During the 2008 market crash, a number of investors who had significant sums parked in consumer loan backed bonds found their investments turning bad. Soaring default rates meant that many such bonds failed to generate the returns that the issuers had ‘guaranteed’. The Securities and Exchange Commission has now proposed some new rules, which are aimed at addressing these risks and making such bonds attractive investment instruments once again.
SEC Chairwoman, Mary Schapiro, outlined her plans for ensuring that loan backed bonds are no longer as risky as they have traditionally been. The line of action she appears to have taken is to pin the responsibility for the bond’s performance to the issuer rather than allow the general investing public to make their own decisions based on credit ratings awarded by independent agencies.
If this proposal is accepted, credit rating agencies will no longer have a role to play in indicating the degree of success of many bonds, for instance, those backed by home mortgages. In place of the credit rating, the issuing company and its CEO will have to vouch for the returns that they claim will be generated from the instrument.
In addition, the issuing company will also be required to have an interest in the bond. Schapiro mooted a proposal to make it mandatory for issuing companies to have at least a 5% stake in the bond, thus making sure that the company remains interested in the instrument. With this, the company’s success will be tied with that of the bond and this will encourage better management, scrutiny, and processes, when the bonds are issued. Schapiro says that making the companies participate in the future of the instruments that they are proposing will ensure that the creditworthiness of borrowers is properly assessed.
Schapiro believes that these measures will restore consumer confidence in such investments, which had taken a major hit during the recession. She is also seeking greater transparency in divulging the details of borrowers on whom the performance of the bond hinges. SEC Commissioner Kathleen Casey however has reservations about the breach of privacy that this could entail.
The government seems to be treading a path similar to the one Schapiro has outlined. Policies and schemes are being formulated to include sufficient exposure to originating institutions so that they have an incentive to ensure profitability of any instrument issued through them.
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