On August 28, 2013, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (Federal Reserve Board), 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) (collectively, Agencies) released a revised proposed rule (Proposed Rule) to implement the risk retention requirement of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The Proposed Rule follows an initial rule proposal released in April 2011 (the Original Proposal). The Proposed Rule reflects comments received on the Original Proposal and re-proposes the risk retention rules with a number of significant modifications. The Proposed Rule can be found here. Comments to the Proposed Rule must be received by October 30, 2013.
The risk retention requirements of Section 941 of the Dodd-Frank Act are intended to align the interests of securitizers with those of other securitization transaction participants by requiring securitizers to retain some of the credit risk in the assets they securitize, or to have “skin in the game.” Section 941 added Section 15G to the Securities Exchange Act of 1934, as amended (Exchange Act), which requires the Agencies to prescribe risk retention rules. Section 15G generally requires a securitizer to retain no less than 5 percent of the credit risk in assets it sells into a securitization and prohibits a securitizer from directly or indirectly hedging or otherwise transferring the retained credit risk. The commentary to the Proposed Rule notes that Section 15G does not distinguish between transactions that are required to be registered with the SEC and those that are exempt from registration and the Proposed Rule applies to both public and private asset-backed securities (ABS) transactions.
The Proposed Rule includes alternative permissible forms for the economic interest required to be retained, provisions for the application of the rules to specific types of securitization transactions, exemptions from the standard 5 percent risk retention requirement and reduced retention requirements for securitizations of certain qualifying types of loans, most notably qualified residential mortgages. The Proposed Rule permits a sponsor to retain any combination of horizontal and/or vertical economic interest in a securitization transaction, provided that those interests generally equal at least 5 percent of the “fair value” of the securitization transaction in the aggregate. The Proposed Rule also includes a “menu of options” for permissible forms of risk retention that purports to take into account transaction-specific features of securitization transactions involving revolving master trusts, asset-backed commercial paper (ABCP) conduits, commercial mortgage-backed securities (CMBS), open market collateralized loan obligations (CLOs), mortgage-backed securities issued and guaranteed by government-sponsored enterprises (GSEs) and municipal bond repackaging securitizations.
While the Proposed Rule addresses many of the comments and concerns raised with respect to the Original Proposal, there are significant issues that have carried over from the Original Proposal and new concerns introduced by the revisions in the Proposed Rule. In general, while the commentary indicates that the Proposed Rule is intended to accommodate prudent features of existing market structures, it is highly prescriptive and would not give credit for many commonly used forms of risk retention.
We have highlighted some of the key provisions of the Proposed Rule and related issues and concerns below. The sections that follow provide a detailed description of the Proposed Rule.
Highlights
- Retention Based on Fair Value. The Proposed Rule permits risk to be retained in the form of a vertical interest in each class of ABS interests issued or in a horizontal, first-loss position but requires the measurement of that interest to be based on the “fair value” of the retained interest relative to the “fair value” of all ABS interests determined in accordance with U.S. generally accepted accounting principles (GAAP). The Agencies acknowledge that fair value is susceptible to yielding a range of results and the Proposed Rule requires disclosure of the key inputs and assumptions used in measuring fair value. Industry participants have expressed concern about sharing proprietary valuation models and assumptions and taking responsibility in disclosure for what is effectively the expression of an opinion. Further, restrictions on the allocation of cash flows to eligible horizontal residual interests while more senior interests are outstanding conflict with features that are standard for some asset classes.
- Flexibility in Structuring Risk Retention But Significant Conditions Have Been Added for Horizontal Interests. The Proposed Rule provides flexibility for a sponsor to hold any combination of an eligible horizontal residual interest and a vertical interest that together meet the 5 percent risk retention requirement. The Original Proposal limited the options to an all-horizontal interest, an all- vertical interest or an equal split of horizontal and vertical interests. The Proposed Rule, however, does not give credit for some commonly used forms of risk retention. For example, subordinated notes which receive interest before principal is paid on more senior notes would not seem to qualify as an eligible form of horizontal risk retention. The provision of the Proposed Rule that requires upfront projections of future cash flow and provides that the eligible horizontal retained interest must not receive distributions (measured as a percentage of “fair value”) faster than the other ABS interests receive principal (measured as a percentage of par) on any payment date, as well as the basic mismatch of the two different measures, raises multiple concerns with typical residual interests, subordinated notes with higher coupons and any subordinated note receiving interest payments prior to the commencement of principal payments as is typical in revolving structures. In addition, the use and disclosure of projections raises proprietary information and liability issues.
- QRM Definition. ABS that are collateralized solely by “qualified residential mortgages” or QRMs are not subject to a risk retention requirement. The Proposed Rule defines QRMs by reference to the Consumer Financial Protection Bureau’s definition of a “Qualified Mortgage” or QM. Under the Dodd-Frank Act the Agencies were required to define QRM to be no broader than the definition of QM, so the QRM definition in the Proposed Rule is as broad as it can be. The Proposed Rule also requests feedback on an alternative approach that would adopt the criteria of the QM definition but add additional requirements, including an LTV of no greater than 70 percent.
