One of the important unfinished aspects of the Dodd-Frank Act (“Act”) is the requirement for Federal agencies (“Regulators”) to issue regulations implementing Section 941 of the Act which generally requires that a securitizer retain at least 5% of the aggregate credit risk for assets that are packaged in an asset-backed securitization (“ABS”) issued by the securitizer. The Regulators originally proposed rules to implement Section 941 over two years ago (“First Proposal”).

On August 28, 2013, the Regulators issued a second proposed rule for public comment (“Re-proposal”). The Regulators responded to a range of concerns expressed in comment letters and made a series of important revisions in the Re-proposal. Among the major changes proposed by the Regulators are much more relaxed requirements for a residential mortgage loan to qualify as a Qualified Residential Mortgage that would be exempt from risk retention requirements. Comments on the Re-proposal must be submitted by October 30, 2013.

Key aspects of the Re-proposal include the following.

Revisions of General Provisions

Under the First Proposal, the form of a securitizer’s risk retention would have been 5% of the par value of either (i) each class of ABS interests (vertical retention), (ii) a first-loss tranche (horizontal retention), or (iii) an L-shaped 50-50 combination of eligible vertical and horizontal residual interests. The Re-proposal modified the basic form of risk retention in two important ways. First, rather than require the eligible residual interests to be calculated based on par value, securitizers would use fair value (as calculated by GAAP) to calculate the eligible residual interests. The calculation would be determined as of the day on which the price of the ABS interests to be sold to third parties is determined. Second, the hybrid vertical/horizontal option was modified to permit any combination of eligible vertical and horizontal residual interests. Additionally, under the Re-proposal the retained risk interest could be held by one or more majority-owned affiliates of the securitizer.

The Regulators also clarified some issues relating to the form of eligible horizontal and vertical residual interests. Securitizers may establish a fully funded cash reserve account held by a trustee in place of all or a portion of their horizontal risk retention interest. Until all ABS interests in the issuing entity are paid in full or the issuing entity is dissolved, amounts in a cash reserve account could only be released to satisfy payments on ABS interests in the issuing entity on any payment date on which the issuing entity has insufficient funds from any source to satisfy an amount due on any ABS interest, and any amounts released or withdrawn may not exceed the closing date projected principal repayment rate as of the date of the release or withdrawal. Under the Re-proposal, a securitizer could retain any interest income on the permitted investments in the account, which could include U.S. Treasury bills or FDIC-insured deposits.

Regardless of whether horizontal interests are held as a single class or multiple classes, such interests must absorb any resulting cash flow shortfalls prior to any reduction in the amounts paid to any other ABS interest issued by the issuing entity. Prior to the issuance of an eligible horizontal residual interest or funding a horizontal cash reserve account, a securitizer must calculate and certify to investors that, for each payment date, the projected cash flow rate for any retained horizontal interest (or amounts released to any horizontal cash reserve account) does not exceed the project principal repayment rate for the other ABS interests on such payment date. Eligible vertical interests may either be a single security or a separate proportional interest in each class of ABS interests, but may not take the form of a participation interest.

As a result of the move away from par value to using fair value to calculate retained interests, under the Re-proposal, securitizers would be required to provide additional disclosure to investors, including the fair value of the ABS interests retained, a description of the material terms of the ABS interests retained and the methodology, key inputs, assumptions and reference data used to calculate the fair value. This change would tie the retention thresholds to overall deal proceeds. Securitizers would also be required to disclose the number of securitization transactions by the securitizer during the previous five-year period in which the securitizer retained an eligible horizontal residual interest, and the number (if any) of payment dates on which actual payments to the securitizer with respect to the eligible horizontal residual interest exceeded the cash flow projected to be paid to the securitizer on such payment date. In the commentary, the Regulators stated that the move to a fair value calculation contributed to their decision to remove the premium cash capture reserve account (a “PCCRA”) concept from the Re-proposal, which would have required all excess interest on collateral mortgages to be held in a PCCRA until all securities with principal balances had been paid in full. This change is likely among the most popular changes, as issuers would otherwise have had to wait until the end of a deal’s life to receive any profits, and any profits would have been at risk any time a transaction suffered even minor losses.

The Re-proposal also introduced the ability to blend qualified assets with non-qualifying assets in certain asset classes (“Blended Pools”), including commercial loans, commercial real estate (“CRE”) loans and automobile loans. Securitizers would be able to reduce the risk retention requirement in proportion to the ratio of qualifying assets to non-qualifying assets, down to a minimum of 2.5%. Blended Pools could contain up to 50% qualifying assets. 

