On August 28, 2013, the FDIC, OCC, FRB, SEC, Federal Housing Finance Agency, and Department of Housing and Urban Development (collectively, the “Agencies”) issued a second Notice of Proposed Rulemaking (the “revised proposal”) that would implement the risk retention requirements of Section 941 of the Dodd-Frank Act, which amended the Securities Exchange Act of 1934 (the “Exchange Act”) by adding a new Section 15G. Section 15G requires the Agencies to issue 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. As discussed in the April 19, 2011 Financial Services Alert, the first Notice of Proposed Rulemaking (the “original proposal”) was jointly approved in April 2011 by the Agencies. In response to numerous comments received on the original proposal, the Agencies collectively developed the revised proposal, which includes significant modifications.
Risk Retention Options
Section 15G(c)(1)(B) of the Exchange Act generally requires a securitizer of an ABS offering to retain not less than 5 percent of the credit risk of the assets collateralizing the ABS issuance. The original proposal provided securitizers with various options to comply with this risk retention requirement. The revised proposal generally maintains the original framework, but makes various changes to the options that are designed to provide additional flexibility to securitizers. For example, the original proposal’s “vertical risk retention” (5 percent of each class of ABS interests), “horizontal risk retention” (5 percent as a first-loss position), and “L-shaped risk retention” (half of risk retention held on vertical basis and the other half of risk retention held as a first-loss horizontal position), have been combined into a single “standard risk retention” option, which requires the sponsor of a securitization transaction to retain a vertical interest or horizontal residual interest, or any combination thereof. In addition, the original proposal’s unpopular “representative sample” option has been eliminated. The revised proposal also requires use of fair value measurements rather than the original proposal’s par value methodology in determining compliance with the risk retention requirement. The fair value of the amount retained by the sponsor must equal at least 5 percent of the fair value of all ABS interests in the issuing entity issued as part of the securitization transaction, determined in accordance with GAAP, as of the day on which the price of the ABS interests to be sold to third parties is determined. In conjunction with the revised proposal’s use of fair value accounting, the requirement in the original proposal that securitizers hold a premium capture cash reserve has been eliminated.
In addition to the standard risk retention option, other risk retention options would be available for certain enumerated types of transactions. These include revolving master trusts, certain issuers of asset-backed commercial paper, issuers of commercial mortgage-backed securities, open-market CLOs, and sponsors with respect to issuances of tender option bonds by a qualified tender option bond entity.
The various options, including the standard risk retention option, generally have specific disclosure and record-keeping requirements intended to provide investors with material information about the retained interest and to permit the Agencies to monitor compliance.
Although the revised proposal generally requires a sponsor to retain the required risk, a sponsor of a securitization transaction that is using the standard risk retention option is permitted to offset the amount of its risk retention requirements by the amount of eligible interests acquired by an originator of one or more of the securitized assets, provided that certain conditions are met, including that the originator must retain the eligible interests in the same manner as the sponsor did prior to the acquisition.
Selling and Hedging Prohibited
The revised proposal generally prohibits a sponsor from selling or otherwise transferring any interests or assets that it is required to retain to any person other than an entity that is and remains a majority-owned affiliate of the sponsor. The retained interests also may not be pledged as collateral for any obligation, unless such obligation is with full recourse to the sponsor. The sponsor and its affiliates are also prohibited from purchasing or selling a security or other financial instrument, or entering into an agreement or derivative, with any other person if (1) the payments on the security or other financial instrument or under the agreement or derivative are materially related to the credit risk of one or more of the ABS interests that the sponsor is required to retain or one or more of the securitized assets that collateralize the ABS issued in the securitization transaction and (2) the security, instrument, agreement, or derivative “in any way reduces or limits” the sponsor’s financial exposure to the credit risk. Similar prohibitions apply to the issuer of a securitization transaction.
Certain hedging activities are permitted under the revised proposal. These include hedging interest rate risk (except for spread risk that is otherwise considered part of the credit risk) and foreign exchange risk arising from one or more of the retained ABS interests. Sponsors and issuers may also buy or sell securities or other financial instruments or enter into agreements and derivatives based on an index of instruments that includes the retained ABS interests, but only if certain rules are satisfied that are designed to ensure that the relevant ABS constitute only a small portion of the index.
