Six Federal Agencies Propose Joint Rules on for Asset-Backed Securities EXECUTIVE SUMMARY Section 15G of the Securities Exchange Act of 1934, added by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires the Federal banking agencies and the Securities and Exchange Commission to jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer transfers to a third party through the issuance of an asset-backed security. It also requires these agencies, together with the Federal Housing Finance Agency and the Department of Housing and Urban Development, to jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any residential mortgage asset that the securitizer transfers to a third party through the issuance of an asset-backed security. These agencies have jointly proposed the required regulations for public comment. The proposed rules provide a menu of seven different alternatives for meeting the risk retention requirements, including some options available for any type of securitization and others specifically designed for certain asset classes. They would also provide a full exemption from the risk retention requirements for securitizations backed by residential mortgages, commercial loans, commercial real estate loans and automobile loans meeting certain precisely specified product and underwriting criteria. Further exemptions are provided for certain government-backed assets and securitizations and certain resecuritizations and offshore transactions. The rules are required to become effective for residential mortgage securitizations one year after publication of final rules and for other securitizations two years after publication of the final rules in the Federal Register. The deadline for public comment is June 10, 2011. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
Table of Contents I. SUMMARY... 1 II. BACKGROUND... 2 III. GENERAL DEFINITIONS AND SCOPE... 6 IV. RISK RETENTION REQUIREMENT... 7 A. Types of Risk Retention... 7 B. Allocation of Risk Retention... 16 C. Restrictions on Transfer and Hedging... 16 V. QRMS... 17 VI. REDUCED RISK RETENTION REQUIREMENTS FOR ABS BACKED BY QUALIFYING COMMERCIAL REAL ESTATE, COMMERCIAL OR AUTOMOBILE LOANS... 21 A. Commercial Loans... 22 B. CRE Loans... 23 C. Automobile Loans... 25 D. Common Requirements... 26 VII. GENERAL EXEMPTIONS... 27 A. Government-backed Assets and Securitizations... 27 B. Resecuritization Transactions... 28 C. Offshore Securitizations... 28
I. SUMMARY Section 15G of the Securities Exchange Act of 1934, added by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires the Federal banking agencies and the Securities and Exchange Commission to jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer transfers to a third party through the issuance of an asset-backed security. It also requires these agencies, together with the Federal Housing Finance Agency and the Department of Housing and Urban Development, to jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any residential mortgage asset that the securitizer transfers to a third party through the issuance of an asset-backed security. These agencies have jointly proposed the required regulations for public comment. Section 15G(c) provides that these regulations must require a securitizer to retain (i) not less than 5% of the credit risk for any asset that is not a qualified residential mortgage that is transferred, sold or conveyed through the issuance of an asset-backed security by the securitizer or that is a qualified residential mortgage that is transferred, sold or conveyed through the issuance of an asset-backed security by the securitizer, if one or more of the assets that collateralize the asset-backed security are not qualified residential mortgages or (ii) less than 5% of the credit risk for an asset that is not a qualified residential mortgage that is transferred, sold or conveyed through the issuance of an asset-backed security by the securitizer, if the originator of the asset meets the underwriting standards established pursuant to the regulations. The proposed rules establish the minimum level of risk retention at 5% for all asset classes and provide a menu of seven different alternatives for meeting the risk retention requirements. The proposed rules would provide for 0% risk retention for assets that meet the contemplated underwriting and product standards. Vertical, horizontal residual, L-shaped and random sample risk retention by the sponsor would be permitted for any type of securitization while retention of a seller s interest would be permitted for revolving asset master trusts, retention of a horizontal residual interest by originators would be permitted for asset-backed commercial paper and acquisition of a horizontal first-loss interest by certain third-party purchasers (known as B-piece buyers ) would be permitted under certain circumstances for commercial mortgage-backed securities. In lieu of a horizontal interest, a sponsor, originator or third-party purchaser may establish and fund a cash reserve account to take the first-loss position in a securitization transaction. The proposed rules would also generally prohibit transfers and hedging of assets or interests that the rules require a sponsor, originator or third party to retain or acquire, and would, in certain circumstances, require the establishment and funding of a premium capture cash reserve account to discourage structures that might otherwise circumvent the intended effect of the 5% risk retention requirements.
