What is this all about?
Prior to the financial crisis, it was common to see securitisation transactions based on the ‘originate to distribute’ model, whereby lenders originate new loans such as residential or commercial mortgages, for the sole purpose of selling them into special purpose vehicles (SPV) that fund such purchase by issuing asset-backed securities (ABS). Regulators across Europe (as well as globally) were concerned about a perceived flaw in the ‘originate to distribute’ model whereby originators were more concerned with the volume of loans originated rather than the quality of those loans. This was because they could transfer their entire exposure to such loans immediately by selling the assets into a securitisation. In such a situation, there would be a fundamental misalignment of interests between the originator and securitisation investors.
A perceived remedy is to implement a ‘risk retention requirement’ for securitisations to ensure that originators retain a stake in the viability of such loans (sometimes referred to as ‘skin in the game’). The concept of ‘skin in the game’ was born out of the financial crisis and is a regulatory response to the misalignment between originators’ and investors’ interests. For example, in the US, mortgage brokers were notorious for pressuring consumers into signing up for mortgages which they couldn’t afford (or could only afford the ‘teaser’ rates that were replaced by much higher rates after a set period of time). Regulators sought to shift towards a mandatory economic alignment of originators’ interests with those of investors in the resulting securitisation.
A major pillar of the European Commission Action Plan on Capital Markets Union (CMU) involves changes to the regulation of securitisations in Europe. While CMU is broadly about making the financial system more stable by broadening the range of funding sources (i.e. growth in non-bank finance), initiatives such as the proposed new ‘Securitisation Regulation’ are intended to free up banks’ balance sheets to help them increase lending. Early key initiatives include creating a new regulatory regime under the Securitisation Regulation, and creating a category of ‘simple, standardized and transparent’ (STS) securitisations that would be subject to preferential capital treatment for investors. The Securitisation Regulation also replaces (and largely replicates) the risk retention requirements currently contained in other, sector-specific legislation described below.
How does it work under the current system?
Articles 405 to 410 of the Capital Requirements Regulation (CRR) set out requirements to be fulfilled by credit institutions when acting in a particular capacity, such as originator or sponsor, and also when investing in securitisations. The CRR requires that an originator, sponsor or original lender must explicitly disclose that it will retain, on an ongoing basis, a material net economic interest in the securitisation for the life of the transaction. For the purposes of the CRR, 5 percent has been specified as the minimum net economic interest required in order for such retention to be ‘material’. The penalty for failing to comply with these requirements will fall on the investor bank, in the form of an obligation to hold more capital against its exposure on the relevant securitisation investment.
While the CRR only applies to regulated credit institutions and investment firms in the EU (i.e. EU banks and investment banks), similar requirements have been incorporated into the Solvency II Directive (Solvency II), which codifies and harmonizes EU insurance regulation. In January 2016, risk retention will apply to insurers under the Solvency II Directive (Solvency II).
Similar requirements have been built into the Alternative Investment Fund Managers Directive (AIFMD), which harmonizes EU regulation of EU-established managers of alternative investment funds (AIFs). As this captures the vast majority of the investor base for securitisations, the risk retention requirements will in effect apply to almost all securitisations, even if the target investor base is not EU banks.
How does the investor ensure that the originator maintains its 5 percent position? This is broadly achieved through representations in the subscription agreement, servicing agreement or asset sale agreement, depending on who is giving the representation, disclosure in the prospectus, and, on an ongoing basis, servicing reports provided by the servicer.
There are a variety of methods by which the originator, sponsor or lender may retain the risk. Calculating the net economic interest can involve one of five different methods:
- Vertical slice: retention of at least 5 percent of the nominal value of each class of notes
- Originator interest (revolving assets): retention of an interest in revolving assets equal to at least 5 percent of the nominal value of the underlying assets
- On-balance sheet (random selection): retention of an interest in randomly selected assets equal to at least 5 percent of the nominal value of the portfolio, provided selection is made from a pool comprising not less than 100 percent of the assets
- First loss tranche in securitisation: retention of the most subordinated payment obligation in the structure
- First loss exposure: retention of the first loss position in 5 percent of the underlying assets.
The net economic interest may not be hedged in any way (so as to ensure that the retaining originator, sponsor or lender shares the losses when the underlying assets are not performing).
How does risk retention work under the AIFMD
Article 17 of the AIFMD empowers the Commission to adopt measures such as imposing requirements in the following areas:
- the requirements that need to be met by the originator, the sponsor or the original lender, in order for an AIF manager to be allowed to invest in ABS on behalf of AIFs, including requirements that ensure that the originator, the sponsor or the original lender retains a net economic interest of not less than 5 percent; and
qualitative requirements that must be met by managers that invest in ABS on behalf of one or more AIFs.
- Article 51 of the Commission Delegated Regulation 231/2013 lays down a requirement for retained material net economic interest as a precondition for an AIF manager assuming exposure to the credit risk of a securitisation on behalf of one or more AIFs.
In addition, the AIF manager must ensure that the sponsor and originator have certain features (article 52) and the AIF manager has itself to comply with a set of qualitative requirements (article 53). Article 54 provides for corrective action if the retained net economic interest is below the required level.
Are UCITS under a risk retention requirement
In addition to credit institutions (i.e. banks), only ‘investment firms’ that are regulated under the MiFID are subject to the CRR risk retention requirements. Generally speaking, collective investment undertakings (UCITS), their depositaries and managers are not regulated by the MiFID under an exemption in article 2.1 of the MiFID.
