Agencies Adopt Final Dodd-Frank Risk Retention Rules for Asset-Backed Securities
During the week of October 20, 2014, several federal agencies (the “Agencies”)1 adopted final rules (the “Final Rules”)2 to implement the Dodd-Frank credit risk retention requirements for asset-backed securities.3 The Agencies originally proposed risk retention rules in April 2011 (the “Originally Proposed Rules”). Following comments received from representatives of the financial industry, trade groups and others, the Agencies re-proposed the rules in August 2013 (the “Re-Proposed Rules” and, together with the Originally Proposed Rules, the “Prior Proposals”).4 The Re-Proposed Rules responded to many, but not all, of the deficiencies in the Originally Proposed Rules cited by commenters. As a result, the Agencies received further comments on the Re-Proposed Rules, seeking additional exemptions and modifications. Despite these comments, the Final Rules leave unaddressed many of those remaining issues. Under the Final Rules, certain asset classes fare better than others, and, in certain cases where industry comments were not fully addressed, the final risk retention requirements may pose challenges for the asset classes in question. Some of the important points include:
- Critically, the Final Rules, unlike the Re-Proposed Rules, do not contain restrictions that limit the cash flow that may be paid to a sponsor from a retained eligible horizontal residual interest.
- The Agencies allow flexible combinations of horizontal and vertical risk retention interests.
- Sunsets on the prohibitions on hedging and transfer of retained interests were retained largely as set forth in the Re-Proposed Rules.
- The Final Rules generally do not recognize unfunded forms of risk retention, such as guarantees, liquidity facilities and letters of credit.
- The Final Rules will become effective one year (in the case of residential mortgages) or two years (for all other asset classes) after the date of their publication in the Federal Register (in either case, the “Effective Date”). Offers and sales of asset-backed securities after the respective Effective Date will be subject to risk retention requirements under the Final Rules.
Residential Mortgage-Backed Securities (RMBS)
- For purposes of the exemption from risk retention for private-label U.S. RMBS, the Final Rules align the definition of “qualified residential mortgage” (or “QRM”) with the definition of “qualified mortgage” (or “QM”) under rules of the Consumer Finance Protection Bureau (with minor adjustments). The definition of qualified residential mortgage will be subject to periodic review, initially four years after the Effective Date, and every five years thereafter, and at any time upon request of one of the Agencies.
- The Agencies did not adopt the more restrictive “QM-plus” construct outlined in the Re-Proposed Rules.
- Under the Final Rules, a limited reduction in risk retention is generally available to sponsors of blended pools in which residential mortgages are mixed with certain community-focused residential mortgages, and an exemption from risk retention is available to sponsors of blended pools of QRMs and three-to four-family residential mortgages that meet the QM criteria other than that they be “covered transactions.”
Commercial Mortgage-Backed Securities (CMBS)
- The third-party purchaser alternative for CMBS risk retention allows up to two third-party purchasers, each of which holds a pari passu portion of the eligible horizontal residual interest (known as the “B-piece”).
- As a condition to the third-party purchaser risk alternative, an operating advisor (representing the interests of CMBS investors as a collective whole) must be appointed and, among other things, have the power to recommend removal of the special servicer; and any such recommendation must be actionable by a majority vote of all CMBS holders voting on the matter–with a maximum quorum requirement of 20% of the outstanding balance (representing at least three unaffiliated ABS interest holders).
- A sponsor of a CMBS transaction that relies on the third-party purchaser alternative remains legally responsible for ongoing compliance by the third-party purchaser. No third-party purchaser may be an affiliate of the sponsor for a CMBS transaction, which will limit sponsors’ ability to monitor satisfaction by third-party purchasers of ongoing conditions.
- The Final Rules did not provide relief for the (not insignificant) portion of the CMBS market that takes the form of single-borrower or single-credit transactions, which often are tranched without a non-investment grade layer and thus are unlikely to attract qualifying third-party purchasers (since there is no traditional B-piece, and purchasers of investment grade tranches would be unlikely to incur the cost of the significant independent due diligence upon which relief is conditioned). The Agencies considered extensive arguments from commenters on this subject, but declined to provide a separate exemption for transactions characterized as “single-borrower or single-credit (SBSC) transactions.”
- The qualifying asset exception for CMBS collateralized by qualifying commercial real estate loans specifies a level payment of principal and interest (as opposed to straight-line amortization of principal and interest) over loan terms of 25 years (or 30 years, for loans on multifamily properties). The qualifying asset exception also excludes interest-only commercial real estate mortgages.
- Under the Re-Proposed Rules, vertical interest risk retention would have been measured by fair value, which would have subjected some CMBS, which commonly are issued at a premium to par, to higher risk retention levels relative to asset-backed securities of other asset classes more commonly issued nearer to par. This measurement criterion for vertical interests was not reflected in the Final Rules.
Collateralized Loan Obligations (CLOs)
- Like the Prior Proposals, the Final Rules reflect the Agencies’ determination that the manager of a CLO transaction is its “sponsor,” even though neither a manager nor any of its affiliates typically acts as a seller or transferor of the securitized assets to the issuing entity. The Agencies rejected proposals made by commenters (i) to recognize the fees of CLO managers (particularly subordinated or incentive management fees) as aligning the interests of CLO managers and investors and (ii) to consider alternative CLO-specific risk retention structures.
- The risk retention requirement is likely to make it more difficult for CLO managers without balance sheet capacity to participate in the CLO market.
- The risk retention alternative for “open market CLOs” first proposed in the Re-Proposed Rules was carried forward into the Final Rules. This alternative will allow risk retention to occur at the asset level instead of at the securitization level by imposing risk retention on the lead arranger of a lending facility in which a CLO invests (and not on the CLO manager). Although this theoretically provides relief to CLO managers, it does so in a manner that is inconsistent with current market practice (for both lending facilities and CLOs). As a result, it is not clear if this alternative approach will in fact provide meaningful relief for CLOs.
- As noted above, proposed restrictions on cash flows in respect of horizontal residual interests were not included in the Final Rules. This is a critical and beneficial change in the Final Rules for CLO transactions, which often permit subordinated CLO tranches to receive cash flows early in a transaction and in excess of those that would have been permitted under the Re-Proposed Rules.
- The Final Rules apply to CLOs that offer and sell asset backed securities following the Effective Date. This will include not only new CLOs but also CLOs that have their initial closings before the Effective Date and then offer and sell asset backed securities after the Effective Date. In general, the exercise of a typical “re-financing” option in a CLO is expected to constitute an issuance of securities that, if occurring after the Effective Date, will require compliance with the Final Rules. It remains unclear whether the exercise of a “re-pricing” option in a CLO will be treated similarly.
- Because of the relatively long tenor of CLO structures, the sunsets on transfer and hedging prohibitions under the standard risk retention approach will likely provide little relief, because the sunsets are tied to pool balance reductions.
- While the Final Rules impose risk retention requirements on CLO managers, they are silent on the consequences of the resignation or removal and replacement of a collateral manager that holds a required risk retention interest. As a result, it is unclear whether the risk retention requirement ceases to apply following such a resignation or removal, whether the retiring or removed CLO manager must continue to hold the required risk retention interest (notwithstanding the fact that it no longer acts as CLO manager), or whether the newly appointed CLO manager must acquire the required risk retention interest.
- Accordingly, risk retention will likely present challenges for the CLO market and, by extension, the loan market that it supports.
Asset-Backed Commercial Paper (ABCP)
- The Final Rules maintain the basic framework contained in the Re-Proposed Rules for the sponsor of an ABCP conduit that elects to satisfy the risk retention requirements by utilizing the “eligible ABCP conduit” option.
- Within that framework, greater flexibility has been introduced in a number of respects. The commercial paper issued by an ABCP conduit is no longer limited to nine-month paper, but may now have a maturity of up to 397 days. The assets acquired by the ABCP conduit are no longer limited to asset-backed securities but may now include any “ABS interest.” There is now some recognition that permitted assets may include not only those originated by an originator-seller but also those acquired by the originator-seller in a business combination. Finally, limited transfers of assets between ABCP conduits are now permitted.
- However, it remains a requirement that an ABCP conduit acquire its assets in an initial issuance by an “intermediate SPV.” The Agencies have allowed some expansion in the definition of intermediate SPV to include certain orphan SPVs, but the Agencies rejected the suggestion to allow direct purchases by an ABCP conduit from an originator-seller without an intermediate SPV.
- Finally, the Final Rules continue to require an unconditional 100% liquidity facility (i.e., one not conditioned on the performance of underlying assets) for a sponsor to utilize the eligible ABCP conduit risk retention option. The Agencies note that “the ABCP option is designed to accommodate conduits that expose the liquidity provider to the full credit risk of the assets in the securitization.” This 100% requirement contrasts with the statutory risk retention standard of 5%.
- The limitations of the eligible ABCP conduit risk retention option can be expected to lead sponsors to consider the alternatives of the standard horizontal and vertical risk retention strategies.
Other Asset-Backed Securities (Other ABS)
- The Final Rules, like the Re-Proposed Rules, do not include a representative sample method for risk retention, which could have been a commercially useful tool for sponsors of granular pools of securitized assets (such as auto loans and credit card receivables).
- The absence of a representative sample option may present challenges for sponsors seeking off-balance sheet treatment of securitized assets for accounting purposes and, for regulated financial institutions subject to the U.S. capital adequacy rules, reduced risk-weighted capital charges.
- The Agencies provided little relief despite industry comments criticizing the underwriting and other criteria making up the definition of “qualifying automobile loan” as inconsistent with standard market underwriting practices. In particular, those criteria that require individualized credit underwriting for automobile loans contrast with current practices that rely on externally generated credit scores and credit reports.
- The Final Rules’ definition of “qualifying automobile loan” excludes asset-backed securities backed by automobile leases, loans to finance fleet and other commercial automobiles, motorcycle loans and recreational vehicle loans.
This Sidley Update summarizes a number of important elements of the Final Rules. The discussion below includes two initial sections, one that provides background on Section 941 of Dodd-Frank and the Prior Proposals, and a second that offers observations applicable generally to all asset-backed securities. Those sections are then followed by sections related to particular asset classes (RMBS, CMBS, CLOs, ABCP Conduits and Other ABS) and other exemptions and exceptions.
Under Section 15G of the Exchange Act, which was added by Section 941 of Dodd-Frank, the Agencies must jointly adopt regulations requiring “securitizers” to retain, on an unhedged basis, not less than 5% 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. The rules must specify certain exemptions and exceptions to the base risk retention rules, including an exemption for asset-backed securities that are collateralized exclusively by residential mortgages that qualify as QRMs and possible exceptions for other assets that meet underwriting standards that entail low credit risk.5
The risk retention requirements apply to “securitizers” of asset-backed securities.6 Although the Final Rules articulate a separate term for “securitizer,” they, like the Prior Proposals, require that the “sponsor” of an asset-backed securities transaction be primarily responsible for retaining an economic interest equal to at least 5% of the credit risk of the assets collateralizing the issuance of “asset-backed securities.” The Final Rules permit a sponsor’s majority-owned affiliates7 (wholly-owned in the case of revolving pool securitizations) to satisfy the standard risk retention requirement at the inception of the transaction; and without the necessity of transfer from the sponsor, such affiliates may share in holding the retained interest with the sponsor. Consistent with the Prior Proposals, a sponsor may share its risk retention requirement with one or more originators that meet certain conditions.8
As required under Section 15G of the Exchange Act, the Final Rules incorporate by reference the definition of “asset-backed security” from Section 3(a)(79) of the Exchange Act (i.e., any fixed-income or other security collateralized by any type of self-liquidating asset that allows the holder of the security to receive payments that depend primarily on the cash flow from the asset) in determining whether a transaction is a “securitization transaction” subject to the risk retention requirements. Accordingly, the Final Rules apply to instruments such as collateralized debt obligations (CDOs) and CLOs that do not meet the more restrictive definition of “asset-backed security” contained in the SEC’s Regulation AB, which governs the disclosure requirements for asset-backed securities offerings that are registered under the Securities Act of 1933 (the “Securities Act”). The Final Rules also apply to offers and sales of asset-backed securities regardless of whether such securities are publicly offered, privately placed or are otherwise exempt from registration under the Securities Act. The Final Rules do not apply to transactions not involving Exchange Act “asset-backed securities,” such as synthetic asset-backed securities.
