Federal Agencies Revise Proposed Securitization Risk
Retention Rules
September 10, 2013
On August 28, 2013, five federal banking and housing agencies 1 and the Securities andExchange Commission (collectively, the “Agencies”) released a proposed rule implementing thecredit risk retention requirement mandated by the Dodd-Frank Wall Street Reform andConsumer Protection Act for certain securitization transactions. The proposed rule revises andre-issues proposed rules originally issued by the Agencies on March 29, 2011.
Section 941 of Dodd-Frank added a new Section 15G to the Securities Exchange Act of 1934,
which directs the Agencies to adopt rules that generally require sponsors of asset-backed
securities to retain at least 5% of the credit risk relating to the assets that underlie such assetbacked securities. The risk retention requirement is intended to provide sponsors with ameaningful incentive to monitor and control the quality of securitized assets and align theinterests of the sponsor with those of investors.
The proposed rule would apply the 5% risk retention requirement to most asset-backed
securities, whether publicly or privately issued and regardless of the whether they are issued orsponsored by a regulated financial institution. However, the proposed rule would exempt
certain asset-backed securities from the risk retention requirement. Chief among them aresecurities backed by “qualified residential mortgages”(sometimes referred to herein as“QRMs”), which are mortgages that lack certain product features that the Agencies cited ascontributing to the high levels of mortgage delinquencies and foreclosures since 2007. Sponsorsof securities backed by qualifying commercial loans, qualifying commercial real estate (“CRE”)
loans and qualifying automobile loans also will not be required to retain any credit risk. The
criteria for the various “qualified” assets are intended to define assets that entail very little
credit risk. Also, the proposed rule exempts loans guaranteed by the Federal National
Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation(“Freddie Mac”), for so long as these government-sponsored enterprises continue to operate
under the conservatorship of the Federal Housing Finance Agency and have capital support
from the United States.
The proposed rule makes several key revisions to the original proposal. Most importantly, it
broadens the exemption for securitizations of qualified residential mortgages by adopting thedefinition of “qualified mortgage” adopted by the Consumer Financial Protection Bureau(“CFPB”) pursuant to the Truth in Lending Act, as amended by Dodd-Frank. Unlike the
The five federal banking and housing agencies are the Federal Deposit Insurance Corporation,
the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, theFederal Housing Finance Agency and the Department of Housing and Urban Development.

1Memorandum – September 10, 2013

original definition of QRM, the new standard does not have a 20% down payment requirement,a loan-to-value (“LTV”) ratio requirement or underwriting standards related to a borrower’s
credit history.
Other significant changes include:•

Combining the horizontal, vertical and L-shaped risk retention options (defined below)
into one standard risk retention option, which allows for any combination of eligible
horizontal and vertical interests;•

Changing the method of measuring risk retention in horizontal interests to fair value, as
opposed to par value, and eliminating the premium cash capture reserve accountrequirement for sponsors issuing “interest only” tranches;•

Creating new risk retention options for open market collateralized loan obligations andmunicipal bond “repackaging” securitizations, and eliminating the “representative
sample” option;•

Requiring third party special servicers of commercial mortgage-backed securities to beoverseen by operating advisors in order to be eligible to meet the risk retention
requirement in place of the sponsor;•

Introducing sunset provisions to allow sponsors to transfer or hedge retained interests
after certain milestone dates; and•Exempting from risk retention qualifying commercial loans, qualifying CRE loans andqualifying automobile loans even when pooled with non-qualifying assets.

This memorandum discusses these and other changes and provides an overview of the
proposed rule. The proposed rule will be published shortly in the Federal Register andcomments will be invited for 60 days. The proposal includes more than 100 questions on which
the Agencies are seeking comment. The risk retention requirement will apply to asset-backed
securities collateralized by residential mortgages issued one year after the effective date of the
final risk retention rule, and to all other asset backed securities issued two years after theeffective date of the final rule.
A.

