Landscape for U.S. Asset-Backed Securities

Transcription

1 The Emerging Regulatory la Landscape for U.S. Asset-Backed Securities June 24, 2014 Presented By Ken Kohler and Jerry Marlatt 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

2 State of the U.S. Structured Finance Markets 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

3 State of U.S. ABS and MBS Markets Our purpose is to provide an update on the state of the U.S. securitization and covered bond markets for prospective issuers who have been out of the U.S. market since the financial crisis. Many issuers have been put off by the uncertainty caused by the large number of reform proposals resulting from the crisis. While there are still many uncertainties, the basic outline of the future U. S. structured finance market is finally emerging. We will review the status of a number of reforms, both adopted and proposed. We will start with an overview of the markets since The following pages show, for 2005 through May 2014: U.S. Mortgage-Related Securities Issuance U.S. Asset-Backed Securities Issuance European Securitization Issuance *Source: SIFMA 3

4 U.S. Mortgage-Related Securities Issuance (USD Billions)* Agency Non Agency Total Year MBS CMO CMBS HEL RMBS Total , , , , , , , , , , , , , , , , /14 ** ,081.0 *Source: SIFMA **Annualized 4

5 U.S. Asset-Backed Securities Issuance (USD Billions)* Year Auto Credit Cards Equipment Housing Related Other Student Loans /14 ** Total *Source: SIFMA **Annualized 5

6 European Securitization Issuance (USD Billions)* *Source: SIFMA **Annualized ABS Year Auto Consumer Credit Cards MBS Leases Other CDO CMBS Mixed RMBS IQ14 **

7 State of U.S. Private-Label RMBS Market Residential MBS Redwood Trust Post-GFC RMBS pioneer Accounts for most of 2010 to 2012 U.S. RMBS Issuance Other issuers entered market in 2013 Credit Suisse, JPMorgan, Citi, Shellpoint and more Post-Crisis Deal Terms Arbitration Time-Limited Representations and Warranties Non-traditional RMBS GSE risk-sharing deals Housing rental income bonds Servicer advance deals 7

8 State of U.S. Private-Label RMBS Market (cont d) Various governmental policies are impeding the market for private-label securitizations Relatively low guarantee fees for GSE loans encourage GSE securitizations High conforming loan limits of the GSEs limit the number of loans for private-label securitizations Regulatory reform has created uncertainty in the market and, in some cases, favors GSE securitizations At the same time, Congress and GSEs are attempting to develop the secondary market for non-agency securitizations In 2012, the Federal Housing Finance Agency (FHFA) proposed a strategic plan for building infrastructure for a new secondary mortgage market Items in the proposal include building a single securitization platform, standardizing data reporting and developing a standard pooling and servicing agreement Corker-Warner GSE reform proposed (2013) Attention now focused on Johnson-Crapo GSE reform bill (2014) Reform proposals include major restructuring of RMBS markets, but at least 5 years off 8

9 State of U.S. Private-Label RMBS Market (cont d) Private-label securitizations took hold in started out on track to be the best year since 2008 At least 8 issuers were in the market in 2013, ending years of Redwood sole dominance Market cooled in mid-2013 when Fed announced end of QE and rates spiked Market ended 2013 with strong issuance of $17 billion, but less than hoped for PLS has cooled in 2014 Only $300 million of traditional prime jumbo deals closed through 5/31/14 Other deals in pipeline Why? 9

10 Post-Financial Crisis Regulation ABS-specific Rules Adopted 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

11 Dodd-Frank Section 943: Reps and Warranties Rule Reason for Section 943: High percentage of rep and warranty breaches claimed in post-financial crisis securitization litigation (including related disclosure claims made in securities litigation Party enforcing repurchase requirement often same entity or affiliate of sponsor and/or loan originator who made the reps and warranties 34 Act Rule 15Ga-1 Replacement and repurchase history Form ABS-15G ongoing disclosure requirement on a quarterly basis of certain repurchase activity Items 1104 and 1121 of Reg AB requires similar information required under Rule 15Ga-1 to be disclosed in the prospectus 34 Act Rule 17g-7 Rating agency disclosure of reps, warranties and enforcement mechanisms Applies to both registered and unregistered ABS The Final Rule was issued on January 20, 2011 and became effective on March 28, There is a series of compliance dates listed in the final rules, including February 14, 2012 for the initial Form 15Ga-1 filing and Reg AB prospectus disclosure. NRSROs were required to become compliant with the requirements of Rule 17g-7 by September 26,

12 Dodd-Frank Section 945: Issuer Diligence Rule Rule 193 requires issuers to perform a review of the assets that is designed and effected to provide reasonable assurance that the disclosure regarding pool assets in prospectus is accurate in all material respects No specific type of review required Sampling may be used when appropriate Third-party may be hired to perform review If hired for review, third party either has to be named in prospectus and consent to be deemed an expert under Section 7 of the 33 Act and Rule 436 and subjected to Section 11 liability, or the issuer has to attribute to itself the findings and conclusions of the independent third party review Item 1111 of Reg AB prospectus disclosure of Rule 193 review Identity of party that performed review; whether sampling was used, and if so, what sampling technique was employed; findings and conclusions of review; whether any assets in pool deviate from underwriting criteria; and provide data on assets for which compensating or other factors were used Final Rule was issued on January 20, 2011, and became effective on March 28, 2011 for issuances after December 31,

13 Dodd-Frank Section 942(a): Elimination of Automatic Suspension of SEC Reporting Section 15(d) of 34 Act suspends reporting requirements for issuers of registered offerings for any fiscal year, other than the fiscal year within which the registration statement became effective, if, at the beginning of such fiscal year, there were less than 300 holders of the class that were sold in a registered transaction. Section 942(a) eliminated automatic suspension for ABS issuers 13

14 Dodd-Frank Section 942(a): Elimination of Automatic Suspension of SEC Reporting (cont d) SEC issued no-action letter in January 2011 stating it wouldn t recommend enforcement action if an ABS issuer continues to determine its reporting obligations based on the standards of Section 15(d) of the 34 Act if: reporting obligation in respect of outstanding ABS had been suspended by operation of Section 15(d) immediately prior to the date of enactment of Dodd- Frank; the issuer continues to comply with requirements under the ABS transaction agreements to make ongoing information regarding the ABS and the related pool assets available to security holders, directly or through the trustee; and the issuer retains the information for at least five years after ABS are no longer outstanding and, upon request, furnishes a copy of any or all such information to SEC. 14

15 Dodd-Frank Section 942(a): Elimination of Automatic Suspension of SEC Reporting (cont d) Rule 15d-22(b) suspends or terminates ABS reporting for registered deals (i) as to any semi-annual fiscal period, if, at the beginning of the semi-annual fiscal period, other than a period in the fiscal year within which the registration statement became effective or, for shelf offerings, the takedown occurred, there are no ABS of such class that were sold in a registered transaction held by non-affiliates of the depositor and a certification on Form 15 has been filed, or (ii) when there are no ABS of such class that were sold in a registered transaction still outstanding, immediately upon the filing with the Commission of a certification on Form 15 if the issuer has filed all required reports for the most recent three fiscal years 15

16 Dodd-Frank Section 942(a): Elimination of Automatic Suspension of SEC Reporting (cont d) Rule 15d-22(b) amends Form 15 to add a checkbox for ABS issuers to indicate that they are relying on Exchange Act Rule 15d-22(b) to suspend their reporting obligation. The Final Rule on Section 942(a) was published in the Federal Register on August 23, 2011, and became effective on September 22,

