Section 941 of the Dodd-Frank Act required various agencies to implement rules that require a sponsor of a securitization to retain at least 5% of the credit risk of the assets underlying its asset-backed securities (“ABS”). After years of proposed rules and intensive comment from the securitization industry, the OCC, Federal Reserve, FDIC, SEC, FHFA and HUD jointly issued a final risk retention rule at the end of 2014. Compliance for ABS collateralized by residential mortgages was required to begin on Dec. 24, 2015, and for other classes of ABS compliance is required to begin on Dec. 24, 2016.
Generally, the final rule requires that the sponsor retain 5% of the credit risk of securitized assets (as determined on the closing date of the securitization) and is subject to significant transfer, hedging and financing restrictions. The standard options for retaining the credit risk are (i) holding a vertical interest in the entire capital structure, (ii) holding an eligible horizontal residual interest (“EHRI”), or (iii) holding a combination of a vertical interest and EHRI. The rules also provide that sponsors may fund an eligible horizontal cash reserve account in lieu of all or part of an EHRI, although the restrictions on the use of funds in such a reserve account make this option generally non-economic.
Under the rules, the option of retaining a vertical interest is much more straightforward – sponsors retain a minimum of 5% of each class of ABS interests issued. By comparison, electing to retain an EHRI is much more complex and is subject to more significant valuation and disclosure requirements. The rules require that the EHRI be equal to at least 5% of the “fair value” of all ABS interests issued as determined using a fair value measurement framework under GAAP. In order to make such a determination, the sponsor must, among other things, make numerous assumptions, including the rate and timing of defaults, prepayment rates and recovery rates on the underlying assets and coupons and principal balances of the ABS interests issued, and determine a discount rate to calculate the present value of the resulting cash flows to the residual interest. Further, the key inputs and assumptions, the sponsor’s valuation methodology and the resulting fair value determination must be disclosed to investors prior to pricing, and post-closing the sponsor is also required to disclose to investors final fair value determinations based on final pricing information and disclose any material differences in inputs and assumptions. As a result of this complexity and the disclosure requirements, for the most part, the initial transactions required to comply with the risk retention rules have opted for having the sponsor retain a vertical interest rather than an EHRI.
The market is beginning to see a shift from sponsors using the vertical interest option to sponsors holding an EHRI. From a structuring point of view, holding an EHRI can be significantly more efficient for the sponsor. Many esoteric asset classes that will be required to comply with risk retention at the end of 2016 are already structured with substantial first loss residual interests retained by the sponsor. Utilizing the EHRI option will allow those sponsors to comply with risk retention rules without making any significant changes to deal structures. Kramer Levin’s Securitization group specializes in the securitization of esoteric assets and has closed a number of transactions utilizing the EHRI risk retention option (including the first two transactions in March 2016).
Other issues that should be considered by sponsors include (i) whether assets fall under the definition of “residential mortgages” such that compliance is currently required (the industry has generally assumed that compliance is now required only for RMBS, but the rule actually covers ABS “collateralized by residential mortgages” where the definition of residential mortgage may apply to asset classes other than just RMBS); (ii) the extent to which inputs, assumptions or methodologies for internal valuations of residual interests differ from those disclosed to investors in respect of the fair value of the EHRI; (iii) whether a warehouse facility is structured such that it could require compliance with risk retention rules; and (iv) options for holding risk retention interests through majority-owned affiliates or other structures.