United States: Reproposed Credit Risk Retention Rules Will Affect All Issuers Of Asset-Backed Securities

Bryan Jung is Senior Counsel in the Fort Lauderdale office
Eileen Bannon is a Partner in the New York office
James Baker is a Partner in the Dallas office

Issuers of asset-backed securities (ABS) need to understand the reproposed rules regarding the credit risk retention requirements of Section 15G of the Securities and Exchange Act, which, when final, will apply to all public and private ABS offerings. The reproposed rules were published on August 28, 2013 by several federal regulators1 in a joint notice of proposed rulemaking (NPR).

Background

Section 15G was added by Rule 941 of the Dodd-Frank Act to better align the economic interests of securitizers with those of the ABS investors by requiring the retention of at least 5 percent of the credit risk by a securitizer or sponsor of ABS (sometimes referred to as "having skin in the game").

Although the NPR contains exemptions for securitizations involving certain types of underlying assets2 and sets forth a number of risk retention provisions specifically dealing with certain types of securitization transactions,3 the following are the relevant provisions generally applicable to all other ABS issuances:

  • The sponsor of a securitization transaction will be required to retain a minimum of 5 percent of the fair value of all ABS interests issued under the transaction.
  • The required risk retention can be held in any combination of horizontal and vertical first-lost interests.
  • The retained risk is required to be held for at least two years for all deals involving assets other than residential mortgages; for residential mortgages, the holding period is at least five years.
  • The sponsor may satisfy its obligation in part through the purchase and retention of some of these interests by one or more significant originators of the underlying assets.
  • The sponsor of the securitization will be required to make calculations and provide disclosures relating to the retained risk.

For securitizations involving residential mortgages, the effective date will be one year after the final rules are published in the Federal Register; for all other securitization transactions, the effective date will be two years after publication.

General Risk Retention Requirements

The sponsor4 of a securitization transaction will be required to retain a minimum of 5 percent of the fair value of all ABS interests issued under the transaction, which may held in any combination of eligible horizontal residual interests or eligible vertical interests. The fair value must be determined as of the pricing date for the ABS interests to be sold to third parties.

Eligible Horizontal Residual Interest

An eligible horizontal residual interest (EHRI) is an interest in a single class or multiple classes in the issuing entity that will absorb the first losses and has the most subordinated claim to payments of both principal and interest. In other words, this interest will be at the bottom of the payment waterfall. Alternatively, the sponsor may satisfy this requirement by funding all or any part of the required amount into a horizontal cash reserve account; the amounts in the account will be used solely to make payments on other ABS interests when there is any shortfall in available funds.

If the sponsor chooses to satisfy the risk retention requirements by retaining any EHRI (or funding a horizontal cash reserve account), the sponsor must, prior to the issuance of such EHRI (or funding such account) or at the time of any subsequent issuance of ABS interests, do both of the following:

  • perform calculations showing that, as of any payment date, the EHRI (or amounts held in the reserve account) is projected to receive cash flow (or be released from the reserve account) at a rate that is no faster than the rate on which the principal of the other ABS interests is projected to be paid
  • certify to the investors that it has performed the above calculations and is in compliance with the requirements

Eligible Vertical Interest

An eligible vertical interest is a separate proportional interest in each class of ABS interests issued in the transaction or alternatively, a single security representing such interest in each class.

Restriction on Transfers/Duration of Restriction

For all transactions involving assets other than residential mortgages, the sponsor will not be permitted to hedge, pledge or transfer the retained risk until the latest of the following:

  • the date on which the total unpaid principal balance of the underlying assets has been reduced to 33 percent of the closing date total unpaid principal balance
  • the date on which the total unpaid principal obligations under the ABS interests has been reduced to 33 percent of the closing date total unpaid principal obligations
  • two years after the closing date

For transactions involving residential mortgage loans, the prohibition will expire on the later of the following:

  • five years after the closing date
  • the first to occur of (a) the date on which the total unpaid principal balance of the underlying residential mortgage loans has been reduced to 25 percent of the closing date total unpaid principal balance, and (b) seven years after the closing date

Allocation of Risk Retention to Originator

A sponsor may satisfy its risk retention requirements through the purchase and retention by a significant originator5 of no more than its pro rata share (based on the unpaid principal balance of underlying assets) of the eligible interests otherwise retained by the sponsor. The purchasing originator will be subject to the same restrictions on hedging, pledging and transferring its retained interests as the sponsor.

Disclosure and Record Retention Requirements

In addition to the disclosures of the repayment rate calculations made with respect to any EHRI described above, the sponsor must provide certain other written disclosures to potential investors. Such disclosures must be provided a reasonable period of time prior to the sale of the related ABS and be included under the caption "Credit Risk Retention."

