welcome 

any questions that you might have about securitization, representations and warranties, or other mortgage industry topics. 

223 

224 

225 

226 

227 

228 

229 

230 

1 ‘‘Private Ordering of Public Markets: The Rating Agency Paradox’’, 2002 U. Illinois L. Rev. 

1, 7–8. 2See, ‘‘Conflicts and Financial Collapse: The Problem of Secondary-Management Agency 

Costs’’, 26 Yale Journal on Regulation 457 (2009), available at http://ssrn.com/abstractlid=1322536. 3 ‘‘Private Ordering of Public Markets’’, supra note 1, at 6 and 6 n. 33. I do not think it would 

be practical to require rating agencies themselves to perform the due diligence needed to discern 

fraud; indeed, no amount of advance due diligence can ever eliminate fraud. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM STEVEN L. SCHWARCZ 

Q.1. In your written statement, you make reference to a kind of expectation gap of investors, where a triple-A rating equated to a certification of ‘‘iron-clad safety’’ and ‘‘investment-grade’’ meant ‘‘freedom from default.’’ Could you expand upon this concept? Is this expectation gap contributing to a lack of confidence in ratings? 

Should rating agencies continue to play a role, and if so, how do 

we deal with this expectation gap? 

A.1. Could you expand upon this concept? 

As you know, ratings are an assessment of the safety of payment 

on debt securities, with a triple-A rating being the highest and 

BBB- or higher ratings being historically called ‘‘investment 

grade’’—meaning securities so rated are generally viewed as eligible for investment by banks, insurance companies, and savings and 

loan associations. 1 Rating agencies clearly perform a social good by 

assessing diverse information and issuing ratings based thereon, 

achieving an economy of scale. A problem occurs, however, when 

investors overrely on ratings as a shortcut for their own diligence 

and analysis. Investors are prone to overrely for two reasons. 

First, there is a secondary-manager conflict, which I referenced 

more generally in my testimony. In the context of rating agencies, 

this conflict occurs when analysts employed by investors recommend that their firms invest in securities that are highly rated, 

without the analyst engaging in the analysis and diligence his or 

her job theoretically requires. This type of conflict can be mitigated 

by more closely aligning analyst (and other secondary-manager) 

compensation with the long-term interests of their firms. 2 As my 

testimony explained, this is an intra-firm conflict, quite unlike the 

traditional focus of scholars and politicians on conflicts between 

managers and shareholders. Dodd-Frank attempts to fix the traditional type of conflict but completely ignores the problem of secondary-management conflicts. 

Second, in my experience investors do not always bother—or perhaps, because of the conflict referred to above, want—to learn the 

limitations of ratings. For example, ratings do not technically cover 

the risk of fraud but, instead, are based on the information received. 3

Is this expectation gap contributing to a lack of confidence in ratings? 

This expectation gap may well be contributing to a lack of confidence in ratings. However, I believe the expectation gap is not 

caused by ratings per se or even by the ratings system as currently 

constituted. Rather, the gap is caused, as discussed above, by a 

combination of (i) the secondary-manager conflict and (ii) investor 

misunderstanding of what ratings provide. This combination of failVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00234 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
231 

4This might be done, for example, through a ‘‘Monte Carlo simulation.’’ 

5See, e.g., ‘‘Disclosure’s Failure in the Subprime Mortgage Crisis’’, 2008 Utah L. Rev. 1109, 

available at http://ssrn.com/abstractlid=1113034; ‘‘Rethinking the Disclosure Paradigm in a 

Continued 

ures leads to variances between what investors ‘‘think’’ they’re investing in and what they’re actually investing in. 

Should rating agencies continue to play a role, and if so, how do 

we deal with this expectation gap? 

I believe that rating agencies should continue to play a role. As 

mentioned, they perform a social good by assessing diverse information and issuing ratings based thereon, achieving an economy of 

scale. 

We could deal with this expectation gap in two ways: 

1. Mitigate the secondary-manager conflict by more closely aligning analyst (and other secondary-manager) compensation with 

the long-term interests of their firms. Volume 26 of the Yale 

Journal on Regulation examines, at pages 465–469, how to accomplish this. 

2. Require investors to educate themselves about the limitations 

of ratings. As discussed above, the secondary-manager conflict 

itself undermines this education process; therefore mitigating 

that conflict is likely to mitigate this education failure. 

Q.2. One of the problems you note in your written statement is the 

‘‘overreliance on mathematical modeling.’’ The SEC has proposed 

that ABS issuers file a waterfall program that demonstrates the 

flow of funds in a transaction. What do you think of this proposal? 

A.2. I do not think this proposal is needed. The materiality requirement of existing disclosure law already requires an explanation of 

waterfalls. In my experience, these explanations are generally clear 

and (insofar as they can be) straightforward. 

I fear this proposal could even backfire. A mathematical program 

demonstrating the flow of funds could aggrandize the waterfall 

model, giving the model (as discussed in the next paragraph) greater credence than it deserves. 

Sophisticated investors do not, in my experience, have a problem 

understanding waterfalls and funds flows. Rather, their problem is 

under-appreciation of how easy it can be—especially in nontraditional transactions involving complex and highly leveraged 

securitizations of asset-backed securities already issued in prior 

securitizations (what I called in my testimony ‘‘securitizations of 

securitizations’’)—for relatively small errors in cash flow projections to significantly impact investor recoveries. To correct this 

under-appreciation, it would be helpful to require some sort of ‘‘sensitivity’’ analysis explaining how the waterfall cash flows would 

change based on changes in collections on the underlying financial 

assets. 4

Even a sensitivity analysis, however, is dependent on assessing 

how likely it is that collections on the underlying financial assets 

will change. No one can know that for sure, ex ante; there are simply too many variables and potentially unknown correlations. This 

illustrates a larger point: In complex financial markets, disclosure 

is necessary but almost always will be insufficient. 5 For an analVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00235 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51
232 

World of Complexity’’, 2004 U. Illinois L. Rev. 1, available at http://ssrn.com/abstract=336685. 

