Securitization is an attractive method for financing portfolios of leases and loans relating to transportation equipment, including aircraft and aircraft engines. In a typical securitization transaction, a lender or lessor (the originator) sells loans or leases (and the related equipment) to a special-purpose entity that finances the purchase through the issuance of securities backed by the cash flow from the loans or leases. During the recent financial crisis, investors in securitization transactions involving certain types of assets (primarily residential mortgage loans) incurred substantial losses. These losses have been largely attributed to poor underwriting of the underlying assets. Commentators have argued that the poor underwriting was the result of a securitization process that created incentives for originators (primarily mortgage loan originators) to acquire and sell loans without regard to whether the loans were properly underwritten, since the originators did not expect to bear the risk of borrower default. The originators received cash up front for selling loans but had little ongoing economic interest (also known as skin in the game) relating to the future performance of the loans.
In 2010, in an attempt to address the "skin in the game" concern in securitization transactions, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Section 941 of the Dodd-Frank Act amended the Securities Exchange Act of 1934 by adding a new section 15G, which requires a securitizer to retain at least 5 percent of the credit risk of the assets collateralizing the securitization transaction. Section 15G also generally prohibits the party that is supposed to retain credit risk from circumventing the risk retention requirement by hedging or otherwise transferring the credit risk. As part of the Dodd-Frank Act, Congress directed the applicable U.S. regulators to jointly implement credit risk retention requirements for securitization transactions.1
Although three years have passed since the Dodd-Frank Act was enacted, the U.S. regulators have not implemented risk retention rules for securitization transactions. In April 2011, the U.S. regulators published a joint notice of proposed rulemaking relating to credit risk retention. After receiving numerous comment letters from interested parties on the joint notice of proposed rulemaking, the U.S. regulators decided to try again. In August 2013, the U.S. regulators issued a second joint notice of proposed rulemaking for the risk retention requirements of the Dodd-Frank Act (the proposed?rules).2
What Type of Securitization Transaction Is Covered?
The Dodd-Frank Act's risk retention provisions apply to the issuance of asset-backed securities (ABS). The definition of ABS includes "a fixed-income or other security collateralized by any type of self-liquidating asset (including a loan, a lease, or other secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset…."3 The risk retention requirements apply to all ABS offerings, even if the ABS offerings are not registered with the Securities and Exchange Commission. This means that the risk retention rules will apply to ABS issued in private placement transactions, including private placements structured as Rule 144A/Regulation S bond offerings.
This article briefly summarizes certain aspects of the proposed rules that may affect the securitization of loans and leases relating to aircraft and aircraft engines. This article does not discuss the application of the proposed rules to loans and leases relating to any other assets.
Who Must Retain the Credit Risk?
The risk retention requirements of the Dodd-Frank Act apply to the sponsor of the ABS transaction. A "sponsor" is defined as the party that "organizes and initiates" a securitization transaction "by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity." Many securitization transactions have more than one sponsor. For these transactions, while the risk retention rules may be satisfied by the risk retained by the sponsors collectively, each sponsor is individually responsible for making sure that the risk retention requirements are complied with, whether or not that sponsor is itself retaining any of the?risk.
How Much Risk Must Be Retained, and What Are Permissible Forms for Holding the Required Amount of Risk Retention?
The proposed rules require the sponsor to retain an economic interest of at least 5 percent of the aggregate credit risk of the assets collateralizing a securitization transaction. There are several permissible options to hold the required amount of risk retention.
Vertical Risk Retention Option
A sponsor may elect to satisfy the 5 percent risk retention requirement through a "vertical" risk retention option. This means that the sponsor would hold at least 5 percent of the fair value4 of each class of securities issued as part of the securitization transaction. For example, if three classes of ABS interests were issued in an aircraft lease securitization transaction, including a senior class of notes, a subordinated class of notes and an E certificate (representing the residual, or equity, interest in the transaction), a sponsor using the vertical risk retention approach would have to retain at least 5 percent of the fair value of each such class or interest.
