On March 30, the SEC, jointly with five other federal agencies, issued a proposed rule to implement requirements for issuers or sponsors (“securitizers”) of asset-backed securities (ABSs). Under the proposed rule, securitizers would retain a portion of the credit risks associated with the assets collateralizing the ABSs, in accordance with (1) Section 15G of the Securities Exchange Act of 1934 and (2) Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. 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. To ensure that securitizers have the incentives to monitor the quality of the securities, the SEC believes that some meaningful risks need to be retained. 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 that they are required to retain.
• Required to apply a “premium capture” mechanism, in which a securitizer is prevented from structuring a deal that could reduce its retained exposure below the minimum amount.

The proposal permits securitizers to select a form of risk retention from a menu of specified options, which is intended to allow them some flexibility in retaining credit risks. Among the options are:

• Vertical risk retention achieved by holding, at a minimum, 5 percent 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 made up of a “first-loss residual interest” retention, representing a minimum of 5 percent of the par value of all ABS interests issued.
• L-shaped risk retention (i.e., an equal combination of vertical and horizontal retentions).
• Premium capture cash reserve account prohibiting the distribution of “excess spread” cash flows (or cash proceeds from ABS sales) to the securitizer. This option is intended to prevent scenarios in which a securitizer recoups more than its minimum required risk retention, often early in the life of the underlying mortgages.

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). To qualify as QRMs, underlying loans must meet certain criteria specified in the proposed rule, including (1) maintaining certain loan-to-value and loan-to-income ratios and (2) meeting certain requirements for payment terms, minimum down payments, and borrowers’ credit history. On the basis of preliminary feedback, the SEC expects to receive comments and questions about the proposed QRM requirements, including whether the term “QRM” is appropriately defined.

In addition, the proposed rule requires disclosure of material information related to the securitizer’s interest in a securitization transaction. The purpose of such disclosure is to provide investors with sufficient information to monitor the securitizer’s compliance with the risk retention requirements.

Comments on the proposed rule are due by June 10, 2011.