See also, ‘‘Regulating Complexity in Financial Markets’’, 87 Washington U.L. Rev. 211, 221–225 

(2009/2010), available at http://ssrn.com/abstractlid=1240863. 6 87 Washington U.L. Rev. 211, 238–245. 

ysis of how to attempt to respond to this insufficiency, see pages 

238–245 of ‘‘Regulating Complexity in Financial Markets’’. 6

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM TOM DEUTSCH 

Q.1. A number of panelists described the development of a new 

model representation and warranties document that would correct 

structural flaws in the current representation and warranties. 

What role should a private-standard setting body play in its development and implementation? What role should Government play? 

What would be the best method for determining whether a particular transaction deviated from the standards? 

A.1. Response not provided. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM MARTIN S. HUGHES 

Q.1. In your statement, you advocate for risk retention that favors 

a ‘‘horizontal slice,’’ which provides for retaining the first-loss securities, rather than a vertical slice. Should risk retention rules prescribe a specific form of risk retention or provide a choice of options 

for investors to choose from? What are the strengths and weaknesses of such an approach? In the wake of the financial crisis and 

evidence that some executives internally disparaged the quality of 

risky loans while publicly exuding confidence, how could investors 

have confidence that horizontal slices were really the rust-loss securities? 

A.1. Response not provided. 

Q.2. In your statement, you noted that ‘‘mortgage servicing issues 

are an impediment to broadly restarting private residential mortgage securitization.’’ How important is it that this be corrected 

quickly? What do you believe are the most critical items that 

should be part of any solution to restarting the RMBS market? 

Should this be a regulatory response or should private industry 

lead the way? 

A.2. Response not provided. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM LISA PENDERGRAST 

Q.1. A number of panelists described the development of a new 

model representation and warranties document that would correct 

structural flaws in the current representation and warranties. 

What role should a private-standard setting body play in its development and implementation? What role should Government play? 

What would be the best method for determining whether a particular transaction deviated from the standards? 

233 

A.1. The Commercial Real Estate (CRE) Finance Council is an association that represents a very broad and diverse constituency 

within the commercial real estate finance market, including portfolio, multifamily, and commercial mortgage-backed securities 

(CMBS) lenders; issuers of CMBS; loan and bond investors such as 

insurance companies, pension funds, and money managers; 

servicers; rating agencies; accounting firms; law firms; and other 

service providers. Even before the passage of the Dodd-Frank Wall 

Street Reform and Consumer Protection Act (Dodd-Frank), market 

participants within our industry were aware of a desire within the 

industry to address concerns that began to emerge at the onset of 

the economic crisis and that admittedly prompted policy makers to 

craft risk retention requirements. To address this demand, the 

CRE Finance Council independently developed a series of market 

reforms to strengthen the securitization market and foster greater 

investor confidence. Given our diverse representation and our stake 

in ensuring that the CMBS market is efficient and sustainable, we 

believe our private organization is uniquely positioned to create 

‘‘best practices’’ initiatives for the CMBS market. And since regulators have been tasked by Congress to consider and implement 

measures that essentially represent ‘‘best practices’’ for the various 

classes of asset-backed securities (e.g., the consideration of representations and warranties and of underwriting standards as part 

of the risk retention framework established in Dodd-Frank Section 

941(b)), we believe that the Government should look to industry-developed standards to help form the basis of such regulations, and 

we have urged the regulators to do this. 

One of the CRE Finance Council’s initiatives builds upon existing 

customary representations and warranties for CMBS to create 

‘‘Model Representations and Warranties’’ that represent industry 

consensus viewpoints. The CRE Finance Council’s model was the 

result of 200-plus hours of work by its Representations and Warranties Committee over the course of many months in 2010, and 

represents the input of more than 50 market participants with diverse views who worked to achieve industry consensus. 

The CRE Finance Council Model Representations and Warranties were specifically crafted to meet the needs of CMBS investors 

in a way that is also acceptable to issuers, and were developed with 

an emphasis on investor concerns about transparency and disclosure. Such Model Representations and Warranties for CMBS are 

designed to be made by the loan seller in the Mortgage Loan Purchase Agreements. The CRE Finance Council’s model will require 

issuers to present all prospective bond investors with a comparison 

via black line of the actual representations and warranties they 

make to the newly created CRE Finance Council Model Representations and Warranties. And in addition, loan-by-loan exceptions to 

the representations and warranties must also be disclosed to all 

prospective bond investors. The Model Representations provide a 

clear benchmark for comparison, and the need to black line to the 

Model Representations is a disclosure best-practice that makes any 

variations from the Model Representations easy for investors to 

evaluate. Use of the Model Representations as a reporting template 

is also a disclosure best-practice that helps investors understand 

what underwriting and documentation practices were applied, and 

234 

what was found in the underwriting process. This provides investors with a key tool that enables them to police the quality and 

completeness of underwriting procedures, and do their part in 

funding good origination practices while defunding bad practices 

that generate risks that can damage market sustainability. 

In this regard, it is important for policy makers to be aware that, 

unlike in the residential loan context, it is the normal course for 

there to be representation and warranty exceptions in CMBS transactions. This is the case because the facts and circumstances of 

each loan transaction are unique. For example, tenant verifications 

may vary from loan to loan depending upon the number and size 

of tenants, or certain environmental concerns may exist with respect to a property and property-specific steps may have been 

taken by a borrower to remediate those conditions. Disclosure of 

these differences is normal course and more broadly, properties 

that have unique features need and should attain financing provided that the loans are properly sized and structured. It would not 

be good public policy to render large swaths of commercial real estate unfinanceable just because the property has unique elements 

that would give rise to a representations exception. Investors understand that any large pool of commercial mortgages will generate 

many representation exceptions. What they seek is a clear disclosure of those exceptions, so that they can assess the quality of the 

prospective investment in the related bonds, in light of all of the 

key facts pertaining to the collateral pool. 

Finally, as part of the Model Representations and Warranties 

project, the CRE Finance Council also has developed a framework 

for addressing and resolving claims for breach of representations 

and warranties. We believe these enforcement standards will satisfy the Dodd-Frank Act’s requirement for ‘‘related enforcement 

mechanisms’’ when coupled with adequate representations and 

warranties. The CRE Finance Council resolution standards provide 

for mandatory mediation before litigation, and represent an industry consensus view on how to resolve disputes in an expedited, reliable, and fair fashion while also avoiding unnecessary costs. 