THE GENERAL 5% CREDIT RISK RETENTION REQUIREMENT

In adopting Section 15G of the Exchange Act, Congress sought to address certain aspects of the
securitization process that it believed masked credit risks and complicated actions to mitigate
losses and reduce loan defaults. In particular, Congress cited an “originate to distribute”
model, in which loans were made for the purpose of selling them into securitization pools
without the originator retaining any risk on the assets, as leading to lax credit and loan
underwriting standards, as well as to practices that rewarded volume over asset quality.
Congress identified such abuses in the securitization process as a “major contributing factor” toPage 2

Memorandum – September 10, 2013

the recent financial crisis, 2 and it adopted the credit risk retention requirement to better alignthe economic interests of securitizers with those of investors in asset-backed securities.
Under the proposed rule, a sponsor of “asset-backed securities” is generally required to retain
at least 5% of the credit risk relating to the underlying assets (in addition to any other risk that
may be retained to satisfy contractual requirements between the parties). The sponsor isgenerally not permitted to hedge or transfer the credit risk that it is required to retain. The term“sponsor” is defined to mean “a person who organizes and initiates a securitization transaction
by selling or transferring assets, either directly or indirectly, including through an affiliate, tothe issuing entity.” The term “asset-backed security” is defined by incorporating the definitionof that term in Section 3(a)(79) of the Exchange Act, where it is generally defined to mean “afixed income or other security collateralized by any type of self-liquidating financial asset(including a loan, lease, mortgage, or other secured or unsecured receivable) that allows theholder of the security to receive payments that depend primarily on cash flow from the asset.”
B.

ACCEPTABLE FORMS OF CREDIT RISK RETENTION

Sponsors may retain credit risk in a number of ways. The proposed rule is designed to beflexible in light of the heterogeneity of securitization markets and practices, the fact thatdifferent forms of risk retention may have different accounting implications for sponsors andthe need to reduce the potential for any negative effect on the availability and cost of credit.
Accordingly, sponsors can select from a “menu of options” to comply with the 5% risk
requirement.
Among the acceptable forms of credit risk retention are the following:

2•Standard Risk Retention Option – Under the standard option, a sponsor would have toretain an eligible vertical interest, an eligible horizontal residual interest, or any
combination of the two, in a total amount of at least 5% of the fair value of allinterests in the issuing entity. An eligible vertical interest is a vertical “slice” of eachclass or tranche of interests in a securitization transaction consisting of the same
percentage of the fair value of each class. An eligible horizontal residual interest is a
“first-loss” interest in the issuing entity that may not receive any payments ofprincipal or interest until all other interests in the issuing entity are paid in full. The
original proposal had also included an “L-shaped” risk retention option composedof specific proportions of vertical and horizontal interests. Under the standard risk
retention option of the revised proposed rule, a combination of vertical andhorizontal interests may consist of any proportion of each type of interest.

•

Revolving Master Trusts (Seller’s Interest)—In securitizations collateralized by assets
held in a revolving master trust, such as credit card accounts or dealer floorplan
loans, a sponsor typically retains a “seller’s interest,” which is a direct interest in theperformance of the underlying assets or receivables that is pari passu to each series
of investors’ interests. Under the proposed rule, a sponsor of an asset-backed

See S. Rep. No. 111-176, at 128 (2010).
Page 3

Memorandum – September 10, 2013

securities issuance collateralized by assets held in a master trust may satisfy the risk
retention requirement by retaining directly or through an affiliate a seller’s interestof at least 5% of the unpaid principal balance of all outstanding investors’ interests
issued by the issuing entity. The sponsor must meet this 5% test at the closing of
every issuance of securities by the master trust and at every seller’s interest
measurement date specified under the securitization transaction documents, but noless than monthly. Under the proposed rule, the sponsor may combine the seller’sinterest with a horizontal risk retention for purposes of meeting the 5% risk retention
requirement by retaining a horizontal interest in every series issued by the trust andreducing its seller’s interest by a corresponding percentage. This combination
approach was not available under the original proposal. The proposed rule alsooffers relief to a sponsor that suffers a decline of its seller’s interest below the 5%
minimum due to an early amortization of investors’ interests under the terms of therevolving trust securitization, provided that the sponsor had been in full compliancewith the risk retention requirements before the early amortization event and themaster trust issues no additional interests other than to the sponsor.
•

