On August 28, 2013, federal regulators re-proposed credit risk retention rules, often referred to as "skin in the game," for US asset-backed securities (ABS). The rules, mandated by Section 941 of the Dodd-Frank Act, are designed to align the interests of originators and securitizers of loans with the interests of ABS investors. The original Dodd-Frank ABS risk retention proposal, released in 2011, was widely criticized as overly stringent, as market participants felt few transactions would qualify for exemption from retention, potentially impeding credit markets.

But the revised proposal seems to miss the mark, relaxing standards for qualified residential mortgage loans (QRMs), which would make it easy to arrange RMBS transactions that are exempt from risk retention rules. At the same time, the revised proposal retains features that could stifle the historically harmless (and currently robust) US CLO market. This disconnect appears to render the revised proposal inconsistent with the legislative purposes of the Dodd-Frank Act.

Section 941 of the Dodd-Frank Act includes a so-called QRM (qualified residential mortgage) exemption for high-quality residential mortgages but the QRM details were left for regulators to determine. Securitizations comprised entirely of QRMs (and QRM equivalents for other asset classes) are exempt from Dodd-Frank risk retention requirements because securities collateralized by these types of loans should be less likely to default. Under the revised proposal, to qualify as a QRM that would be permitted to be included in an RMBS transaction exempt from Dodd-Frank risk retention requirements, a residential mortgage loan must meet the following requirements:

Most noteworthy are the absence of the following borrower criteria from the revised QRM proposal that were included in the original:

Under the original proposal, a QRM was limited to closed-end, first-lien mortgages used to purchase or refinance a one-to-four family property, at least one unit of which is the principal dwelling of the borrower. Under the revised proposal, the scope of loans eligible to qualify as a QRM would be expanded to include any closed-end loan secured by any dwelling (including home purchase, refinancing, home equity lines, and second or vacation homes), not restricted to loans secured by a principal dwelling, as under the original proposal.

The regulators noted in the revised proposal that they decided to soften the QRM requirements in part because of concern "about the prospect of imposing further constraints on mortgage credit availability at this time, especially as such constraints might disproportionately affect groups that have historically been disadvantaged in the mortgage market, such as lower-income, minority, or first-time homebuyers." Under the revised proposal, most residential mortgage loans in the market would qualify as QRMs.

For CLO market participants, however, the revised proposal is a disappointment. CLOs remain subject to the retention requirement under the revised proposal despite low historical default rates. Many CLO industry groups, including the LSTA met with regulators extensively and submitted numerous comment letters on the original proposal. These groups had expressed concern over a variety of matters with respect to the original proposal that remain in the revised proposal.

Under the revised proposal, CLOs would remain subject to risk retention requirements and CLO managers are considered securitizers who must retain the required 5% risk exposure. Additionally, under the revised proposal, there has been no relaxation from the original proposal of the metrics used to define qualified commercial loans (QCLs) that may be included in an exempt CLO transaction as there has been for QRMs. Under the revised proposal, as under the original proposal, for a QCL, the borrower must have for its two most recent fiscal years and be expected to have for the two fiscal years to follow:

QCL borrowers must satisfy certain other criteria as well (see Practice Note, ABS Risk Retention under Dodd-Frank: Exemptions from Dodd-Frank Risk Retention Requirements for Qualified Commercial Loans (QCLs)).

This is despite the fact that the CLO market has enjoyed a comparatively low historical default rate. CLO impairments have been virtually nonexistent, at less than 2%, according to some market estimates. Further, though CLOs have surged over the past two years while the rest of the ABS market (other than auto loan ABS) has struggled, CLO vintages are still estimated at only about $300 billion out of an $11 trillion ABS market.

As groups such as the LSTA have asserted for years, CLOs differ from originate-to-distribute ABS and MBS, which introduced some of the faulty-origination issues that infected the financial markets pre-crisis. In contrast to other types of ABS, CLO managers receive the majority of their compensation only if the CLO is performing well and the noteholders are receiving 100% of their principal and interest payments. Further, the underlying assets in a CLO have typically undergone extensive diligence prior to their origination.

The revised proposal attempts to appease CLO market participants by proposing a complicated and unanticipated "arranger option." Under this option the CLO would be composed of "CLO eligible loan tranches," syndicated term loans for which the lead arranger retained 5% of the credit risk of the loan, which could not be hedged or sold. The arranger would also be required to have held at least 20% of each syndicated term loan at origination, with no other syndicate member holding a greater percentage at closing. Initial market reaction to the arranger option is that it is unworkable as a practical matter and would provide little relief to the CLO market from the effects of the revised proposal, were it implemented as proposed.

According to a survey of CLO managers conducted by the LSTA, most respondents stated that they would anticipate a 75% shrinkage in market CLO formation if CLO managers were required to retain 5% of new CLO issuances. Though this survey was conducted prior to the release of the revised proposal, there is nothing in the revised proposal that would suggest a different outlook.

From a substantive perspective, it is unclear why regulators would choose to implement QRM standards that are not only less stringent than under the original proposal, but appear to go so far as to eliminate many of the metrics for determining QRM. These rules would essentially render the vast majority of the residential mortgage loan market eligible as QRMs with few checks and balances (though repurchase/buyback and certification obligations are included in the revised proposal). This appears inconsistent with the legislative purpose of the Dodd-Frank Act, as this approach would fail to discourage the originate-to-distribute model that lead to the securitization of subprime residential mortgage loans often blamed for triggering the financial crisis. Perhaps equally perplexing is that regulators would choose to impose comparatively stringent standards on non-originate-to-distribute ABS such as CLOs, which have experienced comparatively low default rates and performed well during the crisis.

The revised proposal is likely to receive heavy public comment, and regulators have already received numerous requests for extension of the comment period. As such, it would not be surprising to see yet another substantial revision to the Dodd-Frank ABS risk retention rules in their final version. It would also be unsurprising to see this apparent imbalance corrected in the final retention rule.

Once finalized, which appears likely to occur in early 2014, the rule would take effect one year after publication of the final rules for RMBS transactions and two years after, perhaps early 2016, for all other ABS, including CLOs.

For further details on the revised ABS risk retention proposal, see Practice Note, ABS Risk Retention under Dodd-Frank.