On October 21-22, 2014, federal regulators adopted final risk retention rules for asset-backed securities (ABS) mandated under Section 941 of the Dodd-Frank Act. The rules require that securitizers, including sponsors of ABS transactions, retain 5% of the credit risk of securitized asset pools backing non-exempt ABS. With a few notable exceptions, the final rules track the revised risk retention proposal, released on August 28, 2013 (see Practice Note, ABS Risk Retention under Dodd-Frank).

"Securitizers" include sponsors of ABS transactions, as well as CLO collateral/asset managers. Securitizers may retain the 5% interest in a variety of forms, including:

Treatment of RMBS under the final rules. The final rules retain a comparatively lenient definition of "qualified residential mortgage" (QRM). Residential mortgage-backed securities (RMBS) transactions backed by an asset pool composed of QRMs are exempt from the risk retention requirements.

The QRM definition mirrors the ability-to-repay requirement and qualified mortgage (QM) standards adopted by the Consumer Financial Protection Bureau (CFPB) in January 2013. The QRM rule, among other things, requires a borrower debt-to-income ratio of at least 43% to qualify for the exemption and a QRM requires no down payment (see Practice Note, The Ability-to-Repay and Qualified Mortgage Rule).

The risk retention rules go into effect for RMBS one year after they are published in the Federal Register, and should therefore be effective in late 2015. RMBS issued before the effective date are not subject to the risk retention requirement. Regulators will re-review the QRM standards in four years.

Treatment of CLOs under the final rules. The final rules retain the risk retention requirements for collateralized loan obligations (CLOs) substantially as re-proposed in 2013. CLO managers are considered sponsors of CLO transactions under the rules and are therefore subject to the retention requirement. The rules also retain from the 2013 re-proposal, the so-called "Arranger Option," which allows an exemption from the retention requirement for CLOs in which the securitized asset pool is composed of "CLO eligible" loan tranches. According to the LSTA, "Neither option is broadly feasible for the CLO market."

The final risk retention rules become effective for CLOs two years after they are published in the Federal Register, and should therefore be effective in late 2016. CLOs issued before the effective date are not subject to the risk retention requirement.

Further observations from the LSTA on the retention rules for CLOs:

Treatment of other asset classes under the final rules. Risk retention exceptions apply if the underlying collateral pool is comprised of, among others:

Other securitized assets have also been granted safe harbors from the retention requirements similar to QRM. These include, among others, safe harbors for the following asset classes which may comprise a securitized asset pool for an exempt transaction:

The risk retention rules become effective two years after they are published in the Federal Register for all asset classes other than RMBS, and should therefore be effective for these asset classes in late 2016. ABS issued before the effective date are not subject to the risk retention requirement.

Background and market reaction. Risk retention, or so-called "skin in the game," is the cornerstone of the US regulatory reform efforts in the securitization area, mandated under Section 941 of the Dodd-Frank Act, which added new Section 15G to the Securities and Exchange Act of 1934 (15 U.S.C. § 78o-11). The rule is designed to align the interests of securitizers and originators of securitized assets with those of investors in ABS. The rules are intended to reform the so-called "originate to distribute" ABS model in which flawed loan underwriting standards and origination practices resulted in poor quality loans that were quickly sold and packaged into ABS. These ABS were then sold to institutional investors and financial institutions, eventually resulting in losses that were blamed for ushering in the financial crisis.

Section 941 of the Dodd-Frank Act mandates that securitizers retain at least 5% of the credit risk of any asset pool that is securitized, but leaves for federal regulators to determine:

Market participants were surprised last year when regulators released a QRM definition that was softer than originally proposed in 2011, even though lax residential mortgage underwriting standards did the most damage to the US financial system during the crisis, when those mortgages were bundled into RMBS and sold to investors. Industry groups such as SIFMA have reacted positively to the QRM definition, which will also be welcomed by mortgage lenders and home buyers.

However, groups like the LSTA are no doubt disappointed by the outcome for CLOs. Many felt that the regulators got it backwards in 2013 by writing stringent rules for CLOs, while seemingly letting RMBS off the hook (see Legal Update, The Revised ABS Risk Retention Proposal: A Flawed Approach?). The market is likely to react similarly to the final rules. The requirements for CLOs threaten to stifle the leveraged loan market even though, as recently noted by the LSTA, CLOs performed "spectacularly" during the financial crisis and "not one AAA or AA note has ever suffered a loss." However, regulators may have feared a bubble developing in the leveraged loan market, fueled by the popularity of CLOs (see Legal Update, Next Bubble? US CLO Assets Under Management Hit $340 Billion).

The rules were approved by a number of federal regulators, including the FDIC, the Federal Reserve, the Department of the Treasury, the OCC and the SEC, which adopted the rules by a 3-2 vote, accompanied by a strong dissent from the two Republican commissioners who noted that the rules are likely to increase costs to the market and impair the intended benefits of securitization (see Statement from Commissioner Michael S. Piwowar and Statement from Commissioner Daniel M. Gallagher).