2. GENERAL CONSIDERATIONS UNDER THE FINAL RULES
Base Risk Retention Requirements Under the Re-Proposed Rules
Like the Prior Proposals, the Final Rules generally require the securitizer to hold at least 5% of the securitization transaction, either through a vertical slice of each class of ABS interests or a horizontal slice of the most junior ABS interest, or a combination of a vertical slice and a horizontal slice adding up to 5%. The Final Rules do not require a premium capture cash reserve account (which would have had a negative economic impact on sponsors) or impose a cash flow restriction on any horizontal residual interest (which would have been difficult to administer and would also have had a negative impact).
Flexible Standard Risk Retention Requirement
Under the Final Rules, the Agencies retain the general approach set out in the Re-Proposed Rules, which provided for a base set of risk retention requirements with exemptions and exceptions to those requirements. However, the Final Rules do modify, in various degrees, some of the base set of risk retention requirements and certain of the exemptions and exceptions.
Standard Risk Retention Approach. The Final Rules allow a sponsor to satisfy its risk retention requirement in respect of its securitization transaction (before giving effect to any exemption or exception) by retaining an eligible vertical interest, an eligible horizontal residual interest or any combination thereof, as long as the percentage amount of the vertical interest and the percentage amount of the horizontal vertical interest combined is no less than 5%. The percentage amount of an eligible vertical interest is the percentage of each class of “ABS interests” that is issued in the securitization and held by the sponsor. The percentage amount of eligible horizontal residual interest equals the “fair value” (discussed below) of the eligible horizontal residual interest expressed as a percentage of the fair value of all of the ABS interests issued in the securitization. The Agencies maintain the re-proposed definition of “ABS interest,” but with an exclusion for non-economic REMIC residual interests and certain REMIC regular interests used in multiple-tier REMIC structures. Under the Final Rules, an eligible horizontal residual interest need not be represented by a single class of ABS interests, but may consist of multiple adjacent classes. In addition, a sponsor will be able to hold an eligible vertical interest as a “single vertical security” evidencing interests in each class of ABS interests that result in the security representing the same percentage of each class of ABS interests as if held as multiple vertical interests. A majority-owned affiliate of the sponsor is permitted to hold all or a portion of a required risk retention interest, except such affiliate must be wholly-owned in the case of risk retention interests retained in respect of a revolving pool securitization. Thus, the Agencies provide sponsors with a reasonably flexible basic set of risk retention options that are intended to accommodate an array of securitization transactions across asset classes.
Par Value and Fair Value Measurements. The Originally Proposed Rules measured risk retention with reference to the par value of securitization tranches. The Re-Proposed Rules changed the method for measuring retention for both vertical and horizontal residual interests to one based on the fair value of the ABS interests retained. The Final Rules keep the fair value approach for horizontal residual interests, but revert to the par value method for vertical interests, as the Agencies agreed with commenters that there is no need for a fair value method in the latter context (and thus no requirement to disclose fair value calculations in respect of securitization transactions if risk retention is achieved solely through retained vertical interests).
The Agencies provide little guidance regarding the meaning of fair value other than that it should be determined in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).10 The Agencies state that accountants already address the concept of fair value in various contexts and should not face unusual difficulties in applying it to horizontal residual interests. The time for determining fair value for purposes of satisfying the risk retention requirement is now the date of the initial issuance of the related ABS interests, rather than the date of pricing the ABS interests.
The Final Rules impose detailed disclosure obligations11 and require sponsor certifications with respect to fair value determinations of eligible horizontal residual interests and certain other material items.
As noted above, the Final Rules eliminate restrictions on projected cash flow to the horizontal residual interest out of concern that their operation might produce unintended consequences or might have an unduly restrictive impact on certain asset classes. The Agencies state in the preamble that if they observe in the future that the way fair value is being calculated in practice undermines the effectiveness of the retention of a horizontal residual interest to align the interests of sponsors and investors, the Agencies will consider modifications to the Final Rules.
The Final Rules keep the concept, introduced in the Re-Proposed Rules, that in lieu of holding all or part of the risk retention in the form of a horizontal residual interest, such retention may be satisfied by the maintenance of a funded horizontal cash reserve account in an amount equal to the amount of the horizontal residual interest that is replaced by the horizontal cash reserve account. Investments in such an account are restricted to cash and cash equivalents (e.g., high-quality, highly liquid short-term investments), and the account must be held by the trustee for the benefit of the issuing entity. Amounts in the account must be available to absorb losses on the ABS interests to the same extent as a horizontal residual interest would absorb such losses. Under certain circumstances, funds in the account may be used to pay critical expenses of the issuing entity when the issuing entity otherwise has insufficient funds.
Effects of Elimination of Representative Sample Option. The Final Rules do not provide the representative sample option included as part of the menu of options under the Originally Proposed Rules. Under that approach, a sponsor would have been able to satisfy risk retention by retaining ownership of a representative sample of the pool of assets that are designated for securitization in the transaction.
The representative sample approach has been one of two risk retention options (the other being vertical risk retention) available under the FDIC Safe Harbor Rule (defined below), which is applicable to U.S. insured depository institutions. Sponsors of automobile loan-backed deals that satisfy the risk retention requirements under the FDIC Safe Harbor Rule have taken advantage of this option. However, the option will no longer be available under the FDIC Safe Harbor Rule because, as discussed further below, risk retention under that rule will automatically conform to the final Dodd-Frank risk retention rules.12
The accounting treatment and (for regulated financial institutions) risk-based capital requirements may vary depending on the form in which the sponsor holds a retained interest.13 The elimination of the representative sample option limits a sponsor’s standard risk retention options to horizontal and/or vertical risk retention, which may not be practicable (particularly for horizontal risk retention) if as a result the sponsor must treat the securitization transaction as an “on-balance sheet” transaction for accounting purposes. The absence of the representative sample approach thus may affect sponsors that are concerned about consolidation of the issuing entity for accounting purposes.
“Servicing Assets.” The Final Rules keep the concept of “servicing assets” to address the fact that issuing entities often hold assets other than loans or other types of core assets.14 The preamble describes various types of servicing assets, which include proceeds of the core assets, as well as “cash and cash equivalents, contract rights, derivative agreements of the issuing entity used to hedge interest rate and foreign currency risks, or the collateral underlying the securitized assets.”
Hedging, Transfer and Financing Restrictions and Sunsets
Hedging, Transfer and Financing Restrictions. The Final Rules contain restrictions on hedging, transfer and financing that are substantially the same as those in the Re-Proposed Rules. Consequently, the Final Rules prohibit a retaining sponsor from selling or otherwise transferring any interest or assets that it is required to retain other than to majority-owned (or wholly-owned, as applicable) affiliates of the sponsor. A retaining sponsor and its affiliates also may not hedge their required risk retention positions or pledge those positions as collateral for any obligation (including a loan, repurchase agreement or other financing transaction), unless the obligation is with full recourse to the pledgor.
Certain activities are not considered prohibited hedging activities. Sponsors and their affiliates will be permitted to:
- hedge interest rate or foreign exchange risk; or
- hedge based on an index of instruments that includes asset-backed securities, subject to limitations based on the portion of the index represented by the specific securitization transaction and by all securitization transactions in which the sponsor is required to retain an interest.
If an originator retains all or a portion of the risk otherwise required to be retained by a sponsor, the originator is generally subject to the limits on transfers, hedging and financings that apply to sponsors.
Sunsets. Section 15G of the Exchange Act requires that the risk retention regulations specify the minimum duration of the risk retention required. In a change from the Originally Proposed Rules, the Final Rules (like the Re-Proposed Rules) contain sunsets on the prohibitions on transfer and hedging of retained risk positions, reflecting the view that the effectiveness of risk retention in ensuring sound underwriting diminishes after a period of time has lapsed and peak delinquencies have occurred.
The Agencies have adopted separate sunsets for sponsors of RMBS and non-RMBS transactions to account for longer durations of residential mortgages. For sponsors of RMBS transactions collateralized entirely by residential mortgages, the restriction on transfer and hedging expires on the later of:
- five years after the date of the closing of the securitization transaction; and
- the date on which the total unpaid principal balance of the residential mortgages has been reduced to 25% of their total unpaid principal balance at closing;
provided that the restrictions expire in any case not later than seven years after closing.
For sponsors of other securitization transactions, the prohibition on transfer and hedging sunsets on the latest of:
- the date on which the total unpaid principal balance of the securitized assets has been reduced to 33% of the total unpaid principal balance of the securitized assets at closing;
- the date on which the total unpaid principal obligation under the related ABS interests has been reduced to 33% of the total unpaid principal obligation of the ABS interests at closing; and
- two years after closing.
However, there is no sunset provision for risk retention interests in revolving pool securitizations.
In addition, as noted below, an initial third-party purchaser of an eligible horizontal residual interest of CMBS may transfer its interest commencing five years after closing, so long as the transferee satisfies certain of the conditions applicable to the initial third-party purchaser, including the requirements that the subsequent third-party purchaser acquire its interest in cash and conduct an independent review of the securitized assets prior to purchase.
Option to Allocate the Risk Retention to an Originator
As permitted by Section 15G of the Exchange Act, the sponsor may allocate its risk retention requirement to the “originator” of the securitized assets under the standard risk retention options, subject to the agreement of the originator and to certain other conditions. For this purpose, “originator” is defined in the same manner as in Section 15G (i.e., as a person who, through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security and sells the asset directly or indirectly to the securitizer). As a consequence, only the original creditor under an asset–and not a subsequent purchaser or transferee of the asset–qualifies as an “originator.”15 Any amount allocated to an originator would reduce the sponsor’s risk retention requirement.16 There are only minor changes between the Re Proposed Rules and the Final Rules in respect of originator risk retention.
The originator’s allocation is limited under the Final Rules such that the ratio of the percentage risk position acquired and retained by the originator to the total percentage risk position otherwise required to be retained by the sponsor does not exceed the ratio of the unpaid principal balance of all the securitized assets originated by the originator to the unpaid balance of all the securitized assets in the securitization transaction.
The originator must acquire and retain at least 20% of the aggregate risk retention amount otherwise required to be held by the sponsor, and must comply with the hedging, transfer and other restrictions with respect to such interest as if the originator were a sponsor that acquired the retained interest. The sponsor would remain primarily responsible for compliance and would be required to notify investors of any noncompliance by the originator.