UCITS managers only benefit from the exemption from being an ‘investment firm’ for the purposes of risk retention under CRR in respect of any investment services or activities they may carry on in that capacity. To the extent that they also provide investment services or perform investment activities in a different capacity, for example, by providing investment advice to, or managing the assets of, an individual third party, these services and activities fall outside the scope of the article 2.1 exemption in the MiFID.
Who is able to act as the "retainer of risk"?
The originator, sponsor or original lender may retain the risk. ‘Sponsors’ are defined as an ‘institution’ that establishes and manages an ABS or asset-backed commercial paper (ABCP) programme or other securitised scheme from third parties. ‘Institution’ means either a ‘credit institution’ or an ‘investment firm’. A credit institution is an EU bank.
What is an ‘investment firm’ in the CRR? An investment firm is defined in the CRR by reference to the MiFID with certain exclusions. Under the MiFID, ‘investment firm’ means any undertaking that provides for one or more investment services to third parties and/or the performs one or more investment activities on a professional basis, including:
- reception and transmission of orders in relation to one or more financial instruments;
- execution of orders on behalf of clients;
- dealing on own account;
- portfolio management;
- investment advice;
- underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis;
- placing of financial instruments without a firm commitment basis; and
- operation of multilateral trading facilities.
‘Investment firms’ includes MiFID-regulated portfolio managers, but not alternative investment fund managers regulated under the AIFMD or non-EU investment advisers. Non-EU regulated managers may be unable to fulfil the retention requirements. As mentioned above, UCITS are broadly exempt from the MiFID and therefore fall outside of the definition of investment firm.
The CRR excludes from the definition of investment firm any credit institution (which are separately eligible to act as sponsor in any event), any local firm (defined as firms that are dealing for their own account in derivatives to hedge positions), and any firm not authorized to provide custodial or cash/collateral management services if they provide only certain investment services specified in the CRR and are not allowed to hold client money.
As a result of being outside of the definition of investment firm, none of these entities (other than credit institutions) are eligible to act as the ‘retainer of risk’ while acting in their capacity as sponsor.
Can CLO collateral managers act as the "retainer of risk" in their capacity as sponsor?
Whether a collateral manager for a collateralized loan obligation (CLO) qualifies as a "sponsor" under the CRR will depend upon the MiFID authorizations/permissions the collateral manager holds from its EU home country supervisor.
With the required permissions a collateral manager authorised under the MiFID will qualify as a ‘sponsor’ and can be the retention holder in an EU risk retention compliant CLO transaction. Should a manager’s permissions be too narrow, it may be possible for that manager to apply for a variation to its permissions that will qualify it as a sponsor under the CRR. A collateral manager which is authorised under the AIFMD will not qualify as a manager under the MiFID; therefore, it would be ineligible to retain risk in its capacity as sponsor.
In addition to having the necessary permissions, a qualifying investment firm must ‘establish’ and ‘manage’ a securitisation transaction in order to qualify as a sponsor. Those requirements can presumably be met if a qualifying investment firm acts as the collateral manager in a CLO or is involved in some sub-management or co-management role.
How will it work under the new system?
The Securitisation Regulation will ensure that originators, sponsors or original lenders continue to maintain a 5 per cent net economic exposure to their securitisations (as is the case under existing legislation). This promotes the alignment of their interests with the interests of the investors.
Under existing regulatory schemes including the CRR, Solvency II and the AIFMD; the onus is on credit institutions, insurance companies and AIF managers (respectively) to police compliance with the risk retention requirement where they invest in securitisations. Market practice is to include contractual provisions to that effect in the transaction documentation.
The current proposal imposes a direct risk retention requirement and reporting obligation on the originators, sponsors or original lenders, which is more in line with the risk retention requirements in the US but a significant departure from the current EU regime. Currently, the penalty for non-compliance is a punitive capital charge against investors’ balance sheets. Under the new regime, originators could face a myriad of administrative (or even criminal) sanctions depending on how the Securitisation Regulation is implemented in each Member State (although capital charges remain for investors that fail to conduct proper due diligence).
Originators, sponsors and original lenders will be under a new positive obligation to retain a 5 per cent net economic interest in securitisation transactions, including those invested in by UCITS and occupational pension funds.
The new regime has not completely abandoned the ‘indirect method’ of requiring risk retention. As a precaution, EU-based credit institutions will be required to ensure that the 5 per cent retention requirement is met for fear of a regulatory capital hit. The result is that investors and originators will need to ensure that they onside of this dual-compliance regime.
One additional change is that an originator established or operating for the sole purpose of securitising exposures without a broad business purpose will be excluded from acting as the retainer of risk. This exclusion is intended to close a perceived loophole where the definition of originator was interpreted generously to include entities that would not have the capacity to meet payment obligations from resources unrelated to the securitisation. In other words, the Commission wants a bona fide operating company and not a shell to have a “skin in the game” in the transaction. Fortunately, the Securitisation Regulation excludes companies with the ‘sole purpose’ rather than the anticipated ‘primary purpose’, which means that managers of collateralized debt obligation portfolios should not be categorically excluded from retaining risk.
As is the case under the CRR, the Securitisation Regulation exempts from the risk retention requirement ABS where the underlying assets are obligations of or obligations guaranteed by central governments, central banks, regional governments/local authorities and multilateral development banks.