Q.2. In your written testimony, you described the commercial real 

estate industry’s work on the model representation and warranties 

agreement that you state: ‘‘coupled with extensive disclosure are 

considered a form of risk retention that is more valuable than having an issuer hold a 5 percent vertical or horizontal strip.’’ This appears to be an innovative approach to dealing with risk retention. 

Would you please expand on this concept? How would this approach be more valuable than retaining of a percentage of the risks 

of the underlying securities? 

A.2. The adoption of the CRE Finance Council Model Representations and Warranties is a step that both strengthens risk retention 

and empowers investors with a highly useful informational tool 

that can help them do their part in policing CMBS market practices. Some investors believe that the use of robust, standardized 

representations and warranties should be the key risk retention 

feature that regulators endorse because it helps investors actively 

monitor securitization quality rather than passively delegating that 

policing role to issuers, B-Piece buyers, rating agencies, or others. 

235 

Other investors prefer a regime where robust and standardized 

representations are a key part of a multifaceted risk retention regime, provided that no portion of the risk retention regime is so inflexible or ill constructed that it threatens to shut down or significantly chill origination and investment activities in the CMBS market, given that the vibrancy of this market is essential to the ongoing health of our economy. But the industry is united behind the 

need for, and efficacy of, adopting the Model Representations and 

Warranties as a key element in the solution. 

The CRE Finance Council appreciates the Committee’s interest 

in matters of concern to the commercial real estate finance industry, and we stand ready to work with you on these issues. If you 

have any additional questions, please feel free to contact Michael 

Flood, Vice President, Legislative and Regulatory Policy, CRE Finance Council, at (202) 429-6739 or mflood@crefc.org. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM ANN ELAINE RUTLEDGE 

Q.1. You state in your written remarks, ‘‘[A]n America that can rebuild its economy with sustainable securitization markets while 

building incentives for producers in the capital-intensive sectors of 

the economy will, forcibly, continue to lead the world financially 

. . . ’’ Could you expand on this? What types of incentives should 

be created? Who should be championing them? What policy 

changes should Congress consider? 

A.1. First, the phrase ‘‘sustainable securitization markets’’ needs 

unpacking. It has two underlying ideas— 

a. Securitization markets can be sustainable; and 

b. This would be desirable, because securitization is a fairer, 

more sustainable form of finance for rebuilding the economy. 

The latter point only sounds controversial. It isn’t. Securitization 

is 35 years old. It was an obscure market until the Credit Crisis. 

The best evidence that securitization is inherently stable is its 30- 

year obscurity. 

Securitization is a sustainable market form, if the rules are made 

transparent and enforced. 

The fall of Long Term Capital (LTCM) in 1998 was a watershed 

in securitization history. The culture of the market changed rapidly 

as derivatives traders, who make profits from small pricing inconsistencies and large amounts of leverage, moved into credit arbitrage using the tools of structured finance. As they poured new 

capital into the market, its focus shifted from corporate finance, an 

intrinsically static activity, to dynamic betting. Before, structuring 

bankers strove to keep up with what rating agency analysts were 

thinking. After the demise of LTCM, structured analysts struggled 

to keep up with what the leaders of the banking pack were thinking. 

Securitization was not built to handle credit arbitrage trading because the credit rating system, a key input in pricing and valuing 

structured securities, was static. This defect stimulated the growth 

of the market after LTCM. That’s right: the source of demand for 

236 

RMBS, CDOs, SIVs, and other structured products was not fundamental but generated by flawed market machinery and distorted 

prices. The bank-rush to squeeze as many faulty deals as possible 

through the system before it collapsed contributed massively to its 

ultimate collapse. 

Securitization is an information game. To bring it back, the information layer needs transparency. 

The history lesson should be clear: 

Securitization always worked, more or less, when the objective 

was to raise funds for companies. It only ceased to work when 

banks, who make more profit from trading than lending, found a 

way to book underwriting fees and profits from securitization, not 

just fees. The social lessons should also be clear: 

i. We should not delegate the responsibility for enforcing the 

rules to the banks when self-interest lies in breaking them. 

‘‘We are conflicted about what we want our institutions to do; 

we want them to be ethical, but we also want them to make 

lots of money.’’ http://bit.ly/m9k3zx. Banks are natural rentseekers. If we want them to be profitable, we can’t ask them 

to act like regulators. 

ii. Individuals in a market-capitalist economy cannot delegate 

their responsibility for keeping the market healthy, any more 

than a democracy can delegate the duty of electing its representatives. The responsibility is ours, collectively. 

We can make the securitization market stable again by publishing information that is relevant to dealing, ensure that the 

structuring rules are carried out, and see that benchmarks of value 

are enforced. To these ends, Regulation AB is a highly effective disclosure framework that enables the securitization market to govern 

itself, with or without rating agencies. 

In my opinion, the original 2005 ruling would have been a perfectly adequate standard if the market had been sophisticated 

about securitization. It wasn’t, and it isn’t, so further revisions 

have been proposed to make the practice elements come together 

to form a firmer, fairer market basis. 

Three action items are required to make Regulation AB a complete standard. These are mainly outside the jurisdiction and control of the SEC and therefore merit further comment below: 

i. More education about structured finance and securitization is 

needed. These skills are taught in very few finance departments of business schools. The explanation—that the approach 

is structural rather than empirical, and therefore unorthodox 

and unpopular—is a little bit outside the scope of my responses. But, the result is that people learn structured finance 

and securitization in the workplace—and, as you can imagine 

after the Crisis, in many cases, some of what was learned is 

wrong. 

ii. Numeracy deficits need to be addressed through our educational system. In one of his tweets, Steve Martin says the 

‘‘hat’’ key (shift+6) is a wasted space on the keyboard. This is 

oddly true. The hat key is the operator for exponents in Excel. 

237 

If the average mortgagor knew how to work with exponents, 

they could do loan math. This would be a massive victory for 

consumers and knowledge workers in America’s information 

society. 

iii. The structured finance rating scale should be published 

(Question ii). To foster a genuine two-way market that can 

police itself (and legislators and regulators can take a welldeserved break from dealing with securitization issues) the 

rating scale needs to be a public good, available to everyone 

and anyone. 

Rebuilding the American economy with securitization. 

