Tuesday, March 29, 2011

SEC and Banking Agencies Set to Propose Dodd-Frank Risk Retention Regulations with 5 Percent Benchmark and Conservative QRM Exemption

Consistent with the securitization and ``skin in the game’’ risk retention provisions of Dodd-Frank, the SEC and the Federal banking agencies will propose regulations this week requiring securitization sponsors to retain an economic interest equal to at least 5 percent of the aggregate credit risk of the assets collateralizing an issuance of asset-backed securities. The agencies will structure the risk retention requirements in a flexible manner that will allow the securitization markets for non-qualified assets to function in a manner that facilitates the flow of credit to on economically viable terms and is consistent with investor protection.

The proposed regulations will include disclosure requirements specifically tailored to each of the permissible forms of risk retention. The disclosure requirements are designed to provide investors with material information concerning the securitizer’s retained interests, such as the amount and form of the interest retained, and the assumptions used in determining the aggregate value of asset-backed securities to be issued.

The proposal will provides several options for the form in which a securitization sponsor may retain risk. For example, the securitizer can retain a 5 percent vertical slice of the asset-backed security interests, whereby the sponsor retains a specified pro rata piece of each class of interests issued in the transaction, that is, the sponsor must hold 5 percent of each tranche. Another option will be to hold a 5 percent horizontal first-loss position, whereby the sponsor retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests.

In addition to the base credit risk retention requirement, the proposed regulations would prohibit sponsors from receiving compensation in advance for excess spread income to be generated by securitized assets over time. This is accomplished by imposing a premium capture mechanism designed to prevent a securitizer from structuring an asset-backed security transaction in a manner that would allow the securitizer to take an up-front profit on a securitization before any unexpected losses on the securitized assets appeared that would pay the sponsor more up front than the cost of the risk retention interest it is required to retain.

The proposed regulations would also establish the conditions under which a residential mortgage would have the status of a qualified residential mortgage exempted from risk retention mandates. As required by the statute, the agencies developed these underwriting criteria through evaluation of historical loan performance data. Generally, qualified residential mortgages would be prohibited from having product features that add complexity and risk to mortgage loans, such as terms permitting negative amortization, interest-only payments, or significant interest rate increases.

The proposed definition of qualified residential mortgage would establish conservative underwriting standards designed to ensure that QRM loans are of very high credit quality.These standards would include a maximum front-end and back-end borrower debt-to-income ratios of 28 percent and 36 percent, respectively and a maximum loan-to-value (LTV) ratio of 80 percent in the case of a purchase transaction, as well as a 20 percent down payment requirement in the case of a purchase transaction.

With regard to other quailed asset classes, the proposed rules also would not require a securitizer to retain any portion of the credit risk associated with a securitization transaction if the asset-backed securities issued are exclusively collateralized by auto loans, commercial loans, or commercial real estate loans that meet robust underwriting standards designed to ensure that the loans backing the asset-backed securities are of very low credit risk. They were developed by the Federal banking agencies based on supervisory expertise.

Rather than providing an outright exemption, Dodd-Frank provides that a sponsor of an asset-backed securities issuance collateralized exclusively by loans that meet the underwriting standards must be required to retain less than five percent of the credit risk of the securitized loans. The proposal would set that number at zero percent.

The agencies were concerned that establishing a risk retention requirement between zero and five percent for qualifying assets within these asset classes may not provide sufficient incentives for securitizers to allocate the resources necessary to ensure that the collateral backing an asset-backed securities issuance satisfies the proposed underwriting standards, as there may be significant compliance costs to structure and maintain the retention piece of a securitization structure, irrespective of how it is calibrated, and provide required
disclosures to investors. The underwriting standards the agencies have proposed are conservative, as is appropriate for a zero percent risk retention requirement.

The regulations would prohibit a securitizer from hedging its required retained interest or transferring it, unless to a consolidated affiliate. However, hedging of interest rate or foreign exchange risk would be permitted, as well as pledging the required retained interest on a full recourse basis. Hedging based on an index of instruments that includes the asset-backed securities would also be allowed, subject to limitations on the portion of the index represented by the specific securitization transaction or applicable issuing entities.

Since the sponsor is the true decision maker behind the securitization transaction and determines what assets will be securitized, the regulations would provide that a sponsor of an asset-backed security transaction is the party required to retain the risk. The proposed rules define the term “sponsor” in a manner consistent with the definition of that term in the SEC’s Regulation AB, which defines ``sponsor’’ as the person who organizes and initiates an asset-backed securities transaction by selling or transferring assets to the issuing entity.

However, a securitization sponsor could allocate a proportional share of the risk retention obligation to the originator of the securitized assets, subject to certain conditions. This would have to be voluntary on the originator’s part, however, through a contractual agreement with the sponsor.

In order to ensure that the originator has skin in the game, the regulations would require the originator to be the originator for at least 20 percent of the loans in the securitization, take on at least 20 percent of the risk retention, and pay up front for its share of retention, either in cash or a discount on the price of the loans the originator sells to the pool.