Analysis of Dodd-Frank Act: Risk Retention For Securitizers
September 3, 2010
Section 941 of the Dodd-Frank Act (“Act”), titled “Regulation of Credit Risk Retention,” was included in the Act to protect investors by creating incentives for issuers and sponsors of asset-backed securities to focus more on collateral quality. The Act adds a new section 15g to the securities Exchange Act of 1934. Underlying the new law is the belief that the ability of originators of assets (including residential mortgage loans) and issuers of various types of asset-backed securities to generate substantial fees from securitizing loans and transfer them without residual liability contributed to the mortgage crisis. These conditions created incentives for originators to generate loan volume and focus less on loan quality. Section 941 of the Act requires securitizers and originators to retain an interest in securities generally in the amount of 5% and to provide additional disclosures to help investors to independently assess credit quality. This Bulletin analyzes the retention requirement.
The Act delegates broad authority to the FDIC, Federal Reserve Board, and the OCC (designated as the Federal banking agencies) and the SEC (together with the Federal banking agencies collectively referred to in this Bulletin as the “Agencies”) to develop regulations implementing the risk retention rule. A separate rulemaking is mandated specifically for ABS’s backed by residential mortgage assets, and these regulations are to be developed jointly by the Agencies together with HUD and the Federal Housing Finance Agency. The chairperson of the Financial Stability Oversight Council is given the authority to coordinate all joint rulemaking required under Section 941. The regulations must be issued in final form within 270 days of the Act’s enactment. The regulations become effective one year after publication of the final rules for securitizers and originators of ABS’s backed by residential mortgages, and two years after publication for all others, as described in more detail below.
The key definitions set forth in Section 941 are of “asset-backed security,” “securitizer,” and “originator.”
“Asset-backed security” or ABS is defined in new subsection (77) in Section 3(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)) as: “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or un-secured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including—
- a collateralized mortgage obligation;
- a collateralized debt obligation;
- a collateralized bond obligation;
- a collateralized debt obligation of asset-backed securities;
- a collateralized debt obligation of
- collateralized debt obligations; and
- a security that the Commission, by rule, determines to be an asset-backed security for purposes of this section, and does not include a security issued by a finance subsidiary held by the parent company or a company con- trolled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.
Concerns have been expressed that there is no explicit exemption for collateral loan obligations (CLO’s), but the Agencies have broad discretion to include CLOs in the definition.
The term “securitizer” is defined as: an issuer of an ABS or a person who organizes and initiates an ABS transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.
The term “originator” means a person who creates a financial asset (such as by extending credit) that collateralizes an ABS and sells the asset to a securitizer.
The statutory definitions do not appear to clearly distinguish who is an originator or securitizer in all instances. For example, issuers of collateralized debt obligations or CLO’s can be special purpose vehicles that already hold the underlying assets and presumably the credit risk. Thus, one of the issues to address during the notice and comment period for the regulations is whether the Agencies should exercise their exemption authority (discussed below) with respect to these types of securities or issuers.
The Act establishes several standards that the agencies must conform to when developing the regulations.
No Hedging or Transferring Risk. In order to preserve the incentive value of the statute, the regulation must stipulate that a securitizer may not hedge or transfer the credit risk required to be retained. The use of credit default swaps and other forms of hedging instruments was another concern (addressed in Title VII of the Act), especially among parties other than those who have a direct interest in the assets and securities.
Retention Amount. The required credit risk retention amount varies depending on whether the underlying assets are “qualified residential mortgages” (which as discussed below are exempt) and whether the originator meets certain underwriting standards. The amount of risk required to be retained by securitizers is not less than five percent if any of the assets that collateralize the ABS is an asset other than a qualified residential mortgage. The retention amount is less than five percent if the originator of the asset (other than a qualified residential mortgage) meets the underwriting standards consistent with low credit risk as described below at Asset Classes.
The statutory language does not define credit risk or specify how the retained interest is to be allocated across the underlying assets. As with many other issues, these questions will be handled through rulemaking.
Other Standards. The regulations must specify the permissible forms of risk retention and how long the risk must be retained. With respect to an underlying asset that is a commercial mortgage, the Agencies have the authority to do the following: (1) where a third party negotiates to purchase the first-loss position, set the minimum financial resources of such purchasers as necessary to back losses, impose due diligence requirements, and apply comparable risk retention requirements for purchasers; (2) make a determination regarding the adequacy of the underwriting standards and controls for the asset; and (3) determine the adequacy of representations, warranties, and related enforcement mechanisms.
