United States: Final Credit Risk Retention Requirements For Asset-Backed Securities Transactions

I. Introduction

On October 21-22, 2014, the federal regulatory agencies responsible for implementing regulations under The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") finalized rules for risk retention requirements in asset-backed securities (as further defined below, "ABS") transactions.1  The final rules (the "Final Rules")2 contain clarifications and revisions to the reproposed rules (the "Reproposed Rules")3 highlighted in Part II–Executive Summary of Significant Changes from the Reproposed Rules below, but in most respects the Final Rules are substantially the same as the Reproposed Rules.  Parts III through VII below are a restatement of our prior Clients & Friends Memo4 updated to reflect the Final Rules.

As required by the Dodd-Frank Act, the Final Rules become effective with respect to residential mortgage-backed securities ("RMBS") one year after publication in the Federal Register, and with respect to all other ABS two years after such publication.

II.Executive Summary of Significant Changes from the Reproposed Rules

The highlights of the Final Rules, including the most significant changes between the Reproposed Rules and the Final Rules are:

  • Repeal of Cash Flow Restrictions:  The proposed restrictions on payments to a horizontal interest retained by the sponsor (such that the rate of payment on that retained interest would not exceed the rate of principal amortization on the transaction as a whole) have been eliminated in the Final Rules.  The elimination of the proposed cash flow restrictions is particularly significant for CLOs and CMBS, since compliance with such restrictions was seen by the market as commercially unfeasible, given that investors in the "equity tranche" of a CLO or the "B-piece" in a CMBS transaction require that interest be paid to them on a current basis.
  • Elimination of Certain Fair Value Calculations:  The Final Rules do not require vertical retentions to be measured using fair value.  Horizontal retentions must be valued using a fair value methodology acceptable under U.S. GAAP.
  • Exclusion of non-economic REMIC residual interests. The definition of ABS interest has been modified to exclude non-economic residual interest issued by a REMIC and uncertificated regular interest in a REMIC held only by another REMIC where both REMICs are part of the same structure and a single REMIC issues ABS interests to investors.
  • Credit Risk May be Held Through Majority-Owned Affiliates. In addition to the sponsor being permitted to hold credit risk through a majority-owned affiliate,5 originators, originator-sellers and third party purchasers may also do so.
  • Determination of Retained Value.  The required percentage of eligible vertical, horizontal or combined retained interest must be determined as of the closing date of the securitization transaction.  Disclosure requirements relating to fair value measurement of horizontal and combined residual interests will be required a reasonable time prior to the sale of the ABS as described in the Reproposed Rules but the Final Rules permits ranges of fair values to be disclosed if the tranche sizes or rates have not been determined.  Actual fair value measurements must be disclosed post-closing.
  • Revolving Pool Securitizations.  The term "Revolving Pool has been substituted for "Master Trust" to accommodate revolving deals in other than trust form.  The Reproposed Rules required a sponsor to retain a seller's interest of not less than 5%.  The  Final Rules require the sponsor to maintain a seller's interest of not less than 5%.  The Final Rules amend the definition of "revolving pool securitization" to exclude the monetization of excess spread.  The Final Rules permit Sponsors to satisfy the risk retention requirement by holding a seller's interest that is either pari passu or partially or fully subordinate to one or more series of investor interests issued, or by holding a subordinate horizontal interest, and permit Sponsors to use cut-off dates in establishing the outstanding value of the revolving pool. 
  • ABCP Conduits.  Under the Final Rules an ABCP conduit sponsor may rely on any of the risk retention options in the Final Rules if it meets the criteria for such option and need not be limited to the ABCP option.  The Final Rules clarify the types of assets that can be acquired by an ABCP conduit and extends the maximum maturity of the asset-backed CP to 397 days from the nine-months in the Reproposed Rules.  Disclosure requirements have been simplified and can be updated monthly rather than at each ABCP issuance. 
  • CLOs.  For the most part, the Final Rules relating to CLOs are largely identical to the Reproposed Rules.  The Final Rules continue to apply risk retention requirements to CLOs, irrespective of whether the underlying loans are purchased or transferred from various secondary market sources or otherwise; and the Agencies confirm that they view the manager of an open market CLO6 (the "CLO Manager") as its sponsor.  The Final Rules preserve the "lead arranger" option as a means of satisfying the sponsor's risk retention requirements with respect to "Open Market CLOs" (as defined below).  The disclosures required to be made by sponsors when this option is used have been slightly expanded and the certifications required to be made by the lead arranger and the CLO Manager7 have been revised to be more in line with those required of depositors with respect to QRMs and other qualifying asset classes. 
  • Tender Option Bonds.  The Final Rules permit tender option bonds ("TOBs") with a notice period of up to 397 days (as opposed to 30 days, as in the Reproposed Rules) to qualify for the specialized risk retention options contained in the Final Rules applicable to TOBs.  The Final Rules add flexibility for sponsors to meet the risk retention requirements: the sponsor of a qualified tender option bond entity may combine tender option bond risk retention options with each other, as long as the sum of the retained interests equal at least 5% (e.g., the sponsor may hold 3% of the face value of the bonds deposited into the entity and at least 2% of the fair value of all ABS interests issued by the entity).
  • Residential Loans.  The Final Rules exempt certain types of community-focused residential mortgages that are not eligible for QRM status, and also exempts certain closed-end loans secured by a residential dwelling (e.g., home purchase, refinance, home equity loans, second or vacation homes, and mobile homes and trailers used as residences).  In addition, the definition of QRM and the exemptions for community-focused residential mortgages and 3-4 unit residential mortgages will be subject to period review by the Agencies.  

