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9.11 Improvements to the Asset-Backed Securitization Process

<< Title IX Overview

9.11 Improvements to the Asset-Backed Securitization Process

The following links provide expanded analysis within this section:


9.11.     Improvements to the Asset-Backed Securitization Process.  In the context of asset-backed securitization, the Act pursues the general goal of investor protection by emphasizing the importance of collateral quality and focuses on two main objectives: (i) implementing structural changes in the issuance of certain asset-backed securities ("ABS") to require risk retention by securitizers and originators at a default level of up to 5% to promote the credit quality of the assets being securitized; and (ii) requiring additional disclosure relating to the securitized assets to enable investors to independently assess credit quality. [§941]  The lending standards established under this provision of the Act are likely to have a significant impact on the characteristics of loans originated by lenders.

The SEC and Federal banking agencies (defined as the FDIC, the Fed and OCC) are required to jointly issue risk retention regulations relating to certain securitized assets generally within 270 days of enactment of the Act ("General ABS Rules"). These regulations become effective 1 year after publication of the final rules for residential mortgages and 2 years for all other asset classifications.  

The General ABS Rules will establish a number of exemptions from and qualifications to the general 5% risk retention requirement.  Most significantly, the Act provides that qualified residential mortgages will be exempt from risk retention obligations pursuant to the Residential ABS Rules, though other exemptions may still apply outside of the qualified residential mortgage category.

9.11.1.              General Requirements for Risk Retention.  The main component of the Act's approach to ABS is an effort to ensure prudent origination practices by requiring securitizers (defined as an issuer of ABS or a sponsor of an ABS transaction) and originators of assets sold to a securitizer to retain an interest in a portion of the credit risk in any assets transferred, sold, or conveyed by it through the issuance of ABS.  The theory behind this approach is that requiring securitizers and originators to keep some "skin in the game" in the form of these retained interests, will gives these parties an increased incentive to maintain high quality underwriting and risk management practices.

The core of this risk retention program will be implemented through the General ABS Rules.  Although the SEC and Federal banking agencies are given a great deal of discretion in formulating the risk retention regulations, the regulations must include a number of features, including the following points.

9.11.1.1            Risk Retention Levels.  Securitizers will be required to retain an economic interest at a default level of no less than 5% of the credit risk for any securitized asset.  As discussed below, this default requirement is subject to certain qualifications.  Although qualified residential mortgages will generally be exempt from risk retention, qualified residential mortgages that are securitized in a pool that includes even one residential mortgage that falls outside the definition of "qualified residential mortgage" will nonetheless be subject to risk retention. 

The General ABS Rules will specify the permissible forms of risk retention and the minimum required duration of such retention.  No risk retention will be required with respect to the securities issued by a finance subsidiary and held by its parent company or an affiliate controlled by such parent if none of the finance subsidiary's securities were held by an unaffiliated entity.

9.11.1.2            Prohibition Against Hedging and Transfer.  Securitizers will not be permitted to directly or indirectly hedge or otherwise transfer the credit risk required to be retained by such securitizers.

9.11.1.3            Establishment of Asset Classes.  The General ABS Rules will establish various classes of assets as regulators deem appropriate, such as residential mortgages, commercial mortgages, commercial loans, and auto loans.  The Federal banking agencies will establish underwriting standards for each of these asset classes that indicate the terms, conditions and characteristics of a loan in each asset class that are consistent with reduced credit risk.  These standards will be included in the regulations designating the relevant asset class.  If an originator of assets meets the underwriting standards for such asset class set by these rules, then a securitizer of such assets may be subject to a risk retention requirement of less than 5%.