New companies and small companies are not well served by the 

financial system as it is currently constituted. Moreover, for structural reasons, we can expect things to get worse. In this section, 

I justify my assertions and explain how securitization is an answer—even though we have rarely seen it used that way in the 

past. 

In corporate finance 101, we learn that growing firms need working capital because sales alone are not enough to finance and build 

a sustainable scale of operations. The decision to borrow does not 

signify ‘‘living beyond one’s means’’ (as it may for consumers) but 

rather pride of ownership and an enterprising spirit. Finance theory teaches that equity capital involves loss of some ownership and 

control and costs more than company debt. But, in the trenches of 

finance, we discover a paradox: affordable debt is extended mainly 

to large, mature, well-capitalized firms that don’t need the funding. 

Moreover, middle market lending today has become a casualty of 

the capital management system. To get working capital, small and 

medium sized businesses (SMEs) turn to personal credit cards or 

unlicensed lenders, or leverage their homes. This condition describes a large set of 27 million firms (96 percent of the American 

businesses community), which have fewer than 500 employees yet 

employ 50 percent of the American labor force according to the 

2008 U.S. Census. www.census.gov/econ/smallbusiness.html. Moreover, the ‘‘nonemployer’’ firms who represent 74 percent of the businesses in America may never build up enough equity to be able to 

reach equilibrium and do the normal things most business owners 

long to do—hire employees, provide health care, pay their lenders 

and suppliers, and give to charities. Debt financing for innovative 

startups that produce jobs is also scarce. Wind River Systems, 

founded in 1983, is the prototype of a startup in the engineering/ 

information space that is too sophisticated for the average lender 

to understand. They make embedded operating systems, employ 

1,500 people, and generate over $350 MM in annual revenues. But 

their business is too sophisticated for the debt market, and in the 

early days, the working capital amounts they required would have 

been too small to merit a wholesale lender’s attention. 

The stark reality is, a small business owner or entrepreneur in 

America today may never be bankable—no matter how much we 

trust or like them personally, how much their business enhances 

our lives or how lifesaving their inventions may turn out to be. 

238 

Our economy is severely afflicted by an invisible structural funding gap, and unless the incentives of the financial system are redirected towards putting capital back into the real economy, things 

are going to get worse. Financial system trends towards deregulation, disintermediation, Basel, consolidation, etc., have created incentives for the large banks to deal in ever-larger, ever more 

levered packets of capital at razor-thin margins. The efficiency 

gains are not being redistributed to players in the real economy— 

the gains are feeding the financial economy. 

It does not have to be this way. 

Securitization is a fairer, more sustainable form of finance for rebuilding the economy. 

Any firm that knows its clients and its business, and runs it professionally, becomes bankable with securitization. That is because 

the lending decision is based, not on how big the company brand 

is, but how reliably the receivables perform. With securitization, 

the more professional, targeted, and responsive to market the firm 

is, and the better its collections, the greater its access to affordable 

working capital—if the conditions for market sustainability are 

met. 

Securitization is about putting the value of the capital created by 

firms back to work faster, so that the firm can realize its economic 

potential. Sustainable securitization also realigns the incentives 

along the supply chain of credit so that other institutions in the 

same sector use their capital efficiently and appropriately. This is 

due to the influence of informational feedback: firms that securitize 

and repay according to plan receive lower-cost funding and those 

that violate expectations must pay more for their capital. Below, 

three illustrations of how securitization has been or could be used, 

to revive the American dream: 

Practical examples of how securitization can put certain sectors on 

a more sustainable financing basis. 

#1, Live Example: A securitization of stallion stud fees and associated syndicate shares in 2007 allowed a small but skilled thoroughbred farm to raise five times the amount of its equity capital 

to invest in new stallion syndicate shares. In one go, this breeder 

farm went from a small player to a substantial player, and at the 

same time, halved the interest cost of an on-balance sheet loan. 

This transaction was shadow-rated and funded in a bank conduit. As the senior creditor, the conduit provided a more affordable 

cost of capital (instead of the lending specialist’s cost) because 

i. The investor was not collateralized by individual horses but a 

senior slice of pooled cash flows from the pledged studding fees 

and protected by a pledge of syndicate shares; 

ii. The structure was well-crafted to defend investors against the 

biggest risks in the deal (mortality, infertility, sterility leading to declines in cash flow and share value); and 

iii. Investors were provided ample high quality information 

about the risks and sources of value in the investment. 

The transaction has performed extremely well through the worst 

of the Crisis. 

239 

1 Here is where the numbers come from: a 4:1 leverage ratio implies a debt layer of 80 percent, equity of 20 percent. Therefore, $1 BN/20 percent= $5 BN. If the equity investors demand 

17 percent returns and the debt investors require 5.625 percent returns, the weighted average 

interest cost would be 7.5 percent. 

#2, extending the Live Example to businesses in your State: There 

is nothing special about a securitization of stallion stud fees; this 

financing solution could be applied to other industries in your 

State—for example, to energize solar energy, film, music, digital 

media, information technology, aircraft, health care, and companies 

with commercially viable process patents ranging from toys and 

games to defense industries, to life sciences. 

Start with 2,500 financially viable SMEs that have been around a few years. Suppose that they could each borrow $400,000 at 15 

percent per annum. Or, $1 BN pool of their receivables could be 

securitized off-balance sheet and funded by issuing two tranches 

(slices) of securities: senior debt and equity. On a blended (weighted average) basis, the funding would be cheaper. 

How much capital could be conserved? The blended rate is market-determined, and this is a hypothetical example. But, suppose it 

turns out to be 7.5 percent. Over 10 years, the amount of interest 

expense reduction would exceed 50 percent of the initial borrowing, 

or about $514.8 MM. If a rating agency determined that the senior 

debt can be investment grade with 4:1 leverage in the capital structure, $5 billion of new working capital could be raised for the businesses. 1 The footnote goes through the numbers. 

What about the new capital flows—where does this money go? 

Borrowing firms could redeploy the interest savings as additional 

working capital, reinvestment in the business, or dividends. 

As a condition of participating in this SME fund, the firms could 

be required to earmark a portion of the proceeds to hire and retain 

the best IT and engineering talent for their businesses. This is one 

way to reinforce their responsibility to keep their value proposition 

alive. Their success would be measured by the performance of their 

receivables. If they underperformed expectations, they would have 

to exit the fund. Conversely, as the firms grew in size and reputation, like our Wind River Systems example, they could come off the 

SME Fund and securitize as standalone firms. 