The proposed rules also provide a full exemption from the risk retention requirements for securitizations backed by residential mortgages, commercial loans, commercial real estate loans and automobile loans meeting certain precise product and underwriting criteria. For residential mortgages, the standards would include a limited set of minimum servicing requirements and exclude nontraditional products. The conditions set for these exemptions are generally quite strict and are intended to assure that only securitizations of very high quality assets will be exempt from the risk retention requirements. They impose quality control requirements and require sponsors to repurchase assets for cash at their unpaid principal amount plus accrued interest within 90 days after a determination that they do not meet the applicable standards. Further exemptions are provided for certain government-backed assets and securitizations and certain resecuritizations and offshore transactions. Section 15G(c)(2) stipulates that the required regulations establish asset classes with separate rules for securitizers of different classes of asset, including residential mortgages, commercial mortgages, commercial loans, auto loans and any other classes of assets that the Federal banking agencies and the SEC deem appropriate. The proposed rules would establish standards for the exemption of only the four asset classes listed in the statute. The rules are required to become effective for residential mortgage securitizations one year after publication of final rules and for other securitizations two years after publication of the final rules in the Federal Register. The proposed rules set out an unusually large number of questions for public comment. The deadline for public comment is June 10, 2011. II. BACKGROUND Section 15G of the Securities Exchange Act of 1934 ( Section 15G ), added by Section 941 of the Dodd- Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ), requires the Office of the Comptroller of the Currency ( OCC ), the Board of Governors of the Federal Reserve System ( Fed ), the Federal Deposit Insurance Corporation ( FDIC and, together with the OCC and the Fed, the Federal banking agencies ) and the Securities and Exchange Commission ( SEC ) to jointly prescribe regulations not later than 270 days of the date of enactment of Dodd-Frank, to require any securitizer 1 to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security ( ABS ), 2 transfers, sells or conveys to a third party. 3 It also requires these 1 2 Section 15G(a)(3) defines the term securitizer as: (A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer. As discussed in Part III of this memorandum, the proposed rules generally impose the risk retention requirement not on the issuer of the ABS but on the sponsor of the ABS transaction. Section 3(a)(77), also added by Section 941 of Dodd-Frank, defines an asset-backed security as a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized (footnote continued) -2-
agencies, together with the Federal Housing Finance Agency ( FHFA ) and the Department of Housing and Urban Development ( HUD ), to jointly prescribe regulations not later than 270 days of the date of enactment of Dodd-Frank, to require any securitizer to retain an economic interest in a portion of the credit risk for any residential mortgage asset that the securitizer, through the issuance of an ABS, transfers, sells or conveys to a third party. 4 Section 15G(c) requires that the regulations: prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain with respect to an asset; require a securitizer to retain (i) not less than 5% of the credit risk of any asset that is not a qualified residential mortgage ( QRM ) or that is a QRM that is transferred, sold or conveyed through the issuance of an ABS by the securitizer if one or more of the assets that collateralize the ABS are not QRMs or (ii) less than 5% of the credit risk for an asset that is not a QRM that is transferred, sold or conveyed through the issuance of an ABS by the securitizer if the originator 5 of the asset meets certain underwriting standards; 6 specify (i) the permissible forms of risk retention, (ii) the minimum duration of the risk retention, and (iii) that a securitizer is not required to retain any part of the credit risk for an asset if all assets that collateralize the ABS are QRMs; apply regardless of whether the securitizer is an insured depository institution; specify with respect to a commercial mortgage the permissible types, forms and amounts of risk retention that would meet the above requirements, which in the determination of the Federal banking agencies and the SEC may include certain particular requirements; establish appropriate standards for retention of an economic interest with respect to collateralized debt obligations ( CDOs ), securities collateralized by CDOs and similar instruments collateralized by ABS; and provide for certain exemptions and for the allocation of risk retention obligations between a securitizer and an originator in the case of a securitizer that purchases assets from an originator. (footnote continued) mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the [Securities and Exchange] Commission, by rule, determines to be an asset-backed security for purposes of this section, specifying that the term does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company. The SEC has to date not proposed or adopted rules expanding the definition. 3 4 5 6 Section 15G(b)(1). Section 15G(b)(2). Section 15G(a)(4) defines the term originator as a person who (A) through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security; and (B) sells an asset directly or indirectly to a securitizer. It does not include subsequent purchasers or transferees. As explained below, where the assets meet certain underwriting and product standards, the proposed regulations would provide for a complete exemption from the risk retention requirements. -3-
