On July 15, 2010, the Senate passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed by the House of Representatives on June 30th. The President has indicated that he will sign the bill that has now passed both of the Houses.
The legislation covers a wide variety of topics in an effort to address the causes of the recent turmoil in the financial markets. With respect to securitization, the legislation covers the following topics: (i) whether issuers or other parties should be required to retain a portion of the credit risk in securitizations; (ii) disclosure and reporting standards related to securitization transactions; (iii) representations and warranties required to be provided in securitization transactions and the mechanisms for enforcing such representations and warranties; and (iv) requirements regarding due diligence with respect to loans underlying securitization transactions.
As indicated below, many of the requirements to be imposed have been left by Congress to actions to be taken by the Federal banking agencies, the SEC and other regulatory authorities.
CREDIT RISK RETENTION
The Federal banking agencies (defined as the OCC, the Fed and the FDIC) and the SEC are required to jointly prescribe regulations to require "securitizers" to retain an economic interest in a portion of the credit risk of any securitized asset. In addition, the Federal banking agencies, the SEC, HUD and the Federal Housing Finance Agency (FHFA) are required to jointly prescribe similar regulations focused specifically on residential mortgage securitizations.
Securitizer is defined as (A) an issuer of an asset-backed security or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.
Originator is defined as a person who (A) through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security and (B) sells an asset directly or indirectly to a securitizer.
Amount of Risk to be Retained in Securitizations
- Securitizations that do not consistentirely of "qualified residential mortgages":
- A securitizer will be required to retain a minimum 5% of the credit risk; provided that less than 5% will be required if the originator meets underwriting standards that the legislation requires to be prescribed by the Federal banking agencies.
- With respect to securitizations of commercial mortgages, the risk retention requirement may be satisfied by retention of a first loss position by a third party purchaser who meets the standards to be imposed by the Federal banking agencies and the SEC.
- Securitizations that existentirely of "qualified residential mortgages":
- If all of the securitized assets are "qualified residential mortgages", a securitizer will not be required to retain any credit risk for any of the assets in the securitization. See the discussion below for details regarding "qualified residential mortgages".
- The amount of risk required to be retained with respect to collateralized debt obligations and other resecuritizations will be determined by designated regulatory agencies.
Form and Duration of Risk Retention
- The form and duration of any required credit risk retention will be determined by designated regulatory agencies.
Hedging or Transfer of Risk
- Securitizers will be prohibited from hedging (directly or indirectly) or transferring the risk required to be retained.
Who Retains the Risk?
- The allocation of risk retention obligations between a securitizer and an originator that sells assets to the securitizer is to be determined jointly by the Federal banking agencies and the SEC by taking into account the following items:
- Whether the assets sold to the securitizer have terms, conditions and characteristics that reflect low credit risk;
- Whether the form or volume of transactions creates incentives for imprudent origination of the specific types of assets; and
- The potential impact of the risk retention obligations on the access of consumers and businesses to credit on reasonable terms.
- The percentage of the risk retention obligation imposed on the securitizer will be reduced by the percentage of the risk retention obligation imposed on the originator.
Underwriting Standards to Be Established
- The underwriting standards to be established (as referred to above) must be specific with regard to particular asset classes, including residential mortgages, commercial mortgages, commercial loans and auto loans.
- The underwriting standards must specify the terms, conditions and characteristics within the asset class that indicate a low credit risk for such specific class of loan.
"Qualified Residential Mortgages"
- As discussed above, securitizations existing solely of "qualified residential mortgages" will not be subject to the risk retention requirements. The definition of a "qualified residential mortgage" will be established by regulations to be issued jointly by the Federal banking agencies, the SEC, HUD and the FHFA, "taking into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default", including documentation and verification of assets, front-end and back-end DTI, payment shock, PMI, prepayment penalties and other loan terms and product features.
- The term "qualified residential mortgage" shall be defined in such a way that is no broader than the definition of "qualified mortgage" under Section 129(C) of the Truth in Lending Act. Under the Truth in Lending Act, as amended by the Consumer Financial Protection Act of 2010, a "qualified mortgage" is defined generally as follows: (i) no negative amortization, (ii) no large balloon payment, (iii) VOI and VOA, (iv) DTI based on a fully-indexed rate, (v) compliance with regulations established by the Fed with respect to back-end DTI, (vi) total points and fees not in excess of 3% of the loan amount and (vii) maximum term of 30 years.
Exemptions, Exceptions and Adjustments from Risk Retention Requirements
- The regulations to be prescribed will provide a total or partial exemption from the risk retention requirements for securitizations by federal, state and certain other entities, as follows:
- "Any securitization as may be appropriate in the public interest and for the protection of investors".
- Securitizations of assets issued or guaranteed by the U.S. or a federal agency (specifically excluding Fannie Mae or Freddie Mac).
