The FDIC, Federal Reserve and OCC (the Federal banking agencies), together with the SEC, FHFA and HUD (collectively with the Federal banking agencies, the Agencies) have issued a joint proposed rule (the Proposed Rule) intended to implement the requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Section 941 requires, among other things, that a loan originator or a securitizer of asset-backed securities (ABS) retain a percentage of the credit risk of securitized assets.
Of the more than 200 rules required under Dodd-Frank, the risk retention rule required by Section 941 has the potential to be one of the most sweeping and impactful reforms on the secondary markets and could significantly influence the structure and pricing of securitizations for assets from mortgages to student loans to car loans to commercial loans and commercial real estate loans. As released, the Proposed Rule is living up to its potential by increasing the cost and possibly decreasing the availability of credit; however, the options offered to market participants for alternative risk retention methods can have meaningfully different results for the parties. Nonetheless, retail-level changes can be expected for the credit markets as a result of the reforms mandated by the Proposed Rule – reforms that will weigh heavily on pricing models and structures and provide the GSEs with a competitive advantage that may be difficult for private securitizers to overcome.
In this regard, the Proposed Rule seems to contradict (or at least be inconsistent with) the Obama Administration's proposal released a month earlier outlining reforms to the role of GSEs. That GSE reform proposal calls for an increased role by private parties in the secondary mortgage market and a dramatic, though gradual, lessening of the functions, products and portfolios of the GSEs. In that release, the administration noted that one of the four primary focuses of GSE reform should be a "commitment to affordable rental housing." To the extent there is policy-level consistency between last month's GSE reform proposal and last week's Proposed Rule, it seems to be in the notion that comparatively more American should be renters as opposed to homeowners. The GSE reform proposal would accomplish this result by decreasing government support for large segments of qualified home-buyers; and the Proposed Rule would likewise reduce the universe of Americans who are able to purchase homes by increasing credit prices - once one recognizes that the increased cost created by risk retention will, and in fact must, be passed along to consumers in order to make credit offerings safe and sound products for prudentially regulated banks and lenders.
Barring an exception, Section 941 of Dodd-Frank requires, among other things, a loan originator or a securitizer of asset-backed securities to retain a percentage of the credit risk of securitized assets. The goal of these requirements is to assign accountability for asset quality to parties with the ability to control that asset quality, referred to colloquially as “skin in the game.” The direct result of increased accountability and skin in the game is expected to be more prudent lending standards. The Agencies are also directed by Dodd-Frank to adopt risk retention requirements of less than 5 percent for ABS collateralized by residential and commercial mortgages, commercial real estate loans or automobile loans, if such loans meet certain underwriting standards established by the Federal banking agencies. The statutory amendments of Section 941 of Dodd-Frank are manifest in the form of a new Section 15G to the Securities Exchange Act of 1934.
A securitizer or a sponsor of a securitization, defined as a person who organizes or initiates a securitization transaction by selling or transferring assets to the issuing entity, is exempt from risk retention requirements for any securitization transaction in which all the assets serving as collateral are qualified residential mortgages (QRMs) or are sold to, and in turn securitized by, Fannie Mae or Freddie Mac. Otherwise, the securitizer or sponsor must retain 5 percent of the credit risk associated with the collateral underlying the ABS, with the ability to allocate that risk by contract in whole or in part to loan originators. In cases where there are multiple securitizers or sponsors in an ABS issuance, only one is required to comply with the risk retention requirements, though all are required to ensure compliance.
The Proposed Rule provides several options for compliance with the risk retention requirements.
- Vertical slice. The securitizer or sponsor retains not less than 5 percent of each tranche of ABS interests issued in the securitization.
- Horizontal residual interest. The securitizer or sponsor retains a first-loss position in an amount equal to at least 5 percent of the par value of all ABS interests issued in the securitization. Some concern has surfaced that retention of first-loss risk under the horizontal risk retention option could result in consolidation of the entire securitization under FAS 167 if the issuer has both a significant variable interest and the ability to direct significant activities of the trust.
- Cash reserve fund. The securitizer or sponsor establishes and funds an account in amounts equal to 5 percent of the par value of all ABS interests issued in the securitization which is held in a first-loss position.
- L-shaped. The securitizer or sponsor retains not less than (i) 2.5 percent of each class of ABS interest; and (ii) an eligible horizontal residual interest equal to 2.564 percent of the par value of all ABS interests issued in the securitization.