Knowledge of structure allows States to help industries design 

and plan for the future. To illustrate, a small equity slice could be 

carved out of the capital structure—a ‘‘genius tranche’’—for reinvestment in numeracy, structured finance education, engineering 

sciences, policy projects, with conditions attached to bring the value 

back into the fund, ultimately. Success could be measured in the 

fund’s financial gains. 

Using securitization to put our Federal dollars to work more efficiently. 

Two months ago, an article came out about the House Small 

Business Committee cutting $100 MM from a $985 MM Small 

Business Administration budget. Another way to think about 

achieving more capital efficiency from the SBA would be through 

targeted securitizations where the structuring would be goal-directed and results-oriented; administration costs would be reduced 

240 

2 ‘‘Tough Choices on SBA Budget’’, Portfolio.com, March 15, 2011. 

3 Evans, Harold, ‘‘They Made America’’, New York: Little, Brown & Company, 2004. 

by tying program performance measures to the performance of the 

transactions; and new money would flow back into the markets. 2

That is not to say the SBA has not used securitization—they 

have. But, to reignite the economy, it must be used more effectively, with continuous measurement and reinvestment in what 

works. 

#3, making Health Care Finance sustainable: Another example of 

how securitization could add value at a national and systemic level 

is by using ‘‘true sale’’ securitizations backed by individual receivables (not blanket liens) to reform health care finance. Wherever 

health care is treated as a cost center (Germany or Taiwan, for example) the public bears less than a quarter of the expense where 

health care is considered a revenue center (the U.S.). But a costbased system does not offer the same range of choice, and the 

budget for reinvestment in new techniques is not there. 

Health care finance securitizations are a sustainable compromise 

between patient autonomy and system affordability. ‘‘True sale’’ 

securitization, where the receivables are discounted at their face 

value (not bundled and blindly pledged) accelerates the turnover of 

capital inside hospitals. Insurance companies also love it, because 

health care receivables securitization solves their only real financial challenge: Asset-Liability Management. They do not need capital for this type of securitization; the returns will be very high yet 

stable. When health care receivables are put to work by using 

securitization, our communities will be able to have the quality of 

care they are willing to pay for, affordably. 

Only America has the financial know-how to lead economic growth 

through sustainable securitization. 

America may be the land of plenty but it does not hold an infinite reservoir of cash. We must learn how to use the resources we 

have more efficiently without unthinkable sacrifices. To put our financial assets to work for us, we need securitization. We can create 

a model for economies to follow, to develop their economies and distribute the benefits of hard work more equitably. This is how 

America will reestablish its position as a global financial leader. 

What types of incentives should be created? Who should be 

championing them? What policy changes should Congress consider? 

I believe we do not need new incentives. We need to redirect the 

incentives already there in the financial system, to make capital 

work harder for us. This will require carrots and sticks. 

Carrots first: incentives to recognize and reward the value created 

by knowledge workers outside finance. 

Harold Evans’ book on American innovation, They Made America 3 and the companion PBS series, talk about how promoters and 

financiers harvest the value built created by inventors, who remain 

wage slaves. 

241 

This is a social problem to match the funding problem already 

discussed. Just as most of the value made in the real economy 

feeds the financial economy and does not flow back to the real 

economy, so do knowledge workers follow the money into finance, 

to partake in rewards and recognitions as bankers. Few ever return 

to the real economy. 

Incentives are needed to reverse this direction and encourage 

highly trained people in the sciences and engineering to stay there. 

For this to happen, some of the value created in the real economy 

has to flow back to the real economy. I have already suggested how 

securitization does this through example #2. For engineers that 

prefer to work in finance, they still have a role: putting their deep 

knowledge of processes and mathematics to work in monetizing 

value in IP-intensive businesses. The value will circulate much 

faster with securitization. The lift to the economy, and the job creation flowing from it, would be swift and self-propelling. 

As I see it, securitization in its sustainable form may be the only 

way to systematically realign the incentives to put the economy on 

a more equitable footing. It cannot be done piecemeal. 

We also need sticks. Better enforcement will not stifle borrowing and 

lending. It will revive it. 

If you know how securitization works, fraud is shockingly easy 

to commit and get away with. Cheaters should be punished. We already have clear set of rules that facilitate a bright-line determination of material misstatement, but not enough people know how 

they work. This has to change. 

Embracing and enforcing Regulation AB is the key to market sustainability. 

The latest version of Reg AB boils down to two styles of regulation: disclosure and risk retention. 

I have nothing against risk-retention—in fact, I am in favor of 

it for shelf-registrations, at least until the Crisis is firmly behind 

us. But risk retention takes capital out of the system so we have 

less to work with; and the jury is out on whether it really stops 

the cheating. There was plenty of risk retention before the Crisis— 

it just was not disclosed. And the problem with undisclosed risk is 

just that. No one knows how big the risk actually is. That is why 

disclosure is a much more effective deterrent. Reference the figure 

below: if originators are required to hold a 10 percent ‘‘horizontal 

slice’’ (O/C) then one originator may decide to get around risk-retention by originating and securitizing loans with expected cumulative losses greater than 10 percent while the other follows the 

rules. Note the differences: 

242 

4SEC Commissioner Kathleen Casey makes a strong argument for competition in her speech, 

‘‘In Search of Transparency, Accountability, and Competition: The Regulation of Credit Rating 

Agencies’’, February 2009. 

Senior investors in SPE1 are collateralized by a pool where the 

cumulative loss is 11 percent. They will lose 1 percent of principal 

(the red sliver above the O/C slice). Senior investors in SPE2 are 

protected by the additional asset coverage exceeding the 2 percent 

cumulative loss. 

If all we have to rely on is risk-retention, the quality differences 

between SPEs l and 2 remain invisible. Between tougher disclosure 

requirements and risk retention, cheaters prefer the latter because 

they can go on cheating until the deal collapses. Disclosure shines 

a bright light on cheating for all to see before the deal collapses. 

Competition among NRSROs or surrogates is also key. 

