the form of mortgage-backed securities (MBS) or other asset-backed
securities, and 3.0 percent was in the form of non-U.S. agency backed
(private label) MBS or asset-backed securities. For comparison, 32.9
percent of all debt issued was U.S. Treasury debt, and 5.6 percent was
municipal debt at the end of 2013.\412\ Figure 1 shows the percentage
breakdown of total non-agency issuances from 2009 to 2013 for various
asset classes excluding short term asset-backed securities, such as
asset-backed commercial paper (ABCP) or Tender Option Bonds (TOBs) and
excluding collateralized loan and debt obligations (CLOs and
CDOs).\413\ Consumer credit categories, including asset-backed
securities backed by automobile loans and leases and credit card
receivables, comprise 37 percent and 14 percent of the total annual
issuance volume, respectively. Non-agency RMBS and CMBS comprise 4
percent and 18 percent of the market, respectively, while asset-backed
securities backed by student loans account for 9 percent of the market.
Below the Commission analyzes the variation in issuance among these
five largest asset classes. For several categories, the Commission
outlines detailed information about issuance volume and the number of
active sponsors (Tables 2 and 3).
---------------------------------------------------------------------------

    \412\ Source: SIFMA Statistics available at http://www.sifma.org/research/statistics.aspx, accessed on July 11, 2014.
    \413\ To estimate the size and composition of the private-label
securitization market, the Commission uses data from the Securities
Industry and Financial Markets Association (SIFMA) and Asset-Backed
Alert. It is not clear how corporate debt repackagings are
classified in these databases. In the following analysis, the
Commission excludes all securities guaranteed by U.S. government
agencies. ABCP is a short-term financing instrument and is
frequently rolled over; thus, its issuance volume is not directly
comparable to the issuance volume of other asset classes of asset-
backed securities.
[GRAPHIC] [TIFF OMITTED] TR24DE14.000

    Prior to the financial crisis of 2008, the number of non-agency
RMBS issuances was substantial. For example, new issuances totaled
$760.3 billion in 2005 and peaked at $801.7 billion in 2006. Non-agency
RMBS issuances fell dramatically in 2008, to $34.5 billion, as did the
total number of sponsors, from a high of 80 in 2006 to 27 in 2008. In
2013, there was only $25.2 billion in new non-agency RMBS issuances by
22 separate sponsors.

              Table 2--Annual Issuance Volume and Number of Sponsors by Offering Type for Asset-Backed Securities Backed by Consumer Loans
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                     Credit Card ABS                       Automobile ABS                      Student Loan ABS
                   Year                   --------------------------------------------------------------------------------------------------------------
                                             SEC      144A    Private   Total     SEC      144A    Private   Total     SEC      144A    Private   Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                 Panel A--Annual Issuance Volume by Offering Type ($ bn)
--------------------------------------------------------------------------------------------------------------------------------------------------------
2005.....................................     61.2      1.8       0.0     62.9     85.1      8.7       0.0     93.9     54.1      8.1       0.4     62.6
2006.....................................     60.0     12.5       0.0     72.5     68.0     12.2       0.0     80.2     54.9     10.9       0.5     66.2
2007.....................................     88.1      6.4       0.0     94.5     55.8      6.8       0.0     62.6     41.7     16.0       0.6     58.3
2008.....................................     56.7      5.0       0.0     61.6     31.9      5.7       0.0     37.6     25.8      2.4       0.0     28.2
2009.....................................     34.1     12.5       0.0     46.6     33.9     15.4       0.0     49.2      8.3     12.5       0.0     20.8
2010.....................................      5.3      2.1       0.0      7.5     37.9     15.3       0.0     53.2      2.8     16.2       1.2     20.2
2011.....................................     10.0      4.8       1.5     16.3     41.9     14.4       0.0     56.3      2.5     13.9       1.1     17.5
2012.....................................     28.7     10.5       0.0     39.2     65.6     13.9       0.0     79.5      6.6     23.2       0.0     29.9
2013.....................................     32.0      3.1       0.0     35.1     62.5     12.8       0.0     75.2      6.5     14.9       0.0     21.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                   Panel B--Annual Number of Sponsors by Offering Type
--------------------------------------------------------------------------------------------------------------------------------------------------------
2005.....................................       13        5         0       17       30        9         0       38       13        7         1       19
2006.....................................       10       11         0       18       23       12         0       30        8       17         1       24
2007.....................................       12        8         0       16       23        9         0       28        7       17         1       22
2008.....................................        9        3         0       11       16        8         0       21        3        6         0        8
2009.....................................        9        6         0       11       13       13         0       22        3        6         0        6
2010.....................................        5        5         0        9       19       15         0       27        2       18         1       19
2011.....................................        5        7         1       12       14       16         0       25        1       19         1       20
2012.....................................        7        9         0       13       18       24         0       36        1       26         0       26
2013.....................................        9        5         0       14       17       19         0       32        1       22         0       22
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes: The numbers in the table were calculated by staff from the Commission's Division of Economic and Risk Analysis (DERA) using the Asset-Backed
  Alert database. The deals are categorized by offering year, underlying asset type, and offering type (SEC registered offerings, Rule 144A offerings,
  or traditional private placements). Automobile asset-backed securities include asset-backed securities backed by automobile loans and leases, both
  prime and subprime, motorcycle loans, and truck loans. Panel A shows the total issuance amount in billions of dollars. Panel B shows the number of
  unique sponsors (based on sponsor name) of ABS in each category (the number in the column ``Total'' may not be the sum of the numbers in the columns
  ``SEC'', ``144A'' and ``Private'' because some sponsors may sponsor deals in several categories). Only asset-backed securities classified by Asset-
  Backed Alert as deals sold in the U.S. and sponsors of such deals are counted.

       Table 3--Annual Issuance Volume and Number of Sponsors by Offering Type for Real Estate-Backed ABS
----------------------------------------------------------------------------------------------------------------
                                        Non-agency RMBS                                  CMBS
          Year           ---------------------------------------------------------------------------------------
                             SEC        144A     Private     Total       SEC        144A     Private     Total
----------------------------------------------------------------------------------------------------------------
                             Panel A--Annual Issuance Volume by Offering Type ($ bn)
----------------------------------------------------------------------------------------------------------------
2005....................      738.5       21.7        0.0      760.3     136.23      34.44       0.00     170.68
2006....................      727.1       74.6        0.0      801.7     161.76      41.05       0.00     202.81
2007....................      634.8       80.4        0.0      715.3     190.57      40.58       0.00     231.15
2008....................       12.2       22.3        0.0       34.5      10.71       1.49       0.00      12.20
2009....................        0.0       48.1        0.0       48.1       0.00       6.86       0.00       6.86
2010....................        0.2       67.2       12.8       80.3       0.00      19.54       0.00      19.54
2011....................        0.7       40.8        9.7       51.3       8.45      26.05       0.00      34.50
2012....................        1.9       27.0        0.0       29.0      32.56      18.68       0.00      51.24
2013....................        4.0       21.1        0.0       25.2      53.07      33.27       0.00      86.35
----------------------------------------------------------------------------------------------------------------
                               Panel B--Annual Number of Sponsors by Offering Type
----------------------------------------------------------------------------------------------------------------
2005....................         54         21          0         60         41         42          0         61
2006....................         55         43          0         80         39         40          0         57
2007....................         53         45          0         78         43         29          0         54
2008....................         12         22          0         27         19          2          0         21
2009....................          0         17          0         17          0         13          0         13
2010....................          1         26          1         28          0         25          0         25
2011....................          1         16          2         18         16         31          0         31
2012....................          1         20          0         21         26         33          0         56
2013....................          1         22          0         22         32         57          0         83
----------------------------------------------------------------------------------------------------------------
Notes: The numbers in the table were calculated by DERA staff using the Asset-Backed Alert and Commercial
  Mortgage Alert databases. The deals are categorized by offering year, underlying asset type, and offering type
  (SEC registered offerings, Rule 144A offerings, or traditional private placement). Non-agency RMBS include
  residential, Alt-A, and subprime RMBS. Panel A shows the total issuance amount in billions of dollars. Panel B
  shows the number of unique sponsors (based on sponsor name) of asset-backed securities in each category (the
  number in the column ``Total'' may not be the sum of the numbers in the columns ``SEC'', ``144A'' and
  ``Private'' because some sponsors may sponsor deals in several categories). Only asset-backed securities deals
  classified by Asset-Backed Alert as sold in the U.S. and sponsors of such deals are counted.

    Similar to the market for non-agency RMBS, the market for CMBS also
experienced a decline following the financial crisis. There were
$231.15 billion in new issuances at the market's peak in 2007. New
issuances fell to $12.20 billion in 2008 and to $6.86 billion in 2009.
In 2013, there were $86.35 billion in new CMBS issuances.
    While the markets for asset-backed securities backed by credit card
receivables, automobile loans and leases, and student loans experienced
a similar decline in issuances following the financial crisis, the
issuance trends in Table 2 indicate that they have rebounded
substantially more than the non-agency RMBS and CMBS markets. Asset-
backed securities collateralized by automobile loans and leases
currently have the largest issuance volume and the largest number of
active sponsors of asset-backed securities among all asset classes.
There were $75.2 billion in new asset-backed securities issuances
collateralized by automobile loans and leases in 2013 from 32 sponsors.
This amount of new issuances is approximately twice the amount of new
issuances in 2008 ($37.6 billion) in this asset class and is similar to
the amount of new issuances in this asset class from 2004 to 2007.
    Although the amount of new issuances of asset-backed securities
backed by credit card receivables has not fully rebounded from pre-
crisis levels, it is currently substantially larger than in recent
years. There were $35.6 billion in new issuances of asset-backed
securities backed by credit card receivables in 2013, a five-fold
increase over the amount of new issuances in 2010 ($7.5 billion). The
number of sponsors of such transactions has remained steady over time,
totaling 14 in 2013. The amount of new issuances of asset-backed
securities backed by student loans has also not fully rebounded from
pre-crisis levels.\414\ There were $21.3 billion in new issuances of
asset-backed securities backed by student loans in 2013, compared to a
range from $45.9 billion to $58.3 billion between 2004 and 2007. The
number of sponsors of such transactions has returned to pre-crisis
levels, totaling 22 in 2013.
---------------------------------------------------------------------------

    \414\ The elimination of the Federal Family Education Loan
Program (FFELP), a federally guaranteed student loan program, in
March 2010 may be a significant contributor to the decline in the
issuance of asset-backed securities backed by student loans as no
subsequent loans were permitted to be made under the program after
June 2010.
---------------------------------------------------------------------------

    In addition to these asset classes, sponsors will have to retain
risk for all issuances of asset-backed securities, including equipment
loans and leases, corporate debt repackagings, TOBs, ABCP, CDOs and
CLOs.
    Information describing the amount of issuances and the number of
sponsors in the ABCP markets is not readily available. Information on
the total amount of issuances outstanding indicates that the ABCP
market has decreased since the end of 2006, when the total amount
outstanding was $1,081.4 billion, or 55 percent of the entire
commercial paper market.\415\ As of the end of 2013, there were $254.7
billion of ABCP outstanding, accounting for less than 25 percent of the
commercial paper market.
---------------------------------------------------------------------------

    \415\ Based on information from the Federal Reserve Bank of St.
Louis FRED Economic Data database.

