Financial Services Alert - April 19, 2011

The OCC, FRB, FDIC, and SEC, in conjunction with the Federal Housing Finance Agency (“FHFA”) and the Department of Housing and Urban Development (“HUD”) with respect to the standards applied for qualified residential mortgages, (collectively, the “Agencies”), recently issued a Notice of  Proposed Rulemaking (the “NPR” or the “proposed rules”) to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act.  Section 941 of the Dodd-Frank Act amends the Securities Exchange Act of 1934 by adding a new Section 15G, which requires the Agencies to prescribe rules that would generally require that a securitizer of asset-backed securities (“ABS”) retain an economic interest in not less than 5% of the credit risk of the assets collateralizing such ABS.  The NPR addresses the following issues: (1) the minimum credit risk retention required; (2) the permissible forms of risk retention; (3) the definition of qualified residential mortgage (“QRM”) and the underwriting standards applicable to QRMs, which are exempt from the risk retention requirements; and (4) the underwriting standards applicable to other qualified asset classes, in order for such ABS to be eligible for an exemption from the risk retention requirement.

Minimum Credit Risk Retention

Section 15G(c)(1)(B) of the Securities Exchange Act generally requires a securitizer of an ABS to retain not less than 5% of the credit risk of the assets collateralizing the ABS issuance.  As discussed below, certain low risk assets, most notably QRMs, are exempt from this requirement.  Securitizers are prohibited from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain.

Permissible Forms of Risk Retention

In order to take into account market practices and reduce the potential for the proposed rules to negatively affect the availability and cost of credit, the NPR provides securitizers with five general options for fulfilling their risk retention obligations.  The permissible forms include:

1. A vertical slice option, which requires the securitizer to retain not less than 5% of each class of ABS interests issued in the securitization;
2. A horizontal residual interest option, which requires the securitizer to retain a first-loss position in an amount equal to at least 5% of the par value of all ABS interests issued in the securitization;
3. A cash reserve fund option, which requires the securitizer to cause to be established and funded a reserve account in an amount equal to at least 5% of the par value of all ABS interests issued in the securitization, which account shall be made available to absorb losses on the securitized assets in the same manner and to the same extent as a horizontal first-loss interest;
4. An “L-Shaped interest,” which is a hybrid approach consisting of both a vertical slice and a horizontal residual interest.  More specifically, the securitizer is required to retain at least  2.5% of each class of ABS interests issued as part of the securitization (the vertical component) and at least 2.564% of the par value of all remaining ABS interests (i.e., those interests not a part of the vertical component) issued in the securitization (the horizontal component).  The horizontal component has a slightly increased percentage in order to avoid double counting that portion of an eligible horizontal residual interest that the securitizer is required to hold as part of the vertical component and still ensure that the combined amount would equal 5%.
5. A representative sample option, which requires the securitizer to retain a randomly-selected sample of assets that is equivalent, in all material respects, to the assets collateralizing the securitization.

The proposed rules also include the following transaction-specific risk retention options:

• for securitizations involving a revolving asset master trust (e.g., credit card receivables), a “seller’s interest” option, which requires the securitizer to retain no less than 5% of the unpaid principal balance of all assets held by the revolving asset master trust;
• for eligible asset-backed commercial paper (“ABCP”) conduits collateralized by loans and receivables and supported by a liquidity facility that provides 100% liquidity coverage from a regulated financial institution, the risk retention requirement may be satisfied where each originator-seller that transfers assets to collateralize the ABCP issued by the conduit retains at least a 5% horizontal interest of the par value of all interests issued by an intermediate special-purpose vehicle established by or on behalf of that originator-seller for purposes of issuing interests to the eligible ABCP conduit;
• for commercial mortgage-backed securities (“CMBS”), consistent with Section 15G(c)(1)(E) and industry practice, the risk retention requirement may be satisfied by an unaffiliated third-party purchaser (commonly referred to as a “B-piece” buyer) that retains an eligible horizontal residual interest in the same form, amount and manner as the securitizer would have been required to retain, provided that, among other things, such third-party purchaser conducts its own credit analysis of each commercial loan backing the CMBS, and an independent operating advisor is appointed to oversee servicing of the loans in all cases where the “B-piece” buyer services the loans.

Disclosure requirements.  Under each of the above options, securitizers are subject to disclosure requirements that are specifically tailored to the applicable form of risk retention.  The disclosure requirements are intended to provide investors with material information concerning the securitizer’s retained interest and provide the Agencies with an efficient mechanism to monitor compliance with the risk retention requirements.