The prescription for using securitization to finance emerging enterprises and projects only works if a rating agency or other neutral institution is around to vet the financial viability of these 

transactions in the primary market. 

New rating agencies that are not paralyzed with fear of litigation, that can rate securitizations confidently and without fear of 

liability, are much needed. This is why fostering competition 

among NRSROs by opening up the field to new entrants, as was 

proposed under credit rating agency reform initiatives, continues to 

be so important. 4

Who else should be championing the[se incentives]? 

A financial market is a remarkably agile, resilient source of incentives all by itself. Once we commit to better regulation by inforVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00246 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51 51811167.eps
243 

5 Rutledge, Ann, ‘‘Study Manual for Paper 10 Credit Rating Services of the Licensing Examination for Securities and Futures Intermediaries’’, Hong Kong Securities Institute. May 2011, 

p. 2–11. 

mation make the ratings industry more competitive, the market 

should resurrect itself in due course. 

But this could happen a lot faster if President Obama, the Council of Economic Advisors, and certain key OMB staffers were willing to take a fresh look at how securitization can be used to manage the Federal deficit more effectively. Demonstrating that our 

debt is being used productively to generate future growth and earnings through targeted, well-structured securitizations would not 

only be good for the dollar, it would be a compelling template for 

the global financial markets to manage their assets more effectively 

and democratically. 

Q.2. You also describe the need for a structured rating scale for 

transactions. Would you expand on this concept? How would the 

rating scale be administered? Should the rules be promulgated by 

a private standard-setting body, such as the International Organization for Standardization (ISO)? Who would provide the assessments? Where do rating agencies fall short? 

A.2. The structured finance rating scale (or structured rating scale) 

is the set of performance benchmarks against which structured securities are rated. The structured finance scale does not just permit 

qualitative comparison, like the corporate rating scale, for instance 5: 

The structured finance scale is a numerical scale where the output can be a direct factor in valuation and pricing. The output of 

a corporate finance scale can only be linked to a price through the 

intermediation of the market. Already, it is something special and 

powerful, because the intervals are said to have an objective meaning—similar to a temperature scale. 

Moreover, each rating agency has its own characterization of the 

meaning of the rating but all definitions relate to payment certainty and are similar in nature. In structured finance, each rating 

agency also has its own rating definition, but the differences are 

anchored on measures: projected portfolio default rate, expected 

loss of principal or average reduction of yield. (My testimony referred to average reduction of yield scales, so I will stick with it 

for my numerical illustration in the next section.) Unlike temperature scales, where Fahrenheit can be converted directly to CentiVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00247 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51 51811168.eps
244 

grade, and vice versa, the units are not always convertible. This is 

an incentive for ‘‘rating shopping.’’ 

The macroeconomic significance of the structured finance rating 

scale. 

The design of the scale (choice of measure, length of intervals) 

determines how consistently structured securities are rated. Fundamentally, it also determines the credit quality of the securities 

that bear the rating, not individually but on average across the entire market. In a macroperspective, the structured scale becomes a 

tool for calibrating the amount of leverage in the economy. During 

a bona fide economic expansion, when good quality receivables are 

being generated, more bona fide AAA/Aaa-rated structured securities can come to market when the financing is needed. During economic contraction, fewer will be produced. This is exactly as it 

should be. 

The rigor of the scale sets the overall tone. One with lax benchmarks increases leverage and lowers credit quality. One with high 

hurdles contracts leverage and raises credit quality. Rating agencies will always face pressures from issuers to lower their standards and investors will always prefer that the standards be as 

strict as possible. Giving in will make things worse, since the pressure to lower the standards when credit quality is deteriorating 

will sink the market further, and vice versa. That is exactly what 

we don’t want to happen to the economy. 

That is the rationale for my appeal to separate the roles of setting the structured scale and enforcing the structured scale. Enforcing the scale means reverse-engineering the deal and rerating 

it. This can be done by rating agencies, as well as by any other 

skilled person who bothers to get data from the Reg AB Web site. 

The more opinions, the better! By catching improperly rated or 

mispriced deals early on, the market can prevent a crisis like the 

one we just went through—but only if the structured scale is public. Presently no one knows what the structured rating scale is, and 

this makes arm’s-length assessments of ratings impossible, like 

driving without knowing the speed limit, as I said in my testimony. 

Who should set the structured rating scale? 

Originally I had thought that President Obama and the head of 

the Council of Economic Advisors and the Comptroller General of 

the United States should jointly promulgate the structured scale 

for the U.S. market, as a matter of national economic priority. They 

might wish to consult and coordinate with the Federal Reserve and 

the Treasury—but it should not be decided by the Fed or Treasury 

due to potential conflicts of interest involving the financial sector. 

Since securitization is a global market, it would be advisable for 

the U.S. to share its rationale for setting the levels of the structured rating scale with the G20. The likely outcome would be for 

other economies to adopt the same scale—otherwise, rating shopping would occur between countries until the public officials decided to impose uniform standards. You make a good suggestion 

that the final determination of structured scale could be delivered 

by the ISO, after a pilot period of review and analysis. 

245 

What properties should the scale embody? 

The structured rating scale should be designed to be unambiguous. It should be linked to the Average Reduction of Yield scale 

because it is the only measure that makes sense for structured finance. Public use of the scale will ensure proper calibration between the amount of leverage and certainty of structured debt in 

the system. The scale I would propose based on 30 years of structuring experience, and the underlying concepts, are explained 

below: 

1. The left column represents the rating. The right column represents the benchmark. 

2. To rate a structured transaction, the analyst runs a large series of Monte Carlo scenarios and obtains performance measures on each scenario. 

3. In most scenarios, investors receive all the interest and principal they are promised. But under severely stressed scenarios, they will experience yield shortfalls. The 

arithmetically averaged yield shortfall across all the 

iterations, or Average Reduction of Yield, is mapped to a rating. 

4. So if, through a Monte Carlo simulation, the security loses an 

average of 0.05 basis points (bps) of yield, other things being 

equal, the security should merit a Aaa (triple-A) rating because the benchmark is 0.05 bps. A loss of 0.05 bps of yield 

on a security with (hypothetically) a nominal yield of 4.25 percent at par and an average life of 5 years will have an exVerDate Nov 24 2008 15:42 Nov 21, 2011 Jkt 048080 PO 00000 Frm 00249 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-18 THE STATE OF THE SECURITIZATION MARKETS\HEARING\51 51811169.eps
246 

pected yield of 4.2495 percent. The 4.25 percent yield comes 

from looking at the market and finding where Aaa-rated securities with an average life of 5 years are pricing and what 

they are yielding. 