Asset-Backed Commercial Paper Conduits—The proposed rule includes a special risk
retention option for asset-backed commercial paper (“ABCP”) conduits that issue
short-term commercial paper and that satisfy certain requirements. This option
contemplates a securitization structure in which originators of loans and receivablesor their affiliates sell them to one or more intermediate special purpose vehicles(each, an “intermediate SPV”) that are organized by the sponsor. The intermediate
SPV then issues a senior interest in the loans and the receivables to the ABCP issuingentity and issues a residual interest to the originator-seller. The risk retention
requirement would be satisfied if the originator-seller or an affiliate held thisresidual interest in the same form, amount, and manner as would be required undereither the standard risk retention or revolving master trust options described above,
including the respective 5% retention requirements. The ABCP conduit then issues
short-term (nine months or less) ABCP that is collateralized by the senior interests.
While an intermediate SPV may purchase assets from multiple originator-sellers,each senior interest sold by the intermediate SPV to the ABCP conduit must bebacked solely by (A) asset-backed security interests collateralized solely by assets
originated by a single originator-seller and its affiliates, and by servicing assets 3, (B)special interests in a trust or SPV that retains legal title to leased property underlying
leases transferred to an intermediate SPV in connection with a securitization
collateralized solely by such leases originated by a single originator-seller and its
affiliates, and by servicing assets, or (C) interests in a revolving master trust
collateralized solely by assets originated by a single originator seller and its affiliates,

Servicing assets are any rights or other assets designed to assure the servicing, timely payment,
or timely distribution of proceeds to security holders, or assets related to acquiring and holding theissuing entity’s securitized assets. These may include cash and cash equivalents, contract rights,
derivative agreements of the issuing entity used to hedge interest rate and foreign currency risks, or thecollateral underlying the securitized assets.

3

Page 4

Memorandum – September 10, 2013

and by servicing assets. This option is not available for loans or receivables
purchased by the originator-seller. The ABCP must have 100% liquidity coverage (inthe form of a lending facility, an asset purchase agreement, a repurchase agreement
or similar arrangement) from a regulated liquidity provider. Although this risk
retention option would allow an originator-seller (rather than the sponsor) to retain
the required 5% residual interest, the sponsor will be responsible for ensuring an
originator-seller’s compliance with all of the requirements of this option. For ABCP
conduits that do not meet the requirements for this option, the sponsor will need tosatisfy the 5% risk retention requirement.
•

Commercial Mortgage-Backed Securities—In the market for commercial mortgagebacked securities (“CMBS”) it is common for a third party which is not the sponsor
to acquire a “first-loss” position in the form of a “B-piece.” To manage its risk
exposure, the B-piece buyer is involved in the selection of pool assets, performs
diligence on those assets, and, as special servicer, services loans in default or having
other non-payment issues. The CMBS risk retention option requires the special
servicer role to be overseen by an independent operating advisor that, on behalf of
the investors as a whole, has the ability to recommend replacement of the special
servicer and, if the principal balance of the B-piece declines to 25% or less of its
initial balance, has consultative rights over major decisions of the special servicer.
The proposed rule would permit a sponsor of asset-backed securities that arecollateralized solely by CRE loans and servicing assets to satisfy the risk retention
requirement if: (i) the B-piece buyer retains a horizontal residual interest in the sameform, amount and manner as would be required of the sponsor under the standard
risk retention option (discussed above); (ii) the B-piece buyer pays for this first-loss
position in cash at the closing of the securitization without financing; (iii) the B-piecebuyer has performed a detailed review of the credit risk of each asset in the pool
prior to the sale of the asset-back securities by examining, at a minimum, theunderwriting standards, collateral and expected cash flows of each commercial loanin the pool; (iv) the B-piece buyer is not affiliated with any party to the securitizationtransaction other than the special servicer or investors; (v) the sponsor makes certain
required disclosures to potential investors regarding the B-piece buyer (e.g.,
identifying information, description of experience in CMBS transactions) and othermaterial information on the transaction; and (vi) the B-piece buyer complies with theproposed rule’s restrictions relating to the hedging of retained interests. The B-piecebuyer may not transfer its interest for five years following closing. The proposed
rule, unlike the original proposal, allows a B-piece buyer or sponsor that retains the
B-piece to transfer its interest after five years to any other purchaser satisfying thecriteria applicable to initial B-piece buyers, which may subsequently transfer its
interest to any other eligible purchaser. Further, while the original proposal allowed
only one B-piece buyer per CMBS transaction to satisfy the CMBS risk retention
option, the proposed rule allows two B-piece buyers to share the retained risk,
provided that each buyer’s interest is pari passu with the other’s interest and eachbuyer conducts an independent review of the credit risk of each asset in the pool.

