FDIC Proposal Links Market Reform to the Securitization Safe Harbor - Securitization & Structured Finance

Originally published May 18, 2010

Keywords: FDIC proposal, market reform, securitization safe harbor, NPR, risk retention requirement,

On May 11, 2010, the Board of the Federal Deposit Insurance Corporation (FDIC) released a notice of proposed rulemaking¹ (NPR) concerning the FDIC's rule (the Rule) relating to the treatment of securitizations (and participations²) in receivership or conservatorship (12 CFR 360.6). This is the latest step in the FDIC's reaction to changes in US accounting standards³ that made it difficult for banks⁴ to use the Rule. Comments on the NPR must be received by July 1, 2010.

The NPR proposes significant new requirements in order for bank-sponsored⁵ residential mortgage-backed securities (RMBS) and other asset-backed securities (ABS) to rely on the Rule. Some of these proposals overlap with the recent proposal by the Securities and Exchange Commission (SEC) to amend Regulation AB and other securities regulations and forms relating to ABS.⁶ In the NPR, the FDIC has sought to coordinate the terms of the Rule with the SEC changes and to address market concerns arising from the FDIC's December 2009 release relating to the Rule. However, the NPR goes significantly beyond the SEC proposal in several key areas, including:

Imposing risk retention requirements and Regulation AB-style disclosure and reporting requirements on all ABS transactions closed after September 30, 2010, that rely on the Rule; and
Imposing substantial additional requirements on RMBS transactions closed after September 30, 2010, that rely on the Rule, including limitations on capital structure (no more than six credit tranches and no pool-level external credit enhancement), mandatory terms as to servicer powers and incentives, incentive-oriented deferred compensation for rating agencies, a 5 percent reserve account for repurchases of ineligible receivables and third-party assessments on legal compliance of the underlying loans.

The Original Rule

For transactions that satisfied its requirements, the original Rule provided that the FDIC would not:

Use its repudiation power to reclaim financial assets transferred by the institution in connection with a securitization (the Repudiation Safe Harbor), or
Avoid an otherwise legally enforceable securitization agreement solely because the agreement does not meet the "contemporaneous" component of the "written agreement" requirements under the Federal Deposit Insurance Act (the Avoidance Safe Harbor).

The Repudiation Safe Harbor was originally only available for securitizations that were treated as sales for accounting purposes. Because the recent accounting changes made it difficult for securitizations to achieve sale accounting, this condition threatened to make the Repudiation Safe Harbor unavailable at least for securitizations completed after the accounting changes took effect (January 1, 2010, for most banks). The Avoidance Safe Harbor never required sale treatment, and its availability was not placed in doubt by the accounting changes.

Another issue that arose in connection with these developments relates to an automatic stay that was added to the FDIC's arsenal, subsequent to the adoption of the Rule. In 2005, Congress added section 11(e)(13)(C) to the Federal Deposit Insurance Act. Under this new section, if the FDIC is appointed as conservator or receiver of a failed bank, then the FDIC's consent is required for a secured creditor to take any action against collateral pledged by the failed bank within a 45- or 90-day period, respectively, after the FDIC's appointment as conservator or receiver. Effectively, any such action would be automatically stayed for the specified period.

Although the original Rule did not address this consent requirement, market participants were generally comfortable that assets transferred in an off-balance sheet securitization that qualified for the benefits of the Rule would also not be subject to the automatic stay. The loss of sale accounting treatment and possible unavailability of the Repudiation Safe Harbor posed the additional threat that the automatic stay might apply to some securitized assets. These threats created significant issues for some credit card banks, effectively freezing issuance in the term markets by a number of the largest issuers.

Interim Steps by the FDIC

The FDIC has taken a number of timely and crucial steps to keep the Repudiation Safe Harbor available for bank securitizations:

In November 2009, the FDIC adopted an interim rule (the Interim Rule) that relaxed the accounting sale requirement for securitizations completed through March 31, 2010.⁷
In December 2009, the FDIC released an advanced notice of proposed rulemaking that provided an initial indication of what permanent safe harbor(s) the FDIC might provide going forward.⁸
In March 2010, the FDIC extended the Interim Rule to cover securitizations completed through September 30, 2010.⁹ We refer to the period from November 12, 2009 (when the Interim Rule was adopted) through September 30, 2010, as the Transition Period.