                                Table 4--Commercial Paper (CP) Outstanding ($bn)
----------------------------------------------------------------------------------------------------------------
                                                                                All CP        ABCP share
                              Year                                     ABCP         outstanding         (%)
----------------------------------------------------------------------------------------------------------------
2004............................................................           688.9         1,401.5            49.2
2005............................................................           860.3         1,637.5            52.5
2006............................................................         1,081.4         1,974.7            54.8
2007............................................................           774.5         1,785.9            43.4
2008............................................................           734.0         1,681.5            43.7
2009............................................................           487.0         1,170.0            41.6
2010............................................................           348.1           971.5            35.8
2011............................................................           328.8           959.3            34.3
2012............................................................           319.0         1,065.6            29.9
2013............................................................           254.7         1,086.2            23.4
----------------------------------------------------------------------------------------------------------------
Notes: Source--Federal Reserve.

    Like other asset-backed securities markets, the CLO market went
through the same cycle of high growth right before the crisis in 2005-
2007 followed by steep decline in 2008-2010. However, by 2013 the CLO
market had almost recovered to its pre-crisis level (see Table 5), in
terms of the number of CLO deals per year, the aggregate dollar volume
of issuance, and the number of active sponsors (CLO managers). It
should also be noted that, in most of the years in the table below, the
median sponsor had only one CLO deal sponsored per year.

                 Table 5--Annual Issuance Volume and Number of Sponsors for Arbitrage CLOs \416\
----------------------------------------------------------------------------------------------------------------
                                                                                Total volume,    Unique CLO
                              Year                                     Deals           $ bn          managers
----------------------------------------------------------------------------------------------------------------
2004............................................................              89            30.6              60
2005............................................................             124           56.05              79
2006............................................................             215          106.74             119
2007............................................................             187           95.56             101
2008............................................................              44           22.05              26
2009............................................................               8            2.84               6
2010............................................................               7            2.39               6
2011............................................................              30           12.86              26
2012............................................................             123           55.99              72

2013............................................................             179           85.83              97
----------------------------------------------------------------------------------------------------------------
Notes: The numbers in the table were calculated by DERA staff using the Asset-Backed Alert database. Only
  arbitrage CLOs backed by corporate loans and sold in the U.S. and sponsors of such deals are counted. The
  total issuance amount is in billions of dollars.

b. Current Risk Retention Market Practices
    As noted earlier, the potential economic effects of the final risk
retention requirements will depend on current market practices.
Currently, risk retention is not legally mandated in any sector of the
U.S. asset-backed securities market (with the exception of the FDIC
safe harbor option discussed below where risk retention is one of the
compliance options), although some sponsors of different asset-backed
securities classes do remain exposed to credit risk, at least at
initial issuance, in response to investors' or rating agencies' demand.
The new risk retention requirements will impose a cost on sponsors that
will depend on the amount and form of risk currently retained by a
sponsor of asset-backed securities and the length of time sponsors
remain exposed to such risk. Market practices are different for
different sectors (to the extent that they are applied at all) and
there is no uniform reporting of the types or amounts of risk exposure.
Because of the lack of aggregated quantitative information relating to
the current risk exposure practices of sponsors, the Commission does
not have full information on the extent to which sponsors remain
exposed to risk. Below the Commission describes current risk exposure
practices for various asset classes based upon its understanding of
these markets and public comment received to date.\417\ Almost all
asset classes include structural features in which sponsors remain
exposed to some amount of credit risk, including RMBS, CMBS, automobile
loans and leases, credit card receivables, equipment loans and leases
and automobile floorplan loans. We note, however, that even if some
sponsors voluntarily retain risk in the form of a combination of
several tranches, including residual interest that adds up to 5 percent
of the principal amount of the deal, the sponsors typically do not
contractually commit in the transaction documents to holding these
interests after the initial sale (however, a rating agency might
downgrade the entire securitization if the residual is sold). Notable
exceptions include: TOBs, CLOs and CMBS where depending on the specific
structure and the funding needs of the sponsor, either the sponsor or a
third party might purchase a residual or equity interest; and
structures in which parties involved in the securitization, other than
the sponsors, retain risk, such as ABCP conduits, in which the seller
of receivables holds a pro rata or residual interest in the receivables
sold to the ABCP conduit.
---------------------------------------------------------------------------

    \416\ The agencies are adopting a risk retention option for CLOs
that meet certain criteria, described herein as ``open-market
CLOs.'' Arbitrage CLOs have many of the features of open-market
CLOs, but as these requirements were not part of the market prior to
this rulemaking, there is no reasonable means of determining which
CLOs would have qualified as an open-market CLO.
    \417\ See also the Board of Governors of the Federal Reserve
System's ``Report to the Congress on Risk Retention'' (October
2010), pp. 41-48, where other mechanisms intended to align
incentives and mitigate risk are described, including alternatives
such as overcollateralization, subordination, guarantees,
representations and warranties, and conditional cash flows as well
as the retention of credit risk. The report also contains a
description of the most common incentive alignment and credit
enhancement mechanisms used in the various securitization asset
classes. The report does not establish the extent to which these
alternatives might be substitutes for the retention of credit risk.
---------------------------------------------------------------------------

    In 2010, the Federal Deposit Insurance Corporation (FDIC) adopted
an amended rule regarding the treatment by the FDIC, as receiver or
conservator of an insured depository institution, of financial assets
transferred by the institution in connection with a
securitization.\418\ If the FDIC does not deem a transfer of assets to
a securitization vehicle a true sale, the FDIC could repudiate
transaction agreements for the securitization, recover financial assets
that had been transferred, and thereby compromise the ``legal
isolation,'' as determined by relevant accounting standards, of the
assets upon which the securitization was predicated.\419\ The FDIC's
rule imposes several new conditions to qualify for a safe harbor from
such repudiation, with risk retention being one of the new conditions.
Thus, in the absence of other forms of ``true sale'' protection,
banking institutions that would like to avoid the potential future FDIC
repudiation of a securitization could retain credit risk. As discussed
below in Section 3.b.iii, some banks sponsoring asset-backed securities
comply with the FDIC safe harbor rule by retaining risk in the form of
a representative sample of the securitized assets--one of the forms of
risk retention permitted under the FDIC's rule.
---------------------------------------------------------------------------

    \418\ See 12 CFR 360.6. Upon their effective date, the final
rule will replace the FDIC regulations and shall exclusively govern
the requirement to retain credit risk for insured depository
institutions.
    \419\ The FDIC would have to pay damages to the securitization
vehicle for any repossessed assets; however, those damages might be
less than the full amount of principal and interest due on
outstanding securities backed by such assets.
---------------------------------------------------------------------------

    Finally, sponsors that intend to market their asset-backed
securities in both the United States and the European Union and that
issue securities after January 1, 2014, may need to retain 5 percent
credit risk to comply with E.U. risk retention rules that, instead of
imposing a direct risk retention obligation on sponsors, regulate the
types of securities that certain investors can buy.\420\ The Commission
does not have data on the fraction or types of asset-backed securities
currently sold in the U.S. that retain credit risk to comply with these
rules or asset-backed securities sold by U.S. sponsors to investors
covered by E.U. risk retention rules.
---------------------------------------------------------------------------

    \420\ Article 122a of the Capital Requirements Directive
mandates that European Economic Area-regulated credit institutions
and investment firms and their affiliates may only invest in
securitization transactions if the original lender, originator or
sponsor of the securitization retains 5 percent of the net economic
interest of the transaction. Related EU Alternative Investment Fund
Manager's Directive imposes similar risk retention requirements on
securitizations that most private equity, real estate investment
services and hedge funds are allowed to invest in.
---------------------------------------------------------------------------

i. Residential Mortgage-Backed Securities
    The Commission understands that sponsors of non-agency RMBS
historically did not generally retain a portion of credit risk in the
form and at a level consistent with the rule being adopted. One study
\421\ finds that, on

average, RMBS deals had a 1.2 percent residual interest by face value
that was proportional to the perceived level of information asymmetry
between the sponsor and ABS investors, although the study could not
determine whether sponsors retained the residual interest or, if
retained, for how long it was held after issuance. Thus, even if
sponsors of RMBS deals were holding the residual interest and were not
selling it to third parties, they were not, on average, retaining 5
percent of the credit risk by face value.\422\ Consequently, as
discussed below, except in the case where exemptions are applicable
(e.g., the QRM exemption), the final risk retention requirements likely
will impose new constraints on RMBS sponsors.
---------------------------------------------------------------------------

    \421\ Taylor Begley and Amiyatosh Purnanandam, Design of
Financial Securities: Empirical Evidence from Private-label RMBS
Deals (2014), University of Michigan working paper. They find that
the size of the residual interest is proportional to the fraction of
no document loans--their proxy for increased information asymmetry
between sponsors and investors.
    \422\ We also note that one of the largest sponsors of
registered RMBS has stated it currently retains some interest in the
RMBS transactions that it sponsors. See Sequoia Mortgage Trust 2013-
1, Final Prospectus filed pursuant to Rule 424(b)(5), File No. 333-
179292-06 filed January 16, 2013; http://www.sec.gov/Archives/edgar/data/1176320/000114420413002646/v332142_424b5.htm.
---------------------------------------------------------------------------

ii. Commercial Mortgage-Backed Securities
    The current risk retention practice in the CMBS market is to retain
at issuance the ``first loss piece'' (riskiest tranche). This tranche
is typically sold to a specialized category of CMBS investor, known as
a ``B-piece buyer.'' \423\ The B-piece investors in CMBS
securitizations often hold dual roles as bond investors, if the assets
remain current on their obligations, and as holders of controlling
interests to appoint special servicers, if the loans default and go
into special servicing. As holders of the controlling interest, they
will typically appoint an affiliate as the special servicer. The B-
piece CMBS investors are typically commercial real estate specialists
who use their knowledge about the securitized assets in the pools to
conduct extensive due diligence on new deals.\424\ The B-piece market
has very few participants.\425\ The B-pieces are often ``buy-and-hold''
investments, and, based on the Commission's knowledge of the asset-
backed securities market, the secondary market for B-pieces is
relatively illiquid at this time. According to one comment letter, a
typical B-piece makes up 2.6 percent of economic and 7 percent of the
notional balance of a CMBS. Thus, the Commission believes the
prevailing market practice for risk retention in the CMBS sector is to
hold less than the final rule's risk retention option for CMBS
sponsors.
---------------------------------------------------------------------------

    \423\ However, not every CMBS deal has a B-piece buyer.
According to Commercial Mortgage Alert, 46 percent of CMBS deals in
2009-2013 had a B-piece buyer.
    \424\ CMBS have much smaller number of underlying loans in a
pool (based on data from Commercial Mortgage Alert, in 2009-2013,
CMBS, on average, had about 100 commercial properties in a pool,
whereas RMBS had about 3,000 assets in a pool and automobile loan/
lease ABS typically had 75,000 assets) and these loans are often not
standardized. Thus, direct management of individual underperforming
loans is often necessary and is much more viable for CMBS than for
other asset classes.
    \425\ Based on Commercial Mortgage Alert data, in 2009-2013,
there were 38 different B-piece buyers with 9 of them participating
in 70 percent of CMBS deals.
---------------------------------------------------------------------------

iii. Master Trusts (Revolving Pool Securitizations)
    Master trusts generally issue multiple series of asset-backed
securities over time, backed by a common pool of securitized assets.
The transaction agreements require the sponsor to maintain the
principal balance of the securitized assets at an amount that is at all
times sufficient to back the aggregate amount of asset-backed
securities outstanding to investors with a specified amount of
collateral above that amount. The principal amount of outstanding
investor ABS interests changes over time as new series are issued or
existing series are paid off. Moreover, as each series is issued, it
begins with a revolving period (typically for some number of years),
during which the investors receive only interest, and cash from
borrower principal repayments on the pool assets are used to buy
additional assets for the pool from the sponsor. This provides the
sponsor with ongoing funding for its operations, and maintains the
level of pool assets over time. Then, at a date specified under the
terms of the series, the revolving phase for the series comes to an
end, and cash from borrower principal repayments on pool assets is used
to repay investors and retire that series of investor ABS interests.
    Sponsors of revolving master trusts often maintain risk exposures
through the use of a seller's interest which is intended to be
equivalent to the sponsor's interest in the receivables underlying the
asset-backed securities. In current market practices, the amount and
form of risk exposure generally depends on the asset class in the
master trust; there is typically more risk exposure for assets with
higher rates of default or that are more difficult to assess. For
example, credit card master trusts sponsors retain economic exposure
through excess spread and fees, while dealer floorplan asset-backed
securities have significant residual exposure. The Commission requested
additional information about current practices and data from market
participants, but none was provided. As a result, the Commission does
not have reasonably accessible data about revolving master trusts that
would permit it to estimate current market practice about the amount of
risk exposure held by sponsors.
    As discussed above, banks sponsoring asset-backed securities that
intend to comply with the FDIC safe harbor rule could retain 5 percent
of credit risk of the securitized pool. Some banks that use trust
structures to sponsor asset-backed securities backed by automobile
loans and leases use one of the allowed options under the FDIC rule,
the representative sample option, to comply with the safe harbor rule
requirements. Under this option, the sponsor randomly selects a
separate pool of receivables that represents the characteristics of the
securitized pool of assets and holds it on their balance sheet.\426\
---------------------------------------------------------------------------

