On August 28, 2013, a consortium of U.S. banking, housing and securities regulators (the “Agencies”) re-proposed the joint regulations (the “Re-Proposed Rules”), to implement Section 15G of the Securities Exchange Act of 1934. Section 15G requires the Agencies to prescribe joint regulations to require “any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.” This has popularly been referred to as a “skin in the game” requirement intended to align the interests of those originating or aggregating loans with the interests of investors in securitizations of those loans. The Re-Proposed Rules are the Agencies’ second attempt at rulemaking under Section 15G, the first coming with proposed joint regulations released on April 14, 2011 (the “Initial Proposed Rules”).
Both the Initial Proposed Rules and the Re-Proposed Rules would generally require a “securitizer” to retain at least 5 percent of the credit risk associated with the assets backing a securitization transaction, subject to various exemptions and offsets. The Initial Proposed Rules prescribed some basic forms of risk-retention that could be used in any type of securitization, as well as some forms of risk-retention that would apply only to specific types of securitizations (such as those involving revolving asset master trusts, which are common to credit-card and automobile floorplan securitization, CMBS transactions, certain federal agency securities issuances, and ABCP conduits). The Re-Proposed Rules appear to be dramatically simpler than the Initial Proposed Rules and address many of the more significant issues presented by the Initial Proposed Rules. Nevertheless, the Re-Proposed Rules present a number of issues of their own.
Requirements of the Re-Proposed Rules
For purposes of the Re-Proposed Rules, a “sponsor” is the person that organizes or initiates a securitization. To accommodate the broad definition of the entity that could be required to hold “skin in the game,” the Agencies have moved away from a rigid list of acceptable risk-retention strategies by proposing a more flexible blended risk-retention option. Under that formulation, a sponsor could satisfy its risk-retention obligation by retaining an “eligible vertical interest,” an “eligible horizontal residual interest,” or any combination of the two, as long as the retained interest is not less than 5 percent of the fair value of all ABS interests in the issuing entity that are issued as part of the securitization.
The eligible horizontal interest requirement may be satisfied through the use a single class or multiple classes of ABS interests that constitute the first loss piece of the securitization. The eligible vertical interest requirement may be satisfied through use of a “single vertical security” that entitles the holder to a specified percentage of the payments on each class of ABS interest or through retaining a 5 percent of the fair value of each class of ABS interests issued. Any combination of the two may be used in any proportion in order to satisfy the risk-retention requirements.
A sponsor can offset the amount of retained interest that is held by a significant originator of loans in the securitization against the sponsor’s risk-retention requirement. The offset must be in the same proportion that the loans originated by the originator represent to the aggregate loans in the securitization (measured by unpaid principal balance). The originator offset may only be applied against originator originated loans that represent 20 percent or more of the aggregate loan balance in the securitization. Additionally, a sponsor may only offset a risk-retention interest held by an originator if that originator acquired its interest for cash or in exchange for the securitized assets. A sponsor would need to have controls in place, and would need to monitor originators, as the sponsor maintains responsibility for ensuring compliance with the risk-retention requirement. Where there are multiple sponsors, the responsibility for retained risk could be allocated among the sponsors, but each sponsor would be obligated to ensure compliance with the applicable risk-retention requirements.
Like the Initial Proposed Rules, the Re-Proposed Rules contain several exemptions to the risk-retention requirements. The most-discussed of these exemptions are the zero risk-retention requirements for securitizations that are backed by of qualifying assets and that and satisfy other conditions (e.g., disclosures, certifications, and buy-back requirements).