Alignment of “Qualified Residential Mortgage” with “Qualified Mortgage”; Periodic Review
Among the more discussed aspects of Section 15G was the definition of “qualified residential mortgage” (“QRM”) for purposes of the exemption from standard risk retention for private-label RMBS. Dodd-Frank requires that QRM be “no broader” than “qualified mortgage” (“QM”) under section 129C of the Truth in Lending Act (as amended by Dodd-Frank) and the regulations implemented thereunder. Under the Originally Proposed Rules, the Agencies defined QRM with reference to QM, as well as a number of loan criteria characteristic of higher credit quality loans, including maximum loan-to-value and debt-to-income requirements and minimum down payment and FICO score requirements. As the Agencies acknowledged, the overwhelming majority of commenters objected to various aspects of the originally proposed approach, including banks, industry groups, some consumer advocates and other securitization market participants, as well as members of Congress who advised that the 20% minimum down payment requirement under the Originally Proposed Rules was contrary to legislative intent. Under the Re-Proposed Rules, the Agencies eliminated the underwriting and performance criteria specified in the Originally Proposed Rules and proposed to align QRM with QM. Most commenters viewed the reproposal favorably. Those objecting cited the different purposes of the risk retention and ability-to-repay rules and expressed a desire for specific underwriting criteria, among other things.
The Agencies have opted to align QRM with QM, with limited modification to the Re-Proposed Rules. The Agencies conclude that the alignment of QRM with QM meets the statutory goals and directive of limiting credit risk, preserving access to affordable credit and reducing the compliance burden in the origination of mortgage loans. In addition, the Agencies cite various new and proposed rules and regulations, including the loan-level disclosure requirements for registered transactions recently adopted as part of Regulation AB II, as mitigating the need for any broad-based risk retention requirements for private-label RMBS. Improved industry standards for due diligence and representations and warranties, among other things, also apparently helped to persuade the Agencies. The Agencies acknowledge that bifurcation of QM and non-QM in the mortgage market may lead to a securitization market dominated solely by QMs, yet take the position that alternatives would have presented greater risks, possibly resulting in greater segmentation in the securitization market and increased costs of credit for consumers.
A mortgage loan will be a QRM if the lender satisfies any of the applicable QM definitions under the ability-to-repay rules of the Consumer Finance Protection Bureau (“CFPB”). Sponsors may take advantage of either the legal safe harbor for compliance or the rebuttable presumption of compliance for higher-priced QMs. Accordingly, certain mortgage loans that are prohibited from being QMs, such as negative amortization loans, certain balloon and reverse mortgage loans or home equity lines of credit, will not qualify as QRMs. QMs also must have a term to maturity of 30 years or less. Total fees and points generally must not exceed 3% of the total loan amount. The maximum debt-to-income ratio for a borrower under the QM rules is 43%. Mortgages that are exempt from the ability-to-repay rules are not QRMs; however, certain community-focused residential mortgages will benefit from a separate exemption from risk retention under the Final Rules.
Consistent with the Prior Proposals, reliance on the QRM risk retention exemption is also conditioned on all of the QRMs being currently performing (i.e., the borrower is not 30 days or more past due, in whole or in part, on the mortgage). In an apparent technical glitch, the preamble to the Final Rules states that delinquency is to be measured as of the cut-off date, whereas the text of the Final Rules requires that delinquency be measured as of the closing date (as was proposed). To satisfy the exemption, the depositor with respect to the securitization transaction (which may not be the sponsor) must deliver a certification to the effect that it has evaluated the effectiveness of its internal supervisory controls with respect to the process for ensuring that all assets that collateralize the asset-backed securities are QRMs (or servicing assets) and has concluded that the controls are effective. The depositor must evaluate the effectiveness of its internal supervisory controls as of a date no more than 60 days preceding the cut-off date of the securitization transaction. The certification must be made available by the sponsor to investors and, upon request, to the Agencies.
A sponsor of an exempt QRM-backed securitization transaction will not immediately lose the exemption if it subsequently determines that one or more of the mortgage loans collateralizing the asset-backed securities does not meet all of the criteria to be a QRM. Following such determination, the QRM exemption will be lost unless the sponsor repurchases the loan from the issuing entity at a price at least equal to the remaining aggregate unpaid principal balance and accrued interest on the loan no later than 90 days after the determination that the loan does not satisfy the QRM requirements, and provides holders of the asset-backed securities notice of any such loans required to be repurchased and the cause for such repurchase. The Agencies declined to allow substitution of mortgage loans in lieu of repurchase.
Importantly, as the Agencies acknowledge, the QRM definition will evolve as the CFPB amends, modifies or clarifies the applicable definitions of QM under the ability-to-repay rules. Absent any future action by the Agencies, the primary credit risk retention exemption for RMBS will indirectly fall within the purview of the federal government’s chief consumer protection regulator. The Final Rules require that the Agencies periodically review the definition of QRM to determine whether market or regulatory conditions warrant modification. The initial review will occur four years after the Effective Date, and every five years thereafter. This timeline is intended to coincide with the CFPB’s schedule of periodic reviews of QM standards, to assist in determining whether any modifications would be appropriate. Any Agency may request a review at any time, including following amendment to the definition of QM or due to changes in the residential mortgage market. The commencement of a review will be subject to prior notice in the Federal Register and a solicitation of public comment. The Agencies’ final determination of their review will be published no later than six months after notice of the commencement of the review, unless extended. Any amendment to the definition of QRM must be completed within 12 months of publication of the notice disclosing the final determination, subject to extension by the Agencies.
Exclusion of Non-Economic REMIC Residual Interests from ABS Interests
Under the Final Rules, the Agencies reverse the preliminary position taken under the Re-Proposed Rules by excluding from the definition of “ABS interests” (i) non-economic residual interests issued by a REMIC and (ii) uncertificated regular interests in a REMIC held by another REMIC that is part of the same structure, provided a single REMIC in that structure issues ABS interests to investors. Sponsors of RMBS (or CMBS) issuing entities structured as real estate mortgage investment conduits, or REMICs, that rely on standard risk retention need not take into account non-economic residual tranches in allocating risk retention among horizontal and vertical interests.
Limited Exemption for Mortgages on Three-to Four-Family Residential Properties and Community-Focused Residential Mortgages
Mortgage loans on three-to four-family residential properties that meet all of the QM criteria (other than that they be covered transactions) and certain other criteria have the benefit of a new exemption under the Final Rules.17 As a technical matter, such mortgage loans are excluded from the definition of QM (and, in turn, QRM) because they are not extensions of consumer credit and therefore not covered transactions under the QM rules. The Agencies recognize that such residential mortgages demonstrate credit risk comparable to that of two-unit residential mortgages that are covered transactions under the CFPB’s Regulation Z. If a three- to four-unit residential mortgage loan fails to satisfy the applicable criteria, preservation of the exemption will require repurchase on the same basis as QRMs, as described above.
In addition, certain “community-focused residential mortgages” that do not expressly satisfy the QM rules but are exempt from the ability-to-repay rules will have the benefit of a new limited exemption under the Final Rules. Such residential mortgages, defined as those exempt from the definition of covered transaction under section 1026.43(a)(3)(iv)-(v) of Regulation Z, generally are made under government-sponsored programs or non-profit programs that serve the public interest by facilitating access to credit for low- and moderate-income borrowers. Community-focused residential mortgages under the Final Rules will be subject to periodic review by the Agencies under the terms described above for QRMs. Other mortgage products exempt from the ability-to-repay rules, such as home equity lines of credit, reverse mortgages and timeshares, will not fit within the new exemption.
Limited Partial Exemption for Blended Residential Mortgage Pools
The Agencies generally declined to permit commenters’ requests to blend QRMs with non-QRMs and correspondingly reduce the amount of risk retention by the proportion that QRMs bear to the mortgage pool; however, sponsors of securitization transactions that include a combination of non-exempt residential mortgages and community-focused residential mortgages will be able to reduce the percentage of risk retention required to be held (by the ratio of the unpaid principal balance of the community-focused residential mortgages to the total unpaid principal balance of residential mortgages, up to the maximum upper limit of 50%). In addition, under the Final Rules, blended pools of QRMs and qualifying residential mortgages on three-to four-family residential properties described above will be permissible and have the benefit of a full exemption from risk retention. Except in these limited circumstances, sponsors of RMBS backed by pools containing non-QRMs will not be able to take advantage of the QRM exemption in whole or in part (including any reduction in risk retention for a “blended pool,” as permitted for other “qualifying” asset classes) and must satisfy the standard risk retention requirements.
The Agencies determined not to adopt a narrower definition of QRM introduced in the Re-Proposed Rules that would have required satisfaction of additional underwriting and loan performance criteria believed to further reduce risk of default in addition to meeting the QM standard, referred to as “QM-plus.” Commenters objecting to the QM-plus approach commented that it would limit affordable credit and delay the return of a robust private mortgage market. In declining to implement this option, the Agencies cite the negative impact on the affordability of credit, particularly for low- and middle-income, minority and first-time home purchasers.
Like the Prior Proposals, the Final Rules provide that the 100% guaranty of Fannie Mae or Freddie Mac will be deemed to satisfy the risk retention requirement under the Final Rules so long as Fannie Mae or Freddie Mac, as applicable, is operating under the conservatorship or receivership of the FHFA with capital support from the United States. In addition, the 100% guaranty of any limited-life regulated entity succeeding to the charter of Fannie Mae or Freddie Mac will be treated similarly, provided the entity operates with capital support from the United States. The Final Rules also provide that the hedging prohibitions will not apply to Fannie Mae or Freddie Mac or to any such limited-life regulated entity (under the circumstances described) or to any of their respective affiliates or to the issuing entity for a given securitization transaction.
Increased Flexibility for Sponsors of Commercial Mortgage-Backed Securities
The Final Rules expand the range of risk retention options for sponsors of CMBS and modify other aspects of the Prior Proposals relating to CMBS. The options available to CMBS sponsors under the Final Rules include the following:
- retention either by one or by two third-party purchasers (holding on a pari passu basis) of an eligible horizontal residual interest;
- retention by the sponsor alone under any combination of the standard forms of risk retention described above;
- retention by the sponsor and one or more originators that satisfy the applicable conditions to hold any combination of the standard forms of risk retention described above;
- retention by a combination of the sponsor and one or two third-party purchasers (holding on a pari passu basis), with the third-party purchaser(s) holding an eligible horizontal residual interest and the sponsor holding a vertical interest; or
- exemption from retention requirements where CMBS is collateralized by a pool consisting entirely of qualifying commercial real estate loans (and partial exemption where the pool is mixed).
Third-Party Purchaser Retention. Section 15G of the Exchange Act contemplates an exemption from risk retention for a sponsor if a third-party purchaser specifically negotiates for and holds the first-loss position in the transaction, performs due diligence on the assets in the pool prior to closing and satisfies other conditions.
Under the Final Rules, retention by a third-party purchaser in a CMBS transaction will be available where the third-party purchaser and the securitization transaction meet the following conditions:
- 100% of the securitized assets consist of commercial real estate loans and servicing assets;
- if there are two third-party purchasers of the eligible horizontal residual interest, their residual interests are pari passu;
- each third-party purchaser holds for its own account the eligible horizontal residual interest in the securitization in the same form, amount and manner as would be held by the sponsor;
- each third-party purchaser pays for the eligible horizontal residual interest in cash at the closing without financing being provided, directly or indirectly, from any person that is a party to, or an affiliate of a party to, the securitization transaction other than a person that is a party to the transaction by reason of being an investor;
- each third-party purchaser performs an independent review of the credit risk of each asset in the pool prior to the sale of the CMBS that includes, at a minimum, a review of the underwriting standards, collateral and expected cash flows of each loan in the pool;
- each third-party purchaser is prohibited from being affiliated with any other party to the securitization transaction other than investors, the special servicer or originators that collectively contribute less than 10% of the unpaid balance of the securitized assets; and
- the underlying securitization transaction documents provide for an operating advisor that meets certain qualifications set forth in the Final Rules, including its being unaffiliated with other parties to the securitization transaction; its lack of any financial interest therein (other than its fee), and its acting in the best interest of all investors as a collective whole.
