Introduction

Proposed "Skin in the Game" Rule

Section 941(b) of the Dodd-Frank Act, codified as new Section 15G to the Securities Exchange Act of 1934, requires six Federal agencies—the U.S. Department of the Treasury, Federal Reserve Board, Federal Deposit Insurance Corporation, U.S. Securities and Exchange Commission, Federal Housing Finance Agency, and Department of Housing and Urban Development (collectively, the "Agencies")— jointly to prescribe regulations requiring increased credit risk retention for securitizers of asset-backed securities and limiting the hedging or transferring of securitizers' retained risk.1 Section 15G generally requires securitizers of asset-backed securities ("ABS")2 to retain an unhedged five percent economic interest in the credit risk of securitized assets, but authorizes several exemptions from the general risk retention requirement. These include an exemption for securities collateralized by "qualified residential mortgages," which must be underwritten pursuant to specific standards established by regulation, as well as exemptions for certain other asset classes.

To implement section 941, the Agencies recently issued a proposed rulemaking on Credit Risk Retention, seeking public comment by June 10, 2011. While the Agencies satisfied the section 941 requirement for issuing regulations within 270 days of enactment, the effective date of any rule will not occur until one year after publication of a final rule in the Federal Register for securitizers and originators of asset-backed securities backed by residential mortgages and two years after publication of a final rule for securitizers and originators of all other classes of asset-backed securities.

As proposed, the new rules would profoundly impact mortgage origination by insured depository institutions, non-bank lenders and mortgage servicers, by requiring significant changes to longstanding securitization practices. Accordingly, mortgage industry participants should proactively review the proposed rule and provide comments to the Agencies with respect to the impact of the proposal on their operations. Specifically, the proposal seeks public input on 174 individual questions, which are set forth in Appendix A.

Section 941 is based on concerns that during the period leading up to the recent financial crisis, mortgage originators "retain[ed] little or no continuing exposure to loans they originate[d] for securitization." The result was a focus on mortgage origination volume rather than viable underwriting, decreased transparency in the securitization process, and complicated loss mitigation actions.3 Section 941 and the proposed rule seek to address these perceived abuses by forcibly realigning market incentives and instilling greater discipline in the mortgage origination process by ensuring that participants maintain "skin in the game." 4

The risk retention rule required by section 941 has the potential to constitute the most sweeping and profound of all reforms required by the Dodd-Frank Act, significantly impacting both the secondary market and mortgage lending in this country for years. It will be critically important for banks, thrifts, mortgage lenders, securitizers, rating agencies, investment banking firms, mutual funds, private equity firms, insurance companies, and pension plans, among others, to carefully review and understand the implications of the Proposed Rule.

General Risk Retention Requirement

Under the proposed rule, securitizers5 must retain an economic interest in the credit risk of the assets collateralizing the issuance of an ABS. In particular, securitizers are required to retain a base interest of five percent of the aggregate credit risk of assets transferred, sold, or conveyed to a third party in an ABS issuance, unless an exemption from the risk retention requirements is otherwise available. The five percent requirement is a minimum, and a party to a securitization may retain or be required to retain additional exposure to credit risks beyond five percent. A sponsor/securitizer would also be prohibited from hedging or otherwise transferring this retained interest.

For transactions in which an originator contributed at least 20 percent of the assets, a securitizer can allocate a portion of the credit risk it is required to retain to the originator of the securitized assets. Additionally, to limit the practice of securitizers receiving "excess spread,"6 a sponsor may be required to fund an additional "premium capture cash reserve account"7 in connection with a securitization transaction. Securitizers would also be required to disclose to investors material information concerning their retained interests in a securitization transaction.

