On October 22, the SEC joined with five other federal agencies (the Board of Governors of the Federal Reserve System, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency and the Office of the Comptroller of the Currency) in approving a final rule that implements the risk-retention requirements of Section 941 of the Dodd-Frank Act. The final rule adopted by the joint regulators applies to securitization transactions that are privately placed, sold under Securities Act Rule 144A or publicly offered if they involve asset-backed securities (ABS). A principal feature of the final rule is a requirement that sponsors of ABS retain at least 5% of the credit risk of the assets collateralizing the ABS, although there are exemptions from this requirement and others under the rule. The new rule is described in SEC Release No. 34-73407, which is available here.
Section 941 of the Dodd-Frank Act added a new Section 15G to the Securities Exchange Act of 1934 that mandates risk-retention for a securitizer (or sponsor) of ABS and generally prohibits any direct or indirect hedging or other transfer of the required credit risk. The six federal agencies mentioned above were charged with jointly implementing the credit retention requirement through rulemaking. They issued a proposed rule on March 29, 2011 that attracted considerable negative comment and resulted in the issuance of a revised proposed rule on August 28, 2013. The final rule is substantially similar to the reproposed rule, but contains a number of changes based on the public comments. The final rule will apply to residential mortgage-backed securities one year after the date of publication of the rule in the Federal Register, and to all other ABS two years after that date.
Overview of risk-retention requirements
Consistent with Section 15G, the final risk-retention rule generally provides that sponsors of ABS must retain at least a 5% economic interest of the “fair value” of the aggregate interests in a transaction. A sponsor may satisfy the risk-retention requirement by any one of the following approaches:
- Retaining an “eligible vertical interest,” under which the sponsor holds a portion of each class (or tranche) of ABS interests issued as part of a single securitization transaction or a single eligible vertical security representing the same percentage of each class
- Retaining an “eligible horizontal residual interest,” under which the sponsor retains the first loss position, to ensure that the securitizer bears the risk of loss before the security holders
- Retaining an “eligible horizontal reserve account,” under which the sponsor holds cash or cash equivalents in a specified type of reserve account (with interest-only reserve accounts not eligible)
- Any combination of the approaches
The “fair value” of the retained interests is to be determined in accordance with GAAP, although a fair-value calculation is not required for retention of an eligible vertical interest. In addition, sponsors holding an eligible residual horizontal interest are required by the final rule to disclose certain information related to the fair-value calculation before the sale of ABS that should include a description of the methodology and assumptions used to make the calculation. Within a reasonable time after the closing of the transaction, the sponsor also must disclose the actual fair value of the retained eligible horizontal residual interest at closing, the amount the sponsor was required to retain at closing and any material differences between the actual methodology and assumptions and those used prior to sale. One important change from the reproposal is that the final rule does not require a sponsor holding an eligible horizontal residual interest to be subject to cash flow restrictions.
Hedging and transfers of risk-retention
Under the final risk-retention rule, a sponsor may reduce its risk-retention requirement by the portion of any risk-retention assumed by an originator of the securitized assets, so long as the originator contributes more than 20% of the underlying asset pool. The sponsor, however, is not allowed to allocate to an originator any portion of the required risk-retention amount exceeding the percentage of securitized assets contributed by the originator. The purpose of the 20% threshold is to cause an originator to retain an amount of risk sufficient to create an incentive for it to monitor the quality of the assets in the pool.
Although the rule contains a general prohibition on hedging and transfer, it allows a sponsor to transfer its retained interest to a majority-owned affiliate or, in the case of a revolving pool securitization, a wholly-owned affiliate. In addition, the rule permits the sponsor to take hedge positions that are not materially related to the credit risk of the particular securitization transaction, such as positions related to overall market interest rate movements and currency exchange rates. The rule also allows hedge positions tied to securities that are backed by similar assets originated and securitized by other persons. Further, the rule includes certain hedging and transfer restriction time limits that terminate a sponsor’s prohibition on hedging and transfer of the required risk-retention once a specified time period has passed, based on when delinquencies historically tend to peak. Finally, the rule prohibits a sponsor or any affiliate from pledging any retained interest as collateral unless the obligation is with full recourse to the sponsor or affiliate. Any originator, originator-seller or third-party purchaser that retains credit risk under the rule will have to comply with the hedging and transfer restrictions as if it were the sponsor.