Section 15G(c) also requires that the regulations establish separate rules for residential mortgages, commercial mortgages, commercial loans, auto loans and any other class of assets that the Federal banking agencies and the SEC deem appropriate. For each such asset class, the regulations must include underwriting standards established by the Federal banking agencies that specify the terms, conditions and characteristics of a loan that indicate a low credit risk. Section 15G(e) grants the Federal banking agencies and the SEC authority to adopt exemptions for classes of institutions or assets 7 from the risk retention requirement and hedging prohibition. It also exempts loans made, insured, guaranteed or purchased by any institution that is subject to the supervision of the Farm Credit Administration, including the Federal Agricultural Mortgage Corporation and any residential, multifamily or health care facility mortgage loan asset or securitization guaranteed by the U.S. or any agency thereof. 8 Section 15G(e) further specifies particular factors that the six Federal agencies (the Agencies ) 9 must take into account in jointly defining QRM and requires that the term be defined to be no broader than the term qualified mortgage ( QM ) is defined under Section 129C(c)(2) 10 of the Truth in Lending Act, as amended by Dodd-Frank ( TILA ), and regulations adopted thereunder. On March 31, 2011, the Agencies published the proposed rules under Section 15G and supplementary information and requested comments by June 10, 2011. The proposed rules provide various alternatives for meeting the risk retention requirements, including: retention of risk by holding at least 5% of each class of ABS issued in a securitization transaction ( vertical retention ); retention of a first-loss residual interest in an amount equal to at least 5% of the par value of all ABS interests issued in a securitization transaction ( horizontal retention ); an equally divided combination of vertical and horizontal retention; retention of a representative sample of the assets designated for securitization in an amount equal to at least 5% of the unpaid principal balance of all the designated assets; and for commercial mortgage-backed securities, retention of at least a 5% first-loss residual interest by a third party that specifically negotiates for the interest, if certain requirements are met. The proposed rules also include a premium capture mechanism intended to prevent a securitizer from structuring an ABS in a way that negates or reduces its retained economic exposure to the securitized 7 8 9 10 The proposed regulations include exemptions for classes of assets but not for classes of institutions. For this purpose, Fannie Mae, Freddie Mac and the Federal home loan banks are not considered agencies of the U.S. In view of the differing grants of authority to the six Agencies under Section 15G, as used in the proposal, the term Agencies is deemed to refer to the appropriate Agencies that have rulewriting authority with respect to the asset class, securitization transaction or other matter discussed. The legislative history indicates that the reference to Section 129C(c)(2) of TILA (rather than Section 129C(b)(2) of TILA) was an inadvertent technical error, since qualified mortgage is defined in the latter section. -4-
assets by monetizing the excess spread, which is the difference between the gross yield on the pool of securitized assets less the cost of financing them, charge-offs, servicing costs and other expenses, created by the transaction. The rules propose product and underwriting standards for QRMs and underwriting standards for commercial loans, commercial mortgages and automobile loans ( qualified assets ) that would support a zero percent risk retention requirement, and also include disclosure requirements intended to provide investors and the Agencies with an efficient mechanism to monitor compliance with the risk retention requirements of the proposed rules. The rules also would recognize that the 100% guarantee of principal and interest provided by Fannie Mae and Freddie Mac, for as long as they are in conservatorship or receivership with capital support from the U.S. government, meets their risk retention requirements as sponsors of mortgage-backed securities. The Agencies recognize that many prudently underwritten loans may not satisfy all the criteria in the proposed rules for qualified assets, and thus securitizers of such loans would generally be required to retain credit risk under the rules. They intend the rules, however, to allow the securitization markets for non-qualified assets to function in a manner that both facilitates the flow of credit on economically viable terms and is consistent with the protection of investors. The proposed rules are referenced using a common designation of.1 to.23, and, when codified, will reflect the title and part designations for the relevant Agency. The appropriate Agencies will jointly approve any written interpretations, written responses to requests for no action letters and legal opinions and other written interpretative guidance concerning the scope or terms of Section 15G and the final rules that are intended to be relied on by the public generally, as well as any exemptions, exceptions or adjustments to the final rules. 11 The rules are required to become effective with respect to securitizers and originators of ABS backed by residential mortgages one year after the date on which final rules are published in the Federal Register and with respect to all other classes of ABS, two years after the date on which the final rules are published. 11.23. All references appearing in this memorandum in this format are to sections of the proposed rules. -5-
