In late 2014 a group of six federal regulators (the “Agencies”) adopted a rule (the “Rule”) requiring sponsors of securitizations to retain a portion of the credit risk associated with the securities issued, subject to various exceptions and qualifications. 79 Federal Register (“FR”) page 77,601 (December 24, 2014). Compliance with the Rule with respect to most asset-backed securities (“ABS”) is required beginning December 24, 2016 (compliance for residential mortgage (“RMBS”) ABS was required beginning December 24, 2015). Accordingly, affected market participants should be considering how they will comply with the Rule.
Background. The Rule implements Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. According to the Agencies, prior to the recent financial crisis, “[S]ome lenders loosened their underwriting standards, believing that the loans could be sold through a securitization…, and that… the lender… would retain little or no continuing exposure to the loans.” 79 FR page 77,604. By requiring that a securitizer retain a portion of the risk of securitized assets, Congress sought to “provide securitizers an incentive to monitor and ensure the quality of the securitized assets…, and, thus, help align the interests of the securitizer with the interests of investors.” 79 FR pages 77,604-5.
Basic Rule. The Rule requires the sponsor of a securitization to retain an “economic interest in the credit risk of the securitized assets” of at least five percent. 12 Code of Federal Regulations (“CFR”) section 43.3-4. A sponsor may satisfy the requirement by retaining an eligible horizontal residual interest (an “EHRI”), an eligible vertical interest (an “EVI”) or “any combination thereof”. An EHRI is a “first loss” position in a securitization, and is a form of credit enhancement familiar to the market. If a sponsor elects to use an EHRI, the amount of the retained interest “must equal at least 5 percent of the fair value of all ABS interests in the issuing entity… determined using a fair value measurement under GAAP (Generally Accepted Accounting Principles).” 12 CFR sec. 43.4(a)(2). An EVI is an interest in each class of ABS interests in a transaction “that constitutes the same proportion of each such class,” in effect an equal interest in all such ABS interests. If a sponsor elects the EVI option, it must retain an EVI of not less than five percent, which does not require a fair value measurement, i.e. the EVI amount may be calculated based on the face amounts of the ABS interests.
Sponsors using an EHRI are subject to detailed investor disclosure requirements related to fair value determinations, including the “inputs” and “assumptions” used. In general, the disclosures are required whenever ABS interests are issued, so that frequent issuers, such as asset-backed commercial paper conduits (“ABCP Conduits”), using an EHRI to comply will be subject to substantial new investor disclosure requirements and related costs.
These disclosure requirements apply to securities that are not registered under the Securities Act of 1933 as well as registered securities. This is a significant departure from the SEC’s usual practice of not regulating the content of disclosures in non-public securities issuances. A sponsor may substitute a cash reserve account for an EHRI. However, “unfunded” risk retention, such as a sponsor guarantee, does not qualify.
Who Must Retain Risk? The Rule generally requires risk retention by the “sponsors” of ABS. 12 CFR sec. 43.4(a). A sponsor is defined as someone who, among other things, “organizes and initiates” a securitization. 12 CFR sec. 43.2. The Agencies responded to commenters’ concerns about “open market” collateralized loan obligations (CLOs) by stating that the collateral manager in such transactions would be the sponsor, thus imposing on these CLOs a requirement that pre-Rule deals generally do not satisfy. The Rule exempts a narrow class of CLOs where, among other things, the “lead arrangers” of the underlying loans retain at least five percent of such loans and comply with the limitations on sale and hedging that apply to sponsor-retained interests.
The Rule allows a sponsor that securitizes assets acquired from others to offset its risk retention requirement by an EHRI or EVI retained by an originator/seller (“OS”) if the OS contributed at least 20% by unpaid principal balance (“UPB”) of the securitized assets. This option is unlikely to be popular. Among other things, while the text of the Rule is not clear on the point, the Agencies state, “[T]he Rule requires that originators allocated a portion of the risk retention requirement be allocated a share of the entire securitization pool.” 79 FR page 77,666. Many OSs will be reluctant to assume the risk of assets they did not originate.
A narrower but arguably more practical exemption allows qualifying ABCP Conduits to rely on risk retention by OSs. This is an “all or nothing” arrangement, i.e., the risk retention requirements must be fully satisfied at the OS level, in contrast to the exemption discussed in the preceding paragraph, which permits a division of the retained risk between sponsors and originators. To qualify, an ABCP Conduit must have “100 percent liquidity coverage” from an eligible provider. A “pure” liquidity commitment, i.e. a commitment subject to the credit performance of the ABS assets, does not qualify. When, as is often the case, a bank affiliate of the ABCP Conduit provides liquidity, this feature will increase the difficulty of keeping the conduit’s assets off the bank’s balance sheet.