In order to avoid losing the benefit of a qualified asset in a Blended Pool or a fully-qualified exempt ABS transaction, if it is discovered that a loan did not satisfy the underwriting or other requirements to be qualified for that asset type, the securitizer may preserve the exemption from risk retention by repurchasing the asset or curing the deficiency within 90 days. 

Exemption from Risk Retention for Qualified Residential Mortgages 

One of the most controversial aspects of the First Proposal was the strict standards for a residential mortgage to be treated as a Qualified Residential Mortgage (“QRM”). Securitizations that are composed exclusively of QRMs are exempt from the risk retention requirements. 

Under the First Proposal, in order for a residential mortgage loan to be treated as a QRM, it would have to have a maximum 80% loan-to-value (“LTV”) ratio, a minimum 20% down payment, front-end and back-end debt-to-income (“DTI”) ratios of 28% and 36% or less respectively, and meet certain credit history requirements. A wide range of commenters expressed concern that only a limited portion of mortgage loans would meet this standard. The practical effect of these tight standards would, however, have been limited since ABS that were subject to a full guarantee of principal and interest by Fannie Mae or Freddie Mac (“GSEs”) (as long as they remain in conservatorship and have capital support from the U.S. Government) would be deemed to satisfy the risk retention requirements.  

Under Section 941 of the Act, the QRM definition can be no broader than the standards established for a Qualified Mortgage (“QM”) by the Consumer Financial Protection Bureau (“Bureau”). In January 2013, the Bureau issued a final rule regarding the requirements for a QM (“QM Rule”) that will become effective on January 14, 2014.¹ The QM Rule took a much less strict approach than was contained in the First Proposal. It did not establish any maximum LTV ratio, minimum down payment or credit history requirements and provided for a much looser 43% maximum back-end DTI. 

QM-QRM Equivalent Proposal

In the Re-proposal, the Regulators took a sharp departure from the strict approach to QRM contained in the First Proposal. The Regulators expressed concern about the restrictive lending conditions since 2008 for borrowers with lower credit scores, limited equity in their homes or limited cash reserves. They indicated that they were concerned that imposing further constraints on mortgage credit availability at this time; especially as such constraints might disproportionately affect groups that have historically been disadvantaged in the mortgage market, such as lower-income, minority, or first-time homebuyers. The Regulators also expressed concern that establishing different standards for QM and QRM loans could result in an increase in complexity, regulatory burdens and compliance costs that could be passed on to borrowers in the form of higher interest rates or tighter credit standards.

The Regulators proposed to align the QRM definition with the Bureau’s QM requirements, by directly incorporating the QM definition as set forth in the Bureau’s regulations (including amendments to the QM Rules), into the definition of a QRM (“QRM Proposal”). 

As a result, under the Re-proposal the following types of QMs will qualify as QRMs:

• A standard QM – that meets QM loan term and structure requirements and the maximum 43% DTI ratio; and
• A Government-Related QM – that meets QM loan term and structure requirements, but not the maximum 43% DTI ratio, and is eligible for purchase, guarantee or insurance by a GSE or certain U.S. government entities, but that does not actually have to be subject to such a transaction.²

QMs would qualify as QRMs without regard to whether they are lower-priced and are subject to a safe harbor or are higher-priced and are subject to a rebuttable presumption. 

In order for a securitization to be exempted from the risk retention requirement, each QRM collateralizing the securitization would have to be currently performing (not more than 30 days or more past due, in whole or in part) at the closing of the securitization transaction. The depositor for the securitization would be required to certify that it evaluated the effectiveness of its internal supervisory controls to ensure that all of the assets that collateralize the securities issued in the transactions are QRMs, and that it has determined that its internal controls are effective. This evaluation is to be performed within 60 days prior to the cut-off date for establishing the composition of the collateral pool. 

As in the First Proposal, a sponsor that relies on the QRM exemption with respect to a securitization transaction will not lose its exemption if it is determined that one or more of the residential mortgage loans collateralizing the ABS does not meet all of the criteria to be a QRM, provided that: (i) the depositor complied with the certification requirements, (ii) the sponsor repurchases the loans at a price at least equal to the remaining aggregate unpaid principal balance and accrued interest on the loans not later than 90 days after the determination that the loans do not satisfy the QRM requirements, and (iii) the sponsor provides specified notices to the holders of the ABS. The Regulators note that this provision is intended to help ensure that sponsors have a strong economic incentive to ensure that all mortgages backing a QRM securitization satisfy all of the conditions applicable to QRMs prior to closing of the securitization. At the same time, the Regulators note that subsequent performance of a loan, absent any failure to meet the QRM requirements at the closing of the securitization, would not trigger a buyback requirement.