In contrast to the original proposal, the revised proposal permits the prohibitions on sale and hedging to expire prior to the final maturity or termination of the issued securities. Specifically, the prohibitions would generally expire on the latest of (i) the date on which the total unpaid principal balance of the collateral has been reduced to 33 percent of the total unpaid principal balance of the collateral as of the closing of the securitization transaction; (ii) the date on which the total unpaid principal obligations under the ABS interests issued in the securitization transaction has been reduced to 33 percent of the total unpaid principal obligations of the ABS interests at closing; or (iii) two years after the date of the closing. Later dates apply to the expiration of such prohibitions with respect to residential mortgages with the minimum being 5 years after the date of the closing. The expiration of the prohibitions on sale and hedging were introduced based on an analysis of historical credit defaults for various asset classes and based on the premise that sound underwriting, which the revised proposal calls “the primary purpose of risk retention,” is less likely to be effectively promoted after a certain period of time.
Exemptions from the Risk Retention Requirement
The revised proposal includes various exemptions from the risk retention requirement. Most notably, a sponsor is exempt from the risk retention requirements if, among other conditions, all of the assets that collateralize the ABS are qualified residential mortgages (“QRMs”). The original proposal’s QRM definition received many negative comments; the revised proposal abandons that definition and instead defines “QRM” to equate to the definition of “qualified mortgage” in the Truth in Lending Act and the regulations issued thereunder by the Consumer Financial Protection Bureau (the “CFPB”). The qualified mortgage definition does not include consideration of a borrower’s credit history, loan-to-value or down payment; instead it includes an analysis of, among other things, the borrower’s ability to repay and imposes a maximum debt-to-income ratio of 43 percent. Additionally, the qualified mortgage definition excludes certain types of loans and loan features, including interest-only loans, balloon payments and negative amortization loans, while permitting exceptions for small creditors in rural and underserved areas.
The Agencies chose to define “QRM” as “qualified mortgage” after considering an alternative approach referred to in the release accompanying the proposed rule as “QM-plus.” As described in the release, the QM-plus approach would begin by defining “QRM” based on the same factors adopted by the CFPB in the “qualified mortgage” definition, but would then add four additional factors. Specifically, under this approach, classification as a QRM would only be available if, in addition to satisfying the factors identified by the CFPB, all the following conditions were met:
- The loan secures a one-to-four family real property that constitutes the principal dwelling of the borrower. Therefore, QRM status would not be available to mortgages on, for example, house boats and vacation homes.
- The loan must be a first-lien mortgage. Mortgages used to purchase a residence would only be eligible for QRM status if no other recorded or perfected liens exist on the property at closing, to the knowledge of the originator. Junior liens are permitted for QRMs used for refinancing purposes, but must be included in the loan to value calculations described below.
- The originator must determine that the borrower meets certain credit history criteria, including not currently being 30 or more days past due on any debt obligation and not having been a debtor in a bankruptcy proceeding within the preceding 36 months.
- The loan to value ratio at closing must not exceed 70 percent.
Under the revised proposal, down payments are eliminated as an element required to fit within the definition of QRM.
The proposed rule release requests comments on various aspects of the QM-plus approach.
Interests in commercial loans, commercial real estate loans, and automobile loans that are transferred through a securitization transaction are also exempt from the risk retention requirement, provided that certain conditions are met. In addition, the risk retention requirements would not apply to any securitization transaction collateralized solely by certain loan assets insured or guaranteed by the United States or an agency of the United States or that involve the issuance of ABS that are so insured or guaranteed; any securitization transaction collateralized solely by loans or other assets made, insured, guaranteed, or purchased by any institution subject to the supervision of the Farm Credit Administration; any ABS issued or guaranteed by any State or political subdivision of any State; certain securitization transactions collateralized by existing ABS for which credit risk was retained or that was exempted from the credit risk retention requirements; and certain other transactions.
Comments on the revised proposal are due no later than October 30, 2013.