III. GENERAL DEFINITIONS AND SCOPE 12 The proposed rules incorporate by reference the statutory definition of asset-backed security, and define: asset to mean a self-liquidating financial asset, including loans, leases or other receivables, and securitized asset to mean an asset that is transferred, sold or conveyed to an issuing entity and that collateralizes the ABS interests issued by the issuing entity. Accordingly, synthetic securitizations are not within the scope of the proposed rules. The proposed rules would apply to securitizers of ABS offerings whether or not they are registered with the SEC under the Securities Act. The proposed rules would generally apply for each securitization transaction, which is a transaction involving the offer and sale of ABS by an issuing entity, which is, with respect to a securitization transaction, the trust or other entity created at the direction of the sponsor that owns or holds the pool of assets to be securitized, and in whose name the ABS are issued. ABS interest refers to all types of interests or obligations issued by an issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest or residual interest, the payments on which are primarily dependent on the cash flows on the collateral held by the issuing entity, but does not include common or preferred stock, limited liability interests, partnership interests, trust certificates or similar interests in an issuing entity that are issued primarily to evidence ownership of the issuing entity, and the payments, if any, on which are not primarily dependent on the cash flows of the collateral held by the issuing entity. The proposed rules define sponsor in a manner consistent with Regulation AB of the SEC and provide that a depositor 13 or a sponsor is a securitizer. They generally apply the risk retention requirement to the sponsor of the ABS rather than the depositor, and where two or more entities each meet the definition of a sponsor for a single transaction, they require that one of the sponsors retain credit risk in accordance with the proposed rules, while making each responsible for assuring that at least one sponsor has complied with the requirements. 14 12 13 14 Definitions relevant to multiple parts of the proposed rules are, for the most part, set forth in.2 and discussed in this section, while definitions relevant only to a specific part or section of the proposed rules are set forth in that part or section and discussed in this memorandum where such part or section is discussed. The Agencies interpret the reference to issuer of an asset-backed security in the statutory definition of securitizer as referring to the depositor and not to the issuing entity. The Agencies specifically request comment on alternative approaches to allocating the risk retention requirement among multiple sponsors, and whether the rules should provide additional guidance for the application of risk retention requirements to multi-step transactions. -6-
The proposed rules define originator as a person that (1) through an extension of credit or otherwise, creates an asset that collateralizes an asset-backed security and (2) sells the asset directly or indirectly to a securitizer and originator-seller as an entity that creates assets through one or more extensions of credit and sells those assets (and no other assets) to an intermediate SPV, which in turn sells interests collateralized by those assets to one or more ABCP conduits. IV. RISK RETENTION REQUIREMENT The proposal provides for a base risk retention requirement under which the sponsor (or in some cases, originators or other parties) would have to retain an economic interest equal to at least 5% of the aggregate credit risk 15 of the assets collateralizing an issue of ABS. 16 These requirements would apply regardless of whether the sponsor or other relevant party is an insured depository institution, bank holding company or subsidiary thereof, registered broker dealer or other type of federally supervised financial institution. The relevant party may retain additional exposure beyond that required by the proposed rule on its own initiative or in response to market demands. In some circumstances, the proposed rules would require a sponsor to fund a premium capture cash reserve account in addition to meeting the base risk retention requirement. A. TYPES OF RISK RETENTION Subpart B of the proposed rules offers sponsors several alternatives to satisfy the risk retention requirements of Section 15G, taking into account the heterogeneity of securitization markets. If there is more than one sponsor of a securitization transaction, the proposed rules would make it the responsibility of each sponsor to ensure that at least one of the sponsors of the securitization transaction retains an economic interest in the credit risk of the securitized assets in accordance with any one of these alternatives. 17 15 16 17 The proposed rules define credit risk as: (1) the risk of loss that could result from the failure of the borrower in the case of a securitized asset, or the issuing entity in the case of an ABS interest in the issuing entity, to make required payments of principal or interest on the asset or ABS interest on a timely basis; (2) the risk of loss that could result from bankruptcy, insolvency, or a similar proceeding with respect to the borrower or issuing entity, as appropriate; or (3) the effect that significant changes in the underlying credit quality of the asset or ABS interest may have on the market value of the asset or ABS interest. The Agencies are soliciting public comment on whether the base risk retention requirement would have a significant adverse effect on liquidity or pricing for certain types of securitization, and what modifications to the proposed rules could be made to address these concerns in a manner consistent with the purposes of Section 15G..3(b). -7-
