President Trump signed a memorandum to review Dodd-Frank Act on Friday. Loosening bank regulation, as noted by WSJ, would return approximately $100 Bn excess capital to investors and shareholders and improve bank ROE.
The news is welcome one for banks that struggle to cover their cost-of-capital in a post-crisis regulatory regime. However, in a setback for banks, Asset Backed Alert reported this week that the Comptroller of the Currency disallowed JP Morgan to gain capital relief through on-balance sheet securitizations, departing from European bank regulators. The action, in the long term, will reduce bank capital commitments to the mortgage sector, and hinder revitalization of the private-label securitization market.
Bank partnerships continue. This week, SoFi announced the $100 MM acquisition of Zenbanx, a digital bank that offers mobile banking services including FDIC-insured deposit accounts, debit cards, and currency exchange. Avant is growing and is focused on its core lending product, a new credit card product, and additional bank partnerships.
Further, this week, PeerIQ and Freedom Financial announced that that PeerIQ will provide valuation, reporting, and data & analytics, to both the Freedom capital markets team and institutional buyers of Freedom loans.
Here, we discuss the Dodd-Frank risk retention rules and summarize risk retention solutions from mature securitization markets.
Dodd-Frank Risk Retention (RR) Rule Effective Now
The credit risk retention rules required under the Dodd-Frank Act became effective for all asset types on December 24th last year. Dodd-Frank was enacted in the July 2010 and amended Section 15G of the 1934 Securities Exchange Act. The final rule stipulates a 5% risk retention requirement to align the interests of investors with the sponsors of securitization transactions by requiring “skin in the game” via:
- a 5% interest in each class of the securitization (an “eligible vertical interest,” or “EVI”);
- a 5% of the fair value of the securitization in a first loss, subordinate tranche (an “eligible horizontal residual interest,” or “EHRI”);
- any combination of an EVI and an EHRI such that the sum of the fair value of the EHRI and the percentage of the EVI are equal to at least 5 percent of the securitization (a “L-shaped” retention interest).
The requisite percentage of eligible vertical interest, eligible horizontal residual interest, or combination thereof retained by the sponsor or securitizer must be determined as of the closing date of the securitization. Further, the sponsor or securitizer is prohibited from hedging or transferring its retained interest until the applicable sunset date.
The transfer and hedging restrictions for RMBS are different from those of non-RMBS securitization. For RMBS, they expire on or after the date that is (1) the latest of (a) five years after the date of the closing of the securitization or (b) the date on which the total unpaid principal balance (UPB) of the securitized assets is reduced to 25 percent of the original UPB of the transaction, but (2) in any event no later than seven years after the date of the closing of the securitization.
For all ABS deals other than RMBS, the transfer and hedging restrictions expire on or after the date that is the latest of (1) the date on which the total UPB of the securitized assets that collateralize the securitization is reduced to 33 percent of the original UPB at deal close, (2) the date on which the total UPB under the ABS interests issued in the securitization is reduced to 33 percent of the original UPB at deal closing, or (3) two years after the date of the closing of the securitization transaction.
Further, the eligible retained residual interest may be financed so long as the counterparty is not affiliated with the transactions. The residual interests are the illiquid piece in the capital structure and are costly to finance via repo transactions. However, EVI across the capital structure including rated tranches have competitive repo market financing.
Fair Value of EHRI Requirement
Fair value determination is not required for vertical risk retention. However, the EHRI is determined on a fair value basis, specifically, as a percent of the fair value of the securitization in a first loss, subordinate tranche. Under the Rule, the sponsor is required to disclose key methodologies and assumptions surrounding how it calculates the fair value of eligible horizontal residual interests. The description of the valuation methodology and all key inputs and assumptions or a “comprehensive description” of such key inputs and assumptions include:
- Discount rates
- Forward interest rates
- Loss given default
- Default rates and lag time between loss and recovery
- Prepayment rates
- Summary description of reference data set or other historical information used to develop key inputs and assumptions
The above set of requirement for valuing EHRI is consistent with PeerIQ valuation methodology, which we have discussed in previous newsletters (see Part I and Part II).
The risk retention rule also contains an exemption for securitizations that consist solely of qualifying high-quality loans that satisfied specific underwriting criteria.
For instance, the Dodd-Frank Act requires mortgage originators to “make a reasonable and good faith determination based on verified and documented information” of a borrower’s ability to repay. The qualified mortgage (QM) rule provided lenders with a safe harbor against litigation for mortgages that meet QM standards. The key requirements for qualified mortgage (QM) are 1) having limited points and fees (under 3%), 2) a term of 30-years or less, 3) no interest only loans, negative amortization, or balloon payments, and 4) a DTI max of 43%.