The NPR

The NPR follows up on the December release, proposing definitive language for the Rule going forward. While the Interim Rule temporarily loosened the conditions for the Repudiation Safe Harbor without imposing any additional compensating conditions, the December release contemplated significant new conditions after the Transition Period. The NPR, likewise, proposes significant new conditions in order for securitizations to qualify for the Repudiation Safe Harbor and for new relief from the automatic stay.

The FDIC recognizes the importance of securitization as a source of liquidity for banks, but it also believes that securitization played a significant role in bringing about the credit and market crises of the last three years. Consequently, while the FDIC intends to continue to facilitate bank securitizations by providing safe harbors from its repudiation, avoidance and automatic stay powers, it also wants to use the amended Rule to reshape the securitization market. That is the goal of most of the additional conditions contemplated by the NPR.

The Rule has always included conditions that transactions had to satisfy in order to qualify for its protections. However, apart from the sale accounting condition discussed above, the original conditions were focused on very basic good conduct points (e.g., absence of fraud, written agreements, proper corporate authorizations) that virtually any bona fide transaction could satisfy. We refer to these types of conditions, which are carried forward and elaborated somewhat in the NPR, as good housekeeping conditions. The NPR (like the December release) also contemplates conditions that regulate the substantive terms of transactions in a much more meaningful way, which we refer to as market regulating conditions. We discuss both types of conditions further below, after summarizing the proposed terms of the final safe harbors.

The Safe Harbors

The NPR contemplates three different safe harbors relating to the repudiation power (in addition to the Avoidance Safe Harbor, which is largely unchanged¹⁰). The NPR also contemplates relief from the automatic stay in the form of advance consent to continued payments and contractual servicing activities during the automatic stay period (the Payments and Servicing Consent) in the event of a receivership or conservatorship of the sponsor. The Payments and Servicing Consent would apply to any "securitization" (as defined in the revised Rule) that complied with the market regulating conditions and good housekeeping conditions, regardless of which (if any) of the repudiation safe harbors apply to the transaction.

Safe Harbor for On-Balance Sheet Securitizations Completed after the Transition Period. This is probably the most important of the safe harbors, given the increased difficulty of achieving sale treatment, and would be subject to the new conditions discussed below, including the market regulating conditions. Transactions that met those new conditions would benefit from a substantively new safe harbor that does not parallel the existing Repudiation Safe Harbor, but instead provides special relief relating to the automatic stay and a special rule for calculating damages in case of repudiation. Because these transactions are accounted for as secured loans to the sponsor and may not involve legal true sales, the FDIC applies a traditional secured loan analysis to them, similar to the FDIC's treatment of covered bonds.¹¹

Although the FDIC cannot ordinarily repudiate a valid security interest, it can repudiate the secured obligations of a failed bank. Upon such repudiation, the secured parties are entitled to the benefits of their collateral, but only to cover their actual, compensatory damages arising from the repudiation. In response to the December release, rating agencies and other market participants had expressed concern that these permitted damages could be based on the market value of the related ABS at the time of repudiation, which might mean that the investors would not recover the full outstanding principal amount of the ABS. The FDIC has addressed that concern by saying that the damages for transactions within this safe harbor would equal the par value of the ABS at the time of receivership,¹² less any principal payments made in the interim.

Transactions covered by this safe harbor would also benefit from the Payments and Servicing Consent, so interest and principal payments due during the conservatorship or receivership (and prior to any repudiation) should continue to be made so long as collections on the underlying assets are sufficient to cover those payments.¹³ Finally, transactions in this safe harbor would benefit from special consent procedures relating to the automatic stay, enabling secured parties to exercise remedies on an expedited basis upon (i) a monetary default (as defined in the revised Rule) by the FDIC as receiver or conservator, with respect to the subject ABS or (ii) failure by the FDIC to pay damages (as described above) within 10 days after any repudiation of the securitization documents.

Safe Harbor for Off-Balance Sheet Securitizations Completed After the Transition Period. Transactions in this category that meet the new conditions would benefit from substantially the same protection from the repudiation power as is provided by the existing Repudiation Safe Harbor and would also benefit from the Payments and Servicing Consent. This safe harbor does not include expedited consent for exercise of remedies because the FDIC views the automatic stay as generally not applying to assets that are not reflected on the sponsor's balance sheet.¹⁴

Safe Harbor for Transition Period and Pre-Transition Period Securitizations. Securitizations that satisfied the conditions of the Interim Rule and that were completed prior to or during the Transition Period would generally continue to receive the same benefits as under the Interim Rule and would not have to comply with the market regulating conditions or any new good housekeeping conditions. Securitizations falling in this safe harbor could also benefit from the Payments and Servicing Consent, if they happen to satisfy all of the applicable conditions in the final Rule.

