Federal regulatory agencies this week released for public comment a highly anticipated proposal detailing new risk retention requirements for securitizations under the Dodd-Frank Act. Risk retention, or so-called "skin in the game," is the cornerstone of the US regulatory reform efforts in the securitization area and is designed to align the interests of securitizers and originators of securitized assets with those of ABS investors. The proposal outlines when securitizers must retain a portion of the credit risk of a securitized asset pool when issuing ABS and how they may do so.

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.

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

The proposal outlines these and other specifics of Dodd-Frank's risk retention rules that were not outlined in the Act itself. The proposal is a joint effort by the FDIC, SEC, Federal Reserve, OCC and federal housing regulators.

One of the most highly anticipated aspects of the proposal has been the details of the exemption from risk retention requirements granted to certain securitizations involving high-quality assets. The Dodd-Frank Act includes a so-called QRM (qualified residential mortgage) exemption for high-quality residential mortgages but leaves the particulars for regulators to determine. Securitizations comprised entirely of QRMs are exempt from Dodd-Frank risk retention requirements because securities collateralized by these types of loans are less likely to default.

To qualify as a QRM that may be included in a residential mortgage-backed securities (RMBS) transaction exempt from Dodd-Frank risk retention requirements, a residential mortgage loan must include:

In addition, QRMs may not include features indicative of higher mortgage loan risk, such as negative amortization, interest-only payments or significant interest rate increases. Regulators elected not to account for mortgage insurance in the QRM eligibility criteria, but they are soliciting public comment on whether mortgage insurance should be accounted for.

Regulators also proposed a limited number of specific servicing requirements for QRMs, which they believe may help minimize the risk of a mortgage default. The regulators did state that they do not intend these proposed servicing requirements to replace separate interagency efforts to reform US residential mortgage servicing standards.

The underwriting standards for commercial loans that may be included in an exempt collateralized loan obligation (CLO) transaction are designed to ensure that the borrower's business is in and will remain in solid financial condition, facilitating the ability to repay the loan. These requirements would apply to loans included in CLOs that are exempt from Dodd-Frank risk retention requirements.

To qualify as a qualifying commercial loan that may be included in a CLO transaction exempt from Dodd-Frank risk retention requirements, the originator must determine that during the borrower's two most recently completed fiscal years and the two-year period after the closing of the loan (based on reasonable projections), the borrower had or is expected to have a:

The loan payments must be based on straight-line amortization of principal and interest that fully amortize the debt over a term that does not exceed five years from the closing date of the loan. Loan documents must require payments no less frequently than quarterly over a term that does not exceed five years.

The proposal also includes QRM equivalents for the following asset classes:

Securitizations collateralized exclusively by loans satisfying these criteria are exempt from Dodd-Frank risk retention requirements. Securitizations collateralized by credit card and student loans are not eligible for a QRM-equivalent exemption.

Also exempt from Dodd-Frank risk retention requirements are:

To prevent abuses of the risk retention exemptions, the sponsor of any securitization for which a QRM exemption is sought must:

Regulators also left open the possibility of two alternative risk retention approaches on which it has requested public comment:

The proposed rules require that the retained interest must be retained by the sponsor of the ABS transaction or one of its consolidated affiliates. This is because the sponsor is typically the financial institution that arranges, manages and direct the transactions, while the issuer (and depositor) are usually just special purpose vehicles created for the purpose of undertaking the transaction and are controlled by the sponsor.

The sponsor may, however, contractually assign a portion of the risk retention responsibilities to originators. Sponsors may end up requiring originators to assume some of the retained interest as a condition to purchase of assets from that originator. (For information on the role of the various parties to a securitization transaction, including the originator, sponsor, depositor and issuer, see Practice Note, Securitization: US Transaction Parties and Documents).

The proposed rule prohibits securitizers from hedging or transferring the required retained interest, except to a consolidated affiliate. The rules would, however, permit:

Sponsors are also prohibited from retaining or capturing so-called "excess spread income" from an ABS issuance.

The proposal provides several different options designed to allow securitizers flexibility in determining the risk retention configuration that works best for them. With this framework, the regulators have avoided a one-size-fits-all approach that many market participants had feared could make compliance difficult and transactions challenging to structure. The risk retention options outlined in the proposal include:

The proposal also provides a risk retention option for asset-backed commercial paper transactions.

The flexibility of the retention choices helps banks manage their ABS-related, risk-based capital holdings. Because a horizontal, first-loss slice is relatively riskier, the exposure of a bank that elects to retain a vertical slice of an ABS transaction is lower than if it elects to retain a horizontal interest. This results in lower risk-based capital reserve requirements for the bank that elects to retain the vertical slice.

A securitizer may want to retain a horizontal first-loss interest rather than, for example, a vertical interest, despite the more cumbersome risk-based capital requirements, because:

The QRM requirements are being viewed as stringent by the financial industry, as they exempt only a narrow segment of residential mortgage loans from Dodd-Frank's risk retention requirements. Banks and other financial institutions had been lobbying for a broader asset exemption from risk retention rules. These rules are particularly cumbersome for banks which must hold capital reserves against retained assets, making non-exempt loans more expensive for the borrower. As a result, the proposed rules have already been widely criticized by market participants and industry players. Some opponents have stated that the rules threaten to redefine bank lending practices.

The FDIC has responded that the new rules are not an attempt by regulators to set new underwriting standards for the US residential mortgage market and that any attempt to define the exemption too broadly could lead to the disappearance of credit that does not fit into the exempt category. Nevertheless, many fear that this rule could hinder the fragile recovery of the securitization markets, resulting in a credit crunch and a full-blown double dip in the residential real estate market.

However, market reaction to these proposed rules may be disproportionate to their actual impact, at least over the immediate and intermediate term, because most RMBS transactions in the current market are agency deals (backed by mortgages guaranteed by the GSEs), which, as noted, are exempt from the risk retention requirements. The risk retention rules may have more impact when the GSEs exit conservatorship and are no longer backed by the US government, as planned.

Though market participants in other ABS markets such as CLOs, CMBS and auto loan securitizations had not been planning on large exemptions for these asset classes, many have expressed concern regarding how the risk retention rules might affect the nascent recovery in these markets. CMBS market participants are concerned, in particular, with the impact of the rule's excess-spread capture prohibition, which regulators sought to address because of the possibility that this mechanism could be used to work around risk retention requirements.

It should be noted that securitizations that are exempt from Dodd-Frank risk retention requirements may still be subject to other risk retention rules. This is because it is not yet clear how these Dodd-Frank requirements will dovetail or conflict with risk retention requirements being promulgated separately by the SEC under its Reg AB revisions (see Practice Notes, New Trends in Securitization: Overview: The SEC's Proposed Revisions to Reg AB and Summary of the Dodd-Frank Act: Securitization: The SEC's Proposed Reg AB Revisions) and the FDIC's safe harbor rules for bank securitizations (see Practice Notes, New Trends in Securitization: Overview: The FDIC's Safe Harbor Rules and Summary of the Dodd-Frank Act: Securitization: The FDIC's Bank Securitization Safe Harbor Rules).

Regulators are accepting public comment on the proposed rules until June 10, 2011.

For information on provisions of the Dodd-Frank Act covering securitization, see Practice Note, Summary of the Dodd-Frank Act: Securitization.

For information on the SEC's rulemaking activities implementing those provisions, see Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Securitization.

For a discussion of recently enacted European regulations in the area of securitization risk retention, see Practice Note, New Trends in Securitization: Overview: European Risk Retention Rules.

See Practice Note, New Trends in Securitization: Overview, generally, for information on other current developments in the securitization area.