1. Vertical Risk Retention. 18 Under this option, a sponsor would be required to retain at least 5% of each class of ABS interests issued in the securitization, whether or not it has a par value, was issued in certificated form or was sold to unaffiliated investors. 19 A sponsor that elects to retain a vertical slice of an ABS transaction would be required to disclose to potential investors a reasonable time prior to the sale of the ABS in the securitization transaction and, upon request, to the SEC and to its appropriate Federal banking agency (if any), the percentage and dollar amount of each class of ABS interests in the issuing entity that the sponsor will retain (or did retain) at closing as well as the percentage and dollar amount that the sponsor is required to retain under the proposed rules. To help investors and the Agencies monitor the sponsor s compliance, a sponsor would also have to disclose the material assumptions and methodologies it used to determine the aggregate dollar amount of ABS interests issued by the issuing entity in the securitization transaction, including those pertaining to any estimated cash flows and the discount rate used. 2. Horizontal Risk Retention. 20 Under this alternative, the sponsor would retain an eligible horizontal residual interest in the issuing entity in an amount that is equal to at least 5% of the par value of all ABS interests in the issuing entity that are issued as part of the securitization transaction. A number of terms and conditions governing the structure of an eligible horizontal residual interest are intended to ensure that the interest would be a first-loss position and could not be reduced in principal amount, other than through the absorption of losses, more quickly than the senior interests. Until all other ABS interests in the issuing entity are paid in full, the retained horizontal interest generally would not be permitted to receive payments of principal, such as prepayments or proceeds of the sale of securitized assets, although it may receive its proportionate share of scheduled payments of principal. Under this option, the sponsor would have to disclose the material terms of the eligible horizontal residual interest, such as when the interest is allocated losses or may receive payments, and the material assumptions and methodologies used in determining the aggregate dollar amount of ABS interests issued by the issuing entity in the securitization transaction, including those assumptions and methodologies pertaining to any estimated cash flows and the discount rate used. 18 19 20.4. The 5% risk retention requirement would not apply to common or preferred stock, limited liability interests, partnership interests, trust certificates or similar interests that are issued primarily to evidence ownership of the issuing entity and the payments, if any, on which are not primarily dependent on the cash flows of the assets of the issuing entity, as these types of interests are not ABS interests for purposes of Section 15G..5. -8-
As an alternative to retaining a horizontal residual interest, the proposed rules also would allow a sponsor to establish and fund a horizontal cash reserve account at closing, to be held by the trustee or a similar person for the benefit of the issuing entity. 21 The funds could be invested only in short-term U.S. Treasury securities and deposits with insured depository institutions and used only to satisfy payments on ABS interests when the issuing entity otherwise has insufficient funds from any source, provided that the funds may be released to the sponsor over time in connection with scheduled payments of principal on the securitized assets received by the issuing entity and the sponsor may receive interest payments received by the account on its permitted investments. Similar disclosure requirements would apply to sponsors electing to use a horizontal cash reserve account as an alternative to retaining an eligible horizontal residual interest. 3. L-shaped Risk Retention. 22 The third option combines the first two alternatives by permitting the sponsor to retain a vertical component consisting of at least 2.5% of each class of ABS interests in the issuing entity and a horizontal component consisting of an eligible horizontal residual interest (or in lieu thereof, a horizontal cash reserve account in such amount) in an amount equal to at least 2.564% of the par value of all ABS interests, other than those retained as part of the vertical component. 23 The disclosures described above for both the vertical and horizontal risk retention options would be required. 4. Revolving Asset Master Trusts (Seller s Interest). 24 To accommodate securitizations using a master trust that allow for the issuance of multiple series of ABS backed by a single pool of assets, the proposed rules include an option that would permit a sponsor to retain a seller s interest in an amount not less than 5% of the unpaid principal balance of all the assets held by the issuing entity. The proposed rules define: a revolving asset master trust as an issuing entity that (i) is a master trust and (ii) is established to issue more than one series of ABS, all of which are collateralized by a single pool of revolving securitized assets that are expected to change in composition over time, and a seller s interest as an ABS interest (i) in all of the assets that are held by the issuing entity and that do not collateralize any other ABS interests issued by the entity, (ii) that is pari passu with all other ABS interests issued by the issuing entity with respect to the allocation of all payments and losses prior to an early amortization event (as defined in the transaction documents) and (iii) that adjusts for fluctuations in the outstanding principal balances of the securitized assets. 21 22 23 24.5(b)..6. The percentages are calculated to avoid double counting and to assure that half of the retained risk is retained as the vertical component and half is retained as the horizontal component and that the total retained risk amounts to 5%..7. -9-