    \426\ See, for example, Bank of America Auto Trust 2012-1
(http://www.sec.gov/Archives/edgar/data/1488082/000119312512149853/d309744d424b3.htm) or Ally Auto Receivables Trust 2012-3 (http://www.sec.gov/Archives/edgar/data/1477336/000119312512243201/d357186d424b5.htm).
---------------------------------------------------------------------------

iv. Other Asset-Backed Securities
    The current market practices for other categories of asset-backed
securities that serve to align the interests of the sponsor and
investors vary across asset classes. The Commission understands that
sponsors of automobile loans typically maintain exposure to the quality
of their underwriting by retaining a significant residual interest in
their securitization transactions. However, there is insufficient data
available to the Commission to estimate the fair value of these
retained residual interests. Also, as discussed above, some banking
institutions that are affiliated with a sponsor of asset-backed
securities collateralized by automobile loans and leases retain a 5
percent representative sample to comply with the FDIC safe harbor rule.
As noted above, the final rule does not include a representative sample
option. The Commission also understands that many sponsors of asset-
backed securities backed by student loans did not retain credit risk as
many were federally guaranteed. Sallie Mae, the largest sponsor of
student loan asset-backed securities, typically retains through an
affiliate a residual interest in the form of overcollateralization in
the securitizations that it sponsors.
v. Asset-Backed Commercial Paper
    ABCP is a type of asset-backed security that is typically issued to
investors by a special purpose vehicle (commonly referred to as a
``conduit'')

sponsored by a financial institution. The commercial paper issued by
the conduit is collateralized by a pool of asset-backed securities,
which may change over the life of the entity. ABCP conduits generally
purchase longer-term assets financed by the issuance of shorter-term
liabilities, and the liabilities are ``rolled,'' or refinanced, at
regular intervals.\427\
---------------------------------------------------------------------------

    \427\ See Original Proposal at Sec.  __.9.
---------------------------------------------------------------------------

    In a typical ABCP conduit transaction, the sponsor's customer (an
``originator-seller'') sells loans or receivables to an intermediate,
bankruptcy remote special purpose vehicle (SPV). The credit risk of the
receivables transferred to the intermediate SPV then typically is
separated into two classes--a senior ABS interest that is acquired by
the ABCP conduit and a residual interest that absorbs first losses on
the receivables and that is retained by the originator-seller. The
residual interest retained by the originator-seller typically is sized
with the intention that it be sufficiently large to absorb all losses
on the underlying receivables.
    In this structure, the ABCP conduit issues short-term ABCP that is
collateralized by the senior ABS interests purchased from one or more
intermediate SPVs, which are, in turn, supported by the subordination
provided by the residual ABS interests retained by the originator-
sellers (i.e., the sponsors of underlying ABS interests would be
subject to risk retention requirements). The sponsor of this type of
ABCP conduit, which is usually a bank or other regulated financial
institution or their affiliate, also typically provides (or arranges
for another regulated financial institution or group of financial
institution to provide) 100 percent liquidity coverage on the ABCP
issued by the conduit. This liquidity coverage typically requires the
support provider to provide funding to, or purchase assets or ABCP
from, the ABCP conduit in the event that the conduit lacks the funds
necessary to repay maturing ABCP issued by the conduit.
    Commenting on the original proposal, ABCP conduit sponsors noted
that there are structural features in ABCP securitizations that align
the interests of the ABCP conduit sponsor and the ABCP investors. For
instance, commenters stated that ABCP conduits usually have some mix of
credit support and liquidity support equal to 100 percent of the ABCP
outstanding. In the view of commenters, this liquidity and credit
support exposes the ABCP conduit sponsor to the quality of the assets
in an amount that far exceeds 5 percent of the fair value of the
outstanding ABCP.\428\
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    \428\ See footnote 395 for the general agencies position on
acceptability of unfunded arrangements as forms of risk retention.
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vi. Collateralized Loan Obligations
    A collateralized loan obligation (CLO) is an asset-backed security
that is typically collateralized by portions of tranches of senior,
secured commercial loans or similar obligations of non-investment grade
borrowers.\429\ CLOs are organized and initiated by a CLO manager,
usually when the CLO manager partners with a structuring bank that
assists in financing asset purchases that occur before the formation of
the CLO.\430\ The CLO manager actively manages the asset portfolio and
earns management fees and performance fees for investment management
services provided to the CLO.
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    \429\ The term ``CLO'' is also used to refer to the special
purpose vehicle that issues the asset-backed securities and the
overall securitization structure.
    \430\ Report to the Congress on Risk Retention, Board of
Governors of the Federal Reserve System, at 22 (Oct. 2010),
available at http://federalreserve.gov/boarddocs/rptcongress/securitization/riskretention.pdf.
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    The Commission understands that CLO managers often retain a small
portion--significantly less than 5 percent--of the residual interest,
although the party retaining the risk may vary depending on the CLO.
Some types of CLO managers are more likely to hold a significant
residual interest in their CLO, while others are more likely to secure
a third-party equity investor to purchase the residual interest.
According to one commenter, a common CLO market practice is for the CLO
manager to hold 5 percent of the residual interest, which is typically
around 8 percent of the value of the CLO at issuance.\431\ This level
of retention equates to approximately 0.4 percent of the value of the
CLO.
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    \431\ In general, the size of the equity tranche increases in
downturns and decreases in booms. See Updating the CLO Primer, Bank
of America/Merrill Lynch, July 2012.
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    The Commission understands that many CLO structures use
overcollateralization--the amount by which the face value of the
underlying loan portfolio \432\ exceeds the face value of the
outstanding asset-backed securities--which many CLO managers consider
as a form of risk retention because the value of the
overcollateralization is ascribed to the residual interest. For
example, the current senior overcollateralization for older vintage CLO
1.0 deals (CLO structure used before the crisis) is 132 percent, while
for CLO 2.0 deals (the structure used for newer CLO) it is 135
percent.\433\ This means that a CLO 1.0 deal has $132 supporting every
$100 of the most senior tranche outstanding. The amount of
overcollateralization for the entire CLO structure would be much lower
because it would also include mezzanine and subordinate bonds in
addition to the residual interest. The agencies do not consider
overcollateralization by face value to be an acceptable form of risk
retention because the face values of both the securitized assets and of
the ABS interests can materially differ from their relative value and/
or cost to the sponsor.\434\
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    \432\ The face value of the underlying loans may be adjusted in
accordance with the CLOs transaction documents to reflect
concentration limits, delinquencies and/or discounted purchase
prices.
    \433\ Asset-Backed Alert, July 11th, 2014.
    \434\ As discussed below, the final rule does give sponsors
credit for overcollateralization to the extent the fair value of the
horizontal form of risk retention takes into consideration the fair
value of the overcollateralization.
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    The Commission requested comments on whether any practices in the
CLO market reflected risk retention as envisioned by the proposed rule.
Many commenters indicated that the proposed rule requirements would
change current practices and therefore substantially impact the CLO
market. No commenter indicated the presence of, or development towards,
risk retention practices that would satisfy the requirements of the
proposed rule. Some commenters described the amount of risk retention
currently held and how managers of CLOs often retain a small portion of
the residual interest and asserted that sponsors retain risk through
subordinated management and performance fees that have performance
components that depend on the performance of the overall pool or junior
tranches.\435\
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    \435\ The agencies have not recognized subordinated management
fees as an acceptable form of risk retention in the final rule
because, if the CLO underperforms, subordinate management fees may
not align the interests of the manager with those of investors. See
also footnote 395 for the general agencies position on acceptability
of unfunded arrangements as forms of risk retention.
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vii. Tender Option Bonds
    There are two typical tender option bonds (TOBs) structures that
generally have different amounts of risk retention. One type of TOB is
a bank-sponsored TOB where a single bank and its affiliates serve as
the sponsor, residual holder and liquidity provider; in this structure,
the bank will typically hold nominal equity. Commenters noted that the
bank's credit exposure is significantly greater than 5 percent because
it is the provider of 100 percent