Qualifying assets consist of residential mortgage loans, commercial mortgages, commercial real estate loans, and automobile loans that in each case meet specified underwriting criteria. While qualifying assets are not a new concept, having already been worked into the Initial Proposed Rules, the Re-Proposed Rules take into account the input of industry leaders in the origination of loans in identifying more workable definitions for qualifying assets (in particular, there was much consternation surrounding the definition of a qualifying auto loan under the Initial Proposed Rules, whose definition has been altered significantly in response). Perhaps most importantly, not every asset in a securitization will need to be a qualifying asset in order to take advantage of this exemption. The Re-Proposed Rules allow the securitizer to reduce their 5 percent risk-retention requirement by the ratio of the combined unpaid principal balance of qualified assets bears to the total unpaid principal balance of the assets in the pool.
Additionally, the Re-Proposed Rules exempt securitizations of seasoned loans from the risk-retention requirements. The Agencies have taken the view that seasoned loans have had a sufficient period of time to prove their performance. In a similar vein, prohibitions on the transfer of retained risk sunset after a period of time equivalent to the seasoning period in the regulations. From a common sense standpoint, securitizations backed by loans that have been paying down for longer substantial portions of their life are less likely to have origination defects that an originator or sponsor of a securitization could avoid during the underwriting process.
There are also other exemptions from the risk-retention requirements for certain categories of transactions. In general terms, these include securitizations that are guaranteed or insured by the U.S. government or a government-sponsored enterprise such as Fannie Mae, Freddie Mac, Ginnie Mae, or Farmer Mac, securitizations that are sponsored by the FDIC as conservator or receiver and securitizations that are issued or guaranteed by a state and certain student loan bonds. They also include resecuritizations that are backed solely by servicing assets and tranches of ABS transactions that adhere to the risk-retention requirements and structured as a single class of ABS pass-through interests or are collateralized solely by servicing assets and first-pay classes of residential mortgage-backed securities that satisfy or are exempt from the risk-retention requirements, that are structured to reallocate prepayment risk and not credit risk and that do not include inverse floaters or similarly structured ABS interests.
Additionally, the Re-Proposed Rules exempt ABS issued by regulated electric utilities that are backed by stranded costs, transition property, system restoration property, and other types of property specifically created or defined for regulated utility-related securitizations by state legislatures. Specifically, the Re-Proposed Rules would exempt any securitization transaction where the ABS are issued by an entity that is wholly owned, directly or indirectly, by an investor-owned utility company that is subject to the regulatory authority of a state public utility commission or other appropriate state agency. Additionally, ABS issued in an exempted transaction would be required to be secured by the intangible property right to collect charges for the recovery of specified costs and such other assets of the issuing entity.”  The Re-Proposed Rules would define “specified cost” to mean any cost identified by a state legislature as appropriate for recovery through securitization pursuant to “specified cost recovery legislation.”
Important Differences between the Initial Proposed Rules and the Re-Proposed Rules
Although the Agencies have kept the basic structure of the risk-retention rules similar, there are some significant differences between the Initial Proposed Rules and the Re-Proposed Rules. These rules will cause issues for various securitization markets, which are as diverse as the markets themselves are. CLOs, for example, will face different challenges than ABS backed by residential mortgage loans. Despite many similarities to the Initial Proposed Rules, the Re-Proposed Rules reflect some significant differences in approach from that reflected in the Initial Proposed Rules. Market participants will need to be aware of some significant new wrinkles.
Definition of QRM
A key feature of the Initial Proposed Rules was an exemption from the credit risk-retention requirement for securitized pools entirely backed by qualified residential mortgages (“QRMs”) that are underwritten to specified requirements prescribed by regulation. While this feature has not changed, the definition of a QRM has been vastly simplified by simply cross-referencing to the definition of “qualified mortgage,” a very similar concept, under Section 129C of the Truth in Lending Act and regulations promulgated thereunder. This change avoids the potential for increased compliance burden and unintended consequences that would be present in any definition of QRM not aligned with “qualified mortgage.”
Premium Capture Cash Reserve Account and Fair Valuation
To the relief of many, the Re-Proposed Rules would eliminate the “premium capture reserve account.” Under the Initial Proposed Rules, securitizers would have been required to establish a separate “premium capture cash reserve account” to capture excess spread throughout the life of a transaction until all ABS were paid in full. This was intended to prevent a securitization sponsor from using up-front profits of excess spread monetization to mitigate losses that might arise in tranches that it would be required to retain.