- Qualifying Asset Requirements. While the QRM definition in the Proposed Rule is significantly less restrictive than in the Original Proposal, the definitions of “qualifying commercial loans,” “qualifying commercial real estate loans” and “qualifying automobile loans” continue to reflect nonmarket terms and therefore seem to be of little utility. For example, very few if any automobile loan securitizers originate loans that would constitute “qualifying automobile loans.” The Proposed Rule introduces the concept of “blended pools” that allows qualifying loans to be securitized in the same pool with nonqualifying loans of the same asset class and permits a reduced required risk retention percentage as low as 2.5 percent.
- Premium Capture Cash Reserve Account. The Proposed Rule removed the requirement, included in the Original Proposal, to establish an account to capture the premium received by a securitizer on the sale of any tranches that monetize the excess spread in a securitization transaction and to retain such amounts and apply them to cover losses.
- Representative Sample. The Proposed Rule removes the option to hold a representative sample of assets equivalent to the assets being securitized. A representative sample option has been used by securitizers to satisfy risk retention requirements under the FDIC legal isolation safe harbor and European risk retention rules. The risk retention option in the Original Proposal required the assets to be randomly selected yet representative of the securitized pool and was criticized by commenters for being impractical to implement. The Agencies neither included the option nor have they incorporated a provision that would allow retention in the form of a participation interest in an asset pool that was suggested by commenters as a practical alternative to the Original Proposal’s overly complex representative sample option.
- Seller’s Interest Option for Revolving Master Trusts. The Proposed Rule includes a specific retention option for revolving master trust transactions such as credit card securitizations. Unfortunately the Proposed Rule defines a seller’s interest in a way that does not work for most master trust transactions. It requires the allocation of collections to the seller’s interest to be pari passu with the allocation to each series of investor ABS interests prior to the occurrence of an early amortization event, while master trusts generally allocate principal collections disproportionately in favor of investor ABS interests during any amortization or accumulation period, including a scheduled controlled amortization period. The Proposed Rule has helpful modifications allowing nonrevolving assets and giving credit for a seller’s interest held at a legacy trust that issues a collateral certificate to the issuing entity. The Proposed Rule also includes provisions allowing the 5 percent seller’s interest to be offset by amounts held in an excess funding account or by an eligible horizontal residual interest in each series of ABS interest or a specialized horizontal interest that could give credit for residual interest in excess spread, though there are technical problems with respect to each of these offsetting provisions that would make them of limited utility.
- Open Market Collateralized Loan Obligations. The Proposed Rule introduces a totally new manner of satisfying the risk retention requirements for CLOs conditioned upon the CLO acquiring only loans that are in CLO-eligible loan tranches, which are term loans in a tranche of a syndicated credit facility a minimum of 5 percent of which tranche is retained by the lead arranger of the facility. The lead arranger must also have taken at least 20 percent of the aggregate principal balance of the facility at the time of origination with no other member of the syndication group taking a greater allocation. This new proposal was apparently not requested or vetted by bank lenders; thus its practicality remains to be determined. In addition, the Agencies confirmed their view that a CLO manager is a “securitizer” and “sponsor” for risk retention rule purposes.
- Sale and Hedging Restrictions. The Proposed Rule generally prohibits the sale or transfer of a retained interest except to a majority-owned affiliate of the sponsor. In addition, hedging activity, except with respect to interest rate or foreign exchange risk, or through investment in an ABS indexed instrument, is generally prohibited. The Proposed Rule adds sunset provisions for these transfer and hedging prohibitions in certain circumstances.
- Eligible ABCP Conduits. The Proposed Rule includes a specific risk retention option for asset- backed commercial paper conduits that imposes many conditions that, if met, would exempt the conduit from retaining 5 percent of the commercial paper that it issues. As with many of the other exemptions offered in the Proposed Rule, the Agencies have layered on more conditions than any ABCP conduit in the real world likely would satisfy. Among others, a liquidity provider must provide 100 percent liquidity coverage that is also 100 percent credit enhancement. But that alone does not satisfy the eligible ABCP conduit requirements. The ABCP conduit must be collateralized solely by ABS issued by qualifying special purpose vehicles (SPVs) that satisfy their own risk retention requirements. Note that the application of risk retention rules to issuers of commercial paper indicates an expansive view of the definition of “asset-backed securities” by the Agencies.
- Municipal Bond Repackaging Transactions. The Proposed Rule adds risk retention provisions specific to issuers of tender option bonds or TOBs that constitute “qualifying tender option bond entities.” The Proposed Rule provides relief for such entities if the entity retains interests that meet the requirements of an eligible horizontal interest originally but, upon the occurrence of a termination event, meet the requirements for an eligible vertical interest, or if the sponsor holds municipal securities from the same issuance equal to at least 5 percent of the securities deposited in the issuing entity.
The original and full memo was published by Skadden, Arps, Slate, Meagher & Flom LLP in October 2013 and is available here.