The securitization provisions contained in the Dodd- Frank Wall Street Reform and Consumer Protection Act (the "Act"), which was signed into law on July 21, 2010, are significant and will affect the securitization markets for years to come. With securitization under greater scrutiny as a major contributing factor to the recent financial crisis, legislators took the view that market participants must have "skin in the game" and make greater disclosures to investors. In addition, certain market participants are prohibited for a time period from engaging in certain securitization transactions that involve a material conflict of interest. Set forth below is a brief overview of some of the provisions of the Act that will impact securitization deals.
"Skin in the Game" Requirement (Sections 941 and 944)
The Act directs federal bank regulators and the Securities and Exchange Commission (the "SEC") jointly to impose rules requiring securitizers of asset-backed securities to maintain a 5 percent economic interest ("skin in the game") in the credit risk of any asset transferred, sold or conveyed to a third party through the issuance of asset-backed securities. This 5 percent economic interest can be less than 5 percent if underwriting/diligence meets very high underwriting standards specific to the class of the securitized assets. The economic interest may not be hedged or transferred to a third party. The Act defines an asset-backed security as "fixed-income or other security collateralized by any type of self-liquidating financial asset, including a loan, a lease, a mortgage, a secured or unsecured receivable that allows the holder of the security to receive payments that depend primarily on cash flow from the asset." The Act makes the definition broad enough to cover collateralized debt obligations, collateralized bond obligations, and any security the SEC determined to be an asset-backed security.
A "securitizer" is defined as "(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer."
An "originator" is defined as "a person who (A) through the extention of credit or otherwise, creates a financial asset that collateralizes an asset-backed security; and (B) sells an asset to a securitizer."
Exceptions to the 5 percent risk-retention rule are as follows: securitizers will not be required to retain any portion of the credit risk for an asset that is transferred, sold or conveyed if all the assets that collateralize the asset-backed security are "qualified residential mortgages." Congress directed federal bank regulators and the SEC, together with other federal regulators, jointly to define the category of "qualified residential mortgages" after considering certain product and underwriting features that have historically been associated with lower default risks. Most likely, the category will include a large portion of those loans originated by Fannie Mae and Freddie Mac.
The Act also contemplates the establishment of total or partial exemptions from the risk-retention rule for the following:
- any loan or other financial asset made, insured, guaranteed or purchased by any institution that is subject to the Farm Credit Administration;
- any securitization of an asset issued or guaranteed by the United States or a U.S. agency (except Fannie Mae and Freddie Mac); and
- certain state and municipal securitizations of assets.
The required risk-retention amount may also be allocated between an originator and a securitizer, as deemed appropriate by the regulators.
Additional Disclosure Requirements (Sections 942 – 946)
In addition to the risk-retention requirement, the Act requires more disclosure in the securitization process. Congress has directed the SEC to adopt regulations requiring issuers to disclose – for each tranche or class of security – information regarding the specific assets backing that security. To enable investors to compare data across securities in similar types of asset classes, the SEC is required to establish standardized disclosure formats. At a minimum, the SEC rules must require issuers to disclose asset-level or loan-level data necessary for investors independently to perform due diligence, including: (i) the identity of the loan broker or originator; (ii) the extent and nature of the broker's or originator's compensation; and (iii) the amount of risk retained by the securitizer and the originator.
The Act instructs the SEC to promulgate regulations regarding the use of representations and warranties in the market to require any securitizer to disclose fulfilled and unfulfilled repurchase requests across all the securitizer's securitizations, such that investors may be able to identify originators with underwriting deficiencies. Finally, the SEC is required to issue rules relating to the registration statement that issuers are required to file, which will require the issuer to perform a due diligence analysis of the assets underlying the asset-backed security and disclose the nature of that analysis to potential investors. With these provisions, Congress seeks to ensure that investors will be provided with sufficient disclosures to make an informed decision regarding a securitization investment. The regulations issued under this part of the legislation are to become effective with respect to residential mortgage asset-backed securities one year after final rules are published and with respect to all other asset-backed securities two years after final rules are published.
Prohibitions on Conflicts of Interest for One Year Following First Sale (Section 621)
The Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an asset-backed security from engaging in any transaction for one year after the first closing of the sale of the asset-backed security that would involve or result in any material conflict of interest with respect to any investor in transactions arising out of such activity. This prohibition does not apply to risk mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase or sponsorship of an asset-backed security in certain circumstances. The SEC is required to issue rules for purposes of implementing the conflict of interest prohibition within nine months after the date of enactment of the Act. This conflicts of interest prohibition will take effect on the date of issuance of final rules by the SEC.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
