In order to finance ABS interests retained as required by the credit risk retention rules, a securitization sponsor first must wend its way through a thicket of unclear and sometimes apparently contradictory requirements.
Under the credit risk retention rules adopted[1] pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act),[2] a sponsor of a securitization generally is responsible for retaining not less than five percent of the credit risk of any asset that, through the issuance of asset-backed securities (ABS), is transferred, sold, or conveyed to a third party. Sponsors and other parties that retain ABS interests to satisfy the credit risk retention requirements generally are prohibited from transferring the retained interests (other than to majority-owned affiliates), hedging the retained credit risk, or pledging the retained interests on other than a full recourse basis. The implementation of the credit risk retention rules has involved numerous interpretive questions.[3]
This LawFlash explores a variety of issues that a sponsor may have to address when structuring a financing of its risk retention interests. These issues include the parameters of a permitted “full recourse” financing, the permissibility of repurchase financing in light of the prohibition on transfer, the possibility that a financing whose terms mirror those of the underlying risk retention interests could be considered to constitute a prohibited transfer, and the possibility that a risk retention financing could be deemed to be an impermissible hedge.
Market views on some of these issues vary, by asset class or otherwise. This LawFlash represents our understanding of the current range of approaches in an evolving area. We note that the Agencies have not specifically addressed these issues, and if they did their conclusions could differ.
The risk retention requirements may be satisfied by a sponsor (or its majority-owned affiliates) that retains an “eligible vertical interest” consisting of at least five percent of each class of ABS interests[4] issued as part of the securitization transaction, or a single vertical security representing the same economics. A “majority-owned affiliate” of a sponsor is “an entity other than the issuer that directly or indirectly majority controls, is majority controlled by, or is under common majority control with” the sponsor. For purposes of this definition, “majority control” is ownership of more than 50 percent of an entity’s equity, or ownership of “any other controlling financial interest” in the entity, as determined using generally accepted accounting principles (GAAP).
Alternatively, a sponsor (or its majority-owned affiliates) may retain an “eligible horizontal residual interest” in an amount equal to at least five percent of the fair value of all ABS interests issued as part of a securitization transaction. An “eligible horizontal residual interest,” which represents a first loss position with respect to the entire asset pool, may consist of one or more ABS interests that collectively require any shortfall in funds available to pay principal or interest to reduce amounts payable to the horizontal interest before reducing amounts payable to any other ABS interest, and have the most subordinated claim to payments of both principal and interest. The fair values of the eligible horizontal residual interest and of the other ABS interests issued in the securitization are determined using a fair value measurement framework under GAAP.[5]
The rules also permit a sponsor (or its majority-owned affiliates) to retain any combination of eligible vertical interests and eligible horizontal residual interests, so long as the total percentages of the eligible vertical interest and of the fair value of the eligible horizontal interest equal no less than five percent. There also are other methods of risk retention that only apply to specific transaction types or asset classes.
Neither a sponsor nor any of its affiliates may pledge a risk retention interest that it is required to retain as collateral for any financing, “including a loan, repurchase agreement, or other financing transaction,” unless the financing is “full recourse to the sponsor or affiliate, respectively.”
A sponsor may not sell or “otherwise transfer” any risk retention interest that it is required to retain, except to a majority-owned affiliate that remains subject to the same restrictions.
Under the prohibition on hedging, neither a sponsor nor any affiliate may purchase or sell any security or financial instrument, or enter into any agreement, derivative, or other position, if payments on the instrument, derivative, or other position are materially related to the credit risk of any ABS interests that the sponsor (or majority-owned affiliate) is required to retain, and the position would in any way limit the financial exposure of the sponsor (or majority-owned affiliate) to the credit risk of those ABS interests.[6]
These restrictions do not expire until a specified sunset date. For residential mortgage-backed securities, the restrictions expire on the later of five years after the closing date, and the date that the total unpaid principal balance of the underlying mortgages has been reduced to 25 percent of the unpaid principal balance as of the closing date, but no later than seven years after the closing date. For all asset-backed securities other than residential mortgage-backed securities, the restrictions generally expire on the latest of (i) the date that the total unpaid principal balance (if applicable) of the securitized assets has been reduced to 33 percent of the cutoff date unpaid principal balance, (ii) the date that the total unpaid principal balance of the ABS interests issued has been reduced to 33 percent of the closing date unpaid principal balance, and (iii) two years after the closing date.
