Regulators Give In on Risk-Retention Rule

The six federal regulators that unveiled a sweeping risk-retention proposal on March 29 have backed away from a key provision that market players saw as the biggest threat to securitization.

In effect, the FDIC, Federal Housing Finance Agency, Federal Reserve, HUD, SEC and Treasury Department have acknowledged they made a mistake when they drafted a requirement that would have forced mortgage-bond issuers to deposit the proceeds from sales of interest-only strips into escrow accounts. “IO” tranches allow issuers to monetize the “excess spread” from their deals, and are often a key source of profit when lenders securitize mortgages.

In its original form, the risk-retention proposal would have prevented issuers from immediately pocketing IO proceeds, and instead would have directed the funds to be used as a first-loss buffer protecting bond investors. But now the government has done an about-face and is prepared to allow issuers to keep their IO proceeds, according to industry professionals who have been briefed on the decision.

“The regulators know they completely screwed up” the excess-spread provision, one industry executive said. “That section will change immensely or be removed altogether.”

The move follows an outcry from bank executives and industry lawyers, who warned the provision would have killed private-label mortgage securitization. The intent of the proposal was to ensure lenders keep more “skin in the game” when they securitize their credits. But the effect, market players said, would have been to make it unprofitable to issue mortgage-backed securities.

“They said, ‘Hey, you're free to securitize, you just can't make any money doing it,' ” one source said.

Excess spread refers to the leftover payments from the underlying mortgages in a securitization pool once all bondholders have been paid — assuming all or most of the loans perform. Rather than wait until the deal matures to pocket the excess spread, issuers prefer to securitize that payment stream in the form of high-yield bonds that serve as a first-loss position, also known as the interest-only strip.

Market players had long expected that the risk-retention rules would include several hard-to-swallow provisions — including a requirement that they retain 5% exposures to their deals — but the excess-spread proposal came as a decidedly unpleasant surprise. The provision would have required issuers to park IO proceeds in “premium capture cash reserve accounts” for the lives of their deals. In the event of losses, bondholders — and not the issuers — would be entitled to the money in those accounts.

Regulators were well aware that the excess-spread provision would have led issuers to stop selling interest-only strips. “As a likely consequence to this proposed requirement, the agencies expect that few, if any, securitizations would be structured to monetize excess spread,” the original risk-retention proposal states.

But the agencies apparently were in the dark about the importance of the IO tranche to issuers' bottom lines.

With the excess-spread issue seemingly resolved, industry lawyers and lobbyists are now focused on what they see as the other major threat to securitization contained in the risk-retention package: strict underwriting standards for so-called qualified residential mortgages. Lenders that securitize such credits would be exempt from the requirement that they retain 5% of their deals.

As currently drafted, the proposal would require home buyers to put down least 20% of the purchase price. The minimum equity would rise to 25% for refinancings and 30% for “cash-out” refinancings. The American Securitization Forum has teamed up with groups including the Consumer Federation of America in an effort to ease those underwriting standards, which they say would raise borrowing costs and reduce lending.

The deadline for commenting on the overall risk-retention proposal is June 10. After that, it will likely be 2-6 months before the regulators adopt a final version of the rules.

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