WORD ON THE STREET: During the financial crisis, certain factors at work in the securitization markets distorted incentives for market participants in ways that led to broad problems for consumers and the financial markets. Loan originators were able to underwrite low-quality or even fraudulent-loans for sale through securitization, without any exposure of the originator or securitizer to the future credit risk of the loans.
Section 941 of the Dodd-Frank Act was designed to address this aspect of the problem by requiring the securitizer to retain a portion of the credit risk on assets it securitizes, with exceptions from this risk-retention requirement available only for loans in asset classes designated by regulators as satisfactory underwriting standards that resulted in low credit risk. The goal was to give securitizers direct financial disincentives against packaging loans that were poorly underwritten.
The Office of the Comptroller of the Currency, the board of governors of the Federal Reserve System, the Federal Deposit Insurance Corp. and the Securities and Exchange Commission (SEC) are required by Section 941 to issue joint regulations requiring securitizers of asset-backed securities (ABS) to retain an economic interest in a portion of the credit risk for assets that the securitizer packages into the securitization for sale to others. Where the regulations address the securitization of residential mortgage assets, the Department of Housing and Urban Development (HUD) and the Federal Housing Finance Agency (FHFA) are also part of the joint rulemaking group. The Treasury secretary, as chairperson of the Financial Stability Oversight Council, is directed to coordinate the joint rulemaking.
The agencies are required to define the appropriate form and amount of risk-retention interests to be held by securitizers, and to consider circumstances in which it might be appropriate to shift the retention obligation to the originator of the securitized assets. The statute also requires the agencies to formulate a number of exemptions from the risk retention requirements.
One such exemnption is the criteria for loans meeting an exception for qualified residential mortgages (QRMs) with underwriting and product features that historical loan-performance data indicate result in a lower risk of default. The statute also requires the agencies to establish underwriting standards indicative of low credit risk for certain other classes of assets used in securitizations – commercial mortgages, commercial loans and auto loans – and to determine how much the risk-retention threshold for securitizations of assets meeting those underwriting criteria should be reduced below the 5% minimum generally prescribed by the statute.
The proposed rule prescribes underwriting criteria for QRMs and certain other asset classes, and provides that sponsors of securitizations exclusively comprising of these ‘qualified assets’ are not required to retain risk under Section 941. However, as is appropriate for an exemption from the risk-retention requirement, these underwriting standards are conservative.
For other types of loans that do not qualify for exemption from the risk-retention requirements, the regulatory agencies have sought to structure the proposed risk-retention requirements in a flexible manner that will allow the securitization markets for non-qualified assets to function in a manner that both facilitates the flow of credit to consumers and businesses on economically viable terms and is consistent with the protection of investors.
Sponsor retains risk
Section 941 creates a new Section 15G of the Securities Exchange Act of 1934, requiring the agencies to issue rules requiring securitizers to retain at least 5% of the credit risk of the securitized assets. The nomenclature of the proposed rule refers to the securitizer as the ‘sponsor’ of the securitization transaction, consistent with the SEC's disclosure regulation for registered asset-backed securitizations, Regulation AB.
Practically speaking, the sponsor is the true decision-maker behind the securitization transaction and determines what assets will be securitized. In light of this, the proposed rule generally requires the sponsor to be the party that retains the 5% risk interest under Section 15G.
Section 15G charges the agencies with determining the form of the retention interest to be held by the sponsor, as well as the duration that interest must be held. Consistent with the statute, the proposed rule generally would require a sponsor to retain an economic interest equal to at least 5% of the aggregate credit risk of the assets collateralizing an issuance of ABS (the ‘base’ risk retention requirement), for the duration of the securitization.
In designing options for risk retention under rule, the Agencies took into account not only the flexibility that we believe will be necessary to allow sponsors to structure retention interests that will meet investors' concerns with respect to the alignment of interests between sponsors and investors, but also the structures used by sponsors to satisfy investor demands for risk retention in past and recent markets.
The proposed rule also provides that Fannie Mae and Freddie Mac are deemed to satisfy the 5% risk-retention requirement through their guarantees, under which they retain 100% of the credit risk of the mortgages backing their securities, as long as they continue to operate under the conservatorship or receivership of the FHFA and with direct government support through the Treasury Department's Senior Preferred Stock Purchase Agreement.