Page 5

Memorandum – September 10, 2013•

Open Market Collateralized Loan Obligations—The proposed rule adds a new risk
retention option for certain CLOs. In prevailing market practice, some CLOs consistof commercial loans originated and syndicated by third parties that are selected forpurchase on the open market by CLO managers unaffiliated with the originating andsyndicating third parties and lacking the balance sheet capacity to fund 5% risk
retention of the CLO. The proposed rule defines an “open market CLO” as a CLO
the assets of which consist of less than 50% in aggregate principal amount of loans
syndicated or originated by parties that are affiliates of the CLO. By contrast, a“balance sheet CLO” obtains a majority of its assets from the entity that controls theportfolio selection and, as the originator or syndicator of loans, has the balance sheet
capacity to satisfy risk retention requirements. The Agencies recognized that
imposing the standard risk retention option on open market CLO managers could
cause significant disruption to the CLO market and consolidation among CLO
managers. Accordingly, under the proposed rule, an open market CLO can satisfy
the risk retention requirement if the lead arranger of each loan tranche purchased by
the CLO retains at least 5% of the face amount of the loan tranche purchased by the
CLO and takes an initial allocation of at least 20% of the face amount of the broader
syndicated credit facility. The lead arranger must retain the 5% interest in the CLOeligible tranche until the repayment, maturity, involuntary and unscheduled
acceleration, payment default or bankruptcy default of the loan. However, the open
market CLO would be free to sell its interest in the CLO-eligible tranche. Sponsors
of balance sheet CLOs would still be subject to the standard risk retention option.

•

Municipal Bond “Repackaging” Securitizations (Tender Option Bonds)—The proposed
rule adds two risk retention options for certain municipal bond repackaging
securitizations, also known as tender option bonds (“TOBs”). A TOB typicallyconsists of the deposit of a single issue of highly rated, long-term municipal bonds ina trust and the issuance by the trust of two classes of securities: a floating rate,
puttable security known as the “floater,” and an inverse floating rate security known
as the “residual.” Floaters, typically held by money market mutual funds, are shortterm securities that are typically puttable at par on a daily or weekly basis. Highly
rated institutions provide a liquidity facility to support this put right. Qualified
TOBs eligible for the new risk retention options are those in which: (i) the collateralconsists solely of municipal securities, as defined in Section 3(a)(29) of the ExchangeAct, all of which have the same municipal issuer and obligor, and servicing assets,(ii) only two classes, floater and residual, are issued, (iii) holders of the floater may
tender their interest to the issuer for purchase at any time upon no more than 30
days’ notice, (iv) the floater qualifies for purchase by money market mutual funds
under Rule 2a-7 of the Investment Company Act of 1940, (v) interest payments madeon the floater, residual and underlying municipal security are all tax deductible tothe owners of such securities, and (vi) the issuer has 100% liquidity coverage from a
regulated liquidity provider. A sponsor of a qualified TOB may satisfy the risk
retention rules in two ways, in addition to the any of the other risk retention options.
First, the sponsor may hold municipal securities from the same issuance deposited in
the qualified TOB, the face value of which is 5% of the face value of the municipal
securities deposited in the qualified TOB. Second, the sponsor may retain an interest
Page 6

