The Federal Deposit Insurance Corporation’s (“FDIC”) Board of Directors today gave its approval to a proposed rule (“Rule”) regarding implementation of the asset-backed securities (“ABS”) risk retention provisions of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 941 was drafted with the view that securitizers will act more prudently if they have “skin in the game.” The Rule contains provisions relating to securitization of a wide range of assets, including a general 5% risk retention requirement, that are to be adopted jointly by the FDIC, the Office of the Comptroller of the Currency (“OCC”), the Federal Reserve Board (“FRB”) and the Securities and Exchange Commission (“SEC”).

In connection with the securitization of residential mortgages, the Rule includes an exemption from the risk retention requirement for certain “qualified residential mortgages” (“QRMs”). This portion of the Rule must be adopted jointly by the FDIC, OCC, FRB, SEC, Federal Housing Finance Agency (“FHFA”) and Department of Housing and Urban Development.

Key points contained in the FDIC-released version of the Rule are discussed below. The agencies have announced that they anticipate that they will all take action on the Rule by the end of this week. The FRB also acted today and the SEC is scheduled to take action tomorrow.

The FDIC document indicates that comments on the Rule must be submitted by June 10, 2011.

Risk Retention Generally

For asset-backed securitizations not subject to the QRM, or a zero percent provision as discussed below, the Rule generally requires a securitization sponsor (defined in a manner consistent with the Regulation AB definition) to retain the required risk. Generally, the Rule requires that the sponsor retain an economic interest equal to at least 5% of the aggregate credit risk of the assets collateralizing an issuance of ABS (the “base” risk retention requirement). The sponsor may allocate a proportional share of the risk retention obligation to the originator(s) of the securitized assets, if the originator agrees, subject to certain conditions. The conditions include that the originator be the originator of at least 20% of the loans in the securitization, take on at least 20% of the risk retention, and pay up front for its share of retention, either in cash or at a discount on the price of the loans the originator sells to the asset pool. If a sponsor structures a securitization to monetize excess spread on the underlying assets—which is typically effected through the sale of interest-only tranches or premium bonds—the Rule would “capture” the premium or purchase price received on the sale of the tranches that monetize the excess spread and would require that the sponsor place such amounts into a separate “premium capture cash reserve account” in the securitization. Such amounts would be in addition to the sponsor’s base risk retention requirement. As a general matter, the Rule prohibits a securitizer from hedging its required retained credit risk or transferring it, except to a consolidated affiliate. However, the Rule permits hedging of interest rate or foreign exchange risk (based on an index of instruments that include the ABS, subject to limitations on the portion of the index represented by the specific securitization transaction or applicable issuing entities) and pledging of the required retained interest on a full recourse basis.

Risk Retention Options; Impact on CMBS Securitizations

The Rule provides several options for the form in which a securitization sponsor may retain risk. These include a 5% “vertical” slice of the ABS interests, whereby the sponsor or other entity retains a specified pro rata piece of each class of interests issued in the transaction (that is, the sponsor must hold 5% of each tranche); a 5% “horizontal” first-loss position, whereby the sponsor or other entity retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests; an “L-shaped interest,” whereby the sponsor holds at least half of the 5% retained interest in the form of a vertical slice and half in the form of a horizontal first-loss position; a “seller’s interest” in securitizations structured using a master trust collateralized by revolving assets, whereby the sponsor or other entity holds a 5% separate interest that participates in revenues and losses on the same basis as the investors’ interest in the pool of receivables (unless and until the occurrence of an early amortization event); a representative sample, whereby the sponsor retains a 5% representative sample of the assets to be securitized, thereby exposing the sponsor to credit risk that is equivalent to that of the securitized assets; or, for certain “eligible” single-seller or multi-seller asset-backed commercial paper conduits collateralized by loans and receivables and covered by a 100% liquidity guarantee from a regulated bank or holding company, a 5% residual interest retained by the receivables’ originator-seller. In addition, for certain securitizations of commercial mortgage-backed securities (“CMBS”), the Rule permits a form of horizontal risk retention in which the horizontal first-loss position initially is held by a third-party purchaser (known as a “B-piece buyer”) that specifically negotiates for the purchase of the first-loss position and according to the Rule, conducts its own credit analysis of each commercial loan backing the CMBS. As this B-piece buyer is often the special servicer, the agencies are proposing to require appointment of an independent “operating advisor” in securitizations in which this B-piece buyer option is used.

Strict Requirements for QRM Qualification

During the past several months there has been particular interest in the standards the agencies would propose for residential mortgages to qualify as QRMs exempting such mortgages from the risk retention requirements of the Rule. Private sector observers have expressed concern that strict standards for QRMs may have the result of sharply contracting the availability of housing finance, particularly as it relates to low- to moderate-income borrowers.

The proposed definition of a QRM in the Rule would establish conservative underwriting standards. Such standards include:

■ maximum front-end and back-end borrower debt-to-income ratios of 28% and 36%, respectively;

■ a maximum loan-to-value (“LTV”) ratio of 80% (exclusive of mortgage insurance) in the case of a purchase transaction (with a 75% combined LTV for rate and term refinance transactions, reduced to 70% for cash-out refinancings);

■ a 20% down payment requirement in the case of a purchase transaction; and

■ borrower credit history restrictions including the requirement that there be no 60-day delinquencies on any debt obligation within the previous 24 months.