Transfer prohibitions
To increase the sponsor's incentive to monitor the underwriting quality of assets the sponsor selects to back an ABS deal, the proposed rule requires the sponsor to hold the required retention interest for the full life of the securitization transaction. Consistent with Section 15G, the proposed rule also provides that sponsors cannot sell or transfer the interests they are required to retain under the rule, and cannot hedge the credit risk away.
However, to allow sponsors to continue managing the overall credit risk of their operations, portfolio hedging is not prohibited. The proposed rule would also permit transfer of risk retention in two specific circumstances as contemplated by section 15G.
First, the regulatory agencies propose to exempt from the transfer prohibition certain securitizations of commercial mortgage-backed securities (CMBS) for which a form of horizontal risk retention often has been employed, with the horizontal first-loss position initially being held by a third-party purchaser (known in the securitization markets as a ‘B-piece buyer’) that specifically negotiates for the purchase of the first-loss position and conducts its own credit analysis of each commercial loan backing the CMBS.
Second, the agencies also propose to permit a sponsor to allocate a proportional share of the risk retention obligation (through a voluntary contractual agreement) to the originator(s) of the securitized assets, subject to certain conditions, if the originator in question originated at least 20% of the assets in the securitization pool. To ensure the originator has ‘skin in the game,’ the proposal requires the originator to pay up front for its share of retention, either in cash or a discount on the price of the loans the originator sells to the pool. The originator must also agree to hold the retention interest, subject to the same prohibition against the hedging or transferring of the credit risk that would apply to sponsor.
Many securitization transactions conducted prior to the financial crisis were structured to include a risk retention piece. However, the sponsors were able to sell premium or interest-only tranches to investors for prices that more than offset the sponsors' costs for the amount of the risk retention.
These tranches were funded by ‘excess spread’ interest income expected to be generated by securitized assets over time, which reflected the higher credit risk of, and likely losses on, those securitized assets (such as subprime mortgages). This enabled sponsors to obtain up-front payment for that excess spread at the inception of the transaction, before the losses on the securitized assets appeared – which more than compensated for the sponsor's exposure through risk retention. This created incentives for securitizers to issue many complex securitization transactions of high-credit-risk, high-yield assets. It also made the risk -retention illusory from an incentive standpoint, because the sponsor was paid more for the excess spread than the sponsor's overall cost for the retention interests.
The agencies intended to address this problem thorough the proposed rule. If a sponsor structures a securitization to monetize excess spread on the underlying assets – by selling a tranche of the transaction that would be funded by excess spread income – without making an offsetting increase in the risk-retention piece, the proposed rule would capture the premium or purchase price received on the sale of the tranches that monetize the excess spread and require that the sponsor place such amounts into a separate ‘premium capture cash reserve account’ in the securitization.
The amount placed into the premium capture cash reserve account would be separate from and in addition to the sponsor's base risk-retention requirement, and would be used to cover losses on the underlying assets before such losses were allocated to any other interest or account. The purpose of the account is to keep sponsors from taking an up-front profit on a securitization of high-yield assets that would effectively pay off the sponsor for the risk retention interest it is required to retain, and to keep that excess spread available to cover losses on the assets in the securitization.
QRM criteria
Section 15G provides a complete exemption from the credit-risk retention requirements for ABS collateralized solely by QRMs. The proposed rule establishes the terms and conditions under which a residential mortgage would qualify as a QRM.
Section 15G requires the agencies to define QRM, ‘taking into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default.’
A substantial body of evidence, including data analyzed by the agencies during the rulemaking and academic literature, supports the view that the underwriting criteria in the proposed rule have low credit risk, even in severe economic conditions. The proposed QRM underwriting criteria are also consistent with the premise that a complete exemption from risk retention should be supported by very-high-quality mortgage loans.
The proposed rule generally would prohibit QRMs from having product features that contributed significantly to the high levels of delinquencies and foreclosures since 2007 – such as failure to document income, ‘teaser’ rates, or terms permitting negative amortization or interest-only payments – and also would establish conservative underwriting standards designed to ensure that QRMs are of high credit quality.
