Federal regulators have adopted the long-awaited joint Final Rule (the “Final Rule”)¹ implementing the credit risk retention requirements of Section 15G of the Exchange Act of 1934 (“Section 15G”) for asset-backed securities (“ABS”).

Under Section 941 of the Dodd-Frank Act, the Securities and Exchange Commission, the Federal Reserve Board, the Federal Deposit Insurance Corporation (the “FDIC”), the Office of the Comptroller of the Currency, the Federal Housing Finance Agency, and the Department of Housing and Urban Development (collectively, the “Joint Regulators”) were tasked with jointly issuing regulations implementing the Dodd-Frank Act’s credit risk retention requirements for ABS (codified in Section 15G).²

Coming more than three years (and thousands of comments) after the initial publication by the Joint Regulators of the initial proposed rule, the Final Rule implements the requirement that securitizers of asset-backed securities (“ABS”) retain not less than 5% of the credit risk of the assets collateralizing ABS. The Final Rule contains a number of highly technical exemptions from the risk retention requirements, as well as reduced risk retention requirements applicable to different asset classes, the intricacies of which are beyond the scope of this alert. Please contact one of the authors or your regular Reed Smith service provider with specific questions about the impact of the Final Rule on any particular type of securitization transaction.

The Final Rule will become effective for securitizations collateralized by residential mortgages one year after the date the Final Rule is published in the Federal Register, and two years after the date the Final Rule is published for all other securitizations.

General Risk-Retention Requirement Unless an exemption under the Final Rule applies (see below), the Final Rule requires the sponsor of a securitization (or a majority-owned affiliate of the sponsor) to retain not less than a 5% economic interest in the credit risk of the securitized assets. A “sponsor” includes any entity that “organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to an issuing entity.”³ To the extent that there may be more than one sponsor in a securitization, each sponsor is responsible for ensuring that at least one sponsor in the securitization (or its majority-owned affiliate) retains the minimum 5% required credit risk (i.e., sponsors cannot split the minimum 5% credit risk).

A sponsor’s risk retention can take several forms:

• A single vertical security or an interest in each class of ABS issued as part of the securitization (an “Eligible Vertical Interest” or “EVI”) of not less than 5%.
• An eligible horizontal residual interest (an “EHRI”) equal to at least 5% of the fair value of all ABS issued as part of the securitization (calculated using a fair value measurement framework under GAAP). With the exception of non-economic REMIC residential interests, EHRIs must be the most subordinated class or classes of ABS issued in connection with the securitization.⁴
• A combination of EVI and EHRI (commonly referred to as an “L-shaped interest”), where the EVI and the fair value of the EHRI are equal to at least 5%.⁵
• For specific types of securitization transactions identified in the Final Rule, an alternative form specified in the Final Rule (see Transaction-Specific Risk Retention Options below for more on these).

As an alternative to holding an EHRI (either alone or in combination with an EVI), a sponsor can fund a cash reserve account in an amount equal to the fair value of the EHRI it would have otherwise held, which can be used to act as a first loss reserve for payments on the ABS and can pay certain critical expenses to parties not related to the sponsor.⁶

Measurement and Disclosure by Sponsor of Retained Risk For EHRIs, the Final Rule requires that “the amount of the interest must equal at least 5% of the fair value of all ABS interests in the issuing entity issued as a part of the securitization transaction, determined using a fair value measurement framework under GAAP.”⁷ A fair value calculation is not required for EVIs.

The Final Rule requires that investors be provided with the following disclosures⁸: 
 

Transaction-Specific Risk Retention Options In addition to the general risk retention options for sponsors described above, the Final Rule includes additional methods of complying with the required risk retention obligations for certain specific types of securitizations. These include:⁹

• Revolving pool securitizations
• Eligible ABCP conduits
• Commercial mortgage backed securities (CMBS)
• Federal National Mortgage Association and Federal Home Loan Mortgage Corporation ABS
• Qualified Tender Option Bonds

Allocation of Risk Retention to Originators Consistent with Section 15G, the Final Rule permits a sponsor to reduce its risk retention requirement by the portion of any risk retention assumed by an originator of the securitized assets, so long as:

• The originator acquires the eligible interest from the sponsor and retains such interest in the same manner and proportion as those acquired and retained by the sponsor under the Final Rule
• The originator contributes at least 20% of the underlying asset pool
• The sponsor does not allocate to an originator a greater portion of its required risk retention amount than the percentage of the pool contributed by the originator (i.e., if the originator contributes 30% of the underlying pool, the sponsor may not allocate more than 30% of its required risk retention amount to the originator)
• The originator purchases the eligible interests from the sponsor on a dollar-for-dollar basis, either in the form of cash or a reduction in purchase price received by the originator for the sponsor or depositor for assets sold into the pool¹⁰

Restrictions on Hedging and Transfer of Required Risk Retention Sponsors are prohibited from transferring their required retained credit risk to any person other than their majority-owned affiliates.¹¹ Similarly, sponsors and their affiliates are generally prohibited from financing or hedging any of the credit risk required to be retained under the Final Rule, other than in connection with hedging for basic interest-rate risk or foreign-exchange risk.¹²

For all ABS transactions (other than RMBS), the prohibitions on transfer and hedging of a sponsor’s required retained risk extend until the latest of:

• The date the outstanding principal balance of the securitized pool has been reduced to 33% of the pool balance as of the cut-off date
• The date the unpaid principal obligations of the ABS issued in the securitization are reduced to 33% of the original issuance amount
• Two years after the closing of the securitization¹³

For RMBS, the transfer and hedging restrictions apply instead until the later of: (i) five years after the closing of the securitization; and (ii) the date the outstanding principal balance of the securitized pool has been reduced to 25% of the pool balance as of the cut-off date.

Transactions Exempted from the Risk Retention Requirements

Exemption for Securitizations Backed by QRMs Section 15G exempts from the risk retention requirements securitizations consisting exclusively of qualifying residential mortgages (“QRMs”) or servicing assets.¹⁴ The Final Rule aligns the definition of QRM with the definition of a qualified mortgage ("QM") developed by the Consumer Financial Protection Bureau (“CFPB”),¹⁵ with some modifications. As a result, the final definition of QRM does not include either a loan-to-value (“LTV”) ratio requirement or standards related to a borrower’s credit history.¹⁶ The Joint Regulators will review the definition of QRM periodically – beginning not later than four years after the effective date of the Final Rule with respect to securitizations of residential mortgages, and every five years thereafter, to take into account developments in the residential mortgage market, as well as the results of the CFPB’s five-year review of the ability-to-repay rules and the QM definition.¹⁷

The definition of QRM includes:

• A “covered transaction” ¹⁸ that meets the general definition of a QM, which includes the following criteria:
  • A loan with regular periodic payments that are substantially equal
  • No negative amortization, interest only or balloon features
  • A loan term not exceeding 30 years
  • Total points and fees not exceeding 3% of the total loan amount or the applicable amounts specified for small loans up to $100,000
  • Payments underwritten using maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment is due
  • Consideration and verification of the consumer’s income and assets, including employment status if relied upon, and current debt obligations, mortgage-related obligations, and alimony and child support
  • A total debt-to-income (“DTI”) ratio that does not exceed 43%

Mortgage loans that meet one of the special types of QMs, including the CFPB’s temporary QM definition¹⁹. Mortgage loans satisfying the temporary QM definition must be eligible for sale to, or be insured by, a GSE or other government agency. The significant feature of the temporary QM definition is the treatment of the DTI ratio. The GSEs and government agencies purchase mortgages that have DTI ratios above the standard QM’s 43% cut-off. The temporary QM definition with respect to a GSE expires once the GSE exits conservatorship, and with respect to the government agencies upon each agency’s own QM rules becoming effective – but in any case no later than January 21, 2021.

The Final Rule also exempts certain mortgage loans that do not qualify to be QMs under TILA because they are not “covered transactions," and therefore do not qualify for QRM status. Such exemptions include, for example, (i) certain community-focused residential mortgages, and (ii) certain owner-occupied,three- to four-unit mortgages that meet the exact same underwriting and product standards requirements under the QM rule as one- and two-unit properties (but are not subject to the ability-to-pay rule under TILA because the credits are considered business purpose loans).

