Financial Reform Watch

While the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) has been widely identified as having a broad and sweeping impact on the financial markets as a whole, it will most certainly also have a dramatic impact on the structuring and implementation of asset-backed securities. More particularly, the parties involved in structuring and executing collateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”) may be significantly impacted by the risk retention (or “skin-in-the-game”) requirements under Section 941 of the Dodd-Frank Act (the “Risk Retention Requirements”). Important elements establishing the mechanics and implementation of the Risk Retention Requirements will remain unclear, however, until regulators promulgate further required rules.

As set forth in the Dodd-Frank Act, the Risk Retention Requirements direct that distinct regulations be issued by the Federal banking agencies and the Securities and Exchange Commission (the “Commission”) for each category of ABS, including residential mortgages, commercial mortgages, auto loans, and any other applicable categories of Asset-Backed Securities. The risk retention rules must be prescribed within 270 days after enactment (i.e., by April 15, 2011) and must go into effect within two years after the date final rules are published for all asset classes other than residential mortgages (i.e., not later than April 15, 2013).

The Dodd-Frank Act defines “Asset-Backed Securities” as “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the Commission, by rule, determines to be an asset-backed security for purposes of this section.” While the statutory language makes it clear that the Risk Retention Requirements apply to CDOs, it does not expressly include CLOs. Presumably, CLOs will be included in the regulations either by application of a broad definition of “collateralized debt obligations” or by express inclusion by the Commission as an asset-backed security subject to the Risk Retention Requirements.

The Dodd-Frank Act requires that regulators adopt rules setting forth retention of an economic interest in a portion of the credit risk (which retained credit risk must not be hedged, directly or indirectly). The retained credit risk must be not less than 5% of the credit risk for any asset except that the minimum retained risk may be less than 5% if the “underwriting standards” promulgated by the regulators “specify the terms, conditions, and characteristics of a loan within the asset class that indicate a reduced credit risk with respect to the loan” and which are to be established for each asset class. The statutory language leaves unclear, pending further regulatory action, whether the retained 5% interest is to be allocated equally across the capital structure, concentrated in the most subordinate tranche of securities or allocated on some other basis within the capital structure.

The Dodd-Frank Act further specifies that risk retention obligations may be shared between the “securitizer” and the “originator”. While an “originator” is defined as "a person who (A) through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security; or (B) sells an asset directly or indirectly to a securitizer.”, a “securitizer” is defined as “(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.”

This “originator-securitizer” distinction is problematic in the context of a CDO or CLO as it remains unclear which entity in a CDO or CLO transaction would be the “securitizer” or the “originator.” By way of an example, a “securitizer” who is required to comply with the Risk Retention Requirements could be (i) the CDO or CLO issuer, which is typically a special purpose vehicle presumptively holding all the credit risk and having no independent resources by which it could acquire the retained credit risk (this result may prove impractical), (ii) the provider of warehouse financing, typically the lead underwriting bank (as that person or an affiliate finances and subsequently sells assets into the CDO or CLO issuer), (iii) the collateral manager that initiates or organizes the structuring of the CDO or CLO or (iv) any person who sells assets to the issuer, such as a loan originator into a CLO (which could be expected to adversely affect the syndicated loan market). Similarly, an “originator” could be any entity (i) which makes loans which are sold into a CDO or CLO (which also would have a significant adverse impact on the syndicated loan market) or (ii) the asset manager, arranger or underwriter (in the case of a cash flow CLO) of the transaction. It may be that most CDO and CLO transactions do not have an originator as contemplated by the definition. The ultimate regulatory direction on these definitions and the Risk Retention Requirements will result in a significant shift in the economics of CDO and CLO transactions among these parties, and all potentially affected persons will need to remain alert to the developments as proposed rules are announced in the coming months.

Although the Dodd-Frank Act does not clearly delineate all aspects of the application of the Risk Retention Requirements to CDOs and CLOs, the statue does clearly recognize the distinct differences between CDOs and CLOs on the one hand, and other traditional asset-backed securities (like car loans, student loans, commercial mortgages or residential mortgages) on the other. As a result, the Dodd-Frank Act specifically provides that “regulations shall …establish appropriate standards for retention of an economic interest with respect to collateralized debt obligations, securities collateralized by collateralized debt obligations, and similar instruments collateralized by other asset-backed securities.”

It is expected (and hoped) that the forthcoming regulations will (a) recognize the inapplicability of certain provisions of Section 941 of the Dodd-Frank Act to CDOs and CLOs and (b) promulgate rules that will adequately clarify or limit the application of the Risk Retention Requirements to CDO and CLO transactions. Interested parties will need to monitor and assess these regulations as they are promulgated in order to definitively assess the impact of the Risk Retention Requirements on their future CDO and CLO transactions. Pending announcement of proposed rules and finalization of the definitive regulatory framework, the structured finance markets, in general, and the CDO and CLO market, in particular, may be adversely impacted and may proceed in the interim with a continued and significant lack of legal certainty.