liquidity support. The second type of TOB is one in which the bank that
is the liquidity provider does not hold the residual interest; in this
case the TOB residual holder will retain a more significant amount of
risk. Other features of TOBs include a put feature as part of the bond
that allows investors to put the bond back to the sponsor and a 100
percent liquidity support. The Commission requested data on current
market levels of risk retention for TOBs but received no data from
commenters.
4. Analysis of Risk Retention Requirements
    As discussed above, the agencies are adopting the rule requiring
sponsors of asset-backed securitizations to retain risk. Each of the
asset classes subject to the final rule has its own particular
structure and, as a result, the implementation and impact of risk
retention will vary across asset classes, although certain attributes
of risk retention are common to all asset classes. In this section, the
Commission discusses those aspects of the final rule that apply across
a broad range of asset classes: The requirement that sponsors hold 5
percent of the credit risk of a securitization; the use of fair value
of the securitization to measure the amount of horizontal risk retained
by the sponsor; and the length of time that a sponsor will be required
to hold its risk exposure.
a. Level and Measurement of Risk Retention
i. Requirement To Hold Five Percent of Risk
    Section 15G requires the agencies to jointly prescribe regulations
that require a sponsor to retain not less than 5 percent of the credit
risk of any asset that the sponsor, through the issuance of ABS,
transfers, sells, or conveys to a third party, unless an exemption from
the risk retention requirements for the securities or transaction is
otherwise available. The agencies reproposed a requirement to hold a
minimum 5 percent base risk retention for most ABS transactions that
are within the scope of Section 15G, with some exemptions.
    Commenters did not comment specifically on the discussion of the 5
percent risk retention requirement in the Commission's Economic
Analysis in the 2013 reproposal. One commenter did suggest the minimum
amount of risk retention be increased to 20 percent. As discussed in
more detail below, increasing the minimum amount of risk retention
could increase the cost to sponsors and impede capital formation in the
economy by preventing the more efficient reinvestment of the sponsors'
capital, while not necessarily providing significant incremental
benefit to investors. In addition, several commenters suggested risk
retention requirements be determined by reference to asset
quality.\436\
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    \436\ The agencies do not believe that it is necessary or
appropriate to attempt to vary the amount of risk retention based on
the quality of the assets or other, similar, factors. Doing so would
unnecessarily complicate compliance with the rule. Furthermore, as
discussed in the following section, the Commission believes that
requiring risk retention to be measured by fair value adequately
incorporates the quality of the assets. Specifically, it would
calibrate the sponsor's economic exposure to the asset pool
depending on quality of securitized assets. For example, the
Commission notes that if the securitized asset pool consists of low-
quality assets, the value of the residual interest would be
relatively low and a sponsor would have to hold a larger equity
tranche to meet the five percent fair value credit risk exposure
requirement. On the other hand, if the securitized asset pool
consists of high quality assets, the value of the residual interest
would be relatively higher and a sponsor would be able to satisfy
the requirement by holding smaller residual interest. Use of face
value or overcollateralization to avoid the 5 percent risk retention
requirement will not be possible using fair value methodologies
acceptable under GAAP as it would account for the expected losses
associated with the residual interest.
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    The agencies are adopting a 5 percent risk retention requirement as
reproposed. The Commission lacks the data--and commenters did not
provide quantitative information--to allow for analysis of an optimal
level of retained risk, taking into account the goal of aligning the
incentives of the sponsors and the investors in asset-backed
securities. As discussed above, barring any exemption, the required
level of risk retention is set by statute at no less than 5 percent.
Below is a discussion of the trade-offs between setting the level of
required risk retention too high or too low.
    As a general matter, if the required level of risk retention is set
too low, it may not adequately align the incentives of investors and
sponsors. While we recognize that Congress prescribed a minimum level
of risk retention, the Commission is also aware that, as discussed in
the Economic Baseline, sponsors of asset-backed securities in many
asset classes retained less than 5 percent credit exposure to
securitizations in the past. Moral hazard problems persisted at these
lower levels. In contrast, asset classes with relatively higher levels
of risk retention (e.g., asset-backed securities backed by auto loans
and leases) performed relatively better throughout the financial
crisis.
    A level of risk retention that is set too high, however, could lead
to inefficient deployment of capital by unduly restricting a sponsor's
ability to structure new deals. If sponsors are limited in their
ability to secure the necessary financing to retain the required amount
of credit risk in their intended offerings, then this could adversely
impact the flow of capital from ABS investors to originators of the
assets intended for securitization. Hence, excessive required risk
retention levels may lead to less capital available to lenders,
potentially increasing borrowing rates as borrowers compete for a more
limited supply of credit. In this scenario, the reduction in capital
formation would have a negative impact on competition due to the
increased cost of securitizing non-qualified assets, disadvantaging
their ability to be financed by ABS investors relative to qualified
assets and other sources of capital.
ii. Measurement of Risk Retention Using Fair Value
    The agencies are adopting a requirement for sponsors to measure
risk retention of an ``eligible horizontal residual interest'' (EHRI)
using a fair value measurement framework consistent with GAAP. As
described in the 2013 reproposal, the agencies believe that measuring
risk retention with a fair value measurement framework will align the
measurement more closely with the credit risk of a securitization
transaction than alternative frameworks. The agencies are not requiring
vertical interests to be measured using a fair value measurement
framework, as proposed, because they were persuaded by commenters that
such measurement is not necessary to ensure that the sponsor has
retained 5 percent of the credit risk of the ABS interests issued.
    Commenters generally supported basing the measurement of the
horizontal risk retention requirement on fair value. Some commenters
raised general concerns with the proposed method by which sponsors
would be required to measure their risk retention because some sponsors
do not currently use fair value calculations. Thus, requiring such
sponsors to measure their risk retention with fair value would create
significant burden and expense. Commenters also expressed several
specific accounting concerns regarding use of fair value to measure
risk retention. Specifically, they expressed concern regarding the
timing of the pre-sale fair value disclosure requirement. Commenters
noted that the most objective and accurate way to calculate the fair
value of the residual interest is to base the valuation on observable
market prices for the remaining securities; however, because the
reproposal required that sponsors

calculate the fair value of the residual interest in advance of the
final pricing of the issued securities, the fair value of the residual
interest would have to be calculated using estimates of final pricing
levels. Commenters asserted that potential differences between the pre-
sale fair value calculated using estimated pricing levels and the post-
closing fair value calculated using actual pricing levels would confuse
investors.
    To provide investors with sufficient information to allow them to
evaluate whether the sponsor's estimated calculation of fair value was
reasonable, the proposed rule would have required sponsors to disclose
the key inputs and assumptions used in measuring fair value and the
sponsor's technique(s) used to derive the key inputs and assumptions.
Many commenters expressed concerns about the proposed requirement,
indicating that the proposal would require sponsors to disclose
information that is proprietary, highly confidential and commercially
sensitive, which could be used by third parties to the competitive
disadvantage of the sponsor. Other commenters suggested significant
modifications to the disclosure requirements. For example, several
commenters asserted that sponsors should only be required to make
disclosures to the Commission and banking agencies, rather than to
investors. Significant concern was raised regarding potential liability
and litigation that commenters indicated may result when fair value
projections, assumptions and calculations disclosed to investors turn
out to be incorrect.
    A few commenters asserted that for simple structures, sponsors
should not be required to make fair value determinations or related
disclosures, nor should the cash flow restriction (as described below)
apply. Several commenters requested that the final rule should not
require sponsors to measure and disclose the fair value of eligible
vertical interests, so long as the underlying ABS interests have either
a principal or notional balance. The commenters noted that a 5 percent
interest in the cash flow of each class would always be equivalent to 5
percent of the fair value of each class. In this regard, the commenters
asserted that requiring fair value measurement and disclosures for the
vertical option would be unnecessary for ensuring compliance with the
rule.
    The final rule does not require sponsors holding risk retention in
a vertical form to measure and disclose the fair value of their
vertical risk retention. With the vertical form of risk retention,
requiring sponsors to measure and disclose the fair value would impose
additional cost on the sponsor with little, if any, corresponding
enhancement of investors' ability to evaluate and understand the amount
of credit risk exposure of the sponsor. This is because 5 percent of
the fair value of each tranche will be equal to 5 percent of face value
of each tranche. Therefore, if investors know that a sponsor is holding
5 percent of each tranche, they will be able to assess the credit
exposure of the sponsor regardless of whether it is face value or fair
value.
    Using a fair value measurement framework acceptable under GAAP, as
applicable, to value the EHRI will provide a number of benefits. First,
it allows investors and sponsors to objectively measure and understand
the amount of credit risk exposure of the sponsor. The use of fair
value is intended to prevent sponsors from structuring around risk
retention, as may otherwise be the case when using the face value of
residual interests or overcollateralization to measure the amount of
horizontal risk retention. For example, if a sponsor issues $100
million in asset-backed securities at par and retains a first-loss
residual interest with a face value of $5 million, that residual
interest could yield a market value below $5 million given the expected
losses associated with the securitized assets, in which case the
sponsor would be holding less than 5 percent of the deal's value. Use
of face value or overcollateralization to avoid the 5 percent risk
retention requirement will not be possible using fair value
methodologies acceptable under GAAP as it would account for the
expected losses associated with the residual interest. Moreover, and as
a general matter, most investors and sponsors have experience with fair
value methodologies acceptable under GAAP and therefore using it in
this context will help to minimize the costs of evaluating the amount
of risk retention held by sponsors because it will be consistent with
other valuation experiences.
    There are also potential costs to investors associated with the use
of a fair value measurement framework. Fair value is a measurement
framework that, for certain types of instruments, where significant
unobservable inputs are used to determine fair value, requires an
extensive use of judgment. Because of this extensive use of judgment,
an investor may be unable to determine if the sponsor's fair value
calculation uses assumptions that are similar to the investor's
assumptions. In order to help mitigate this potential cost, the
agencies also are requiring, as proposed, that the sponsor disclose
specified information about how it calculates fair value. While this
requirement should discourage manipulation, sponsors will incur
additional costs to prepare the necessary disclosures. In addition,
because the final rule specifies that fair value must be determined
using a fair value measurement framework consistent with GAAP, sponsors
will incur costs to ensure that the reported valuations are compliant
with the valuation standard.
    With respect to the disclosure required in order to allow investors
to evaluate and understand the sponsor's fair value calculation, the
reproposal discussed the appropriate level of detail to be provided to
investors. One approach would be to provide the same model inputs
(e.g., prepayment rate, discount rates) that the sponsors used so that
investors could more precisely evaluate the sponsor's fair value
calculations. While sponsors already have the model inputs they use to
calculate fair value, as commenters noted, there may be costs to the
sponsors associated with providing investors with sponsors' proprietary
information. For example, sponsors may base their model inputs on
proprietary information derived from the historical performance data of
their loan pools, information that has commercial value and is often
compiled and sold to market participants who purchase the data in order
to derive model inputs similar to the ones that sponsors would be
required to disclose. Disclosure of the model inputs could thus lower
the commercial value of the historical data. Disclosing their inputs
could also provide competitors--with similar access to historical
performance data--with insight into the sponsor's interpretation or
selection of relevant benchmark data. Access to this insight could
reveal proprietary valuation methods or, as some commenters suggested,
give rise to litigation risk to the extent that there are differences
in opinions on how to interpret the data. Taken together, requiring
sponsors to disclose precise information about their model inputs could
increase the cost to sponsors without necessarily providing additional
benefit to investors.
    To help mitigate these potential costs, the final rule permits the
disclosure of fair value based on estimated ranges for tranche size,
interest rates for each tranche, and underwriting discount. The
information is required to be provided a reasonable amount of time
prior to the sale of the asset-backed security. Also required to be
included are the sponsor's key inputs and assumptions that may be
described as a curve. The rule requires that this disclosure be

