The SEC has proposed new rules governing various aspects of the asset-backed-securities (ABS) market. One in particular is a true surprise: The SEC wants to require that ABS issuers release Python code (!!) that will codify (literally) the contractual provisions of the ABS. The SEC also wants to reduce the reliance on credit ratings during the issuance process. To think about these proposals, we first need to remember what an asset-backed security is.
An asset backed security is a debt-like claim that makes payments based on the performance of an underlying asset pool. If you buy a bunch of mortgages and then sell debt which makes payments based on the cash flows produced by these mortgages, you’ve created an asset backed security. The actual details of an ABS can be mind-numbingly complex. Typically the ABS is structured to carve up the return on the underlying asset pool into different tranches, so that a senior tranche gets paid based on the best-performing mortgages and an equity tranche gets paid only if the worst-performing mortgages perform well. There can be thousands of underlying securities and a dozen or more tranches in these structures, and the rules determining who gets paid when can be very complicated. The SEC has an outstanding proposal in this regard (emphasis added):
We also are proposing to require that, with some exceptions, prospectuses for public offerings of asset-backed securities and ongoing Exchange Act reports contain specified asset-level information about each of the assets in the pool. The asset-level information would be provided according to proposed standards and in a tagged data format using eXtensible Markup Language (XML). In addition, we are proposing to require, along with the prospectus filing, the filing of a computer program of the contractual cash flow provisions expressed as downloadable source code in Python, a commonly used open source interpretive programming language.
In other words: The ABS issuer will have to supply a computer file in a standard format that documents the underlying assets, and will also have to supply a computer program so that you can see exactly how the cash flows work. This is a clear win for transparency and efficiency. It will be interesting to see what happens the first time there is a conflict between the computer code and the written documentation for the ABS. If an ABS ends up in court, which will be definitive?
The SEC is also proposing to eliminate a requirement that an ABS issuer obtain credit ratings if they wish to shelf-register the ABS. This is part of an ongoing effort to eliminate references to credit ratings from regulations. My own view is that the SEC should completely divorce itself from any reliance on credit ratings, and they should do away with the Nationally Recognized Statistical Rating Organization designation. So I think this is a step in the right direction. As a quid pro quo for getting rid of ratings in a shelf-registration, the SEC wants to require that the issuer hold a piece of all tranches.
In the past it’s been all too easy to criticize the SEC. I hope this proposal is indicative of things to come.