The credit risk retention rules do not define what is meant by “full recourse.”
As a practical matter, a borrower that wishes to limit a lender’s recourse may do so directly, by negotiating contractual limitations on the lender’s recourse after default to the pledged risk retention interests or to the borrower’s other assets. Obviously, in order to avoid the prohibition on non-recourse financing, direct limitations on the lender’s recourse in a risk retention financing facility should be avoided.
The Agencies stated clearly that if a sponsor or affiliate defaults under a permitted recourse financing and allows the risk retention interest to be taken by the lender (by the exercise of remedies or otherwise), the sponsor will have violated the prohibition on transfer. Some sponsors have attempted to avoid this possibility by negotiating restrictions on the ability of a lender to foreclose on their pledged risk retention interests, but the overall benefit of such limitations should be carefully considered in light of the requirement of full recourse. If a sponsor allows its risk retention financing to go into default, it is likely to be in dire enough financial straits that the possibility of an enforcement action for violation of the risk retention rules would not be its biggest concern.
In addition to directly negotiating contractual limitations on a lender’s recourse, a borrower may achieve substantially the same effect indirectly, by borrowing through a special purpose affiliate. For example, a sponsor that wishes to limit a lender’s ability to realize on assets other than its pledged risk retention interests could transfer those interests to a special purpose majority-owned affiliate that has no other assets, and cause the lender to lend to that entity, with no parent guarantee, additional contributed assets or other credit support. While the wording of the prohibition on non-recourse financing on its face simply requires recourse to the relevant sponsor “or affiliate,” a general market consensus seems to have been reached that the use of an undercapitalized special purpose majority-owned affiliate as a risk retention borrower may be contrary to the Agencies’ intent.
In most circumstances, a full guarantee of the sponsor of the affiliate’s obligations should be sufficient to avoid the issue entirely. However, a guarantee is not always practical, and may pose other issues. For example, if the lender’s credit analysis depends on the affiliate’s bankruptcy remoteness from the sponsor, a full guarantee of the financing by the sponsor would impair that result.
Sponsors have used guarantees and several other methods, alone or in combination, in an effort to mitigate the possibility that a risk retention financing undertaken by a special purpose majority-owned affiliate may be deemed to indirectly violate the prohibition on non-recourse financing. Some sponsors have transferred additional assets to the majority-owned affiliate borrower or provided other sources of credit support for the financing in an effort to ensure that sufficient assets will be available to the lender to repay the financing after default. The means by which the sufficiency of these assets has been analyzed has varied. Sponsors in some market sectors have focused on requiring additional assets or other credit support in a fixed percentage of the value of the pledged risk retention interests, though consideration should be given as to whether the “one size fits all” nature of this approach is adequate in all scenarios. Other sponsors have used a more flexible, albeit more complex, approach that requires the amount of additional available assets or credit support to be sufficient to ensure repayment of the debt under fully stressed cash flow models based on appropriate loss assumptions. As of the date of this LawFlash, there does not appear to be a market consensus on which approach is more appropriate.
It is wise to consider whether a risk retention financing should be considered “full recourse” if the lender insists on significant credit support from parties other than the borrower, such as a third-party guarantee. However, this issue may be of less concern where such a guarantee comes from a close affiliate of the borrower. For example, assume that the corporate parent of a sponsor borrower guarantees its obligations under a risk retention financing. Enforcement of the lender’s remedies directly against the borrower would result not only in a direct loss by the borrower, but also in a corresponding decline in value of the parent guarantor’s ownership interest in the borrower, substantially the same economic result for the parent as if the lender were to proceed directly against the parent under the guarantee. Or assume, in a fund structure, that the funds that were the source of the pool assets for the securitization guarantee their affiliated sponsor’s obligations under a risk retention financing. One might reasonably conclude that the funds’ guarantee in these circumstances does not interfere with the full recourse nature of the financing.