Some changes in defined terms proposed in the NPR can be read as narrowing the scope of this safe harbor, though it is not clear that the FDIC actually intended to narrow the scope. The issues relate to:

RMBS that rely on pool-level external credit support, as these would not be "securitizations" under the revised definition and thus would seem not to be covered by the Transition Period safe harbor, and
Investors holding ABS that represent ownership of an issuing entity, as ABS of this type are not "obligations" under the revised definitions.

The NPR does not discuss any narrowing of the Transition Period safe harbor. To the contrary, the NPR states that this safe harbor is intended to continue the safe harbor provided by the Interim Rule.¹⁵ Consequently, it is likely that the arguable narrowing by the definitions discussed above was not intentional, and we hope that the FDIC will confirm this when finalizing the amendments to the Rule.

Summary. The following table summarizes how each of the proposed safe harbors deals with the FDIC's repudiation, automatic stay and avoidance powers, as well as the applicability of the proposed market regulating conditions.

	POST-TRANSITION PERIOD TRANSACTIONS		TRANSITION PERIOD TRANSACTIONS
	On Balance Sheet	Off Balance Sheet	TRANSITION PERIOD TRANSACTIONS
Market Regulating Conditions	Required	Required	Not required¹⁶
Repudiation Power	Damages covering par balance in the event of repudiation	Safe harbor in rule	Safe harbor in rule
Automatic Stay Payments and Servicing Consent Expedited consent for remedies	Applies Available upon monetary default or repudiation	Applies Should not be necessary, as stay should not apply	Applies if new conditions satisfied¹⁷ Should not be necessary, as stay should not apply ¹⁸
Avoidance Power	Safe harbor in rule	Safe harbor in rule	Safe harbor in rule¹⁹

The Conditions

Paragraphs (b) and (c) of the proposed revised Rule set out conditions that a securitization would have to satisfy in order to qualify for either of the safe harbors available for post-Transition Period transactions, as well as the Payments and Servicing Consent. Paragraph (b) sets out the market regulating conditions, including some that would apply to all ABS and some that would apply only to RMBS. We have summarized the proposed market regulating conditions in the following table.

CONDITIONS APPLICABLE TO ALL ABS	ADDITIONAL CONDITIONS FOR RMBS ONLY
Capital Structure and Financial Assets Conditions
Resecuritizations and CDOs only qualify if investors have access to disclosure on the underlying assets consistent with the new disclosure requirements below. Payments of principal and interest must depend primarily on securitized assets and must not be contingent on extraneous market or credit events, except interest rate and currency mismatches. Synthetic and "unfunded" securitizations are not eligible (but this does not seem to preclude variable funding securities).²⁰	Capital structures limited to no more than six credit tranches (though the most senior may be further divided into time tranches, and resecuritizations can be completed to further tranche²¹). No pool-level credit enhancement (such as surety bonds), though temporary liquidity facilities (such as servicer advances) are permitted within limits
Disclosure
Regulation AB disclosure required in all transactions (both prior to sale and periodically thereafter), whether or not registered. This goes beyond the SEC's recent proposal in that it covers even private placements that do not rely on the SEC's Rule 144A (or 144) or Regulation D. As revised Regulation AB is likely to require loan level disclosure for all asset classes other than credit and charge cards and stranded costs, this requirement effectively requires loan level disclosure for many asset classes other than RMBS. The NPR also sets out detailed disclosure requirements of its own, which largely seem to overlap with existing Regulation AB requirements. Market participants will, however, have to compare the separate requirements carefully with Regulation AB to check for incremental disclosure requirements.		Prior to issuance: loan-level disclosure (including loan type, loan structure, maturity, interest rate and property location); affirm compliance with all applicable legal origination standards for the underlying mortgage loans; disclose a third-party due diligence report on compliance with such standards and the related representations and warranties. Prior to issuance and periodically thereafter, servicers to disclose any ownership in whole loans secured by the same real property as any loan in the securitized pool.
Documentation and Recordkeeping
Must "use as appropriate any available standardized documentation for each different asset class." Must set out all necessary rights and responsibilities of all parties and provide sufficient authority for the parties to fulfill their respective duties and exercise their rights.		Servicers must be authorized to mitigate losses consistent with maximizing the net present value of the underlying mortgage loans, modify the loans to address reasonably foreseeable default and generally to maximize value and minimize losses on the loans. Servicers must act for the benefit of all investors, not any particular class, and must commence action to mitigate losses no later than 90 days delinquent. Servicers must not be required to advance delinquent principal and interest for more than three payment periods, unless financing or reimbursement facilities are available (which must not depend upon foreclosure proceeds).
Compensation
NA		Compensation to rating agencies and similar third-party evaluation companies to be payable in part (at least 40 percent) over five years after issuance of the related ABS, based on performance of surveillance services and performance of the underlying loans. Compensation for servicers must provide incentives for servicing which maximizes the net present value of the underlying loans (which may include payments for specific services and actual expenses).
Origination and Retention Requirements
Sponsors must retain at least a 5 percent economic interest in the transaction, either through a "vertical slice" of all tranches or retention of a five percent representative sample of the securitized assets. This goes beyond the SEC proposal, which applied only to ABS issued under shelf registration statements. Required retentions cannot be hedged (although interest rate and currency hedging are permitted, as under the SEC's proposals²²).		Five percent reserve fund required to cover repurchases of ineligible assets; may be released after one year. Underlying loans must have been originated in compliance with all applicable legal origination standards, including underwriting at the fully indexed rate, based upon the borrowers' ability to repay the loan; must rely on documented income and comply with existing supervisory guidance.

