SEC Approves New Securitization Risk Retention Rule with Broad Exception for Qualified Residential Mortgages
The Securities and Exchange Commission (SEC) and five other federal agencies recently approved a joint rule (the “Risk Retention Rule”) mandating that sponsors of certain types of securitizations retain a minimum level of credit risk exposure in those transactions and prohibiting such sponsors from transferring or hedging against that retained credit risk.[i]The final Risk Retention Rule will be effective one year after its publication in the Federal Register for securitizations of residential mortgages, and two years after publication for securitizations of all other asset types. The SEC vote was 3-2, with sharp dissents from Commissioners Gallagher and Piwowar concluding that the adopting agencies had missed a prime opportunity to rein in risky mortgage lending practices that had precipitated the 2008 financial crisis.
Following the meltdown of the securitization markets in 2007 (particularly subprime residential mortgage-backed securities), and the resulting global financial crisis, the Dodd-Frank Act mandated that the U.S. federal banking, securities and housing agencies adopt and implement rules to require sponsors of most new securitizations to retain not less than five percent of the credit risk of any assets that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party. It was thought that requiring securitization sponsors to keep “skin in the game” would align the interests of the sponsors with the interests of investors and thereby incentivize the sponsors to ensure the quality of the assets underlying the securitization through appropriate due diligence and underwriting procedures when selecting assets for securitization. Although the Dodd-Frank Act explicitly exempted securitizations of certain types of mortgage loans called “qualified residential mortgages” (or “QRMs”) from this risk retention requirement, it invited the rulemaking agencies to define that key term, provided that their definition could be no broader than the definition of “qualified mortgage”adopted by the Consumer Financial Protection Bureau (CFPB) pursuant to the Truth in Lending Act.[ii] In considering how to define QRM, the rulemaking agencies were directed by the Dodd-Frank Act to take into consideration “underwriting and product features that historical loan performance data indicate result in a lower risk of default.”[iii]
Qualified Residential Mortgage Definition
The final Risk Retention Rule generally follows the provisions of the revised proposed Risk Retention Rule announced by the agencies in August 2013. Instead of creating its own definition of QRM, the final Risk Retention Rule adopts and incorporates the CFPB’s definition of “qualified mortgage” as its own, with a provision requiring the rulemaking agencies to periodically review the definition, which was apparently added at the SEC’s request.[iv] By incorporating the CFPB’s definition, the final Risk Retention Rule did not adopt the agencies’ original proposal that, among other things, would have tightened the definition of QRM in two important respects, with the agencies citing potentially deleterious effects on the availability of credit and the private mortgage markets.
Specifically, the final Risk Retention Rule’s definition of QRM does not incorporate either a minimum down payment requirement or a borrower credit history standard, notwithstanding the rulemaking agencies’ explicit acknowledgement that small down payments (in proportion to loan size) and negative credit histories are, in fact, significant predictors of the likelihood of borrower default.[v] Indeed, the adopting release concedes that those two factors are “important aspects of prudent underwriting”, but concludes that, on balance, incorporating them into the QRM definition would potentially impede access to credit for borrowers with poor credit and limited assets and hinder the return of private capital to the mortgage market.
In his dissent, Commissioner Gallagher chastised the rulemaking agencies for failing to adopt a meaningful QRM definition. In his view, by adopting the CFPB’s definition without any minimum down payment, the agencies had reverted to “the meaningless standards of the past”. Worse yet, the adopting agencies had also placed a government imprimatur on mortgages meeting these new standards. Mortgages which had previously been categorized as “subprime” due to low down payments, low borrower credit scores or other indicators of repayment risk, would now be “qualified”. And, according to Commissioner Gallagher, “when every mortgage is labeled as ‘qualified,’ investors should assume none really will be.”