Premium Capture Cash Reserve Account.  The proposed rules also include a special “premium capture” mechanism designed to prevent a securitizer from structuring an ABS transaction in a manner that would allow the securitizer to effectively negate or reduce its retained economic exposure to the securitized assets by immediately monetizing the excess spread created by the securitization transaction.  If a securitizer 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 rules would capture the premium or purchase price received on the sale of the tranches that monetize the excess spread and require that the securitizer place such amounts into a separate premium capture cash reserve account that would be used to cover losses on the underlying assets before such losses were allocated to any other interest or account.  By requiring any compensation received in advance for excess spread income to be held in a premium capture cash reserve account, the proposed rules prevent securitizers from making an up-front profit which is in excess of the cost of the risk retention interest the securitizer is required to retain.  A likely consequence of these new proposed requirements is that few, if any, securitizations will be structured to monetize excess spread at closing.  The amount placed into the premium capture cash reserve account would be in addition to the securitizer’s risk retention requirement in one of the permissible forms discussed above.

Allocation to the Originator.  Although the proposed rules generally require a securitizer to retain the required risk, a securitizer is permitted to allocate a share of its risk retention obligation to the originator of the securitized assets, subject to certain conditions.  In order to qualify, the originator must originate at least 20% of the loans in the securitization, retain at least 20% of the required risk retention amount, but no more than the percentage of the securitized assets it originated, and pay up front for its share of the risk retention.  The securitizer’s risk retention obligation would then be reduced by the amount allocated to the originator.

Prohibition on Hedging or Transferring.  Consistent with the statutory directive of Section 15G(c)(1)(A), the proposed rules prohibit a securitizer from transferring any interest or assets that it is required to retain to any person other than an affiliate whose financial statements are consolidated with the securitizer (a “consolidated affiliate”).  The securitizer and its consolidated affiliates are also prohibited from hedging the required credit risk.  However, hedge positions that are not materially related to the credit risk of the particular ABS interests required to be retained are not prohibited under the proposed rules.  Permitted hedges would include positions related to overall market interest rate movements, currency exchange rates, home prices or the overall value of a particular broad category of ABS.  In addition, hedges tied to securities that are similar to the ABS issuance would be permitted. 

However, a securitizer and its consolidated affiliates are prohibited from pledging as collateral for any obligation any interest or asset that the securitizer is required to retain unless the obligation is with full recourse to the securitizer or consolidated affiliate, respectively.

Risk Retention Exemptions

While the proposed rules generally require securitizers to retain at least 5% of the credit risk of any securitization, certain types of transactions may be exempted from the risk retention requirements.  For example, any ABS that is collateralized solely by QRMs (discussed in more detail below) is exempt from the risk retention requirements.  The proposed rules also include a complete exemption for securitizations of other asset classes - commercial loans, commercial real estate loans, and automobile loans - if the underlying assets meet certain underwriting standards.  For Fannie Mae and Freddie Mac, the proposed rules provide that the guarantee of either entity satisfies the risk retention requirement so long as such entities are operating under FHFA conservatorship or receivership with capital support from the U.S. government. 

Qualified Residential Mortgages.  Pursuant to Section 15G(e)(4), the Agencies issued regulations to exempt ABS backed entirely by QRMs from the risk retention requirements.  The proposed rules establish strict terms and conditions for a residential mortgage to qualify as a QRM.  QRMs are generally prohibited from having nontraditional product features that add complexity or risk to mortgages.  In addition, residential mortgages will not qualify as QRMs if they have terms permitting negative amortization, interest-only payments, significant interest rate increases or penalties for prepayment.

The proposed rules also include conservative underwriting standards for QRMs, which are designed to ensure that QRMs are of especially high credit quality.  These standards include:

• borrower credit history restrictions, including no 60-day delinquencies on any debt obligations within the previous 24 months; 
• a maximum loan-to-value (“LTV”) ratio of 80% in the case of a purchase transaction, a 75% combined LTV ratio for refinance transactions, and a 70% LTV ratio for cash-out refinance transactions (with conditions on the sources from which the down payment may come);
• maximum front-end and back-end borrower debt-to-income ratios of 28% and 36%, respectively.

Notably, the LTV ratio is calculated without considering any mortgage insurance.

The NPR also includes certain servicing requirements for originators of QRMs that are designed to reduce the risk of default on the mortgages.  The proposed rules would require an originator of a QRM to incorporate in the mortgage documents requirements regarding servicing policies and procedures for the mortgage, including requirements regarding risk mitigation actions, subordinate liens and originator responsibility for assumption of these requirements if servicing rights with respect to a QRM are sold or transferred.  These servicing requirements do not supplant the ongoing interagency efforts to develop national mortgage servicing standards, which would apply not only to QRMs but to all residential mortgages. 