An alternative method for a sponsor to satisfy the vertical risk retention option is to hold a separate "single vertical security" issued by the issuing entity. This type of security would entitle the sponsor to 5 percent of the principal and interest paid on each class of ABS interests issued in the securitization transaction. In an aircraft lease securitization transaction, a new class "V" might be issued to the sponsor, which would represent a single vertical security for risk retention purposes.
Horizontal Risk Retention Option
A sponsor may elect to satisfy the 5 percent risk retention requirement through a "horizontal" risk retention option. This means that the sponsor would retain a first-loss risk exposure in an amount equal to at least 5 percent of the fair value of all of the ABS interests in the transaction. "ABS interests" are defined to include all types of interests or obligations issued by the issuer in the securitization transaction, including any note, certificate or residual interest, the payments on which are primarily dependent on the cash flows of the loans or leases held by the issuing entity.
In order to satisfy the requirements for horizontal risk retention, the sponsor would be required to hold the most subordinated claim to payments of principal and interest from the issuing entity. The holder of a horizontal residual risk may receive a share of prepayments, but only to the extent that other, more senior classes of interests first receive their share of such prepayments.
Subordinated classes of securities are not unusual in aircraft securitization transactions. For example, in a recent securitization of aircraft engine leases, the issuer issued Series X Notes, Series A Notes and a Series E Certificate. The Series A Notes were subordinated to the Series X Notes, and the Series E Certificate was subordinated to the Series X Notes and the Series A Notes. The Series E Certificate represented the right to receive cash flow at the bottom of the securitization payment waterfalls, and may be the type of security that could be used for purposes of satisfying the horizontal risk retention option of the proposed rules.
Cash Reserve Fund Option
A third option for a sponsor is to fund a cash reserve account in an amount equal to the horizontal residual risk that the sponsor otherwise could have held. The cash reserve account would need to be held by a trustee for the securitization transaction. Amounts in the cash reserve account may be invested only in short-term government securities or in fully insured deposit accounts. Cash may be released from the reserve account to satisfy the issuing entity's obligation to make payments of interest and principal on the notes or other securities issued in the securitization transaction.
Reserve accounts are not unusual in securitization transactions. For example, the deposit accounts that were part of a recent aircraft engine lease securitization transaction included a maintenance support account and a liquidity facility reserve account. It would be relatively simple to add a cash reserve account to an aircraft securitization transaction in order to satisfy the horizontal risk retention option.
The proposed rules allow the sponsor to satisfy its risk retention requirements by holding a combination of a vertical interest, a horizontal interest or a cash reserve account.
Transfer of Risk Retention
Allocation to Originators
The proposed rules permit a sponsor to reduce its risk retention by allocating a portion of any risk retention to an originator of the applicable loans or leases that agrees to assume that risk retention. Under the proposed rules, an "originator" is the original lender or lessor of the loan or lease that is the collateral for the securitization transaction. The risk retention allocated to an originator can equal an amount up to that originator's pro rata share of the assets in the transaction (based on the amount of assets acquired from that originator). However, the proposed rules permit risk retention to be allocated only to originators that originated at least 20 percent of the loans or leases collateralizing the securitization transaction.
In a future aircraft securitization transaction, an issuing entity might acquire 50 percent of the aircraft leases from one originator, 35 percent of the aircraft leases from a second originator, and 15 percent of the aircraft leases from a third originator. The sponsor could allocate up to 50 percent of its risk retention to the first originator and up to 35 percent of its risk retention to the second originator, but would not be able to allocate any of its risk retention to the third originator (since the third originator is providing fewer than 20 percent of the leases to be securitized).
Transfer to Affiliates
The proposed rules allow a sponsor to transfer all or any portion of its risk retention obligations to one or more affiliates that are majority-owned by the sponsor.
Restriction on Hedging
Under the proposed rules, a sponsor is not allowed to hedge the credit risk it is required to retain except in limited circumstances. These hedging restrictions also apply to an originator or an affiliate of a sponsor that has accepted the transfer of some or all of the sponsor's risk retention obligations. The proposed rules would allow a sponsor, an originator or an affiliate of the sponsor, as applicable, to enter into a hedge that is not materially related to the credit risk of the particular securitization transaction. For example, a sponsor would be able to enter into a hedge against currency exchange rates without contravening the proposed rules.