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1 The Dodd-Frank Act was signed into law by President Obama on July 21, 2010.  On April 29, 2011, the Federal banking agencies (the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System), the Securities and Exchange Commission ("SEC"), the Department of Housing and Urban Development ("HUD"), and the Federal Housing Finance Agency (collectively, the "Agencies") published a joint notice of proposed rulemaking containing proposed rules (the "Original Proposal", available at http://www.sec.gov/rules/proposed/2011/34-64148.pdf) to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act, codified as Section 15G ("Section 15G") of the Securities Exchange Act of 1934 (the "Exchange Act").

2 The Final Rules are available at https://www.fdic.gov/news/board/2014/2014-10-21_notice_dis_a_fr.pdf.

3  The Reproposed Rules were released by the Agencies on August 28, 2013 pursuant to a notice of proposed rulemaking after receipt of comments from over 10,500 persons, institutions and groups on the Original Proposal.  The Reproposed Rules are available at  https://www.sec.gov/rules/proposed/2013/34-70277.pdf).

4  Our prior Clients & Friends Memo, "Reproposed Credit Risk Retention Requirements for Asset-Backed Securities Transactions", dated September 13, 2013, is available at http://www.cadwalader.com/resources/clients-friends-memos/reproposed-credit-risk-retention-requirements-for-asset-backed-securities-transactions.

5  "Majority-owned affiliate" of a person means an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by or is under common majority control with, such person. For purposes of this definition, majority control means ownership of more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under U.S. GAAP.

6  Throughout this memo, the lowercase use of "open market CLO" denotes an "arbitrage" or "broadly syndicated CLO" (in which the securitized loan assets are purchased on the secondary market), as distinct from a "balance sheet CLO" (in which the securitized loan assets are purchased as a portfolio from a single institution or its affiliates, including the entities that originated such loan assets), while the title case use of "Open Market CLO" denotes a CLO that purchases and holds "CLO-eligible loan tranches" in conformity with §__9 of the Final Rules (i.e., the "lead arranger" option).

7     Note that §__9 of the Final Rules, which sets forth the risk retention requirements for "Open Market CLOs," defines "CLO manager" as "an entity that manages a CLO, which entity is registered as an investment adviser under the Investment Advisers Act of 1940, as amended (15 U.S.C. 80b-1 et. seq.), or is an affiliate of such a registered investment adviser and itself is managed by such registered investment adviser."  References throughout this memo to "CLO Manager," solely in the context of "Open Market CLOs," should be read to include the foregoing definition from §__9 of the Final Rules.  See the discussion of "Open Market CLOs and the 'Lead Arranger' Option," below.

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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