- Representative sample. The securitizer or sponsor retains a randomly-selected pool of assets that are materially similar to the assets underlying an ABS issuance in an amount equal to 5.264 percent of the unpaid principal balance of the underlying assets.
Additionally, in what many market participants view as a positive outcome designed to accommodate market practice, certain risk retention options are available in transaction-specific instances:
- Revolving asset master trusts. Securitizers or sponsors of securitizations collateralized by assets held in a revolving asset master trust, such as credit card or floor plan loans, typically retain a seller’s interest in the securitization consisting of a direct, shared interest with all of the investors in the performance of the underlying assets. The Proposed Rule adopts the seller’s interest concept and permits a securitizer or sponsor to meet the risk retention requirement by holding the seller’s interest in an amount not less than 5 percent of the unpaid principal balance of assets held in the master trust.
- Asset-backed commercial paper conduits. Risk retention for the sponsor of an asset-backed commercial paper conduit that is fully supported by a liquidity facility provided by a prudentially-regulated or foreign financial institution can also be met in a manner that mirrors existing market practice. If the conduit meets certain conditions and is not operated as a securities or arbitrage program, the sponsor of the conduit can satisfy the risk retention requirements by requiring the originator-seller to retain an eligible horizontal residual interest equal to at least 5 percent of the par value of all interests issued by an intermediate special purpose vehicle.
- Commercial mortgage-backed securities. The Proposed Rule provides that securitizers or sponsors of commercial mortgage-backed securities (CMBS) can negotiate risk retention of a first-loss position with a third-party purchaser. The third-party purchaser must also pay for the first-loss subordinated interest at closing in cash without financing from other parties to the securitization transaction, conduct due diligence on each asset entering the CMBS pool and meet the same risk-retention requirements as the securitizer or sponsor. A qualified third-party purchaser would satisfy this requirement if it acquired an eligible horizontal residual interest in the issuing entity in the same form, amount and manner as would have been required by the sponsor.
Qualified residential mortgages
In defining QRMs, Section 15G directs the Agencies to consider “underwriting and product features that historical loan performance data indicate result in lower risk of default” such as (i) documentation and verification of borrower resources; (ii) the borrower’s debt-to-income ratio; (iii) payment shock mitigation features on adjustable rate mortgages; (iv) mortgage guarantee insurance and other credit enhancement at the time of origination; and (v) balloon payments, negative amortization, prepayment penalties, interest-only payments and other features that have historically increased the likelihood of borrower default. The underwriting standards for a QRM set for the in the Proposed Rule are rigorous and only a small subsection of residential mortgages should be expected to satisfy the requirements. In fact, the Federal banking agencies explicitly referred to the QRM standards as ones that are “not intended to set a new national standard for mortgages.”
The Proposed Rule adopts QRM underwriting standards that focus on a borrower’s ability to repay, including documentation and verification of borrower funds and source of down payment, and requires the lender to have evaluated the borrower’s monthly housing debt, total monthly debt and monthly gross income. The Proposed Rule establishes the following standards, among others, for QRMs.
- Loan-to-value ratio. A purchase money mortgage must have a loan-to-value ratio (LTV) that does not exceed 80 percent, meaning that a QRM borrower must have a cash down payment in the amount of closing costs and 20 percent of the purchase price. In the case of rate and term refinancing, a QRM borrower's LTV cannot exceed 75 percent, or 70 percent for a cash-out refinancing.
- Borrower credit history. A creditor must verify that a QRM borrower (i) is not 30 days past due on any debt obligation; (ii) has not been 60 days or more past due on any debt obligation in the past 24 months; and (iii) has not declared bankruptcy, had any personal property repossessed or real property foreclosed on in the past 36 months.
- Debt-to-income ratios. A creditor must also verify that a QRM borrower’s monthly housing debt to monthly gross income does not exceed 28 percent and total monthly debt to monthly gross income does not exceed 36 percent.
- Minimum servicing standards. A QRM must carry commitments with minimum servicing standards designed to mitigate the risk of default. Creditors are required to include servicing policies and procedures in the mortgage transaction documents which provide for, among other things, loan modification where the net present value of the modified loan exceeds the estimated net present value of recovery in foreclosure.
