1. Art and Diseño

Financial ServicesAlert
January 28, 2015
Berwyn | Boston | Detroit | Harrisburg | Los Angeles | New York | Orange County | Philadelphia | Pittsburgh | Princeton | Silicon Valley | Washington, D.C. | Wilmington
The Risk Retention Rules: A Victory for Securitizations Involving
Residential Mortgage-Backed Securities?
Frank A. Mayer, III | [email protected]
Andrew J. Victor | [email protected]
When Congress passed the Dodd-Frank Act, it mandated the
creation of risk retention rules in an effort to align the incentives
of sponsors of asset-backed securities (ABS) with the interests
of investors and to improve the underwriting and selection
of securitized assets. As with much of the Dodd-Frank Act,
Congress left the details of the risk retention requirements
to be developed by various agencies. After more than three
years of development, the Board of Governors of the Federal
Reserve System, the Department of Housing and Urban
Development, the Federal Deposit Insurance Corporation, the
Federal Housing Finance Agency, the Office of Comptroller
of the Currency and the Securities and Exchange Commission
(collectively, the Agencies) jointly issued the risk retention rules
on October 22, 2014. The rules were then published in the
Federal Register on December 24, setting off the rules’ one- and
two-year periods for the industry to conform operations.
• This alert provides an overview of the significant features of
the risk retention rules, including the following:
• generally, sponsors of ABS must retain a minimum of 5
percent of the credit risk from an ABS transaction
• the Agencies issued the risk retention rules that include
collateralized loan obligations (CLOs) and other
securitization transactions.
the regulations provide an exemption for ABS collateralized
with qualified residential mortgages (QRMs) and exceptions
for ABS collateralized with commercial loans, commercial real
estate loans and automobile loans with heightened underwriting
standards.
Who Must Comply with the Risk Retention Requirements?
In a word, “sponsors” must comply with the risk retention
requirements. The regulations define a “sponsor” as a person who
organizes and initiates a securitization transaction by selling or
transferring assets, either directly or indirectly, including through
an affiliate or issuer.
What Are the Risk Retention Requirements?
The minimum risk retention requirement, located at section 15G
of the Securities Exchange Act of 1934, as amended by Ssection
941 of the Dodd-Frank Act, is no less than 5 percent for any
asset that a sponsor, through the issuance of ABS interests,
transfers, sells or conveys to a third party, unless an exemption
applies. The Agencies did not increase the minimum requirement
of 5 percent from section 15G, but they noted that parties to a
securitization transaction are free to agree that more risk should
be retained. Although the rules do not prohibit more than
one sponsor from participating in a securitization, they do not
allow multiple sponsors to divide the required risk retention.
Furthermore, sponsors are generally prohibited from transferring
or hedging the interests they retain for two years from the date
of the closing for the securitization, although the time limit for
residential mortgage-backed securities (RMBS) is five years.
What Is an “ABS Interest” under the Risk Retention
Requirements?
The risk retention requirements apply to the issuance of “ABS
interests.” Under the risk retention rules, the Agencies defined
an “ABS interest” generally 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, payments on which are primarily dependent on the cash
This publication may contain attorney advertising.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that
time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of
it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended
or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to
another party any transaction or matter addressed herein. Please send address corrections to [email protected]. © 2015 Pepper Hamilton LLP. All Rights Reserved.
flows of the collateral owned or held by the issuing entity. As
such, the definition applies to RMBS, commercial mortgagebacked securities (CMBS), auto and auto lease-back securities,
revolving pool securitizations and asset-backed commercial paper
conduits. In a somewhat controversial decision, the Agencies’
regulations include CLOs as well.1 Under the rules, a CLO is a
special purpose entity that issues debt and equity interests and
whose assets consist primarily of loans that are securitized assets
and servicing assets. Sponsors of transactions involving CLOs
that are securitized by the purchase of assets on the secondary
market, known as “open-market CLOs,” must comply with
the risk retention requirements. Conversely, the definition of
an “ABS interest” does not include common stock, partnership
interests or trust certificates. Similarly, rights to receive payments
for services provided by the holder of such rights, including
servicing, trustee services and custodial services, are also not ABS
interests.
When Must Sponsors Comply with the Risk Retention
Requirements?
The risk retention requirements will become effective one year
from the date of publication in the Federal Register for RMBS
and two years from the date of publication for other ABS.
Therefore, the compliance deadlines are, respectively, December
24, 2015 for RMBS and December 24, 2016 for other ABS.
How Can Sponsors Comply with the Risk Retention
Requirements?
As concerns the form through which a sponsor retains its risk,
the regulations offer a “menu of options,” including a “standard”
option, because the Agencies perceived a need to accommodate
the variety of the securitization structures covered by the final
rule. Under the “standard” risk retention option, the minimum 5
percent amount held by a sponsor must be in the “issuing entity,”
which the regulations define as the entity that owns or holds
the pool of assets to be securitized and in whose name the ABS
are issued. The regulations permit a sponsor to shape its form of
risk retention by providing the choice of retaining an “eligible
horizontal residual interest,” retaining an “eligible vertical
interest” or retaining a combination of such interests.
Eligible Horizontal Residual Interest. In selecting to retain an
“eligible horizontal residual interest,” a sponsor will retain the
most subordinate 5 percent interest of the issuing entity. In
doing so, the regulations generally require sponsors to disclose
information about their interests to investors. In particular, a
sponsor will, in most instances, have to disclose the expected fair
2
www.pepperlaw.com
value for its interest calculated pursuant to GAAP, the actual
fair value post-closing, any material differences in making its
calculations before and after closing and a description of its
methodology to assess fair value. Alternatively, a sponsor may
fund an account at the closing of the securitization in an amount
equal to the same dollar amount as would be required to hold an
eligible horizontal residual interest, thereby creating an “eligible
horizontal cash reserve account.” Because the purpose of the
risk retention rules is to keep the sponsor exposed to credit risk,
the funds in the account are restricted to ensure that cash will
be available to absorb losses to the same extent as an eligible
horizontal residual interest.
