At last count, we now have four separate risk retention regimes (maybe five) that we need (or will soon need) to deal with as we attempt to restructure any securitization. They are, of course, all different. And let’s be crystal clear. This isn’t an issue for the distant future. Risk retention is here now and soon, much sooner than most think, it will become a front and center issue for all of us. We’ve written about skin in the game many times in the past (e.g., here, here and here), and I’m not going to re-litigate both the intellectual unsoundness of the notion and the negative impact on capital formation, but as we await developments, I thought it would be useful to compare and contrast the four variations on the theme and sound the heads up. It’s time for us to focus.
Let’s count ’em down. First, we’ve got the mother of all “Skin in the Games”: the Dodd-Frank risk retention scheme. This, at least theoretically, won’t go into effect until two years after final regulations are issued. So, to some extent, it gets ignored. While regulations have been promised, if promised is the right word, for several months now, no new iteration of the proposed rule has been published. At this point, no one is certain whether we will see a complete re-proposal and a new comment period, an actual final rule (one hopes not), or an interim final rule which would allow for comments but begin the clock ticking on the two year transition rule.
Second, we have a standalone 5% risk retention regime promulgated by the FDIC.This has been in effect for a couple of years. Here, risk retention is an element of a true sale safe harbor when an insured depository institution is the seller of assets into a securitization.
Third, we’ve got Article 122a promulgated by the European Banking Authority ("EBA") governing risk retention for most structured product purchased by a European bank. This is in effect right now. In late May, the EBA published a Consultative Paper which modified the original Guidelines to Article 122a. The EBA materially narrowed the structural design flexibility of the rule by limiting the parties who can satisfy the rule by holding the 5% strip. It goes effective January 1, 2014.
Finally, we now have a new risk retention regime embedded in the EU’s Alternative Investment Fund Manager’s Directive ("AIFMD"). This will govern a wide range of investment vehicles operating in the European Union. It contains its own form of skin in the game provision, much like, but not exactly like, 122a.
That’s four. I said five. Read on, gentle reader.
The principal US risk retention rule can be found, sort of, in Dodd-Frank. The statute, in the broad brush way, has provided that the sponsor of a securitization retain a 5% portion of the risk. For our purposes, the requirement may be satisfied in several different transaction structures, including (i) retaining a pro rata interest in each class of securities, known as vertical risk retention, (ii) retaining the first loss position; horizontal risk retention, or (iii) a combination of vertical and horizontal risk retention. The statute also allows for CMBS sponsors to transfer the risk to B-piece buyers by requiring the B-piece buyer to hold a first-loss horizontal 5% first-loss strip of the underlying assets.
Dodd-Frank became the law of the land in 2010. A year later, an interagency rule writing committee (the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Federal Reserve, the Office of the Comptroller of the Currency, and the U.S. Securities and Exchange Commission) charged with actualizing the skeletal guidance in the statute issued a Proposed Rule. This rule, showing every evidence of being written by a Committee, was a long and deeply flawed attempt to implement the statute which was, itself, long and deeply flawed. The Proposed Rule contained some additional detail on how risk retention would work in the real world, spawned more questions than it answered and contained an ultimate regulatory Frankenstein’s Monster called the Premium Capture Cash Reserve Account (“PCCRA”), which, in a breathtaking exercise of regulatory creativity, subordinated a bank’s profits and fees on a transaction to repayment in full of all the bonds. Given that it is highly unlikely that an entire pool of securitized loans will perform through maturity, it is therefore a virtual certainty that not all the bonds will be repaid in full. This meant to securitize is to work for free. Only in France is that capitalism! This broadly reviled rule, purportedly abandoned by most of the constituents of the interagency rule writing committee, is allegedly no longer likely to be included in the final rule when (yes, I actually do mean when) this rule is ultimately issued.
The inside the Belt chattering had been that the Committee would issue its risk retention rule in April. Whoops. It is no longer April and there is no rule and now the talk is late fourth quarter or even early 2014. It seems the Committee is tired of being yapped at and will issue a Final Rule. No more comments. No more negotiations. Done. The talk during the spring had been that the rule, when published, would require 5% retention by value of the underlying assets, not 5% of the face amount of the certificates to be issued. That means retention into the BBBs. There will be flexibility to meet this through the so-called B-piece buyer alternative. The B buyer can hold the retention as opposed to the sponsor (on the same conditions), provided it will only have to hold the position, unlevered, for 5 years (5 years!). There seems to be no likelihood of workable qualified mortgage exceptions and no special rule for investment grade deals. Lots of unanswered questions. Recently the leak machine has shut down. Crickets.
