The following is a brief memo outlining the impact of the final risk retention rules on the securitization of residential mortgage loans.

Overview

In October 2014, the final Credit Risk Retention rules were adopted by the six federal agencies charged with jointly promulgating those rules as mandated by Section 941 of the Dodd-Frank Act.  These rules apply generally to "asset backed securities" as defined in Section 3(a)(79) of the Securities Exchange Act of 1934 (as added pursuant to the Dodd-Frank Act), which is a broadly worded definition that generally encompasses all residential mortgage-backed securities (RMBS) and other types of asset-backed securities (not including synthetics).  Accordingly, the risk retention requirements will apply to all RMBS issued in the United States on or after the applicable effective date, regardless of whether publicly offered or sold under Rule 144A or another private exemption, unless an exemption from the risk retention requirements is available.

The rules were originally proposed in March 2011, and were re-proposed in August 2013 with significant changes from the original proposal (including removal of the premium capture reserve account concept). 

Required Amount and Permitted Forms of Risk Retention

The rules require a minimum retention of 5% of the credit risk of the securitized assets, for asset-backed securities subject to this requirement.  The rules provide a standard menu of options for how risk may be retained.  For RMBS, there are no additional asset specific options, therefore only the standard options are available.

Generally, the risk retention requirements are imposed on the sponsor of the securitization.  See "Who Must Hold Risk Retention" below for a further discussion.

The standard options for risk retention are:

• An "eligible vertical interest" of at least 5%.  In this case, the percentage may be measured by face or notional amount.  This may be a single class representing a pro rata 5% interest in the issuing entity, or it may be a 5% share of each and every class of “ABS Interests” (which is defined to exclude a non-economic residual interest in a REMIC).
• An "eligible horizontal residual interest" (EHRI) of at least 5% measured by fair value.  This may consist of one or more classes, but must be fully subordinated on a cash flow basis to all contractual interest and principal payable on each payment date to all other classes (other than a non-economic REMIC residual).
  • Any portion of an EHRI may alternatively be held in an "eligible horizontal cash reserve” meeting specified requirements.
  • Fair value must be determined under a measurement framework acceptable under GAAP.
• Any combination of an eligible vertical interest and an eligible horizontal residual interest totalling at least 5%.
• In each case the percentage is tested as of the closing date.

The final rules do not permit a representative sample option, as had been included in the initial proposal.  Also the final rules do not permit retention in the form of a 5% pro rata participation in each asset, as had been requested by some commenters.

Disclosure Issues

While the final rules eliminated a proposed cash flow restriction on the rate of pay down of any eligible horizontal residual interest, the rules do contain extensive disclosure requirements, which are particularly complex as they pertain to fair valuation of an eligible horizontal residual interest.

A sponsor using the standard options for risk retention must provide certain required written disclosures a "reasonable time" prior to the sale of any security in the same offering, and again a “reasonable time” after the closing of the securitization.  The final rules and adopting release do not contain any guidance as to what would be a “reasonable time” for this purpose.

Where an EHRI is used, the sponsor mandatory pre-sale disclosure is quite extensive, and includes the following items (partial list only):

• The fair value of the EHRI expected to be retained as a percentage of the fair value of all ABS interests to be issued, or a range of fair values based on estimated prices
• Description of the valuation methodology used to calculate fair value
• All key inputs and assumptions in the fair value calculation including the following
  • Discount rate
  • Loss given default rate
  • Prepayment speed
  • Default rates
  • Lag time between default and recovery
  • Forward interest rates
• If the above disclosure includes description of a curve, the methodology used to derive the curve and “a description of any aspects or features of each curve that could materially impact the fair value calculation or the ability of a prospective investor to evaluate the sponsor’s fair value calculation.”
• Summary description of any reference data set or historical information used to develop key inputs and assumptions, including loss given default rate and default rate

The mandatory post-closing disclosure for an EHRI includes the fair value based on actual sale prices and tranche sizes, as well as any material differences in the fair valuation methodology from pre-sale to post-closing.

For a sponsor using vertical retention, the required disclosure is much simpler because no fair value calculation is required.  The pre-sale disclosure includes the form and material terms of the vertical interest, the required percentage, and the amount expected to be retained at issuance. Post-closing disclosure is required only if there was a material change.

Who Must Hold Risk Retention

Interests in the transaction that are retained to satisfy the risk retention requirements must be held by the sponsor, except as otherwise permitted as discussed below.

Sponsor definition

"Sponsor" is defined in the rules as "a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity."  The final rules also define “securitizer” as either the depositor or the sponsor, but the risk retention obligation falls on the sponsor.

While the risk retention “sponsor” definition is substantially the same definition as appears for the term in Regulation AB II, under risk retention there are additional nuances added to the meaning which must be taken into account.