Certain asset classes are singled out for special treatment with respect to risk retention.  For instance, the Act designates collateralized debt organizations ("CDOs"), securities collateralized by CDOs, and similar instruments collateralized by other ABS as assets for which the SEC and Federal banking agencies must specifically develop appropriate risk retention standards.  The SEC and Federal banking agencies are also required to specify the permissible types, forms, and amounts of risk retention appropriate for commercial mortgage assets.  With respect to commercial mortgage assets, these risk retention requirements may involve: (i) retention of either a specified amount or a percentage of the asset's total credit risk; (ii) retention of a first loss position by a third-party purchaser that specifically negotiates the acquisition of such position, holds adequate loss reserves, performs due diligence on all individual assets in the pool and meets the same standards for risk retention that would be required of the securitizer; (iii) a determination with respect to the adequacy of underwriting standards and controls; and (iv) provision of adequate representations, warranties and enforcement rights.

9.11.1.4            Allocation of Risk Retention Between Securitizers and Originators.  With respect to any securitizer that purchases assets from an originator, risk retention obligations will be allocated between the securitizer and the originator.  Distributing the risk retention obligation among securitizers and originators will not increase the total level of risk retention.  The amount of risk otherwise required to be retained by the securitizer will be reduced by the amount of the risk retention allocated to the originator.  In determining the appropriate allocation, the SEC and Federal banking agencies will consider whether the assets sold to the securitizer have features suggesting low credit risk, whether the form or volume of transactions in the relevant securitization market encourages imprudent origination practices, and how the distribution of risk retention obligations might affect business and consumer access to credit.

9.11.2  Exemption for Qualified Residential Mortgages; Other Exemptions.  The Act's implementing regulations will include a number of mandatory and elective exemptions and exceptions to the risk retention requirement.  The specified exemptions, and the exemptions that regulators may adopt going forward, may apply both to asset classes and institutional categories.  The most important among these is the exemption applicable to qualified residential mortgages. 

9.11.2.1            Exemption for Qualified Residential Mortgages.  Subject to some limitations, qualified residential mortgages will be exempt from the general 5% risk retention requirement as established by the Residential ABS Rules.  The theory behind the exemption is that mortgages meeting the definition of "qualified residential mortgage" will represent assets of a sufficiently high credit quality to obviate the need for risk retention.  To ensure that this is the case, the rulemaking entities will jointly define the term "qualified residential mortgage" to reflect underwriting and product features historically associated with reduced risk of default, including: (i) documentation and verification of mortgagor financial resources; (ii) standards with respect to mortgagor's income relative to housing and other monthly payment obligations; (iii) mitigation of the potential for payment shock on adjustable rate mortgages; (iv) mortgage guarantee insurance or other types of insurance or credit enhancement to the extent it reduces the risk of default; and (iv) limitations on balloon payments, negative amortization, prepayment penalties, interest only payments and other features associated with increased risk of default.

The definition of "qualified residential mortgage" will not be permitted to be broader than the definition of "qualified mortgage" provided in the Truth in Lending Act, as amended by the Consumer Financial Protection Act of 2010 and regulations thereunder.

To qualify for the exemption, an issuer of ABS collateralized solely by qualified residential mortgages will be required to certify that it has effective internal controls for ensuring that all the assets collateralizing such issuance of ABS are qualified residential mortgages. ABS collateralized by tranches of other ABS (whether or not this collateral includes residential mortgage backed securities backed by qualified residential mortgages) will not be eligible for this exemption. 

9.11.2.2            Other Categories of Exemptions.  Besides the qualified residential mortgage exemption, the Act identifies various types of assets and institutions that will be eligible for total or partial exemptions if the SEC and Federal banking agencies jointly determine that they are in the public interest and appropriate for protection of investors.  The implementing regulations will provide for such exemptions for assets issued or guaranteed by: (i) the United States or an agency of the United States (excluding Fannie Mae and Freddie Mac); (ii) any political subdivision of a State or territory; (iii) or any public instrumentality of a State or territory that is exempt from registration under Section 3(a)(2) of the Securities Act and (iv) certain qualified scholarship funding bonds.  The SEC and Federal banking agencies are given discretion to determine whether an exemption based on the above authority will be total or partial. 

The Act also provides a definitive exemption (an exemption not dependent on subsequent regulation) from its risk retention provisions for any loan or other financial asset made, insured, guaranteed, or purchased by any institution subject to the supervision of the Farm Credit Administration.  Definitive exemptions are also given to residential, multi-family, or health care facility mortgage loan assets (or securitizations based on such assets) insured or guaranteed by the United States or an agency thereof (excluding the Fannie Mae, Freddie Mac and the Federal Home Loan Banks).