Other Asset Class Exemptions.  The proposed rules would also completely exempt certain ABS with respect to other assets classes - auto loans, commercial loans and commercial real estate loans - from the risk retention requirements if the underlying assets meet certain underwriting standards.  These robust underwriting standards, which are designed to focus on particular risks associated with each specific asset class, generally focus on the borrower’s ability to repay the loan. 

More specifically:

• Auto loans would be subject to underwriting standards focused on the borrower’s ability to repay the loan and would require a fixed interested rate.
• Commercial loans would be subject to underwriting standards designed to assure that the borrower’s business is in, and will remain in, sound financial condition such that the borrower will maintain the ability to repay the loan.
• Commercial real estate loans would be subject to underwriting standards that ensure the property securing the loan is stable and provides sufficient net operating income to repay the loan.

Government Sponsored Entities.  Fannie Mae and Freddie Mac (the “GSEs”), while under the conservatorship or receivership of the FHFA, are exempt from the risk retention requirements.  Because the GSEs fully guarantee the payments of principal and interest on the ABS they issue, the GSEs are exposed to the entire credit risk of the mortgages that collateralize those securities.  The Agencies stated in the NPR that additional risk retention is unnecessary because, as a result of the capital support provided by the United States government, investors in ABS issued by the GSEs are not exposed to any credit losses.  Additionally, the premium capture cash reserve account requirements and the hedging restrictions do not apply to the GSEs while operating under the conservatorship or receivership of the FHFA.

Comments on the NPR are due by June 10, 2011.  The Alert will continue to monitor and report on material developments in this area.

Paul Mathews, the Director of the FINRA Corporate Financing Department, in remarks during the ABA Business Law Section Spring meetings in Boston, provided information concerning anticipated rulemaking relating to several pending and proposed rules.  Of particular interest were a planned delay in implementation of the spinning prohibition in new Rule 5131 (see related story in this issue) and changes to the proposed expansion of Rule 5122 (the Member Private Offering Rule) as applied to offerings by unaffiliated issuers.

In FRN 11-04 (which was as discussed in the January 18, 2011 Alert), FINRA proposed to amend Rule 5122, which currently applies to member private offerings (i.e., offerings by affiliates, as defined in the rule, of participating member firms), to extend its application to private offerings by issuers not affiliated with the participating member firms.  Rule 5122 has three basic requirements: disclosure of the use of proceeds of the offering, a limitation on the amount of proceeds used for offering expenses (including commissions) to 15% of the total offering, and filing offering material with FINRA by the date of first use.  According to Mathews, FINRA received approximately 35 comment letters, most objecting to all or portions of the rule proposal, particularly the 15% limitation on offering expenses.  Mathews stated that FINRA is considering significantly revising its rule proposal to address industry concerns.  Mathews and his staff expect that the rulemaking filed with the SEC will propose a new Rule 5123, applicable to private offerings that are not subject to Rule 5122 because they do not involve offerings by issuers affiliated with member firms.  Unlike Rule 5122, Rule 5123 will not contain restrictions on the percentage amount of offering expenses.  It will, however, require written disclosure about the use of proceeds of the offering and filing of the offering document with FINRA.  The deadline for filing would be extended to 15 days following the first offer or sale (although the date starting the 15-day period is subject to further consideration).  Rule 5123 would generally include the same exemptions found in Rule 5122.

The proposed changes discussed by Mr. Mathews would be subject to filing with and approval by the SEC.

The FRB issued a proposed rule (the “Proposed Rule”) that would repeal the FRB’s Regulation Q (“Reg Q”).  Under Section 19(i) (“Section 19(i)”) of the Federal Reserve Act (the “FRA”), member banks of the Federal Reserve System are prohibited from paying interest on demand deposits.  Section 18(g) (“Section 18(g)”) of the Federal Deposit Insurance Act imposes the same prohibition on state nonmember banks, and Section 5(b)(1)(B) (“Section 5(b)(1)(B)”) of the Home Owners’ Loan Act applies the same restriction to federal savings associations.

Reg Q has implemented Section 19(i) since 1933. However, Section 627 of the Dodd-Frank Act, as of July 21, 2011, repeals Section 19(i), Section 18(g) and Section 5(b)(1)(B).  Accordingly, the FRB, in the Proposed Rule, proposes the elimination of Reg Q (including, without limitation, Reg Q’s definition of “interest”) “and would remove references to [Reg Q] found in the [FRB’s] other regulations, interpretations and commentary.” 