5. But, if the security loses 25 bps of yield, it merits a Baa2 (triple-B flat) rating. A loss of 25 bps of yield on a security with 

a nominal yield of 6.25 percent will have an expected yield of 

6.00 percent, by the same logic as in (4). 

6. If, several months later, the same ‘‘Baa2’’ security is reanalyzed in a responsible manner and, on an apples-to-apples 

basis, produces an average reduction of yield of 5 bps, it is no 

longer a Baa2 but an A1. If reanalysis produces an average 

reduction of yield of 200 bps, it is now a B1. 

Where do rating agencies fall short? 

The rating agencies fall short in two ways: first, competition between the agencies based on the rating scale is likely to exacerbate 

credit rating arbitrage, or ‘‘rating shopping.’’ But, the agencies will 

not give up their power to make the scale voluntarily. This means 

a uniform measure is unlikely to emerge, unless the scale is imposed from outside the system—preferably by a body that is independent, unbiased and interested in solving the ages-old dilemmas 

of calibrating credit extension/curtailment to economic growth/contraction. 

The other way credit rating agencies fall short is by failing to 

rerate structured securities using the original benchmarks for the 

primary market. As mentioned previously, securitization was not 

built to handle credit arbitrage trading because the credit rating 

system, a key input in pricing and valuing structured securities, 

was static. When all is said and done, lagging ratings in structured 

finance is the underlying cause of the credit crisis. 

Who would provide the assessments? 

If the market is held to a consistent set of benchmarks so that 

AAA always signifies the same risk-return proposition over the life 

of a structured security—in the same way that a 25-mile an hour 

speed limit always means the same thing, or a foot is always 12 

inches—then it does not matter who provides the assessments. Rating agencies will . . . but others with investments on the line, or 

ambitions to be recognized for their analytical excellence, will set 

up to the plate. That is financial democracy in action. 

Senator Reed, thank you again for your questions and the opportunity to respond to them. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM CHRIS J. KATOPIS 

Q.1. In your written statement, you stated: ‘‘Mortgage investors 

seek effective, long-term sustainable solutions for responsible 

homeowners seeking to stay in their homes . . . [and] mortgage investors, primarily first lien holders, do not object to modifications 

as part of the solution. Unfortunately, mortgage investors are powerless under the [servicing agreements] to offer such support.’’ 

247 

1http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/securitization-tamingwild-west 2 It is estimated that the five largest servicers control 59 percent of the Nation’s residential 

mortgage servicing. 

• Why are investors powerless? 

• Are there ways to empower investors to ensure that decisions 

that make financial sense are actually made? In other words, 

is there a reasonable way to help both homeowners and investors? 

• Could you please explain why, from an investor’s perspective, 

a loan modification in some cases can make more financial 

sense than pursuing foreclosure? 

A.1. The business environment and dominant mortgage 

securitization practices preceding the financial crisis are well-documented. Economist Joshua Rosner has likened this period to a 

‘‘wild, west’’ which ultimately proved harmful for consumer, investors, and the Nation-at-large. 1 The legal structure that underlies 

and controls the residential mortgage-backed securities (RMBS) 

pools and servicing are governed largely by contracts, such as Pooling and Servicing Agreements (PSAs). These contracts govern the 

rights and remedies for first-lien holders (e.g., mortgage investors) 

and consumers. 

Investors comprise the ‘‘buy-side’’ of the securities industry, i.e., 

they purchase and hold securities like RMBS; whereas, bank 

servicers and their affiliates comprise what is known as the ‘‘sellside,’’ i.e., they create and sell securities like RMBS. The mortgage 

securitization business has evolved over the past several decades in 

a manner strongly influenced through the sell-side’s control over 

the structuring and documentation of RMBS and on the ad hoc collection of State law that governs real estate ownership, financing 

and foreclosure. 2 Accordingly, the terms of RMBS securitization 

are one-sided in favor of the sell-side and against investors in 

many important respects due to the investors’ lack of bargaining 

power relative to underwriters, including: 

• The entities offering RMBS securities have enormous market 

power and concentration; 

• Securities were offered on a take-it-or-leave it basis, providing 

investors only hours to make a deal decision normally requiring enormous diligence and review; 

• The PSAs were very complicated legal documents that varied 

widely from deal-to-deal (we believe that more than 300 variations of PSAs were in use), written by the sell-side and with 

little to no input from investors; and, 

• The PSAs contained a variety of contractual clauses which favored the rights of originators, servicers, and their affiliates 

over investors and consumers. One example is that these contracts provide a very high bar for parties to enforce their legal 

rights and pursue remedies; if RMBS servicers and trustees do 

not honor their obligations to service mortgages properly and 

to enforce representations and warranties against the parties 

that originated the mortgages in the first place, there is little 

that investors can do. Accordingly, it is extremely difficult for 

248 

investors to push for changes in mortgage servicing even if 

such changes would increase the economic value available to 

investors while keeping people in their homes through NPVpositive loan modifications. 

We believe that it is reasonable for the RMBS securities comprising more than one trillion dollars of U.S. mortgage financing to 

be governed by documents that are fair to both investors and the 

sell-side, not the one-sided documents putting the sell-side at the 

center of every conflict of interest, adverse to investors and consumers, as they were prior to the financial crisis. The Association 

of Mortgage Investors calls on policy makers to help develop the 

necessary standards, structures, and systems to ensure a sound 

securitization system and robust capital markets. These solutions 

range from enacting legislation analogous to the Trust Indenture 

Act (which solved problems for corporate bonds revealed by the 

1929 financial markets crash similar to the problems that exist for 

RMBS today), to developing a uniform and standardized Pooling 

and Servicing Agreement for all widely offered and traded RMBS 

securities. A properly developed capital market infrastructure will 

assist both investors (and our affiliated public institutions such as 

pensions and retirement systems) and consumers enforce their 

rights and remedies, such getting effective remedies to breaches of 

representations and warranties in securitizations. Additionally, 

such reforms, including nationwide servicing standards, would 

serve to facilitate remedies for distressed borrowers. 

