On January 18, 2011, the Financial Stability Oversight Council (the “FSOC”) issued its study on the Macroeconomic Effects of Risk Retention Requirements (the “FSOC Study”). The FSOC Study, which was mandated by Section 946 of the Dodd-Frank Act, considers the macroeconomic effects of the credit risk retention requirements called for by Section 941 of the Dodd-Frank Act.
While the FSOC Study mainly provides background information on the securitization market and its impact on the financial crisis and a general discussion of the issues to be considered by regulators in developing a risk retention framework, it also offers the OCC, the FRB, the FDIC, and the SEC (collectively, the “Agencies”) principles and recommendations to consider as they develop regulations to implement the risk retention requirements of Section 941 (the “Risk Retention Regulations”).
The Risk Retention Regulations
Under Section 941, the applicable regulators are required to establish Risk Retention Regulations, including separate underwriting standards, for different classes of assets, including residential mortgages, commercial mortgages, commercial loans and auto loans. In general, the Risk Retention Regulations must: (1) require a securitizer to retain not less than 5% of the credit risk for any asset that is transferred, sold, or conveyed through the issuance of an asset-backed security (“ABS”) by the securitizer; (2) prohibit a securitizer from hedging or otherwise transferring such risk; and (3) specify the permitted forms and minimum duration of the risk retention.
In developing the Risk Retention Regulations, the Agencies have broad discretion to establish exceptions to the 5% risk retention requirement, including: (a) a total exemption if all of the assets that collateralize the ABS are “qualified residential mortgages” (which term is to be jointly defined by the Agencies, the Secretary of Housing and Urban Development, and the Director of the Federal Housing Finance Agency); (b) a lesser risk retention requirement if the originator of the underlying assets meets certain underwriting standards prescribed as part of the Risk Retention Regulations; and (c) a set-off of the securitizer’s risk retention obligation by the amount of credit risk retained by the originator of the assets collateralizing the ABS. In addition, the regulations must provide total or partial exemptions for, among other things, securitizations of assets issued or guaranteed by the Federal government or one of its agencies (not including Fannie Mae or Freddie Mac) or any ABS issued or guaranteed by an state or any political subdivision of any state or territory.
The Risk Retention Regulations may also include other exemptions, exceptions, or adjustments, including for classes of institutions or assets, that the Agencies determine help ensure high quality underwriting standards and (i) encourage appropriate risk management practices by securitizers and originators, (ii) improve the access of consumers and businesses to credit on reasonable terms, or (iii) otherwise are in the public interest and are for the protection of investors.
The Dodd-Frank Act requires the Agencies to issue the Risk Retention Regulations no later than April 17, 2011. The regulations with respect to residential mortgage-backed securities shall become effective one year after they are published. With respect to all other asset classes, the regulations shall take effect two years after they are published. In addition, as noted in the article above regarding the Final FDIC Safe Harbor Rule, IDIs should be aware that upon the effective date of the Risk Retention Regulations, the risk retention requirements of the FDIC Safe Harbor will be superseded.
Formulating a Risk Retention Framework
The FSOC Study emphasized that the risk retention framework should balance the benefits of risk retention against the potential costs of raising credit prices. While the FSOC Study offers few concrete recommendations, it suggests that the Agencies consider the following principles in formulating the Risk Retention Regulations:
align the incentives of securitizers and originators with those of investors without changing the basic structure and objective of securitization transactions;
provide greater certainty and confidence among market participants;
promote efficiency of capital allocation;
preserve flexibility as markets and circumstances evolve; and
allow a broad range of participants to continue to engage in lending activities, while doing so in a safe and sound manner.
The FSOC Study also discusses the factors the Agencies must evaluate as they determine how to implement a risk retention framework.
Form of Risk Retention. There are three possible forms of risk retention that are considered in the FSOC Study: (i) a vertical slice, equivalent to retaining a pro rata piece of every tranche of the securitization; (ii) a horizontal slice, equivalent to a first loss interest in the securitization; and (iii) an equivalent exposure of the securitized pool, which would consist of a random selection of assets from the securitized pool.
No recommendation among the options is provided, but other organizations that have dealt with this issue have developed regulations or recommendations regarding the form of risk retention. For example, the FDIC’s new securitization safe harbor rule, discussed in more detail above, currently requires insured depository institutions to retain an interest of at least 5% in each credit tranche or in a representative sample of securitized assets that they transfer. By comparison, Article 122a of the European Capital Requirements Directive (“Article 122a”), which applies to any European Union credit institution that invests in or holds securitization positions, provides a range of options to the market with regards to the form of risk retention required, including each of the forms considered in the FSOC Study. The potential effects of the form of risk retention were also considered by the FRB, in its Report to the Congress on Risk Retention issued in October 2010 (the “FRB Report”).
Allocation of Risk. The Dodd-Frank Act places the primary responsibility for retaining credit risk on the securitizer, but the originator, and in some cases other third-party participants, may be permitted to hold this exposure in the place of the securitizer. While the FSOC Study does not offer guidance about how to allocate the risk retention between the securitizer and the originator, it highlights that Section 941 contemplates that the Agencies could determine that a first-loss exposure by a third-party purchaser of securities backed by commercial mortgages, under certain conditions, could satisfy the risk retention requirements. The FSOC Study also notes that the Risk Retention Regulations could allow a third-party guarantor to satisfy the risk retention requirements by taking all or part of the credit risk.
Amount of Risk Retention. The FSOC Study notes that the required level of risk retention under the Risk Retention Regulations could be applied uniformly across all securitizations and across time, or the amount could vary based on the quality and characteristics of the particular assets securitized and certain other factors. The FSOC Study does not take a position in this regard, but rather notes that both options have costs and benefits. The FRB Report, on the other hand, recommends that the Agencies consider crafting credit risk retention requirements that are tailored to each major class of securitized assets, concluding that “simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the [Dodd-Frank] Act.”
Hedging. The FSOC Study notes that allowing securitizers and originators to hedge or otherwise transfer the credit risk that is required to be retained would undermine the goals of the Dodd-Frank Act’s risk retention requirements. Therefore, Section 941 prohibits the direct or indirect hedging of the retained credit risk. In spite of this prohibition, the FSOC Study recommends that the Risk Retention Regulations permit securitizers and originators to manage risks other than the specific credit risk retained, such as interest rate, foreign exchange, and macroeconomic risks. This recommendation is consistent with the regulations of the FDIC Safe Harbor, which allows for hedging of interest rate or currency risk.