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Financial Services Alert
Agencies Issue Notice of Proposed Rulemaking Implementing Risk Retention Requirements of Dodd-Frank Act

The OCC, FRB, FDIC, and SEC, in conjunction with the Federal Housing Finance Agency (“FHFA”) and the Department of Housing and Urban Development (“HUD”) with respect to the standards applied for qualified residential mortgages, (collectively, the “Agencies”), recently issued a Notice of  Proposed Rulemaking (the “NPR” or the “proposed rules”) to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act.  Section 941 of the Dodd-Frank Act amends the Securities Exchange Act of 1934 by adding a new Section 15G, which requires the Agencies to prescribe rules that would generally require that a securitizer of asset-backed securities (“ABS”) retain an economic interest in not less than 5% of the credit risk of the assets collateralizing such ABS.  The NPR addresses the following issues: (1) the minimum credit risk retention required; (2) the permissible forms of risk retention; (3) the definition of qualified residential mortgage (“QRM”) and the underwriting standards applicable to QRMs, which are exempt from the risk retention requirements; and (4) the underwriting standards applicable to other qualified asset classes, in order for such ABS to be eligible for an exemption from the risk retention requirement.

Minimum Credit Risk Retention

Section 15G(c)(1)(B) of the Securities Exchange Act generally requires a securitizer of an ABS to retain not less than 5% of the credit risk of the assets collateralizing the ABS issuance.  As discussed below, certain low risk assets, most notably QRMs, are exempt from this requirement.  Securitizers are prohibited from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain.

Permissible Forms of Risk Retention

In order to take into account market practices and reduce the potential for the proposed rules to negatively affect the availability and cost of credit, the NPR provides securitizers with five general options for fulfilling their risk retention obligations.  The permissible forms include:

  1. A vertical slice option, which requires the securitizer to retain not less than 5% of each class of ABS interests issued in the securitization;
  2. A horizontal residual interest option, which requires the securitizer to retain a first-loss position in an amount equal to at least 5% of the par value of all ABS interests issued in the securitization;
  3. A cash reserve fund option, which requires the securitizer to cause to be established and funded a reserve account in an amount equal to at least 5% of the par value of all ABS interests issued in the securitization, which account shall be made available to absorb losses on the securitized assets in the same manner and to the same extent as a horizontal first-loss interest;
  4. An “L-Shaped interest,” which is a hybrid approach consisting of both a vertical slice and a horizontal residual interest.  More specifically, the securitizer is required to retain at least  2.5% of each class of ABS interests issued as part of the securitization (the vertical component) and at least 2.564% of the par value of all remaining ABS interests (i.e., those interests not a part of the vertical component) issued in the securitization (the horizontal component).  The horizontal component has a slightly increased percentage in order to avoid double counting that portion of an eligible horizontal residual interest that the securitizer is required to hold as part of the vertical component and still ensure that the combined amount would equal 5%.
  5. A representative sample option, which requires the securitizer to retain a randomly-selected sample of assets that is equivalent, in all material respects, to the assets collateralizing the securitization.

The proposed rules also include the following transaction-specific risk retention options:

  • for securitizations involving a revolving asset master trust (e.g., credit card receivables), a “seller’s interest” option, which requires the securitizer to retain no less than 5% of the unpaid principal balance of all assets held by the revolving asset master trust;
  • for eligible asset-backed commercial paper (“ABCP”) conduits collateralized by loans and receivables and supported by a liquidity facility that provides 100% liquidity coverage from a regulated financial institution, the risk retention requirement may be satisfied where each originator-seller that transfers assets to collateralize the ABCP issued by the conduit retains at least a 5% horizontal interest of the par value of all interests issued by an intermediate special-purpose vehicle established by or on behalf of that originator-seller for purposes of issuing interests to the eligible ABCP conduit;
  • for commercial mortgage-backed securities (“CMBS”), consistent with Section 15G(c)(1)(E) and industry practice, the risk retention requirement may be satisfied by an unaffiliated third-party purchaser (commonly referred to as a “B-piece” buyer) that retains an eligible horizontal residual interest in the same form, amount and manner as the securitizer would have been required to retain, provided that, among other things, such third-party purchaser conducts its own credit analysis of each commercial loan backing the CMBS, and an independent operating advisor is appointed to oversee servicing of the loans in all cases where the “B-piece” buyer services the loans.

Disclosure requirements.  Under each of the above options, securitizers are subject to disclosure requirements that are specifically tailored to the applicable form of risk retention.  The disclosure requirements are intended to provide investors with material information concerning the securitizer’s retained interest and provide the Agencies with an efficient mechanism to monitor compliance with the risk retention requirements.

Premium Capture Cash Reserve Account.  The proposed rules also include a special “premium capture” mechanism designed to prevent a securitizer from structuring an ABS transaction in a manner that would allow the securitizer to effectively negate or reduce its retained economic exposure to the securitized assets by immediately monetizing the excess spread created by the securitization transaction.  If a securitizer structures a securitization to monetize excess spread on the underlying assets – which is typically effected through the sale of interest-only tranches or premium bonds – the proposed rules would capture the premium or purchase price received on the sale of the tranches that monetize the excess spread and require that the securitizer place such amounts into a separate premium capture cash reserve account that would be used to cover losses on the underlying assets before such losses were allocated to any other interest or account.  By requiring any compensation received in advance for excess spread income to be held in a premium capture cash reserve account, the proposed rules prevent securitizers from making an up-front profit which is in excess of the cost of the risk retention interest the securitizer is required to retain.  A likely consequence of these new proposed requirements is that few, if any, securitizations will be structured to monetize excess spread at closing.  The amount placed into the premium capture cash reserve account would be in addition to the securitizer’s risk retention requirement in one of the permissible forms discussed above.