Rather than retaining this feature, which was the subject of much consternation throughout the industry, the Re-Proposed Rules provide that the 5 percent risk-retention requirement would be calculated on the basis of fair value of the securitization determined in accordance with U.S. GAAP rather than based on par value of tranches measured as of the pricing of the transaction. This change effectively increases the value of the retained interest from what it would have been under the Initial Proposed Rules. Owing to this change, the Re-Proposed Rules do not include a premium capture cash reserve account requirement. It is important to note that the methodology for calculating the fair value will be required to be disclosed to investors.
Sales and Hedging of the Retained Risk
While both the Initial Proposed Rules and the Re-Proposed Rules permitted the credit risk to be retained by the originator of the underlying assets under certain circumstances, the Initial Proposed Rules would have prohibited the sponsor or originator from hedging the credit risk, pledging the retained asset or interest as collateral for any obligation, or selling or transferring any retained asset or interest to any person other than a majority-owned affiliate throughout the life of the securitization. The Re-Proposed Rules retain that prohibition but significantly shorten the period of time during which it is effective.
For securitizations where all securitized assets are residential mortgages, the prohibitions expire beginning five years after the date of closing, after the total unpaid principal balance of the residential mortgages has been reduced to 25 percent of the unpaid principal balance at closing, but in all cases, not later than seven years after transaction closing. For other securitizations as well as transfers of the horizontal residual interest in CMBS securitizations, the prohibitions on hedging referenced above expire on the date that is the latter of (1) when the total unpaid principal balance of the securitized assets that collateralize the transaction has been reduced to 33 percent of the original unpaid principal balance at closing, (2) when the total unpaid principal obligations under the ABS interests issued under the securitization transaction has been reduced to 33 percent of the unpaid principal obligations of the ABS interests at closing, or (3) two years after the securitization transaction closing.
With respect to CMBS, the Re-Proposed Rules, similar to the Initial Proposed Rules, allow a third-party purchaser – typically referred to as a “B-piece buyer” – to acquire the retained risk in the form of a first-loss piece horizontal slice of the securitization. However, under the Re-Proposed Rules, a B-piece buyer or a sponsor that initially retained an eligible horizontal residual interest to transfer that interest to a subsequent qualified third-party purchaser five years after the date of the securitization closing.
This change reflects the Agencies’ acknowledgment that losses due to underwriting quality occur early in the life of a securitization. Further along in the transaction, risk-retention will do little to improve the underwriting quality of ABS, as most subsequent losses are due to events unrelated to the underwriting process.
L-Shaped Structuring Flexibility/Removal of Representative Sample
The Initial Proposed Rules permitted a sponsor to comply with the risk-retention requirement by retaining a pari pasu interest in a representative sample of assets that are materially similar to the securitized assets and held on its balance sheet. This branch of the Initial Proposed Rules was substantially similar to the rule applied by the FDIC to banks issuing securitizations over the last few years. The representative sample approach would have favored securitization sponsors that have large balance sheets and that do not rely on securitization for all of their funding needs. However, the representative sample method of risk-retention set forth under the Initial Proposed Rules has been removed entirely. Since the Re-Proposed Rules will supersede the old rule as applied by the FDIC, banks which were making use of the representative sample method of risk-retention will need to adjust their securitization strategies.
However, securitizers will have increased flexibility in structuring their risk-retention as the horizontal slice and the vertical slice, if used in the same transaction, are no longer required to be equal under the Re-Proposed Rules. Under the Initial Proposed Rules, the vertical and horizontal slice needed to be effectively equal. Securitizers under the Re-Proposed Rules may use any combination of horizontal and vertical slices, allowing them much greater leeway in finding a structure that works for them.