The Agencies intend these definitions to be consistent with market practice and ensure that any retained seller s interest would expose the sponsor to the credit risk of the underlying assets. A sponsor using the seller s interest option would have to disclose the percentage and dollar amount of the seller s interest that the sponsor will retain (or has retained) in the transaction at closing and the percentage and dollar amount that the sponsor is required to retain, the material terms of the seller s interest and the material assumptions and methodology used in determining the aggregate dollar amount of ABS interests issued by the issuing entity in the securitization transaction, including those pertaining to any estimated cash flows and the discount rate used. 25 5. Representative Sample. 26 The fifth option permits a sponsor to meet its risk retention requirements by retaining a randomly selected representative sample of assets that is equivalent in all material respects to the assets subject to the securitization. Since the sponsor would retain exposure to substantially the same type of credit risk as investors in the ABS, the Agencies believe that it should have an incentive to monitor and control the quality of the underwriting of the securitized assets. At the time of issuance of the ABS by the issuing entity, the unpaid principal balance of the retained assets would have to be at least 5.264% of the aggregate unpaid principal balance of all the securitized assets in the securitization transaction. To avoid bias, the sponsor would have to designate a pool of at least 1,000 assets and randomly select the sample exclusively from the pool without taking into account any characteristics of the assets other than their unpaid principal balance. It would then have to assess the sample to ensure that for each material characteristic of the assets in the designated pool, the mean of any quantitative characteristic, including the unpaid principal balance, and the proportion of any characteristic that is categorical in nature, of the sample of assets randomly selected from the designated pool is within a 95% two-tailed confidence interval of the mean or proportion, respectively, of the same characteristic of all the assets in the designated pool. The sponsor must repeat the process as often as necessary until it produces a sample with equivalent material characteristics within the required confidence level. The sponsor would be required to implement policies and procedures for (i) identifying and documenting the material characteristics of the assets in the designated pool, (ii) selecting assets randomly from the designated pool for inclusion in the representative sample, (iii) testing the randomly selected sample of assets in the designated pool, (iv) maintaining, until all ABS interests are paid in full, documentation that clearly identifies the assets included in the representative sample and (v) prohibiting, until all ABS interests are paid in full, assets in the 25 26 The Agencies are requesting comment on whether this form of risk retention should be applied to any other types of securitization transaction..8. -10-
representative sample from being included in the designated pool of any other securitization transaction. The sponsor would be required to obtain an agreed-upon procedures report from an independent public accounting firm covering a number of specified items and the same entity would have to service both the securitized and the retained assets. Servicing would have to be subject to the same contractual standards as the servicing of the securitized assets, and the individuals responsible for servicing the assets must not be able to determine whether an asset is held by the sponsor or the issuing entity. Until all ABS interests are repaid, the sponsor would be prohibited from removing any assets from the representative sample for any reason and from including any assets that are in the representative sample in any other designated pool or representative sample established in connection with another securitization transaction. The restrictions on sale and hedging of a retained interest described below would also apply to assets in the representative sample. Finally, disclosure would be required of the amount of assets included and required to be included in the sample, the material characteristics of the designated pool and the sample and the methodology used to select the sample, the policies and procedures that the sponsor used for ensuring that the sample complies with the rule, confirmation that the required procedures report was obtained, the material assumptions and methodology used in determining the aggregate dollar amount of ABS interests issued by the issuing entity and, at the end of each distribution period, a comparison of the performance of the pool of securitized assets and the representative sample. Asset-Backed Commercial Paper Conduits. 27 The sixth option would be available for assetbacked commercial paper ( ABCP ) having a term of up to nine months collateralized by receivables or loans and supported by a liquidity facility that provides 100% liquidity coverage from a regulated liquidity provider. 28 A sponsor of an ABCP securitization transaction would satisfy its base risk retention requirement with respect to the issuance of ABCP by an eligible ABCP conduit if each originator-seller retains an eligible horizontal residual interest in each intermediate SPV established by or on behalf of that originator-seller for purposes of issuing interests to the eligible ABCP conduit. The eligible horizontal residual interest retained by the 27 28.9. The proposal defines a regulated liquidity provider as: a depository institution (as defined in Section 3 of the Federal Deposit Insurance Act); a bank holding company or a subsidiary thereof; a savings and loan holding company provided all or substantially all of the holding company s activities are permissible for a financial holding company under 12 U.S.C. 1843(k) or a subsidiary thereof; or a foreign bank (or a subsidiary thereof) whose home country supervisor (as defined in 211.21 of the Fed s Regulation K) has adopted capital standards consistent with the Capital Accord of the Basel Committee on Banking Supervision, as amended, provided the foreign bank is subject to such standards. -11-