Exemption for Securitizations Backed by Qualifying Commercial Loans, Commercial Real Estate Loans and Automobile Loans Qualifying commercial loans, commercial real estate (CRE) loans and automobile loans (“Qualifying Assets”) that are securitized are subject to a zero risk retention requirement, so long as all of the following conditions are met:

• The assets meet certain specified underwriting criteria set forth in the Final Rule
• The securitization is collateralized solely by loans of the same asset class (i.e., all auto loans) and by servicing assets
• There are no reinvestment periods
• Prospective investors are provided with a description of the manner in which the sponsor determined its applicable required risk retention requirement (after including the Qualifying Assets)²⁰

For securitizations where only a portion of the pool consists of Qualifying Assets, the sponsor’s required risk retention for the transaction will be reduced up to a maximum reduction of 50%, based on the percentage of Qualified Assets in the pool.²¹ This means that the minimum risk retention for an ABS backed by a blended pool will be at least 2.5% (even if Qualified Assets make up more than 50% of the collateral pool).

Other Exemptions for Specified Types of Securitizations The Final Rule also exempts a number of other types of securitizations from the risk retention obligations described above, in each case subject to certain qualifications described in the Final Rule.²² These include certain U.S. government-backed securitizations, agricultural loan securitizations, securities issued by state and municipal entities, qualified scholarship funding bonds, pass-through securitizations, securitizations backed by seasoned loans, public utility securitizations, and securitizations of assets issued, insured or guaranteed by the federal government. 

1. See http://www.federalreserve.gov/newsevents/press/bcreg/20141022a.htm. Final Rule Implementing Credit Risk Retention Requirements of Section 15G of the Securities Exchange Act of 1934, as added by Section 941 of the Dodd-Frank Act (Oct. 21, 2014).
2. Pub. L. No 111-203, 124 Stat. 1376 (2010).
3. Final Rule, supra note 1, at 573 (Subpart A, §__.2).
4. Id. at 570-571 (Subpart A, §__.2).
5. Id. at 574-575 (Subpart B, §__.4(a)).
6. Id. at 575-576 (Subpart B, §__.4(b)).
7. Id. at 575 (Subpart B, §__.4(a)(2)).
8. Id. at 576-580 (Subpart B, §__.4(c)).
9. For more on the specifics of these, see Id. at 581-618 (Subpart B, §__.5 through §__.10).
10. Id. at 619-620 (Subpart C, § __.11(a)).
11. Id. at 621 (Subpart C, § __.12(a)).
12. Id. at 621-626 (Subpart C, § __.12).
13. Id. at 624-626 (Subpart C, § __.12(f)).
14. Id. at 626-638 (Subpart C, § __.13). The QRM exemption also requires that each QRM collateralizing the ABS be currently performing, collateralizing assets can’t include ABS, and the depositor has to certify as to effectiveness of internal supervisory controls for ensuring that all assets collateralizing the ABS are QRMs or servicing assets.
15. See the definition of QM under Section 129C of Truth-in-Lending Act (“TILA”) and its implementing regulations, as amended from time to time.
16. The agencies had proposed an alternative QRM definition that would have added such features as a maximum 70% LTV and certain credit history requirements. It is Joint Regulators' stated belief in adopting QM/QRM alignment that they are meeting the statutory requirement under Dodd-Frank to take into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default, while at the same time promoting access to affordable credit by minimizing additional regulatory burden and compliance cost, and facilitating the return of private capital to the mortgage market. See Final Rule, supra page 357.
17. See Final Rule, supra note 1, at 668-670 (Subpart D, § __.22).
18. A “covered transaction” is generally a consumer credit transaction that is secured by a dwelling, including real property attached to a dwelling. For entire definition, see 12 CFR 1026.43(b)(1).
19. In 2013, the CFPB established a temporary QM category of loans eligible to be purchased by Fannie Mae and Freddie Mac, or to be insured by the government through the Federal Housing Administration, the Department of Veterans Affairs, the U.S. Department of Agriculture, or the Rural Housing Service. See 12 CFR 1026.43(e)(4).
20. Id. at 635-636 (Subpart D, § __.15(a)).
21. Id. at 636-637 (Subpart D, § __.15(b)).
22. Id. at 656-664 (Subpart D, § __.19).

Client Alert 2014-293