Paragraph (c) sets out an expanded set of good housekeeping conditions (e.g., arms length, bona fide transactions; written agreements with proper corporate approval), which include some that may be problematic:

Paragraph (c)(1) adds a requirement that the obligations issued in the transaction must not be sold to an affiliate or insider (an even tighter standard than a controversial proposal included in the December release).
Paragraph (c)(6) requires that transfers and the duties of a transferor as such must be evidenced in a separate agreement from duties of the same entity in other capacities (e.g., as servicer), which will necessitate changes in the documents for many transactions.

Proposed paragraph (c)(7) (relating to segregation of securitized assets and related records from the general assets and records of the bank) has been revised from the version in the December release and appears much more practicable than the December version.

Non-Safe Harbor Transactions

The safe harbors provided by the Rule have never been the exclusive means for a bank-sponsored securitization to achieve legal isolation, and the NPR confirms this is still the case.²³ Traditionally, the legal isolation analysis for banks has focused on the repudiation power, and the adopting releases for the initial Rule²⁴ and the Interim Rule²⁵ both confirmed that legal true sales completed prior to the appointment of the FDIC as conservator or receiver cannot be repudiated. Although the NPR does not reaffirm this point as clearly as we would have preferred,²⁶ we believe the prior releases stated the law correctly and provide ample support for favorable legal opinions on this point. A similar analysis with respect to the avoidance power generally has not been necessary, as the Avoidance Safe Harbor has never been subject to substantive conditions.

The automatic stay applies to actions relating both to property of a failed bank and to contracts to which the bank is a party. We believe a legal true sale is also effective to avoid the property element of the stay, since assets sold in a true sale would not be property of the bank.²⁷ The applicability of the contractual element would require an analysis of each of the contracts used in a securitization to which the bank is a party, and the potential impact can be limited by reducing the bank's contractual connections to the transaction. While we believe transactions can be structured to avoid material stay risks, the Payment and Servicing Consent makes this much easier and hence provides a strong incentive for banks to comply with the final conditions of the Rule.

Conclusion – Some Initial Issues

The changes proposed in the NPR would add considerably to the complexity of the Rule, including the number and terms of the available safe harbors, the conditions for safe harbor treatment and related definitions. It will take some time for market participants to identify all of the material issues relating to the changes. Initially, the following appear to be the most important types of issues:

Whether the proposed new safe harbor for on-balance sheet securitizations adequately addresses all of the issues necessary for the credit ratings of bank-sponsored ABS to be de-linked from the ratings of the sponsor. The FDIC provided several helpful clarifications on this point, but the rating agencies and investors will be strongly motivated to make sure that nothing slips through the cracks. In particular, we suggest careful review of the timing of interest payments permitted by the Payment and Servicing Consent vis-à-vis the timing of a final principal payment using a damages payment after repudiation.
Many of the proposed market regulating conditions would impose substantive terms that various market participants find objectionable. Now that the FDIC has provided definitive proposals and responded to comments on related issues in the December release, market participants will have to prioritize and fine tune their objections. Among other things, sponsor banks will want to minimize the differences between the Rule and Regulation AB, as incremental requirements under the Rule could place banks at a competitive disadvantage.
While the FDIC made significant strides in removing subjective elements and ongoing compliance requirements from the market regulating conditions, there are still conditions that are not as clear as they could be. To the extent that these conditions survive in the final revisions, we hope that the FDIC will clarify them further.
The proposed new prohibition on sales of ABS to affiliates must be clarified or modified, as affiliates of sponsoring banks often hold some of the ABS issued in bank-sponsored transactions. In addition, any risk retention requirement in the final Rule should permit retention by a sponsor or its affiliates(like the SEC proposal), not exclusively the sponsor (like the NPR).
The FDIC should confirm that the portion of the final Rule dealing with transactions completed prior to or during the Transition Period is meant to fully continue the benefits of the Interim Rule, with no change in the scope of transactions covered. Similarly, the FDIC should clarify that ABS in the form of beneficial interests in a trust qualify as "obligations" under the final Rule.

Footnotes

1. Federal Register, Vol. 75, p. 27471 (May 17,2010), available at http://edocket.access.gpo.gov/2010/pdf/2010-11680.pdf.

2. We will not discuss the participation portion of the Safe Harbor in this update.

3. Summarized at http://www.mayerbrown.com/publications/article.asp?id=7063&nid=6.

4. We use the term "bank" in this update to refer to all depository institutions with deposits insured by the FDIC.

5. The revised Rule would define "sponsor" as a person or entity that organizes and initiates a securitization by transferring financial assets, either directly or indirectly, including through an affiliate, to an issuing entity, whether or not such person owns an interest in the issuing entity or owns any of the obligations issued by the issuing entity.

6. Summarized at http://www.mayerbrown.com/publications/article.asp?id=8892&nid=6.

7. Summarized at http://www.mayerbrown.com/publications/article.asp?id=7966&nid=6.

8. Summarized at http://www.mayerbrown.com/publications/article.asp?id=8345&nid=6.

9. Summarized at http://www.mayerbrown.com/publications/article.asp?id=8708&nid=6.

10. Changes in proposed definitions create issues as to the availability of the Avoidance Safe Harbor for wrapped transactions and ABS in the form of ownership interests in issuing entities. As discussed in connection with the Transition Period safe harbor, it is not clear that any narrowing was actually intended.

11. Available at http://edocket.access.gpo.gov/2008/pdf/E8-17168.pdf. The NPR discusses the similarity between this safe harbor and the covered bond policy statement at p. 14.

12. The proposed language refers only to receivership, but presumably conservatorship is also intended. We hope the FDIC will correct this point in finalizing the changes to the Rule.

13. See assurance provided by the FDIC on this point at pp. 43-44 of the NPR.

14. See, e.g., discussion of the stay at NPR, pp.6-7.

15. NPR, pp. 1 and 40.

16 However, changes in proposed definitions create issues for wrapped transactions and ABS in the form of ownership interests in issuing entities.

17. In addition, the FDIC stated in a press release relating to the Interim Rule that the automatic stay would not apply to assets transferred in a transaction that qualified under that rule.

18. In connection with the adoption of the Interim Rule, the FDIC issued a press release stating essentially that the automatic stay would not apply to assets transferred in securitizations covered by the Interim Rule.

19. Changes in proposed definitions create issues for wrapped transactions and ABS in the form of ownership interests in issuing entities.

20. See pp. 24-25.

21. NPR, p. 23.

22. NPR, p. 37.

23. NPR, p. 20.

24. Federal Register, Vol. 65, p. 49189, 49191 (August 11, 2000).

25. Federal Register, Vol. 74, p. 59066 at 59067 (November 17, 2009).

26. Instead, the FDIC states more narrowly that "the power to repudiate a contract is not a power to recover assets that were previously sold and are no long reflected on the book and records of an [insured depository institution]" and explicitly declines to provide any comfort as to transactions falling outside the proposed safe harbors. NPR, p. 20.

27. See NPR, p. 7: "An FDIC receiver generally makes a determination of what constitutes property of an IDI [insured depository institution] based on the books and records of the failed IDI. If a securitization is reflected on the books and records of an IDI for accounting purposes, the FDIC would evaluate all facts and circumstances existing at the time of receivership to determine whether a transaction is a sale under applicable law or a secured loan." It is hard to see why the FDIC would make the evaluation referred to in the second sentence unless it viewed the legal sale characterization as affecting the powers of the receiver.

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United States: FDIC Proposal Links Market Reform to the Securitization Safe Harbor