Recently imposed U.S. rules outlining risk retention requirements for residential mortgage-backed securities (“RMBS”) transactions that came into effect late last year and other asset classes which will come into effect later this year are prompting asset managers to explore new strategies to ensure their compliance, including the use of majority-owned affiliate structures.
The changes come in response to the updated Credit Risk Retention rules a group of federal bodies, including the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, adopted in October 2014, as required by Section 941 of the Dodd-Frank Act. The rules require the sponsor of a securitization transaction to retain a 5% interest in the securitized assets. The retained credit risk is measured by face or notional amount for an eligible vertical interest and by fair value for an eligible horizontal interest, and must be retained (and unhedged) for a minimum period of time that varies depending on the type of securitization transaction.
The most popular method emerging in response to the rules is the use of a majority-owned affiliate structure. This strategy involves the formation of a separate, majority-owned entity in the form of a fund, which then acquires the interest representing the 5% credit risk. This majority-owned affiliate is a subsidiary of the collateral manager and may be funded, in part, through a credit facility that is full recourse to the retention holder, and may also be capitalized by third party investors. The rule requires the sponsor of the securitization transaction to own “more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity,” in order to meet the definition of “majority control,” while no limit exists on the amount of credit risk that may be held by such sponsor’s affiliate. As a result, this structure effectively allows the originator of the securities to relinquish management responsibilities of the transactions to the newly created funds while satisfying the requirement of retaining a measure of risk.
The updated risk retention rules were put in place following the financial crisis to ensure that originators of a securitization maintained some measure of risk and to ensure the interests of originators were better aligned with their investors. Securitizations collateralized by residential mortgages issued on or after Dec. 24, 2015, are required to be in compliance, while securitizations collateralized by other assets are required to comply on or after Dec. 24, 2016.
This relatively new space remains fluid and will certainly continue to evolve, as the market both adjusts to the risk retention rules for transactions collateralized by residential mortgages and prepares for other types of securitizations at the end of 2016. Although that deadline remains months away, planning for an appropriate strategy to ensure risk retention compliance should already be underway and should take into account the legal, tax and cost considerations involved. Analysts are currently projecting reduced activity in commercial mortgage-backed securities and other assets for the remainder of 2016 – due in part to this uncertainty – however, that could change as participants continue to adjust to the new securitization landscape.