Conform or Explain: Regulating the Private Market for Asset-Backed Securities

The Securities Act of 1933 (the “Act”) regulates the offering of securities to the public through strict disclosure and registration requirements. There are, however, numerous exemptions that ease or eliminate these requirements for transactions involving sophisticated buyers. In the decade preceding the 2008 Financial Crisis, an overheated housing market resulted in the explosion of the securitization business on Wall Street. The business consisted of financial institutions pooling mortgages and using the asset pools as collateral for bonds sold to investors. The simpler versions of these asset-backed securities (“ABS”) were sold in the public market, subject to the requirements of the Act. The more complex spin-offs, such as collateralized debt obligations (“CDOs”), were issued in the exempt, quasi-unregulated private market. As 2007 approached and investors grew hungrier for exposure to the housing market, the asset pools became polluted with increasingly risky (subprime) mortgages. The resulting bubble, fueled largely by CDO investors in the private market, grew ominously large. Eventually, the housing market came to a screeching halt as homeowners began defaulting on their mortgage payments, setting off a catastrophic domino effect that culminated in the Financial Crisis. In response to the Crisis, Congress passed the Dodd-Frank Act in 2010. The law sought to tighten the regulation of non-corporate ABS and directed the Securities and Exchange Commission (“SEC”), the agency in charge of securities regulation, to revise its rules accordingly. The SEC did so by enhancing the disclosure requirements on public offerings of ABS. The agency failed, however, to intervene in the private market for ABS, despite compelling evidence of its systemic importance. The result is that today, the market that gestated the collapse of the global economy remains mostly unregulated. To close this regulatory gap, this article draws heavily from the post-crisis literature on financial complexity and systemic risk and proposes a Jill Fisch-inspired “conform or explain” product-based approach to regulating the private ABS market. The objective is to reduce dangerous systemic complexity by encouraging standardization through a non-prohibitive regime. The regime would give issuers the attractive low-cost option of issuing “plain vanilla” products from an SEC-established menu, having only to provide investors with streamlined deal-specific disclosure in the form of a “term sheet.” Issuers would still be free, however, to offer innovative, off-menu products. The burden for selling these non-conforming products would be significantly higher. Issuers would have to file an offering memorandum with the SEC (1) explaining how their product differs from the most similar product category in the menu, thus providing valuable comparative information to investors, and (2) showing that the new product passes three systemic tests. The first is that the new product has some economic and social utility that exists outside financial markets. The second is that the institution offering it has the capacity to manage the risks associated with the product. The third is that the product does not inject an unacceptable amount of systemic risk into the market and does not pose other public policy concerns.