Qualifications and exemptions
The new rule allows a securitization transaction to be exempt from the risk-retention requirement if it is collateralized solely by a single class of qualifying assets and by servicing assets. Qualifying assets are assets meeting prescribed underwriting criteria, including criteria for commercial loans, commercial real estate loans and auto loans that are described below. For ABS issuances involving a blended pool of qualifying assets and non-qualifying assets, the rule reduces the required risk-retention percentage by the “qualifying asset ratio” (calculated as the unpaid principal balance of the qualifying loans in the pool divided by the total unpaid principal balance of all loans in the pool) at the cut-off date, but not to less than 2.5%. In addition, the sponsor must disclose the qualifying loans, the non-qualifying loans and the material differences between them.
Qualifying residential mortgage loans. Under the new rule, residential mortgage loans that meet the definition of a “qualified residential mortgage” are exempt from the standard risk-retention requirements. The final rule aligns this definition with the Consumer Financial Protection Bureau’s definition of “qualified mortgage” that became effective on January 10, 2014. The risk-retention rule requires the joint regulators to review the definition of “qualified residential mortgage” to determine its adequacy at any time upon request by a joint regulator, or periodically beginning no later than four years from the rule’s effective date, and every five years thereafter. The final rule also contains a new exemption for securitization transactions collateralized solely by community-focused residential mortgage loans that are not otherwise eligible for “qualified residential mortgage” status and are exempt from the ability-to-pay rules under the Truth in Lending Act (TILA). In addition, the final rule exempts certain owner-occupied three-to-four unit residential mortgage loans that are exempt from TILA’s ability-to-pay rules, but that otherwise meet the same requirements under the “qualified mortgage” definition as a one-to-two unit residential mortgage loan.
Qualifying commercial loans. To be considered a “qualified commercial loan” under the rule, the borrower must satisfy each of the following requirements, among others:
- The borrower’s total liabilities ratio must be 50% or less, the borrower’s leverage ratio must be 3.0 times or less and the borrower’s debt service coverage ratio must be 1.5x or greater based on two years’ projections
- The borrower’s primary repayment source must be its business operating revenue
- The borrower must make equal monthly payments that fully amortize a loan over a term that is no greater than five years from origination
Qualifying commercial real estate (CRE) loans. To be considered a “qualified CRE loan” under the rule, among other requirements:
- The loan must be secured by a first mortgage on a commercial property
- The debt service ratio must be 1.25x for qualifying multi-family loans, 1.5x for qualifying leased loans and 1.7x for other CRE loans
- The amortization term must be less than 30 years for multi-family loans and 25 years for other loans
- There must be a maximum loan-to-value (LTV) ratio of 65% and combined LTV ratio of 70% at origination
One important modification under the final rule is that the CRE loan definition now includes land loans, which are loans secured by improved land if the obligor owns the fee interest and the land is leased to a third party who owns all improvements on the land.
Qualifying auto loans. The requirements for treatment as a “qualified automobile loan” under the final rule are substantially the same as those in the reproposal. Among the requirements:
- The borrower must make equal monthly payments that fully amortize a loan over an expanded maximum allowable loan term that is no greater than (a) six years from the origination date for new cars or (b) ten years minus the difference between the model year of the vehicle and the current model year for used cars
- The borrower must make a minimum down payment of approximately 10%
- The borrower’s debt-to-income ratio must be less than or equal to 36%
- The borrower must have at least 24 months of credit history, including no current 30-day delinquencies and no payments 60 days past due during the past two years
Unfortunately, the “qualified automobile loan” exemption likely will not be useful for many issuers, since the manner in which automobile loans currently are originated in the industry would not enable them to qualify as “qualified automobile loans.” For example, it is unusual to require a 10% down payment for auto loans, and the current underwriting standards used with respect to consumer reporting do not focus on the same criteria as those in the rule. In addition, the “qualified automobile loan” definition omits an important exclusion for auto leases.