The operating advisor’s role under the Final Rules largely reflects current industry practice and includes consulting with the special servicer on material servicing decisions after the eligible horizontal residual interest has a principal balance of 25% or less of its initial principal balance (taking into account appraisal reductions) and reviewing the actions and reports of the special servicer and issuing periodic reports to investors.
In addition, the operating advisor may recommend in its periodic report to investors that a special servicer be replaced if the operating advisor determines, in its sole discretion exercised in good faith, that (1) the special servicer has failed to comply with a standard required under the applicable transaction documents, and (2) a replacement would be in the best interest of the investors as a collective whole. Upon such recommendation, the special servicer would be subject to replacement upon the affirmative vote of a majority of the outstanding principal balance of ABS interests voting. A quorum for any such vote must be set forth in the transaction documents and may not specify a quorum of more than the holders of 20% of the outstanding principal balance of all ABS interests, with such quorum including at least three investors.
Notwithstanding comments requesting that the sponsor not be primarily responsible for a third party maintaining compliance with the risk retention rules, the sponsor will retain the responsibility for compliance by any third-party purchaser with the risk retention requirements. The sponsor will be required to notify investors if it discovers that a third-party purchaser is not in compliance. The sponsor’s obligation will apply with respect to both initial third-party purchasers and subsequent transferees that acquire the eligible horizontal residual interest after the five-year sunset on transfers and hedging.
The Final Rules did not provide relief for “single-borrower or single-credit” transactions, which are not an insignificant portion of the CMBS market. Most single-borrower or single-credit transactions are tranched without a non-investment grade layer. Purchasers of investment grade tranches are unlikely to be willing to incur the expense required to conduct the due diligence upon which the third-party purchaser alternative is conditioned. Thus, for transactions that are normally structured without a traditional B-piece, this alternative will likely be irrelevant, leaving the standard risk retention approach as the only option.
Sunset on Third-Party Purchaser Option. A third-party purchaser of an eligible horizontal residual interest of CMBS may transfer its interest commencing five years after closing so long as the transferee satisfies certain of the conditions applicable to the initial third-party purchaser.
Disclosure Requirements Relating to the Third-Party Purchaser Option. A reasonable time prior to the sale of the CMBS, the sponsor will be required to disclose to potential investors (and, upon request, the SEC and the appropriate federal banking agency) the name and form of organization of each initial third-party purchaser, a description of such initial third-party purchaser’s experience in investing in CMBS and any other information regarding such initial third-party purchaser or its retention of the first-loss position that is material to investors in light of the circumstances of the particular securitization transaction. In addition, the sponsor will be required to disclose the purchase price paid by each initial third-party purchaser for the first-loss position, the material terms of such position and the fair value of the position the sponsor would have retained if the sponsor had relied on retaining an eligible horizontal residual interest. The sponsor will also have to cause to be provided to potential investors the representations and warranties concerning the securitized assets, the schedule of any securitized assets that are determined not to comply with such representations and warranties, and the factors that were used to make the determination that securitized assets should be included in the pool notwithstanding that they did not comply with such representations and warranties, such as compensating factors or a determination that the exceptions were not material.18 The Final Rules add disclosure requirements with respect to the operating advisor and material terms of the applicable transaction documents, including the name and form of organization of the operating advisor, any material conflict of interest between the operating advisor and any other transaction party, its compensation and a description of the operating advisor’s experience, expertise and financial strength to fulfill its obligations.
Qualifying Commercial Real Estate Loans
As further discussed below in Section 7 describing full and partial exceptions from risk retention for asset-backed securities backed by qualifying assets, CMBS sponsors may take advantage of a full or partial exception from risk retention for a securitization transaction backed in whole or in part by a pool of commercial real estate loans that satisfy certain underwriting and product standards. Currently, very few commercial real estate loans satisfy these requirements.
In connection with both of the Prior Proposals, the Agencies took the position that the manager of a CLO transaction is the securitizer (and sponsor) for purposes of risk retention. There was criticism from market participants that neither CLO managers nor their affiliates typically act as sellers or transferors to the issuing entities and that many CLO managers, particularly those that organize CLOs for loans traded in the secondary market, may not have the balance sheet capacity to hold risk retention. Despite the criticism, the Agencies made no change to this position, and under the Final Rules the CLO manager is the sponsor for purposes of risk retention. Moreover, the Agencies rejected industry arguments that the fees of CLO managers, in particular subordinated fees, align the interests of CLO managers and investors, and thus the Final Rules do not permit such fees to satisfy CLO risk retention obligations.
Open Market CLOs
The Agencies retained an alternative manner of risk retention, originally proposed in the Re-Proposed Rules, for CLOs that satisfy the requirements of a so-called “open market CLO.” Under this alternative, CLO managers do not need to satisfy the standard risk retention requirement for a CLO transaction if the transaction meets certain conditions, most notably a requirement that arrangers of underlying syndicated loans retain risk interests in the loans as a condition to such loans being included in the CLO. As discussed below, however, the proposed open market CLO approach is inconsistent with current market practice and is expected to be of limited utility.
As conceived by the Agencies, the open market CLO exemption will impose, among other conditions, the following:
- The open market CLO does not acquire or hold any assets other than senior, secured syndicated loans that are “CLO-eligible loan tranches” (described below) and servicing assets.
- The open market CLO does not invest in ABS interests or in credit derivatives (other than hedging transactions that are servicing assets to hedge risks of the open market CLO).
- All purchases of CLO-eligible loan tranches by the open market CLO issuing entity (including loan tranches acquired in a warehouse period) are made in open market transactions on an arm’s-length basis.
- The manager of the open market CLO is not entitled to receive any management fee or gain on sale at the time the open market CLO issues its ABS interests.19
Under the Final Rules, to qualify as a “CLO-eligible loan tranche” a loan must have the following features:
- The loan is a term loan of a syndicated credit facility to a commercial borrower.
- The loan is a senior secured loan, which will exclude second lien loans, unsecured loans and bonds, which have historically been eligible for purchase (subject to limited baskets) in CLO structures.
- At least 5% of the face amount of the CLO-eligible loan tranche is retained by the “lead arranger” of the credit facility until the earliest of the repayment, maturity, involuntary and unscheduled acceleration, payment default or bankruptcy default of such CLO-eligible loan tranche. In addition, the lead arranger must comply with limitations on hedging, transferring and pledging the interest retained by the lead arranger.
- Lender voting rights give holders of the CLO-eligible loan tranche consent rights with respect to, at minimum, any material waivers and amendments of the credit agreement, any intercreditor agreement and other applicable documents governing such CLO-eligible loan tranche.
- The pro rata provisions, voting provisions and similar provisions applicable to the security associated with the CLO-eligible loan tranches are not materially less advantageous to the holders of such CLO-eligible loan tranche than the terms of other tranches of comparable seniority in the broader syndicated credit facility.
The Final Rules include certain minimum collateralization requirements for a CLO-eligible loan tranche (the adequacy of which is to be determined in the commercially reasonable judgment of the CLO manager).20 These provisions require the CLO manager to certify, on or prior to each date that it acquires a loan constituting part of a new CLO-eligible loan tranche, that it has policies and procedures to evaluate the likelihood of repayment of loans acquired by the CLO and it has followed such policies and procedures in evaluating each CLO-eligible loan tranche.
To qualify as a “lead arranger,” with respect to a CLO-eligible loan tranche, an institution must:
- be active in the origination, structuring and syndication of commercial loan transactions and have played a primary role in the structuring, underwriting and distribution on the primary market of the CLO-eligible loan tranche;
- have taken an allocation of the funded portion of the syndicated credit that is at least 20% of the aggregate principal balance at origination and that equals or exceeds the allocation to any other member of the syndication group that funded at origination; and
- be identified in the applicable agreement governing the CLO-eligible loan tranche; represent therein to the holders of the CLO-eligible loan tranche and any participation interest that the lead arranger satisfies the first item above and, at the time of the initial funding of the CLO-eligible loan tranche, will satisfy the second item above; further represents that in its reasonable judgment, the terms of the CLO-eligible loan tranche are consistent with the requirements of the certain provisions of the Final Rules; and covenant to the holders that it will fulfill the requirements of the first item above.
The open market CLO exemption also requires disclosure, both before closing and on at least an annual basis thereafter, of every asset held by the CLO, including the name, standard industrial category code (SIC Code) and legal entity identifier of the obligor, the full name of the CLO-eligible loan tranche, the face amount of the CLO-eligible loan tranche and the face amount of the portion thereof held by the CLO, the price at which the loan tranche was acquired by the CLO, the name of the lead arranger for each CLO-eligible loan tranche, and the name and form of organization of the CLO manager.
Given the substantial restrictions and requirements of the open market CLO exemption, it is highly unlikely that it presents a practical alternative to the standard risk retention requirements. For example, revolving loans and participations in letters of credit do not qualify as CLO-eligible loan tranches under the Final Rules. Moreover, lead arrangers do not have risk retention requirements imposed on them in the current loan market, and imposing a new requirement to maintain minimum unhedged positions in loans may be inconsistent with the business, operations and risk management policies of lead arrangers. It would require a substantial change to terms currently found in the syndicated loan market to create a volume of CLO-eligible loan tranches sufficient to provide meaningful investment opportunities for open market CLOs. At this time, such a change seems unlikely.
CLO Market Challenges
Given the likelihood that the open market CLO exemption will not be available for most CLOs, new CLOs will be generally required to comply with the standard risk retention requirement. As noted above, only CLO managers that are able and willing, directly or through majority-owned affiliates, to purchase and hold a standard 5% risk retention interest (vertical, horizontal or combined) will be able to participate; this may exclude CLO managers that do not have significant balance sheet capacity, a group that historically has played an important role in the CLO market. Moreover, the sunsets on transfer and hedging prohibitions under the standard risk retention requirements are likely to be of little value in the case of CLOs. CLO assets have relatively long tenors and, as noted above, these sunsets are tied to pool balance reductions and thus will likely provide little relief.
Moreover, a number of issues remain unresolved with respect to the application of the Final Rules to CLOs.21
The Final Rules apply to issuing entities that offer and sell asset-backed securities following the Effective Date. While this will not include a CLO that has offered and sold all of its securities prior to the Effective Date, it would include any CLO, even one that initially closed prior to the Effective Date, if the CLO offers and sells any additional securities after the Effective Date. This will affect any CLO that permits additional issuances of securities. In addition, many CLOs include provisions permitting the issuance of securities or the incurrence of indebtedness after the initial closing to refinance one or more of the tranches of securities previously issued by the CLO. Under the terms typically included in CLO documents, it is expected that the exercise of such a “re-financing” option would likely constitute an offer and sale of securities that, if occurring after the Effective Date, would require compliance with the Final Rules. In addition, some CLOs include provisions permitting the re-pricing of one or more of its tranches of securities. While such a re-pricing does not typically involve the actual issuance of new securities, the SEC has determined, in other contexts, that a material change in the terms of a security can constitute a deemed new issuance. As a result, it remains unclear whether the exercise of such a “re-pricing” option in a CLO after the Effective Date would require compliance with the Final Rules.
Unlike many securitization transactions that include an originator that transferred a pool of securitized assets, a CLO involves a manager that is only a service provider to the issuing entity. As a result, a CLO manager may, subject to the terms of its management agreement, resign or be removed and replaced as the manager of a CLO. The Final Rules do not address whether, in the event of the replacement of a CLO manager, the risk retention ceases to apply, must remain satisfied by the original CLO manager, or must thereafter be satisfied by the replacement CLO manager. As a result, the consequences of the resignation or removal and replacement of a CLO manager following the Effective Date are unclear.
