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Risk Retention Rules Adopted for Asset-Backed Securities

The SEC adopted final rules from the Dodd-Frank Act intended to lessen risk in mortgage lending and the market for asset-backed securities. The rules, which are also being adopted by the federal banking regulators, require more issuers of asset-backed securities to retain 5 percent of the loans they issue. The regulators hope the rules discourage practices that contributed to the 2008 financial crisis.

The SEC on October 22, 2014, issued Release No. 34-73407, Credit Risk Retention, shortly after voting 3-2 to approve rules intended to lessen risk in the asset-backed securities market.

The rules require issuers of asset-backed securities to retain 5 percent of the loans underlying the securities, unless the loans meet certain criteria for low risk.

The rules become effective one year after publication in the Federal Register, which normally occurs a few days after rules are posted on the SEC’s website.

The rules are a joint effort with the Treasury Department, the Federal Reserve, the Department of Housing and Urban Development, the Federal Deposit Insurance Corp., and the Federal Housing Finance Agency.

The SEC’s two Republican appointees, Daniel Gallagher and Michael Piwowar, dissented.

The rules are mandated by the Dodd-Frank Act and intended to address the weaknesses in the asset-backed securities market that contributed to the financial crisis.

SEC Chair Mary Jo White said securitization was misused by lenders and sponsors of asset-backed instruments in the years leading up to the crisis. The home mortgage market abandoned traditional loan practices and established credit criteria and instead sought the income from marketing and securitizing loans in volume. Loan officers were pushed by the banks and other mortgage lenders that employed them to approve loans to risky borrowers who couldn’t afford their homes. Bond underwriters and traders didn’t properly review the securities they packaged from the loans before pushing them out onto investors.

“The credit risk retention requirements… are designed to realign the incentives of securitizers and investors by requiring securitizers to retain an economic interest in the credit risk of the assets they securitize,” White said. “At the same time, the Dodd-Frank Act provided exemptions for assets that meet underwriting and other standards designed to help ensure that these assets are a low credit risk — and therefore do not require risk retention measures.”

The rules provide sponsors of securities with a number of options to meet the risk retention requirements, and the sponsors have to disclose to investors how they’re satisfying the rules.

The rules have an exemption for asset-backed securities collateralized by high-quality loans called qualified residential mortgages (QRM). The criteria for the QRM designation has been a contentious issue throughout the rulemaking process.

The rule ties the definition of a QRM to the Consumer Financial Protection Bureau’s definition of a qualified mortgage, which assesses a borrower’s ability to repay the loan. The definition also won’t apply to loans that are more than 43 percent of a borrower’s income or mature in more than 30 years. Products that are considered riskier, such as interest-only loans, balloon payments, and negatively amortizing loans, won’t be eligible for the definition.

White said the requirement reflects “the judgment of the six agencies of the right balance between two of the central purposes of the statutory mandate — protecting investors and not unnecessarily inhibiting the residential mortgage market.”

Financial companies lobbied heavily for a loosely written set of criteria for the QRM designation, pressuring lawmakers and regulators with warnings of an economic slowdown if the rules were so strict that they prevented a recovery in the home mortgage market.

Gallagher, as he explained his dissent, said, “By applying the government’s QRM label — with its unambiguous declaration that a loan is ‘qualified’ — to virtually any residential mortgage, we render the new standard meaningless at best, deleterious at worst.”

Dennis Kelleher, president and CEO of Better Markets, agreed that the expanded definition of a QRM essentially erases the point of having risk retention rules. The organization has lobbied for stricter oversight of Wall Street, mortgage lending, and trading in asset-backed securities.

“Policymakers shouldn’t confuse housing policy with eliminating systemic risk, and unfortunately the final rule prioritizes this housing policy over reducing systemic risk,” Kelleher said. “A rule that applies to no mortgages is not a rule that will help to protect the American people from another crash fueled by products designed to increase profits regardless of quality.”

A coalition of 52 groups, including the American Bankers Association (ABA), the progressive think tank the Center for American Progress, and the Consumer Federation of America, strongly supported the definition in the revised proposed Release No. 34-70277, Credit Risk Retention, from August 2013.

The coalition said the approach would protect the marketplace while ensuring that borrowers have access to safe mortgages. Loans with the highest risk will be subject to risk retention.

The group said it had strongly opposed the alternative “qualified mortgage-plus” approach in the proposal, which would require borrowers to make a 30 percent down payment to obtain a home loan.

The final version of the QRM definition “will help ensure the largest number of creditworthy borrowers are able to access safe, quality loan products at competitive prices,” said ABA President and CEO Frank Keating.