The FRB seeks public comment on all aspects of the Proposed Rule and specifically invites comments on whether the repeal of Reg Q: (1) will have significant implications for the balance sheets and income of depository institutions; (2) will have implications for short‑term funding markets (e.g., the overnight federal funds market and Eurodollar markets); (3) is likely to result in strong demand for interest-bearing demand deposits; and (4) will have implications for the competitive burden on smaller depository institutions.

Comments on the Proposed Rule are due by May 16, 2011.

FINRA filed with the SEC proposed amendments to Rule 5131 (New Issue Allocations and Distributions) that would simplify, and delay implementation of, the rule’s so-called spinning prohibition, and would also delay implementation of the rule’s provision prohibiting members from accepting market orders for the purchase of IPO shares in the secondary market prior to the commencement of trading for the IPO shares.  The implementation date for both provisions would be delayed from May 27, 2011 to September 26, 2011.

Rule 5131 was adopted to address several issues that were observed to have arisen in the IPO allocations process during the active IPO market that existed from the late 1990’s through 2000.  Rule 5131(b) is designed to prevent spinning, a practice in which an underwriter allocates IPO shares, which often trade at a premium in the immediately following secondary market, to executive officers and directors of public companies and large non-public companies who are or may be in a position to influence the hiring of the underwriter for investment banking services.  Subparagraph (b)(1) as currently adopted would require member firms to “establish, maintain and enforce policies and procedures reasonably designed to ensure that investment banking personnel have no involvement or influence, directly or indirectly, in the new issue allocation decisions of the member.”  However, because the term “investment banking personnel” is not defined in the rule, FINRA reports that members have raised the concern that if the term is read to mean persons who provide “investment banking services” as defined in the rule, certain necessary functions traditionally performed by syndicate personnel would be prohibited.  To avoid this unintended consequence, and in the belief that spinning can be adequately prevented without that provision, FINRA proposes to delete 5131(b)(1).

The remainder of 5131(b), which prohibits the allocation of new issue shares to executive officers and directors of public companies and covered non-public companies to which the allocating firm is providing or expects to provide investment banking services (as well as certain family members and accounts, including investment funds, in which those persons are investors), would remain in the rule.  However, the implementation date for Rule 5131(b) would be delayed to September 26, to give member firms additional time to prepare for compliance with the spinning provisions.

Finally, FINRA would also delay to September 26 the implementation of paragraph (d)(4), which prohibits members from accepting any market order for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market.  According to FINRA, member firms had requested additional time to develop a process for reliably identifying new issues and to modify their order handling systems to prevent the acceptance of market orders in new issue shares in contravention of the rule.

Comments on the rule proposal will be due 21 days after its publication in the Federal Register.

SEC and CFTC staffs announced that they will hold a two-day joint public roundtable on May 2-3, 2011, to discuss the schedule for implementing final rules for swaps and security-based swaps under the Dodd-Frank Act.  The roundtable will provide an opportunity for public comment on whether to phase implementation of final rules based on factors such as: the type of swap or security-based swap, including by asset class; the type of market participants; the speed with which market infrastructures can meet the new requirements; and whether registered market infrastructures or participants might be required to have policies and procedures in advance of non-registrants.  The roundtable is expected to include panel discussions of (1) compliance dates for new rules for existing trading platforms and clearinghouses and the registration and compliance with rules for new platforms, such as swap and security-based swap execution facilities, and data repositories for swaps and security-based swaps; (2) compliance dates for new requirements for dealers and major participants in swaps and security-based swaps; (3) implementation of clearing mandates; (4) compliance dates for financial entities such as hedge funds, asset managers, insurance companies and pension funds subject to a clearing mandate and other requirements; and (5) considerations with regard to non-financial end users.  The roundtable will be held from 9:30 am to 4:00 pm each day in the Conference Center at the CFTC’s Headquarters in Washington, DC.  The event will be open to the public on a first-come, first-served basis.  Members of the public may also listen to the event by telephone.

The FRB, OCC, FDIC, Farm Credit Administration and Federal Housing Finance Agency (the “Agencies”) issued a proposed rule that would establish margin and capital requirements for swap dealers, major swap participants, security-based swap dealers and major security-based swap participants (collectively, “swap entities”) as required by the Dodd-Frank Act.  The proposed rule would require swap entities regulated by the Agencies to (a) collect minimum amounts of initial and variation margin from counterparties  to non‑cleared swaps and non-cleared, security-based swaps (including, in certain cases, end users), and (b) comply with the existing capital standards regarding those instruments.  Comments are due by June 24, 2011.