Given the expected limited utility of the open market CLO alternative and of the limited relief otherwise provided by the Final Rules, the risk retention requirements are expected to have an adverse effect on the CLO market and on the loan market that it serves. Although market participants have over two years to prepare for the Effective Date, participants are currently working to identify alternatives that satisfy the risk retention requirements of the Final Rules in a manner that would permit many current CLO managers to continue to participate in the CLO market and would also permit certain new CLO managers to enter the market. Such alternatives may include, for example, structures involving the establishment by CLO managers of majority-owned affiliates to acquire and hold the required interests in CLOs. In those structures, the CLO manager would be required to provide sufficient capital in order to qualify the holder of the retained interests as a majority-owned affiliate, but third parties could provide additional investment capital, and further capacity may be provided through leverage (though, as noted above, any pledge of the retained interests must collateralize full-recourse obligations). Such approaches would come at a cost, which would need to be considered by market participants. Other alternatives may be identified as discussions continue.
6. ABCP CONDUITS
The Agencies considered a wide variety of comments with respect to the treatment of ABCP conduits under the Re-Proposed Rules, but elected to retain largely intact the Re-Proposed Rules’ framework for ABCP conduits. The Agencies affirmed their view that an arranger or manager of an ABCP conduit is a sponsor or “securitizer” for purposes of the statutory mandate and thus subject to the risk retention rules. They also affirmed the view that, while a specific ABCP conduit option is made available under the Final Rules, an ABCP conduit sponsor is not limited to using the ABCP conduit option to satisfy the risk retention requirements. A sponsor may elect to utilize other available means of satisfying the risk retention requirements.
The basic structure of the ABCP conduit risk retention option under the Final Rules is modeled on a classic ABCP conduit two-step transaction with limited flexibility for ABCP programs that feature variations on this traditional model and with no flexibility for programs that do not have an unconditional 100% liquidity facility.
In order to avail itself of the “eligible ABCP conduit” option (in lieu of satisfying the standard risk retention requirements), an ABCP conduit must satisfy the following conditions:
- Commercial Paper Issued. All asset-backed commercial paper issued by the ABCP conduit must have a maturity at the time of issuance not exceeding 397 days (exclusive of days of grace, or any renewal thereof, the maturity of which is likewise limited). This represents a change from the Re-Proposed Rules, which set the maximum tenor for commercial paper at nine months. The Agencies took note of the fact that the maximum maturity for securities that are eligible for purchase by money market mutual funds pursuant to Rule 2a-7 under the Investment Company Act is 397 days. They were persuaded that the longer tenor under the Final Rules was merited in light of the perceived likelihood that many conduits will need to issue ABCP with a longer maturity in the future in order to accommodate the needs of regulated institutions that are subject to the new Basel liquidity requirements.
- Qualification as an “eligible ABCP conduit.” In addition to being a bankruptcy-remote entity, in order to qualify as an “eligible ABCP conduit,” the ABCP conduit must have the following features:
- Assets. Assets held by the ABCP conduit are limited to “ABS interests” acquired by the ABCP conduit in an “initial issuance” from an “intermediate SPV.” Each of these components is discussed below.
ABS Interest. Under the Re-Proposed Rules, an ABCP conduit was permitted to acquire only asset-backed securities. This has been changed under the Final Rules to permit the ABCP conduit to acquire any “ABS interest,” which is defined to be “any type of interest or obligation issued by an issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest or residual interest . . . payments on which are primarily dependent on the cash flows of the collateral owned or held by the issuing entity.” Thus, for example, the claim arising from a loan made by an ABCP conduit that would not constitute an asset-backed security is now an asset permitted to be held by the ABCP conduit.
ABS interests permitted to be acquired by an eligible ABCP conduit are limited to (i) those collateralized solely by assets originated by an originatorseller (or acquired by an originator-seller in a business combination that qualifies for business combination accounting under U.S. GAAP) and by servicing assets, (ii) special units of beneficial interest (or similar ABS interests) in trusts or special purpose vehicles that retain legal title to leased property underlying leases originated by originator-sellers, or (iii) ABS interests in a revolving pool securitization.
Each transaction to which the ABCP conduit is party must entail a two-step structure, one in which an “originator-seller” originates assets and sells or transfers those assets, directly or through a majority-owned affiliate, to an “intermediate SPV,” and the intermediate SPV then enters into a transaction with the ABCP conduit.
Originator-Seller. The Agencies expressly declined to permit an ABCP conduit under this option to lend to or purchase assets directly from an originator-seller. The economic value of assets originated by an originator-seller may be conveyed to an ABCP conduit only through the intermediation of an intermediate SPV.
Intermediate SPV. An intermediate SPV is a bankruptcy-remote special purpose vehicle that is a direct or indirect wholly-owned affiliate of the originator-seller. Under the Final Rules, an intermediate SPV may also be an unaffiliated orphan SPV, an entity that has nominal equity owned by a trust or corporate service provider that specializes in providing independent ownership of special purpose vehicles. The assets that an intermediate SPV holds must have been acquired directly from an affiliated originator-seller or an affiliated intermediate SPV, and the ABS Interests it issues in turn must be collateralized solely by those assets.
Acquisition by ABCP Conduit. An eligible ABCP conduit must acquire ABS interests by one of two means. The primary means is to acquire an ABS interest in an initial issuance by or on behalf of an intermediate SPV. Under the Final Rules, an ABCP conduit may also acquire ABS interests from another ABCP conduit in cases where (i) the transferring ABCP conduit acquired the ABS interest in an initial issuance from an intermediate SPV, and (ii) the same liquidity provider supports both ABCP conduits.
- Liquidity. A “regulated liquidity provider” must have entered into a commitment to provide 100% liquidity coverage to all ABCP issued by the ABCP conduit. Liquidity facilities of the type that are commonly referred to as “partially supported liquidity” will not satisfy this requirement if they contemplate any adjustment to the available loan or purchase price in the event of a deterioration in the underlying assets. The Final Rules state that “liquidity support that only funds performing loans or receivables or performing ABS interests does not meet the requirement.” The Agencies expressly rejected the use of partially supported liquidity facilities in their response to commentators, citing a concern that:
[such facilities] could serve to insulate the liquidity provider from the credit risk of non-performing assets in the securitization transaction. The ABCP option is designed to accommodate conduits that expose the liquidity provider to the full credit risk of the assets in the securitization, with the expectation that exposure to the credit risk of such assets will provide the liquidity providers with incentive to undertake robust credit underwriting and monitoring.
As under the Re-Proposed Rules, a liquidity facility cannot be syndicated; it must be provided by a single liquidity provider. However, unlike other risk retention options, a liquidity provider may hedge its liquidity obligation or procure credit support by selling participations or implementing other backstop arrangements so long as it remains directly responsible to the ABCP conduit for funding its obligations under the liquidity facility.
- The Originator-Seller: Risk Retention. It remains a fundamental part of the eligible ABCP conduit option that each originator-seller holds an economic interest in the credit risk of the assets collateralizing the related ABS interest held by the ABCP conduit. This economic interest must be in the amount and manner (horizontal, vertical or as otherwise permitted) required under the Final Rules. Thus, investors in the commercial paper issued by an eligible ABCP conduit will have the benefit of both the 5% risk retention generally required for any sponsor of a securitization transaction, in this case provided by the originator-seller (at the intermediate SPV level), and, in addition, the 100% unconditional liquidity facility required to be provided by a regulated liquidity provider (at the ABCP conduit level).
Additional Duties for ABCP Conduit Sponsor; Disclosure. The additional duties for the ABCP conduit sponsor have not changed materially under the Final Rules. The sponsor continues to be required to approve and monitor each originator-seller and intermediate SPV in respect of which the ABCP conduit holds any ABS interests. The sponsor is also required to provide each purchaser of commercial paper, before or contemporaneously with the first sale of commercial paper to such purchaser and at least monthly thereafter, specific information with respect to the liquidity provider, the asset class and standard industrial category code (SIC Code) for each originator-seller, and a description of the risk retention being provided by each originator-seller. Furthermore, the sponsor must be prepared to provide such information and the names and supplemental information for the originator-sellers to the Agencies, if requested. Finally, in the event a sponsor determines that an originator-seller is not in compliance with its risk retention requirements, the sponsor must notify the holders of the ABCP conduit’s commercial paper of the name of such originator-seller and the nature of the related ABS interest held by the ABCP conduit, and must “take other appropriate steps . . . which may include, as appropriate, curing any breach . . . or removing from the eligible ABCP conduit any ABS interest that does not comply with [the risk retention requirements].” This suggests that a liquidity facility is envisioned to be used, among things, for the disposition of nonconforming assets held by an ABCP conduit.
The eligible ABCP conduit option is expected to be of somewhat limited utility. The generally inflexible structural features at the transaction level and the requirement for 100% unconditional liquidity can be expected to lead sponsors to more actively consider the alternatives of the standard horizontal and vertical risk retention strategies. Any analysis of the alternatives will need to balance the requirement under the standard strategies that the risk retention be in a form that is fully funded (standby letters of credit, guarantees, repurchase agreements, asset purchase agreements and other unfunded forms of credit enhancement cannot be used to satisfy the standard risk retention requirement), against the need to observe the structural requirements of the eligible ABCP option.
7. OTHER ABS
Reduced Risk Retention Requirements for Certain Non-RMBS Securities
Dodd-Frank authorizes the Agencies to adopt regulations imposing a risk retention requirement of less than 5% for assets other than QRMs if the originator of the assets meets certain prescribed underwriting standards. The Final Rules make just limited changes to the exception qualifications set out in the Re Proposed Rules for asset-backed securities that are collateralized by (1) commercial real estate loans, (2) commercial loans, or (3) automobile loans, in each case that meet certain underwriting standards.
Common to each qualifying asset class exception are the following principal conditions:
- Single Asset Class Per Pool. The underlying assets for a given securitization must be of the same asset class (e.g., no mixing of qualifying commercial real estate loans and qualifying commercial loans).
- Reinvestment Prohibition. The securitization transaction may not permit a reinvestment period.
- Cure or Buy-Back Requirements. The exception for a given securitization transaction is not lost if, after closing, it is determined that an underlying asset failed to meet the relevant conditions, provided that either (i) the failure is not material, or (ii) the sponsor, within 90 days, effectuates a cure or repurchases the asset (and relevant disclosures are made).
- Certification. The sponsor must certify, prior to each issuance of asset-backed securities, that it evaluated the effectiveness of its internal supervisory controls for ensuring that the loans meet the underwriting requirements for the applicable exception and has concluded that those controls are effective. The sponsor must provide the certification to investors prior to sale.
- Blended Pool Option. Although, as noted above, the assets of a given securitization must be of the same asset class, they may consist of a blend of qualifying and non-qualifying assets in that class. Sponsors may take advantage of a pro rata reduction in the 5% risk retention requirement (subject to a minimum of 2.5% retention) in respect of the share of the pool constituted by the qualifying assets.22
- Securitization of Qualifying Assets Only. The risk retention requirements do not apply at all to a securitization collateralized solely by servicing assets and either qualifying commercial real estate loans, qualifying commercial loans or qualifying automobile loans.
Qualifying Commercial Real Estate Loans. A qualifying commercial real estate loan must satisfy certain specific underwriting criteria. Among the more significant are the following:
- The originator must have determined that (i) based on the previous two years’ actual performance, the borrower had, and (ii) based on two years of projections, which include the new debt obligation, following the origination date of the loan, the borrower will have:
- a debt service coverage ratio of 1.5 or greater, if the loan is a qualifying leased real estate loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
- a debt service coverage ratio of 1.25 or greater, if the loan is a qualifying multifamily property loan; or
- a debt service coverage ratio of 1.7 or greater, if the loan is any other type of commercial real estate loan.