The Initial Proposed Rules did not allow the zero risk-retention option for qualified assets to apply unless all of the assets underlying the securitization were qualifying assets. The Re-Proposed Rules are more permissive, allowing a securitization sponsor to benefit from a proportional reduction of the risk-retention requirement for homogenous pools that consist only in part of qualifying assets. The Re-Proposed Rules would permit a securitizer to reduce its risk-retention requirement by the ratio of the combined unpaid principal balance of qualified loans to the total unpaid principal balance of the loans in the pool, with a floor of 2.5 percent risk-retention for any securitization that includes both qualifying and non-qualifying assets. However, any non-qualifying assets would be subject to full risk-retention requirements. An important limitation to this flexibility is that the blended exemption described above would not apply to a securitization that includes mixed asset classes. Additionally, in order to benefit from the risk-retention relief for blended pools the sponsor would be required to disclose to investors a description of the qualifying and non-qualifying groups, how they differ and the risk-retention calculation methodology.
The treatment of CLOs was one of the more controversial aspects of the Initial Proposed Rules and remains controversial in the Re-Proposed Rules. The Initial Proposed Rules did not distinguish CLOs from true sale securitization, and, in the infamous footnote 42 of the Initial Proposed Rules, the SEC suggested that the CLO manager was the sponsor and as such the party required to retain risk. In response to comments that observed that CLO managers would typically not have the financial capacity to hold risk-retention, the Re-Proposed Rules provide that for “open market CLOs” the risk-retention requirement may be satisfied by the lead arrangers of loans purchased by the CLO rather than by the CLO manager. An “open market CLO” is a CLO (1) whose assets consist only of senior, secured syndicated loans constituting CLO-eligible loan tranches that are acquired directly in open market transactions and of servicing assets, (2) that is managed by a CLO manager, and (3) that holds less than 50 percent of its assets in loans syndicated by lead arrangers that are affiliates of the CLO or originated by originators that are affiliates of the CLO. Pursuant to this option, the lead arranger is defined as the institution that: (1) is active in the origination, structuring, and syndication of commercial loans transactions and played a primary role in the structuring, underwriting, and distribution on the primary market of the CLO-eligible loan tranche; (2) took an allocation of the syndicated credit facility under the terms of the transaction that includes the CLO-eligible loan tranche at least equal to the greater of 20 percent of the aggregate principal balance at origination or the largest allocation of any syndication member at origination; and (3) is identified at the time of origination in the credit agreement and inter-creditor documents. For CLOs that do not qualify for treatment as open market CLOs, the CLO manager is still the “securitizer” and responsible for risk-retention.
The re-proposal of risk-retention rules reflects an acknowledgment of fundamental conceptual shortcomings contained within the Initial Proposed Rules. While the Re-Proposed Rules certainly make strides in addressing the concerns of commenters to the Initial Proposed Rules, there are wide ranging implications for all transaction parties, which should be considered in determining the impact of the Re-Proposed Rules.
 The Agencies that issued the Proposing Release are: the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (the “FDIC”), the Office of the Comptroller of the Currency (the “OCC”), the Securities and Exchange Commission (the “SEC”), the U.S. Department of Housing and Urban Development (“HUD”) and the Federal Housing Finance Agency (“FHFA”). HUD and FHFA participated in the rulemaking only with respect to provisions governing residential mortgage loan securitizations.
 Credit Risk-Retention, 76 Fed. Reg. 24090 (April 29, 2011) (the “Initial Proposing Release”).
 For our alert on the Initial Proposed Rules, please click here.
 The exemption for government-sponsored enterprise securitizations is effective only while the government-sponsored enterprises are in conservatorship.
 The SEC regards the stranded cost legislation and the rate-setting authority as equivalent to a government guarantee. Although stranded costs securitizations have not been a prominent feature of securitization markets since the early 2000s, the immense strains to the utility business model caused by renewable energy technology and micro grids is likely to make stranded costs legislation and concomitant securitization more prominent as a potential source of financing for the utility industry.