The SEC adopting release includes an extensive discussion on the meaning of the term “sponsor”.  The agencies indicate that, in order for a person to be a sponsor for purposes of the risk retention rules, “the party must have actively participated in the organization and initiation activities that would be expected to impact the quality of the securitized assets underlying the asset backed securitization transaction, typically through underwriting and/or asset selection.”  The agencies place critical importance on the “organization and initiation” criteria in the definition, and less importance on where the party falls in the chain of transfer to the issuing entity.

Additional discussion in the adopting release states:

"an entity that serves only as a pass-through conduit for assets that are transferred into a securitization vehicle, or that only purchases assets at the direction of an independent asset or investment manager, only pre-approves the purchase of assets before selection, or only approves the purchase of assets after such purchase has been made would not qualify as a “sponsor”…" and  "…negotiation of underwriting criteria or asset selection criteria or merely acting as a “rubber stamp” for decisions made by other transaction parties does not sufficiently distinguish passive investment from the level of active participation expected of a sponsor or securitizer." [SEC Release No. 34-73407, pp. 33-34.]

Generally, for consistency, we would recommend that the party identified as sponsor for risk retention purposes should have taken actions in the transaction that are normally taken by the sponsor, including conducting the pre-offering review or engaging (or having reliance letters from) the third party diligence providers, and also making Form ABS-15G filings both as to reps and warrants (Rule 15Ga-1) and third party diligence prior to issuance (Rule 15Ga-2).  However, the adopting release does note that the party who is "sponsor" for risk retention purposes may not necessarily be the "sponsor" as that term is used in other rules.

Multiple sponsors

The rules provide that if there is more than one entity that meets the definition of “sponsor” for a transaction, each sponsor is legally required to ensure that at least one of the sponsors holds the required risk retention.  Risk retention would only be satisfied if one of the sponsors held the entire required 5% retention.  The parties could agree by contract which one would hold the retention, but as indicated in the rule the legal obligation to ensure that one sponsor actually held the required risk retention would fall on all sponsors.

While the adopting release does not make this entirely clear, it appears that this rule is intended in part to address situations where multiple sellers transfer assets directly to the depositor, and each such seller exercises control over asset selection on the loans that it sold such that it could be considered the sponsor.  However, the discussion relevant to tender option bonds indicates that “it is possible that more than one party could meet the definition of sponsor in the rule” and that “depending on the specific facts and circumstances of the issuance and how the parties structure the transaction, either the arranging bank or the residual holder could be designated as the sponsor in accordance with the final rule.”  Based on this language, where there are two or more parties (related or unrelated) in the chain of transfer of a pool of assets to the depositor who each had sufficient involvement in the origination and initiation activities such that either could appropriately be viewed as sponsor, it is possible that the parties could in effect determine by contract which one will be required to hold the risk retention.

Majority Owned Affiliate

The final rules generally permit a sponsor to transfer any of its required risk retention to a “majority-owned affiliate” (MOA).  A “majority-owned affiliate” of a person is an entity that directly or indirectly, majority controls, is majority controlled by or is under common majority control with the person.  Under the rule, “majority control” means owning more than 50% of the equity of an entity, or having any other controlling financial interest under GAAP.  This does not include all consolidated entities, or all affiliates in a broader sense.  For example, various funds managed by a common manager would not be MOAs solely as a result of the common management, but only would be if there was majority control as so defined.

Originator

For any originator that originated at least 20% of the assets in the pool, the originator and the sponsor can agree by contract that the originator will hold a portion of the risk retention.  There is no legal or regulatory obligation of an originator to agree to do so.

If a portion of the risk retention is to be transferred to an originator, the portion must be in proportion to the assets originated by the originator, and the form of retention (vertical, horizontal or combination) must be the same as is held by the sponsor.

Hedging, Transfer and Financing Restrictions

A retaining sponsor is prohibited from hedging by transacting in any security, financial instrument, agreement, derivative or other position, if payments on the position are materially related to the credit risk of the retained interests or the underlying pooled assets, and the position in any way reduces the credit risk of the retained interests or the underlying pooled assets.  However there are exemptions from the hedging prohibitions for interest rate and currency hedging, and for positions in an ABS index subject to certain limitations.

The retaining sponsor in an RMBS transaction is required to hold the retained interests, directly or through an MOA, until the later of 5 years after the securitization closing date, or the date when the residential mortgages have paid down to 25% of the closing date balance, but in no event more than 7 years after the securitization closing date.

A retaining sponsor or MOA may pledge the retained interests as collateral in a financing transaction, provided that the financing is with full recourse to the sponsor or MOA.