Other general exemptions. In addition to the qualifications and exemptions summarized above, the new rule contains other complete and partial exemptions from the risk-retention requirements for some types of securitization transactions. These include, among others, residential, multi-family and healthcare facility mortgage loan securitizations insured or guaranteed by the United States or by obligations of the U.S. Government (including agency obligations), securitization transactions collateralized solely by loans guaranteed by Fannie Mae and Freddie Mac, and several types of re-securitization transactions collateralized solely by servicing assets and meeting other specified requirements.
Risk-retention requirements for specified types of transactions
In addition to the general risk-retention requirements under the new rule, there are risk-retention requirements that apply to specified types of ABS transactions.
Commercial mortgage-backed securities (CMBS). Under the rule, a third-party purchaser that meets the same risk-retention standards as the securitizer and conducts due diligence on each asset before the issuance of the CMBS may retain the first-loss position, known as a “B piece.” In addition, the B piece may be sold and held by no more than two third-party purchasers in some circumstances. Further, the sponsor or initial third-party purchaser is allowed to transfer the B piece after five years from the date of closing. As under the reproposal, the risk-retention requirement may be satisfied if the third-party purchaser holding the B piece combines its interest with the interest of the sponsor that retains an additional required retention. For this option to be available, however, an independent operating advisor must be appointed.
Collateralized loan obligations (CLOs). The joint regulators rejected attempts to exempt CLO managers from treatment as “securitizers” and thus not subject to the risk-retention rule. The final rule does provide a risk-retention option for open-market CLOs that allows the 5% risk-retention requirement to be satisfied by lead arrangers of loans purchased by the CLO, rather than by the CLO manager. This option is available for an open-market CLO that is managed by a CLO manager:
- That holds less than 50% of its assets in loans syndicated by lead arrangers that are affiliates of the CLO or originated by originators that are affiliates of the CLO, and
- Whose assets consist only of CLO-eligible loan tranches and related servicing assets
This option is similar to a previously-proposed option the CLO market generally viewed as impractical.
Revolving pool securitizations. The final rule changed the definition of “revolving master trust” to “revolving pool securitization” and allows any type of legal entity to use this risk-retention option, whether or not the entity is organized as a trust. Under this option, a sponsor of a “revolving pool securitization,” such as a securitization of credit card receivables, may satisfy the risk-retention requirements by retaining a transaction-level seller’s interest of at least 5% of the unpaid principal balance of all outstanding ABS held by the investors in the issuing entity. In addition, the seller’s interest may be reduced by combining it with a series-level seller’s interest or other horizontal forms of risk-retention issued after the effective date of the risk-retention rule (although the horizontal risk-retention may be held only by the sponsor or a wholly-owned affiliate). The horizontal forms of risk-retention are measured on a fair value basis and include an “eligible horizontal retained interest” or a residual interest in excess interest and fees meeting certain requirements, or a combination of the two. Under the rule, there is no time limit terminating a sponsor’s prohibition on hedging and transfer of the required risk-retention for revolving pool securitizations. In addition, the seller’s interest must be maintained during the life of the securitization.
Asset-backed commercial paper (ABCP) conduits. The final rule provides a separate risk-retention option for asset-based commercial paper conduits that is substantially similar to an option contained in the reproposal. Under the rule, the sponsor of an “eligible ABCP conduit” will satisfy the risk-retention requirements if, for each ABS interest the ABCP conduit acquires from an intermediate special purpose entity (SPE), the originator-seller of the SPE retains an economic interest in the credit risk of the assets collateralizing the ABS interests being acquired in the same form, amount and manner required under one of the standard risk-retention options or revolving pool securitization risk-retention options. The definition of “eligible ABCP conduit” under the rule requires that the ABS interests acquired by an ABCP conduit be collateralized solely by ABS interests acquired from intermediate SPEs and servicing assets and that qualify as any one of the following:
- ABS interests collateralized solely by assets originated by an originator-seller and by servicing assets
- Special units of beneficial interest (or similar ABS interests) in a trust or SPE that retains legal title to leased property underlying leases originated by an originator-seller that were transferred to an intermediate SPE in connection with a securitization collateralized solely by such leases and by servicing assets
- ABS interests in a revolving pool securitization collateralized solely by assets originated by an originator-seller and by servicing assets
- ABS interests that are collateralized, in whole or in part, by assets acquired by an originator-seller in a business combination that qualifies for business combination accounting under GAAP, so long as, if the assets are collateralized in part, the remainder of such assets meet the criteria in the three items above
The ABS interests also must be acquired by the ABCP conduit in an initial issuance by or on behalf of an intermediate SPE either directly from the intermediate SPE, from an underwriter of the ABS interests issued by the intermediate SPE, or from another person who acquired the ABS interests directly from the intermediate SPE. In addition, the ABCP conduit must be bankruptcy-remote from the sponsor of the ABCP conduit and from any intermediate SPE, and a single eligible liquidity provider must enter into a legally binding commitment to provide 100% liquidity coverage to all of the ABCP issued by the ABCP conduit.
