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Federal agencies issue proposed rule on credit risk retention

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Sep 03, 2013

On August 28, 2013, the SEC and five other federal agencies (The Office of the Comptroller of the Currency, Treasury; the Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Federal Housing Finance Agency; and the Department of Housing and Urban Development) jointly issued SEC Proposed Rule Release No. 34-70277, "Credit Risk Retention," that would implement certain requirements for issuers or sponsors (“securitizers”) of asset-backed securities (ABSs).

Under the proposed rule (which revises the agencies’ 2011 proposal), if certain conditions are met, securitizers would retain a portion of the credit risks associated with the assets collateralizing the ABSs under the requirements established by Section 15G of the Securities Exchange Act of 1934 in accordance with Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed risk retention requirements would apply to all securitizers of ABS offerings (i.e., regardless of whether the offering is registered with the SEC under the Securities Act of 1933).

One of the objectives of the proposed rule is to address what some believed to be a critical weakness in the securitization market that led to the financial crisis; namely, that some meaningful risks need to be retained to ensure that securitizers have the incentives to monitor the quality of the securities. Therefore, under the proposed rule, securitizers would be:

  • Required to retain no less than 5 percent of the credit risk of assets within an ABS.
  • Prohibited from hedging or transferring the credit risk they are required to retain.

The proposed rule changes the basis of the 5 percent retention requirement from the original proposal’s par value of ABSs issued in a securitization transaction (with a “premium capture” element aimed at preventing a securitizer from structuring a deal that could reduce its retained exposure below the minimum amount) to one measured on the fair value of the assets in an ABS, and it removes the premium capture component.

Like the original proposal, the proposed rule permits securitizers to select a form of risk retention from a menu of specified options, but it changes certain of the original proposal’s options. According to the agencies, allowing securitizers to select from a menu of options gives them the flexibility to choose a credit risk retention structure that is consistent with current securitization market practices. The options include:

  • Vertical risk retention, which is achieved by holding, at a minimum, 5 percent of the fair value of each class of ABS issued in a securitization transaction, regardless of whether the interest is “certificated.” Under this option, the securitizer would have an interest in the entire structure of the securitization transaction.
  • Horizontal risk retention, which is made up of “first-loss residual interest” retention, representing a minimum of 5 percent of the fair value of all ABS interests issued (the “eligible horizontal residual interest”). The interest may consist of either a single class or multiple classes in the issuing entity, but in either case the interest retained must represent the most subordinated ABS interest(s).
  • Any combination of vertical risk retention and horizontal risk retention in a total amount equal to 5 percent of the fair value of all ABS interests issued.

The proposed rule indicates that some offerings would be exempt from the risk retention requirements, including ABSs that are collateralized exclusively by qualified residential mortgages (QRMs), which the original proposal defined as loans that must be secured with a first lien on a “principal dwelling” and that meet certain specified criteria. Specifically, QRMs would have been required to (1) maintain certain loan-to-value and loan-to-income ratios, (2) include a minimum 20 percent down-payment from borrower funds, and (3) meet certain requirements related to payment terms and borrowers’ credit history. Rather than retaining the original definition, the proposed rule links the definition of QRMs to the definition of a “qualified mortgage” as defined by the Consumer Financial Protection Bureau. As stated in their joint press release on the proposed rule, the agencies are requesting “comment on an alternative definition of QRM that would include certain underwriting standards in addition to the qualified mortgage criteria.”

ABSs that would continue to be excluded from the proposed rule’s credit risk retention requirements include (1) commercial loans, (2) commercial mortgages, (3) low credit risk auto loans, and (4) guaranteed Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) loans while such loans are in conservatorship or receivership and have capital support from the U.S. government. In addition, certain disclosures would be required about an issuer’s interest in a securitization transaction.

For securitization transactions collateralized by residential mortgages, the risk retention requirements would be effective one year after the date of their publication in the Federal Register. For any other securitization transaction, they would be effective two years after that date.

Comments on the proposed rule are due by October 30, 2013.

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