originator-seller in each such intermediate SPV must equal at least 5% of the par value of all interests issued by that SPV. Accordingly, each originator-seller would be required to retain credit exposure to the receivables sold by that originator-seller to support issuance of the ABCP. The eligible horizontal residual interest retained by the originator-seller would be subject to the same terms and conditions as apply under the horizontal risk retention option. This option would not be available to entities or programs that operate as securities or arbitrage programs, which typically purchase securities rather than receivables and loans from originators. This option will be available only if (i) the issuing entity is bankruptcy remote or otherwise isolated for insolvency purposes from the sponsor and any intermediate SPV, (ii) the ABS issued by an intermediate SPV to the issuing entity are collateralized solely by assets originated by a single originator-seller, (iii) all the interests issued by an intermediate SPV are transferred to one or more ABCP conduits or retained by the originator-seller and (iv) a regulated liquidity provider has entered into a legally binding commitment to provide 100% liquidity coverage (in the form of a lending facility, an asset purchase agreement, a repurchase agreement or similar arrangement) to all the ABCP issued by the issuing entity by lending to, or purchasing assets from, the issuing entity in the event that funds are required to repay maturing ABCP issued by the issuing entity. The sponsor of an eligible ABCP conduit that issues ABCP in reliance on this option must also provide to holders of all ABS interests the name and form of organization of each originator-seller, a description of the form, amount and nature of the retained interest, the name of each regulated liquidity provider that provides liquidity support to the eligible ABCP conduit and a description of the form, amount and nature of such liquidity coverage. The sponsor would be responsible for compliance with the requirements of this risk retention option and must maintain policies and procedures to monitor the originator-sellers compliance with the requirements of the proposal. If the sponsor determines that an originator-seller no longer complies with the requirements of the rule (for example, because the originator-seller has sold the interest it was required to retain), the sponsor would be required to promptly notify, or cause to be notified, the investors in the securitization transaction of such noncompliance. 6. Commercial Mortgage-Backed Securities. 29 The proposed rules would permit a sponsor of ABS that are collateralized by commercial real estate ( CRE ) loans to meet its risk retention requirements if a third-party purchaser acquires an eligible horizontal residual interest in the issuing entity in the same form, amount and manner as the sponsor would have been required to retain under the horizontal risk retention option and certain additional conditions are met. This 29.10. -12-
option would be available only for securitization transactions where CRE loans constitute at least 95% of the unpaid principal balance of the assets being securitized. The interest acquired by the third-party purchaser must be the most junior interest in the issuing entity and must be subject to the same limits on payments as would apply if the eligible horizontal residual interest were held by the sponsor pursuant to the horizontal risk retention option. The third-party purchaser must pay for the first-loss subordinated interest in cash at the closing of the securitization without financing being provided, directly or indirectly, from any other person that is a party to the securitization transaction (including the sponsor, depositor or an unaffiliated servicer), other than a person that is a party solely by reason of being an investor. The third-party purchaser must also perform a review of the credit risk of each asset in the pool prior to the sale of the ABS that includes, at a minimum, a review of the underwriting standards, collateral and expected cash flows of each commercial loan in the pool. A third-party purchaser may not be affiliated with any other party to the securitization transaction (other than investors) 30 or have control rights in the securitization (including acting as servicer or special servicer) that are not collectively shared by all other investors in the securitization, unless the underlying securitization transaction documents provide for the appointment of an independent Operating Advisor. An Operating Advisor would be defined as a party that (i) is not affiliated with any other party to the securitization, (ii) does not directly or indirectly have any financial interest in the securitization other than in fees from its role as Operating Advisor, and (iii) is required to act in the best interest of, and for the benefit of, investors as a collective whole. An Operating Advisor would have to have certain powers and responsibilities to ensure that it can effectively fulfill its role, including authority to recommend replacement of a servicer that is, or is affiliated with, the third-party purchaser. The relevant transaction documents must provide that, if such a recommendation is made, the servicer that is, or is affiliated with, the third-party purchaser must be replaced unless a majority of each class of certificate holders eligible to vote on the matter votes to retain the servicer. By removing the possibility that the third-party purchaser could manipulate cash flows from the pool assets through its position as servicer or special servicer, these restrictions are intended to provide a stronger incentive for the third-party purchaser to be diligent in assessing the credit quality of the pool assets at the outset of the transaction. This option also requires disclosure of the amount of the horizontal residual interest that will be retained, the purchase price, its material terms and the amount that the sponsor would have been required to retain under the horizontal option, as well as the material assumptions and 30 The third-party purchaser may be affiliated with one or more originators of the securitized assets so long as the assets originated by the affiliated originator or originators collectively comprise less than 10% of the unpaid principal balance of the securitized assets included in the securitization transaction at closing of the securitization transaction. -13-