17 Post-Financial Crisis Regulation ABS-specific Rules Proposed 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

18 Regulation AB Originally adopted in December 2004 Governs disclosure and reporting requirements for SEC-registered securitization transactions Proposed and adopted on the view that the securitization market had become so significant that additional regulatory attention was warranted 18

19 Regulation AB II In April 2010, the SEC proposed substantial revisions in the wake of the financial crisis, attempting to provide greater investor protection and restore investor confidence The SEC re-proposed its revisions in July 2011 following Dodd-Frank Act provisions concerning asset-level disclosure, broker and originator compensation and risk retention Adoption of the final rules expected in 2014 and currently hangs over the ABS market 19

20 Regulation AB II Proposed Revisions Extensive asset-level data disclosure Reg AB extended to cover Rule 144A and Reg D offerings Same disclosure as S-1 offering Departure from sophisticated purchaser paradigm for private placements Shelf offerings require: A preliminary prospectus be available 5 days prior to pricing Executive officer certification that structure designed to produce cash flow sufficient to pay offered securities Credit risk manager to perform an asset review in certain circumstances (e.g. when credit enhancements not met or at direction of investors) 20

21 Regulation AB II Proposed Revisions (cont d) Issuers to file a computer program giving effect to waterfall provisions. The SEC is reconsidering this requirement and expected to re-propose separately Reg AB II will apply to any issuer offering MBS and ABS in the U.S. (if private offerings included) Partial re-opening of comment period February 2014 SEC re-opened comment period on certain aspects of asset-level disclosure to address privacy concerns SEC memo proposed issuers be responsible for assuring borrower privacy, including possible use of secure websites Comment period ended on April 28, 2014 Many commenters still concerned that SEC proposals will not solve privacy concerns and will expose issuers to additional liability 21

22 Dodd-Frank Section 941 Risk Retention Section 941(b) requires 6 federal agencies (UST, FRB, FDIC, SEC, FHFA, HUD) to jointly adopt regulations requiring credit risk retention by securitizers of ABS (including MBS) Section 941(b) is codified as new Section 15G of Securities Exchange Act of 1934 Purpose: to require skin in the game by securitizers Section 941(b) generally requires securitizers to retain an unhedged 5% economic interest in securitized assets, subject to certain exemptions, including an exemption for qualified residential mortgages (QRMs) Proposed rules initially issued in March 2011 Re-Proposal issued in August 2013; comment period ended October 30, 2013 Final rule expected in

23 Risk Retention Original Proposal Proposed rules issued by SEC and federal banking agencies in March 2011 Required securitizers to retain not less than 5% of credit risk of assets collateralizing ABS issuance whether vertical, horizontal, L-shaped, cash reserve account, or representative sample Premium cash capture reserve account (PCCRA) Transaction specific risk retention options for certain revolving master trusts, CMBS, ABCP conduits, and agency ABS Exemptions for govt. guaranteed ABS, certain resecuritizations, QRMs, and certain auto loans, commercial loans and commercial real estate 20% down payment for QRM Foreign transaction safe harbor for transactions predominantly outside the US Prohibition on hedging or transferring required risk retention Comment period expired in August

24 Risk Retention Re-Proposal Issued in August 2013 Changes in risk retention methods Eliminates representative sample method L-shape in any percentage combination Eligible horizontal retained interests (EHRIs) may be multiple first lost classes Eliminates PCCRA Fair value replaces par in measuring retention Disclosure of FV calculation Retention may be held by majority owned subsidiary Blended pools for qualifying commercial real estate loans, commercial loans and auto loans For most ABS types, hedging and transfer restrictions expire upon latest of 2 years Assets pay down to 33% of initial UPB ABS pay down to 33% of original balance For RMBS, hedging and transfer restrictions expire upon latest of 5 years Mortgages pay down to 25% of initial UPB Outside limit of 7 years 24

25 Risk Retention Re-Proposal (cont d) QRM definition linked to TILA/CFPB qualified mortgage (QM) definition Eliminates down payment requirement Requests comment on QM-Plus CMBS B-piece option Up to 2 pari passu interests Operating advisor, disclosure and transfer requirements 5-year sunset on B-piece retention Rejects industry comments that a CLO manager is not a securitizer Qualifying auto loan securitizations All loans must be current at closing date 10% minimum down payment Foreign safe harbor Rejects mutual recognition framework approach Requests comments on increasing safe harbor percentage 25

26 Risk Retention Major Issues Fair value Calculation Disclosure Representative sample Treatment of participations CMBS B-piece option CLO securitizer definition Foreign safe harbor Regulatory interpretation process 26

27 Dodd-Frank Section 621: Conflicts of Interest Rules Adds section 27B to 33 Act proposed Rule 127B prohibits certain persons involved in structuring, creating and distributing ABS from engaging in transactions within 1 year after date of first closing of sale of such ABS that would involve or result in a material conflict of interest with respect to any investor in such ABS SEC proposed Rule 127B in September 2011 Comment period was extended to, and expired in, February 2012 Exceptions Risk-mitigating hedging activities Liquidity commitments Bona fide market-making Conditions: ABS transaction that involves covered persons, covered products, a covered timeframe, a covered conflict, and a material conflict of interest 27

28 Dodd-Frank Section 621: Conflicts of Interest Rules (cont d) Covered persons include underwriters, placement agents, initial purchasers, sponsors, and any affiliate or subsidiary of any such entity Covered products is any ABS as defined in section 3 of the 34 Act and covers both private and registered deals, as well as synthetic ABS Covered timeframe is any transaction engaged in prior to the date that is 1 year after the closing of the sale of the ABS 28

29 Dodd-Frank Section 621: Conflicts of Interest Rules (cont d) Covered conflict is any material conflict of interest between an entity that is a securitization participant and an investor in such ABS that arises as a result of or in connection with such ABS transaction Expressly excluded are conflicts that arose exclusively between securitization participants, or exclusively between investors, conflicts that did not arise as a result of or in connection with the ABS transaction, and conflicts that did not arise as a result of or engaging in connection with engaging in any transaction, such as issuing investment research by a securitization participant 29

30 Dodd-Frank Section 621: Conflicts of Interest Rules (cont d) Material conflict is a two-prong test: (1) securitization participant would benefit directly or indirectly from actual, anticipated, or potential (a) adverse performance of the asset pool, (b) loss of principal, monetary default or early amortization event on the ABS, or (c) decline in markets value of the ABS; or (2) securitization participant who directly or indirectly controls the structure of the ABS or selection of assets in ABS would benefit directly or indirectly from fees or other forms of remuneration as a result of allowing a third party, directly or indirectly, to structure the relevant ABS; and there is a substantial likelihood that a reasonable investor would consider the resulting conflict important to his or her investment decision Status of proposed Rule 127B: final rule expected in

31 Post-Financial Crisis Regulation General Financial Crisis Rule Changes that Impact ABS and Covered Bonds 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

32 Volcker Rule On December 10, 2013, the federal banking agencies, the SEC and the CFTC approved the final version of the Volcker Rule Very detailed release of almost 900 pages The rule, based on section 619 of Dodd-Frank, will substantially limit the circumstances in which many banking entities may enter into derivatives The rule also prohibits proprietary trading, which could substantially reduce market liquidity The rule will prohibit sponsorship or ownership of some securitizations 32

33 Volcker Rule (cont d) The rule applies to a very broad range of banking entities, including insured depository institutions, companies controlling an insured depository institution, and companies treated as bank holding companies, and any affiliate or subsidiary of any of the foregoing The general rule a banking entity may not engage in proprietary trading except as permitted by the rule. a banking entity may not acquire or retain any ownership interest in or sponsor a covered fund except as permitted by the rule There is generally no grandfathering for ownership interests 33