- At origination, the applicable loan-to-value ratios (LTV) for the loan are:
- LTV of less than or equal to 65% and combined LTV of less than or equal to 70%; or
- LTV of less than or equal to 60% and combined LTV of less than or equal to 65%, if the capitalization rate used in the required appraisal is less than or equal to the 10-year swap rate plus 300 basis points.
- All loan payments required to be made under the loan agreement are:
- based on level payments of principal and interest (as opposed to straight-line amortization) over a term that does not exceed 25 years, or 30 years for a qualifying multifamily loan (e.g., no interest-only loans); and
- to be made no less frequently than monthly over a term of at least 10 years.
- Under the terms of the loan agreement, any maturity of the mortgage note occurs no earlier than 10 years following the date of origination.
As noted above, very few current commercial real estate loans currently satisfy these requirements. As a result, we do not believe this is likely to prove a viable alternative to standard risk retention requirements.
Qualifying Automobile Loans. A qualifying automobile loan similarly must satisfy certain specific underwriting criteria. The Agencies specify a number of express exclusions from the types of automobile financings that qualify, the most relevant being:
- lease financings;
- loans to finance fleet sales;
- personal cash loans secured by a previously purchased automobile; and
- loans to finance the purchase of a commercial vehicle or farm equipment that is not used for personal, family or household purposes.
Among the more notable affirmative conditions are the following:
- The originator of the loan must have determined and documented that:
- the borrower has at least 24 months of credit history;
- the borrower’s debt-to-income ratio is less than or equal to 36%; and
- within the previous 36 months, certain specified adverse credit events in respect of the borrower have not occurred.
- The borrower must make a down payment from the borrower’s personal funds and trade-in allowance, if any, that is at least equal to 10% (reduced from 20% in the Originally Proposed Rules) of the vehicle purchase price plus various fees and tax.
- The terms of the loan agreement provide a maturity date for the loan that does not exceed the lesser of:
- six years from the date of origination (extended from five years in the Originally Proposed Rules); or
- 10 years minus the difference between the current model year and the vehicle’s model year.
- The terms of the loan agreement provide for, among other things, a fixed rate of interest and a level monthly payment that fully amortizes the loan over its term.
As noted above, the definition of “qualifying automobile loan” is inconsistent with standard market underwriting practices. In particular, the criteria that require individualized credit underwriting for automobile loans contrast with current practices that rely on externally generated credit scores and credit reports. As a result, we do not believe this is likely to prove a viable alternative to standard risk retention requirements.
Qualifying Commercial Loans. For reduced risk retention requirements to apply to a commercial loan, the loan must satisfy certain specific underwriting criteria. Among the more significant are the following:
- Prior to the origination of the loan, the originator of the loan must have determined that (i) based on the previous two years’ actual performance, the borrower had, and (ii) based on two years of projections, which include the new debt obligation, following the closing date of the loan, the borrower will have:
- a total liabilities ratio of 50% or less;
- a leverage ratio of 3.0 or less; and
- a debt service coverage ratio of 1.5 or greater.
- The loan must satisfy certain requirements as to collateralization, and include covenants relating to the delivery of financial statements, the incurrence of liens on, or the transfer of, collateral securing the loan, and the maintenance of insurance and the payment of taxes relating to such collateral.
- Loan payments required under the loan agreement must be:
- based on level monthly payments of principal and interest (at the fully indexed rate) that fully amortize the debt over a term that does not exceed five years from the date of origination; and
- made no less frequently than quarterly over a term that does not exceed five years.
We note that few if any commercial loans in the current market have payment terms that would satisfy the requirements for a qualifying commercial loan. As a result, we do not believe this is likely to prove a viable alternative to standard risk retention requirements.
Master Trusts: Revolving Pool Securitizations
For revolving pool securitizations (referred to as revolving master trusts in the Prior Proposals), the sponsor may satisfy the standard risk retention requirement under the Final Rules by maintaining a pari passu “seller’s interest” (or an interest that is fully or partially subordinated to one or more series in identical or varying amounts) of not less than 5% of the unpaid principal balance of all outstanding investor ABS interests issued by the issuing entity, which percentage is subject to offset as described below. Most of the changes in respect of revolving pool securitizations in the Re-Proposed Rules and Final Rules are designed to accommodate market practices.
- The 5% seller’s interest required retention may be reduced by a corresponding percentage of the fair value of ABS interest in each series in the form of any combination of (i) a residual ABS interest in excess interest and fees that would otherwise be available to the seller but are subordinated to ABS interests (to the extent provided in the Final Rules), and (ii) a horizontal residual interest with respect to such series. The amount of the residual ABS interest in excess interest and fees and the amount of the horizontal residual interest are calculated on the basis of their fair values.
- The following ABS interests are excluded from the calculation of the seller’s interest: (i) servicing assets allocated to a specific series, and (ii) assets (often referred to in transactions as “ineligible assets”) that are not eligible to be included in the calculation of the amount of assets required to support the investor ABS interests.
- Funds in a principal accumulation account satisfying certain conditions may reduce the amount of investor ABS interests for purposes of calculating the required seller’s interest.
- The 5% minimum seller’s interest requirement must be satisfied on the closing date and then measured and satisfied at least monthly thereafter, with a one month cure period if it is not satisfied. The fair value of any excess interest and fees offset must be calculated at the same intervals, but is subject to special calculation methods. The fair value of any horizontal residual interest offset need only be calculated at closing, and certain amounts must be excluded in the calculation.
- The Final Rules provide that a seller’s interest maintained at the legacy trust level may, subject to certain limitations, be set off against the risk retention requirement at the issuing trust level.
- The sponsor will not fall out of compliance with risk retention requirements as a result of the reduction of the seller’s interest below the required level during early amortization, subject to certain conditions.
- Funds in a pool-level excess funding account that satisfy certain conditions may also be applied to reduce the seller’s interest retention requirement.
- As noted above, the sunset provisions elsewhere in the Final Rules do not apply to revolving securitization pools since new assets are continually being added.
- As noted above, only the sponsor and its wholly-owned subsidiaries may hold the required risk retention interests.
Tender Option Bonds
In the Final Rules, the Agencies refused to provide an exemption from the risk retention requirement for securitizations or repackagings of municipal debt obligations (commonly known as “tender option bonds” or “TOBs”); however, acknowledging the unique features of TOB programs, the Agencies did provide some relief for TOBs issued by a “qualified tender option bond entity” (“QTOB”).23
Recognizing the unique nature of the securities issued by QTOB issuers, the Agencies expressly acknowledged that residuals would qualify as a qualified horizontal residual interest before a tender option termination event (“TOTE”)24 and as an eligible vertical interest after a TOTE. In addition to the residuals, the Agencies also permit a sponsor’s direct ownership of the same municipal securities held as collateral by a TOB issuer to count towards the 5% risk retention requirement (subject to the Final Rules’ transfer and hedging prohibitions).25 Similar to the risk retention requirement for other ABS structures, the 5% risk retention requirement may be satisfied by the sponsor26 or its majority-owned affiliates. The Agencies have also permitted the municipal securities required to be held as collateral for QTOBs to include certain pass-through and pro rata interests in municipal securities,27 and also provided relief from some of the disclosure requirements for sponsors that retain municipal securities outside of the QTOB structure. For QTOBs, the disclosure requirements are limited to:
- the name and form of organization of the QTOB entity;
- a description of the form and subordination features of the retained residuals;
- to the extent any portion of the retained interest is a horizontal residual interest, the fair value of that interest (expressed as a percentage of the fair value of all the ABS interests issued by the QTOB);
- to the extent any portion of the retained interest is a vertical residual interest, the percentage of ABS interests issued represented by such vertical interests; and
- to the extent any portion of the retained interest involves directly holding the municipal security outside of the QTOB entity, the name and form of organization of the QTOB entity, the identity of the issuer of the municipal securities, the face value of the municipal securities deposited into the QTOB entity and the face value of the municipal securities retained by the sponsor or its majority-owned affiliates.28
Finally, consistent with the operation of historical TOB programs, the Agencies expressly recognized that the 100% guarantee or liquidity coverage from a regulated liquidity provider29 for QTOBs is not required to apply upon the occurrence of a TOTE.30
8. OTHER EXEMPTIONS AND REQUIREMENTS
Exemption for Certain Resecuritization Transactions
In the Final Rules, the Agencies adopt as proposed the two exemptions from risk retention for resecuritization transactions specified in the Re-Proposed Rules, with some minor technical revisions. One exemption applies to certain single-class pass-through resecuritizations, and the second is available to sponsors of resecuritizations of “first-pay-class” RMBS backed by first-lien residential mortgages. The Agencies declined to make changes in response to commenters who advocated for a resecuritization exemption for structures that re-tranche the credit risk on the underlying asset-backed securities.
The Final Rules exempt a pass-through resecuritization transaction from the credit risk requirements if:
- the collateral consists solely of servicing assets and existing asset-backed securities for which credit risk was retained or an exemption from retention under the Final Rules was utilized; and
- the transaction involves the issuance of only a single class of ABS interests and provides for the pass-through of all principal and interest payments received on the underlying asset-backed securities (net of expenses of the issuing entity) to holders of such class.
The Agencies also provide for an exemption for resecuritizations collateralized solely by servicing assets and so-called “first-pay classes” of asset-backed securities for which credit risk was retained or an exemption from risk retention under the Final Rules was utilized. The Final Rules generally define first-pay classes as classes of ABS interests for which all interests in the class are entitled to the same priority of payment and that, at the time of closing of the transaction, are entitled to principal and interest prior to or pro rata with all other classes of securities collateralized by the same pool of first-lien residential mortgages. The resecuritization transaction must not provide for reallocation of credit risk (except as a consequence of reallocation of prepayment risk), which would appear to permit limited time-tranching, but not credit tranching. No class of ABS interests may absorb realized principal losses on the first-pay classes constituting the collateral in priority to any other class. In addition, the exemption will not permit any class of ABS interests to bear interest at an inverse floating rate and will prohibit any other “similarly structured ABS interest.”
Each exemption requires that the underlying asset-backed securities in the resecuritization either satisfy risk retention or be subject to an exemption, which will limit the pool of asset-backed securities eligible for a sponsor of a resecuritization that relies on one of the exemptions described above following the Effective Date. Legacy asset-backed securities would not be grandfathered for purposes of either exemption even though the alignment of incentives with originators would have been realized years prior to the resecuritization. In addition, the Agencies were not persuaded that a resecuritization exemption could facilitate customary REMIC or other resecuritizations that provide valuable liquidity to the asset-backed securities markets without also easing requirements for collateralized debt obligation transactions and other perceived high-risk structures. The Agencies intend for the exemptions to allow for transaction structures that reallocate prepayment risk in the manner seen in resecuritizations of senior RMBS tranches without providing for tranching of credit risk more characteristic of collateralized debt obligation transactions.
