Credit Risk Retention Rule Explained
This week, the six federal agencies finalized the credit risk retention rule as required by Section 941 of the Dodd Frank Act.
The final Credit Risk Retentions Rule “largely mirrors” the 2013 proposal to lenders’ dismay. The 2013 proposal was largely scrutinized by the mortgage industry, especially as it related to cash flow restrictions on the eligible horizontal residual interest risk retention option and the treatment of collateralized loan obligations (also known as CLOs). The Agencies did not adopt the cash flow restrictions and rejected exemptions for open-market CLO transactions. The final rules generally align the QRM definition with the Qualified Mortgage (“QM”) definition as defined in rules of the CFPB. The rules also allow for multi-family homes with up to four units to be included within the definition of residential mortgages.
The 527 page rule requires that a “sponsor” of an asset-backed securitization (ABS) transaction retain 5 percent risk exposure in one of several permitted forms including vertical, horizontal, and a combined method. Other methods apply only to specific types of assets or transactions, such as commercial mortgage-backed securities.
· Retaining a 5% “eligible vertical interest” of “vertical strip of risk” (a proportionate 5% interest in every tranche of a securitization)
· Retaining a “eligible horizontal residual interest” (a proportionate interest in the equity/first loss tranche of a securitization), with a market value at least equal to 5% of the market value of all the securities issued in the ABS transaction
· Combined vertical and horizontal interests for which the sum of the percentage held as a vertical strip and the percentage of the market value of the eligible horizontal residual interest compared to all the issued ABS securities must be at least 5%
The credit risk retention rules apply to sponsors of virtually all securitizations whether the asset-backed securities are publicly or privately offered, and only permit limited circumstances in which the required risk retention may be held by an originator or other party rather than the sponsor.