Under the proposal, the risk retention requirements can be satisfied through one of several options, including but not limited to:

  • a "vertical" slice of the ABS interest, whereby the securitizer retains a specified pro rata piece of every class of interests issued in the transaction;
  • a "horizontal" first-loss position, whereby the entity retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests;
  • an "L-shaped" interest, which would allow an entity, subject to certain conditions, to use an equal combination of vertical and horizontal risk retention;
  • a "seller's interest" in securitizations structured using a master trust collateralized by revolving assets whereby an entity holds a separate interest that is pari passu with the investors' interest in the pool of receivables, unless and until the occurrence of an early amortization event; or
  • retention of a representative sample of the assets to be securitized that exposes the securitizer to credit risk equivalent to that of the securitized assets.

While these risk retention options apply to residential mortgages, the proposal also sets forth risk retention options specifically designed for structures involving asset-backed commercial paper and commercial mortgage-backed securities. Certain credit risk retention requirements also apply to Fannie Mae and Freddie Mac, although the requirements are deemed satisfied while these entities are operating under conservatorship or receivership of the Federal Housing Finance Agency with capital support from the United States.

Exemption for Qualified Residential Mortgages

Notwithstanding the general requirements, the heart of the proposed rule centers on its exemptions, primary among these being the Qualified Residential Mortgage ("QRM") exemption. The proposal provides a complete exemption from the risk retention requirements for securitizations solely involving QRMs. Because a sponsor will not be required to retain any portion of the credit risk associated with a QRM securitization, the underwriting standards are designed to ensure that the underlying mortgages are of very high credit quality. This is accomplished by the rule's restrictive definition of a QRM, which is limited to:

  • a closed-end first-lien mortgage; " used to purchase or refinance a one-to-four family property;
  • at least one unit of which is the principal dwelling of a borrower; and
  • the property is perfected in accordance with applicable law.

QRMs exclude bridge loans, loans used to purchase time-share properties, and reverse mortgages, in part to limit the complexity of underwriting the QRMs.

Eligibility Requirements for QRMs

The proposed rule imposes additional eligibility requirements for QRMs, including:

  • a loan-to-value ("LTV") ratio of 80 percent for purchase mortgage transactions and a combined LTV ratio cap of 75 percent on rate and term refinance loans and 70 percent for cash-out refinance loans;
  • borrowers must provide a cash down payment;8
  • a qualifying appraisal that conforms to generally accepted appraisal standards;
  • a front-end debt-to-income ("DTI") ratio limit of 28 percent and a back-end limit of 36 percent, as calculated using the borrower's monthly gross income and as verified and documented by the originator; and
  • total points and fees payable by the borrower of not more than three percent of the total loan amount, calculated in the same manner as in Regulation Z.

QRMs would be restricted from payment terms allowing for interest-only payments, negative amortization, balloon payments, or any prepayment penalty. While fixed- and adjustable-rate mortgages ("ARMs") could both qualify as QRMs, interest rate adjustments on ARMs would be limited to avoid the potential for consumer payment shock following the expiration of a "teaser rate" period. An increase could not exceed: (a) 200 basis points in any twelve month period and (b) 600 basis points over the life of the mortgage transaction. Finally, QRMs would not be assumable by any person who was not a borrower under the original mortgage transaction.

While the current challenges facing the mortgage servicing industry were not an impetus for Section 941, the Agencies have boot-strapped mortgage servicing standards to the QRM definition as a means to develop and implement comprehensive national mortgage servicing standards. As a result, the originator of a QRM would be required to incorporate certain servicing policies and procedures for loss mitigation into its mortgage transaction documents. These would require that a servicer promptly initiate loss mitigation activities, such as engaging in loan modifications, within 90 days of a loan becoming delinquent.

QRM Transaction Requirements

Two additional requirements for a securitization to qualify for the QRM exemption relate to performance and verification. First, at closing of the securitization, each QRM must be currently performing (i.e., the borrower is not 30 days or more past due, in whole or in part, on the mortgage). Second, the depositor for the ABS must certify to potential investors prior to sale that it evaluated and determined the effectiveness of its internal supervisory controls for ensuring that all of the assets collateralizing the ABS are QRMs.