Exemptions for Certain Other Securitization Classes
Government-Related Exemptions. Consistent with the Prior Proposals, the Final Rules would exempt the following:
- any securitization transaction that is collateralized solely by residential, multifamily or health care facility mortgage loan assets that are insured or guaranteed by the United States or an agency of the United States, and servicing assets;
- any securitization transaction that involves the issuance of asset-backed securities that are insured or guaranteed by the United States or an agency of the United States; and are collateralized solely by residential, multifamily or health care facility mortgage loan assets or interests in such assets, and servicing assets;
- any securitization transaction that is collateralized solely by loans or other assets made, insured, guaranteed or purchased by any institution that is subject to the supervision of the Farm Credit Administration, including the Federal Agricultural Mortgage Corporation, and servicing assets;
- any asset-backed security that is a security issued or guaranteed by any State, or by any political subdivision of a State, or by any public instrumentality of a State that is exempt from the registration requirements of the Securities Act by reason of Section 3(a)(2) of that Act;
- any asset-backed security that meets the definition of a qualified scholarship funding bond under the Internal Revenue Code;
- any securitization transaction, if the asset-backed securities issued in the transaction are collateralized solely by obligations issued by the United States or an agency of the United States and servicing assets, collateralized solely by assets that are fully insured or guaranteed by the United States or an agency of the United States (other than those referred to in the first bullet point above) and servicing assets, or fully guaranteed as to the timely payment of principal and interest by the United States or any agency of the United States;
- any securitization transaction where the asset-backed securities issued in the transaction are secured by the intangible property right to collect charges for the recovery of specified costs and such other assets, if any, of an issuing entity that is wholly owned, directly or indirectly, by an investor owned utility company that is subject to the regulatory authority of a State public utility commission or other appropriate State agency (commonly referred to as “stranded-cost” securitizations); and
- any securitization transaction that is sponsored by the FDIC acting as conservator or receiver under any provision of the Federal Deposit Insurance Act or of Title II of Dodd-Frank.
Certain Student Loan Securitizations. The Agencies declined to implement a complete exemption for securitization transactions collateralized solely by student loans made under the Federal Family Education Loan Program (“FFELP loans”), and instead adopted substantially as re-proposed the reduced risk retention requirements for securitization transactions of FFELP loans and servicing assets. For securitization transactions for which the collateral consists only of servicing assets and (1) FFELP loans guaranteed as to at least 98% (but less than 100%) of defaulted principal and accrued interest, and (2) FFELP loans guaranteed as to 100% of defaulted principal and accrued interest, the risk retention requirements are 2% and zero, respectively. For other FFELP-loan backed securitizations, the sponsor must hold at least 3% risk retention.
Seasoned Loans. The Agencies adopted as re-proposed the exemption from risk retention for securitization transactions collateralized by highly seasoned loans (both residential mortgages and other kinds of loans). To satisfy the conditions for being a seasoned loan under the Final Rules, a loan must not have been modified since origination or been delinquent for 30 days or more, and must satisfy a minimum seasoning requirement. For RMBS transactions, the loan must be outstanding and performing for the shorter of (1) the longer of five years and such time that its outstanding principal balance has been reduced to 25% of its original principal balance and (2) seven years. For all other asset classes, the loan must be outstanding and performing for the longer of two years and such time that its outstanding principal balance has been reduced to 33% of its original principal balance. The Agencies decided against a seasoned loan exemption that would allow for loans subject to prior delinquency, regardless of any subsequent record of performance.
Additional Exemptions. The Agencies generally reserve authority to jointly adopt or issue additional exemptions, exceptions and adjustments to the credit risk retention requirements, including exemptions, exceptions and adjustments for classes of institutions or assets.
Safe Harbor for Certain Foreign-Based Transactions. The Agencies adopted substantially as re-proposed the safe harbor from risk retention for certain predominantly foreign-related transactions. The Final Rules’ risk retention requirements will not apply to a foreign-based securitization transaction if, among other things:
- the securitization transaction is not, and is not required to be, registered under the Securities Act;
- no more than 10% of the dollar value (or the equivalent amount in a foreign currency) of all classes of ABS interests are sold or transferred to U.S. persons or for the account or benefit of U.S. persons (which the Agencies clarify in the preamble should be applied only to ABS interests sold in the initial distribution);
- neither the sponsor of the securitization transaction nor the issuing entity is chartered, incorporated or organized under the laws of the United States or any State or is the unincorporated U.S. branch or office of an entity not chartered, incorporated or organized under the laws of the United States or a State (collectively, a “U.S.-located entity”); and
- no more than 25% of the assets collateralizing the asset-backed securities sold in the securitization transaction were acquired by the sponsor, directly or indirectly, from a consolidated affiliate of the sponsor or issuing entity that is a U.S.-located entity.
The Final Rules also contain an anti-evasion provision that limits the applicability of the safe harbor by restricting transactions that, while in technical compliance with the safe harbor, are part of a plan or scheme to evade the requirements of Section 15G and the Final Rules.
Given the limited nature of the safe harbor, it remains the case that many foreign-related securitizations could be subject to Dodd-Frank risk retention, notwithstanding that substantially all of the assets underlying the related asset-backed securities may have foreign obligors, have been originated and underwritten by non-U.S. entities subject to foreign rules and regulations and collateralize asset-backed securities primarily targeted to non-U.S. investors.
9. RELATIONSHIP TO OTHER RISK RETENTION RULES AND PROPOSALS
No Mutual Recognition with Other Risk Retention Rules
The Agencies determined not to recognize satisfaction of risk retention under other regimes as sufficient to satisfy Dodd-Frank risk retention, observing in the preamble to the Final Rules that non-U.S. jurisdictions do not recognize U.S. risk retention and that accommodating different interests across regimes would be impracticable. In addition, the Agencies state that unfunded forms of risk retention, which may be permissible under other regimes, do not provide for sufficient alignment of incentives.31 As a result, unfunded forms of risk retention such as guarantees, liquidity facilities, letters of credit and synthetic exposures, which are acceptable in certain circumstances under European Union (“EU”) risk retention requirements (discussed below), would not be available under Dodd-Frank risk retention requirements except as described above in Section 3 under “Government-Sponsored Enterprises.”
FDIC Securitization Safe Harbor Rule
The Final Rules’ risk retention requirements apply to sponsors without regard to whether the securitizer is a financial institution or other regulated entity. In September 2010, the FDIC adopted a safe harbor rule (the “FDIC Safe Harbor Rule”) regarding treatment by the FDIC, as conservator or receiver of an insured depository institution, of securitizations issued after September 30, 2010, that conditions its applicability on compliance with certain securitization best practice requirements, including a credit risk retention requirement.32 In anticipation of the Final Rules, the FDIC Safe Harbor Rule provides that its risk retention requirements (but not its other requirements) will automatically conform to the final Section 15G risk retention rule upon the “effective date” of such final rule. It is not entirely clear from the FDIC Safe Harbor Rule whether the term “effective date” refers to the date on which the Final Rules are published in the Federal Register or the actual Effective Date of the requirements (which, as noted above, will be one year or two years after such publication date, depending on the type of asset-backed security); however, it appears that the latter is the more reasonable conclusion.33
The FDIC Safe Harbor Rule’s current risk retention requirement differs materially from that under Section 15G and the Final Rules, including by limiting the forms of risk retention to two options: vertical slice and representative sample risk retention. By operation of the “auto-conform” provision of the FDIC Safe Harbor Rule, risk retention will be governed by the Final Rules, which will result in the elimination of the representative sample risk retention option. This alternative has been popular among FDIC-regulated sponsors of automobile asset-backed securities.
European Union Risk Retention Regime
Securitization risk retention, due diligence and ongoing monitoring requirements apply to EU credit institutions (generally, banks) and EU investment firms under Articles 404-410 of the EU Capital Requirements Regulation (Regulation (EU) No 575/2013) (“CRR”). The current CRR risk retention regime generally restricts a European credit institution or investment firm (together with its consolidated group affiliates) from investing in a securitization (as defined by the CRR) unless the originator, sponsor or original lender (within the meaning of CRR) in respect of that securitization has explicitly disclosed that it will retain, on an ongoing basis, a material net economic interest of not less than 5% in that securitization in the manner contemplated by Article 405 of the CRR. Similar, but not identical, requirements to those set out in Articles 404 to 410 of the CRR also apply to regulated alternative investment fund managers under the European Union’s Alternative Investment Fund Managers Directive (Directive 2011/61/EU).34
There are some fundamental differences in approach between the EU risk retention requirements and Section 15G of the Exchange Act and the Final Rules, including, among others, the absence of sunset provisions and asset-based exemptions under the EU regime, the absence of a representative sample option as a form of risk retention under the Final Rules (which continues to be available under the EU provisions), and the differing requirements as to persons that may hold the retained interest within the context of CLO transactions. Accordingly, the interplay between the Final Rules and the EU regime will require close consideration when structuring asset-backed securities offered globally. This may present challenges in certain cases, particularly because no mutual recognition exists between the United States and European Economic Area regulators with regard to risk retention.
1 The Agencies are: the Securities and Exchange Commission (“SEC”); Office of the Comptroller of the Currency; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation (“FDIC”); and, with respect to the rules relating to residential mortgages, the Federal Housing Finance Agency (“FHFA”) and the Department of Housing and Urban Development.
2 The joint release of the Agencies is available at: http://www.sfindustry.org/images/uploads/pdfs/Risk_Retention_Final_Rule.pdf.
3 Section 15G of the Securities Exchange Act of 1934 (the “Exchange Act”) was added by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).
4 The Re-Proposed Rules were published in the Federal Register on September 20, 2013: http://www.gpo.gov/fdsys/pkg/FR-2013-09-20/pdf/2013-21677.pdf. We summarized the Re-Proposed Rules in a Sidley Update dated October 22, 2013 (“Agencies Re-Propose Dodd-Frank Act Risk Retention Rules for Asset-Backed Securities and Request Further Comment”).
The Originally Proposed Rules and related proposing release are available at: http://www.gpo.gov/fdsys/pkg/FR-2011-04-29/pdf/2011-8364.pdf. We summarized the Originally Proposed Rules in a Sidley Update dated April 13, 2011 (“Agencies Issue Proposed Dodd-Frank Act Risk Retention Rule for Asset-Backed Securities”).
5 Generally, the risk retention requirements aim to remedy the general erosion of lending standards purportedly resulting from the “originate to distribute” business model practiced in the lending market. As noted in the preambles of the Prior Proposals, the legislative history of Section 15G states that “[w]hen securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interest with those of investors in asset-backed securities.” The Agencies reaffirm this position in the preamble to the Final Rules, stating that “[b]y requiring that a securitizer retain a portion of the credit risk of the securitized assets, the requirements of section 15G provide securitizers an incentive to monitor and ensure the quality of the securitized assets underlying a securitization transaction and, thus, help align the interests of the securitizer with the interests of investors.”
6 The term “securitizer” is defined under Section 15G of the Exchange Act to include both (i) the “issuer” of an asset-backed securities transaction and (ii) the person that initiates or organizes the asset-backed securities transaction by selling or transferring assets, directly or indirectly, including through an affiliate, to the issuer. The Agencies refer to any person covered by prong (ii) as the “sponsor.”
7 Under the Final Rules, “majority-owned affiliate” of a person means an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by or is under common majority control with, such person, where majority control means ownership of more than 50 percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under U.S. generally accepted accounting principles.
8 The subsection of the Final Rules providing for retention by “multiple sponsors” remains substantially the same as under the Prior Proposals. For securitizations where two or more entities would each meet the definition of sponsor, the Final Rules require that one of the sponsors must comply with the rule (although the Final Rules do not prohibit multiple sponsors from retaining credit risk as long as one of those sponsors complies with the requirement).