34 Volcker Rule/Proprietary Trading Proprietary trading engaging as principal for its own trading account in a purchase or sale of one or more financial instruments, including derivatives Definition of trading account incorporates concept of short-term resales, price movements or arbitrage profits Definition of financial instrument includes most derivatives There is a rebuttable presumption that if a banking entity holds in its trading account a financial instrument for less than 60 days, the purchase or sale of such instrument is for the banking entity s trading account 34

35 Volcker Rule/Proprietary Trading (cont d) Certain types of trading are excluded from the definition of proprietary trading: Repo/reverse repo; Securities lending; Liquidity management pursuant to a plan; Derivative clearing organization (DCO) and clearing agency trades; Trades to satisfy an existing delivery obligation; Trades to satisfy a court, judicial or similar proceeding; Trades where the banking entity is acting solely as agent, broker or custodian; Trades through a deferred compensation plan; and Trades made in the ordinary course of collecting a debt previously contracted. No exclusion for interaffiliate trades 35

36 Volcker Rule/Proprietary Trading (cont d) The prohibition on proprietary trading also does not apply to: Trading in US government/agency securities; Trading in munis; Trading by a foreign bank sub of a US banking entity in debt of the foreign government where the sub is located; Trading on behalf of a customer in a fiduciary or riskless principal capacity; or Trading by a banking entity that is a regulated insurance company 36

37 Volcker Rule The prohibition on proprietary trading does not apply to certain riskmitigating hedging activities or certain market-making activities as well as certain underwriting activities Permitted risk-mitigating hedging activities do not explicitly include a portfolio hedge However, they do permit hedging activities that are: in connection with and related to individual or aggregated positions, contracts or other holdings and designed to reduce the specific risks to the banking entity that are related to such positions, contracts or other holdings 37

38 Volcker Rule/Market-Making Activities (cont d) The prohibition on proprietary trading does not apply to certain market-making activities; Requirements for permitted market-making activities: Trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles The amount, types, and risks of the financial instruments in the trading desk s market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties 38

39 Volcker Rule/Underwriting The underwriting exception is permitted only if the trading desk underwriting position is related to a distribution of securities for which the bank is an underwriter Distribution: 33 Act registered, or otherwise characterized as different from ordinary trading by virtue of selling efforts Securities law terms Underwriter: defined broadly to include selling group members and other distribution participants Securities law terms Amount and type of securities in the underwriting position: cannot exceed the reasonably expected near term demands of clients, customers, counterparties, etc. The trading desk must use reasonable efforts to reduce the position within a reasonable time 39

40 FBOs The rule establishes an exemption for proprietary trading by an FBO to the extent that the trading is conducted solely outside the United States (SOTUS exemption) SOTUS means FBO not organized under U.S. or State law majority of total assets held outside the U.S. majority of total revenues derived from business outside U.S. majority of total net income derived from business outside U.S. the personnel of FBO (or affiliate) that negotiate or execute the trade are not located in the U.S. or organized under U.S. law the personnel who make the decision to trade are not located in U.S. the trade and any related hedging is not accounted for by any breach or affiliate located in the U.S. or organized under U.S. law no financing for the trade is provided by a branch or affiliate located in U.S. or organized under U.S. law with certain exceptions, the trade is not conducted with or through a U.S. entity 40

41 Prudential backstop Proprietary trading activities are not permissible if: They involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties, or They would result in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy, or They pose a safety and soundness threat to the institution or a threat to US financial stability 41

42 Covered funds The rule prohibits a banking entity, as principal, directly or indirectly from acquiring or retaining an ownership interest in, or sponsoring, a covered fund Does not apply to banking entity: solely acting as agent, broker or custodian and the activity is conducted for the account of or on behalf of a customer and the banking entity does not retain an interest; the banking entity s ownership interest is held/controlled by it as trustee in connection with a deferred comp or similar plan; owns interest in the ordinary course of collecting a debt; or holds as trustee or on behalf of a customer that is not itself a covered fund A covered fund is an issuer: that would be a 40 Act entity but for 3(c)(1) or 3(c)(7) any commodity pool CPO relies on exemption or units sold to QEPs and not publicly offered 42

43 Covered funds (cont d) exemptions; certain CPOs; foreign funds that have no connection to the U.S. For any banking entity that is, or is controlled by a banking entity that is, located in or organized under the laws of the U.S., any entity organized outside the U.S. whose ownership interests are offered and sold solely outside the U.S. organized primarily for the purpose of trading in securities the banking entity sponsors or holds an ownership interest in the entity 43

44 Covered funds (cont d) Various entities are excluded from the definition of a covered fund: foreign public funds; wholly owned subs; joint ventures; acquisition vehicles; certain qualifying securitization vehicles; registered 40 Act entities Other entities: Foreign pension or retirement funds Insurance company separate accounts Bank-owned life insurance company separate accounts SBICs and certain permissible public welfare and similar funds Entities used by FDIC to dispose of assets as receiver or conservator 44

45 Covered funds (cont d) The agencies expressly excluded certain entities from the definition of covered fund. In some cases, these entities may be able to rely on exclusions from the definition of investment company other than section 3(c)(1) and section 3(c)(7) Entities include Financial market utilities Collateral cash pools Pass-through REITs Municipal securities tender option bond transactions Venture capital funds Credit funds Employee securities companies 45

46 Covered funds (cont d) Scope of prohibition The basic prohibition is that banking entities are not permitted to sponsor or acquire an ownership interest in a covered fund, subject to certain exceptions Sponsorship means To serve as a general partner, managing member, trustee or CPO of a covered fund To select or control selection of a majority of directors, trustees or management of a covered fund To share with the covered fund the same name or a variation of the name Ownership interest Means any equity, partnership or other similar interest Other similar interest includes an interest in or security issued by a covered fund that exhibits certain characteristics on a current, future or contingency basis Definition of ownership interest may include interests in a covered fund that might not be considered an ownership interest or an equity interest in other contexts 46

47 Covered funds (cont d) Permitted covered fund sponsorship and investments Notwithstanding the prohibition on sponsorship and investment in ownership interests in covered funds, the rule permits investment and sponsorship of the certain covered funds, subject to prescribed limitations and conditions Customer funds A BE may acquire ownership interests in or sponsor a covered fund, including acting as a general partner, managing member, trustee or CPO as a means of offering investment opportunities to customers Covered fund activity must be in connection with BE s trust, fiduciary or investment management services for customers pursuant to a written plan 47

48 Covered funds Permitted covered fund sponsorship and investments (cont d) Limited investments in customer funds Per-fund investment limitation Entities issuing asset-backed securities Ownership limitation exception for required risk retention rules Permissible underwriting and market making Restrictions do not apply to BE s underwriting and market-making related activities provided they conform to the requirements for permitted activities under the proprietary trading prohibitions Aggregate value of covered fund investments may not exceed 3% of Tier 1 capital 48

49 Covered funds (cont d) Super 23A BEs may not enter into with the funds discussed above (covered funds) transactions that are covered transactions under Section 23A of the FRA No BE that (directly or indirectly) serves as investment manager, investment adviser, CTA or sponsor of a covered fund may engage in any transaction with the covered fund if the transaction would be a covered transaction as defined in Section 23A, as if the BE or its affiliate were a member bank and the covered fund were an affiliate Covered transactions include Loan or extension of credit (including repo) Purchase or investment of securities issued by affiliate Purchase of assets from the affiliate Acceptance of securities as collateral for a loan Issuance of guarantee, acceptance or LOC on behalf of affiliate Transaction with affiliate that involves borrowing or lending securities Derivative transactions 49

