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From Banking and Finance Law Daily, October 21, 2014

FDIC and OCC approve “skin in the game” rule; industry supports QRM=QM

By John M. Pachkowski, J.D.

At its Oct. 21, 2014, meeting, the board of directors of the Federal Deposit Insurance Corporation approved a final rule to implement the credit risk retention requirements found in section 941 of the Dodd-Frank Act. The FDIC staff also released a memorandum recommending the board approve the final rule for publication in the Federal Register.

The Federal Reserve Board is scheduled to vote on the final rule at its Oct. 22, 2014, open meeting. Thomas J. Curry, the Comptroller of the Currency and anex officio member of the FDIC board, signed off the final rule for the Office of the Comptroller of the Currency earlier in the day.

Section 941, which added section 15G of the Securities Exchange Act of 1934 (15 U.S.C. §78o-11), was enacted to address problems in the securitization markets that led to the financial crisis, namely the deficiencies in the prevailing “originate-to-distribute” business model, which rewarded volume over asset quality, as lenders retained little or no continuing exposure in loans they originated for securitization. The legislative history of section 941 noted, “When securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interest with those of investors in asset-backed securities.”

Exchange Act requirements. Under Exchange Act section 15G, a securitizer, or sponsor, of asset-backed securities (ABS) is generally required to retain not less than 5 percent of the credit risk of the assets collateralizing the ABS. Section 15G includes a variety of exemptions from these requirements, including an exemption for ABS that are collateralized exclusively by residential mortgages that qualify as “qualified residential mortgages (QRM),” as that term is defined by the agencies by rule. In crafting the QRM definition, section 15G required the agencies to develop a definition for QRM that takes into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default. In addition, the QRM definition may be no broader than the definition of qualified mortgage (QM), as implemented by the Consumer Financial Protection Bureau.

Rulemaking process. The FDIC, along with the OCC, Fed, Securities and Exchange Commission, Federal Housing Finance Agency, and Department of Housing and Urban Development issued a proposed rulemaking in April 2011. The agencies subsequently issued a reproposed rulemaking in August 2013. The agencies took this action in light of the over 10,500 comment letters they received in response to their April 2011 proposal. A large majority of commenters criticized the agencies’ definition of QRM, which included a requirement for a loan-to-value ratio no higher than 80 percent (and lower, if the mortgage was a refinancing), credit history metrics, conservative debt-to-income requirements (no greater than 36 percent), and certain other requirements. The original proposal also included underwriting standards for commercial, CRE, and automobile loans underlying ABS to qualify for exemption from risk retention.

Affected entities. The risk retention requirements of the final rule apply to any sponsor of ABS and include an insured depository institution, a bank holding company or a subsidiary, a registered broker-dealer, or other type of entity. The final rule also provides where two or more entities each meet the definition of sponsor for a single securitization transaction, one of the sponsors must retain the entire amount of credit risk required, but each sponsor is still responsible for ensuring compliance with the risk retention requirements.

Risk retention. The final rule retains the 5 percent risk retention requirement found in Exchange Act section 15G. In addition, the final rule allows sponsors to hold risk retention in any combination of eligible vertical or horizontal interests. A sponsor can satisfy its risk retention obligation under the vertical option by holding a portion of each class, or tranche, of ABS interests issued as part of the securitization transaction or a single eligible vertical security representing the same percentage of each class. Under the horizontal option, a sponsor must hold an eligible horizontal residual interest (EHRI) or cash in a specified type of reserve account. The final rule requires EHRI to be measured on a fair value basis and includes disclosure requirements to provide investors, regulators, and others with information as to the fair value calculation, including a description of assumptions and methodologies used to determine the fair value of the retained interest.

A sponsor will also be able to reduce its risk retention requirement by the portion of any risk retention assumed by an originator of the securitized assets, provided that the originator contributes at least 20 percent of the underlying asset pool. By limiting this option to originators that have originated at least 20 percent of the asset pool, the final rule ensures that the originator retains risk in an amount significant enough to function as a meaningful incentive for the originator to monitor the quality of all assets being securitized.

Finally, the final rule offers risk retention options that may be used for certain types of ABS structures. These transactions include: the first loss position for commercial mortgage-backed securities; government sponsored entities; Open Market collateralized loan originations; municipal bond repackagings or tender option bonds; revolving pool securitizations; and asset-backed commercial paper conduits.

QRM exemption. As noted earlier, Exchange Act section 15G includes a variety of exemptions from the risk requirements, with the most prominent being the QRM exception.

The definition of QRM tracks the definition of “qualified mortgage” as found in the CFPB’s QM rule that was finalized in January 2013 and supplemented in May 2013. The agencies used the CFPB’s QM definition for the final rule to achieve an appropriate balance between limiting credit risk for the protection of investors, as required under section 15G, and preserving credit access. The agencies also noted that the aligned definition facilitates clarity for all participants in the mortgage market, as well as compliance, and reduces associated costs by providing the mortgage market the benefit of a uniform regulatory framework for underwriting residential mortgages.