An unusual exemption allows a sponsor of commercial mortgage-backed securities (“CMBS”) to satisfy some or all of its risk retention requirement by transferring an EHRI to up to two unaffiliated third parties. To qualify, a third party may not be an originator of 10 percent or more of the securitized assets, or an affiliate thereof. 12 CFR sec. 43.7(b)(ii)(B). Eligible CMBS must have an operating adviser who is responsible for, among other things, supervising the special servicer. The third party EHRI holder is subject to the transfer and hedging restrictions that would apply to the sponsor, except that it may transfer the EHRI after five years to another qualifying third party purchaser.
Certain sponsors are exempt from the Rule, regardless of the nature of their securitizations. These include any institution for which the FDIC is acting as conservator or receiver; certain foreign issuers under the “safe harbor for foreign-related transactions”; and FNMA (Fannie Mae) and FHLMC (Freddie Mac), but only while they are in conservatorship or receivership. Certain public utility securitizations are also exempt.
In general, when a sponsor’s risk retention requirement is satisfied by retention of risk by OSs or other third parties, (i) those parties are subject to the same restrictions on transfer and hedging that would apply to the sponsor (see below) and (ii) the sponsor remains responsible for such parties’ compliance with the Rule.
Transfer and Hedging Prohibitions. The Rule for specified periods prohibits (i) the transfer by a sponsor of its retained interest except to a majority-owned affiliate, (ii) the hedging of the credit risk thereof and (iii) non-recourse financing thereof. Certain other hedges, such as interest rate and currency hedges, are permitted. For most ABS, these prohibitions expire on the later of (i) two years after closing, (ii) the date on which the UPB of the ABS interests has been reduced to 33 percent of their original UPB and (iii) the date on which the UPB of the securitized assets has been reduced to 33 percent of their original UPB. For residential mortgage securitizations, these prohibitions expire on the later of (i) five years after closing and (ii) the date on which the Unpaid Principal Balance (“UPB”) of the underlying loans is 25 percent or less of their original UPB, except that in any event they expire seven years after closing. 12 CFR sec. 43.12.
Exemptions. In addition to the exemptions related to the locus of the retained interest discussed above, the Rule includes a variety of exemptions based on the nature of the underlying assets. Under these exemptions, generally none of the sponsor, an OS or a third party is required to retain an EHRI or an EVI. We expect to discuss these exemptions in detail in a future post. In the meantime, set forth below are some highlights.
Arguably the most important of these exemptions is that for qualified residential mortgages (“QRMs”). The Rule defines a QRM as a “qualified mortgage” under the regulations of the Consumer Financial Protection Bureau (CFPB). Those regulations define a qualified mortgage by reference to loan-to-value ratio, debt-to-income ratio and income verification, among other things, and excludes loans with non-traditional features such as negative amortization, interest-only periods and balloon payments. 79 FR page 77,688. The Rule also exempts RMBS of “seasoned” residential mortgage loans – generally loans outstanding for five years or more – and RMBS of “community focused exempt loans” as defined in CFPB regulations.
The Rule exempts ABS of three broad asset classes: qualifying commercial loans, qualifying commercial real estate loans and qualifying automobile loans. 12 CFR sec. 43.15. However, the detailed underwriting and other criteria required for qualification are rather restrictive, and the Agencies acknowledge as much. They state, “The agencies note the concern expressed by some commenters with respect to all three of these asset classes that, for the residential mortgage asset class…, a significant portion of the existing market would qualify for an exemption…, whereas for qualifying commercial loans, commercial real estate loans, and automobile loans, the agencies proposed conservative underwriting criteria that would not capture an equivalent portion of the respective markets.” 79 FR page 77,677. Nonetheless the Agencies adopted these exemptions largely as proposed.
Securitizations of various other asset types are fully or partially exempt from risk retention. These include: assets issued or fully guaranteed by the U.S. or a U.S. agency, or by a State or State agency or political subdivision; assets issued by the Federal Agricultural Mortgage Corporation; certain repackagings of ABS interests; and qualified scholarship funding bonds. The Rule also includes reduced requirements for securitizations of federally guaranteed student loans.
Final Comment. The Rule’s risk retention requirements are an oddity in American law. Automobiles kill more people than automobile loan securitizations, but the latter are subject to risk retention requirements and the former are not. Of course, one can sue an auto manufacturer for damages caused by a defective vehicle, but that remedy was not deemed sufficient by Messrs Dodd and Frank in the case of auto loan securitizations. Would it be a good idea to require auto manufacturer management and employees to drive their own cars, and chefs to eat some of their own food (five percent of it perhaps)? That way those who build our cars and cook our souffles would have “skin in the game.” Get busy, Congress!
Dan Mette concentrates his practice on structured finance. He represents sponsors, underwriters and investors in asset securitization transactions and borrowers and lenders in asset-based lending transactions. Over his many years of experience he has worked on structured financings involving a great many asset types, including auto loans and leases, credit card receivables, trade receivables, residential and commercial mortgage loans, aircraft and aircraft engines, other equipment leases, corporate bonds and loans, oil and petroleum products, drug royalty payments, insurance products, hedge fund assets, securities lending accounts and asset management fees.
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