As required by the statute, these standards were developed through evaluation of historical loan-performance data that are described in the preamble to the proposal. These underwriting standards include, among other things, maximum front-end and back-end debt-to-income ratios of 28% and 36%, respectively;Â credit-history restrictions, including no 60-day delinquencies within the previous 24 months; a maximum loan-to-value (LTV) ratio of 80% in the case of a purchase transaction (with a 75% combined LTV for refinance transactions, reduced to 70% for cash-out refis); and a 20% down-payment requirement in the case of a purchase transaction.
The agencies propose to require the LTV to be calculated without taking any mortgage insurance into consideration. The preamble discusses several possible alternatives in the event that the agencies are persuaded that the QRM underwriting criteria are too restrictive on balance.
One of these alternatives would be to permit the use of private mortgage insurance obtained at origination of the mortgage for loans with LTVs higher than the 80% level specified in the proposed rule. The guarantee provided by private mortgage insurance, if backed by sufficient capital, lowers the credit risk to investors by covering the unsecured losses attributable to the higher LTV ratio once the borrower defaults and the loan is liquidated. However, to include private mortgage insurance in the QRM criteria, Congress required the agencies to determine that the presence of private mortgage insurance lowers the risk of default – not that it reduces the ultimate amount of the loss.
Other alternatives discussed in the proposal are imposing less-stringent QRM underwriting criteria but are also imposing more stringent risk-retention requirements on non-QRM loan ABS to incentivize origination of the QRM loans and reflect the relatively greater risk of the non-QRM loan market and creating an additional residential mortgage loan asset class alongside the QRM exemption. Some of these include the underwriting asset classes for commercial loans, commercial mortgages, and auto loans under the proposed rule – with less-stringent underwriting standards or private mortgage insurance, subject to a risk-retention requirement set somewhere between 0% and 5%.
The proposal recognizes as a permissible form of risk retention the government-sponsored enterprises' (GSEs') 100% guarantee of principal and interest payments on mortgage-backed securities (MBS) that they sponsor. Through this guarantee, the GSEs retain 100% of the credit risk in the transaction.
Since the release of the proposal, some have expressed concerns that this aspect of the proposed rule disadvantages private securitizers, which will incur the funding costs of holding a 5% interest in each ABS they sponsor relative to the GSEs. The agencies are very cognizant of the complex issues affecting the treatment of the GSEs under the proposal and look forward to considering the comments we receive.
The approach contained in the proposal reflects several factors:
- the GSEs already retain 100% of the credit risk in each ABS they sponsor as a result of their guarantees;
- requiring the GSEs to retain a 5% interest in each ABS they sponsor would significantly increase their holdings of MBS at a time when there is strong interest in reducing such holdings;
- the proposed rule's restrictions against hedging or transferring the risk of these interests also would have increased the overall risk of their operations at the time such risks create exposure to U.S. financial support through the Treasury Department's Senior Preferred Stock Purchase Agreement; and
- requiring the GSEs to hold these interests would not have increased their incentives to be vigilant about the credit quality of assets they securitize, because they already guarantee 100% of that risk already.
More fundamentally, requiring the GSEs to hold these interests would not create a ‘level playing field’ between the GSEs and private securitizations. The GSEs' funding costs to hold these interests are, because of the perception of a government guarantee, lower than the costs their private competitors face to hold the same interests, and the GSEs enjoy other cost advantages from the scale of their operations, which is generated by investor demand for their fully guaranteed ABS. These differences translate into the GSEs' ability to offer mortgage originators better prices for their mortgage loans, even if they were required to retain the additional 5% interest.
Even with respect to the retention-exempt QRMs, the GSEs' QRM securitizations will be more attractive to investors from a credit-risk standpoint than a private-label QRM, due to the GSEs' 100% guarantee of their QRM securitizations. These are larger issues that cannot be reached through the risk-retention rule.
However, Congress has begun to consider fundamental questions about the future structure and role of the GSEs and the agencies have committed to revisiting and changing the retention approach for the GSEs as appropriate when those changes occur.
Julie L. Williams is first senior deputy comptroller and chief counsel for the Office of the Comptroller of the Currency. This article is adapted and edited from testimony delivered before the House Financial Services Committee's Subcommittee on Capital Markets and Government-Sponsored Enterprises. The full testimony is available online.