We highlight two important benefits from issuer’s perspective for QM designation. Issuers are 1) insulated from claims and defenses by borrowers due to safe harbor, and 2) are not required to retain 5% of capital structure per the credit risk retention rule. For example, all loans in SFPMT 2016-1 collateral pool are designated as QM and SFPMT 2016-1 is exempted from the risk retention rule.
Further, securitizers can lower risk retention requirements for securitizations by blending qualified and non-qualified loans into the collateral pool. However, the Rule mandates that the minimum risk retention requirement cannot be below 2.5%, implying a 50/50 split between qualified and non-qualified assets in blended pools.
Risk Retention Solutions
Marketplace lending ABS is a relatively young segment in the securitization space. Here, we summarize risk retention solutions in other mature securitization markets. At the onset of the Dodd Frank risk retention proposal, the CLO industry has been exploring a number of financing approaches for retained risk as an alternative to outright buying the retained pieces. The three most prominent options are: majority owned affiliate (MOA), capitalized manager vehicle (CMV) and capitalized majority-owned affiliate (C-MOA).
Majority owned affiliate (MOA) – CLO managers raise equity capital from 3rd party investors through the creation of MOA to finance the purchase of risk retention securities. MOA holds the retention interest, but the securitizers control the major economic decisions of the MOA in relation to the retention interest and any other assets owned by the MOA. Control is measured by ownership of 50% or more of the equity of an entity or ownership of any other controlling financial interest under GAAP.
Capitalized Majority owned affiliate (C-MOV) – The C-MOA can function as an originator and comply with both US and European retention requirements. The C-MOA has an option to act as the asset manager. As the asset manager, it can originate a small proportion of the assets owned by the CLO and still earn a management fee. The first CLO of the year, Venture XXVI, employs C-MOA.
Capitalized Manager Vehicle (CMV) – In this solution, instead of CLO Managers serving as asset managers, the CMV is the primary asset manager. The CMV then hires CLO Managers as sub‐advisors. The CMV receives management fees on retained interest. The key accounting consideration is ensuring the CMV is not consolidated by the CLO Manager.
In addition to the three risk retention solutions in CLO land, we have also seen alternatives applied to CMBS deals. In this case, B‐piece buyers (holders of the residual tranche of CMBS) can meet the risk retention requirements rather than the Sponsor/Asset Managers holding the securities through holding an EHRI. There cannot be more than two B‐Piece Buyers. If there are two, each B-Piece Buyer’s interest must be in pari passu with the other.
The above discussion suggests that the risk retention rules are complex and originators, securitizers, analytical service providers, and regulatory experts need to work together to devise solutions. For instance, the PeerIQ, through its sophisticated and robust analytical platform, enables sponsors to efficiently manage capital and liquidity while complying with valuation and risk retention requirements.
- LendIt on March 6-7 in New York.
PeerIQ in the News:
- Even Good-Guy Student Loan Startups Still Favor the Rich (Buzzfeed, 2/4/17)
- PeerIQ Inks Agreement with Freedom Financial Network (CrowdFundInsider, 2/1/17)
- PeerIQ Announces Agreement with Freedom Financial Network (Globenewswire.com, 2/1/17)
- PeerIQ Announces Agreement with Freedom Financial Network(Yahoo! Finance), Rated: A(Lending Times, 2/1/17)
- Even Good-Guy Student Loan Startups Still Favor the Rich (Buzzfeed, 2/4/17)
- Comptroller Swats Down JP Morgan Program (AB Alert, 2/3/17)
- Online Lender SoFi Buys Digital-Banking Startup (WSJ, 2/2/17) SoFi acquires mobile-banking startup Zenbanx for $100 MM.
- The $100 Bn Reason Investors Loved Trump’s Bank Order (WSJ, 2/5/17) Banks may enjoy capital relief if Dodd-Frank rules are relaxed.
- FinTech Startups Want to Save One Key Page of Dodd-Frank (WSJ, 2/5/17) Banks and FinTechs seek to preserve some aspects of Dodd-Frank.
- OCC Releases New Supplemental Examination Procedures Regarding Management of Third-Party Relationships (1/24/17) To keep up with the rapidly evolving nature of the fintech industry, the OCC released a supplement to it’s Third-Party Guidance.
- AmEx’s Issuance Program is Back on Track (AB Alert, 1/27/17) AmEx is returning to the asset backed bond market with plans to resume its issuance program with a $1b transaction in the coming weeks.
- After a Tumultuous 2016, Avant is Growing Again (Bizjournas, 1/31/17) Avant is hiring 25 technologists.
- Billionaire Dan Loeb Is Preparing To Make A Major Bet On Marketplace Loans (Forbes, 2/2/17) Third Point increases its focus on Marketplace Lending ABS.
- Calling the Bluff of the Machines That Beat Us at Poker (Bloomberg, 2/1/17) AI is consistently beating humans at games with imperfect information such as poker.