Allocation to the Originator.  Although the proposed rules generally require a securitizer to retain the required risk, a securitizer is permitted to allocate a share of its risk retention obligation to the originator of the securitized assets, subject to certain conditions.  In order to qualify, the originator must originate at least 20% of the loans in the securitization, retain at least 20% of the required risk retention amount, but no more than the percentage of the securitized assets it originated, and pay up front for its share of the risk retention.  The securitizer’s risk retention obligation would then be reduced by the amount allocated to the originator.

Prohibition on Hedging or Transferring.  Consistent with the statutory directive of Section 15G(c)(1)(A), the proposed rules prohibit a securitizer from transferring any interest or assets that it is required to retain to any person other than an affiliate whose financial statements are consolidated with the securitizer (a “consolidated affiliate”).  The securitizer and its consolidated affiliates are also prohibited from hedging the required credit risk.  However, hedge positions that are not materially related to the credit risk of the particular ABS interests required to be retained are not prohibited under the proposed rules.  Permitted hedges would include positions related to overall market interest rate movements, currency exchange rates, home prices or the overall value of a particular broad category of ABS.  In addition, hedges tied to securities that are similar to the ABS issuance would be permitted. 

However, a securitizer and its consolidated affiliates are prohibited from pledging as collateral for any obligation any interest or asset that the securitizer is required to retain unless the obligation is with full recourse to the securitizer or consolidated affiliate, respectively.

Risk Retention Exemptions

While the proposed rules generally require securitizers to retain at least 5% of the credit risk of any securitization, certain types of transactions may be exempted from the risk retention requirements.  For example, any ABS that is collateralized solely by QRMs (discussed in more detail below) is exempt from the risk retention requirements.  The proposed rules also include a complete exemption for securitizations of other asset classes - commercial loans, commercial real estate loans, and automobile loans - if the underlying assets meet certain underwriting standards.  For Fannie Mae and Freddie Mac, the proposed rules provide that the guarantee of either entity satisfies the risk retention requirement so long as such entities are operating under FHFA conservatorship or receivership with capital support from the U.S. government. 

Qualified Residential Mortgages.  Pursuant to Section 15G(e)(4), the Agencies issued regulations to exempt ABS backed entirely by QRMs from the risk retention requirements.  The proposed rules establish strict terms and conditions for a residential mortgage to qualify as a QRM.  QRMs are generally prohibited from having nontraditional product features that add complexity or risk to mortgages.  In addition, residential mortgages will not qualify as QRMs if they have terms permitting negative amortization, interest-only payments, significant interest rate increases or penalties for prepayment.

The proposed rules also include conservative underwriting standards for QRMs, which are designed to ensure that QRMs are of especially high credit quality.  These standards include:

  • borrower credit history restrictions, including no 60-day delinquencies on any debt obligations within the previous 24 months; 
  • a maximum loan-to-value (“LTV”) ratio of 80% in the case of a purchase transaction, a 75% combined LTV ratio for refinance transactions, and a 70% LTV ratio for cash-out refinance transactions (with conditions on the sources from which the down payment may come);
  • maximum front-end and back-end borrower debt-to-income ratios of 28% and 36%, respectively.

Notably, the LTV ratio is calculated without considering any mortgage insurance.

The NPR also includes certain servicing requirements for originators of QRMs that are designed to reduce the risk of default on the mortgages.  The proposed rules would require an originator of a QRM to incorporate in the mortgage documents requirements regarding servicing policies and procedures for the mortgage, including requirements regarding risk mitigation actions, subordinate liens and originator responsibility for assumption of these requirements if servicing rights with respect to a QRM are sold or transferred.  These servicing requirements do not supplant the ongoing interagency efforts to develop national mortgage servicing standards, which would apply not only to QRMs but to all residential mortgages. 

Other Asset Class Exemptions.  The proposed rules would also completely exempt certain ABS with respect to other assets classes - auto loans, commercial loans and commercial real estate loans - from the risk retention requirements if the underlying assets meet certain underwriting standards.  These robust underwriting standards, which are designed to focus on particular risks associated with each specific asset class, generally focus on the borrower’s ability to repay the loan. 

More specifically:

  • Auto loans would be subject to underwriting standards focused on the borrower’s ability to repay the loan and would require a fixed interested rate.
  • Commercial loans would be subject to underwriting standards designed to assure that the borrower’s business is in, and will remain in, sound financial condition such that the borrower will maintain the ability to repay the loan.
  • Commercial real estate loans would be subject to underwriting standards that ensure the property securing the loan is stable and provides sufficient net operating income to repay the loan.

Government Sponsored Entities.  Fannie Mae and Freddie Mac (the “GSEs”), while under the conservatorship or receivership of the FHFA, are exempt from the risk retention requirements.  Because the GSEs fully guarantee the payments of principal and interest on the ABS they issue, the GSEs are exposed to the entire credit risk of the mortgages that collateralize those securities.  The Agencies stated in the NPR that additional risk retention is unnecessary because, as a result of the capital support provided by the United States government, investors in ABS issued by the GSEs are not exposed to any credit losses.  Additionally, the premium capture cash reserve account requirements and the hedging restrictions do not apply to the GSEs while operating under the conservatorship or receivership of the FHFA.

Comments on the NPR are due by June 10, 2011.  The Alert will continue to monitor and report on material developments in this area.

© 2014 Goodwin Procter LLP. All rights reserved. This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP, Goodwin Procter (UK) LLP or their attorneys. Prior results do not guarantee similar outcome.

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