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One of the most important pieces of the Dodd-Frank Act — regulators' risk retention proposal — is set to start falling into place Tuesday. Following is a guide to the plan.
March 28
WASHINGTON — The Federal Deposit Insurance Corp. became the first regulator to release to the public a plan that would force institutions to retain 5% of the credit risk for securitized loans.
At the Tuesday morning meeting, the agency also considered proposed standards for large financial firms to compose their so-called "living wills" to help regulators take them apart if they were expected to fail.
The risk retention plan was one of the most significant reforms for the banking industry stemming from the Dodd-Frank Act. The proposal, which was a joint plan from several regulators, also includes criteria for certain exempt home loans — known as "qualified residential mortgages" — that would be exempt from the risk retention requirement. Public commenters can weigh in about the proposal until June 10.
Regulators hailed the plan even as they signaled they were open to changes.
"This will encourage better underwriting by assuring that originators and securitizers cannot escape the consequences of their own lending practices," FDIC Chairman Sheila Bair said at the FDIC board meeting. "Fundamentally, this rule is about reforming the 'originate-to-distribute' model for securitization, and realigning the interests in structured finance towards long-term, sustainable lending."
Regulators appeared ready for criticism that the proposed QRM standard was too narrow. Under the plan, borrowers must have a 20% down-payment for the loan to qualify as well as meet certain other tests regarding their income, debt and credit history.
Acting Comptroller of the Currency John Walsh said the standards were intentionally narrow, designed to exempt the best underwritten loans. Regulators were not trying, he said, to establish new underwriting standards for the entire market.
"The QRM has a loan-to-value ratio of 80% or less — a very high standard — so securitizations comprised entirely of QRMs are exempt from risk retention," Walsh said. "The definition is an exemption, not intended to set a new national standard for mortgages."
Walsh warned against attempts to broaden the exemption too far.
"Any exemption from risk retention is intended to be narrow, and include only loans of high credit quality," Walsh said. "This should ensure that normal securitizations thrive because risk retention requirements are of a type, and in an amount, consistent with the protection investors will demand. This balance is important. Expanding exemptions too broadly could cause credit availability outside the exempt category to evaporate."
Still, regulators said they were open to changes, as indicated by several questions in the plan that asked the industry to weigh in on alternatives.
Under the proposal, the risk retention is held generally by the sponsor of a securitization.
But firms have numerous options of how to structure the risk. For example, they could take a "vertical slice" of a securitization, meaning they would hold at least 5% of each tranche. Alternatively, the retention piece could be a "horizontal" first-loss position, essentially meaning a 5% interest in the whole securitization.
The board also proposed guidelines — drafted jointly with the Federal Reserve Board — for the internal resolution plans systemically important firms must craft in order to help guide regulators in a wind-down scenario.
Under Dodd-Frank, the FDIC gained enormous powers to resolve institutions deemed too systemically important to go through the bankruptcy process.
The proposal for resolution plans, including a 60-day comment period, would require a firm to undertake a "strategic analysis" of how it could be subject to the bankruptcy code without posing systemic risk.
In its memo for the proposal, FDIC staff said a firm's plan would aim to "help the FRB and the Corporation to better understand a covered company's business and how that entity may be resolved."
The internal plans, the FDIC said, "will also enhance the regulators "understanding of foreign operations in an effort to develop a comprehensive and coordinated resolution strategy for a cross-border firm." A living will would have to be filed within 180 days of the regulation. Firms would also have to submit interim updates of the plan.
Under the proposal, a plan is required to include an executive summary, a strategic analysis laying out a plan's elements, an outline of a company's organizational structure, as well as information about its management information systems and interconnectedness with other entities.
A firm would have to map its business lines to legal entities; provide analysis of its corporate structure; and discuss credit exposures, as well as liquidity, capital and cash flows. The plan would also include material on the domestic and foreign jurisdictions in which a company operates.