Memorandum – September 10, 2013that upon issuance meets the requirements of an eligible horizontal residual interest
but upon the occurrence of certain events including bankruptcy, default or credit
downgrade, will meet the requirements of an eligible vertical interest.
The proposed rule eliminates the “representative sample” option from the original proposal,
which would have allowed a sponsor to retain a randomly selected representative sample ofassets that is the equivalent in all material respects to the securitized assets.
Notably, the proposed rule changes the method of measuring the 5% retention requirementswith respect to eligible horizontal interests by replacing par value in the original proposal withfair value as defined in GAAP. The use of par value in the horizontal risk retention option of
the original proposal had been intended to provide a simple and transparent measure ofcalculation, but introduced other complexities. With the switch to fair value, the proposed rulealso eliminated the “premium cash capture reserve account” requirement for sponsors issuinginterest-only tranches. 4
Consistent with the original proposal, the proposed rule would allow a sponsor that satisfies its
risk retention requirement to allocate the retained risk to any originator of the securitized assetsthat contributed at least 20% of the underlying assets. An originator may not be allocated agreater portion of the risk than the percentage of the securitized assets that it contributed by theoriginator, and must be allocated horizontal and vertical interests in the same proportion as thesponsor. The sponsor will be responsible for the originator’s compliance with, among otherthings, the prohibition on an originator hedging or transferring the risk it retains.
C.

THE RESTRICTIONS ON HEDGING OR TRANSFERRING

As a general matter, a sponsor may not transfer any interest or assets that it is required to retain
to any person other than an affiliate that majority controls, is majority controlled by, or is undercommon majority control with, the sponsor. As discussed above, the proposed rule creates an
exception for B-piece interests in CMBS transferred to eligible purchasers after five years. A
sponsor and its affiliates are also generally restricted from hedging the credit risk the sponsor isrequired to retain. The proposed rule creates a new “sunset” on the transfer and hedging
restrictions. Retained interests of asset-backed securities other than residential mortgage
backed securities (“RMBS”) may be transferred or hedged after the latest of (i) the date on
which the total unpaid principal balance of the collateral is reduced to 33% of the unpaid
principal balance at closing, (ii) the date on which the unpaid principal balance of the interests
issued in the securitization is reduced to 33% of the unpaid principal balance at closing, or (iii)
two years after closing. Because residential mortgages typically have a longer duration thanother assets and weaknesses in underwriting may take longer to manifest, retained interests in
RMBS may be transferred or hedged after the later of (i) the date on which the unpaid principal

The original proposal required sponsors to place funds in a premium capture cash reserve
account when they sold interest-only tranches at the outset, in order to prevent sponsors from reducing
the economic impact of risk retention by monetizing the excess spread that was expected to be generated
over time and diminishing, over time, the value of the most subordinated tranche relative to par.
4

Page 7

Memorandum – September 10, 2013balance of the residential mortgage collateral is reduced to 25% of the unpaid principal balance
at closing, or (ii) five years after closing.
Additionally, limited exceptions to the hedging restrictions exist for certain risks that are notmaterially related to the credit risk of the sponsor’s retained interest or of the particular assetsthat underlie the securitization transaction. Permitted hedges include positions related tooverall market interest rate movements; currency rates; or the overall value of a particularbroad category or index of asset-backed securities (such as home prices), subject to limitations
on the portion of the index that may be represented by the specific securitization transaction orapplicable issuing entities. Hedges based on securities that are backed by similar assets
originated and securitized by other sponsors also would be permitted. The proposed rule also
restricts a sponsor and its affiliates from pledging as collateral for any obligation any interests
or asset that the sponsor is required to retain, unless the obligation is with full recourse to thesponsor or consolidated affiliate.
Importantly, an originator, originator-seller or a third party purchaser that retains credit risk inaccordance with the proposed rule must comply with these restrictions to the same extent as thesponsor.
D.

