The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) provides for improvements to the asset-backed securitization process. Among other improvements, the Act includes new credit risk retention requirements that impact securitizers of asset-backed securities and originators of financial assets that collateralize asset-backed securities. These “skin in the game” requirements will have a significant impact on securitization transactions.
Section 941 of Subtitle D of Title IX of the Act amends the Securities and Exchange Act of 1934 (the “1934 Act”) by adding a new section addressing “Credit Risk Retention.” As amended, the 1934 Act includes several new definitions applicable to credit risk retention and requires the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (the “Federal banking agencies”) and the Securities Exchange Commission (the “SEC”) to jointly prescribe regulations requiring securitizers to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party. With respect to residential mortgage assets, the Secretary of the Department of Housing and Urban Development (“HUD”) and the Federal Housing Finance Agency (the “FHFA”) will join the Federal banking agencies and the SEC in prescribing regulations. The amendments to the 1934 Act include standards and guidelines for the regulations.
Securitizers and Originators. The new credit risk retention requirements impact securitizers and originators. “Securitizer” means an issuer of an asset-backed security or a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate to the issuer. “Originator” means a person who, through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security and sells an asset directly or indirectly to a securitizer.
“Asset-backed security” means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including: (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the SEC, by rule, determines to be an asset-backed security for purposes of the credit risk retention requirements.
Retention Requirements. The amended 1934 Act sets forth minimum standards that the regulations must reflect in regard to the portion of the credit risk that a securitizer must retain. The specific retention requirement for any asset depends primarily on whether the asset is a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer. The Federal banking agencies, SEC, HUD, and FHFA will jointly define the term “qualified residential mortgage” (“QRM”).
If the asset is not a QRM, or if the asset is a QRM that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, but one or more of the assets that collateralize the asset-backed security are not QRMs, the securitizer must retain at least 5% of the credit risk for the asset. If the asset is not a QRM, and if the originator of the asset meets certain underwriting standards established by regulation, the regulations may require the securitizer to retain less than 5% of the credit risk for the asset. A securitizer need not retain any part of the credit risk for an asset that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, if QRMs make up all of the assets that collateralize the asset-backed security. The retention requirements will apply regardless of whether the securitizer is a federally insured depository institution.
The regulations must prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer must retain with respect to an asset. The regulations must also specify the permissible forms of risk retention and the minimum duration of risk retention. In addition, the regulations must provide for the allocation of risk retention obligations between a securitizer and an originator where a securitizer purchases assets from an originator, as the Federal banking agencies and the SEC jointly determine appropriate. In making these determinations, the Federal banking agencies and the SEC must reduce the securitizer’s percentage of risk retention obligations by the percentage of risk obligations required of the originator and must consider (a) whether the assets sold to the securitizer have terms, conditions, and characteristics that reflect low credit risk; (b) whether the form or volume of transactions in securitization markets creates incentives for imprudent origination of the type of loan or asset to be sold to the securitizer; and (c) the potential impact of the risk retention obligations on access to credit by consumers and businesses on reasonable terms, which may not include the transfer of credit risk to a third party.
Asset Classes and Retention Guidelines. The amended 1934 Act requires that the regulations establish asset classes with separate rules for securitizers of different classes of assets, including residential mortgages, commercial mortgages, commercial loans, auto loans (which could include motor vehicle retail installment sales), and any other class of assets that the Federal banking agencies and the SEC deem appropriate. For each established asset class, the regulations must include underwriting standards established by the Federal banking agencies that specify the terms, conditions, and characteristics of a loan within the asset class that indicate a low credit risk with respect to the loan.
For commercial mortgages, the regulations must specify the permissible types, forms, and amounts of risk retention. The amended 1934 Act contains potential requirements applicable to commercial mortgages that the Federal banking agencies and the SEC may include in the regulations at their discretion. In addition, the regulations must establish appropriate standards for retention of an economic interest with respect to collateralized debt obligations, securities collateralized by collateralized debt obligations, and similar instruments collateralized by other asset-backed securities.
Exemption for Qualified Residential Mortgages. The Federal banking agencies, SEC, HUD, and FHFA must jointly issue regulations to exempt QRMs from the risk retention requirements. However, the regulators cannot exempt an asset-backed security that is collateralized by tranches of other asset-backed securities from the risk retention requirements as a QRM.
In addition, as mentioned above, the Federal banking agencies, SEC, HUD, and FHFA must jointly define the term “QRM,” taking into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default. Such features include:
The regulators may not promulgate a broader definition of QRM than the definition of “qualified mortgage,” as defined by the Truth in Lending Act, as amended by the Act and regulations adopted under the Act.
Other Exemptions. The Federal banking agencies and the SEC may jointly adopt or issue exemptions, exceptions, or adjustments to the credit risk retention rules. Any exemption, exception or adjustment must help ensure high quality underwriting standards and encourage appropriate risk management practices by the securitizers and originators of assets, improve access to credit by consumers and businesses on reasonable terms, or otherwise be in the public interest and for the protection of investors.
The amended 1934 Act expressly exempts certain institutions and programs from the credit risk retention requirements, including (i) loans and other financial assets made, insured, guaranteed, or purchased by any institution that is subject to the supervision of the Farm Credit System Institutions; and (ii) other federal programs, including any residential, multifamily, or health care facility mortgage loan asset, or securitization based directly or indirectly on such an asset, which is insured or guaranteed by the United States or an agency of the United States. In addition, the regulations may provide for a total or partial exemption for the securitization of certain assets, including those issued or guaranteed by the United States, or an agency of the United States, or by any state of the United States. Importantly, Fannie Mae and Freddie Mac are not agencies of the United States for purposes of this provision.
Enforcement. The appropriate Federal banking agency will enforce the regulations with respect to any federally insured depository institution securitizer. For any non- insured depository institution securitizer, the SEC will enforce the regulations.
Effective Date. As amended, the 1934 Act requires the Federal banking agencies and the SEC (along with HUD and FHFA in regard to residential mortgage assets) to issue regulations no later than 270 days after the date of enactment of Section 941 of the Act. The regulations will become effective one year after the date on which the regulators publish the final rules in the Federal Register for securitizers and originators of asset-backed securities backed by residential mortgages. For securitizers and originators of all other classes of asset-backed securities, the effective date is two years after the date on which the regulators publish the final rules in the Federal Register.
The credit risk retention requirements will significantly impact securitizations. Although the amendments to the 1934 Act establish minimum standards for credit risk retention, the regulators must address many important details in the regulations, including how to define “credit” risk (and whether certain risks need not be retained) and how to measure credit risk (such as where a loan is purchased at a discount or premium, and whether a pro rata share of the risk must be retained as opposed to the first risk of loss or the last risk of loss). Consequently, the full impact of the credit risk retention requirements on securitizations is yet to be determined.
Sharon Bangert is a partner in the Washington, D.C., office of Hudson Cook, LLP. Basis Points readers can reach Sharon at 202-327-9703 or by email at sjbangert@hudco.com.
Catharine Andricos is an associate in the Washington, D.C., office of Hudson Cook, LLP. Basis Points readers can reach Catharine at 202-327-9706 or by email at candricos@hudco.com.
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