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.
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.
“Using the financial crisis as an example, when home values fell 35% or more, after losses ate through the bottom 5%, sponsors wouldn’t care anymore,” Grady said, adding that the vertical option serves to align a sponsor’s interests in the deal further up the capital stack, to the triple-A bonds where it would hold the largest stake. “If you’re playing in just one part of the capital structure, then your interests are not really aligned with the entire investor base.”
King said, however, that the vertical option is unrealistic for sponsors. “If a sponsor has to hold a slice of each tranche, it really damages the economics of a deal for the sponsor,” he said, adding, “If you want the sponsor to retain risk, having him retain the bottom portion achieves that.”
In fact, sponsors would be making higher returns on only 0.25% of the deal, likely an insufficient compensation for monitoring the assets and otherwise fulfilling their role as sponsors.
Some argue, however, that for bank sponsors especially, securitization represents more of a financing tool than a profit center, and the ability to remove balance-sheet assets and servicing income could make the vertical option viable.
Under the vertical option, Grady said, sponsors may hold only a tiny portion of the first loss layer, but they would still have to find someone willing to take on the risk of buying the rest of the first-loss layer.
King acknowledged that loan losses eating through the bottom portion are a concern, and that investors would like sponsors to hold risk further up the capital stack. Still, he points out that “the first-loss guy is at the back of the principal stack, so they’re going to be in the deal longer than anybody, and they won’t get their money back until after the triple-A guys get all theirs.”
A Choice for Sponsors?
Assuming that regulators maintain similar options in the final rule, sponsors will be in a position to choose the one that best fits their own business model. It remains to be seen whether investors will demonstrate a preference for one or the other.
“The more onerous you make the rules, the higher the loan rates will have to be in the first place [to justify sponsors’ higher costs], and that’s not good for the housing market, mortgage market or consumers,” King said.
Redwood Trust has been one of the few issuers of private-label RMBS since the financial crisis, and its policy has been to hold the bottom 5% to 7% of the offering. Investors may also take comfort from the strong collateral in these deals — jumbo prime loans with low LTVs and borrowers holding high credit scores—and from the fact that Redwood has signed agreements with third-party originators that have included strong representations and warranties. Under the terms of these agreements, loans that appear to be fraudulently underwritten or underwritten to poor standards can be pushed back to third-party originators. Disputes are solved through binding arbitration, instead of court.
In Redwood’s model, according to Mike McMahon, a managing director at the Mill Valley, CA-based firm, the company is the first-loss holder and is often the collateral manager with ready access to all loan-related data. If the first-lost portions are held by another party, which was often the case prior to the financial crisis, then at least 25% of investors must prompt the deal’s trustee to push the servicer to investigate problematic loans.
“Triple-A investors in theory should feel more comfortable in deals where the sponsor retains the first 5% of credit losses, since that provides a strong alignment of interests among the subordinate and AAA investors,” McMahon said. “The sponsor who also holds the first credit loss tranche has a strong interest in the performance of the deal.”
There is some concern that the options for meeting risk-retention requirements under the final rule will be watered down in favor of lenders. That is what many market participants believe happened with the recently issued Qualified Mortgage rule, which determines which loans qualify for legal protection under the CFPB’s ability-to-repay standards. Lenders had launched a major lobbying effort to lessen their liability for riskier loans and allow for some riskier loan types.
“If the qualified mortgage is any indication, the risk requirements for risk retention will be significantly watered down to benefit issuers and sponsors,” Grady said.