In a complex and nuanced 233-page release, the Securities and Exchange Commission, Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, and U.S. Department of Housing and Urban Development have jointly released a notice of proposed rulemaking to implement Section 941(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010—the “skin-in-the-game” rule.
Section 941(b), which became Section 15G of the Securities Exchange Act of 1934, generally requires securitizers of an asset-backed securities (ABS) investment to retain at least 5 percent of the credit risk of the underlying assets. Section 15G and the proposed rule are designed to better align the interests of ABS securitizers and investors, thereby reducing overall risk to the banking system and economy.
Under the proposed rule, issued March 29, 2011, the 5 percent risk retention can be structured in various ways:
- A 5 percent “vertical” slice of the ABS interests, where the securitizer retains 5 percent of each tranche
- A 5 percent “horizontal” first-loss position, where the securitizer retains a subordinate interest in the issuing entity and bears losses before any other investor
- An “L-shaped interest,” where the securitizer holds at least a 2.5 percent interest vertically and at least 2.564 percent in the form of a horizontal first-loss position
- A “seller’s interest” in securitizations structured using a master trust collateralized by revolving assets, where the securitizer holds a 5 percent separate interest that participates in revenues and losses on the same basis as the investors’ interest in the pool
- A “representative sample,” where the securitizer retains a 5 percent representative sample of the assets to be securitized
- For certain single-seller or multi-seller short-term asset-backed commercial paper conduits, in which the commercial paper is collateralized by loans and receivables and covered by a 100 percent liquidity guarantee from a regulated bank or holding company, a 5 percent residual interest retained by the receivables’ originator-seller
The proposed rule also contemplates that Fannie Mae and Freddie Mac will be able to satisfy the risk retention requirement through their guarantees (which cover 100 percent of principal and interest), as long as they continue to operate under the conservatorship or receivership of the FHFA and with direct support from the federal government. For certain securitizations of commercial mortgage-backed securities (CMBSs), a third-party purchaser (known as a “B-piece buyer”) may specifically negotiate for the purchase of the first-loss position if it conducts its own credit analysis of each commercial loan backing the CMBSs. The B-piece buyer must retain the requisite exposure to the credit risk of the underlying assets and must meet six enumerated conditions.
In addition to the base credit risk retention requirement, the proposed rule would prohibit sponsors from reducing their exposure below 5 percent by hedging and/or the receipt of advance compensation for excess spread income to be generated by securitized assets over time.
The agencies are also proposing disclosure requirements designed to provide investors with material information concerning the securitizer’s retained interests, such as the amount and form of the interest retained and the assumptions used in determining the aggregate value of ABSs to be issued. It is anticipated that such disclosures will also be useful in monitoring compliance.
Certain ABSs, for assets deemed to be low-risk, would be exempt from the rule’s requirements. The most prominent exemption would be for an ABS collateralized exclusively by “qualified residential mortgages” (QRMs). Under the Dodd-Frank Act, the definition of QRM must be at least as narrow as the definition of “qualified mortgage” under Title 14. Under the proposed rule, a QRM must not involve negative amortization, interest-only payments, or the possibility of significant interest rate increases, and must be underwritten to a maximum LTV ratio of 80 percent and maximum front-end and back-end debt-to-income ratios of 28 percent and 36 percent, respectively. Additionally, a securitizer is not required to retain any portion of the credit risk for ABSs exclusively collateralized by commercial loans, commercial mortgages, or automobile loans meeting underwriting standards set forth in the rule for each individual asset class.
The proposed rule solicits comments on no fewer than 174 specified questions, including whether the minimum 5 percent risk retention requirement for non-exempt ABS transactions is adequate or whether a higher level should be established, either in general or for particular classes or types of non-exempt ABSs. Each agency is requesting comments separately, and any comments must be received by June 10, 2011.