By Patrick Dolan and Robert Ledig, with Kira Brereton
A proposed rule regarding implementation of the asset-backed securities (ABS) risk retention provisions of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act was recently approved by several government agencies.
The rule requires a securitization sponsor to retain an economic interest equal to at least 5% of the aggregate credit risk of the assets collateralizing an issuance of ABS.
The sponsor may allocate a proportional share of this obligation to the originator(s) of the securitized assets, if the originator (i) is the originator of at least 20% of the loans in the securitization, (ii) takes on at least 20% of the risk retention, and (iii) pays up front for its share of the risk retention.
If a sponsor structures a securitization to monetize excess spread on the underlying assets, the rule would “capture” the premium received on the sale of the tranches that monetize the excess spread and would require the sponsor to place such amounts into a separate “premium capture cash reserve account.” Such amounts would be in addition to the sponsor’s base risk retention requirement.
The rule prohibits a securitizer from hedging its required retained credit risk or transferring it, except to a consolidated affiliate. However, the rule permits some hedging of interest rate or foreign exchange risk and pledging of the required retained interest on a full recourse basis.
Risk Retention Options
The rule provides several risk retention options, including retention of:
• A 5% “vertical” slice of ABS interests, whereby the sponsor or other entity retains a pro rata piece of each class of interests (i.e., 5% of each tranche).
• A 5% “horizontal” first-loss position, whereby the sponsor or other entity retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests.
• An “L-shaped interest,” whereby the sponsor holds at least half of the 5% retained interest as a vertical slice and the remainder as a horizontal first-loss position.
• A “seller’s interest” in securitizations using master trust structures collateralized by revolving assets, whereby the sponsor or other entity holds a 5% separate interest that participates in revenues and losses on the same basis as the investors’ interest in the receivables pool (until the occurrence of an early amortization event).
• A representative sample, whereby the sponsor retains a 5% representative sample of the assets to be securitized, thereby exposing the sponsor to credit risk that is equivalent to that of the securitized assets.
• For certain “eligible” single-seller or multi-seller asset-backed commercial paper conduits collateralized by loans and receivables and covered by a 100% liquidity guarantee from a regulated bank or holding company, a 5% residual interest retained by the receivables’ originator-seller.
• For certain securitizations of commercial mortgage-backed securities (CMBS), a form of horizontal risk retention in which the horizontal first-loss position is held by a third-party purchaser (“B-piece buyer”) that specifically negotiates for the purchase of the first-loss position and according to the rule, conducts its own credit analysis of each commercial loan backing the CMBS.
Strict Requirements for QRM Qualification
The rule includes an exemption from the risk retention requirement for certain “qualified residential mortgages” (QRMs) in residential mortgage securitizations.
The proposed definition of a QRM includes the following underwriting standards:
maximum front-end and back-end borrower debt-to-income ratios of 28% and 36%, respectively
maximum loan-to-value (“LTV”) ratio of 80% (exclusive of mortgage insurance) in the case of a purchase transaction (with a 75% combined LTV for rate and term refinance transactions, reduced to 70% for cash-out refinancings);
20% down payment requirement in the case of a purchase transaction; and borrower credit history restrictions.
The rule also contains safeguards against abuse of the QRM (and other qualifying asset) exemptions, such as imposing repurchase obligations on the sponsor if it is subsequently determined that any loan does not satisfy the QRM requirement.
The rule also requires that the originator of a QRM incorporate servicing policy and procedure requirements in the mortgage transaction documents, such as procedures for loss and default risk mitigation and to address subordinate liens on the same property securing other loans held by the same creditor.
Freddie Mac and Fannie Mae (and presumably lenders participating in Freddie Mac or Fannie Mae securitizations) would be treated as satisfying QRM requirements while they are under Federal Housing Finance Agency conservatorship and parties to a Preferred Stock Purchase Agreement with the Department of the Treasury.
Another significant provision of the rule would impose a 0% risk retention requirement on ABS that are exclusively collateralized by auto, commercial or commercial real estate loans if the loans meet the underwriting standards set forth in the rule for the related asset class.
Patrick Dolan and Robert Ledig are partners at Dechart LLP. Kira Brereton is an associate.