50 Covered funds (cont d) Super 23A Volcker Rule imposes an absolute transactional prohibition, subject to explicit exceptions Thus, we call the Volcker Rule s 23A prohibitions Super 23A Exceptions Acquisitions of ownership interests in covered funds that are not proscribed to the extent permitted elsewhere in the rule BEs, subject to certain conditions, may enter into prime brokerage transactions with covered fund that is managed, sponsored or advised by the BE or its affiliates Other permitted covered fund activities Permitted risk-mitigating hedging activities Fund investment and sponsorship by FBOs solely outside the U.S. Permitted fund activities by regulated insurance companies Prudential backstops Above activities not permissible if they result in material conflicts of interest 50

51 Securitization Overview Banking entities involved as investors in, sponsors of, or transaction parties (e.g., credit or liquidity providers) with, securitization issuers are subject to severe restrictions or divestiture if the securitization issuer is a covered fund. Congress stated in the Dodd-Frank Act its intention that the Volcker Rule not limit or restrict the ability of banking entities to sell or securitize loans. In the Final Rule, the Agencies generally followed Congressional intent by making clear that most securitizations of traditional loan products (e.g., mortgage loans, auto loans, student loans and credit card receivables) are not covered funds. 51

52 Securitization Overview (cont d) However, the Final Rule creates the possibility that certain securitization vehicles whose assets include securities or derivatives (as opposed to loans) may be covered funds. Banking entities must closely examine the securitizations with which they are involved to determine if they are covered funds. If a banking entity has an investment in, sponsors, or engages in certain transactions with a securitization vehicle that is a covered fund, it must closely examine such relationships to determine if they are permissible or require divestiture or restructuring. 52

53 Definition of Covered Fund The basic definition of covered fund is a three-pronged test previously described. For most securitization issuers, the relevant test will be that set forth in the first prong of the definition whether the issuer would be an investment company under the 1940 Act but for the exemptions set forth in Section 3(c)(1) or 3(c)(7) of the 1940 Act. Many securitizations rely on other exemptions from the 1940 Act and are therefore not covered funds. A banking entity involved with a securitization should be able to determine the applicable 1940 Act exemption by reviewing the offering documents. If beneficial ownership of securities is limited to 100 or fewer persons, the deal probably relies on Section 3(c)(1). If investors are required to be qualified purchasers for purposes of the 1940 Act, the deal probably relies on Section 3(a)(7). 53

54 Definition of Covered Fund (cont d) The Agencies have stated that a deal that relied on Section 3(c)(1) or 3(c)(7) may still not be a covered fund if another 1940 Act exemption is also available. If a securitization issuer relied on 3(c)(1) or 3(c)(7), is another 1940 Act exemption available? Section 3(c)(5)(C) for certain mortgage-backed securities Rule 3a-7 for many traditional securitizations Section 3(c)(5)(A) for certain securitizations of consumer receivables Section 3(c)(5)(B) for certain securitizations of trade receivables Rule 3a-5 for finance subsidiaries whose securities are guaranteed by parent 54

55 Exclusions from Covered Fund Definition General If the issuer relied on Section 3(c)(1) or 3(c)(7) of the 1940 Act and another 1940 Act exemption is not available, it may still avail itself of one or more of the 14 enumerated exclusions from the definition of covered fund. Of the 14 exclusions, four are most likely to be applicable to a securitization issuer: Loan securitization exclusion Qualifying asset-backed commercial paper (ABCP) conduit exclusion Qualifying covered bond exclusion Wholly owned subsidiary exclusion 55

56 Loan Securitization Exclusion This exclusion applies to an issuer of ABS if its underlying assets are comprised solely of: loans (defined as any loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative); rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders or related or incidental to purchasing or otherwise acquiring, and holding loans, subject to certain limitations; certain interest rate or foreign exchange derivatives that (i) directly relate to the loans in the issuing entity, the related ABS or certain related contractual rights or assets and (ii) reduce the interest rate and/or foreign exchange risks related to such loans, the related ABS or permitted contractual rights or assets; 56

57 Loan Securitization Exclusion (cont d) certain special units of beneficial interest ( SUBIs ) and collateral certificates (which are issued by certain intermediate special purpose vehicles that themselves satisfy the requirements of the loan securitization exclusion); and certain securities constituting cash equivalents and securities received in lieu of debts previously contracted with respect to the loans underlying the ABS. In addition, in order to qualify for the loan securitization exclusion, the issuer may not hold (i) a security, including an ABS, or an interest in an equity or debt security other than as permitted above; (ii) a derivative, other than as permitted above; or (iii) a commodity forward contract. The Agencies stated in the preamble that the determination whether a loan or other financial asset is a security is made by reference to the federal securities laws. 57

58 Qualifying ABCP Conduit Exclusion This exclusion applies to an issuer of asset-backed commercial paper (ABCP) if the underlying assets are comprised solely of: loans or other assets that would be permissible under the loan securitization exclusion described above, and ABS that are supported solely by assets permissible under the loan securitization exclusion and are acquired by the ABCP conduit as part of the initial issuance of the securities. In addition, to qualify for the qualifying ABCP conduit exclusion, a regulated liquidity provider (as defined in the Final Rule) must provide a legally binding commitment to provide full and unconditional liquidity coverage with respect to all the outstanding ABCP issued in the event that funds are required to redeem the maturing ABCP. 58

59 Qualifying Covered Bond Exclusion This exclusion applies to an entity that owns or holds a dynamic or fixed pool of assets that covers the payment obligations of covered bonds if such assets or holdings meet the requirements of the loan securitization exclusion. In addition, the covered bonds must be debt obligations that are issued either directly by a foreign banking organization ( FBO ) (in which case, the payment obligations of the covered bonds must be fully and unconditionally guaranteed by the entity that owns the permitted cover pool) or by the entity that owns the permitted cover pool (in which case, the payment obligations of the covered bonds must be fully and unconditionally guaranteed by an FBO and the issuer of the covered bonds must be a wholly owned subsidiary that satisfies the requirements of the wholly owned subsidiary exclusion (described below) of the FBO. 59

60 Wholly Owned Subsidiary Exclusion This exclusion applies to an entity if all of its outstanding ownership interests are owned directly or indirectly by a banking entity or an affiliate thereof, except that: up to five percent of the entity s ownership interests may be owned by directors, employees, and certain former directors and employees of the banking entity or its affiliates; and within the five percent ownership interest, up to 0.5 percent of the entity s outstanding ownership interests may be held by a third party if the ownership interest is held by the third party for the purpose of establishing corporate separateness or addressing bankruptcy or insolvency. This exclusion was added to the Final Rule to clarify that wholly owned depositors and other intermediate transferors of assets in a securitization are not considered covered funds. This exclusion is also likely to be very helpful for banking entities that establish or rely on special purpose funding programs that utilize trust or other tax pass-through vehicles. 60

61 Covered Fund Problem Areas Most covered fund problems arise for Section 3(c)(1) or Section 3(c)(7) funds whose assets include securities or derivatives: CDOs backed by securities or derivatives (including CDOs backed by trustpreferred securities ( TruPS )) CLOs that hold debt securities Certain CMOs backed by mortgage securities Auction rate preferred securities Resecuritizations Bond Repackagings Synthetic ABS Synthetic structured products Funding vehicles Domestic covered bonds 61

