A Key Bond Market Thaws, but It May Be Only Temporary

Ice melting with polar bear
Ice melting with polar bear

The market for asset-backed securities has reopened after being essentially closed for a week. That shutdown is the first example of how unintended consequences from the Dodd-Frank financial regulatory overhaul can create mischief in the financial markets. But the solution is only temporary, and it may be a sign of big changes to come.

The market reopened when Ford Motor's (F) financial division on Monday brought to market a $1 billion bond backed by prime auto loans. Ford did that only after getting the Securities and Exchange Commission to write a so-called no-action letter that would allow the company to issue a prospectus without including the bond's normally required ratings from the major ratings agencies.

The Securities Act of 1933 had previously shielded the ratings agencies from the liability of investor lawsuits because the old law defined ratings as "opinions." But Dodd-Frank changed the law, known as Rule 4369(g), and the three major agencies are now defined as "experts," and are therefore potentially liable for mistakes in ratings included in the disclosure documentation bond issuers provide to investors. Lacking the protection from liability that they previously had, the agencies quickly declined to have their ratings included in disclosure documents after President Obama signed Dodd-Frank.

In its temporary fix, the SEC says no action would be taken in the next six months against Ford or other bond issuers for not including the required ratings, thus allowing the asset-backed securities market to reopen.

Business as Usual -- but Only for Six Months

Tom Deutsche, executive director of the American Securitization Forum, says in addition to the Ford bond, "a couple of other deals in the pipeline had been stopped because of this issue but now will look to go back out to the market." But Paul Jablansky, a senior debt strategist at RBS Securities in Stamford, Conn., says the longer-term issue hasn't been resolved.

"The net impact of what the SEC has done is that for the next six months deals can continue as usual, and the ratings agencies don't have to assume that liability," Jablansky says. "After six months is over, we go back to the situation where they do have to take that liability. Unless there is some change in Dodd-Frank or some more permanent change by the SEC, then I think we face this problem again."

Jablansky says the asset-backed market is shrinking because outstanding bonds are being paid off faster than new issuers are coming to market. "For that reason, I think [investor] demand will stay strong, but there are legitimate concerns about what the future of the market looks like," he says.

"A Lot of Uncertainty"

Adding uncertainty to asset-backed securities, whose interest payments come from a pool of assets like auto loans and credit card debt, is a proposed change in the rules that would require issuers to provide more transparency in their offerings. Some issuers have complained that the proposed rule change would increase their costs and force them to reveal proprietary information. The SEC has set Monday, Aug. 1, as the deadline for comments on that proposed change.

"I think right now there is a lot of uncertainty in the market, but that hasn't seemed to be an impediment to investors," Jablansky says. According to Deutsche, the Dodd-Frank rule change doesn't affect investors, who he says don't take on any additional liability.

In another odd twist, the ratings agencies will continue to rate new asset-backed securities, but they won't allow their ratings to be published as "expert" advice in the bonds' disclosure documents the way that an auditor's report is. They argue that ratings are essentially forward-looking forecasts, and they can't guarantee that their ratings will be 100% accurate.

Deutsche says the impact of Dodd-Frank -- and a myriad of other new rules -- may be that asset-backed securities issuers consider moving to new markets to raise capital, such as issuing traditional corporate bonds. "It may be more efficient and more cost-effective [for issuers] to pursue other forms of financing," he says, "which will ultimately raise the price of credit to consumers."