A sponsor relying on the QRM exemption in a securitization would not lose the exemption if, after closing, it is determined that one or more of the mortgages collateralizing the ABS do not meet all of the criteria to be a QRM if:

  • the depositor provided the required certification regarding the effectiveness of its internal supervisory controls in ensuring that all of the loans collateralizing the ABS are QRMs;
  • the sponsor must repurchase from the issuer, within 90 days of the determination that a loan does not qualify as a QRM, at a price at least equal to the remaining principal balance and accrued interest on the loan; and
  • the sponsor must promptly notify all investors regarding any loans that are required to be repurchased, including the principal amount of the loans and the cause for repurchase.

QRM Borrower Credit History

The proposal does not include a borrower credit score threshold in the QRM underwriting standards. Instead, the rule defines a set of "derogatory factors" relating to a borrower that would disqualify a borrower's mortgage from qualifying as a QRM. In particular, an originator would be required to verify with at least two consumer credit rating agencies, and document within 90 days prior to the closing of the mortgage transaction, that a borrower satisfies all of the following requirements:

  • currently, borrower is not 30 or more days past due, in whole or in part, on any debt;
  • within the preceding 24 months, borrower was not 60 or more days past due, in whole or in part, on any debt; and
  • within the preceding 36 months, borrower was not a debtor in a bankruptcy proceeding, did not have property repossessed or foreclosed upon, was not involved in a short sale or deed-inlieu of foreclosure, and was not subject to a judgment for collection of any unpaid debt.

Reduced Risk Retention for Qualifying Commercial Real Estate, and Commercial and Automobile Loans

Similar to QRMs, the proposed rule does not require a securitizer to retain any portion of the credit risk associated with a securitization of "qualifying" commercial loans, commercial mortgages or automobile loans that meet conservative underwriting standards specified by the Federal banking agencies. For a commercial loan to be considered "qualifying," the originator must verify and document the borrower's ability to repay and the transaction documentation must include covenants restricting the borrower's ability to incur additional debt or transfer or pledge its assets. Similar underwriting standards are imposed on commercial real estate ("CRE") and automobile loans, which also include an LTV ratio requirement; consideration of the value of, and the originator's security interest in, the collateral; whether the loan documentation includes the appropriate risk management and monitoring requirements; and a requirement for fixed interest rates for automobile loans.

Similar to the repurchase requirement for QRMs, the proposed rule requires the buy-back of qualifying CRE, commercial and automobile loans that are subsequently determined to be in conflict with the applicable underwriting requirements.

General Exemptions

In addition to the exemptions discussed above, certain other ABS and securitization transactions are completely exempt from the proposed risk retention requirement. These include:

  • Federally insured or guaranteed residential, multifamily, and health care mortgage loan assets;
  • ABS collateralized solely by obligations issued by the U.S. or an agency of the U.S.;
  • ABS collateralized solely by assets that are fully insured or guaranteed by the U.S. or an agency of the U.S.;
  • ABS fully guaranteed as to the timely payment of principal and interest by the U.S. or an agency of the U.S.;
  • securitizations collateralized solely by loans or other assets made, insured, guaranteed, or purchased by an institution subject to supervision of the Farm Credit Administration, including the Federal Agricultural Mortgage Corporation;
  • ABS in which the security is issued or guaranteed by a State, political subdivision, or public instrumentality thereof that is exempt from registration under the Securities Act of 1933;
  • ABS in which the security is defined as a qualified scholarship funding bond;9
  • certain resecuritization transactions;10 and
  • certain foreign-related transactions that fall within a designated safe harbor provision.11

The proposed rule provides that the Agencies may jointly adopt or issue additional exemptions, exceptions or adjustments to the credit risk retention requirements.