Under the Re-proposal, ABS subject to a GSE full guarantee of principal and interest would be deemed to satisfy the risk retention requirement. 

QM-plus Alternative

While the Regulators incorporated the QM equivalent-QRM Proposal in the text of the proposed rule,³ the Regulators in the preamble to the Re-proposal suggest a very different alternative QRM definition referred to as “QM-plus” that would be far narrower than the QRM Proposal. In order to qualify as a QM-plus, a loan would have to meet the following requirements:

• Satisfy Core QM requirements. A loan would have to meet the core criteria for QM status including product type requirements, loan term, points and fees, underwriting, income and debt verification, and maximum DTI ratio. There would be no distinction between loans that are safe harbor loans and those that are rebuttable presumption loans.
  
  Significantly, loans that are QMs because they are Government-Related QMs or Small Creditor QMs, would not be considered QRMs under the QM-plus approach.

• One-to-four family principal dwelling. QM-plus treatment would only be available for loans secured by 1-4 family real properties that constitute the principal dwelling of the borrower. Other types of loans that would be eligible for QM treatment would not be eligible for QM-plus treatment.
• Lien requirements. QM-plus treatment would only be available for a first lien mortgage. For purchase loans, the QM-plus approach would exclude “piggy-back” loans and no other recorded or perfect liens on the property could exist at closing to the knowledge of the originator. For refinance loans, junior liens would not be prohibited, but would be factored into the QM-plus LTV calculations.
• Credit history. In order to make a QM-plus loan, an originator would have to determine that the borrower was not currently 30 days or more past due on any debt obligation and was not 60 days or more past due on any debt obligations within the preceding 24 months. Furthermore, that borrower must not have, within the preceding 36 months, been a debtor in a bankruptcy proceeding or been subject to a judgment for collection of an unpaid debt; had personal property repossessed; had any 1-4 family property foreclosed upon or engaged in a short sale or deed in lieu of foreclosure.
• LTV ratio. In order to be a QM-plus loan, LTV at closing could not exceed 70 percent. Junior liens, permitted only in the case of non-purchase loans, must be included in the LTV calculation if known to the originator at the time of closing, and if the lien secures a HELOC, must be included as if fully drawn. Property value would be determined by an appraisal, but for purchase loans, if the contract price at closing for the property was lower than appraised value, the contract price would be used as the value.

The Regulators stated that they have concluded that the QRM Proposal covers most of the present mortgage market, and a significant portion of the historical market (putting aside non-traditional mortgages related primarily to subprime lending and lending with little documentation). The Regulators stated that the QM-plus approach would cover a significantly smaller portion of the mortgage market. 

The Re-proposal requests comments on a range of questions about the likely impact on mortgage market participants of the implementation of either the QRM Proposal or the QM-plus Alternative.⁴

Exemption from Risk Retention for Commercial Mortgage Backed Securities and Commercial Real Estate Loans

The First Proposal included definitions and underwriting standards for qualified commercial mortgage backed securities (“CMBS”) that, when pooled and securitized, would have been exempt from risk retention requirements. Risk retention could be satisfied under the “B-Piece Option” if one third-party purchaser (a “B-Piece Buyer”) held a horizontal interest (the “B-Piece”). A B-Piece Buyer would be prohibited from obtaining financing, directly or indirectly, for the purchase of the B-Piece from any other party to, or affiliate of any party to, the securitization transaction at issue. The Re-proposal continues to permit securitizers to split the 5% risk retention with the B-Piece Buyers, where the B-Piece Buyer would hold a first-loss position, and the securitizer would hold a percent share of every tranche in the deal, but unlike in the First Proposal, the actual percentages held by each party could be flexible, allowing for greater customization of deal terms, so long as the overall 5% target is hit.

One significant change to the B-Piece Option under the Re-Proposal is that one or two B-Piece Buyers would be permitted to purchase the B-Piece in order to satisfy the risk retention requirements. If two B-Piece Buyers enter a deal, each B-Piece Buyer’s interest must be pari passu, and each B-Piece Buyer would have to conduct its own independent review of the credit risk of each securitized asset. The B-Piece Option could be combined with an eligible vertical residual interest by the servicer if the B-Piece alone is not sufficient to achieve the required amount of risk retention. The Re-proposal only permits the B-Piece Buyer to be affiliated with the special servicer or any originator who contributes assets constituting less than 10%  of the unpaid principal balance of the securitized assets at the closing the securitization transaction, but no other parties to the securitization transaction.