Under Dodd-Frank, these risk retention rules have a one year transition rule for most asset classes and a two year transition rule for CMBS. But remember I said there’s a fifth rule? If you’re out of things to worry about, remember that the once and perhaps future revamped Reg AB also had a risk retention provision included as one of the conditions to shelf registration. This rule came out for comment in the summer of 2010 and hasn’t been seen since. The SEC has stated that, if and when the newly refurbished Reg AB is issued, it will not include its own separate version of risk retention but will simply adopt the work product of the Joint Committee on risk retention. Of course we’ve no idea when Reg AB will resurface, but the SEC now has a full roster of members and can, for the first time in a while, actually issue rules. Certainly no Rule appears to be imminent (maybe the sequester gets the credit for this one?), but, if Dodd Frank’s risk retention is published in final form, query whether the SEC will feel compelled to honor the transition rules embedded in Dodd-Frank? Conceivably, the SEC could elect to make risk retention a condition to shelf registration immediately. One hopes not, and the “in” beltway gang assures me it will not happen. But I’m not taking that to the bank.
The FDIC’s risk retention rules are related to a safe harbor for sale treatment and, hence, meeting the rule protects the transaction from FDIC’s power as conservator or receiver for a failed insured depository institution (“IDI”). The Federal Deposit Insurance Act grants the FDIC the power, in its capacity as conservator or receiver for an IDI, to repudiate contracts and recover relevant collateral. The FDIC rules provide a safe harbor such that a transaction that meets the safe harbor’s requirements is free from the risk of the FDIC recovering the relevant collateral from such related securitization. One of the requirements of the safe harbor is that the securitization documents require 5% risk retention on the transferred assets. The credit risk retained may be either 5% of the interest in each of the credit tranches sold or a representative sample of the securitized assets equaling not less than 5% of the principal amount of the financial assets at transfer. This has been a relatively inconsequential regulation since securitization counsel has been prepared to deliver legal true sale opinions outside of the safe harbor. One wonders, however, if the FDIC will get tired of being ignored and somehow make its own risk retention rule harder to ignore.
There are two related European rules. Article 122a of the EU Capital Requirements Directive (“CRD”) and Article 17 of the AIFMD, instead of regulating what a securitizer does, regulates what an investor can buy by not allowing credit institutions and alternative investment fund managers, to invest in a securitization unless the original lender, originator or sponsor meets certain risk requirements.
Article 122a mandates, among other things, that credit institutions only invest in securitization transactions if the original lender, originator or sponsor of the securitization retains 5% of the net economic interest of the transaction. The original lender, originator or sponsor may meet the 5% risk retention requirement in any one, but not a combination of a Vertical Slice, by retaining 5% of each securitized tranche sold or transferred to investors, a 5% or a First Loss Slice (and, in certain other ways, similar to but not exactly the same as Dodd-Frank, but not really relevant for CRE). 122a covers all insured depository institutions within the European community. That means it includes the UK banks.
The AIFMD rules will prevent most private equity, real estate investment services and hedge funds from investing in a securitization unless the securitization’s original lender, originator or sponsor retains a net economic interest of at least 5%. According to the regulations, Article 17 is to be interpreted in a manner consistent with Article 122a. AIMFD goes effective January 1, 2014.
So let me try to summarize. Right now, the only place where risk retention matters is if you want to sell a bond to a European IDI. But by January 1st, the AIFMD will kick in and make risk retention obligatory for virtually all European buyers (banks, hedge funds, private equity funds and the like). That’s a big chunk of the market. In the U.S., the FDIC continues to not matter and the best thinking is that Dodd Frank risk retention won’t begin to bite much before the first quarter of 2016. But, let’s not be entirely heedless of the possibility of early SEC action on shelf registered deals. Since the credit crisis, governments across the western world have embraced a narrative that unregulated securitization had been among the root causes of the financial crisis. So the narrative goes, governments need to make markets stop doing things that governments think should not have been done. Those things have not stopped; witness the robust return of CMBS, and CLOs.
I worry that while engaged by a still powerful populist consensus that bankers are bad and need governmental keepers and confronting evidence that markets are not changing the ways they conduct business, our governments and their regulatory praetorian guards will become impatient and be incented to make the regulatory infrastructure more proscriptive and intrusive over time. To some, this process may be the pursuit of perfection: if there are no securitizations, there are no risks in need of mitigation, there are no innocent investors to make bad decisions, and there are no losses!
We need to redouble our vigilance and try our best to ensure that all this regulatory chest thumping doesn’t strangle the capital markets just when they are most needed.
Just something else to worry about.
By Rick Jones