November 13, 2013

Qualifying Loans Will Reduce or Eliminate Risk Retention Obligations of Issuers Under Reproposed Credit Risk Retention Rules

Holland & Knight Alert
Jay Baker

The general risk retention requirements mandated under section 15G of the Securities and Exchange Act of 1934 (added by section 941 of the Dodd-Frank Act) will be applicable to all issuers of asset-backed securities (ABS) once the reproposed rules published by federal regulators on Aug. 28, 2013, become final and effective. (See our Holland & Knight alert, "Reproposed Credit Risk Retention Rules Will Affect All Issuers of Asset-Backed Securities," Sept. 27, 2013.)

Notwithstanding the broad application of these rules, an issuer of ABS backed by commercial real estate loans, commercial loans, or automobile loans may be permitted to retain less than the otherwise required level of credit risk provided the loans are "qualifying loans" and certain other conditions are met.

Underwriting Standards Determine Which Loans Are Qualifying Loans

Commercial real estate loans, commercial loans and automobile loans that meet certain underwriting standards are considered qualifying loans under the reproposed rules. (Here is a summary of the underwriting standards: commercial real estate loanscommercial loans and automobile loans.)

Included in all of the underwriting standards is a condition that requires the depositor of the related securitization transaction to certify that it has evaluated the effectiveness of its internal controls with respect to the process for ensuring that all qualifying loans included in the underlying pool have met all of the other underwriting criteria and has concluded that its internal controls are effective. A copy of this certification must be delivered to potential investors (and upon request to any applicable federal regulator) prior to the sale of the related ABS.

The underwriting standards are by design set very high to ensure that qualifying loans pose a low credit risk, making it a potential challenge to originate sufficient loans of this quality to get the benefit of the credit risk retention relief.

Remaining Conditions for Reduction of Credit Risk Retention

Assuming that a sponsor of a securitization transaction is able to assemble a pool of commercial real estate loans, commercial loans, or automobile loans that have, at least in part, satisfied the applicable underwriting criteria to be considered qualifying loans under the reproposed rules, to be eligible for a reduction (or elimination) of the 5 percent credit risk retention requirements the following remaining conditions must also be met:

  • the transaction is collateralized solely by loans of the same asset class and servicing assets (no mixed-asset pools)
  • the asset pool must be fixed at closing (no reinvestment periods)
  • prior to the sale of the related ABS, the sponsor provides the following disclosures to potential investors (and upon request to the SEC and any applicable federal regulator) under the caption "credit risk retention":
    • a description of the manner in which the sponsor determined the aggregate risk retention requirement for the transaction after taking into account the qualifying loans   
    • descriptions of the qualifying loans and those loans that are not qualifying loans and the material differences between those two groups with respect to the composition of each group's loan balances, loan terms, interest rates, borrower credit information and the characteristics of any loan collateral

For eligible transactions collateralized by both qualifying loans and non-qualifying loans, the amount of required credit risk retention will be reduced by the ratio (not to exceed 50 percent) of the unpaid principal balance of qualifying loans in the pool to the total unpaid principal balance of all the loans in the pool, resulting in a minimum credit risk retention of 2.5 percent. In addition, all of the other general risk retention requirements described in our Sept. 27, 2013, alert must be met with respect to the non-qualifying loans in the pool.

For eligible transactions collateralized solely by qualifying loans, the credit risk retention requirement will be 0 percent. In addition, none of the other general risk retention requirements must be met.

Handling Defective Qualifying Loans

If any qualifying loan turns out not to have met the required underwriting criteria, the sponsor will not lose the risk retention benefit so long as:

  • the failure of the loan to meet the underwriting criteria is not material, or
  • within 90 days after the non-compliance has been determined, the sponsor either:
    • cures the defect, or   
    • repurchases the loan at a price at least equal to the remaining principal balance and accrued interest thereon

In addition, the sponsor is required to promptly notify the holders of the related ABS of its cure or repurchase, including the principal amount of the loans and the cause for the cure or repurchase.

Stay Tuned

The key to obtaining the credit risk retention relief set forth in the reproposed rules will be satisfying the applicable underwriting standards. Comments to these rules were due on October 30 and it is anticipated that many commentators will advocate for a loosening of certain of these standards because of the potential difficulty in originating sufficient qualifying loans. Whether this advocacy results in meaningful changes will be known when the final rules are published (presumably in early 2014).  

To ensure compliance with Treasury Regulations (31 CFR Part 10, §10.35), we inform you that any tax advice contained in this correspondence was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.

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