The Dodd-Frank Act’s required credit risk retention rules were finalized and adopted by US regulators this week. Below are certain excerpts from the adopting release and from the final rule regarding credit risk retention in student loan securitizations. Essentially, the specific rules related to student loans are unchanged from the previous rule proposed by the federal agencies charged with formulating risk retention rules under the Dodd-Frank Act.
Risk retention as related to the Federal Family Education Loan Program (FFELP) loans depends upon the guaranty percentage of the loans in the pool to be securitized: If the pool contains only loans that are 100% guaranteed then there is no risk retention requirement (these pools would be extremely rare). If the pool contains loans that are all at least 98% guaranteed then risk retention is 2%. If the pool contains any loans that are 97% guaranteed (no matter how small the percentage of such loans is in the pool) risk retention is set at 3%. Thus a typical pool that includes some loans with each level of guaranty will have a risk retention requirement of 3%. This means that compared to a health receivables securitization that has no risk retention requirement because all of the assets are 100% guaranteed by the federal government, senior ABS in a FFELP securitization, depending upon how the transaction is structured, could have more than 100% credit protection!
Commentators made these points regarding the proposed risk retention rule, and the points were acknowledged in the adopting release but dismissed.
The final rule does not include any special exemptions from risk retention for non FFELP or private student loan securitizations, even those issued by nonprofit public purpose student loan providers. Private student loan securitizations will be subject to the standard 5% risk retention that can be held vertically or horizontally or in some combination of ABS interests. Holding a representative sample of assets was not permitted, even though commentators requested special consideration of this approach to risk retention for student loan financings.
Lastly, the final rule does not include specific guidance as to the exemption for "qualified scholarship funding bonds." The adopting release states that both taxable and tax exempt ABS could be exempt from the risk retention rule if "a security satisfies the requirements of the qualified scholarship funding bond" under the relevant federal tax rules. Tax advices, as usual, will be necessary in connection with any such transaction.
Please contact Capital Markets partner Lauris G.L. Rall to further discuss final risk retention rules, including the rules of general applicability related to valuing and holding ABS to satisfy the risk retention requirement.
Final Rule Regarding Credit Risk Retention
Adopted October 2014 by federal agencies under Section 941 Of The Dodd–Frank Act.
Excerpts from the adopting release related to student loan securitization:
C. Federal Family Education Loan Program and Other Student Loan Securitizations
The reproposal would have exempted any securitization transaction that is collateralized solely (excluding servicing assets) by student loans made under the Federal Family Education Loan Program (“FFELP”) that are guaranteed as to 100 percent of defaulted principal and accrued interest (i.e., FFELP loans with first disbursement prior to October 1993, or pursuant to certain limited circumstances where a full guarantee was required). A securitization transaction that is collateralized solely (excluding servicing assets) by FFELP loans that are guaranteed as to at least 98 percent (but less than 100 percent) of defaulted principal and accrued interest would have its risk retention requirement reduced to 2 percent. Any other securitization transaction that is collateralized solely (excluding servicing assets) by FFELP loans would have its risk retention requirement reduced to 3 percent.
Several commenters urged the agencies to expand the proposed exemption for securitization transactions collateralized by FFELP loans to a full exemption from risk retention requirements. These commenters asserted that a risk retention requirement ranging from zero percent to 3 percent for FFELP loan securitizations that are subject to a guaranty ranging from 97 percent to 100 percent means risk retention is required in an amount greater than the loss exposure on the loans. These commenters stated that other securitization products would receive a full exemption under the reproposal even if they are only partially insured or guaranteed. A few of these commenters also asserted that risk retention would have no effect on the underwriting standards since these loans have already been funded and the program is no longer underwriting new loans. One of these commenters urged the agencies to apply the risk retention requirement only to the portion of the FFELP loans that are not guaranteed. [ This commenter suggested, as an example, that if only 3 percent of a FFELP loan is uninsured, the 5 percent risk retention requirement should only apply to the 3 percent uninsured portion, resulting in a 0.15 percent risk retention requirement with respect to such loan.]
Commenters also recommended that the agencies accept alternative forms of risk retention for FFELP loan securitizations. The suggested alternative forms of risk retention include a simplified representative sample method, an exemption for on-balance sheet transactions where the structure clearly demonstrates at least 5 percent risk retention, initial equity contribution, overcollateralization, and unfunded forms of risk retention. One of these commenters cited the European Union risk retention regime which recognizes certain unfunded forms of risk retention.