updated to reflect actual fair values of the ABS interests sold at the
closing date. This approach may enable investors to make meaningful
assessments of whether a sponsor's fair value calculations are
reasonable prior to making their investment decisions, and at the same
time may help to address sponsors' concerns about disclosing what they
believe to be proprietary information and the timing of the disclosure.
The ranges of pricing information will allow investors to decide if the
sponsor's model input curves are aggressive or conservative compared to
their own expectations based on their experiences and knowledge of the
asset class.
    In the case of revolving pool securitizations, the agencies are
permitting the seller's interest option to be measured using face
value. These securitizations have unique structures described further
below that would address the agencies' concerns about the use of face
value of the ABS interests or the face value of the securitized assets
to circumvent risk retention requirements as described above. This
option recognizes the unique characteristics of certain structures and
the impact of those structures on the alignment of incentives for the
transaction parties. This option also helps to minimize the burden of
fair value disclosure discussed in the reproposal while still allowing
certain structures to have a meaningful amount of risk retained and
addressing some commenters' concerns about using a fair value
measurement framework to measure risk retention. One unique
characteristic is that the vehicle will engage in multiple issuances
for the life of the master trust. Because of this, if the revolving
pool securitization contains poorly underwritten receivables that are
expected to default then, in the future, this will impact the ability
of the sponsor to make future issuances of asset-backed securities
using the revolving pool securitization. The structure of revolving
pool securitizations aligns incentives between sponsors and investors,
reduces the need for fair value measurement that does not bring
benefits to investors, and allows for face value measurement, which
will help to minimize costs for sponsors of revolving pool
securitizations.
b. Duration of the Risk Retention Requirement
    Under the reproposal, sponsors would have been prohibited from
selling or otherwise transferring any interest or assets that they
would be required to retain under the rule to any person other than a
consolidated affiliate for specified time periods. For all ABS other
than RMBS, the specified time period would have been the later of two
years after the closing date of the securitization or when the
aggregate unpaid balance of the ABS interests has been reduced to 33
percent. For RMBS, the specified time period would have been the later
of five years after the closing of the securitization or when the pool
balance has been reduced to 25 percent, but in no event later than
seven years after the closing of the securitization.
    In response to the reproposal, commenters recommended various
modifications to the length of risk retention requirements. Some
commenters suggested lengthening the non-RMBS duration to three years,
while other commenters questioned why only RMBS and CMBS had asset
specific durations and suggested lengthening or shortening periods of
time that were tied to a specific asset class or securitized asset
quality. Finally, some commenters suggested eliminating the alternative
sunset period contingent on the unpaid pool balance.
    The agencies are adopting the sunset provisions as reproposed. The
Commission lacks the data to determine an optimal duration of these
risk retention requirements, and while commenters supported their
positions based on relevant time periods that are tied to securitized
assets, no commenters submitted relevant data or other quantifiable
information. In particular, as stated in the reproposal, these time
periods were chosen to strike a balance between retaining risk long
enough to align the sponsors' and investors' incentives and allowing
the redeployment of retained capital for other productive uses. A
shorter duration was chosen for non-mortgage asset classes, because
these loans tend to have shorter maturities than mortgages and thus it
may not be necessary to retain risk for a longer period. The
alternative sunset component contingent on the reduction of pool
balance further calibrates the required duration of risk retention
based on the remaining balances. By the time the loan pool balance
decreases to 33 percent, the information about the loan pool
performance will be largely revealed, at which point the moral hazard
problem between the sponsor and the investor is likely to be
significantly reduced.
    We recognize that, in the case where the loan pool balance drops
below the prescribed threshold (25 percent for RMBS and 33 percent for
other ABS) before the prescribed number of years (five years for RMBS
and two years for other ABS), the additional required duration might be
costly to the sponsor. A requirement that the sponsor continue to
retain exposure to the securitization once the impact of the initial
uncertainty about the ABS is resolved could potentially impede
allocative efficiency by limiting the sponsor's ability to redeploy
capital to new securitizations or other investment opportunities.
Moreover, as loan balances are paid down, the sponsor may hold more
risk relative to other investors because the size of the credit risk
retention piece is based on the initial size of the securitization and
does not change with the current market value. Thus, sponsors could
face increased levels of risk retention on a percentage of outstanding
basis at the same time retained risk becomes less necessary. While
economic efficiency might be increased in certain circumstances by
allowing sponsors to withdraw their risk retention investment to use in
new securitizations or other credit forming activities,\437\ the
minimum fixed duration of risk retention is appropriate to prevent
structuring securitizations that would be quickly paid off to the
balance threshold points (25 percent or 33 percent) for the purposes of
avoiding risk retention.
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    \437\ See Hartman-Glaser, Piskorski and Tchistyi, 2012, Optimal
Securitization with Moral Hazard. Journal of Financial Economics,
vol. 104, no. 1, April 2012, pp. 186-202. They consider the optimal
design of MBS contracts between a mortgage underwriter that can
engage in costly hidden effort to screen borrowers and investors and
show, among other things, that the maturity of the optimal contract
can be short.
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5. Forms of Risk Retention Menu of Options
    Rather than prescribe a single form of risk retention, the final
rule allows sponsors to choose from a range of options to satisfy their
risk retention requirements. As a standard form of risk retention
available to sponsors of all securitizations, sponsors may choose
vertical risk retention, horizontal risk retention, or any combination
of those two forms. Both the vertical and horizontal forms of risk
retention require the sponsor to share the risk of the securitized
asset pool. The final rule also includes options tailored to specific
asset classes and structures such as revolving master trusts, CMBS,
ABCP, CLOs, and TOBs. Given the special characteristics of certain
asset classes, some of these options permit the sponsor to allocate a
portion of the shared risk to originators, allow the risk to be held by
specified third parties, or

allow the risk to be held in an identical asset outside of the
securitization.
    Commenters generally supported the menu-based approach of providing
sponsors with the flexibility to choose from a number of permissible
forms of risk retention. These commenters believed that this provides
sponsors with the flexibility to structure their risk retention
requirements to accommodate current market practices.
    By adopting a rule that will allow sponsors flexibility to choose
how they retain risk, the agencies seek to enable sponsors to select
the approach that is most cost-effective for them, while still
fulfilling the purposes of Section 15G. As discussed previously, the
agencies are sensitive to the need to balance the goals of risk
retention (reduction of the moral hazard problem and better
underwriting) with the need to facilitate the efficient deployment of
capital. A flexible approach to retaining risk will permit sponsors to
take into account a variety of factors, as discussed in more detail
below.
    Various factors are likely to impact sponsors' preferred method of
retaining risk, including size, funding costs, financial condition,
riskiness of the securitized assets, potential regulatory capital
requirements, return on capital requirements, risk tolerances, and
accounting conventions. All else being equal, sponsors may prefer the
option that involves the least exposure to credit risk. For example,
the horizontal form of standard risk retention creates a fully
subordinated residual interest that is more exposed to the expected
losses of the deal than a similarly sized vertical form, and therefore
is more sensitive to the deal's credit risk. By contrast, a vertical
form of standard risk retention is comparable to a stand-alone pass-
through securitization, which when held by the sponsor, is the form of
risk retention least exposed to a deal's credit risk. As discussed
below, some sponsors may choose to use the horizontal method of risk
retention or some combination of the horizontal and vertical method in
order to meet the risk retention requirement.
    In particular, sponsors have an incentive to calibrate the level of
risk exposure that minimizes their overall cost of funding. For
example, some investors may be more likely to purchase senior ABS
interests if the sponsor retains a larger residual interest and thus
has more ``skin in the game.'' Alternatively, the sponsor may be unable
to sell the residual interest on terms that would minimize the
sponsor's cost of funding. In both instances, sponsors would prefer an
option with a higher level of exposure to credit risk. This might be
particularly true for securitizations that involve riskier or more
opaque assets or more complicated securitization structures. As
discussed previously, the potential need for retaining risk in a more
costly form because the sponsor could not sell the residual interest on
acceptable terms could be attenuated for registered offerings that are
subject to the asset-level disclosure requirements under revised
Regulation AB to the extent that investors are able to quantify risks
using the required loan-level disclosures and are willing to purchase
more of the residual interest on terms acceptable to the sponsor.
    As the Commission discusses below, a number of the options also
attempt to correspond to current market practices. By allowing sponsors
to satisfy their risk retention requirement while still maintaining
current market practices, the proposed menu of options approach should
help to reduce additional costs of the required regime. Moreover, the
flexibility sponsors have to design how they hold credit risk will
allow them to calibrate and adjust their selections for each
transaction according to changing market conditions.
    On the other hand, because sponsors will have a choice on how to
retain risk, their chosen structure may not always align interests and
mitigate risks for investors in the same manner. Thus, to the extent
that some forms of risk retention create disparate incentives for
sponsors and investors,\438\ the ability to rely on those options may
not fully address some of the conflicts of interest that contribute to
the moral hazard problem that characterize securitizations. In
addition, the flexibility of this approach may increase the complexity
of implementation of risk retention because of the wide range of
possible choices available to sponsors.
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    \438\ For example, if a sponsor is affiliated with a servicer
(or has another way to influence the servicing of assets), then
different forms of risk retention may change how distressed assets
are serviced--more to the benefit of all investors or more to the
benefit of junior tranche holders'. In most cases, investors in the
more senior tranches would favor liquidation because liquidation of
the securitized assets would reduce uncertainty and eliminate the
credit risk of a delinquent or defaulted asset and because losses
resulting from such liquidation of the securitized assets would be
absorbed by investors in more subordinated tranches. Alternatively,
investors in more subordinated tranches would favor a modification
of the terms of a defaulted or delinquent asset because modification
potentially could minimize losses.
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a. Standard Risk Retention
    The agencies are adopting the standard risk retention option as
reproposed. In the reproposal, the Commission provided separate
analyses of the economic effects of vertical risk retention, horizontal
risk retention, or any combination of these two forms. Many commenters
generally supported the reproposal to allow a sponsor to meet its risk
retention obligation by using the standard risk retention option and
approved of the flexibility that the proposal would provide to sponsors
in structuring their risk retention. One commenter specifically
expressed support for the single vertical security option, asserting
that it would simplify compliance and monitoring obligations of the
sponsor.
    The agencies continue to believe that it is appropriate to provide
flexibility to sponsors. This approach allows sponsors to minimize
costs by selecting a customized combination of vertical and horizontal
risk retention that suits their individual situation and circumstances,
including relative market demand for the various types of interest that
may be retained under the rule. To the extent that the costs and
benefits of credit risk retention vary across time, across asset
classes, or across sponsors, this approach would implement risk
retention in the broadest possible manner such that sponsors may choose
the combination of vertical and horizontal risk retention that they
view as optimal. For example, if investors are unable to accurately
estimate the risk of the securitized asset, the sponsor may be unable
to sell the residual interest on acceptable terms, which would mean any
excess vertical risk retention would be an additional cost to such a
sponsor. Allowing flexibility will not only benefit sponsors but also
will allow investors' demands to be more easily satisfied.
    Below we discuss the economic implications of particular risk
retention structures.
i. Eligible Horizontal Residual Interest
    Under the eligible horizontal residual interest (EHRI) option,
sponsors would hold the first loss piece, which as described above,
would reflect a larger credit exposure than an equal percentage of
retained risk using a form that included vertical retention. To the
extent that such a holding signals to investors that the information
about the asset portfolio being securitized is accurately represented
and fairly priced, having this option available to sponsors may improve
investor participation and lead to enhanced capital formation. However,
horizontal risk retention used without vertical risk retention may not
fully align sponsor incentives with the incentives of investors in all
of the

tranches or classes. Investors who are investing in the most senior
tranches will have different interests than the sponsor holding the
residual interest, which is the most junior tranche, especially
concerning the servicing of under-performing assets.\439\
---------------------------------------------------------------------------

