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:
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:
Borrower Credit History
Ability to Repay
Points and Fees
Prohibition on Assumability
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.
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.
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.
Pepper Hamilton’s Financial Services Practice Group will continue to monitor developments in the proposed regulations as comments are submitted and will provide an update once they become final. For additional information regarding the issues addressed in this Alert, please contact either of the authors.
1 Section 15G grants the FRB, FDIC, SEC and OCC primary rulemaking authority, with HUD and the FHFA also having rulemaking authority with respect to residential mortgage-backed securities.
2 The proposed regulations also offer options specifically designed for certain structures involving asset-backed commercial paper and commercial mortgages.
Audrey D. Wisotsky and David W. Freese
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The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.