On March 31, 2011, the Federal Reserve Board (FRB), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the U.S. Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA), and the Department of Housing and Urban Development (HUD, and collectively, the “regulators”) issued a joint release requesting comment on proposed regulations that require originators and sponsors (securitizers) of asset-backed securities (ABS) to retain a certain amount of risk of securitized assets so that they keep “skin in the game,” as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Comments are due by June 10, 2011. Once the proposed regulations become final and are published in the Federal Register (the “final regulations”), those regulations relating to credit risk retention requirements for residential mortgage assets will become effective one year from the date of publication of the final regulations. Regulations relating to all other asset classes will become effective two years from the date of publication of the final regulations.

Pursuant to Section 15G of the Securities Exchange Act of 1934, created by Section 941 of the Dodd-Frank Act, the regulators1 must promulgate rules that (i) require securitizers to retain at least 5 percent of the credit risk of the assets collateralizing an ABS and (ii) prohibit securitizers from hedging the retained risk. However, Section 15G completely exempts certain types of ABS from these risk retention requirements. For example, if all of the assets that collateralize an ABS are “qualified residential mortgages” (QRMs), as defined by the regulators, then the securitizer need not retain any risk. Section 15G also requires the regulators to allow a securitizer to retain less than 5 percent of the credit risk of ABS exclusively collateralized by commercial mortgages, commercial loans, and automobile loans that meet certain underwriting standards. This Alert highlights important aspects of the proposed regulations, including details of the general risk retention requirements, the asset classes that are exempt from those requirements and other asset classes that qualify for reduced risk retention.

General Risk Retention Requirements

The proposed regulations require that the sponsor or one of its affiliates retain the required risk, although it is permitted to allocate a portion of the risk to the originator of the loan by contract so long as the originator contributed at least 20 percent of the underlying assets in the pool. The originator would have to hold at least a 20 percent interest, and it could not hold more than the percentage of the securitized assets it originated. The proposed regulations provide securitizers the following five2 non-exclusive options for the form in which they may retain the required risk:

  • a “vertical” slice of the ABS interests, whereby a securitizer retains a specified pro rata piece of every class of interests issued in the transaction (e.g., if a senior AAA-rated class, a subordinated class, an interest-only class, and a residual interest were issued, a sponsor must retain a 5 percent interest in each of those four classes)
  • an “eligible horizontal residual interest” that (i) is allocated all losses on the securitized assets until its par value is reduced to zero and has the most subordinated claim to payments by the issuing entity and (ii) cannot receive any unscheduled payments of principal made on a securitized asset until all other ABS interests in the issuing entity are paid in full
  • an “L-shaped interest” whereby a securitizer uses an equal combination of vertical risk retention and horizontal risk retention to retain the required 5 percent exposure
  • a “seller’s interest” in securitizations structured using a master trust collateralized by revolving assets whereby the securitizer holds a separate interest that is pari passu with the investors’ interest in the pool of receivables, unless and until the occurrence of an early amortization event (which a securitizer could use with respect to securitizations backed by credit card accounts or other revolving credit lines that are often structured using a revolving master trust), and
  • a representative sample, whereby the securitizer retains a representative sample of the assets to be securitized that exposes the securitizer to credit risk that is equivalent to that of the securitized assets.

 Further, the proposed regulations seek to prohibit securitizers from structuring deals where they receive up front the “excess spread” that is expected to be generated by the securitized assets over time. To combat this practice, the proposed regulations require securitizers to establish a “premium capture cash reserve” account and deposit into it the proceeds on the sale of the tranches that monetize the excess spread. The amount deposited must be separate from and in addition to the 5 percent risk required to be retained and would be used to cover losses on the underlying assets before such losses were allocated to any other interest or account.

Section 15G also requires that securitizers not be permitted to hedge their retained interest. Therefore, the proposed regulations prohibit a securitizer from hedging its retained interest or transferring it to anyone other than a consolidated affiliate. However, securitizers are permitted to hedge foreign exchange or interest rate risk or hedge using an index that includes ABS, subject to certain limitations. Securitizers also will be able to pledge their retained interest on a full recourse basis.

Qualified Residential Mortgages

A securitizer will be exempt from the above risk retention requirements if all of the assets that collateralize an ABS are QRMs and no assets are other ABS. The proposed regulations limit mortgages that qualify as QRMs to only the most conservative variety. A QRM must have the following characteristics:

General Requirements

  • it must be a closed-end first-lien mortgage to purchase or refinance a one-to-four family property, at least one unit of which is the principal dwelling of a borrower
  • the maturity date, at the closing of the mortgage transaction, must not exceed 30 years
  • no other recorded or perfected liens on the one-to-four family property can, to the creditor’s knowledge, exist at the time of the closing of the mortgage transaction
  • the borrower must complete and submit to the creditor a written application for the mortgage transaction on which the borrower must attest to the truth of the information provided
  • the application must disclose that any intentional or negligent misrepresentation of the information provided in the application may result in civil liability and/or criminal penalties.

Borrower Credit History

  • the creditor must verify within 90 days before closing that as of such date the borrower is not 30 or more days past due on any debt obligation, and the borrower has not been 60 or more days past due on any debt obligation within the preceding 24 months
  • the creditor also must verify within 90 days before closing that as of such date the borrower has not, within the preceding 36 months, been a debtor in a bankruptcy proceeding, had property repossessed or foreclosed upon, engaged in a short sale or deed in lieu of foreclosure, or been subject to a federal or state judgment for collection of any unpaid debt.