Request for Comment

Pursuant to the proposal, the Agencies are seeking comment on an unprecedented 174 specific questions. Notwithstanding the comprehensive nature of the proposed rule, the Agencies are seeking through the comment process a better understanding of the industry and the market implications of the proposal consistent with their statutory responsibilities to adopt rules to implement section 941.

The questions set forth by the Agencies include a wide range of inquiry covering all aspects of the proposed standards, ranging from the sufficiency of the defined terms to the appropriateness of the standards posed for varying classes of assets. Notwithstanding the volume, each question raises important issues regarding loan origination and securitization.

Action Plan

Mortgage loan originators and securitizers should solidify an action plan anticipating the implementation of the proposed risk retention changes. We recommend that your action plan include:

  • a careful review of the proposed rule and the specific questions posed by the Agencies, which are set forth in Appendix A to this alert;
  • review of your current underwriting, sales, and securitization practices and the wide range of regulatory implications in light of the proposed rule;
  • providing your views and concerns on the relevant questions posed by submitting a comment letter to the Agencies by the June 10, 2011 deadline.

Paul Hastings attorneys are actively working with clients to identify and address the impact of the Proposed Rule on their operations, and to assist in drafting comments to provide to the Agencies.

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Footnotes

1 Joint Press Release, Agencies Seek Comment on Risk Retention Proposal (March 31, 2011), available at http://fdic.gov/news/board/29Marchno2.pdf .

2 An asset-backed security is defined as "a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, lease, mortgage, or other secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset." See 15 U.S.C. § 78c(a)(77).

3 Memorandum from Michael H. Krimminger to the Board of Directors, FDIC, Notice of Proposed Rulemaking to Implement Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act at 5 (Credit Risk Retention) (March 21, 2011).

4 See S. Rep. No. 111-176, at 129 (2010).

5 The term "securitizer" includes both "(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." 15 U.S.C. § 78o-11(a)(3). For purposes of Section 15G, a "sponsor" of an ABS transaction is a "securitizer."

6 See n. 18 of Preamble to the Proposed Rule.

7 See Part III.B.9 (premium capture cash reserve account) of Preamble to the Proposed Rule.

8 The down payment must be in an amount equal to at least the sum of: (i) the closing costs payable by the borrower in connection with the transaction; (ii) 20 percent of the lesser of the estimated value of the property as determined by a qualifying appraisal, and the purchase price of the property to be paid in connection with the transaction; and (iii) if the estimated market value is less than the purchase price to be paid in connection with the transaction, the difference between these amounts.

9 See 26 U.S.C. 150(d)(2) (bonds issued by a not-for-profit corporation operated exclusively for the purpose of acquiring student loans and organized at the request of a State or political subdivision thereof).

10 The resecuritization transaction must meet two requirements: (i) the transaction must be collateralized solely by existing ABS issued in a securitization transaction for which credit risk was retained as required under the rule or which was exempted from the requirements of the rule, and (ii) the transaction must be structured so that it involves the issuance of only a single class of ABS interests and provides for the pass-through of all principal and interest payments received on the underlying ABS to the holders of such class.

11 Requirements for the safe harbor provision include: (i) the securitization transaction is not required to be and is not registered under the Securities Act of 1933; (ii) no more than 10 percent of the dollar value by proceeds (or equivalent if sold in a foreign currency) of all classes of ABS interests sold in the securitization transaction are sold to U.S. persons or for the account or benefit of U.S. persons; (iii) neither the sponsor of the securitization transaction nor the issuing entity is (A) chartered, incorporated, or organized under the laws of the U.S., or a U.S. State or Territory or (B) the unincorporated branch or office located in the U.S. of an entity not chartered, incorporated, or organized under the laws of the U.S., or a U.S. State or Territory (collectively, a U.S.-located entity); (iv) no more than 25 percent of the assets collateralizing the ABS sold in the securitization transaction were acquired by the sponsor, directly or indirectly, from a consolidated affiliate of the sponsor or issuing entity that is a U.S.-located entity.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.