Credit Risk Retention: Six Federal Agencies Adopt Final Joint Rule on Credit Risk Retention

Sullivan & Cromwell LLP - December 8, 2014

The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission ("SEC"), the Federal Housing Finance Agency ("FHFA") and the Department of Housing and Urban Development ("HUD" and, collectively, the "Agencies") recently approved a final rule implementing the credit risk retention requirements of Section 941 of the Dodd-Frank Act. The final rule will become effective with respect to securitizations of residential mortgages one year after it is published in the Federal Register and with respect to all other securitizations two years after it is published in the Federal Register.

Section 941 of the Dodd-Frank Act amended the Securities Exchange Act of 1934 by adding a new section 15G ("Section 15G"), which generally requires a securitizer or sponsor of asset-backed securities ("ABS") to retain not less than 5% of the credit risk of the assets collateralizing the ABS issuance. Section 15G exempts certain types of assets from these requirements and authorizes the appropriate Agencies to establish a lower risk retention requirement for other types of assets. In particular, Section 15G exempts securitizations collateralized exclusively by qualified residential mortgages ("QRMs") from the risk retention requirements and directs the Agencies to develop a definition that takes into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default. The Agencies' definition of QRM may be no broader than the definition of qualified mortgage ("QM") under Section 129C(c)(2) of the Truth in Lending Act, as amended by the Dodd-Frank Act (the "TILA"), and as implemented by the Consumer Financial Protection Bureau (the "CFPB").

A rule implementing the credit risk retention requirements of Section 941 of the Dodd-Frank Act was initially proposed in 2011. That proposal was revised and the risk retention rule was reproposed in September 2013. The final rule retains the framework of the revised proposal, but has been modified to address some of certain comments received in connection with the reproposal. In particular, the final rule abandons the proposed requirements that:

  • a sponsor holding an eligible horizontal residual interest (an "EHRI") be subject to cash flow restrictions; and
  • a sponsor holding an eligible vertical interest (an "EVI") calculate and disclose its fair value.

Consistent with the 2013 reproposal, the final rule defines a QRM to mean a QM as defined in Section 129C of the TILA, while adding new exemptions for certain types of community-focused residential mortgages and certain three-to-four unit residential mortgage loans that are not eligible for QRM status under the final rule and are exempt from the ability-to-pay rules under the TILA. The final rule includes a requirement that the Agencies periodically review the definition of QRM, the exemption for community-focused residential mortgages and the exemption for certain three-to-four unit residential mortgage loans.

The Agencies declined:
  • to adopt the view advanced by some commenters that managers of open-market CLOs not be treated as securitizers for purposes of the rule; and
  • to provide an exemption for open-market CLOs meeting specified criteria as requested by industry participants in comment letters.

The Agencies also rejected proposals by commenters to include additional forms of risk retention such as participation interests and companion notes, expressing concerns about complexity and potential regulatory arbitrage, and also rejected requests to allow various forms of third-party credit support and overcollateralization to satisfy the risk retention requirement.

The final rule includes adjustments and modifications for specific asset classes in order to address specific functional concerns and avoid unintended consequences.