Insights

The much-touted Wall Street Reform and Consumer Protection Act of 2010 (you remember, that giant piece of legislation that created the new Consumer Financial Protection Bureau) is the gift that keeps on giving, and not in the good way. Turns out, there’s another concern for dealers, whether or not they are excluded from the CFPB’s jurisdiction – that is, the ABS risk retention provisions found in Title IX of the Act. This is of critical interest to any dealer who sells his retail installment sale paper to third-party banks and finance companies that securitize that paper to raise new capital.

These provisions direct the Securities and Exchange Commission to develop and implement regulations to require retention of credit risk in ABS transactions as follows:

• 5% Retention Requirement: The Act requires originators and securitizers to retain a minimum of 5% of the credit risk attributable to financial assets transferred. The SEC must develop regulations implementing this requirement. In the typical indirect (three-party) transaction, the originator is the dealer, and the securitizer is generally the finance source.
• Permissible Forms of Risk Retention and Minimum Duration: The SEC’s regulations must establish the permissible forms and methods of risk retention and the minimum duration for which the risk must be retained.
• Allocations of Risk Retention Between the Parties: The SEC must establish jointly with the federal banking agencies (the OCC, Federal Reserve, FDIC, etc.) the allocation of risk between the originator and securitizer. That portion of the risk retention allocated to the originator (i.e., the dealer) reduces that allocated to the securitizer.
• Exempt Classes of Assets: The SEC’s regulations must provide for reductions in risk retention requirements for certain classes of assets that meet underwriting criteria established by the federal banking agencies.

These requirements have serious implications for finance companies and dealers. For example, finance companies that raise capital through ABS channels may find it harder to engage in these transactions, thus limiting their ability to provide financing through dealers. Add to that the new standards imposed on credit rating agencies, and you have the potential for even more limited capital access. While current first-loss retention provisions may (ultimately) be adequate, there is no guarantee that the SEC’s regulations will reflect that. And costs associated with ABS transactions will rise as a result of increased due diligence and more rigorous scrutiny by the rating agencies.

For dealers, the potential that they formally retain some percentage of credit risk can be cataclysmic. High volume dealers with outstanding portfolios of $100 million or more may not have an extra $5 million lying around to keep in reserve. Even assuming only 1% of the risk is allocated to dealers, most may not have
$1 million to sequester from working capital. And dealers’ abilities to provide financing may be curtailed to the extent a reduction in the availability of low-cost ABS funding causes finance sources to dial back their financing activities.

But wait – there’s more! The SEC’s regulations will come with new disclosure requirements for ABS issuers. These include:

• Loan-level data with unique loan broker and originator identifiers (i.e., dealers).
• Nature and extent of the compensation of the broker or originator of the assets.
• Amount of risk retained by the originator and securitizer.

These requirements, depending on how they are structured, also have potential negative effect. For example, finance sources can anticipate higher compliance costs for ABS transactions and will need to be careful not to disclose proprietary information. Dealers should anticipate higher costs and less credit availability if finance sources find it more difficult to obtain funding through low-cost ABS markets. And both dealers and finance companies should be concerned about disclosure of sensitive information with respect to dealer compensation.

Many finance and dealer trade associations are actively working to educate the SEC about the intricacies of auto finance (and why it’s different from mortgage finance), such that industry risk retention requirements get appropriate treatment under the new SEC regulations (in a perfect world, that would be to exclude auto finance securitizations from the SEC’s regulations). But this is uncharted territory for the SEC. While all reports are that SEC staff has been listening, the education process is always an ongoing venture. Make sure you’re doing your part.

Michael A. Benoit is a partner in the Washington, D.C., office of Hudson Cook LLP. Michael can be reached at 202-327-9705 or by email at mbenoit@hudco.com.