FSR Insights. Risk Retention 19 Questions. Financial Instruments, Structured Products & Real Estate Insights December 2014.

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1 FSR Insights Financial Instruments, Structured Products & Real Estate Insights December 2014 Risk Retention 19 Questions Executive Summary The rule will have significant impacts on originators, sponsors, and investors. Those who utilize securitization financing (including originators who sell to parties utilizing securitization financing) should begin assessing the impact to their business. The disclosure rules are extensive and will require significant planning both to determine the appropriate disclosure and develop a corresponding compliance framework. Ongoing compliance with the rule will require new processes, controls and procedures. Securitizations targeting domestic and international investors will face challenges achieving compliance with European and US risk retention rules. 1. What is the rule? Section 941 of the Dodd-Frank Act added section 15(G) to the Securities Exchange Act of Section 15(G) requires the Agencies to prescribe rules requiring the securitizer of an asset-backed security to retain an economic interest in a material portion of the credit risk for any asset it sells, transfers, or conveys to a third party. The Credit Risk Retention Rule (CRR) generally requires sponsors of securitizations to hold 5% of the credit risk, and prevents hedging and transferring the risk for a specified period of time. The rule was intended to align the interests of investors and sponsors by requiring sponsors to have skin in the game. Regulators believed that misaligned incentives were a key cause of the financial crisis. 2. What types of deals are impacted by the rules? The rule applies to all securitization transactions. Securitization transactions are defined as a transaction involving the offer and sale of asset-backed securities by an issuing entity. The rule defines asset-backed securities consistent with section 3(a)(79) of the Exchange Act. An asset-backed security means a fixed income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on the cash flow form the asset, including; A collateralized mortgage obligation; A collateralized bond obligation; A collateralized debt oblation; A collateral debt obligation of assetbacked securities; A collateralized debt obligation of collateralized debt obligations; and A security that the Commission, by rule, determines to be an asset-backed security for purposes of this section.

2 FSR Insight: Generally speaking, the rule applies to all securitization transactions with the exception of synthetic securitizations. Sponsors of transactions backed by certain qualifying assets are exempt from risk retention, but still must meet certain disclosure and compliance requirements. Companies utilizing the securitization market to obtain financing should evaluate the characteristics of their transactions when assessing the potential impact of the CRR. 3. What are the acceptable methods of risk retention? The final rule allows sponsors to retain risk as either an eligible horizontal retained interest (EHRI), an eligible vertical interest (EVI), or an L-shaped interest. Retained Risk Eligible horizontal retained interest (EHRI) Eligible vertical interest (EVI) Combination (L-shaped) Definition 1. All shortfalls of scheduled principal and interest payments must reduce amounts payable to the EHRI prior to any reduction in the amounts payable to any other ABS interest, either through loss allocation, operation of the waterfall, or any other mechanism; and 2. Must be the most subordinate claim to payments of both principal and interest by the issuing entity. 1. A single vertical security; or 2. An interest in each class of ABS interests in the issuing entity issued as part of the securitization transaction that constitutes the same proportion of each such class. A combination of EHRI and EVI provided the percentage of the fair value of the EHRI and the percentage of the EVI meets or exceeds 5%. FSR Insight: The final rule includes three primary methods of risk retention: EHRI, EVI, and a combination of EHRI and EVI, Lshaped. For certain asset classes, sponsors already retain residual tranche or other interests. These entities may be least impacted by the proposed rules. Sponsors retaining risk currently should evaluate their existing business practices to determine whether the retained risk meets the requirements under the rule. The method of risk retention will be driven by a number of factors including: The capital impact of the retained risk; Accounting considerations, such as the impact on consolidation conclusions; Differences in disclosure requirements between EHRI and EVI; and Existing structuring techniques within asset classes. 4. How do you measure the 5% credit risk retention? Sponsors retaining an EHRI will be required to calculate the size of the EHRI based on the fair value of ABS interests. Sponsors retaining an EVI can hold 5% of the notional amount of all issued ABS interests. The definition of fair value in the rule is aligned with the definition of fair value in US GAAP (ASC 820). The final rule requires sponsors disclose the fair value of EHRIs and allows sponsors to provide a range of fair values where specific price, size, or interest rate information for each tranche of the securitization is not available. Sponsors must disclose the closing date fair value of retained EHRI s within a reasonable time after the closing of the securitization. The sponsor must provide significant disclosures regarding their EHRI fair value calculations, including a description of their calculation methodology, PwC 2