- Securitizations issued or guaranteed by any State, political subdivision or public instrumentality exempt from the registration requirements of the Securities Act of 1933 (the "'33 Act") pursuant to Section 3(a)(2) of the '33 Act, or qualified scholarship funding bonds under the Internal Revenue Code.
- Farm Credit System: Loans made, insured, guaranteed or purchased by any institution subject to Farm Credit Administration supervision are not subject to the risk retention provisions of the legislation.
- Other Federal Programs: Securitizations backed by residential, multifamily or health care facility loans insured or guaranteed by the U.S. or a federal agency (not including Fannie Mae or Freddie Mac or the Federal Home Loan Banks) are not subject to the risk retention provisions of the legislation.
- In addition to the above, the Federal banking agencies and the SEC are specifically empowered to jointly adopt exemptions, exceptions and adjustments to the risk retention rules required to be issued in order to assure high quality underwriting standards, encourage appropriate risk management practices, improve the access to credit, or otherwise be in the public interest and for the protection of investors.
- The regulations called for by the legislation are required to be prescribed not later than 270 days after enactment of the legislation.
- The legislation requires that the regulations prescribed shall become effective (i) for residential mortgage securitizations, one year after the date on which the final rules are published in the Federal Register, and (ii) for all other securitizations, two years after the date on which the final rules are published in the Federal Register.
Risk Retention Study and Report
- The Fed Board, in coordination and consultation with the OCC, the OTS, the FDIC and the SEC, is required by the legislation to conduct a study of the impact of the credit risk retention requirements and FAS 166 and 167 and to submit a report to Congress not later than 90 days after enactment of the legislation including recommendations for "eliminating any negative impacts on the continued viability of the asset-backed securitization markets and on the availability of credit for new lending" identified by the study.
- In addition, the Chairman of the newly created Financial Services Oversight Council is required by the legislation to carry out a study on the macroeconomic effects of the risk retention requirements imposed by the legislation "with emphasis placed on potential beneficial effects with respect to stabilizing the real estate market." A report to Congress containing any findings and determinations is required to be made no later than 180 days after enactment of the legislation.
Securitization Disclosure and Reporting
- Section 7 of the '33 Act sets forth the information required to be disclosed in registration statements filed under the '33 Act.
- The legislation empowers the SEC to adopt regulations under Section 7 to require securitization issuers to disclose information regarding the assets backing the securitization, including information in a format that would facilitate comparisons of data across securities in similar asset classes, and data necessary for investors to independently perform due diligence, such as data identifying loan brokers and originators, the nature and extent of broker or originator compensation and the amount of risk retention by the loan originator and securitizer.
Reporting and Suspension of Duty to File
- Generally, under Section 15 (d) of the Securities Exchange Act of 1934, issuers of securities registered under the '33 Act are required to file with the SEC certain supplementary and periodic information, documents, and reports with regard to the registered securities. The duty to file reports is automatically suspended as to any fiscal year, other than the fiscal year within which such registration statement became effective, if, at the beginning of such fiscal year, the securities of each class to which the registration statement relates are held of record by less than three hundred persons.
- The legislation amends the forgoing provision by eliminating the automatic suspension with respect to asset-backed securities and giving the SEC the ability to determine whether issuers of particular types of securitizations will be able to suspend or to terminate their duty to make the filings otherwise required.
Representations and Warranties and Enforcement Mechanisms
The legislation requires that the SEC prescribe regulations on the use of representations and warranties in securitizations. Such regulations, which are required to be prescribed no later than 180 days after enactment of the legislation, must include the following requirements.
Rating Agency Reports
- Rating agencies will be required to include in any report accompanying a credit rating on a securitization a description of the representations and warranties included in the transaction and the enforcement mechanisms available to investors, as well as how those provisions differ from such provisions in similar securitizations.
- Securitizers (as defined above) will be required to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer "so that investors may identify asset originators with clear underwriting deficiencies".
Due Diligence ANALYSIS AND DISCLOSURE
Section 7 of the '33 Act is further amended by the legislation that require the SEC to prescribe regulations, no later than 180 days after enactment of the legislation, that require securitization issuers to perform a review of the assets underlying their securitizations and to disclose the nature of the review.
CONFLICTS OF INTEREST
General Prohibition Against "Material Conflicts of Interest"
- The legislation requires the SEC to issue rules, no later than 270 days after enactment of the legislation, to require that no underwriter, placement agent, initial purchaser or sponsor (or any affiliate or subsidiary of any such entity) of any asset-backed security (including, for these purposes, any synthetic asset-backed security) shall engage in any transaction that would involve or result in any "material conflict of interest" with respect to any investor for a period of one year after the date of the first closing or sale.
- The prohibition will not apply to:
- Risk-mitigating hedging activities specifically designed to reduce specific risks associated with positions or holdings arising out of the party's role in the securitization;
- Purchases or sales made pursuant to and consistent with commitments to provide liquidity for the asset-backed security; and
- Bona-fide market-making in the asset-backed security.