No Investor Consensus On Risk Retention Rules

Risk-retention rules were designed to encourage more responsible underwriting and to better align the interests of securitization sponsors and investors.

However, the rules originally proposed a year and a half ago provide sponsors of residential mortgage-backed securities (RMBS) with more than one way to meet this requirement. The regulators’ goal, if the final rule echoes the proposal, is to let investors decide, by putting their money to work, with which version they are more comfortable. Currently, however, investors differ on which option is best.

“Regulators have to strike a balance between aligning the interests of sponsors and investors. A failure to satisfy the interests of these parties will only delay the return of private capital to the mortgage market,” said Rich King, head of Invesco’s structured securities team that manages the Invesco Stable Value fund, which holds approximately $40 billion of mortgage-backed securities and other kinds of asset-backed securities.

The Dodd-Frank Act requires lenders to hold 5% of the credit risk for mortgages that they securitize. Prior to the financial crisis, many sponsors—especially the large banks—tended to hold far less than that on their books, even though in addition to sponsoring the offering they often originated and serviced the pooled mortgages.

Congress left it to regulators including the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corp. (FDIC), the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA) and the Department of Housing and Urban Development (HUD) to decide how this requirement should be met.

Given the wide variety of assets that are securitized and the various structures used in these deals, regulators were compelled to provide multiple ways for sponsors to keep some proverbial skin in the game. The proposed rules provide no fewer than nine options. After receiving extensive feedback from market participants, regulators have indicated that a final rule will be released sometime after the Consumer Finance Protection Bureau’s (CFBP) release of the Qualified Mortgage rule, which came on Jan. 10.

Three Options

Just three of the nine proposed options are applicable to residential mortgage-backed securities. The proposed “vertical” option would require sponsors to hold 5% of each tranche of a securitization, from the triple-A portion down to the bottom first-loss layer, whereas the “horizontal” option would require sponsors to retain the bottom 5% of the deal, including the first lost piece.

The so-called “L option” would split the retained portion equally between the vertical and horizontal pieces.

The horizontal option is anathema to big banks because it would likely force them to consolidate all the loans pooled in a securitization on their balance sheets. The vertical model, requiring banks to hold only 5% of the bottom 5% portion, or 0.25%, is unlikely to do so.
However, if the sponsor also acts as servicer for the pooled loans—as many large banks did before the financial crisis—they may still need to consolidate the loans on their balance sheets using the vertical option. This is because of another risk retention requirement regulators are considering that securitizers set aside the profits from the sales of securities in a premium capture cash reserve account (PCCRA).

“In fact, by effectively adding the value of the excess spread to a 5% vertical slice risk retention, the premium capture rule would likely cause the total risk retention to be viewed as a significant interest and result in consolidation (assuming servicing is retained by an affiliate of the sponsor),” the American Securitization Forum said in its comment letter.

Regulators designed the PCCRA to prevent a sponsor from reducing its exposure to the securitized assets by monetizing the excess spread that is supposed to protect higher rated investors. If banks were unable to get sale treatment and were forced to consolidate those loans, it could greatly reduce their capacity to lend.

Pros & Cons of the Vertical Option

James Grady, a managing director at Deutsche Asset Management, said there are strong arguments for the vertical, as well as horizontal risk-retention options, although he views the vertical option as ultimately better for aligning sponsors’ and investors’ interests.

Grady compared the 5% first-loss layer to an insurance deductible, which gives little incentive to policy holders to contain further costs, and little incentive to sponsors to prevent further losses.