THE EXEMPTION FOR “QUALIFIED RESIDENTIAL MORTGAGES”

Section 15G of the Exchange Act provides that a securitizer shall not be required to retain any
part of the credit risk for an asset that is transferred or sold through the issuance of asset-backed
securities by the securitizer if all of the assets that collateralize such securities are “qualified
residential mortgages.” Section 15G requires that the definition of a QRM be “no broader than”
the definition of a qualified mortgage (sometimes referred to herein as a “QM”) under Section
129C of the Truth in Lending Act, but otherwise left it to the Agencies to define what constitutes
a qualified residential mortgage.
The proposed rule defines a qualified residential mortgage as a qualified mortgage as definedby the CFPB under the Truth in Lending Act. 5 Dodd-Frank amended the Truth in Lending Act
to require originators of residential mortgages to make a reasonable and good faith
determination, based on verified and documented information, that the borrower has areasonable ability to repay the loan according to its terms. To meet this standard, Dodd-Frankestablishes a rebuttable presumption and a safe harbor for loans that are qualified mortgages.
The final QM rule is effective January 10, 2014.
Defining QRMs as QMs represents a significant departure from the original proposal, which
provided a framework for assessing whether residential mortgage assets underlying a
See 78 Fed. Reg. 6407 (Jan. 30, 2013) as amended by 78 Fed. Reg. 35429 (June 12, 2013) and 78 Fed.
Reg. 44686 (July 24, 2013). Dodd-Frank delegated initial rulemaking authority to define qualified
mortgages to the Federal Reserve Board, and provided for a transfer of this authority to the Consumer
Financial Protection Bureau on July 21, 2011. For more information regarding the CFPB’s definition ofqualified mortgage, please see our memorandum, dated January 29, 2013, available at
http://www.stblaw.com/about-us/news/details?id=8d2e5d51-041b-40fd-a828-5f6bc23f5286.
5Page 8

Memorandum – September 10, 2013

securitization were of such quality that they merited a complete exemption from any risk
retention requirement. This framework included relatively strict minimum underwriting
standards with specific LTV ratios and a minimum 20% down-payment requirement, as well as
disqualifying “derogatory factors” relating to borrowers. The CFPB’s final QM rule, on theother hand, is concerned primarily with product features and a borrower’s debt repayment
capacity. The Agencies noted that of loans originated from 2005 to 2008 that met the QM
criteria, 23% experienced a foreclosure or a delinquency of 90 days or more by the end of 2012,
compared to 44% of loans that did not meet the QM criteria.
1.

General Definition of Qualified Mortgages

The final QM rule provides several definitions of qualified mortgages, and the proposed rule
allows a loan meeting any of these definitions to be a QRM. Below are the general requirementsthat must be met for a residential mortgage loan to be considered a “qualified mortgage”:•

Regular Payments—The loan must have regular periodic payments that aresubstantially equal.

•Elimination of Nontraditional Loan Features—The loan generally cannot have features
such as negative amortization (where the principal amount increases), interest-only
payments (where a borrower only pays the interest for a specified period of time so
the principal does not decrease with payments), or balloon payments (where thepayment is more than two times a regular periodic payment).

•

Maximum Loan Term—The loan cannot have a term exceeding 30 years.

•

Limits on Points and Fees—If the loan is for $100,000 or more, it cannot have points orfees greater than 3% of the total loan amount. Stricter limits apply for smaller loans.

•

Income Verification and Monthly Debt-to-Income Ratio Cap—Creditors must satisfy
general underwriting criteria for the loan, including by verifying a potential
borrower’s current or reasonably expected income or assets (other than the value ofthe home securing the loan). The final QM rule also generally requires that monthly
payments be calculated based on the highest payment that will apply in the first five
years of the loan and that the borrower have a total “back-end” debt-to-income ratio
no greater than 43%.