The basis for mortgage investors preferring mortgage modifications in many circumstances is founded on a sound business case. 

First, we believe that a population of distressed borrowers have 

both the willingness to pay a certain monthly mortgage payment, 

local taxes, and related expenses and the ability to pay after a 

modification. In contrast, we concede that not every distressed borrower is an eligible candidate for a mortgage modification, inter 

alia, some may have too much aggregate household debt or may be 

a victim of long-term unemployment. We believe that a reallocation 

of one’s cash flows, assets, and liabilities is exemplary of sound 

business judgment. Accordingly, we favor a modification under certain conditions (e.g., the NPV-positive calculation) because a percentage modification is a far superior (business) proposition for investors and our affiliates, such as State pension funds and retirement systems, over a default (a loss arising from a foreclosure). 

Q.2. In your written statement, your advocate for the creation of 

an independent trustee, similar to that created under the Trust Indenture Act of 1939. What benefits would such a proposal provide? 

What are the weaknesses? Could this same result be achieved 

under a national pooling and servicing standard? Why or why not? 

A.2. AMI raises this point to illustrate a serious problem facing investors, public institutions, and consumers. The current RMBS system is not functioning properly. With no properly independent and 

incentivized third party looking after the interests of investors in 

securitizations, there are strong incentives to put bad mortgages 

into RMBS securitizations and to mismanage them to maximize income to servicers after the mortgages are no longer the economic 

concern of the originators. As previously explained, the documents 

249 

controlling a RMBS securitization, such as Pooling and Servicing 

Agreement (PSA), provide for a trustee to oversee the pool of collateral underlying the trust (i.e., residential mortgages). 

Neither the current servicing model nor trustee model is well-designed for today’s economic climate and its default rates. The 

RMBS pool trustee cannot adequately serve the role of a fiduciary 

as envisioned for a variety of reasons, including, 

1. Being inherently conflicted, as they are employees of the 

servicer and its affiliates; 

2. Failing to provide the necessary financial resources to adequately oversee the trust; and, 

3. Insisting on being indemnified by the trust and/or investors 

for anything short of the basic ministerial functions that the 

originator and servicer want them to do. 

As a consequence, as a general matter trustees have been unresponsive to their investors and reluctant to address problems that 

have emerged in the mortgage pools which they are nominally 

charged with overseeing. This may be addressed in several possible 

manners, including legislation analogous to the Trust Indenture 

Act of 1939 or the adoption of a national uniform, standardized 

Pooling and Servicing Agreement that provides for a true third 

party fiduciary to act on behalf of investors. 

The Trust Indenture Act of 1939 (the ‘‘TIA’’) is very instructive 

on a number of levels. It was enacted following the Great Depression and the 1929 stock market crash. As a result, the corporate 

bond market and the related legal environment have functioned 

positively for decades. However, it was enacted against a background where the Nation’s bond markets were not functioning effectively and investors lacked sufficient safeguards. 

In developing this legislation, the U.S. Senate Banking Committee tasked the Securities and Exchange Commission to study 

the issue and develop a report. The effort was spearheaded by Abe 

Fortas and William O. Douglas (both future U.S. Supreme Court 

justices). The text of the resulting TIA directly speaks to these 

points of that era, which are equally applicable today: 

Upon the basis of facts disclosed by the reports of the Securities and Exchange Commission made to the Congress 

. . . it is hereby declared that the national public interest 

and the interest of investors in notes, bonds, debentures 

. . . which are offered to the public, are adversely affected— 

(1) When the obligor fails to provide a trustee to protect 

and enforce the rights and to represent the interests of 

such investors . . . 

(2) When the trustee does not have adequate rights and 

powers, or adequate duties and responsibilities, in connection with matters relating to the protection and enforcement of the rights of such investors . . . 

(3) When the trustee does not have resources commensurate with its responsibilities . . . 

250 

3Trust Indenture Act of 1939, §302, as added Aug. 3, 1939, ch. 411, 53 Stat. 1150. 

(4) When the obligor is not obligated to furnish to the 

trustee under the indenture and to such investors adequate current information as to its financial condition, and 

as to the performance of its obligations with respect to the 

securities outstanding under such indenture . . . 

(5) When the indenture contains provisions which are misleading or deceptive, or when full and fair disclosure is not 

made to prospective investors of the effect of important indenture provisions . . . 

Practices of the character above enumerated have existed 

to such an extent that, unless regulated, the public offering of notes, bond, debentures [etc.] is injurious to the capital markets, to investors, and to the general public . . . 3

The Trust Indenture Act has proven an effective reform for establishing an effective corporate bond structure. It brought reluctant investors back into the bond market, just as the U.S. Government needs to bring reluctant investors back into the private 

RMBS market. The backdrop for the enactment of the Act is very 

similar to the circumstances witnessed today. In theory and in the 

absence of any specific draft legislation, we are not aware of any 

weaknesses arising from such a legislative remedy. As an alternative to legislation, these defects could also be addressed through 

regulation or an enhanced set of provisions in a national, standardized, mandatory PSA. 

In response to the SEC’s 2010 notice and comments for Regulation AB II, the AMI, along with other financial services associations, called for the establishment of a true, independent thirdparty to review the matters arising pertaining to the rights and 

remedies of investors. A qualified credit risk manager (CRM) would 

be independent from other parties to the Asset-Backed Securities 

(ABS) trust, represent the interests of all certificate-holders in investigations, and, if warranted, pursue claims for breaches of contractual obligations against responsible parties. A CRM should 

have the independent authority and independent discretion to pursue claims as a fiduciary of the certificate holders or act on behalf 

of individual certificate holders under special, limited circumstances. Finally, we agree that in discharging its obligations as 

a compensated third party to the PSA, the CRM, or any equivalent, 

must have complete access to loan and servicing files in order to 

conduct a proper examination and effectively pursue resulting 

claims. 

Again, we greatly appreciate the opportunity to respond on the 

record to the Committee’s questions as part of the ongoing inquiry. 

Please do not hesitate to use us as resource as you continue your 

review of the state of the U.S.’s securitization markets.