62 Covered Fund Restrictions If a securitization issuer is determined to be a covered fund, banking entities are prohibited from: acquiring ownership interests in the securitization issuer, sponsoring the securitization issuer, and making loans to, or entering into certain other types of transactions with a securitization issuer for which the banking entity acts as sponsor, investment manager, investment adviser or commodity trading advisor. The prohibitions described in the third bullet point above are defined in the Final Rule by reference to the restrictions of Section 23A and 23B of the Federal Reserve Act, and are commonly referred to by commenters as the Super 23A provisions. These restrictions, among other things, severely limit the ability of banking entities to provide credit and liquidity support to covered fund securitizations to which they are related as investors, sponsors or advisors. Additionally, permitted transactions between the banking entity and the securitization issuer must be on market terms. 62

63 Covered Fund Restrictions (cont d) The Final Rule also includes a limited exemption from ownership and sponsorship restrictions to the extent banking entities retain ownership interests in sponsored securitizations not otherwise excluded from the covered fund definition in order to comply with risk retention requirements. This exemption, however, does not exempt banking entities from Super 23A restrictions. Additionally, the exemption does not apply if banking entities retain ownership interests in excess of the required retention under risk retention rules, defeating its utility in situations in which rating agencies or prospective investors require a retention in excess of the regulatory risk retention requirement. The Final Rule does not itself grandfather, or exempt, structures and investments put in place before the effective date of the Final Rule or before the enactment of the Dodd-Frank Act. Accordingly, banking entities will need to closely examine their existing securitization investments and relationships, and prospective transactions, for compliance with the Volcker Rule. 63

64 Definition of Ownership Interest An ownership interest includes any equity or partnership interest in a covered fund or any other interest in or security issued by a covered fund that exhibits any of certain characteristics on a current, future or contingent basis, including: has the right to participate in the selection or removal of a general partner, managing member, member of the board of directors, investment manager, investment adviser or commodity trading advisor (not including rights of a creditor to exercise remedies in the event of a default); has the right under the terms of the interest to receive a share of the income, gains or profits of the covered fund (regardless of whether the right is pro rata with other owners); has the right to receive the underlying assets of the covered fund, after all other interests have been redeemed and/or paid in full (the residual in securitizations); has the right to receive all or a portion of excess spread; 64

65 Definition of Ownership Interest (cont d) provides that the amounts payable by the covered fund with respect to the interest could, under the terms of the interest, be reduced based on losses arising from the underlying assets of the covered fund, such as allocation of losses, write-downs or charge-offs of the outstanding principal balance, or reductions in the amount of interest due and payable on the interest; receives income on a pass-through basis from the covered fund, or has a rate of return that is determined by reference to the performance of the underlying assets of the covered fund (excluding interests that are entitled to received dividend amounts calculated at a fixed or floating rate); and any synthetic right to have, receive or be allocated any of the rights described above (which would not allow banking entities to obtain derivative exposure to these characteristics). Of particular importance to banking entities engaged in investment banking activities, notwithstanding the general prohibition of a banking entity acquiring an ownership interest in a covered fund, a banking entity may acquire such an ownership interest in connection with certain permitted underwriting and market making-related activities. 65

66 Definition of Ownership Interest (cont d) It is also important to note that the definition of ownership interest in the Final Rule may include interests in a covered fund that might not usually be considered an ownership interest or an equity interest. Of particular concern is the first of the indicia of an ownership interest list above that the interest has the right to participate in the selection or removal of a general partner, managing member, director, investment manager, investment adviser or commodity trading advisor. Many CLOs and CDOs provide rights to a controlling class of senior debt security holders to participate in the designation of investment managers or investment advisers, creating the potential that the holders of even the most senior, highly rated debt securities may be considered to hold ownership interests. It is hoped that further regulatory guidance will clarify whether senior debt interests in such structures are susceptible to classification as ownership interests. 66

67 Definition of Sponsor The Final Rule defines sponsor to mean any entity that: serves as general partner, managing member, or trustee of a covered fund, or that serves as a commodity pool operator of a covered fund, selects or controls (or has employees, officers, or directors, or agents who constitute) a majority of the directors, trustees, or management of a covered fund, or shares with a covered fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name. A key question for trustees of ABS issuing trusts (which are typically appointed by the party usually regarded as the sponsor of the securitization) is whether such trustees may themselves be considered sponsors of the securitization. The Agencies stated in the Preamble that the term sponsor includes a trustee that has the right to exercise any investment discretion with respect to the securitization. The Agencies also indicated that for ABS issuers, this would generally not include a trustee that executes decision making, including investment of funds prior to the occurrence of an event of default, solely in accordance with the provisions of a written contract or at the written direction of an unaffiliated party. 67

68 Interim Final Rule re TruPS CDOs The Final Rule caused considerable industry outcry over the definition of ownership interest as applied to CDOs and CLOs particularly from community banks that hold CDOs backed by trust preferred securities ( TruPS ). On January 14, 2014 the Agencies issued an interim final rule providing grandfathering for certain existing TruPS CDOs. The interim final rule allows the retention of an interest in or sponsorship of covered funds by banking entities if, among other things, the following conditions are met: The TruPS CDO was established, and the interest was issued, before May 19, 2010; The banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in qualifying TruPS collateral; and The banking entity s interest in the TruPS CDO was acquired on or before December 10, 2013, the date the Agencies issued the Final Rule implementing the Volcker Rule. 68

69 Consumer Mortgage Lending Reform Consumer Financial Protection Bureau was established under the Dodd-Frank Act and began operation on July 21, 2011 The jurisdiction of the bureau includes banks, credit unions, securities firms, payday lenders, mortgage-servicing operations, foreclosure relief services, debt collectors and other financial companies, and its most pressing concerns are mortgages, credit cards and student loans. Consolidates responsibilities from various federal regulatory bodies, including the Federal Reserve, the Federal Trade Commission, the Federal Deposit Insurance Corporation, the National Credit Union Administration and the Department of Housing and Urban Development. It writes and enforces bank rules, conducts bank examinations, monitors and reports on markets, as well as collects and tracks consumer complaints. 69

70 Consumer and Mortgage Lending Reform (cont d) In January 2013, the Consumer Financial Protection Bureau issued the Ability-to-Repay and Qualified Mortgage rule Amends Regulation Z to require lenders to account for a borrower s ability to repay Regulation Z applies to all persons extending consumer credit to U.S. residents Final rule took effect on January 10, 2014 Ability-to-Repay Requirement For residential mortgages, creditors must make a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms 70

71 Consumer and Mortgage Lending Reform (cont d) Eight enumerated underwriting factors for creditors to consider, including: Borrower s income or assets (excludes assets securing the loan) Borrower s employment status Borrower s expected monthly payment for the loan Borrower s debt obligations Borrower s credit history 71

72 Consumer and Mortgage Lending Reform (cont d) Qualified Mortgage ( QM ) definition Residential mortgage loan that meets the following criteria: No excess upfront points and fees No negative amortization Term not exceeding 30 years Consumer cannot defer repayment of principal No balloon payment (with a very narrow exception) Income and financial resources must be verified and documented Limits on debt-to-income ratios Borrowers may sue under TILA for 3 years; always a foreclosure defense QMs provide compliance safe harbor or rebuttable presumption that abilityto-repay requirements satisfied Safe harbor for loans that are not higher priced based on APR formula Rebuttable presumption for higher priced loans 72

73 Consumer and Mortgage Lending Reform (cont d) Consequences of the Ability-to-Repay and QM rule Complexity may create compliance challenges and litigation risks Restrictions may tighten access to credit Non-U.S. issuers not subject to these requirements may have an advantage over other market participants Assignee liability concerns likely to constrain securitization and secondary market for non-qm loans 73

