A final credit risk retention rule was recently issued with respect to asset-backed securities (ABS) by the prudential bank regulators (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency) and the Securities Exchange Commission, and, with respect to residential mortgage assets only, the Federal Housing Finance Agency and the Department of Housing and Urban Development. The final rule bears little resemblance to the approach originally proposed in April 2011 but is essentially (i.e., with the exception of a few details) identical to the rule as re-proposed in September 2013.

The rulemaking was mandated by Section 941 of the Dodd-Frank legislation. Dodd-Frank added Section 15G to the Securities Exchange Act of 1934 (Section 15G) and required a sponsor or securitizer of ABS to retain at least 5 percent of the credit risk of the assets collateralizing the ABS issuance, subject to certain exemptions and authorization to the agencies to fine-tune the requirements in certain circumstances.

The final rule generally contemplates risk retention through holding a vertical interest (at least 5 percent of each class of ABS issued), a horizontal interest (a first-loss residual interest in an amount equal to at least 5 percent of the par value of all ABS interests issued), or a combination of the two (an “L-shaped interest”). The percentages, in the case of a combination, must be determined as of the securitization’s closing date. Calculation of the percentages will be based, in the horizontal case, on the “fair value” of the securitization interests, and, in the vertical case, at par value. These different valuation methodologies must be used, pro rata, in a combination of the horizontal and vertical approaches.

Given the prolixity of the rule (550 pages), it is not possible to detail every nuance, but the following key points, organized by category, are worthy of mention:

Transaction-specific retention options apply to:

• Revolving securitization pools
• Asset-backed commercial paper conduits
• Commercial mortgage-backed securities (MBS)
• The MBS of the government-sponsored entities (GSEs)
• Open-market collateralized loan obligations (CLOs)

Exemptions:

• Government guaranteed securitizations
• Qualifying “pass through” resecuritizations
• ABS backed by auto loans, commercial loans, and commercial real estate loans if specified underwriting standards are met
• Qualified residential mortgage loans (QRMs)
• Certain community-focused and 3-4 unit residential mortgage loans
• Certain predominantly foreign securitizations (no more than 10 percent involvement by U.S. persons)

Restrictions:

• Hedging or transferring retained interests is prohibited for specified time periods after closing:

- For residential MBS, on or after seven years after the closing date, or alternatively the later of five years after the closing date or the date on which the total unpaid principal balance diminishes to 25 percent of the original principal balance

- For all other ABS, the latest of two years after the closing date, the date on which the unpaid principal balance of the collateralizing assets is reduced to 33 percent of the original unpaid principal balance as of the closing, or the date on which total unpaid principal obligations under the ABS interests issued in the securitization is reduced to 33 percent of the original unpaid principal obligations as of the closing

Perhaps the most significant aspects of the final rule—certainly from the perspective of the real estate and mortgage banking industries—are those dealing with QRMs. First, the rule requires no minimum down payment for QRMs, thereby abandoning the 20 percent requirement that was a feature of the original 2011 proposal. Second, the final rule defines QRM coextensively with the definition of “qualified mortgage” (QM) under the “ability-to-repay” rules of the Consumer Financial Protection Bureau.

As noted, mortgage loans that meet the QRM definition are exempt from risk retention requirements, as are those for 3-4 residential units and those having a community focus (but are not otherwise eligible for QRM status). The latter are those exempt from the ability-to-repay requirement under the CFPB’s QM rule and include loans made:

• Under programs administered by a housing finance agency
• By an entity designated by the Treasury Department as a Community Development Financial Institution
• By a HUD-designated Down Payment Assistance through a Secondary Financing Provider
• By certain HUD-designated Community Housing Development Organizations
• By certain eligible nonprofit organizations
• Under a program authorized under Sections 101 and 109 of the Economic Stabilization Act of 2008

As Section 15G provides that the definition of QRM can be “no broader than” the definition of QM, the agencies felt they had no choice but to exempt these loans as well.

The final rule does, however, provide that the QRM definition will be revisited four years after the final rule becomes effective and every five years thereafter, or at any other time upon the request of any one of the agencies, in order to determine whether the QM definition is still the appropriate standard.

At the other end of the spectrum are CLOs, which remain fully subject to the 5 percent risk retention requirement even though, unlike securitized mortgage loans, none of them played any part in the making of the financial crisis that led to Section 15G’s enactment. Indeed, in sharp contrast to the QRM scenario, the agencies actually rejected a number of burden-reducing measures urged by commentators.

Take, for example, the municipal bond financing technique known as tender option bonds (TOBs), which involve deposit of a highly rated municipal bond into a trust and issuance by the trust of two classes of securities: floating rate, puttable securities, and an inverse floating rate security. TOBs provide municipalities with access to a diverse investor base and a more liquid market. Because subjecting TOB sponsors (predominantly banks) to risk retention requirements significantly increases the costs, the final rule will likely have an adverse impact on local governments indirectly receiving funding from such programs, and decrease the availability of tax-exempt investments for money market funds. Yet, notwithstanding the rather benign and low-risk nature of these instruments, the agencies refused to adopt any of a plethora of mitigating suggestions offered by industry commentators.

Adoption of the final rule was not without controversy and a fair degree of rancor, as strong dissenting votes, with accompanying statements, were cast at both the FDIC and the SEC. The rule has already seen criticism from Capitol Hill, and if Republicans gain control of the Senate in the upcoming election, one can expect the introduction of legislation that may undo, in whole or in part, this rule and certain other controversial aspects of Dodd-Frank.