9 The Final Rules define an “ABS interest” as any type of interest or obligation issued by an issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest or residual interest (other than (i) non-economic residual interests in a REMIC and (ii) an uncertificated REMIC regular interest that is held in another REMIC where both REMICs are part of the same structure and a single REMIC in that structure issues ABS interests to investors (these exclusions are new in the Final Rules and clause (ii) relates to the typical multiple-tier REMIC structure)), payments of which are primarily dependent on the cash flows of the collateral owned or held by the issuing entity. As further defined, “ABS interest” excludes common or preferred stock, limited liability interests, partnership interests, trust certificates or similar interests that are issued primarily to evidence ownership of the issuing entity and the payments, if any, of which are not primarily dependent on the cash flows on the collateral held by the issuing entity, and does not include the right to receive payments for services provided by the holder of such right, including servicing, trustee services and custodial services.
10 The preamble to the Final Rules cites Accounting Standard Codification (ASC) Topic 820, published by the Financial Accounting Standards Board.
11 For details regarding these disclosures, please see Appendix A.
12 A representative sample alternative remains available under the European Union’s capital requirements regime. That regime is briefly discussed in Section 9 below.
13 Under Statement of Financial Accounting Standards (SFAS) Nos. 166 and 167, retention of a material risk can result in all assets in the securitization transaction (and not just the retained risk) being required to be accounted for on balance sheet. The form and amount of risk retention can also affect the amount of risk-based capital a regulated financial institution is required to maintain with respect to the securitization.
14 The Final Rules define “servicing assets” as rights or other assets designed to assure the servicing or timely distribution of proceeds to ABS interest holders and rights or other assets that are related or incidental to purchasing or otherwise acquiring and holding the issuing entity’s securitized assets.
15 It remains unclear how the Agencies would interpret this definition in the context of correspondent lending arrangements where the original creditor is in effect originating for another entity in accordance with that entity’s underwriting standards.
16 We note that the Final Rules include an analogous mechanism in the provisions applicable to open market CLOs. In that context, lead arrangers of syndicated loans that retain risk positions in the loans themselves can satisfy the risk retention requirement, provided a number of conditions are met. This is discussed in Section 5 below.
17 The Agencies correspondingly define “residential mortgage” under the Final Rules to include mortgage loans secured by a residential structure that contains one to four units. Under the Prior Proposals, a “residential mortgage” was defined only in reference to covered transactions (or transactions exempt from the definition of covered transactions) under Regulation Z.
18 This requirement is similar to the items of Regulation AB requiring disclosure regarding pool assets that deviate from the disclosed underwriting criteria or other benchmarks or criteria used in the issuer’s asset review for registered transactions.
19 The definition of “CLO manager,” for the purposes of the open market CLO exemption, requires that the CLO manager be a registered investment adviser under the Investment Advisers Act, or be an affiliate of a registered investment adviser which is itself managed by such registered investment adviser. Because of this definition, affiliates of the CLO manager that are managed by the CLO manager also may not benefit from any management fees or gains on sale at the time the CLO ABS interests are issued.
20 To qualify, a loan must meet the following conditions:
- the loan is not subordinate in right of payment to any other obligation for borrowed money of the commercial borrower;
- the loan is secured by a valid first priority security interest or lien in or on specified collateral securing the commercial borrower’s obligations under the loan; and
- the value of the collateral subject to such first priority security interest or lien, together with other attributes of the obligor (including, without limitation, its general financial condition, ability to generate cash flow available for debt service and other demands for that cash flow), is adequate (in the commercially reasonable judgment of the CLO manager exercised at the time of investment) to repay the loan and to repay all other indebtedness of equal seniority secured by such first priority security interest or lien in or on the same collateral, and the CLO manager certifies on or prior to each date that it acquires a loan constituting part of a new CLO-eligible loan tranche, that it has policies and procedures to evaluate the likelihood of repayment of loans acquired by the CLO and it has followed such policies and procedures in evaluating each CLO-eligible loan tranche.
21 The Loan Syndications and Trading Association, Inc. (the “LSTA”) has filed in federal court a challenge focusing on the CLO portion of the Final Rules and brought under the Administrative Procedure Act of 1946. Sidley is representing the LSTA in the proceeding.
22 The share of the pool constituted by the qualifying assets is measured by the ratio of the total unpaid principal balance of the qualifying assets to the total unpaid principal balance of all securitized assets in the pool.
23 A QTOB is defined as an issuing entity in which: (i) the entity is collateralized solely by servicing assets and by municipal securities that have the same municipal issuer and the same underlying obligor or source of payment (determined without regard to any third-party credit enhancement) and such municipal securities are not subject to substitution; (ii) such entity issues no securities other than: (x) a single class of TOBs with a preferred variable return payable out of capital, and (y) one or more residual equity interests, that in the aggregate are entitled to all remaining income of the issuing entity (commonly known as the “residuals”), provided that any such securities described in clause (x) or (y) constitute asset-backed securities; (iii) the municipal securities held as assets by the entity are structured in compliance with Section 103 of the Internal Revenue Code of 1986 (the “Code”), such that the interest payments on such securities are excludable from the gross income of the owners; (iv) the terms of all securities issued by the issuer are structured so that all holders of such securities who are eligible to exclude interest received on such securities will be able to exclude that interest from gross income pursuant to Section 103 of the Code or as exempt interest dividends pursuant to Section 852(b)(5) of the Code; (v) such entity has a legally binding commitment from a regulated liquidity provider to provide a 100% guarantee or liquidity coverage with respect to all of the outstanding TOBs; and (vi) such issuing entity qualifies for monthly closing elections pursuant to IRS Revenue Procedures 2003-84. The Agencies limited their QTOB relief to TOBs that can be tendered for purchase to the issuer of such securities at any time, upon no more than 397 days, notice, for a purchase price equal to amortized cost of the security, plus accrued interest, at the time of tender.
24 Tender Option Termination Events are defined in the Final Rule by reference to the definition used in Section 4.01(5) of IRS Revenue Procedure 2003-84, which includes: (1) bankruptcy of the municipal security issuer; (2) a downgrade of the municipal security below investment grade; (3) a payment default on the municipal security; (4) the municipal security loses its tax exempt status; (5) the QTOB is downgraded below investment grade; or (6) bankruptcy of the QTOB issuer.
25 The Agencies have expressly permitted the 5% risk retention to be satisfied through any combination of ownership of the residuals or the direct ownership of the municipal securities that are collateral for the QTOB.
26 The Agencies acknowledged that in TOB structures (as in other securitization transactions) there may be more than one “sponsor.” In such a situation, it is the responsibility of the transaction parties to designate which party is the sponsor and is subject to the requirements of the Final Rules.
27 The Agencies expressly prohibited a QTOB from holding interests in another TOB issuer or from holding preferred stock in a closed-end investment company that invests in municipal securities.
28 See discussion above under “Hedging, Transfer and Financing Restrictions” regarding prohibition on transfer and hedging with respect to 5% risk retention requirement.
29 A regulated liquidity provider for a QTOB is limited to an entity that is a depository institution, a bank holding company (or a subsidiary thereof), a savings and loan holding company (provided all or substantially all of the holding company’s activities are permissible for a financial holding company under 12 USC 1843(k) (or a subsidiary thereof)), or a foreign bank (or a subsidiary thereof) whose home country supervisor has adopted capital standards consistent with the Capital Accord of the Basel Committee on Banking Supervision, provided the foreign bank is subject to such standards.
30 The preamble states: “In response to commenters’ requests for certain clarifications with respect to the required liquidity coverage, the agencies recognize that the liquidity coverage may not be enforceable against the regulated liquidity provider upon the occurrence of a tender option termination event. Liquidity coverage subject to this condition would nevertheless satisfy the liquidity coverage requirement in the final rule.”
31 The Agencies appear to believe that a contractual promise to absorb losses, rather than actual investment at risk, is not sufficient to satisfy its notion of “skin in the game.” The Agencies acknowledge the (sometimes stark) bifurcation of approaches proposed–sponsors either may take advantage of an exemption or full or partial exception, or must satisfy the more onerous standard risk retention option–yet appear to have ignored the role unfunded risk retention options could play.
32 We summarized the FDIC Safe Harbor Rule, including its risk retention requirement, in a Sidley Update dated October 4, 2010.
33 The FDIC may have intended the former, but there has been no formal statement in this regard.
34 We address the EU risk retention regime in the following Sidley Updates: (i) Sidley Update dated January 30, 2014 (“EU Securitization Risk Retention Proposals: Issues for Consideration in Cross-Border Transactions”), available at: http://www.sidley.com/European-Banking-Authority-Proposals-on-EU-Risk-Retention-Rules-Issues-for-Consideration-on-Cross-Border-Transactions-01-30-2014/; and (ii) Sidley Update dated May 22, 2013 (“AIFM Directive 2013 Sidley Update: Securitisation Risk Retention Requirement”).
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Fair Value Disclosures and Recordkeeping Requirements
The Final Rules impose disclosure obligations with respect to the sponsor’s fair value determination of a horizontal residual interest and certain other material items. The Final Rules require disclosure at two points in time: (i) first, to potential investors under the caption “Credit Risk Retention” (presumably, this will be in the preliminary offering document) a reasonable period of time prior to the sale of the asset-backed securities and (ii) second, to investors a reasonable period of time after the closing of the securitization transaction.
Prior to sale:
- the fair value (expressed as a percentage of the fair value of all of the ABS interests issued in the securitization transaction and dollar amount) of the horizontal residual interest that the sponsor expects to retain at the closing of the securitization; if specific prices, sizes or rates of interest of each tranche of the securitization are not available, the sponsor must disclose a range of such fair values based upon a range of bona fide estimates of such prices, sizes and rates of interest; the sponsor disclosing such ranges must also disclose the method by which it determined such ranges;
- a description of the material terms of the horizontal residual interest;
- a description of the valuation methodology used to calculate the fair value (or range of fair values) of all classes of ABS interests;
- the key inputs and assumptions (or a comprehensive description thereof) used in measuring the estimated total fair value (or ranges thereof) of all classes of ABS interests; to the extent applicable, such disclosure of inputs and assumptions must include (1) discount rates, (2) loss given default (recovery ), (3) prepayment rates, (4) default rates, (5) lag time between default and recovery, and (6) the basis for forward interest rates used;
- a summary description of the reference data set or other historical information used to develop these key inputs and assumptions;
- descriptions of all inputs and assumptions that could have a material impact on the fair value calculation or would be material to an investor’s ability to evaluate the calculation. If the description includes a description of curves, it must include the methodology used to derive each curve and a description of any aspects of each curve that could materially affect the fair value calculation or an investor’s ability to evaluate the calculation; and
- if the sponsor uses information about the securitized assets in its fair value calculation, that information must be as of a date not more than 60 days prior to the date of first use by investors (or 135 days in the case of a securitization that pays quarterly or less frequently).
- the fair value calculation for the actual retained horizontal residual interest at closing time, based on actual sales prices and tranche size;
- the fair value (expressed as a percentage of the fair value of all ABA interests) of the actual retained horizontal residual interest and such fair value percentage for the required retained horizontal residual interest; and
- if the valuation methodology or key inputs or assumptions used prior to sale materially differ from those used at the closing, a description of those material differences.
If the sponsor uses a horizontal cash reserve account, the sponsor must disclose comparable information. If the sponsor retains a vertical interest, it must disclose, a reasonable time both before the sale and after the closing, various information, including the amount and form of the vertical interest and the material terms thereof.
The special calculation and disclosure rules for revolving pool securitizations are discussed in Section 7.
The Final Rules add records maintenance requirements with respect to the disclosures described above. Sponsors would be required to maintain written records and provide disclosures to the SEC and, if applicable, its federal banking agencies, until three years after all ABS interests are no longer outstanding.35
35 Perhaps because of an oversight, the express language setting forth the three-year recordkeeping requirement does not appear to limit the disclosure requirement to a single series of asset-backed securities or securitization transaction, but instead applies to “all ABS interests.”