74 Consumer and Mortgage Lending Reform (cont d) In January 2013, the CFPB issued new mortgage servicing standards focused on helping troubled borrowers Final rules took effect on January 10, 2014 and apply to all U.S. servicers Among other items, the new standards: Forbid servicers from dual-tracking (i.e. evaluating a consumer for loan modifications at same time as preparing to foreclose) Require servicers to provide delinquent borrowers with direct and continuous access to servicing personnel Prevent servicers from making a first foreclosure notice or filing until a mortgage is at least 120 days delinquent Require servicers to provide written notice of loss mitigation options to borrowers Servicers that service less than 5,000 loans that they or an affiliate either own or originated are exempted Also in January 2013, CFPB issued final rule on mortgage loan originator compensation and qualifications generally effective on June 1,

75 Credit Ratings Dodd-Frank Act eliminated certain safeguards against strict liability for credit rating agencies rating securities offered and sold pursuant to a US registration statement Issuers must obtain consent from such credit rating agencies in order to include such ratings in the registration statement or prospectus Because credit rating agencies now face strict liability for that portion of any registration statement or prospectus they have in essence expertised, they have routinely declined to provide the necessary consents Applies only to registered deals; not applicable to Rule 144A or Reg S offerings 75

76 Post-Financial Crisis Regulation CFTC as Regulator of Securitizations 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

77 Definitional Changes Dodd-Frank s inclusion of swaps as commodity interests means that pooled investment vehicles trading in swaps (and their operators or advisors) must consider whether they may be subject to regulation as a Commodity Pool, a Commodity Pool Operator or a Commodity Trading Advisor 77

78 Commodity Pool Definition As amended by Dodd-Frank, the Commodity Exchange Act ( CEA ) now defines the term commodity pool to include any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any (i) commodity for future delivery, security futures product, or swap; (ii) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of the CEA or section 2(c)(2)(D)(i) of the CEA; (iii) commodity option authorized under section 6c of the CEA; or (iv) leverage transaction authorized under section 23 of the CEA In addition, the CFTC, by rule or regulation, may include within, or exclude from, the term commodity pool any investment trust, syndicate, or similar form of enterprise if the CFTC determines that the rule or regulation will effectuate the purposes of the CEA 78

79 Commodity Pool Operator Definition As amended by Dodd-Frank, the CEA now defines the term commodity pool operator to include any person: (i) engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests, including any (I) commodity for future delivery, security futures product, or swap; (II) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of the CEA or section 2(c)(2)(D)(i) of the CEA; (III) commodity option authorized under section 6c of the CEA; or (IV) leverage transaction authorized under section 23 of the CEA; or (ii) who is registered with the CFTC as a commodity pool operator In addition, the CFTC has the authority to include within, or exclude from, the CPO definition any person if such inclusion or exclusion will effectuate the purposes of the CEA 79

80 Why should you avoid CPO status? A CPO: Is de facto a financial entity and not able to avail itself of the end-user exemption Must register itself, and register its principals and associated persons, as members of the NFA Requires filing of a Form 7-R for the entity, and an 8-R for each AP/principal A principal will be understood to include a director, officer, or anyone with decision-making authority A holder of 10% or more of the equity of the entity also is considered a principal An AP must take a Series 3 exam, required ethics training, and subject itself to fingerprinting and other registration obligations Is subject to ongoing compliance obligations 80

81 Compliance obligations of CPOs A CPO will be subject to oversight and examinations by the NFA A CPO must be prepared to comply with various initial and ongoing reporting, recordkeeping and other requirements, including: The requirement to appoint a CCO The obligation to file with, and have approved by, the NFA a disclosure document, and comply with regulations relating to information disclosures A requirement to maintain compliance policies and procedures to provide for appropriate custody of client assets; secure privacy of client information; comply with anti-money laundering requirements; prevent manipulative or disruptive trading practices, ensure business continuity, maintain accurate records, etc. File certain annual and other reports, such as Forms CPO-PQR and CTA-PR 81

82 Exclusions from Definition of Commodity Pool No-Action Relief The CFTC has issued no-action relief to the effect that certain vehicles that trade in swaps need not be considered as a commodity pool In no-action letters relating to securitization vehicles (each, an SV ) and equity real estate investment trusts (each, an equity REIT ), the CFTC has applied a fact-intensive analysis to determine whether or not an SV or equity REIT constitutes a commodity pool A primary inquiry is the extent to which such a vehicle s entering into swaps actually drives (or could actually drive) the investment returns of investors in the vehicles, as opposed to being used for certain limited permitted uses (e.g. credit enhancement and altering rates or currency flows from underlying assets) 82

83 Securitizations No-Action Relief CFTC No-Action Letter (October 11, 2012) provides that a securitization vehicle will not constitute a commodity pool if it conforms to the following criteria: the issuer of the asset-backed securities is operated consistent with the conditions set forth in Regulation AB, or Rule 3a-7, whether or not the issuer s security offerings are in fact regulated pursuant to either regulation; the entity s activities are limited to passively owning or holding a pool of receivables or other financial assets (either fixed or revolving) that by their terms convert to cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders; the entity s use of derivatives is limited to the uses of derivatives permitted under the terms of Regulation AB, which include credit enhancement and the use of derivatives such as interest rate and currency swap agreements to alter the payment characteristics of the cash flows from the issuing entity; the issuer makes payments to securities holders only from cash flow generated by its pool assets and other permitted rights and assets, and not from or otherwise based upon changes in the value of the entity s assets; and the issuer is not permitted to acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changes in market value of the vehicle s assets. 83

84 Securitizations More No-Action Relief CFTC No-Action Letter (December 7, 2012) provides further detail with regard to securitization vehicles that may or may not constitute commodity pools: certain securitization vehicles that do not satisfy the operating or trading limitations contained in Regulation AB or Rule 3a-7 may be properly excluded from the definition of commodity pool, provided that the criterion with respect to the ownership of financial assets continues to be satisfied and the use of swaps is no greater than that contemplated by Regulation AB and Rule 3a-7, and such swaps are not used in any way to create an investment exposure Examples: A standard asset-backed commercial paper conduit Even if not falling within the letter of the letter, an investment in this securitization is not unlike an investment in a traditional securitization that satisfies Regulation AB or Rule 3a-7 in that the investment is essentially in the financial assets in the vehicle and not in the swaps A CDO using swaps to convert fixed rate assets into floating rate assets and FX swaps to convert a foreign currency into dollars Similarly, such an investment is not unlike an investment in a traditional securitization that satisfies Regulation AB or Rule 3a-7 in that the investment is essentially in the financial assets in the vehicle and not in the swaps A covered bond transaction The collateral pool (and any special purpose vehicle) would not be a commodity pool if it contains no commodity interests other than any swaps which are used only for purposes permitted by Regulation AB, and covered bond holders are only entitled to receive payments of accrued interest and repayment of principal of their covered bonds, without any condition to payment based upon any derivative exposure 84

85 Securitizations (further cont d) However, if investors in an SV have exposure to swaps which are used to create investment exposure (e.g., the payment to investors is affected by swaps in a way other than to enhance credit (within reason) or to swap interest rates or currencies, each as permitted by Regulation AB), then the securitization vehicle may be a commodity pool Examples: CDO holding a 5% bucket for synthetic assets consisting of swaps rather than having 100% of its holdings in financial assets Repackaging vehicle that issues credit-linked or equity-linked notes where the repackaging vehicle owns high quality financial assets, but sells credit protection on a broad based index or obtains exposure to a broad based stock index through a swap (SV may be a commodity pool because investors in the SV are obtaining a significant component of their investment upside or downside from the related swaps) Repackaging vehicle that acquires a three-year bond, issues a tranche of notes, and uses swaps to extend investment experience of the bond (and notes) to four years Commercially unreasonable use of swaps as credit support in a securitization (e.g., to raise CCC rated underlying assets to AA rating level, thereby making the swap a significant aspect of the investment ) 85