    \439\ See footnote 438.
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    There are several reasons why a sponsor may choose to hold a
residual interest instead of a vertical interest. Sponsors may be
unable to sell the residual interest or, if they are securitizing
riskier loans, may hold the residual interest to increase investors'
interest in more senior tranches. In particular, to the extent that a
sponsor is willing to incur exposure to the first losses, investors may
be willing to purchase the senior tranches at higher prices. Also, if
sponsors have a cost of capital that is higher than the return provided
by holding vertical risk retention, sponsors may choose to hold more
subordinated tranches and more of the credit risk to generate a return
sufficient to meet their required cost of capital. The holder of the
residual interest generally receives a higher rate of return than any
other tranche of the deal and therefore a sponsor may choose to hold
horizontal risk retention in order to make the deal economically viable
for the sponsor. This would increase the amount of capital available
for riskier loans as sponsors' demand for loans of a higher risk
increases. In all these cases, any requirement to retain a vertical
interest would only impose additional costs on such sponsors.
    In the reproposal, the agencies included cash flow restrictions
with EHRI, reasoning that if sponsors can structure securitizations in
such a way that the residual interest is able to receive cash early on
in the deal then the sponsor's incentive to select loans with better
underwriting may be reduced because the sponsor may be repaid all of
their principal investment (``cash out of the deal'') before losses
accumulate and the deal underperforms.
    Many commenters supported elimination of the cash flow
restrictions. They asserted that these restrictions are incompatible
with a variety of securitization structures, that the certifications
and disclosures to investors that would be required by the proposed
cash flow restriction would create potential liability, and that there
are possible ways around these restrictions such that they will not be
meaningful but only increase costs to sponsors. Commenters also stated
that cash flow restrictions would prohibit almost all securitizations
from being issued as they are designed to pay high interest rates early
on to the residual holder as compensation for risk taken, and that most
of the structures in previously issued asset-backed securities would
have failed the cash flow restriction tests. According to these
commenters, imposing the cash flow restrictions could thus require
current market participants to change their current practices, which
could lead to a reduction or cessation of the securitization markets,
resulting in a decrease in capital formation and reduction in
allocative efficiency.
    After considering the numerous comments received, the agencies have
concluded that the proposed cash flow restrictions on the EHRI (as well
as the alternative described in the reproposal and alternatives
suggested by commenters) could lead to unintended consequences and
impose unnecessary burdens on some asset classes. Therefore, the
agencies have eliminated the previously proposed restrictions from the
final rule. The revised disclosure requirements being adopted relating
to the key inputs and assumptions underlying fair value calculations,
however, should provide investors with the information necessary to
analyze whether the sponsor is being conservative or aggressive in its
estimate of the 5 percent risk retention holding. The rule also
requires disclosure of the material terms of the residual interest. By
providing this information to investors, the disclosure helps mitigate
the concern that sponsors may provide accelerated returns to themselves
through the residual interest since investors will be able assess the
likelihood of such scenario based on this information. Eliminating the
cash flow restriction requirements would eliminate the costs to
sponsors associated with changing their market practice while
potentially promoting competition among the sponsors for alternative
structures that optimize their retention and investor preferences.
ii. Eligible Vertical Interest
    A sponsor relying solely on the vertical option would hold a
percentage of each tranche, resulting in an economic exposure of 5
percent of the credit risk of the entire loan pool. The primary benefit
of vertical risk retention as compared to other standard forms of risk
retention is that investor-sponsor incentives will be equally aligned
across all ABS tranches.
    Vertical risk retention is also subject to less credit risk
exposure, and thus it will be a cheaper method for the sponsor to
satisfy the requirement both in terms of cost of capital and in
measurement and disclosure to investors. There is no requirement for
sponsors to provide a fair value estimate to investors, which could
reduce the cost of retaining risk relative to the costs associated with
the other risk retention options. Vertical risk retention will be
relatively simple for investors to evaluate because the sponsor will
hold a specified percentage of each tranche. However, vertical risk
retention may be less optimal for sponsors who typically hold a first
loss piece with the intent of signaling higher quality of the senior
tranches or for other reasons.
    The benefits of the vertical form of risk retention extend to other
market participants as well. By allowing sponsors to choose a vertical
form of risk retention, there will be increased flexibility to choose
higher yielding assets and provide greater access to credit to viable
but higher-risk borrowers than would otherwise be possible through only
a horizontal form of risk retention. Investors interested in holding
residual interests will benefit from a vertical form of risk retention
as they will be able to purchase more higher-yielding first loss pieces
of securitizations, while investors who demand tranches above the first
loss piece will have less supply available because the sponsor would
hold 5 percent of each tranche instead of holding all of its retained
risk in the residual interest.
    The final rule also permits a single vertical security, as
proposed. All economic considerations that apply to vertical risk
retention will apply to the single vertical security except that the
single vertical security may allow sponsors to comply with risk
retention in a less costly manner in terms of administrative fees and
accounting costs. If the sponsors' costs of risk retention are lower
while still providing the same incentive alignment, then cost of credit
for borrowers may be lower.
iii. Combined Risk Retention Option
    The final rule allows sponsors to retain risk through any
combination of a vertical form and a horizontal form provided that the
total percentages of retained forms in the securitization add up to 5
percent. For example, a sponsor can hold 3 percent in the vertical form
and 2 percent in the horizontal form in reliance on a combination of
the horizontal and vertical forms of risk retention.
    As noted above, horizontal risk retention allows sponsors to
provide a stronger signal about their private information about asset
quality than vertical risk retention because of the increased amount of
credit exposure for

sponsors. Hence, a sponsor choosing to retain risk in a more expensive
horizontal form over a vertical form would have greater exposure to
credit risk, and that sponsor's incentives should be better aligned
with investors'. As previously described, by choosing a higher cost
method of retaining risk, such as through the horizontal form, a
sponsor can signal to the market greater certainty about the quality of
assets and the level of risk in the senior tranches because the sponsor
is willing to incur the losses in the lower subordination. However, the
optimal size of the residual interest for a sponsor that seeks to
maximize the proceeds and minimize the sponsor's overall cost of
funding from securitization may not be 5 percent.
    Finally, sponsors may choose to hold some residual interest in an
attempt to gain a higher return on capital. In this case, again, the
optimal size of the residual interest to achieve sponsor's required
return may not be 5 percent. The combination of the horizontal and
vertical forms reduces costs to sponsors by allowing them to hold some
of their risk retention in the cheaper vertical form while still
receiving credit for the residual interest they retain. Moreover, the
vertical form of risk retention still allows for a more equal alignment
of sponsors' interests with all types of investors because the sponsor
will hold a portion of all of the tranches in the securitization.
    Allowing a flexible combination of the horizontal and vertical
forms accommodates various current market practices. Some asset classes
have been able to monetize more of their exposure to securitized assets
than other asset classes. Typically the range for RMBS has been closer
to 1-3 percent of overcollateralization than to the 5 percent of fair
value for the retained first loss piece required by the final rule.
Thus, the flexible combination of horizontal and vertical forms will
allow sponsors to continue to retain risk as they have in the past
while keeping the cost of risk retention to a minimum.
    The flexibility of the combination of the horizontal and vertical
forms also allows sponsors to better meet demands of investors. If
investors want to hold more of the residual tranche, the sponsor can
hold less risk in the horizontal form and more risk in the vertical
form to be able to sell interests in the residual tranche to investors.
Alternatively, if there is a larger demand for more senior tranches,
then sponsors can hold more risk horizontally. This flexibility will
increase allocative efficiency within the ABS market. The flexible
combination of the horizontal and vertical forms also increases
competition among sponsors because it allows sponsors to adjust several
dimensions of the securitization: risk retention costs, expected
returns on retained pieces, and supply of tranches with different risk
characteristics.
b. Options for Specific Asset Classes and Structures
i. Seller's Interest Option
    The reproposed rule would have allowed a sponsor of a revolving
master trust that is collateralized by loans or other extensions of
credit to meet its risk retention requirement by retaining a seller's
interest in an amount not less than 5 percent of the unpaid principal
balance of the pool assets held by the sponsor. Commenters stated that
the reproposed version of the seller's interest option would not
accommodate all the common market practices in the master trust market.
They suggested methods to broaden the options available to revolving
master trusts to allow a wider variety of market practices to count as
risk retention.
    The agencies are revising the seller's interest option for
revolving pool securitizations (referred to as revolving master trusts
in the reproposal) in the final rule in order to accommodate more of
the practices of sponsors that currently rely on revolving pool
securitizations as an important component of their funding. These
revisions recognize and accommodate the meaningful exposure to credit
risk currently held by sponsors of these revolving pool
securitizations, in light of the heightened alignment of incentives
between sponsors and investors that attaches to their structural
features. The agencies are also making a number of other refinements in
the final rule in order to align the seller's interest option more
closely with the mechanics of revolving pool securitizations as they
are structured in the market today.
    The pari passu seller's interest option in the final rule
represents a special form of exposure to credit risk for the asset-
backed security issued by a revolving pool securitization. Under this
option, the sponsor must maintain the size of the seller's interest
position, most commonly through the ongoing addition of receivables to
the pool or repayment of investor ABS interests. Commenters also
requested that the agencies accommodate other revolving pool
securitizations that are common in the market and rely on a seller's
interest that is structured in a different manner, which varies among
the revolving pool securitizations used for certain asset classes.
Commenters described two different structures, which the agencies
believe should be recognized as an eligible form of risk retention
under the final rule.
    The agencies have recognized a series subordinated seller's
interest in a revolving pool securitization as eligible risk retention
in the final rule. As described by commenters, a series subordinated
seller's interest is a common feature of revolving pool securitizations
for certain asset classes, such as equipment leasing and floorplan
financing. In these revolving pool securitizations, the sponsor is
obligated, as is the case with the pari passu seller's interest, to
maintain an undivided interest in the receivables in the collateral
pool, in an amount equal to a specified percentage of the trust's
outstanding investor ABS interests. Whereas the pari passu seller's
interest is a trust-level interest equal to a minimum percentage of the
combined outstanding investor ABS interests, the minimum percentage in
subordinated seller's interest revolving pool securitizations may be
tied to the outstanding investor ABS interests of each separate series.
While the sponsor's right to receive distributions on the seller's
interest included in the reproposal was required to be pari passu, the
sponsor's right to receive distributions on its share of distributions
in subordinated seller's interest revolving pool securitizations may be
subordinated to varying extents to the series' share of credit losses.
    Importantly, commenters noted that notwithstanding these
differences with the pari passu seller's interest, the sponsor of a
series subordinated seller's interest revolving pool securitization is
still required to maintain the minimum amount of securitized assets in
the pool, if the securitization is to continue revolving, through the
ongoing addition of assets to the pool if necessary. The sponsor has
incentives to monitor the quality of the assets added to the pool in
both structures. If the sponsor replaces repaid or defaulted assets
with poorly underwritten assets, those assets will, in turn, suffer
losses, and the sponsor will be obligated to add even more assets. If
this cycle is perpetuated and the minimum asset target is breached, the
revolving pool securitization will enter an early amortization period,
and the sponsor will no longer have access to future funding from the
revolving pool securitization. Because the subordination of the
seller's interest does not change this potential consequence and
provides similar economic incentives as the pari passu seller's
interest for the sponsor to