The proposed rules also prohibit a sponsor (or the applicable affiliate or originator) from pledging as collateral for a loan or other financing transaction the ABS interest that the sponsor is required to retain, unless the loan or other financing transaction has full recourse to the sponsor (or such affiliate or originator). U.S. regulators view a limited recourse loan secured by the sponsor's retained interest as a potential disguised transfer of the retained interest because any payment default by the sponsor under the limited recourse loan will undoubtedly result in the lender's foreclosing upon the pledged retained interest. As a result, the sponsor would no longer own the retained interest and would cease to have the required "skin in the game" relating to the transaction.
Expiration of Restrictions on Transferring and Hedging of Risk Retention
The proposed rules reflect a belief that any credit losses on loans and leases due to poor underwriting will tend to occur in the first few years of a securitization transaction, and that defaults may occur less frequently as the underlying loans and leases are seasoned. As a result, the proposed rules provide that the restrictions on transferring and hedging of risk retention expire on the date that is the last to occur of the following: (1) the date on which the total unpaid principal balance of the securitized assets is less than or equal to 33 percent of the original unpaid principal balance at the closing of the securitization transaction; (2) the date on which the total unpaid principal obligations under the bonds and other ABS interests issued in the securitization transaction are less than or equal to 33 percent of the original unpaid principal obligations of the ABS interests at the closing of the securitization transaction; and (3) two years after the closing of the securitization transaction.
Exception for Certain Loans
The proposed rules exempt certain types of loans on the theory that risk retention to promote sound underwriting is less relevant in the case of loans that meet specified underwriting standards or loans that have been performing for an extended period of time.5
Under the proposed rules, if a securitization transaction is collateralized by qualifying commercial loans, those loans may qualify for a zero percent risk retention requirement. A loan is a "qualifying commercial loan" if the originator has analyzed the borrower's ability to service all of the borrower's outstanding debt for the next two years, and the originator has determined that, after giving effect to the loan, the borrower would have (i) a total liabilities ratio of less than or equal to 50 percent, (ii) a leverage ratio of not more than 3.0, and (iii) a debt service coverage ratio of at least 1.5. A qualifying commercial loan also must satisfy additional criteria, including that the loan payment amount must be determined based on straight-line amortization over a term not in excess of five years from origination. This exception from the risk retention rules could be available for a securitization of aircraft loans if the borrowers of the underlying loans and the terms of the underlying loans satisfy the criteria described above.
The proposed rules also exempt from the risk retention requirements securitization transactions collateralized solely by seasoned loans. For this purpose, a "seasoned loan" is a loan that (i) has not been modified since its origination, (ii) has never been delinquent for 30 days or more, and (iii) has been outstanding for at least two years or, if later, until the outstanding principal balance of the loan has been reduced to 33 percent of the original principal balance. This seasoned loan exemption might be useful for securitizations that involve the repackaging of previously issued aircraft loans. In a recent transaction, a Delaware statutory trust was established to acquire an aircraft loan made to one of the major U.S. airlines that had been outstanding for more than ten years. The Delaware trust raised funds to acquire the aircraft loan by "tranching" credit exposure to the aircraft loan: the trust borrowed a senior loan from a bank lender secured by the aircraft loan, and the trust also issued subordinate certificates to third-party investors in a private placement. If the outstanding principal balance of the underlying aircraft loan had been less than 33 percent of its original principal balance, the transaction would have had a zero-risk-retention requirement.
Effective Date of Proposed Rules
The risk retention requirements in the proposed rules, if adopted by the U.S. regulators, will not become effective until a transition period has elapsed. In the case of securitization transactions collateralized by loans and leases relating to aircraft and aircraft engines, the risk retention requirements will become effective two years after the date that final rules are published in the Federal Register.
The proposed risk retention rules should not have a significant impact on securitizations of loans and leases relating to aircraft and aircraft engines. The issuance of subordinated securities and retained interests, and the establishment of reserve accounts, have been typical features of those securitization transactions. If and when the proposed rules become effective, the skies should still be clear for securitizations of aircraft assets.