On all B-Piece Options, the Re-proposal requires that an independent operating advisor (the “Operating Advisor”) be appointed to oversee the special servicer. The Operating Advisor may not have any financial interest in the securitization other than its fees, and would be required to act for the benefit of the investors as a collective whole. When the eligible horizontal residual interest has a principal balance of 25% or less of its initial principal balance (when the control period ends), the Re-Proposal would require the special servicer to consult with the Operating Advisor in connection with, and prior to, any material decision in connection with its servicing of the securitized assets. The Operating Advisor would have the authority to recommend that the investors remove the special servicer, which could be achieved by an affirmative vote of a majority of the outstanding principal balance of all ABS interests voting on the matter, with a minimum quorum of the holders of 5% of the outstanding principal balance of all ABS interests.

The Regulators also revised the prohibition on transferring the B-Piece during the life of a deal. The Re-proposal permits a B-Piece Buyer to transfer the B-Piece to a new qualified third-party purchaser that satisfies the criteria applicable to B-Piece Buyers in that securitization at any time after five years from the date of closing of the securitization transaction have elapsed. The B-Piece could be transferred freely to subsequent qualified third-party purchasers after that initial transfer, so long as each transferor provides notice to the securitizer. The securitizer would be responsible for monitoring the B-Piece Buyers’ compliance with the terms and conditions of the transaction documents (including B-Piece Buyer eligibility, qualifications and transfer restrictions) and risk retention rules. If the securitizer discovered a B-Piece Buyer was not in compliance, the securitizer would be required to promptly notify the investors. Additionally, the five-year horizon to the holding period would apply only to B-Piece Buyers, and not to any cash reserve account (as discussed above).

While no change was made to the definition of a qualifying commercial loan, the Re-Proposal modified the definition of commercial real estate loans (“CRE”) to permit repayment from rental income from affiliates of the borrower, so long as the ultimate income stream for repayment comes from unaffiliated parties. Additionally, loans to REITS would no longer be excluded from the CRE category. To be a qualified CRE (a “QCRE”), a loan must have: (i) an interest rate that is fixed or fully convertible into fixed using a derivative, (ii) no interest only period, (iii) an amortization period of no greater than 30 years for multifamily loans or 25 years for all other loans, (iv) a maximum LTV ratio of 65% (60% if the cap rate is less than a prescribed rate), (v) a maximum CLTV ratio of 70% (65% if the cap rate is less than a prescribed rate), and (vi) a DSCR of 1.25 for multifamily loans, 1.5 for leased loans, or 1.7 for all other loans.

Notably, the Re-proposal does not include any exemption for “non-conduit” CMBS deals. This would include all single borrower and large loan floating rate CMBS. This may lead to a change in how such deals are structured.

Risk Retention Rules for Other Asset Types

The Re-proposal changed the proposed rules for a number of other asset types as well. A few of the highlights for these classes are listed below.

Collateralized Loan Obligations (“CLO”)

The most significant change to the CLO risk retention rules is that a lead arranger in the underlying loan would also be permitted to retain risk in certain circumstances instead of only the CLO manager. For detailed analysis on how the Re-proposal will affect CLOs, please see our DechertOnPoint, Risk Retention Reproposal’s Impact on CLOs: Loan Arrangers Get Invited to the Party That No One Wants to Attend (August 30, 2013).

Automobile Loans

The Re-Proposal would modify the definition of “qualified automobile loan” in a number of ways. Specifically, the changes include: (i) the originator must verify a borrower has at least 24 months of credit history, (ii) the maximum permissible age of a borrower’s credit report is 30 days, (iii) a minimum down payment of 10%, although additional warranties, insurance, or other requirements may be necessary, and (iv) a borrower must make equal monthly payments that fully amortize the loan over a maximum of six years from origination for new cars, or ten years minus the difference between the current model year and the vehicle’s model year for used cars. It is interesting that the Regulators are requiring a 10% down payment for qualified automobile loans but are not requiring a down payment for QMs.

Asset Backed Commercial Paper

The main revisions in the Re-proposal for this asset class include permitting a “majority-owned OS affiliate” to sell assets and retain risk on behalf of an originator-seller, no longer requiring all interests issued by an intermediate special purpose vehicle to be issued to a conduit, removing the requirement to disclose the identity of the entity that has retained an interest in the ABS interests unless such entity defaults in its risk retention obligations, and broadening the types of assets that may collateralize asset-backed securities acquired by an eligible conduit. 

Other Asset Types

The Re-proposal also included rules for master trusts, student loans, municipal bonds, resecuritizations and seasoned loans.