Risk Retention | Dodd-Frank Wall Street Reform Act

risk retention(US)

The retention of a part of a risk, usually by ‘self-insurance’, of all or part of a potential business loss. As a rule, risk retention represents a contingent liability against which a company should set aside a reserve fund.

In particular, a requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. A “securitizer” of an asset-backed security (ABS) continues to accept part of the credit risk of any loss that might occur during the life of the securitized loan (Securities and Exchange Act of 1934, Sec. 15G, as added by Dodd-Frank Act of 2010, Sec. 941(a) (15 USCA § 78o-11)).

Credit risk retention

Risk Retention | Dodd-FrankTypically, such ‘credit risk retention’ requires that any party who originates, securitizes, or invests in the loan retain enough financial risk from the ultimate performance or failure of that loan. In that way the originator will continue to be engaged in the success of the loan as an investment throughout its life. In accordance with the provisions of the Dodd-Frank Act, regulations have been introduced that require any securitizer to retain an “economic interest” in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security (ABS), transfers, sells, or conveys to a third party. Risk retention may include ‘‘(i) retention of a specified amount or percentage of the total credit risk of the asset; (ii)  … go to http://www.realestatedefined.com/php/statutes_usa.php#Dodd-Frank for more.

The regulations will set the minimum retention for asset-backed securities at 5% of the risk of loss. The retained portion of the security may not be transferred to another party, nor can it be pledged or the risk hedged so that the securitizer no longer has any further risk of loss in the event of a default of the security. Certain forms of asset-backed securities may be exempt or may be permitted a lower minimum retention requirement.

In particular, a mortgage-backed security (MBS) that is based on a package of qualified residential mortgages (QRMs), will be exempt from the risk retention. QRMs are residential mortgages that meet underwriting standards that significantly reduce the risk of default. There is also an exemption for securitizations of certain federally insured or guaranteed assets, as well as those based on Freddie Mac and Fannie Mae guarantees. In addition, a sponsor that is subject to credit risk retention is required to provide a cash reserve if a tranche of the security is issued at a premium or on an interest-only basis.

‘Risk retention’ is sometimes referred to as retaining ‘skin in the game’ by the originator, or another related party .

Bibliographical references for asset-backed security & mortgage-backed obligation:

J.C. Hu. Asset Securitization: Theory and Practice (Hoboken, NJ: 2011) pp. 216, 220 (risk retention).
R.L. Kuhn (ed.). Mortgage and Asset Securitization, Volume V of the Library of Investment Banking (Holmwood, IL: 1990).
V. Kothari. Securitization: The Financial Instrument of the Future (Hoboken, NJ: 2006), Ch. 18 ‘Asset-backed commercial paper’.
J.A. Tavakoli. Structured Finance & Collateralized Debt Obligations (2nd ed. Hoboken, NJ: 2008).

T. Baums & E. Wymeersch (editors). Asset-Backed Securitization in Europe (Boston, MA & The Hague: 1996).

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Read all about the valuation and risk retention and other provisions of the Dodd-Frank Act, with multiple cross references and other sources for further research, in Real Estate Defined.

(Risk Retention)

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