monitor and maintain the quality of securitized assets in the pool, the
final rule recognizes this ``series subordinated'' form of seller's
interest as an eligible form of risk retention for revolving pool
securitizations. Allowing the series subordinated seller's interest
accommodates existing market practice and will therefore minimize costs
to certain revolving pool securitizations, while providing the intended
benefit of aligning sponsor and investor incentives which will
encourage higher quality underwriting.
    Commenters also described another form of seller's interest used in
revolving pool securitizations for certain asset classes, such as
equipment leasing and floorplan financing, which are often
collateralized by various types of ``excess'' receivables. The
transaction documents for revolving pool securitizations typically
impose eligibility requirements on the receivables that are allowed to
be included as collateral for purposes of calculating the total amount
of outstanding investor ABS interests that may be issued by the
revolving trust. These eligibility requirements include concentration
limits on receivables with common characteristics, such as those
originating from a particular manufacturer or dealer or a particular
geographic area. The sponsor places assets that exceed these
concentration limits (ineligible assets) in the revolving pool
securitization, where they are often subject to the pledge of
collateral to the holders of the ABS interests, but they are not
included when calculating the amount of the seller's interest under the
revolving pool securitization. Distributions on these ineligible assets
are typically allocated to the sponsor, but depending on the terms of
the securitization, the sponsor's claim to the cash flow from these
assets may be partially or fully subordinated to the claims of investor
ABS interests, and these subordination features may be at the trust
level, at the series level, or some combination of both.
    While the agencies are persuaded that revolving pool
securitizations should be allowed to hold these receivables without
violating the common pool requirement, the final rule, consistent with
market practice described above, does not allow these excess
receivables to be included in the measurement of seller's interest.
Because these are assets that by their terms are not representative of
the assets that stand as the principal repayment source for investor
ABS interests issued by the revolving pool securitization, the agencies
believe, in conformance with market practice, that it would be
inappropriate to include them in the calculation of the seller's
interest. This accommodation for existing market practice allows a
greater number of existing revolving pool securitization structures to
meet the risk retention requirements, which should reduce the costs of
compliance with the final rule and minimize disruption to existing
structures. The agencies also recognize that some revolving pool
securitizations make distributions on these receivables available to
cover losses on eligible pool assets, which increases the amount of
credit enhancement available to investors.
    The agencies are adopting the seller's interest option generally as
reproposed with certain modifications to incorporate more existing
revolving pool securitizations. The Commission believes that there are
several benefits to recognizing the existing seller's interests in
revolving pool securitizations as an eligible form of risk retention.
Aligning the rule's requirements with current market practice will
reduce implementation costs for sponsors using the master trust
structure while still retaining the benefits that investors receive
through improved selection of underlying assets by the sponsors of
revolving pool securitizations. Accommodating current practice will be
transparent and easy for the market to understand and will preserve
current levels of efficiency and help to maintain investors'
willingness to invest in the market. Accommodating current practice
will also provide clarity to market participants and may encourage
additional investor participation given the removal of previous
uncertainty about potential changes to current practices, thereby
helping to promote capital formation. Under this option, there would be
a cost to sponsors of measuring the seller's interest amount on an
ongoing basis in accordance with the final rule, but since ongoing
measurement is a current market practice, the additional cost should be
low. Unlike more traditional securitization transactions collateralized
by a static pool of assets, revolving pool securitizations use a single
issuing entity to issue multiple series. These accommodations should
allow sponsors of revolving pool securitizations to continue to use the
same issuing entity and minimize the potential disruption to the market
that could be caused by bifurcating the common pool of securitized
assets or any other restructuring of the issuing entities, and any of
their outstanding asset-backed securities issued prior to the
applicable effective date of the final rule.
    As discussed above, the agencies are modifying the seller's
interest option to accommodate more of the market practices that
currently exist. Accommodating more market practices will reduce costs
for sponsors of revolving pool securitizations that otherwise would not
been able to rely on the reproposed version of the seller's interest
option and thereby help to promote competition within this segment of
the market.
ii. Representative Sample
    The agencies also considered the alternative option of risk
retention held through a representative sample of the securitized
assets that was proposed in 2011, but not included in the 2013
reproposal.
    While some commenters were supportive of the original proposal's
inclusion of the representative sample option, many commenters were
critical of the option, stating that it would be impractical to
implement this option for a variety of reasons, including that it would
be unworkable for various asset classes, it would be subject to
manipulation, and its disclosure requirements were too burdensome. Some
commenters on the reproposal asked for the representative sample to be
reinstated, asserting that a revised representative sample option would
be particularly useful for automobile loan and lease securitizations,
and more generally, for securitizations with large pools of consumer or
retail assets, such as student loans. However, these commenters did not
specify the costs of not including such an option in the final rule.
    The agencies continue to believe a representative sample option
should not be included in the final rule because, among other reasons,
it would be difficult and potentially costly for investors and
regulators to monitor or verify that exposures were indeed selected
randomly, rather than in a manner that favored the sponsor. In order to
allow sponsors to hold a representative sample, a number of material
factors would need to be considered for the sample to be truly
representative. However, even if many factors are considered, a factor
could potentially be missed, and as a result, sponsors would end up
holding a sample that differed in a material way from the pool assets.
This could lead to ineffective alignment of incentives and therefore
fail to realize one of the intended benefits of the rule. Due to these
concerns, the agencies have decided not to include a representative
sample option in the final rule. Sponsors using this structure will
incur costs to comply with the requirements of the final rule because
the final rule

does not include a representative sample option as one of the
permissible forms of risk retention.
iii. Asset-Backed Commercial Paper Conduits Option
    Under the reproposal, sponsors of ABCP conduits could either hold 5
percent of the risk using the standard risk retention option, as
discussed above, or could rely on the ABCP option. The proposed ABCP
option would not have required the sponsor of the conduit, which is
typically a special purpose vehicle, to retain risk as long as the
assets held in the ABCP conduit, which are often ABS interests in other
asset classes, are not purchased in the secondary markets, and the
sponsor of every ABS interest held by the ABCP conduit complies with
the credit risk retention requirements. Another condition of the
proposed conduit option was the requirement that the ABCP conduit have
100 percent liquidity support from a regulated institution.
    Commenters generally repeated earlier requests that the agencies
provide an exemption based on, or otherwise recognize, unfunded risk
retention provided by banks in the form of liquidity support, program
wide credit enhancement, unconditional letters of credit, and similar
features, as satisfying the risk retention requirements. Commenters
also requested that ABCP conduits relying on this option be permitted
to use a broader range of transaction structures and purchase a wider
variety of assets. Finally, some commenters suggested the elimination
or modification of the proposed requirements to disclose fair value
calculations and supporting information by conduit managers about an
originator-seller's failure to comply with risk retention requirements,
stating that such disclosure under current market conditions could risk
the collapse of the particular ABCP conduit and pose a contagion risk
to the other conduits.\440\
---------------------------------------------------------------------------

    \440\ The Commission believes that the diversification of ABS
interests and the 100 percent liquidity support requirement make
this scenario highly improbable.
---------------------------------------------------------------------------

    The agencies are adopting the ABCP option substantially as
reproposed except for certain modifications based on comments received
to accommodate a greater range of current market practices for existing
ABCP structures in the ABCP option. The agencies have not adopted
commenters' suggestion to permit the application of the ABCP option to
certain types of assets not covered by the reproposal or transaction
structures with less than 100 percent liquidity support. Restricting
the option to ABCP conduits that hold only certain ABS interests is a
structural safeguard that while possibly limiting the ability raise
capital through ABCP conduits, will increase the alignment of
incentives between sponsors of ABCP conduits and investors.
    Under the final rule, eligible ABCP conduits may only purchase ABS
interests in an initial issuance. By limiting an eligible ABCP conduit
to holding ABS interests acquired in initial issuances, a sponsor will
be in a better position to potentially influence the terms of the deal
and have an effect on the quality of assets underlying the ABS
interests relative to if the ABS interests were acquired in the
secondary market post issuance. However, by conditioning ABCP conduit
eligibility to rely on the ABCP option on the purchase of ABS interests
in an initial issuance, the rule could have a negative impact on
secondary markets, possibly resulting in lower liquidity and
potentially decreasing the efficiency in the secondary markets for ABS
interests. Additionally, the agencies understand that ABCP conduit
structures that primarily relied on secondary market purchases
(arbitrage ABCP conduits) performed poorly during the financial crisis.
    Allowing the ABCP option provides incentive to improve underwriting
while minimizing the impact on ABCP funding costs, thereby lessening
the potential burden on capital formation as ABCP conduit sponsors will
not need to use their capital to retain 5 percent of the ABS interest
issued by the ABCP conduit. The risk retention option for ABCP conduits
includes specific requirements for a regulated liquidity provider that
provides liquidity support with contractual terms that meet certain
requirements. We estimate that approximately half of existing ABCP
conduit sponsors may need to adjust the terms of their existing
liquidity support in order to comply with the requirements of the final
rule, and therefore will incur costs to implement the liquidity support
necessary to meet the new requirements. The liquidity support
requirements are largely consistent with the exclusion from the
definition of covered fund for certain ABCP conduits in the rules
implementing Section 619 of the Dodd-Frank Act. As a result, the
Commission believes ABCP conduits sponsored by banks, which make up the
bulk of the ABCP market,\441\ already have or will have liquidity
support that will comply with the final rule, and therefore the new
requirements will not materially increase their costs.
---------------------------------------------------------------------------

    \441\ Asset-Backed Alert, March 28, 2014, lists the 20 largest
ABCP conduit administrators. All but one of them are large banks.
The non-bank is Lord Securities.
---------------------------------------------------------------------------

    Maintaining current practice and requiring 100 percent liquidity
coverage without regard to asset performance will be transparent and
easy for investors to understand and implement, and help to maintain
investor's willingness to invest in ABCP. Adoption of the liquidity
coverage requirement and removal of previous uncertainty about
liquidity coverage (i.e. under what conditions liquidity support would
be provided) should also provide clarity to investors and may encourage
additional investment, thereby lowering the cost, or increasing the
amount, of capital formation in ABCP and underlying asset-backed
securities markets. However, the liquidity support could have the
effect of lowering the yields of the ABS interests because investors
will face less risk compared to less than 100 percent liquidity
support.
    Other modifications that the agencies are making will also permit
more existing market practices to be used with the ABCP option.
Accommodating these market practices will reduce costs to those ABCP
conduits that were not covered under the reproposed version of the ABCP
option and thereby help to promote competition within this segment of
the market.
iv. Commercial Mortgage-Backed Securities Option
    The agencies are adopting the CMBS option largely as reproposed.
The Commission continues to believe that the option provides a means to
satisfy the risk retention requirements that, for the most part, will
allow CMBS issuers to continue current market practice relating to
techniques that align incentives and improve underwriting standards.
Under the final rule, a sponsor will be able to satisfy the risk
retention requirements by having up to two third-party purchasers
(provided that each party's interest is pari passu with the other
party's interest) purchase an eligible horizontal residual interest (B-
piece) in the issuing entity if it is backed solely by commercial real
estate loans and servicing assets. The third-party purchaser(s) would
be required to acquire and retain an eligible horizontal residual
interest in the issuing entity in the same form, amount, and manner as
the sponsor (with the same hedging, transfer, and other restrictions)
except that after five years the third-party

purchaser can sell the B-piece to another eligible third-party
purchaser.
    As discussed in Section 3.b.ii of this Economic Analysis, currently
the B-piece investors in CMBS often hold dual roles as bond investors,
if the assets remain current on their obligations, and as holders of
controlling interests to appoint special servicers, if the loans
default and go into special servicing. The B-piece investors are
typically real estate specialists who use their extensive knowledge
about the underlying assets and mortgages in the pools to conduct
extensive due diligence on new deals. Such due diligence is feasible
because typically CMBS have much smaller number of underlying loans in
a pool.\442\ Consequently, since B-piece buyers are taking the credit
risk and have an ability to perform their own due diligence on
securitized assets before purchasing the residual tranche, the third
party holding risk effectively serves as an independent re-underwriter
of the underlying loans, achieving a quality of re-underwriting
consistent with the quality of underwriting of a sponsor that would
retain credit risk on its own balance sheet. B-piece buyers also have
the ability to affect the performance of the securitization when
problems arise. Because they usually have expertise in commercial real
estate and are holders of controlling interests to appoint special
servicers (and often have special servicers affiliates), they
facilitate restructuring of underperforming loans to maintain the
structure of a CMBS. By providing for the continued retention of risk
and strong incentive to the sponsor to limit potential moral hazard
problems at the time the structure is put in place, the effect of the
CMBS risk retention option on the moral hazard problem will likely be
similar to the effect of one of the standard risk retention options.
---------------------------------------------------------------------------

    \442\ See also footnote 424.
---------------------------------------------------------------------------

    Allowing the third-party purchaser to sell the B-piece to another
eligible third-party purchaser after a minimum holding period should
generate secondary market liquidity, thereby lessening the original
purchaser's cost of retaining the risk and encourages greater
participation in the CMBS market by eligible B-piece purchasers. The
resulting secondary market transactions could generate additional
benefits to CMBS investors to the extent that B-piece buyers have
differential skills with respect to assessing the risk at the time of
origination, monitoring performance, and engaging in restructuring
activity when performance issues arise. Allowing the transfer of the B-
piece will allow the transfer of the B-piece to a purchaser with
specialized skills appropriate to the particular situations.
    Under the final rule, use of the CMBS option requires the
appointment of an independent operating advisor who, among other
obligations, has the authority to recommend and call a vote for removal
of the special servicer under certain conditions. This requirement may
serve to limit potential conflicts of interest between the investors in
senior tranches and the B-piece buyer(s), thus helping to ensure that
the benefits of the risk retention requirements are preserved and
extended to all investors. There will be costs, however, related to the
appointment of the independent operating advisor, including, but not
limited to, the payments to the advisor.\443\
---------------------------------------------------------------------------