Qualified Residential Mortgages

The final rules provide an exemption from the risk retention requirements for RMBS backed entirely by Qualified Residential Mortgages (QRM).  QRM is defined to be equal to the “qualified mortgage” (QM) definition established by the CFPB under the ability-to-repay rules, which became effective in January 2014.  Because the QRM definition simply incorporates the QM definition without reference to its effective date, the plain reading is that a loan will be considered a QRM if it complies with the words of the QM definition, even if the loan was originated prior to January 2014.  However, there may be practical difficulties in evaluating whether a loan complied with the QM definition, if this determination was not made at origination.

Additional requirements for the QRM exemption include:

• All assets must be QRMs or servicing assets, none can be non-QRMs or asset-backed securities
• As of the cut-off date, each QRM must be currently performing (not 30 or more days past due)
• The depositor must certify that it has evaluated its internal controls for ensuring that each asset is a QRM or servicing asset and has concluded the controls are effective.  This certification must be provided to investors a “reasonable period of time” prior to the first sale in the offering.

If after issuance the pool is found to contain a non-QRM, there is a mechanism for preserving the exemption by buying the non-QRM from the pool at par.

There is no QRM blend concept that would have allowed a reduced risk retention requirement based on the percentage of non-QRMs in the pool, as some commenters had requested.

The final rules contemplate that the agencies will revisit the definition of QRM after five years.

Other Exemptions

In addition to QRM, there are the following exemptions of note:

• Fannie Mae and Freddie Mac, while in conservatorship, have the benefit of a provision that for securities sponsored by them, their guaranty satisfies risk retention.
• There are additional exemptions for securitizations insured or guaranteed by the US or an agency of the US, or any securitization sponsored by the FDIC as receiver or conservator.
• There is an exemption for seasoned loans.  To qualify, all loans must never have been modified and never have been delinquent 30 days or more.  In addition, each loan must have been outstanding and performing for the longer of 5 years or until the loan has paid down to 25% of original balance, or alternatively the loan must have been outstanding and performing for 7 years.
• Certain “community-focused residential mortgages” are exempt from risk retention.  These are loans to lower and middle income borrowers by non-profit and other community focused lenders.  These loans are technically not QMs under the CFPB rules.  A pool consisting solely of these loans is exempt from risk retention, and there is a blending provision allowing a reduced risk retention where these loans are combined with other loans that do not qualify for an exemption from risk retention.
• There is also an exemption for 3-4 unit mortgage loans, which are technically not QMs.  If these loans otherwise meet the QM criteria, they are exempt from risk retention, and they can be combined with QRMs in a pool that will be exempt from risk retention.

Resecuritizations

There is an exemption for “pass-through resecuritizations”, which have only a single class of ABS interests that pass through payments received on the underlying ABS.  However, the underlying ABS themselves must all be either risk retention compliant, or must have an exemption from risk retention.  For this purpose, issuance prior to the effective date of the rule is not an exemption.

There is a further exemption for “first-pay-class securitizations”, backed by first-pay classes of first lien RMBS, where the resecuritizaton classes reallocate prepayment risk but do not reallocate credit risk, so that losses are shared pro rata based on the then outstanding balances of the classes.  Again however,   the underlying RMBS themselves must all be either risk retention compliant, or must have an exemption from risk retention.  Further consideration could be given as to whether a legacy RMBS backed solely by loans meeting the QM definition could be considered exempt for purposes of these provisions.

Aside from the foregoing exemptions, resecuritizations are generally subject to risk retention.  We view the 2-year effective date (and described below) as applicable to resecuritizations of RMBS, because the pooled assets in the resecuritization are RMBS, not residential mortgages.  The SEC treats residential mortgages on the one hand, and RMBS as underlying securities in a resecuritization on the other hand, as separate and distinct asset types, as indicated by the foregoing limited exemptions for resecuritizations, and also as indicated in Regulation AB II where there are separate asset level data requirements for these different asset types.

Cross-border Issues

There is a foreign-related exemption for a securitization meeting these criteria:

• Not US registered offering
• 10% limit by "dollar value" of all interests sold to US persons (defined in a manner similar to Reg. S) in initial distribution - tested at issuance only - secondary sales to US persons not counted (unless contemplated at issuance)
• Sponsor and issuing entity not US chartered (including a US chartered entity operating through a  branch outside US), and not non-US chartered entity operating through a US branch
• Not more than 25% of the pooled assets acquired from a MOA of the sponsor in the US, or a US branch of the sponsor

Effective Date

All securitizations backed by residential mortgages, issued on or after December 24, 2015, must comply with risk retention unless exempt.

All securitizations backed by all other asset types, issued on or after December 24, 2016, must comply with risk retention unless exempt.