86 Legacy Securitizations CFTC No-Action Letter also contains no-action relief for certain legacy securitization issuers of fixed-income securities The relief applies if: the issuer issued fixed income securities before October 12, 2012 that are backed by and structured to be paid from payments on or proceeds received in respect of, and whose creditworthiness primarily depends upon, cash or synthetic assets owned by the issuer; the issuer has not issued and will not issue new securities on or after October 12, 2012; and issuer agrees, upon request, to provide disclosure documents and other information 86

87 Other Relief CFTC No-Action Letter (March 29, 2013) provides securitizations not meeting the or letters partial relief from the limitations of Part 4 of the regulations until June 30, 2013, if CPO registration is initiated by March 31, CFTC No-Action Letter (April 5, 2013) provides reporting relief for between affiliated counterparties if neither are SDs or MSPs; for 100%- owned counterparties, transaction information must be retained; for majorityowned counterparties, aggregate transaction data may be reported quarterly. ASF requested an explicit exemption in a May 16, 2013 letter from the clearing requirement for swaps with limited recourse and non-petition clauses; it was reported that the DCR staff stated in a telephone call that it could not provide a written response before the June 10, 2013 effective date. 87

88 Exemptions from CPO Registration CFTC Regulation 4.13(a)(1) single pool not required to register as CPO if does not receive any form of compensation; operates only one pool at a time; not otherwise required to register with the CFTC; and does not advertise CFTC Regulation 4.13(a)(2) small pool not required to register if no pools have more than 15 participants (not including pool s operator, CTA and certain other related persons); and total gross capital contributions in all pools do not exceed $400,000 CFTC Regulation 4.13(a)(3) de minimis exemption exclusion from CPO registration for entities that engage in a de minimis amount of derivatives trading activity 88

89 The 4.13(a)(3) Exemption CFTC Regulation 4.13(a)(3) exempts pools with investors that are either non-us persons or that meet an accredited investor - like standard provided that the pools trades only a de minimis amount of commodity interests, whether or not for bona fide hedging purposes Limitations are similar to those in new Rule 4.5: aggregate initial margin, premiums and required security deposit for commodity positions cannot exceed 5% of the liquidation value of the fund s portfolio (after taking into account unrealized profits and losses), OR the aggregate net notional value of commodity positions will not exceed 100% of the liquidation value of the fund s portfolio (after taking into account unrealized profits and losses) Commodity positions include commodity options, certain swaps, certain forex transactions and futures (including security futures) 89

90 Regulation 4.5 Exclusion CTFC Regulation 4.5 excludes from the definition of a CPO qualifying entities that operate pools regulated by some other regulatory authority Qualifying entities include Registered investment companies (that comply with restrictions) Insurance companies with respect to separate account Bank, trust company or financial depository institution with respect to trust or custodial assets while acting in fiduciary capacity Trustee or named fiduciary of, or employer maintaining an ERISA pension plan February 9, 2012 CFTC amended Rule 4.5 to sharply limit the ability of advisers to registered investment companies that use derivatives to rely on the exclusion 90

91 Swaps - Clearing Dodd-Frank Act provides that the CFTC or the SEC in consultation with the US Treasury Secretary may prohibit an entity domiciled in a non-us jurisdiction from participating in any swaps activities in the US if it determines that the regulation of swaps markets in that country undermines the stability of the US financial system Dodd-Frank Act s provisions apply only to swaps activities in the United States, except where activities outside the United States have a direct and significant connection to activities in, or effect on, US commerce, or contravene any rules designed to prevent the evasion of US derivatives laws. If issuer is not a dealer or major participant and enter into swaps in the US for purposes of hedging or mitigating commercial risk, issuer may be eligible to utilize the end-user exemption from mandatory clearing 91

92 Swaps End User Exemption Mandatory centralized clearing of swaps unless one of the counterparties: is (i) not a dealer, major participant, commodity pool, private fund, employee benefit plan, or entity that predominantly engages in financial or banking activities, (ii) using the swap to hedge or mitigate commercial risks, and (iii) notifies the CFTC or the SEC how it generally meets its financial obligations associated with non-cleared swaps This exemption is also available to an affiliate of an entity that meets the criteria above (a Qualifying Entity ) so long as such affiliate: is (i) not a dealer, major participant, commodity pool, private fund or bank holding company with over US$50 billion in consolidated assets, (ii) acts on behalf of the Qualifying Entity and as an agent, and (iii) uses the swap to hedge or mitigate the commercial risks of the Qualifying Entity or other affiliate of the Qualifying Entity Swaps entered into in the US for purposes of speculation, trading, or investing are not eligible for the end-user exemption. 92

93 Covered Bonds in the United States 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

94 Foreign Bank Issuance into U.S. Some tranches of European offerings were sold into the U.S. prior to 2008 Post-crisis issuance resumed in 2010 with $25 billion of offerings 2011 followed with more than $35 billion of issuance and 2012 provided almost $50 billion of issuance 2013 has started somewhat slowly at a time when European issuance is at historic lows and continued slowly Only $22 billion of issuance 2014 has been even slower; to date, only one offer in the U.S. Pricing has been better in Europe due to the size of the market and crosscurrency swap costs Currently we have about $150 billion of covered bonds outstanding 94

95 Foreign Bank Issuances Foreign banks issuing into the US market have been relying on their domestic covered bond framework and have been using cover pool assets that are foreign (not in the United States). Issuances into the United States have been structured as program issuances (or syndicated takedowns) conducted on an exempt basis; that means that the foreign issuer is relying on exemptions from the U.S. securities laws requiring registration of public offerings of securities. As a result, offerings have been targeted at U.S. institutional investors and generally conducted in reliance on Rule 144A. On May 18, 2012, Royal Bank of Canada obtained a no-action letter from the SEC that permitted RBC to register its covered bond program on Form F-3. On July 30, 2012, RBC obtained SEC approval for a registration statement for its covered bond program ( ): On September 19, 2012, RBC issued $2.5 B of 5 year covered bonds under this registration statement. On December 6, 2012, RBC issued $1.5 B of 3 year covered bonds. In 2013, BMO and BNS obtained SEC approval for registration statements 95

96 Issuance Alternatives In a private placement in reliance on U.S. private placement exemptions (generally Section 4(a)(2)). In an offering structured as a private placement, with resales under Rule 144A (to qualified institutional buyers, or QIBs). In an offering by a bank that is excepted from registration under Section 3(a)(2) (a 3(a)(2) offering). In an SEC registered offering, public offering without restrictions. 96

97 Domestic Covered Bond Issuance 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

98 Covered bonds in the United States Historically, housing finance in the United States has depended on other sources (instead of covered bonds). For example, the GSEs. The GSEs were essential to the growth of the securitization market in the United States. Securitization. U.S. banks became dependent on securitization. There was a significant market for securitization and securitization provided off-balance sheet treatment for regulatory capital and GAAP accounting purposes. FHLB funding. U.S. banks had access to funding from the Federal Home Loan Bank system. 98