Payment Terms

  • the mortgage cannot have payment terms that allow interest-only payments; negative amortization; balloon payments; or significant rate increases, such as from the expiration of a “teaser” rate (any interest rate increase after closing may not exceed: (a) 2 percent in any 12-month period and (b) 6 percent over the life of the mortgage transaction)
  • the mortgage cannot have a prepayment penalty.

Loan-to-Value Ratio

  • the mortgage must have a maximum loan-to-value ratio (LTV) of 80 percent for purchase transactions, 75 percent for refinances and 70 percent for cash-out refinances.

Down Payments

  • a 20 percent minimum down payment is required
  • the funds used to make the down payment must come from enumerated sources, such as the borrower’s savings and checking accounts, cash saved at home, stocks, bonds and gifts.

Qualifying Appraisal

  • the mortgage must be supported by a written appraisal that conforms to generally accepted appraisal standards.

Ability to Repay

  • the mortgage must have a front-end ratio limit of 28 percent and a back-end ratio limit of 36 percent.

Points and Fees

  • the total points and fees payable by the borrower in connection with the mortgage transaction may not exceed 3 percent of the total loan amount.

Prohibition on Assumability

  • the mortgage cannot be assumable by any person who was not a borrower under the original mortgage transaction.

Default Mitigation

  • the “mortgage transaction documents,” which the proposed regulations do not define, must include a provision requiring the creditor to have servicing policies and procedures designed to mitigate risk of default and mitigate losses promptly, and
  • the regulators also have requested comments on whether the servicing requirements should be part of the pooling and servicing agreement rather than part of the mortgage transaction documents (which appear to be the loan documents), or both sets of documentation.

Further, to prevent securitizers from abusing the QRM standard, the proposed regulations require securitizers to certify to investors that the securitized assets were selected and assembled pursuant to internal policies and procedures designed to ensure compliance with the proposed regulations’ underwriting standards. If a securitizer later determines that a loan does not qualify as a QRM, it would have to purchase the loan for cash within 90 days.

Note that the regulators have requested comments on an alternative approach that would include a broader definition of QRMs and permit less conservative mortgages to qualify, offset by higher risk retention requirements for securitizers.

Reduced Risk Retention for Other Qualified Assets

The proposed regulations do not require a securitizer to retain any portion of the credit risk associated with an ABS securitization if the assets collateralizing the issue are exclusively auto loans, commercial loans or commercial mortgages that meet certain underwriting standards, which vary by asset class.

  • with respect to ABS collateralized exclusively by commercial loans, the underwriting standards are designed to ensure the borrower will be able to repay the loan and that its business is, and will remain, financially strong. •with respect to ABS collateralized exclusively by commercial mortgages, the underwriting standards focus on the borrower’s ability to repay the loan; the value of, and the originator’s security interest in, the collateral; the LTV ratio; and whether the loan documentation includes the appropriate covenants to protect the collateral.
  • with respect to ABS collateralized exclusively by auto loans, the regulators recognize that the automobiles serving as collateral depreciate quickly. Therefore the underwriting standards are consistent with those commonly used for unsecured installment loans.
  • Section 15G contemplates a residential mortgage asset class that is not a QRM but qualifies for reduced risk retention. The proposed regulations do not propose such an asset class but do request comment on whether one should be created and with what characteristics.

 The proposed regulations contain the same certification and repurchase provisions with respect to these other qualified assets as they do for QRMs.

Further, the proposed regulations fully exempt from the risk retention requirements any securitization transaction if the ABS issued in the transaction are: (i) collateralized solely by obligations issued by the United States or an agency of the United States; (ii) collateralized solely by assets that are fully insured or guaranteed by the United States or an agency of the United States; or (iii) fully guaranteed by the United States or any agency of the United States. The proposed regulations also exempt resecuritizations that: (i) were collateralized solely by existing ABS issued in a transaction that complied with the credit risk retention requirements or was exempted from them; and (ii) consists of a single-class and provides for the pass-through (net of expenses) to holders of all principal and interest received.

Pepper Points:

While to date they have been unsuccessful, the question yet to be answered is whether financial institutions will be able to convince regulators during the comment period that the current narrowly drawn definition of QRMs will have a significant negative impact on the cost of credit to consumers and the credit markets. The regulators at least have allowed the possibility of less stringent QRM requirements, albeit at the cost of securitizers or other market participants retaining a greater percentage of risk.

Market participants, including loan originators and other secondary market participants, should expect to adopt uniformly stringent underwriting standards and perform detailed analyses of asset quality and credit risk for loans that may be included in future securitizations. To be sure, the structuring of future securitizations will impose a new balance among fundamental economic objectives, equity investment and risk mitigation, which will be borne by various market participants.

The regulators indicate that the inclusion of servicing standards for QRMs in the proposed regulations is not intended to deter their ongoing efforts to create national mortgage servicing standards. Since the issues to be considered in developing such standards are significant and the cost (both economic and otherwise) of development and implementation of servicing standards on an already overwhelmed servicing industry are considerable, we anticipate that the industry will tenaciously promote the adoption of all servicing standards in a single process. However, if the servicing procedures are included in the QRM requirements, they should be included in a servicing agreement assigned into the securitization or in the pooling and servicing agreement itself.