methodology used in determining the aggregate amount of ABS interests of the issuing entity and the representations and warranties concerning the securitized assets, a schedule of assets that are determined not to comply with the representations and warranties and the factors used to determine that any noncompliant assets should be included in the pool, such as compensating factors or a determination the exceptions were not material. The third-party purchaser would be subject to the same restrictions on sale and hedging of the retained interest as any sponsor holding an eligible horizontal residual interest. As with the sixth option, the sponsor would have to maintain policies and procedures to monitor compliance by the third-party purchaser with certain of the applicable conditions, including the third-party purchaser review requirement, and notify holders of the ABS interests of any noncompliance. 7. Treatment of Government-Sponsored Entities. 31 This option would cover Fannie Mae and Freddie Mac while operating under the conservatorship or receivership of the FHFA, as well as any limited-life regulated entity succeeding to either of their charters pursuant to Section 1367 of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 ( Safety and Soundness Act ). Because these entities fully guarantee the timely payment of principal and interest on the mortgage-backed securities they issue, they are exposed to the entire credit risk of the mortgages that collateralize those securities. The proposed rules provide that the guaranty provided by these entities while operating under the conservatorship or receivership of the FHFA with capital support from the U.S. will satisfy the risk retention requirements under Section 15G with respect to the mortgage-backed securities issued by them. Similarly, an equivalent guaranty provided by a limited-life regulated entity that has succeeded to either of their charters, and that is operating under the direction and control of the FHFA under Section 1367(i) of the Safety and Soundness Act, will satisfy the risk retention requirements, provided that the entity is operating with capital support from the U.S. These entities and their affiliates and issuing entities would also be exempt from the premium capture cash reserve account requirement and the restrictions on sale and hedging described below. 8. Premium Capture Cash Reserve Account. 32 In order to achieve the goals of risk retention, the proposed rules would adjust the required amount of risk retention to account for any excess spread that is monetized at the closing of a securitization transaction. If a sponsor structures a securitization to monetize excess spread on the underlying assets which is typically effected through the sale of interest-only tranches or premium bonds the proposed rule would capture the premium or purchase price received on the sale of the tranches that monetize the excess spread and require that the sponsor place such amounts into a separate premium capture cash 31 32.11..12. -14-
reserve account. This account would be used to cover losses on the underlying assets before such losses were allocated to any other interest or account. The Agencies expect that few, if any, securitizations would be structured to monetize excess spread at closing and thus require the establishment of a premium cash reserve account. If required, the account would have to be funded in an amount equal to the difference (if a positive amount) between (i) the gross proceeds received by the issuing entity from the sale of ABS interests in the issuing entity to persons other than the sponsor (net of closing costs paid by a sponsor or the issuing entity to unaffiliated parties) and (ii) 95% of the par value of all ABS interests in the issuing entity issued as part of the transaction if the sponsor retains credit risk under the vertical, horizontal, L-shaped or revolving master trust options, or 100% if the sponsor or another entity retains credit risk under the representative sample, ABCP or CMBS third-party purchaser options, and could be invested only in short-term U.S. Treasury securities and deposits with insured depository institutions. Until all ABS interests in the issuing entity (including junior or residual interests) are paid in full or the issuing entity is dissolved, amounts in the account would be required to be released to satisfy payments on ABS interests in the issuing entity (in order of the securitization transaction s priority of payments) on any payment date on which the issuing entity has insufficient funds to make such payments. The determination of whether insufficient funds are available must be made prior to the allocation of any losses to (i) any eligible horizontal residual interest held under the horizontal, L-shaped, ABCP or CMBS third-party purchaser risk retention options or (ii) if none of these options applies, the class of ABS interests in the issuing entity that effectively stands in a first loss position. The sponsor would need to add to the gross proceeds amount that is used to calculate the amount (if any) that must be placed in the premium capture cash reserve account an amount equal to the par value of any ABS interest (or the fair value of the ABS interest if it does not have a par value) in the issuing entity that is directly or indirectly transferred to the sponsor in connection with the closing of the securitization transaction and that (i) the sponsor does not intend to hold to maturity or (ii) represents a contractual right to receive some or all of the interest, and no more than a minimal amount of principal payments received by the issuing entity, and that has a priority of payment of interest (or principal, if any) senior to the most subordinated class of interests in the issuing entity. The value of any interest-only tranche that the sponsor retains at closing must also be included in the calculation of the premium capture reserve account (regardless of whether the sponsor intends to hold it to maturity) if such tranche has priority of payment senior to the most subordinated class of interests in the issuing entity (other than any senior tranche required to be retained by a sponsor using the vertical or L-shaped options). -15-