As part of the final rule, the agencies are required to periodically review the definition of QRM to take into account developments in the residential mortgage market. Specifically, the agencies will review the QRM definition four years after the effective date and every five years thereafter. This review mechanism ties-in with the CFPB’s statutorily mandated assessment of its QM definition.

FDIC director Jeremiah O. Norton, who did not support the promulgation of the final rule, raised concerns that the legal authority pursuant to which the QRM definition was being adopted was “not clear.” He noted that by using the CFPB’s definition of QM, the agencies have “subdelegated” their decision-making authority and there was no explicit Congressional authority allowing them to do so. Norton added that the QRM review mechanism “does not and cannot ensure the outcome of any future rulemaking process, which further enshrines the subdelegation.”

Agency comment. Following the FDIC board meeting, agency chairman Martin J. Gruenberg said, “This Final Rule addresses one of the major remaining provisions of the Dodd-Frank Act requiring implementation.” In regards to aligning the definition of QRM to the CFPB’s definition of QM, Gruenberg noted, “Commenters overwhelmingly supported this approach, and the Agencies believe that it strikes an appropriate balance between providing important protections for investors and credit markets while minimizing costs and burden for consumers and market participants.”

FDIC Vice Chairman Thomas M. Hoenig stated, “While there are elements that I am not completely satisfied with, on balance the final rule provides standards that will serve to contain some of the excessive risk taking that was an important contributor to the crisis of 2008.” He added, “The rule seeks to provide a simpler and more flexible standard for residential borrowers as it equates QM to QRM and does not require that residential loans have a 70 or 80 percent loan-to-value ratio to qualify for the exemption from the risk retention requirement. While this may facilitate greater home ownership, a goal we all share, there are data to suggest it might increase the risk that borrowers will more frequently default and lose their homes. Thus, while I support going forward as proposed, I join those who judge it important to monitor this definition of QRM to be confident its benefits exceed long run costs.”

Comptroller of the Currency Thomas J. Curry called the final rule “an important milestone on the road to completing the rules implementing the Dodd-Frank Act.” Commenting on the QRM equals QM and review mechanism, he noted, the agencies “should have enough experience with the standards to know whether they strike the right balance between long-term financial stability and the home-financing needs of American families, and we can adjust them if necessary.”

Finally, Melvin L. Watt, Director of the FHFA said, “Finalizing this rule represents a major step forward to providing greater certainty to the housing finance market and paves the way for increased participation by the private sector. Aligning the Qualified Residential Mortgage standard with the existing Qualified Mortgage definition also means more clarity for lenders and encourages safe and sound lending to creditworthy borrowers. Lenders have wanted and needed to know what the new rules of the road are and this rule defines them.”

Industry reaction. Various banking and financial services trade groups were also supportive of the approval of the final rule, especially equating QRM with QM.

In a statement, the Financial Services Roundtable called the final rule “an important step forward in completing regulations that will give the financial services industry more confidence and certainty, enabling lenders to provide high-quality mortgage loans to credit worthy consumers.” Richard Foster, FSR’s vice president and senior counsel for Regulatory and Legal Affairs noted, “Consumers will have better access to mortgages now that the industry has certainty that a Qualified Residential Mortgage under the Risk Retention Rules is the same as a Qualified Mortgage under the CFPB rule.” Also, John Dalton, president of FSR’s Housing Policy Council said, “Today’s joint rule provides for strong consumer protections while allowing lenders to continue making the American dream of homeownership a reality and moving the mortgage market forward.”

Frank Keating, president and chief executive officer of the American Bankers Association, stated, “We are largely pleased with the Qualified Residential Mortgage final rule released today, which will help ensure the largest number of creditworthy borrowers are able to access safe, quality loan products at competitive prices. By law, the QRM definition cannot cover more loans than the existing Qualified Mortgage rule, but it might have been more restrictive. Gratefully, the QRM definition aligns with QM, an approach ABA has strongly advocated. This will encourage lenders to continue offering carefully underwritten QM loans, and avoid placing further hurdles before qualified borrowers, allowing them to achieve the American dream of homeownership.”

Finally, Independent Community Bankers of America® president and CEO Camden R. Fine said, “The credit risk-retention final rule approved today is less restrictive than the agencies’ original proposal and will minimize the negative impact of new regulations on our housing recovery.” He added, the banking regulators’ decision to include in the “qualified residential mortgage” definition “qualified mortgage” loans as defined under the CFPB’s ability-to-repay rules, as well as loans backed by Fannie Mae and Freddie Mac, “will provide much-needed clarity and consistency to an industry already heavily burdened by new mortgage rules.”

Companies: American Bankers Association; Fannie Mae; Financial Services Roundtable; Freddie Mac; Housing Policy Council; Independent Community Bankers of America

MainStory: TopStory BankingOperations DoddFrankAct FederalReserveSystem FinancialStability Mortgages SecuritiesDerivatives

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