On August 28, 2013, six federal financial regulatory agencies re-proposed the so-called Credit Risk Retention Rule, a regulation mandated by the 2010 Dodd-Frank Act, intended to require sponsors of securitization loans considered to be risky to have "skin in the game." Among the objectives of the rule was to impose stricter credit underwriting standards. The revised proposed rule, which follows a previous version, issued on April 29, 2011, reflects a considerable retreat by the federal regulators, who were widely criticized for their earlier proposal to exempt only those residential mortgage loans with a minimum of a 20 percent down payment from the risk retention requirement. More than 300 original comments were submitted, the majority of which criticized this so-called "qualified residential mortgage" (QRM) standard.
Additionally, in the revised proposed rule, the regulators agreed with NAREIT and other critics who questioned an anomalous provision in the prior version of the rule that would have exempted many high quality/low risk commercial real estate (CRE) loans from the retention requirement, unless such loans were made to REITs. This would have precluded high quality/low risk CRE loans to REITs from receiving comparable "zero risk retention" treatment in a securitized pool. This provision has now been dropped.
Finally, the revised rule also discards a controversial "premium capture cash reserve" account proposal, which critics argued would have required all issuer profits to be placed in a first-loss position as a reserve.
Credit Risk Retention
On August 28, 2013, six federal agencies—the Board of Governors of the Federal Reserve System, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency and the Securities and Exchange Commission—issued a revised proposed "Credit Risk Retention" rule, which was mandated by the 2010 Dodd-Frank Act and intended to require sponsors of securitized loans considered to present risks to the financial system to "have skin in the game," i.e., to retain a piece of the loan pool.
The proposal would exempt securitizations of QRMs from this requirement. Responding to broad criticism that the 2011 formulation of this standard was too onerous and would choke off lending, the new proposal would define QRMs to have the same meaning as the term "qualified mortgages" as defined by the Consumer Financial Products Bureau (CFPB), which appears to have appeased its critics.
Unchanged under the new proposal, securitizations of lower risk commercial loans and mortgages and automobile loans remain exempt from the risk retention requirement. Agency securities issued during the remaining period that Fannie Mae and Freddie Mac are in conservatorship, or receivership, and/or have capital support from the federal government would remain exempt as well.
The new rule, like its predecessor, would permit securitization sponsors to meet the 5 percent requirement by utilizing several different transaction structures; however, sponsors would not be permitted to hedge or transfer the risk. The original proposal would have required sponsors to value securities issued in a securitization transaction at par for purposes of determining compliance and also included a so-called premium capture provision, essentially requiring lenders to retain a stake in mortgages with down payments of less than 20 percent. The revised proposed rule permits these calculations to be based on fair value measurements and omits the premium capture provision.
Mortgage bankers, housing advocates and consumer groups hailed the revised QRM standard and the jettisoning of the 20 percent down payment requirement, which they believed would greatly curtail mortgage availability. However, the proposal also requests comment on a possible alternative approach that would require 30 percent down payments, which has already generated critical comment. Moreover, the regulators are apparently not united in their views concerning certain key provisions of the rule, including the QRM definition. SEC Commissioners Dan Gallagher and Michael S. Piwowar issued statements explaining their respective dissenting votes on the revised proposed rule. Commissioner Gallagher's dissent focused on the reformulated QRM standard, which he called "unrealistic and dangerously broad" and predicted that it would lead to an expansion of subprime lending.
Treatment of Loans to REITs
With regard to REITs in particular, as noted above, somewhat inexplicably the original proposed rule would have excluded high quality/low risk loans to REITs from a definition of CRE loans that would have been eligible for complete exclusion from the risk retention requirement, even if such loans would otherwise meet the definition, solely because the borrower was a REIT. Accordingly, on August 1, 2011 NAREIT submitted a comment letter to the six authoring federal agencies strongly objecting to this anomalous exclusion arguing that "the same high quality secured loan used to finance a commercial or multifamily property would receive different treatment based solely on whether the borrower–or potentially the borrower's owner(s) – elects to be taxed as a REIT." Several other commenters echoed NAREITs arguments.
In NAREIT's letter, and in the course of a series of meetings with relevant federal agency officials over the last two years, NAREIT emphasized the "flawed logic" underlying the rule, noting that "the blanket exclusion of a loan to a REIT from the definition of a qualifying commercial real estate loan, as mandated by the Proposed Rule, is a fundamentally flawed approach to regulation in this area." NAREIT further noted that there is no basis in the Dodd-Frank Act or its legislative history for wholesale discrimination against loans to REITs in this context.
The revised proposed rule vindicates NAREIT's concerns in their entirety by reversing this prior exclusion of high quality CRE loans to REITs. The commentary accompanying the revised proposed rule lays out this welcome reversal, acknowledging the input from the REIT community:
…many commenters criticized the agencies for excluding loans to REITs from the definition of CRE loans in the original proposal. These commenters asserted that mortgage loans on commercial properties where the borrower was a REIT are no riskier than similar loans where the borrower was a non-REIT partnership or corporation and that a significant portion of the CMBS market involves underlying loans to finance buildings owned by REITs. These commenters requested that the agencies delete the 221 restriction against REITs, or in the alternative clarify that the prohibition only applies to loans to REITs that are not secured by mortgages on specific commercial real estate…After reviewing the comments and the definition of CRE loan, the agencies have decided to remove the language excluding REITs in the proposed definition.
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The six authoring agencies are requesting public comment on the revised proposed rule by October 30, 2013. Notwithstanding the regulators' retreat with regard to the QRM standard, market stakeholders can be expected to have strongly held views on aspects of this revised version as well. NAREIT will be carefully monitoring the reception of this version of the rule and will report further developments.
If you would like to obtain more information about this development, please contact Victoria Rostow at firstname.lastname@example.org or (202) 739-9431.