3 quantitative information about key inputs and assumptions (including prepayment, default, severity, and discount rates), and a description of the historical data set or other market information used to develop the assumptions. FSR Insight: Sponsors electing to retain a horizontal or L-Shaped interest will need to measure fair value of their retained interest and comply with the associated disclosure requirements. While the rule provides flexibility in the timing of providing the required disclosures both pre and post-issuance, sponsors will be incentivized to close transactions quickly after marketing the deal in order to reduce the risk of changes in fair value occurring from the initial pricing. Sponsors will also need to consider the impact of NRSO and Reg AB II rulemaking on their transaction timelines. 5. Are there any exemptions? The Rule provides for a number of exemptions to the standard risk retention requirements. Sponsors of securitizations backed by qualifying assets are exempt from risk retention, but do have disclosure and compliance obligations. Additional exemptions include, but are not limited to: Freddie Mac and Fannie Mae securitizations; US Government-backed securitizations; Certain agricultural loan securitizations; State and municipal securitizations; Certain public utility securitizations; Securitizations of assets issued, insured or guaranteed by the United States; FDIC securitizations; and Certain community-focused lending securitizations. The rule provides a reduced requirement for certain student loan transactions backed by FFELP loans. FSR Insight: While the rule provides numerous exemptions, most relate to securitizations sponsored or guaranteed by federal, state, and local governments. There are also exemptions for securitizations backed by qualifying residential mortgage, auto, commercial, and commercial real estate loans. Specifically the definition of Qualified Residential Mortgage (QRM) was tied to the Consumer Financial Protection Bureau s (CFPB) definition of the Qualifying Mortgage (QM). The rule allows significantly more flexibility to create a qualifying mortgage in comparison to the original proposed rules. Previous definitions of QRM required a maximum LTV of 80%. It remains uncertain if significant volume of qualifying auto, commercial, and commercial real estate loans will be originated due to the underwriting requirements. 6. Who should be evaluating the impact of the new rule? Originators, sponsors and securitization investors should evaluate the impact of the CRR on their business. The securitization industry has experienced unprecedented regulatory changes in the past few months. Reg AB II, Nationally Recognized Statistical Rating Organization (NRSO) Rulemaking, and Risk Retention will impact securitization market participants. Regulators believed that fundamental reforms in certain elements of the capital markets were necessary in response to the financial crisis. FSR Insight: Reg AB II and NRSO rulemaking will result in additional infrastructure investments to meet disclosure and reporting requirements. Risk retention will require many sponsors (and some originators) to commit capital. Stakeholders should evaluate the impact of all three rules PwC 3

4 jointly to understand the overall impact on their securitization processes. Engage stakeholders including the frontoffice, compliance, risk management, accounting policy, and the finance to evaluate the impact of the rule. 7. When is the rule effective? The CRR rule becomes effective one year after publication in the federal register for securitization transactions collateralized by residential mortgages, and two years after publication for all other securitization transactions. FSR Insight: We expect the finalized rules to be published in late 2014 or Q1 2015, thus making the rules active for residential mortgage securitizations as early Q Stakeholders in the securitization market should begin preparing well in advance of the effective date. The CRR rule imposes new disclosure and compliance requirements on sponsors. The requirements will vary depending on each stakeholder s role in the securitization market. In certain instances, sponsors will be required for monitoring third-parties compliance with the rule. This may pose unique challenges, particularly when thirdparties are unaffiliated with the sponsor. 8. How should sponsors prepare for the rule? Your response is largely dictated by your role in the securitization market, and the asset class being securitized. Sponsors Identify and catalog instances where the organization may be acting as a sponsor under the rule. Perform an impact analysis by asset-class and role. FSR Insight: The impact on CLO asset managers is well-known and widely discussed throughout the industry. Other parties are likely to be impacted by the rule such as hedge funds that securitize re-performing and nonperforming residential assets. Transactions should be evaluated individually given the breadth of exceptions and exemptions. In addition, US based issuers relying on EU based investors may need to evaluate existing structures against EU risk retention requirements or potentially risk losing investors. 9. How should originators prepare for the rule? Identify the different forms of securitization finance used in the business. Educate the relevant stakeholders in the organization including production, underwriting, finance and compliance. Evaluate the existing qualifying exemptions versus current business processes. Engage with underwriters and sponsors of your financing vehicles to discuss changes in the securitization process and allocation of risk retention. Plan to perform a capital impact analysis. 10. How should securitization investors prepare for the rule? Evaluate the nature of the rules in both the US and Europe. Review the impact to your foreign and domestic investments, as well as the potential for disruption in supply. Understand the new disclosures that will be available to you and engage the industry on how it will be most helpful to you. PwC 4