Commission Piwowar was also outspoken in his dissent, assailing the adopting agencies for insufficient economic analysis of the rule, particularly the scope of the exemptions and the appropriate risk retention levels for various asset classes. The Commissioner noted that no rulemaking agency other than the SEC had conducted any economic analysis of the rule and that, even though the SEC’s analysis had concluded broadly that the risk retention requirements would impose significant costs on the financial markets that would likely be passed on to borrowers in terms of increased borrowing costs and/or reduced access to credit, no effort was made by the banking and housing regulators to “calibrate the level of risk retention in order to avoid significant unintended consequences” -- the agencies had simply adopted five percent as the appropriate retention level across the board. Instead of analyzing whether different risk retention levels might be appropriate for different asset classes, he concludes that the banking and housing regulators had simply “thrown up their hands and simply decided that getting it done [was] more important than getting it right.”
The Risk Retention Rule, as finally adopted, is viewed by many as a concession to political pressure exerted by the mortgage banking industry, housing advocacy groups and others who claimed that access to housing credit would have been overly restricted by a narrower QRM definition. It certainly is much more lenient than the original rule proposal, which is in stark contrast to many other rulemaking projects under the Dodd-Frank Act, where the final versions of rules are frequently more restrictive than the proposed versions. It is also remarkable that a rule focused on risk retention, when applied to the asset type at the very center of the recent financial crisis (residential mortgages), requires no significant principal risk to be retained by either the securitizer/lender (QRMs are not subject to 5 percent risk retention) or the borrower (QRMs do not require a minimum down payment). In fact, securitizers of the few asset types that performed relatively well during the financial crisis will now find themselves subject to more restrictive risk retention rules than securitizers of the one asset type that was a principal cause of the financial crisis. Having said that, a cynic might conclude that the only party retaining risk in the context of the Risk Retention Rule (at least for residential mortgage securitizations) is the taxpayer. Whether that risk has been sufficiently ameliorated by the other regulatory reforms arising out of the financial crisis remains to be seen.
[i] The other five agencies were the Board of Governors of the Federal Reserve System, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency and the Office of the Comptroller of the Currency. The final rule and accompanying release can be found at http://www.sec.gov/rules/final/2014/34-73407.pdf
[ii]The Dodd-Frank Act also permitted the implementing agencies to require less than a five percent risk retention for securitizations of commercial mortgages, commercial mortgages and auto loans meeting underwriting standards established by the federal banking agencies, and authorized total or partial exemptions for securitizations as “may be appropriate in the public interest and for the protection of investors” including with respect to securitizations of certain government obligations. Pursuant to this authority, the final Risk Retention Rule does not require risk retention for securitizations of commercial loans, commercial mortgages or auto loans meeting certain “high quality” underwriting standards.
[iii] Such features include “(i) documentation and verification of the financial resources relied upon to qualify the mortgagor; (ii) standards with respect to--(I) the residual income of the mortgagor after all monthly obligations; (II) the ratio of the housing payments of the mortgagor to the monthly income of themortgagor; (III) the ratio of total monthly installment payments of the mortgagor to the income of the mortgagor; (iii) mitigating the potential for payment shock on adjustable rate mortgages through product features and underwriting standards; (iv) mortgage guarantee insurance or other types of insurance or credit enhancement obtained at the time of origination, to the extent such insurance or credit enhancement reduces the risk of default; and (v) prohibitingor restricting the use of balloon payments, negative amortization, prepayment penalties, interest-only payments, and other features that have been demonstrated to exhibit a higher risk of borrower default.” Dodd-Frank Act, Section 941(b); 15 USC78o-11(e)(4)(B).
[iv] Generally, a “qualified mortgage” under the CFPB rules is a mortgage made to a borrower with a debt-to-income ratio of 43% or less (except for certain GSE eligible loans), with a loan term of not more than 30 years, with points and fees not greater than 3% (for loans of $100,000 or more) and with no “risky” features, such as negative amortization, interest-only or balloon loans.
[v] The Risk Retention Rule originally proposed in 2011 had included a 20% down payment requirement and a maximum loan to value ratio of 80%, among other criteria, for qualified residential mortgages. Additionally, the lender would have been required to verify the absence of certain adverse events (e.g., delinquencies, defaults, bankruptcies) in the borrower's recent credit history, which requirement could be satisfied by the lender reviewing credit reports of the borrower from at least two consumer reporting agencies. 76 FR 24090 (April 29, 2011). These requirements were eliminated in a re-proposal of the Rule in 2013. 78 FR57928 (September 20, 2013).