Agencies that have been asked about the permissibility of various risk retention financing scenarios often have emphasized that any financing transaction must not only be “full recourse,” but also must comply with the prohibitions on transfer and hedging.
While as a practical matter a repurchase agreement is simply another means of providing financing, it is a sale in form and under applicable state law. Further complicating matters, most institutions providing repurchase financing obtain some or all of the capital to fund the transaction by “rehypothecating” the securities, i.e., reselling them to other institutions under separate repurchase financings.
The prohibition on transfer clearly restricts sales. However, the language of the financing restriction exempts a full recourse “loan, repurchase agreement, or other financing transaction.” Because of this specific reference to repurchase agreements, many market participants have become comfortable that a repurchase financing of a risk retention interest that is full recourse and that does not have any other troublesome characteristics[7] is not a prohibited sale or transfer, even if the repo buyer is permitted to rehypothecate the risk retention interest. If repurchase financings were strictly prohibited, the reference to repurchase transactions in the provision restricting non-recourse financing would be meaningless.
The prohibition on transfer states that a sponsor may not sell or “otherwise transfer” any risk retention interest that it is required to retain, except to a majority-owned affiliate.
Sponsors should consider the possibility that the entry by a sponsor (or majority-owned affiliate) into an otherwise permitted full-recourse financing that mirrors the terms of the risk retention interest that it is required to hold could be deemed to “otherwise transfer” those risk retention interests. For example, a sponsor or a majority-owned affiliate could issue notes or loan tranches that match the principal amounts, interest rates, maturities, and payment schedules of the underlying risk retention interests.
As of the date of this LawFlash, there does not appear to be a market consensus on this question. Some market participants believe that “mirror” financing should not be an issue so long as the financing is full recourse because that means the sponsor or its majority-owned affiliate remains sufficiently subject to the credit risk of the interests it is required to retain. However, others are concerned that such financing may be viewed by the Agencies as a prohibited indirect transfer of risk, and prefer to see a significant mismatch between the terms of the risk retention interests and the terms of any financing.
This issue may be of heightened concern if the financing is undertaken by means of a resecuritization structure, because a sponsor might expect its primary regulatory Agency to place additional scrutiny on a risk retention financing accomplished through resecuritization mechanics.[8]
Some market participants have expressed concern that a financing of risk retention interests could violate the rules’ prohibition on hedging, particularly for “mirror” financing. There does not yet appear to be a market consensus on this question, but any concern regarding these structures may more properly rest with the prohibition on transfer than the prohibition on hedging.
There are two prongs to the prohibition on hedging, both of which must be met before an agreement or position is prohibited. Neither a sponsor nor any affiliate may enter into any agreement or position if (first) payments on the position are materially related to the credit risk of any ABS interests that the sponsor (or a majority-owned affiliate) is required to retain, and (second) the position would in any way limit the financial exposure of the sponsor (or majority-owned affiliate) to the credit risk of those interests.
Payments under a credit hedging transaction generally are made to the party that hedges its credit risk, so that is the type of payment that likely was contemplated by the Agencies when promulgating the first prong of the prohibition (i.e., there are payments on a position that are materially related to the credit risk of the retained interests). In contrast, the borrower in a financing is almost never paid by the lender for losses that it incurs.
Moreover, absent unusual circumstances, a financing that satisfies the “full recourse” requirement likely would not limit the financial exposure of a sponsor or majority-owned affiliate to a risk retention interest in violation of the second prong of the prohibition.
A sponsor or majority-owned affiliate must reconcile a variety of different requirements in structuring a secured financing of its risk retention interests.