9.11.2.3            General Exemptions.  The SEC and Federal banking agencies may, in the General ABS Rules, provide for total or partial exemption of any securitization from risk retention requirements if such exemption is deemed to be in the public interest and appropriate for the protection of investors.  The SEC and the Federal banking agencies also have general authority to jointly adopt exemptions, exceptions, or adjustments to the rules issued in regard to risk retention requirements.  Such exemptions, exceptions or adjustments may be made available for categories of institutions or classes of assets and may relate to risk retention requirements or the prohibition against hedging.  Any such exemption, exception or adjustment must help ensure high underwriting standards for affected securitizers and originators, encourage appropriate risk management practices, and improve consumer and business access to credit.

The FRB, in consultation with the OCC, FDIC, OTS and SEC, will study the combined impact on each individual class of ABS of the new risk retention requirement and FAS 166-167.  The report, due within 90 days of enactment, will include statutory and regulatory recommendations for eliminating negative impacts on the ABS markets and on the availability of credit for new lending.

The Chair of the Oversight Council will study and report on the macroeconomic impact of the risk retention requirements, with a particular focus on the potential benefits to the stability of the real estate market within 180 days of enactment of the Act. [§946]

9.11.3.  Required Issuer Due Diligence.  In addition to imposing a risk retention feature to encourage higher origination standards, the Act calls for issuers of ABS to conduct an assessment of the quality of the assets underlying such securities.  The SEC will issue rules requiring each issuer of ABS to review the assets underlying such ABS and to disclose the nature of this review. [§945]

The SEC is required, not later than 180 days following the enactment of the Act, to issue rules relating to the registration statements filed by issuers of ABS.

9.11.4.  Required Issuer Disclosures.  The disclosures regarding an ABS issuer's asset diligence described above will help provide investors with information regarding the quality of assets included in a securitization.  Moreover, to meet the objective of enabling investors to independently assess the credit quality of the assets underlying an issuance of ABS, the Act requires disclosure of additional information relating to the assets included in the securitization.

9.11.4.1.           Asset-level Information.  The centerpiece of this enhanced disclosure is the requirement that each issuer of ABS must disclose, for each tranche or class of security, specific information regarding the underlying assets.  The SEC is required to adopt regulations establishing standards for the format and content of such disclosure, though no time frame for their adoption is given.  To the extent feasible, the format of disclosure must facilitate comparisons of data across ABS in similar asset classes.  To the extent necessary for the investor's independent diligence, the disclosure must include asset-level or loan-level data, including unique identifiers of loan brokers or originators, the type and amount of compensation received by such brokers or originators, and the amount of risk retention by such originator and the securitizer. [§942(b)]

9.11.4.2            Disclosures Accompanying Ratings.  In addition to the asset-level information described above, the Act also requires enhanced disclosure with respect to the representations and warranties used in the ABS market.  Each NRSRO providing a credit rating with respect to an issuance of ABS will be required to include in its ratings report a description of the representations and warranties made in, and the investors' enforcement rights under, the transaction documents relating to such issuance.  This description must also include an indication of how these representations, warranties, and enforcement rights differ from those found in similar ABS issuances. [§943]

The SEC is required, not later than 180 days following the enactment of the Act, to issue rules relating to the disclosure to be included in the ratings report provided by an NRSRO in connection with its rating of an issuance of ABS.

9.11.4.3            Repurchase Requests.  While asset-level information will assist investors in independently assessing the quality of assets comprising a securitization pool, such assessment does not address the historical performance of the securitizer's or originator's underwriting or risk management practices.  To address this, the regulations relating to disclosures accompanying ratings will also require that each sponsor of a securitization must disclose its history of repurchase requests and the fulfillment or non-fulfillment thereof across all ABS issuers aggregated in the securitization platform of such sponsor so that investors may identify originators with clear underwriting deficiencies. [§943]