Notwithstanding a statutory directive to the Agencies in Section 15G to assess the impact of private mortgage guarantee insurance (PMI) in reducing the risk of default, the Proposed Rule does not acknowledge PMI as a factor in determining QRM qualification. Instead, the Agencies noted that they were unable to find any empirical evidence that, when holding underwriting standards constant, PMI decreased the likelihood of mortgage defaults. However, the Proposed Rule specifically requests comment on this point and asks for any research, studies or other data which would support a correlation.
Additionally, the Proposed Rule does not establish underwriting standards for mortgages other than QRMs. The Agencies, however, seek public comment on whether standards should be adopted to essentially create a sliding scale whereby certain non-QRM loans that have credit enhancing characteristic are subject to risk retention of less than 5 percent. If such a sliding scale is adopted, the Agencies have asked for comment on what standards or characteristics should be among those that impact risk retention percentages of non-QRM mortgages.
Qualifying non-residential loans
The Proposed Rule also sets forth underwriting standards that the Agencies acknowledge are "very conservative" for securitization of non-residential mortgage loans, such as commercial loans, commercial real estate mortgages and automobile loans, with a zero risk retention requirement. For example, the originator of a qualifying commercial loan must consider the borrower’s creditworthiness and verify, among other things, that based on actual performance over the past 2 years the borrower had a total liabilities ratio (meaning total liabilities divided by total liabilities and equity, less intangible assets) of 50 percent or less, a leverage ratio of 3.0 or less (meaning three dollars of debt for every dollar of income) and a debt service coverage ratio of 1.5 or better (where current industry standard is generally 1.2). Collateral is not required for qualifying commercial loans; however, where a loan is secured, the creditor must have a first-lien position and ensure that the collateral is maintained and available to satisfy the borrower’s loan obligations.
In addition to the QRM and qualifying non-residential loan exemptions from the risk retention requirements, the Proposed Rule provides that a GSE guarantee on any ABS issued by either Fannie Mae or Freddie Mac eliminates the risk retention requirement so long as the GSEs are operating under FHFA conservatorship or receivership with capital support from the federal government. Given the expectedly small segment of mortgage loans that will meet QRM standards and the fact that GSEs own or insure more than 90 percent of home mortgages now being originated, some argue that this exemption for GSE securities gives the GSEs an insurmountable competitive advantage as compared to private party transactions.
Presumably to avoid duplication of risk retention requirements in re-securitization transactions, the Proposed Rule also offers a limited exemption from risk retention for single-tranche re-securitizations that do not alter payment terms or credit risk of underlying ABS that is itself exempt from or complies with risk retention requirements. Other exemptions include:
- A safe harbor for certain foreign-related ABS transactions
- ABS collateralized by obligations or assets issued, insured or guaranteed by the federal government
- ABS issued by any state or state subdivision that is exempt from registration under Section 3(a)(2) of the Securities Act of 1933
- ABS collateralized by obligations or assets issued, insured or guaranteed by institutions supervised by the Farm Credit Administration
- ABS that constitute qualified scholarship funding bonds
The Proposed Rule also addresses situations in which a securitizer is able to sell senior bonds for prices that more than cover the risk retention requirement, so-called monetization of the excess spread. In these instances, risk retention requirements were historically ineffective as an incentive to curb securitizer behavior because the spread covered the securitizer’s the risk retention requirement. In order to prevent this, the Proposed Rule requires the creation of a premium capture reserve fund as a first-loss position before any of the risk retention options described above. The premium capture reserve fund also eliminates the incentive to structure mortgages to maximize initial cash flow because such a structure would only increase fund’s cushion for future losses. The premium capture elements of the Proposed Rule apply to all asset classes and all risk retention options.
As released, the Proposed Rule includes numerous requests for public comment and has already generated widespread industry and Capitol Hill reaction – primarily focused on the treatment of residential mortgage loans, the GSE exemption and the narrow definition of QRMs. In fact, Senator Kay Hagan drafted Section 941's risk-retention provision and reportedly referred to the Proposed Rule as inflexible, and Representative Barney Frank has expressed support for legislation that would eliminate the GSE exemption. Those involved in the mortgage, lending, servicing and securitization markets should assess how the Proposed Rule will impact their operations and cost of doing business and consider weighing in on the ultimate outcome by commenting on relevant portions. Comments to the Proposed Rule are expected to be due on or around June 10, 2011.
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