The final QM rule draws a distinction between higher-priced QMs, which receive a rebuttablepresumption of compliance with the Truth in Lending Act, and QMs that are not higher-priced
loans, which receive a legal safe harbor for compliance. For the purpose of the proposed risk
retention rule, both higher-priced and non-higher-priced QMs are eligible as QRMs and can bepooled together in the same securitization.

Page 9Memorandum – September 10, 20132.

Temporary Second Qualified Mortgage Definition

The final QM rule provides for an temporary second QM definition, which is similar to thegeneral QM definition, but does not independently require for creditors to verify income nor
require a specified debt-to-income ratio. Loans are eligible for this definition if they are eligible
for purchase, guarantee or insurance by Fannie Mae, Freddie Mac, the Department of Housing
and Urban Development (including the Federal Housing Administration, or FHA), the Veterans
Administration, the U.S. Department of Agriculture or Rural Housing Service.
The temporary second definition will expire as to any loan eligible for purchase or guarantee by
Fannie Mae or Freddie Mac once that institution exits conservatorship, and will expire as to any
loan eligible to be insured or guaranteed by the FHA, the U.S. Department of Veteran Affairs,
the U.S. Department of Agriculture, and the Rural Housing Service once the relevant agency
issues its own QM rule.
3.

Small Creditors

The final QM rule provides additional QM definitions for small creditors, i.e., lenders
originating 500 or fewer first-lien residential mortgage loans in the preceding calendar yearwith assets under $2 billion. For example, small creditors operating predominantly in rural orundeserved areas may originate balloon-payment loans, but these loans must have a term of atleast five years, a fixed-interest rate, and meet certain basic underwriting standards. Other
small creditors may originate balloon loans for a two year grace period. However, QMs underthese definitions are required to be held by lenders for three years, and thus would not be
eligible for securitization during that time.
4.

Alternative Proposal

The Agencies are seeking comment on an alternative approach to defining QRMs. The
alternative approach would begin with the CFPB’s QM definition and add additional
requirements: (i) a QRM must be secured by a one-to-four family property that constitutes theborrower’s principal dwelling; (ii) a QRM must be a first-lien mortgage; (iii) the borrower’s
credit history must meet certain requirements; and (iv) the LTV ratio at closing cannot exceed
70%. While the Agencies did not select the alternative approach for the proposed rule, they
provided data from several studies demonstrating that of QM-eligible loans originated in theyears leading up to the recent financial crisis, those with an LTV ratio of 70% experienced
significantly lower delinquency rates.
E.

OTHER QUALIFIED ASSET CLASSESIn addition to the general exemption for qualified residential mortgages, the proposed ruleprovides special treatment for qualified loans in certain other asset classes. Asset-backed
securities that are collateralized exclusively by qualifying commercial loans, qualifying CRE
loans and qualifying automobile loans would not require risk retention. These qualifying loans
would need to meet conservative underwriting standards that ensure they are of very low
credit risk, which are more stringent than existing supervisory guidelines of the federal banking
regulators. The underwriting standards applicable to these asset classes are summarized below.
Page 10Memorandum – September 10, 2013•

Commercial Loan Asset Class—The underwriting standards for commercial loans will
require an originator to conduct an analysis of the borrower’s ability to service all
outstanding debt over the next two years and to determine that, following
origination, the borrower will have a total liabilities to total tangible assets ratio of
50% or less, a leverage ratio of 3.0 or less and a debt service coverage (“DSC”) ratio
of no less than 1.5. The loan payment amount must be determined based on
straight-line amortization of principal and interest over a term that does not exceed
five years from origination, and the primary repayment source for the loan must
consist of business revenue of the borrower. Loan documentation must include
covenants that restrict the borrower’s ability to incur additional debt or transfer orpledge its assets. There must also be financial reporting covenants, which provide aservicer with financial information on at least a quarterly basis.

