Securitizations (§§ 941 – 945)
Although the financial crisis has had a devastating effect on the securitization markets, certain aspects of those markets have been criticized as playing a role in the meltdown. Some critics have maintained that the incentives of both mortgage originators and underwriters of securities backed by those mortgages were not fully aligned with the incentives of investors who eventually purchased the securities. Underwriters and originators have been largely compensated on the basis of the initial sale of the securitized products and the underlying assets, respectively. But the benefits (and burdens) accrue to investors only with the longer-term performance of those assets.
“Skin-in-the-Game” Requirement (§§ 941 & 944)
Congress has accordingly directed federal bank regulators and the SEC jointly to prescribe rules requiring securitizers of ABS to retain an economic interest (“skin in the game”) in the credit risk (generally 5%) of any asset transferred, sold, or conveyed to a third party through the issuance of an ABS. That economic interest may not be hedged or transferred to a third party. The legislation defines an ABS as a fixed-income or other security collateralized by a self-liquidating financial asset (i.e., a loan, lease, mortgage, or receivable) that allows the holder of the security to receive payments depending primarily on cash flow from the asset. Congress has made the definition broad enough to cover collateralized debt and mortgage obligations.
As with most of the bright-line rules in the legislation, the 5% risk-retention requirement has some exceptions. Securitizers will not be required to retain any portion of the credit risk for an asset that is transferred, sold, or conveyed if all the assets that collateralize the ABS are “qualified residential mortgages.” Congress has directed federal bank regulators and the SEC, together with the US Department of Housing and Urban Development (HUD) and the FHFA, jointly to define the category of “qualified residential mortgages” after considering certain product and underwriting features that have historically been associated with lower default risks. Most likely, the category will include a large portion of those loans originated by Fannie Mae and Freddie Mac.
In addition, the legislation directs the regulators to establish various asset classes with different credit risk retention rates, including ABS backed by automobile loans, commercial mortgages, home mortgages, and any other asset class deemed appropriate. For each asset class, the relevant regulators (e.g., Federal Reserve, OCC, and FDIC) will establish underwriting standards specifying the terms, conditions, and characteristics of a loan that indicate a reduced credit risk. Most important, the regulations may provide that if an originator meets these reduced credit risk standards, then the securitizer may retain less than 5% of the credit risk. In this respect, these rules may provide the equivalent to an additional exemption.
The legislation also contemplates the establishment of total or partial exemptions from risk retention for the following:
- any loan or other financial asset made, insured, guaranteed, or purchased by any institution that is subject to the Farm Credit Administration
- any securitization of an asset issued or guaranteed by the United States or a US agency (except Fannie Mae and Freddie Mac)
- certain state and municipal securitizations of assets (related to the cases above)
The required risk-retention amount may also be allocated between an originator and a securitizer as deemed appropriate by the regulators.