One commenter asked that the agencies extend the FFELP loan securitization exemption to include student loan-backed securities issued by entities exempt from registration under section 3(a)(4) of the Securities Act and by entities that have received tax-exempt designations under section 501(c)(3) of the IRS Code. This commenter asserted that these issuers are constrained in their ability to raise sufficient capital to meet the risk retention requirements. One other commenter requested that student loan revenue bonds issued by nonprofit issuers that are supported by third-party credit enhancement be exempted. This commenter asserted that investors in these bonds are not making their investment decisions based on the credit risk and performance of the asset pool, and that these bonds are assessed based on the creditworthiness and structure of the third-party credit enhancement. Another commenter requested that all nonprofit public purpose student loan providers be fully exempted from risk retention requirements. This commenter asserted that the structure of the securitizations issued by these entities, and the history of investor interest in security issuances by nonprofit organizations, reflect the strong alignment of interests between the investors and sponsors of these types of securitization transactions.
Another commenter requested clarification that the exemption for qualified scholarship funding bonds apply to both securities issued on a federally taxable basis and securities issued on a federal tax-exempt basis.
After considering the comments received, the agencies are adopting the reductions in the amount of required risk retention for FFELP loan securitization as reproposed. The agencies do not believe that providing a full exemption to partially insured or guaranteed FFELP loans is warranted. The agencies believe that the reductions in risk retention for FFELP loan securitizations described in the reproposal reflect the appropriate level of “skin in the game” for these transactions, encouraging high quality underwriting generally in the selection of assets for securitization and appropriate risk management practices in post-default servicing. The agencies also reiterate that they have generally declined to recognize unfunded forms of risk retention and continue to do so for purposes of the final rule.
Consistent with the reproposal, the agencies are not expanding the proposed exemptions to cover student loans other than FFELP student loans, including student loan-backed securities issued by entities exempt from registration under section 3(a)(4) of the Securities Act or entities that have received tax exempt designations under section 501(c)(3) of the IRS Code, because comments received on the reproposal did not provide a basis to allow the agencies to conclude that the structures or underwriting practices of these securitizations align the interests of securitizers with the interests of investors such that an exemption would be appropriate under section 15G(c)(1)(G) or section 15G(e) of the Exchange Act. The agencies are concerned that an exemption for sponsors of student loan-backed securities issued by entities exempt from registration under section 3(a)(4) of the Securities Act or entities that receive tax exempt designations under section 501(c)(3) of the IRS Code would permit evasion of the rule through the use of an entity that meets the requirements of such exemption, but whose sole purpose is the issuance of ABS interests. Regarding whether the exemption for qualified scholarship funding bonds would apply to both securities issued on a federally taxable basis and securities issued on a federal tax-exempt basis, the agencies note that the text of the exemption does not specifically make a distinction between taxable and tax-exempt securities. To the extent a security satisfies the requirements of the qualified scholarship funding bond exemption in the rule, such security is exempt from the risk retention rule. The agencies believe that there is not sufficient justification to provide an exemption for bonds that may have some similarities to a qualified scholarship funding bond, but do not meet the statutory definition.
Excerpts From The Adopted Rule
§ __.19 General exemptions.
(b) This part shall not apply to:
(3) State and municipal securitizations. Any asset-backed security that is a security issued or guaranteed by any State, or by any political subdivision of a State, or by any public instrumentality of a State that is exempt from the registration requirements of the Securities Act of 1933 by reason of section 3(a)(2) of that Act (15 U.S.C. 77c(a)(2)).
(4) Qualified scholarship funding bonds. Any asset-backed security that meets the definition of a qualified scholarship funding bond, as set forth in section 150(d)(2) of the Internal Revenue Code of 1986 (26 U.S.C. 150(d)(2)).
(e) Reduced requirement for certain student loan securitizations. The 5 percent risk retention requirement set forth in § __.4 shall be modified as follows:
(1) With respect to a securitization transaction that is collateralized solely by student loans made under the Federal Family Education Loan Program (“FFELP loans”) that are guaranteed as to 100 percent of defaulted principal and accrued interest, and servicing assets, the risk retention requirement shall be 0 percent;
(2) With respect to a securitization transaction that is collateralized solely by FFELP loans that are guaranteed as to at least 98 percent but less than 100 percent of defaulted principal and accrued interest, and servicing assets, the risk retention requirement shall be 2 percent; and
(3) With respect to any other securitization transaction that is collateralized solely by FFELP loans, and servicing assets, the risk retention requirement shall be 3 percent.