Eligible Vertical Interest. A sponsor may also elect an “eligible
vertical interest,” whereby the sponsor retains either (i) a
minimum 5 percent of each class of ABS interests issued in the
securitization or (ii) a single vertical security that provides the
sponsor 5 percent of the cashflows or losses on each class of the
issued ABS interests.
Important caveats:
• the rules permit sponsors to combine holdings of horizontal
residual interests and vertical interests, informally known as
an “L-shaped interest,” to meet the 5 percent requirement
• sponsors electing to meet their risk retention requirements
under the standard option may also offset some of the
retained risk if interests in the ABS are acquired by the
entity (the “originator”) that created and sold the asset that
collateralizes the ABS
• the regulations prohibit sponsors from using third-party
credit support, such as insurance policies, guarantees or
standby letters of credit.
What Are the Other Options for Risk Retention?
In addition to standard risk retention for ABS, the regulations
permit sponsors to meet specific risk retention requirements
for various other securitizations, including revolving pool
securitizations, asset-backed commercial paper conduits, CMBS
and municipal bond repackaging securitizations. Although the 5
percent risk retention requirement applies to each of these kinds
of securitizations, the specific requirements for compliance may
vary due to the nature of the underlying assets. For instance,
on one hand, sponsors of ABS collateralized by commercial
real estate loans can meet their risk retention requirements if
third-party purchasers acquired eligible horizontal residual
interests in the issuing entity, reflecting the historical market
Financial ServicesAlert
practice of third-party purchasers acquiring first loss positions in
CMBS transactions. On the other hand, sponsors of municipal
bond repackaging securitizations, also known as “tender option
bonds,” may elect the standard option or retain a 5-percent facevalue amount of the municipal securities of the same issuance.
Regarding CLOs, sponsors generally must retain a minimum
5 percent of the face amount of the CLO until a terminating
event, such as maturity or default. The regulations permit the
risk retention requirement to be satisfied if the “lead arranger”
(effectively the underwriter) of each CLO-eligible loan agrees to
retain at least 5 percent of the contributed loan.
Are There Exemptions or Exceptions to the
Risk Retention Requirements?
Yes, the regulations afford several exemptions and exceptions.
Importantly, ABS securitized solely by QRMs are exempt from
the risk retention requirements. In making the QRM exemption,
the Agencies aligned the definition of a QRM with the detailed
definition of “qualified mortgages,” or “QMs,” under section
129C of the Truth in Lending Act and that statute’s regulations
developed by the Consumer Financial Protection Bureau. The
regulations provide that the Agencies will reevaluate the QRM
definition in December 2018 and will periodically review
thereafter every five years to determine whether the definition
is limiting credit risk, promoting sound underwriting and
providing access to credit.
Additionally, the regulations provide an exception of a 0 percent
risk retention requirement for ABS with commercial loans,
commercial real estate loans and automobile loans made under
heightened underwriting standards. For securitizations involving
these three kinds of loans, sponsors may also reduce their risk
retention requirement up to 2.5 percent by creating a transaction
that draws upon the loans with the heightened underwriting
standards and loans that do not qualify. The amount of the
reduction in risk retention is measured by the ratio of the two
different types of loans.
Several other exemptions, such as for securitizations involving
assets issued, insured or guaranteed by the federal government;
student loans made under the Federal Family Education Loan
Program; and seasoned loans are available. Even though not
labeled as an exemption, Fannie Mae and Freddie Mac, as
sponsors, may meet their risk retention requirements if they fully
guarantee the timely payment of principal and interest on all
ABS interests and are under conservatorship or receivership with
capital support from the United States.
Pepper Points:
Financial institutions will have to make business decisions
about whether to combine retention of horizontal residual and
vertical interests. As recognized by the Agencies, holding a single
vertical security provides financial institutions with the simplest
way to meet their risk retention requirements. Additionally, we
expect that financial institutions will be attracted to the vertical
security option because the disclosure requirements for fair value
only apply to eligible horizontal residual interests.
Financial institutions will be forced to choose whether they
will deal in ABS that qualifies for the 0 percent retention
requirement or if they will create ABS subject to the risk
retention requirements by pooling qualifying loans and nonqualifying loans. Depending on the availability of the assets that
meet the higher underwriting standards, strategies for successful
pooling with be critical for ABS with commercial mortgages,
commercial loans and automobile loans. However, qualifying for
an exemption under the heightened underwriting standards is
difficult and may prove to be a disincentive.
Because the risk retention requirements will require banks to list
the retained interests on their balance sheets, banks will have
to meet higher regulatory capital requirements. We expect this
development to spur the migration of certain financial products
away from banks to non-bank financial institutions, such as
hedge funds.
In light of the exemptions for QRMs and ABS of Fannie Mae
and Freddie Mac, a large segment of all RMBS will not be
covered by the risk retention requirements. This will incentivize
sponsors to market ABS with qualifying assets so as to avoid the
risk retention requirements.
Endnote
1. Due to the inclusion of CLOs without an exemption,
the Loan Syndications & Trading Association sued the
Securities and Exchange Commission and the Federal
Reserve in federal court, seeking review of the Agencies’
decision. The case is Loan Syndications & Trading Association
v. SEC, No. 14-1240 (D.C. Cir.).
www.pepperlaw.com
3