On October 15, 2014, the LSTA announced that the final risk retention rules for asset-backed securities (ABS) mandated under Section 941 of the Dodd-Frank Act will be released by federal bank regulators on October 22, 2014. The final version of the rules have been highly anticipated by market participants since they were re-proposed by regulators more than a year ago.

Of particular interest will be how regulators treat residential mortgage-backed securities (RMBS) and collateralized loan obligations (CLOs).

CLOs. Over the past year, the LSTA has attempted to persuade regulators to adopt a so-called "Qualified CLO" exemption, which would exempt from the risk retention requirements high-quality CLOs with asset pools that meet certain criteria relating to:

If a CLO were to meet all the criteria, then the manager of a Qualified CLO would be required to purchase and retain 5% of the CLO equity (as opposed to 5% of the credit risk, as generally required under the rules). According to the LSTA, the Qualified CLO approach that they have advocated with regulators is similar to the Qualified Securitisation approach proposed by European regulators for ABS issued in the EU. The revised US risk retention proposal, released in 2013, included no such exemption, and regulators have given no indication that they intend to adopt a Qualified CLO exemption, despite the fact that, as the LSTA notes, "CLOs played no role in the financial crisis, they performed spectacularly during the financial crisis - not one AAA or AA note has ever suffered a loss - and they would be materially harmed by the risk retention rules."

RMBS. Also of interest will be whether regulators retain their softened definition of QRM (qualified residential mortgage), which, under the revised 2013 proposal, would exempt many RMBS transactions from the risk retention requirements. Most market participants were surprised last year when regulators released a comparatively lenient QRM definition, even though lax residential mortgage underwriting standards did the most damage to the US financial system during the crisis, when those mortgages were bundled into RMBS and sold to investors.

Many felt that the regulators got it backwards in 2013 by writing stringent rules for CLOs, while seemingly letting RMBS off the hook (see Legal Update, The Revised ABS Risk Retention Proposal: A Flawed Approach?). The big question is whether regulators will:

These questions, the answers to which are critical to the US ABS markets, will be answered when regulators meet next Wednesday at 3:30 pm to approve the final rules. Many banking industry advocates, including the LSTA, assert that if the rules are adopted as re-proposed in 2013, US lending activity, particularly in the leveraged loan market, could be severely restricted.

Risk retention, or so-called "skin in the game," is the cornerstone of the US regulatory reform efforts in the securitization area. Risk retention, mandated under Section 941 of the Dodd-Frank Act, which added new Section 15G to the Securities and Exchange Act of 1934 (15 U.S.C. § 78o-11), is designed to align the interests of securitizers and originators of securitized assets with those of investors in ABS. The rules are intended to reform the so-called "originate to distribute" ABS model in which flawed loan underwriting standards and origination practices resulted in poor quality loans that were quickly sold and packaged into ABS. These ABS were then sold to institutional investors and financial institutions, eventually resulting in losses that were blamed for ushering in the financial crisis.

Section 941 of the Dodd-Frank Act mandates that securitizers retain at least 5% of the credit risk of any asset pool that is securitized, but leaves for federal regulators to determine:

In March 2011, US federal regulators released for public comment the initial risk retention proposal detailing proposed risk retention requirements for securitizations under the Dodd-Frank Act (see Legal Update, Dodd-Frank Securitization Risk Retention Rules Proposed by Federal Regulators). That proposal met with much public criticism, most of which focused on the possibility that the risk retention rules, if implemented as initially proposed, could severely restrict lending activity.

As a result of this reaction, on August 28, 2013, federal regulators released the revised risk retention proposal, which the market viewed as less stringent than the original proposal (see Legal Update, Regulators Soften Dodd-Frank ABS Risk Retention Rules). However, banking industry groups, most notably the LSTA, remained disappointed with the treatment of CLOs under the revised proposal.