New financing structures for RMBS residuals raise red flags

The following article is supplied by Change Wholesale.

Private lenders are offering sponsors of private label residential mortgage backed securities (RMBS) innovative financing arrangements for the residual interests they retain to meet Dodd Frank’s risk retention requirements. These lenders are offering to provide non-recourse debt financing secured against the residual securities, and they are structuring the financing agreements to allow the Sponsor to: (1) obtain attractive accounting treatment under GAAP; (2) limit recourse to the issuer from the loan; and (3) conceal from purchasers, underwriters, and regulators that the sponsor is no longer in compliance with the risk retention requirements of Dodd Frank.  The Securities and Exchange Commission, Federal Housing Finance Agency, Department of Housing and Urban Development, and various depository bank regulators have oversight over Sponsors who issue RMBS. It is becoming increasingly clear that Sponsors who finance their residuals without full recourse in an attempt to end-run important consumer protections contained in Dodd-Frank are assuming significant regulatory risks relating to securities fraud and predatory lending practices. 

When properly structured, securitization provides economic benefits that can lower the cost of credit.”  However, “[w]hen incentives are not properly aligned and there is a lack of discipline in the credit origination process, securitization can result in harmful consequences to investors, consumers, financial institutions, and the financial system.”  When passing the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress intended the risk retention requirements mandated by the newly added section 15G (15 U.S.C. § 780-11) to help address problems in the securitization markets by generally requiring that securitizers of asset-backed securities to retain not less than 5% of the credit risk of the assets collateralizing the asset-backed security.

Unless an exemption applies, “neither a retaining sponsor nor any of its affiliates may pledge as collateral for any obligation (including a loan, repurchase agreement, or other financing transaction) any ABS interest that the sponsor is required to retain with respect to a securitization transaction pursuant to subpart B of this part unless such obligation is with full recourse to the sponsor or affiliate, respectively. [emphasis added]”

For RMBS, the transfer and hedging restrictions expire on or after the date that is (1) the later of (a) five years after the date of the closing of the securitization or (b) the date on which the total unpaid principal balance of the securitized assets is reduced to 25 percent of the original unpaid principal balance as of the date of the closing of the securitization, but (2) in any event no later than seven years after the date of the closing of the securitization. A sponsor that retains a B-piece also may transfer it to a qualified third-party purchaser after five years from the closing date.

Sponsors of RMBS securitizations, where no exemption applies, seeking to pledge residual securities from RMBS transactions as collateral for non-recourse financing where they have a right, but not an obligation, to repurchase the collateral may be able to evade realizing losses under GAAP, as such transaction may not be deemed to be a “true sale” by their accounting firm; however, they do so at their own risk as this practice is expressly prohibited by Section 15G – and the potential consequences are severe.  Additionally, lenders who facilitate these transactions may incur regulatory liability unless they first confirm their non-recourse loans are not secured.

Section 15G includes a variety of exemptions including an exemption for asset-backed securities that are collateralized exclusively by residential mortgages that qualify as “Qualified Residential Mortgages” (“QRM”).  While Section 15G has been effective since February 23, 2015, it defines QRM to mean “Qualified Mortgage” as defined in Section 129C of the Truth-in-Lending Act (“QM”).

The Consumer Financial Protection Bureau (“CFPB”) amended the general definition of QM in the Truth-in-Lending Act’s implementing regulation (“Regulation Z”) which became mandatory  on October 1, 2022.  In doing away with the objective test (debt-to-income ratio < 43% calculated in accordance with Appendix Q) the CFPB clarified that both QM loans containing the mere presumption of compliance and Non-QM loans utilizing bank statements to verify income or assets must source deposits into the consumer’s bank account to confirm the deposits are income and not, for example proceeds from a loan.  Sourcing deposits poses an additional layer of risk and uncertainty when a consumer has a commingled bank account.  How can a creditor possibly differentiate and prove which portion of a deposit is income v. prepayment of expenses (such a building materials)?

While it’s true that violations of the Truth-in-Lending Act contains substantial monetary penalties for violating its Ability-to-Repay Rule; they pale in comparison to the penalties under the Security Exchange Act where a sponsor of an RMBS transaction can expect that (1) the Securities and Exchange Commission will have broad discretion when selecting enforcement options, (2) Rule 10b-5 claims could be a ripe source of third-party actions at least for transactions where there is a failure to properly disclose the material terms of the risk retention, and (3) in the event of a Rule 10b-5 violation, investors may have a private rescission right under Section 29(b).

While bank statement loans have been included in Non-QM securitizations for years, far greater issues arise when the securitizer invokes the exemption for QRMs they risk violating Section 15G if it is subsequently discovered that the creditor failed to source the deposits into the bank account to ensure it is income making the loan not a QM or QRM; thus, losing the exemption from section 15G.  This additional layer of uncertainty and risk has caused Rating Agencies to be reluctant to allow bank statement loans to be classified as QM.

Sponsors who seek circumvent Dodd-Frank’s risk retention rules on securities comprised of bank statement loans that do not fully verify deposits are compromising two layers of the overlapping consumer protections which protect borrowers from predatory practices: (1) sourcing deposits to confirm a borrower’s ability to repay and (2) retaining risk to confirm the lenders belief in the borrower’s ability to repay.  While each infraction carries serious consequences independently, taken together, they provide a case study of willful, predatory practices that Dodd Frank sought to end but that appear to be reemerging today.

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