99 Covered bonds in the United States Given a mix of the financial crisis, GSE financial circumstances, market forces, accounting developments and regulatory changes, new housing finance alternatives are becoming more important. Covered bonds have been in the news in the United States since In September 2006, Washington Mutual became the first North American financial institution to offer covered bonds in an offering in Europe. In 2007, Bank of America followed with its own covered bond offering in Europe. In 2012, RBC obtained SEC approval for registered covered bonds; BMO and BNS have followed. 99

100 The Emergence of US Domestic CB Supply is Anticipated Subject to the Establishment of US Covered Bond Legislation In 2011, Covered Bond legislation was introduced in the House as H.R. 940 and passed the Financial Services Committee by a strong bi-partisan vote of 44-7 Covered Bonds legislation was introduced in the Senate on November 9, 2011 as S No hearings were held. A new Congress began in 2013, so the legislation had to be reintroduced. Rep. Hensarling introduced H.R.2767, the PATH Act, which include GSE reform provisions and covered bond legislation and was passed by the House Financial Services Committee by straight party-line vote. S.1217 was introduced in the Senate for GSE reform and include no covered bond legislation. The Johnson-Crapo amendments to S.1217 were introduced in 2014 and have been approved by the Senate Banking Committee, but the prospects for S.1217 appear dim. Currently, there is no legislation for covered bonds appears to be active WaMu issues first North American covered bond into Euro market 2007 Bank of America issues first USD covered bond by a US bank 2007 RBC launches the first Canadian covered bond program January 2010 CIBC issues the first USD 144A covered bond since 2007 March 2011 US Covered Bond Act introduced by Rep. Scott Garrett November 2011 US Covered Bond Act introduced by Senators Hagan and Corker /14 No significant legislative developments RBC first SEC registered covered bond Anticipated completion of US covered bond legislation The Development of US Domestic Covered Bonds in the USD Market 100

101 Proposed Legislation in the U.S. mofo.com

102 Essential Legal Elements Federal legislation. Creation of a separate insolvency estate Necessary to protect the maturity of the bond We have a unitary insolvency system Only a single estate to meet the claims of creditors Priority claim for bondholders. Covered bond regulator Regulatory oversight of the quality of covered bonds Regulatory approval of issuance Regulatory oversight of the administration of the separate estate No tax on separate estate or its activities. 102

103 Proposed U.S. Structure Legislation enables direct issuance from the bank to investors while ensuring the assets are segregated in the event of an issuer insolvency The statute generally enables cash flow from the collateral to continue to pay covered bonds as scheduled notwithstanding the insolvency of the issuer. Covered Bond Security Trustee Security Covered Bond Proceeds Cover Pool Issuer Covered Bonds Covered Bondholders 103

104 Key Elements of the Legislation Cover Pool Assets Eligible Asset complying first-lien residential mortgage loan complying commercial mortgage loan loans or securities of States or municipalities complying auto loans or leases complying student loans complying revolving credit receivable any loan made or guaranteed under a Small Business Administration program any other asset designated by the covered bond regulator in consultation with the primary financial regulatory agency of the issuer substitute asset cash, overnight Federal funds, US Government obligations and GSE obligations 20% of pool 104

105 Key Elements of the Legislation (cont d) Legal Attributes of Statutory U.S. Covered Bonds Only one asset type permitted in a cover pool. The Issuer s primary Federal financial regulator to be the covered bond regulator. The regulator is required to set a limit for each issuer on the amount of covered bonds an issuer may have outstanding based on total assets Cease and desist authority if program does not comply with legislation Upon insolvency of a bank issuer, 180 days for the FDIC to transfer the covered bonds to another bank. The cover pool becomes a separate estate if the covered bonds are not transferred or if the FDIC is not the receiver. Upon default prior to insolvency, the cover pool becomes a separate estate immediately. 105

106 Key Elements of the Legislation (cont d) Legal Attributes of Statutory U.S. Covered Bonds The covered bond regulator as the trustee of the pool. Appoints one or more servicers or administrators. Administers the estate for the benefit of the bondholders and other secured parties (e.g., swap counterparties). Authority for the cover pool to borrow for liquidity purposes. FDIC granted a residual interest in the cover pool. Covered bonds issued by a bank are deemed to be issued under Section 3(a)(2) of the Securities Act Covered bonds are not an asset-backed security and therefore should not be subject to SEC Regulation AB 106

107 Prospects for Legislation Several factors favor U.S. Covered Bonds legislation in 2013 Prices in the housing market are recovering Fannie Mae and Freddie Mac are being wound down Had been 95% of financing for new mortgage loans FDIC unlimited deposit account guarantee has terminated Presidential election behind us Ways and Means Committee cleared bill Steadily growing issuance by foreign banks into U.S. Currently there are about $150 billion of covered bonds outstanding SEC approval of RBC, BMO and BNS registration statements RMBS market still has little traction Possible solution to FDIC concerns 107

108 SEC Registration 2014 Morrison & Foerster LLP All Rights Reserved mofo.com

109 SEC Registered Covered Bonds RBC obtained a no action letter from the SEC SEC link RBC filed its registration statement of Form F-3 ( ). A shelf registration statement. SEC link There are eligibility requirements for Form F-3, including at least 12 months of SEC reporting history. Form F-9 or Form F-10 issuers generally would be eligible for Form F

110 SEC Registered Covered Bonds (cont d) The covered bonds were not deemed to be ABS, although disclosure consistent with Regulation AB was required. Disclosure about the cover pool assets is similar to a credit card or UK RMBS master trust. No loan level disclosure for loans in the cover pool. No financial statements required for the Guarantor. 110

111 Canadian Covered Bond Architecture The structure first launched by RBC has been established as the market standard for Canadian issuers with CIBC, BMO, BNS, TD and NBC utilizing the same basic structure. The Canadian covered bond architecture below closely resembles the UK covered bond architecture: Covered bonds are issued to investors with full recourse to the Issuer and the cover pool. The issuer, as Seller, sells mortgage loan assets to the Guarantor, which uses proceeds from the Intercompany Loan to purchase the mortgage loans from the Issuer and provide a guarantee to the covered bond investors. Canadian Bank Seller Mortgage Loans and Related Security Consideration Covered Bond Guarantor Guarantor Interest Rate Swap Provider CB Swap Provider Intercompany Loan Repayment of Intercompany Loan Canadian Bank Issuer Trust Deed (incl Covered Bond Guarantee) and Security Agreement Covered Bond Proceeds Covered Bonds Bond Trustee Covered Bondholders 111

112 Why a No Action Letter? Required by Canadian/U.K. structure Separate Guarantor deemed to be issuing a separate security, the guarantee The guarantee needs to be registered with the SEC The Guarantor is not an SEC reporting company Nor is it a 100% owned subsidiary under Rule 3-10 of Regulation S-X Not a full and unconditional guarantee under Rule 3-10 of Regulation S-X So Guarantor does not qualify for a shelf registration statement No action letter from SEC permits both Bank and Guarantor to register on a shelf registration statement This would not be a requirement for a Pfandbrief-type structure 112

113 Advantages of Registration No offering restrictions; no transfer restrictions. No investment restrictions; the bonds are not restricted securities. No requirement for the issuing bank to have a U.S. branch or agency; no capital impact on a U.S. branch or agency. No discussion required with U.S. banking regulators. No private placement restrictions on communications. No limits on repatriation of proceeds. 113

114 Advantages of Registration Wider investor base State retirement funds ~ 200 investors compared to 75 in a typical 144A Attractive pricing basis points savings compared to 144A RBC $2.5 billion 5 year Better secondary market Eligible for major bond indices e.g., Barclays Aggregate Bond Index TRACE Reporting System Pricing transparency 114

115 Advantages of Registration - TRACE