As under the reproposal, the originator-seller will be considered the sponsor of the ABS issued by an intermediate SPE. As a result, the use of the ABCP option by the sponsor of an “eligible ABCP conduit” will not relieve the originator-seller from its independent requirement to comply with risk-retention obligations with respect to the assets collateralizing the ABS issued by the intermediate SPE. Some notable differences between the final rule and the reproposal are that the intermediate SPE may be an “orphan” rather than wholly-owned by the originator-seller, and that the term of the commercial paper may be up to 397 days (the standard under Investment Company Act Rule 2a-7), rather than nine months.
Foreign-related transactions. The new rule creates a safe harbor from the risk-retention requirements for certain “foreign related” transactions that have limited connections to the United States and U.S. investors. The purpose of this safe harbor is to exclude from the risk-retention requirements some transactions with a sufficiently remote impact on U.S. interests that the transactions will not significantly affect the interests of U.S. investors or underwriting standards and risk management practices in the United States. Under the final rule, a securitization transaction will be subject to the foreign-related transaction safe harbor if all of the following requirements are satisfied:
- Registration is not required, and the transaction is not registered, under the Securities Act of 1933
- Not more than 10% of the value of all classes of ABS interests are sold to U.S. persons or for the account or benefit of U.S. persons
- Neither the sponsor nor the issuing entity is (a) organized under U.S. law (or the law of any other possession of the United States), (b) an unincorporated branch of a U.S. entity or (c) an unincorporated branch of a non-U.S. entity located in the United States
- Not more than 25% of the securitized assets were acquired from an affiliate or branch organized or located in the United States
Other risk-retention options. In addition to the foregoing transaction-specific risk-retention options, the new rule provides separate risk-retention options for certain other types of ABS transactions, including those involving student loans.
Comparison of U.S. and European Union risk-retention requirements
The European Union (EU) has risk-retention rules that are governed by Article 405 of the Capital Requirements Regulation and Article 51 of the Alternative Investment Fund Managers Regulation. Unfortunately, the U.S. and EU risk-retention rules are not completely aligned with each other, so that persons selling into both the European and U.S. markets must be careful to comply with both sets of rules. There are a number of key differences between the U.S. and EU risk-retention rules, including the following:
- The U.S. risk-retention rule regulates issuers, whereas the EU risk-retention rules apply to investors
- Unlike the U.S. rule, the EU rules do not contain exemptions for qualifying asset classes
- The U.S. rule measures the retention requirements using a fair-value calculation, whereas the EU rules measure the retention requirements based on nominal value
- Although the U.S. rule provides for a sunset mechanism that terminates the restrictions on hedging and transfer of the retention requirements in some instances, no such provisions exist in the EU rules
- Persons selling into both markets who wish to obtain off-balance sheet treatment will have to comply with both the U.S. and international accounting rules, a complicated process since such persons will be required to retain risk in the manner prescribed by the U.S. risk-retention rule
The final risk-retention rule is complex and has both positive and negative features. It provides more flexibility than originally proposed for the mortgage industry and greater transparency for investors. On the other hand, it maintains, without significant change from the reproposal, requirements for auto, commercial real estate and other commercial loans that some view as overly restrictive. In addition, the rule may create accounting concerns regarding balance sheet consolidation for sponsors who do not meet certain asset-specific exemptions. At the least, the final rule seems certain to result in a significant change in the business practices of participants in the securitization market.