The financing must be “full recourse,” a term that is not defined by the rules. Direct limits on the lender’s ability to realize on the risk retention interests and the borrower’s other assets should be carefully weighed in light of this requirement. If the financing is undertaken through a special purpose majority-owned affiliate, the borrower should consider how best to mitigate the possibility that the structure may be deemed to indirectly limit the lender’s recourse. Some methods that have been used, either alone or in combination, include a full guarantee by the sponsor, or the transfer of additional financial resources to the borrower (either in a fixed percentage or in an amount sufficient to ensure repayment of the financing under fully stressed cash flow models).
The rules generally restrict any sale or other transfer of the risk retention interests that are required to be retained. While repurchase financing is in form a sale, the explicit reference to repurchase financing in the provision prohibiting financing unless it is full recourse has led to a general market consensus that such financing is acceptable, if it meets all the other requirements of the rules.
The sponsor should consider its position on whether financing that mirrors the terms of the underlying risk retention interests could be considered to be a prohibited “other transfer” of those interests, particularly if the financing is accomplished by means of a resecuritization.
Finally, the rules generally prohibit hedging the credit risk of a sponsor’s risk retention interests. While some market participants are concerned that a financing transaction could be deemed to be an impermissible hedge, such a result appears unlikely.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the author, Charles A. Sweet, or any of the following Morgan Lewis lawyers:
New York
Reed Auerbach
Harlyn Bohensky
Matthew Joseph
Steve Levitan
Philip Russell
Edmond Seferi
Washington, DC
Cory Barry
Asa Herald
Jeffrey Johnson
Mark Riccardi
Charles Sweet
[1] Credit Risk Retention, SEC Rel. No. 34-73407, 79 Fed. Reg. 77602 (Dec. 24, 2014) (the Adopting Release). The Risk Retention Rules became effective December 24, 2015 for ABS backed by residential mortgage loans, and on December 24, 2016 for all other asset classes. For more details on the credit risk retention rules, see Morgan Lewis’s publication titled “A Guide to the Credit Risk Retention Rules for Securitizations.”
[2] Implementing Section 941(b) thereof. The agencies that adopted the implementing rules (the Agencies) consist of the Securities and Exchange Commission, the Department of the Treasury, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Department of Housing and Urban Development.
[3] Morgan Lewis previously analyzed the issues involved in identifying the sponsor of a securitization transaction in our LawFlash titled “Credit Risk Retention: Who Is the Sponsor of a Securitization?” and addressed the difficulty of simultaneously complying with both the US credit risk retention rules and the EU credit risk retention rules in our LawFlash titled “Multijurisdictional Securitization in the Age of Risk Retention.”
[4] An “ABS interest” includes most types of interests issued by an issuing entity, whether or not certificated, the payments on which primarily depend on the cash flows from pool assets, other than a non-economic REMIC residual interest.
[5] The sponsor also may establish an “horizontal cash reserve account” in lieu of retaining all or any part of an eligible horizontal residual interest, containing cash equivalents equal to the same amount that would be required if the sponsor held an eligible horizontal residual interest.
[6] However, certain hedges that are not tied specifically to the credit risk of the retained interests are expressly permitted. These include hedges related to interest rates, currency exchange rates, or home prices, or tied to other sponsors’ securities, and hedges involving instruments tied to an index that includes the ABS (if any class of ABS interests in an issuing entity as to which the sponsor was required to retain risk represents no more than 10 percent of the dollar-weighted average of all instruments in the index, and all classes of ABS interests in all issuing entities as to which the sponsor or its majority-owned affiliates was required to retain risk represent no more than 20 percent of the dollar-weighted average of all instruments in the index).
[7] Potentially including, for example, terms that mirror those of the risk retention interests as discussed below.
[8] Although resecuritizations generally are a customer-driven product, during the comment process for the risk retention rules, some Agency staff members expressed particular concerns about resecuritizations, viewing them as conceptually indistinguishable from collateralized debt obligations.