Introduction

Six federal agencies approved a final rule requiring sponsors of securitization transactions to retain risk in those transactions. The final rule implements the risk retention requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

The final rule is being issued jointly by the Board of Governors of the Federal Reserve System, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission. As provided under the Dodd-Frank Act, the Secretary of the Treasury, as Chairperson of the Financial Stability Oversight Council, played a coordinating role in the joint agency rulemaking.[1]

The rule will update The Securities Exchange Act of 1934 (also called the Exchange Act, ‘34 Act, or 1934 Act) (Pub.L. 73–291 48 Stat. 881 enacted June 6, 1934, codified at 15 U.S.C. § 78a et seq.) is a law governing the secondary trading of securities (stocks, bonds, and debentures) in the United States of America.

The Rule
The securitization of any “residential mortgage asset,” (i) requires a securitizer to retain not less than 5 percent of the credit risk of any asset that the securitizer, through the issuance of an asset-backed security (ABS), transfers, sells, or conveys to a third party, and (ii) prohibits a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain under section 15G and the agencies’ implementing rules.

Effective Date: The final rule is effective February 23, 2015.

Compliance dates: Compliance with the rule with respect to asset-backed securities collateralized by residential mortgages is required beginning December 24, 2015. Compliance with the rule with regard to all other classes of asset-backed securities is required beginning December 24, 2016.

Background
Congress intended the risk retention requirements mandated by section 15G to help address problems in the securitization markets by requiring that securitizers, as a general matter, retain an economic interest in the credit risk of the assets they securitize.

Required Disclosures
The final rule requires that the sponsor provide a summary description of the reference data set or other historical information used to develop the key inputs and assumptions used in the sponsor’s calculation of the fair value of the ABS interests, including loss given default and default rates. This disclosure should meaningfully inform third parties of the reasonableness of the key cash flow assumptions underlying the sponsor’s measurement of fair value. Relevant information may include the number of data points, the time period covered by the data set, the identity of the party that collected the data, the purpose for which the data was collected and, if the data is publicly available, how the data may be accessed.

The sponsor needs to do two calculations, a redundant calculation of what would have been required to retain if the sponsor held the eligible vertical interest as a separate proportional interest in each class of ABS interest in the issuing entity; and the calculation under which the sponsor is applying the rule (vertical + horizontal = 5%).

  • The fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS interests are issued, as applicable)) of any single vertical security or separate proportional interests that would be (or was retained) by the sponsor at closing, and the fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS interests are issued, as applicable)) of the single vertical security or separate proportional interests required to be retained by the sponsor in connection with the securitization transaction;
  • A description of the methodology used to calculate the fair value of all classes of ABS interests; and
  • The key inputs and assumptions used in measuring the total fair value of all classes of ABS interests (including the range of information considered in arriving at such key inputs and assumptions and an indication of the weight ascribed thereto) and the sponsor’s technique(s) to derive the key inputs.

Final Rule Mandatory Disclosure Reference clauses
Sponsors of securitizations that issue ABS interests must retain risk in accordance with the standardized risk retention option (an eligible horizontal residual interest (as defined in the rule) or an eligible vertical interest (as defined in the rule) or a combination of both).

  • The amount of the eligible vertical interest is equal to the percentage of each class of ABS interests issued in the securitization transaction held by the sponsor as eligible vertical risk retention.
    • For eligible vertical interests, the sponsor is required to disclose: the form of the eligible vertical interest;
    • the percentage that the sponsor is required to retain;
    • a description of the material terms of the vertical interest and the amount the sponsor expects to retain at closing;
    • and the amount of vertical interest retained by the sponsor at closing.
  • The amount of eligible horizontal residual interest is equal to the fair value of the eligible horizontal residual interest divided by the fair value of all ABS interests issued in the securitization transaction.
    • The sponsor is required to disclose: the fair value (or a range of fair values and the method used to determine such range) of the eligible horizontal residual interest that the sponsor expects to retain at the closing of the securitization transaction;
    • the material terms of the eligible horizontal residual interest;
    • the methodology used to calculate the fair value (or range of fair values) of all classes of ABS interests;
    • the key inputs and assumptions used in measuring the estimated total fair value (or range of fair values) of all classes of ABS interests;
    • the reference data set or other historical information used to develop the key inputs and assumptions;
    • the fair value of the eligible horizontal residual interest retained by the sponsor;
    • the fair value of the eligible horizontal residual interest required to be retained by the sponsor;
    • description of any material differences between the methodology used in calculating the fair value disclosed prior to sale and the methodology used to calculate the fair value at the time of closing;
    • and the amount placed by the sponsor in the horizontal cash reserve account at closing, the fair value of the eligible horizontal residual interest that the sponsor is required to fund through such account, and a description of such account.

Conclusion
For better or worse banks that wish to continue to operate in the Asset Securitization business will have in our opinion to manage a somewhat larger residual risk than they were previously accustomed to managing. It is imperative that banks consider putting in place mechanisms to help optimize the big data analytics that will help integrate the market data, position data, securitization agreements and risk calculations to a single platform.

This would allow for real time, “what if” analysis to help banks discover the optimum portfolio to retain from their securitization business. Ideally, it would help leverage the current collateral management analytics tools to define the “cheapest to hold portfolio” as opposed to the cheapest to deliver.

Additional References

Newsletter Author: Craig Unterseher

Newsletter Contact Person: Hamish Wynn, Janki A.Shah

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[1] “Six Federal Agencies Jointly Approve Final Risk Retention Rule,” Board of Governors of the Federal Reserve System, Press Release, October 22, 2014. Access at: http://www.federalreserve.gov/newsevents/press/bcreg/20141022a.htm

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