Disclosures for Eligible Horizontal Residual Interests

If the sponsor retains an EHRI (or funds a horizontal cash reserve account), the required disclosures include the following:

  • if an EHRI is retained, the fair value of the interest required under these rules to be retained by the sponsor in the transaction and the fair value of the interest actually (or to be actually) retained by the sponsor in the transaction, both expressed in dollar amounts and as a percentage of the fair value of all ABS interests issued in the transaction; if a horizontal cash reserve account is funded, the fair value of the interest required under these rules to be funded through the reserve account (expressed as a dollar amount and as a percentage of the fair value of all ABS interests issued in the transaction) and the amount actually (or to be actually) deposited in the reserve account must be disclosed
  • a description of the material terms of any EHRI (or horizontal cash reserve account)
  • a description of the methodology used to calculate the fair value of all classes of ABS interests, including the EHRI
  • the key inputs and assumptions used in calculating the fair value, including but not limited to quantitative information about:

    • discount rates
    • loss given default (recovery rates)
    • prepayment rates
    • defaults
    • lag time between default and recovery
    • the basis of forward interest rates used
  • the data or historical information used to develop the key inputs and assumptions described above, including loss given default and actual defaults
  • no more than 60 days prior to the closing date:
  • the number of securitization transactions during the previous five-year period in which the sponsor retained an EHRI (or funded a horizontal cash reserve account) under these rules

    • the number (if any) of payment dates in each such securitization on which actual payments to the sponsor with respect to the EHRI (or amounts released from the horizontal cash reserve account) exceeded the cash flow projected to be paid (or released) to the sponsor on such payment date(s)

Disclosures for Eligible Vertical Interests

If the sponsor retains an eligible vertical interest, the required disclosures include the following:

  • whether the sponsor will retain (or did retain) the eligible vertical interest as a single vertical security or as a separate proportional interest in each class of ABS interests issued in the transaction
  • if a single vertical security is retained:

    • the fair value amount of the interest required under these rules to be retained by the sponsor in the transaction and the fair value of the interest actually (or to be actually) retained by the sponsor in the transaction
    • each class of ABS interests underlying the single vertical security at the closing and the percentage of each class of ABS interests that the sponsor would have been required to retain if held as a separate proportional interest in each class of ABS interests
  • if a separate proportional interest in each class of ABS interests is retained, the percentage of each class that the sponsor is required under these rules to retain and the percentage of each class of ABS interests actually (or to be actually) retained by the sponsor in the transaction
  • to the extent not otherwise disclosed in connection with the retention of an EHRI (or funding of a horizontal cash reserve account):

    • a description of the methodology used to calculate the fair value of all classes of ABS interests, including the retained interest
    • the key inputs and assumptions used in calculating the fair value, including but not limited to quantitative information about:

      • discount rates
      • loss given default (recovery rates)
      • prepayment rates
      • defaults
      • lag time between default and recovery
      • the basis of forward interest rates used
  • the data or historical information used to develop the key inputs and assumptions described above, including loss given default and actual defaults

Disclosures Upon Purchase by Originator of Eligible Interests

If the sponsor satisfies its risk retention requirements through the purchase and retention by a significant originator of a portion of the eligible interests, each of the following disclosures is required:

  • the name and form of organization of the originator
  • a description of the form, amount (expressed as a dollar amount and percentage), and nature of the interest
  • the method of payment for such interest by the originator

Record Retention Requirements

For each securitization transaction, the sponsor must retain written records of the above certifications and disclosures (including the repayment rate calculations made with respect to any EHRI) until three years after all related ABS interests have been paid in full and must provide the disclosures upon request to the SEC and any applicable federal regulator.

Footnotes

1 The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, U.S. Securities and Exchange Commission, Federal Housing Finance Agency and Department of Housing and Urban Development.

2 These include qualified residential mortgages, qualifying commercial loans, qualifying commercial real estate loans, qualifying auto loans, U.S. government-backed securitizations, certain agricultural loan securitizations, state and municipal securitizations, qualified scholarship funding bonds, seasoned loans, certain public utility securitizations, securitizations of assets issued, insured or guaranteed by the United States, FDIC securitizations and partial exemption for certain student loan securitizations.

3 These include revolving master trusts, eligible ABCP conduits, commercial mortgage-backed securities, FNMA and FHLMC ABS, open market CLOs and qualified tender option bonds.

4 Defined as a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, to the issuing entity.

5 An originator that has sold more than 20 percent of the underlying assets in the securitization transaction.

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.

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