The regulations will set forth an allocation of risk retention obligations between a securitizer and an originator where a securitizer purchases assets from an originator. The allocation will reduce the securitizer’s risk by the percentage of risk retained by the originator and thus not increase the aggregate risk retained, and consider the presence of low credit risk conditions (see Asset Classes section below), whether there are market incentives for imprudent origination practices, and the potential impact of the risk retention obligations on the accessibility of affordable credit. The regulation will also specifically state that insured depository institutions that are securitizers are not exempt.
Other Types of Securities. The Act singles out certain securities for special treatment in the regulations, such as collateralized debt obligations, securities collateralized by collateralized debt obligations, and similar instruments collateralized by other ABS’s.
The Act empowers the Agencies to create a total or partial exemption of any securitization as may be appropriate in the public interest and for the protection of investors. Specifically, the Agencies will, by regulation, totally or partially exempt (1) the securitization of an asset issued or guaranteed by the United States or an agency ; (2) any ABS that is a security issued or guaranteed by any state or political subdivision of a state or territory, or by any public instrumentality of a state or territory that is exempt from SEC registration requirements under 15 U.S.C. Section 77c(a)(2); or (3) a security defined as a qualified scholarship funding bond (150(d)(2) of the Internal Revenue Code of 1986).
Under a separate provision of the Act, the Agencies also have discretionary authority to establish “exemptions, exceptions, and adjustments” (hereafter “exemptions”) including for classes of institutions or assets and the prohibition on hedging. Any exemption adopted must help ensure high quality underwriting standards, encourage appropriate risk management practices, improve access to credit, as well as be in the public interest and for the protection of investors.
The Act itself creates exemptions for the following:
- assets made, insured, guaranteed, or purchased by any institution that is subject to the supervision of the Farm Credit Administration, including the Federal Agricultural Mortgage Corporation.
- residential, multifamily, or health care facility mortgage loan asset, or securitizations based on these assets, which are insured or guaranteed by the United States or an agency .
Significantly, the Act also establishes an exception for a “qualified residential mortgage.” This represents a victory of sorts for the mortgage industry, who successfully argued that residential loans that are soundly underwritten do not present the same kind of risks as other assets. The term is to be defined jointly by the Federal banking agencies, SEC, HUD, and the Federal Housing Finance Agency. It is similar to a “qualified mortgage” defined in Title XIV of the Act (titled the “Mortgage Reform and Anti-Predatory Lending Act”). In that section, an originator enjoys a safe harbor in connection with a claim that it failed to assess a borrower’s ability to repay a mortgage but only if the mortgage is a qualified mortgage. The responsible agencies may not define qualified residential mortgage to be broader than the definition for qualified mortgage in Title XIV.
In issuing the joint regulation here, the named agencies are to examine historical data to determine the kinds of underwriting and product features that indicate lower default risks. The Act lists some of the factors to consider:
- documentation and verification practices
- standards related to various debt to income ratios
- ways to mitigate payment shock
- mortgage guarantee insurance and other types of insurance or credit enhancement that reduces the risk of default, and
- regulation of terms and features that are associated with higher default risks, such as balloon payments, negative amortization, prepayment penalties, and interest-only payments.
Issuers of ABS’s that are collateralized exclusively by qualified residential mortgages are required to certify to the SEC, in each instance, that the issuer has evaluated the effectiveness of its internal supervisory controls to ensure that all assets are so qualified. As discussed above, regardless of the presence of qualified residential mortgages, an ABS that is collateralized by tranches of other ABS’s may not be exempt from the risk retention requirements.
Asset Classes. The regulations must establish separate rules for securitizers of different classes of assets, including residential mortgages, commercial mortgages, commercial loans, auto loans, and any other class of assets in the discretion of the Agencies. Underwriting standards are to be established that specify the terms, conditions, and characteristics of a loan within each asset class that meet the criterion of a low credit risk. As discussed above, compliance with regulatory underwriting standards has implications for the amount of the required risk retention and the allocation of retention between a securitizer and originator in certain circumstances.
Enforcement. With respect to securitizers that are depository financial institutions, the regulations to be issued will be enforced by the appropriate Federal banking agency. All other securitizers are within the jurisdiction of the SEC.
Study and Report. The Federal Reserve Board, in coordination and consultation with the OCC, OTS, FDIC, and SEC, is required to conduct a study of the impact of the retention requirements and of Financial Accounting Statements 166 and 167 on each individual class of ABS established pursuant to Section 941. Within 90 days after enactment, the Board is required to submit the study to Congress.
- For purposes of this provision, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation are not agencies of the United States.
- The Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Federal home loan banks are not considered U.S. Agencies for purposes of this provision.
The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.
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