•

CRE Loan Asset Class—The underwriting standards for CRE loans focus principallyon the borrower’s ability to repay the loan (including a requirement that a borrower
have a DSC ratio of at least 1.7 or greater or, in the case of certain types of properties
with a demonstrated history of stable net operating income, 1.5 or greater or 1.25 orgreater); the value of, and the originator’s security interest in, the collateral; an LTV
ratio of no more than 65% and combined LTV ratio of no more than 70%; andwhether the applicable loan documentation includes appropriate collateralprotecting covenants.

•

Automobile Loan Asset Class—The underwriting standards for automobile loans are
generally comparable to industry standards for unsecured lending, focusing
principally on the borrower’s ability to repay the loan. At the time of origination, theborrower’s debt-to-income ratio, including payments on the proposed loan, must be
no greater than 36% and the borrower’s credit history must be clear of any
delinquency of 30 days or more within the past 30 days, as well as of any
bankruptcy, foreclosure or similar proceeding within the previous 36 months. The
borrower must also have 24 months of credit history, meet a 10% down payment
requirement and will be prohibited from deferring principal or interest under theloan documents. These conservative underwriting standards are, in large measure,a reflection of the highly depreciable nature of the collateral involved in automobileloans.

The proposed rule, unlike the original proposal, exempts from risk retention qualifying assets(qualifying commercial loans, CRE loans and automobile loans) even when pooled with nonqualifying assets securing the same asset-backed security. A sponsor may reduce its 5% risk
retention requirement by the ratio of the unpaid principal balance of qualified assets to the total
unpaid principal balance of all assets in the pool, provided that the sponsor discloses toinvestors, its primary Federal regulator and the SEC the manner in which it determined its
aggregate risk retention requirement. This treatment is not available for securitization of loans
from different asset classes (i.e., automobile and commercial) that secure the same asset-backed
security.

Page 11

Memorandum – September 10, 2013

F.

TREATMENTOF
GOVERNMENT-SPONSORED
GOVERNMENT AGENCIESENTERPRISESAND

For so long as Fannie Mae and Freddie Mac continue to operate under the conservatorship of
the Federal Housing Finance Agency and have the benefit of the Senior Preferred Stock
Purchase Agreement with the U.S. Treasury Department, the 100% guarantees they provide formortgage-backed securities that they issue would be deemed to satisfy the risk retention
requirement. This treatment is significant because these government-sponsored enterprises,
together with other government agencies (most notably, the FHA and VA) whose guarantees
will exempt a securitization transaction from the risk retention requirement (provided that suchtransaction is collateralized solely by loans guaranteed by such agencies), backstop
approximately 90% of single-family conforming loans currently being issued in the residential
mortgage loan market.
Finally, the proposed rule adds an exemption from the risk retention requirements forsecuritization transactions that are sponsored by the FDIC acting as conservator or receiverunder any provision of the Federal Deposit Insurance Act or its Orderly Liquidation Authority
under the Dodd-Frank Act.
***For more information about the proposed risk retention rule, please contact a member ofSimpson Thacher’s Financial Institutions Group.
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Stacie McGinn(212) 455-2250
smcginn@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

Randy Benjenk(212) 455-2307
randy.benjenk@stblaw.com

This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we informyou that any tax advice contained in this memorandum was not intended or written to be used, andcannot be used, for the purpose of avoiding tax-related penalties under federal, state or local tax law.
Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independenttax advisor.
The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

Page 12

Memorandum – September 10, 2013

UNITED STATESNew York
425 Lexington Avenue
New York, NY 10017-3954+1-212-455-2000

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Palo Alto
2475 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

Washington, D.C.
1155 F Street, N.W.
Washington, D.C. 20004+1-202-636-5500

Houston2 Houston Center

ASIA
Beijing3919 China World Tower One
1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Seoul
West Tower, Mirae Asset Center 1
26 Eulji-ro 5-gil, Jung-gu
Seoul 100-210
Korea+82-2-6030-3800

Tokyo
Ark Hills Sengokuyama Mori Tower

909 Fannin Street
Houston, TX 77010+1-713-821-5650

9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032
Japan+81-3-5562-6200

EUROPE

SOUTH AMERICA

LondonSão Paulo

CityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

www.simpsonthacher.com