    \443\ According to CRE Finance World, Autumn 2012, Volume 14,
No.3, pp. 47-50, the operating advisor fee rate is ``modest.'' Other
costs may include delays in special servicer replacement due to the
need to call for investors' vote, and a possible loss of efficiency
because operating advisors may be less knowledgeable of the special
servicing market than B-piece buyers.
---------------------------------------------------------------------------

    The primary benefit of allowing sponsors to maintain their current
market practices is to effectively achieve the intended objectives of
risk retention with minimized cost to the CMBS market. Commenters
generally supported the CMBS option as reproposed, with one investor
commenter cautioning against further modifications to the proposed CMBS
option, expressing the view that CMBS underwriting standards were
beginning to deteriorate. However, some comment letters suggested
changes from the reproposal.
    Commenters suggested increasing the 5 percent minimum quorum
requirement for a vote to replace the special servicer to 15 percent or
20 percent, and adding a requirement that no fewer than three
unaffiliated investors participate in the vote. The agencies have
decided to permit CMBS transaction parties to specify in the underlying
transaction documents the quorum required for a vote to remove the
special servicer, provided it is not more than 20 percent of the
outstanding principal balance of all ABS interests in the issuing
entity, with such quorum including at least three ABS interest holders
that are not affiliated with each other.
    The final rule includes these suggested changes to address the
concern that a 5 percent quorum could allow a B-piece buyer holding 5
percent of the CMBS deal to replace the special servicer alone without
consent of other investors. As discussed in Section 3.b.ii of this
Economic Analysis and in Part III.B.5 of the Supplementary Information,
the B-piece investors in CMBS often have an affiliate special servicer
and, as holders of controlling interests, they can appoint that
affiliated entity if the loans default and go into special servicing.
An affiliate special servicer could make decisions about loan
restructuring in the interest of its affiliated B-piece holder that are
inconsistent with the interests of all investors. Thus, requiring at
least three investors that are not affiliated with each other for the
quorum would ensure that the economic interest of at least some senior
tranche investors would be accommodated in the selection of the special
servicer and subsequent restructuring.
    Raising the maximum quorum requirement to 20 percent from 5 percent
in the final rule will further ensure that other CMBS investors will
participate in the selection of the special servicer. Limiting the
maximum quorum requirement to 20 percent also ensures that investors do
not face an undue burden in coordinating with other dispersed investors
to call a vote to change the special servicer. Currently, transaction
agreements can stipulate any quorum threshold. If a transaction
agreement currently stipulates a threshold that is too high, the
coordination costs attributed to collective action could prevent
potentially efficient changes in the special servicer. On the other
hand, with less ability to influence the selection of the special
servicer, combined with an inability to disinvest until the expiration
of the sunset period, B-piece buyers will have less incentive to invest
in B-pieces. Hence, relative to current practices, mandating a lower
maximum quorum requirement could generate benefits in some cases.
    The agencies considered but did not adopt the suggestion to allow
third party purchasers to hold their interests in a senior/subordinate
structure, rather than pari passu, to match the risk of loss of each B-
piece interest and the risk tolerances of each B-piece buyer.
Commenters asserted that a senior-subordinated structure would better
allow the market to appropriately and efficiently price the B-piece
interests in a manner that is commensurate with the risk of loss of
each interest, and to address the different risk tolerance levels of
each third-party purchaser. However, other commenters strongly opposed
allowing third-party purchasers to satisfy the risk retention
requirements through a senior-subordinated structure, commenting that
such a change would significantly

dilute and render ineffective the risk retention requirements. The
agencies have decided not to allow third-party purchasers to satisfy
the risk retention requirement with a senior-subordinated structure. As
noted earlier, the purpose of third-party risk retention is to create a
transaction participant that would serve as an independent re-
underwriter of the underlying loans. A ``senior'' B-piece holder in
this structure might not be appropriately compensated for employing
sufficient resources to re-underwrite a CMBS transaction because its
expected return would be too low to compensate for the expenditure of
resources necessary for re-underwriting. In addition, the pari passu
requirement better aligns the interests of the most junior tranche
buyer(s) with those of more senior noteholders whereas the senior/
subordinated structure for the B-piece would further separate the
interests of most junior tranche buyer(s) (that in this case could hold
the first loss tranche that might be significantly smaller than 5
percent) from those of the senior noteholders, which could exacerbate
conflicts of interest issues in this area.
    Some commenters opposed the disclosure of the purchase price paid
by third-party purchasers for the eligible horizontal residual
interest. These commenters pointed out that such information has
traditionally been viewed by all market participants as highly
confidential and proprietary, and that the disclosure requirement would
deter B-piece buyers from retaining risk. The Commission acknowledges
that, if B-piece buyers are deterred from purchasing eligible residual
horizontal interests, this could lower the liquidity of the junior
tranches of CMBS and, thus, potentially increase the sponsors' cost of
capital and the cost of credit for borrowers. However, the agencies
continue to believe that requiring disclosure of the price at which the
B-piece is sold is important to understanding the value of the third
party's risk retention (and therefore whether the required amount has
been retained) and would be consistent with other required fair value
disclosures for any eligible horizontal residual interest retained by
the sponsor that allow investors to assess the amount of risk being
retained.\444\ Hence, the ability of investors to quantify the amount
of credit risk exposure of the B-piece buyer, and thus the level of
incentive alignment with other investors, generates benefits that would
not be possible if B-piece buyers were able to keep the price
confidential.
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    \444\ See Section 4.a.ii of this Economic Analysis.
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    The final rule provides additional flexibility for the CMBS option
by allowing up to two third-party purchasers to satisfy the risk
retention requirement. This provision accommodates the current market
practice \445\ and should facilitate liquidity of the residual piece
market, contributing to a lower cost of capital for sponsors and
borrowers. While commenters generally supported allowing up to two
third-party purchasers to hold risk retention, one commenter
recommended expanding the number of third-party purchasers to allow
participation by more than two B-piece investors. The agencies do not
believe it would be appropriate to allow more than two third-party
purchasers in a single transaction. While allowing more than two
purchasers could increase B-piece market liquidity and, in turn, reduce
costs for CMBS sponsors, it also could dilute the incentives generated
by the risk retention requirement to monitor the credit quality of the
commercial mortgages in the pool, thereby undermining the intended
benefits of the rule. Each B-piece investor who has exposure to
significantly less than 5 percent credit risk, would have not enough
``skin in the game'' to be incentivized to monitor the quality of
underwriting as discussed in Section 4.a.i. of this Economic Analysis.
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    \445\ Based on Commercial Mortgage Alert, out of 61 private
label U.S. CMBS deals in 2013 that had B-piece buyers, 50 had a
single B-piece buyer, 12 had two B-piece buyers, and none of the
deals had more than two B-piece buyers.
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v. Government Sponsored Entities Option
    The final rule allows the full guarantee of the Enterprises under
conservatorship or receivership to count as risk retention for purposes
of the risk retention requirements. Because of the capital support
provided by the U.S. government for the Enterprises, investors in
Enterprise ABS are not exposed to credit loss, and there is no
incremental benefit to be gained by requiring the Enterprises to retain
risk.
    Commenters generally supported allowing the Enterprises' guarantee
to be an acceptable form of risk retention in accordance with the
conditions proposed and did not suggest any alternatives. The agencies
are adopting the Enterprise option as reproposed.
    This option along with the Enterprises' capital support from the
U.S. government creates a competitive advantage for the Enterprises
over private-sector sponsors when purchasing non-QRM loans as long as
they are conforming to the Enterprises underwriting standards.
Recognizing the Enterprises' guarantee as fulfilling their risk
retention requirement and the resulting additional competitive
advantage over sponsors of non-QRM conforming loans has two significant
economic benefits. First, it will allow the Enterprises to facilitate
the availability of capital to segments of the population that might
not otherwise have access through private sector channels. Second, it
will provide stable funding of home financing in periods when lenders
curb their lending due to limited access to capital and private-sector
sponsors are unable or unwilling to meet excess demand.
    A potential cost of recognizing the Enterprises' guarantee as
fulfilling their risk retention requirement is that it may incentivize
them to purchase loans that do not meet the QRM criteria (i.e.,
expanding the Enterprises' conforming loans underwriting criteria),
which would introduce risk that the risk retention requirement is
intended to mitigate. However, analysis of loans originated between
1997 and 2009, a period that spans the onset of the financial crisis,
shows that private label loans had a much higher serious delinquency
rate than Enterprise purchased loans, even after accounting for
different underlying loan characteristics.\446\ Hence, this historical
performance-based evidence suggests that Enterprise underwriting
standards may offset any incentive to incur excess risk because of
their capital support, at least in relation to the incentives and
behaviors among private label sponsors during the same period.
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    \446\ See Joshua White and Scott Bauguess, Qualified Residential
Mortgage: Background Data Analysis on Credit Risk Retention, (August
2013), available at http://www.sec.gov/divisions/riskfin/whitepapers/qrm-analysis-08-2013.pdf.
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    If the Enterprises' conservatorship is terminated, their
securitizations will no longer be exempt from risk retention
requirements unless the securitized assets meet the QRM definition.
This will put the Enterprises on even footing with private label
securitizations in terms of risk retention, but, as was the case before
the crisis, the Enterprises still carry an implicit guarantee of the
U.S. government and, thus, will retain some of their funding advantage
for both QRM and non-QRM securitizations. Private label securitizations
may still have limited ability to be a significant source of capital to
conforming non-QRM loan originations until the Enterprises wind down
their activity or the implicit guarantee is eliminated. As is the case
now, private label

securitizations would not have to compete with the Enterprises for
securitizations of non-conforming loans (e.g., riskier non-qualified
mortgage (non-QM) loans or jumbo loans), which will still fall outside
of the Enterprises domain if current conforming loan underwriting
standards remain in place.
vi. Open Market Collateralized Loan Obligations
    A collateralized loan obligation (CLO) is an asset-backed security
that is typically collateralized by portions of tranches of senior,
secured commercial loans or similar obligations of borrowers who are of
lower credit quality or that do not have a third-party evaluation of
the likelihood of timely payment of interest and repayment of
principal. Commenters distinguished between two general types of CLOs:
open market CLOs and balance sheet CLOs. As described by commenters, a
balance sheet CLO securitizes loans already held by a single
institution or its affiliates in portfolio (including assets originated
by the institution or its affiliate). An open market CLO securitizes
assets purchased on the secondary market at the direction of an asset
manager, in accordance with investment guidelines. Under the final
rule, sponsors of CLOs are required to retain 5 percent of risk using
the standard form of risk retention and have not been provided with an
exemption from the rule's requirements. CLOs are subject to the same
sunset provisions as other non-residential mortgage securitizations.
    As an alternative to this standard risk retention, the agencies are
adopting, as proposed, an option for sponsors of open market CLOs to
satisfy the risk retention requirement by holding only ``CLO-eligible''
tranches for which the syndicated loan's ``lead arranger'' retains (for
the duration of the loan) at least 5 percent of the tranche's value. A
syndication's ``lead arranger'' is defined as a syndicated member that
holds an initial allocation of the overall syndicated credit facility
equal to (at least) the greater of (a) 20 percent of the aggregate
principal balance and (b) the largest allocation taken by any other
member (or members affiliated with each other) of the syndication
group. The agencies have defined open market CLOs for purposes of the
lead arranger option being adopted. The analysis below considers the
impact of the risk retention requirements and the lead arranger option
on the market for open market CLOs, which was the subject of many
comment letters.\447\
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    \447\ In balance sheet CLOs the originator of the loan is the
sponsor or an affiliate of the sponsor. For balance sheet CLOs,
economically there is no difference between the lead arranger option
and standard risk retention when the sponsor is the originator or
its affiliate.
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    Under the final rule, the risk retention requirements for open
market CLOs are subject to the same sunset provisions as other non-