5 FSR Insight: There are no direct regulatory impacts or requirements placed on investors by the rule. Investors are likely to be impacted indirectly as sponsors and other affected parties pass along increased costs of compliance. European investors will need to evaluate both EU and US risk retention requirements. Investors should also monitor the impacts of liquidity in market as sponsors (many of which are marketmakers) balance risk retention requirements with evolving regulatory capital rules. 11. What do the enhanced disclosures require? The rule was highly prescriptive as to the disclosures that will be required by sponsors. The disclosures are segmented based on: The method of risk retention; Qualifying exemptions; and Allocation of risk to an originator. Disclosures are required both prior to the securitization, and shortly after the securitization. Ongoing compliance obligations may require the sponsor to provide notice to investors of changes to methodology and assumptions. We have summarized the disclosures required under standard risk retention options. There are other requirements for those utilizing certain exceptions. SRR Pre securitization Post securitization EHRI EVI 1) Fair value, (or if uncertain, a range of fair values) as a percentage of the fair value of all ABS interests issued 2) The material terms of the EHRI 3) Disclose the: a. Methodology b. Key inputs and assumptions or a comprehensive description of the key inputs and assumptions. This includes, to the extent used, prepayment rates, default rates, loss given defaults, discount rates, lag time between default and recovery, and the basis for the forward interest rates c. Summary description of the reference data set or other historical information used to calculate the fair value (or range of fair values) of all ABS Interests 1) The form of the EVI 2) The Percentage the sponsor must retain 3) Description of the material terms of the EVI 1) The fair value of a. the EHRI retained and the amount required to be retained by the Sponsor (both expressed as a percentage of the fair value of all the ABS interests issued) b. all of the ABS interests issued based on actual sales prices 2) Description of material differences between the methodology used to calculate fair value prior to and post the securitization 3) For the horizontal cash reserve account ( HCRA ) a. The amount placed in by the sponsor b. The fair value of the EHRI the sponsor is required to fund such account c. Description of the HCRA 1) The amount of EVI retained by the sponsor PwC 5

6 FSR Insight: The timing, form and the extent of information to be disclosed will require significant judgment. Furthermore, sponsors may consider incremental review from external accountants prior to providing the disclosures to investors. While the EVI option is simpler to comply with, sponsors in many asset classes have historically held the EHRI in their transactions. As a result, we expect many sponsors will navigate the more complex requirements associated with the EHRI. Those who use an L-Shaped interest will need to satisfy the more robust set of disclosure standards. 12. What are the ongoing compliance requirements for transactions meeting qualifying exemptions? Depositors of asset-backed securities backed by qualifying auto, commercial real-estate and commercial loans must certify that they have evaluated the effectiveness of their internal supervisory controls with respect to the process or ensuring that all qualifying loans that collateralize the asset-backed security and reduce the sponsors risk retention requirements meet all the requirements of the rule. The evaluation of the effectiveness of the depositor s internal supervisory controls shall be performed for each issuance within 60 days of the cutoff date for establishing the composition of the asset pool collateralizing the transaction. Sponsors must retain a copy of the depositor s certification and provide the certification to potential investors within a reasonable period of time prior to the sale of securities. The sponsor is required to promptly notify the holders of the asset-backed securities of any loan included in the transaction that is required to be cured or repurchased, including the principal amount of such loan and the cause for such cure or repurchase. FSR Insight: Many of the requirements relate to monitoring third-parties compliance with applicable underwriting and risk retention requirements. Sponsors looking to leverage qualified asset exemptions should begin evaluating existing processes. Certain information may not be currently provided by depositors and other third-parties. A gap analysis may be useful for identifying areas in need of additional documentation. 13. Can anyone other than the sponsor hold retained risk? The rule firmly establishes that the sponsor is responsible for monitoring the ongoing compliance with the rule, in particular where risk retention is shared with third parties or a qualifying exemption is utilized. The rule allows sharing of risk with the originator of the assets. Qualified b-piece investors in CMBS transactions can also satisfy risk retention requirements. Those third-parties are generally required to follow the restrictions on hedging, transfer, and financing similar to a sponsor. The obligation to monitor compliance remains with the sponsor. The sponsor is required to develop and maintain policies and procedures that monitor the originator s compliance with retention amount, hedging, transferring and pledging requirements. Sponsors must also promptly notify investors and regulators in the event of originator non-compliance. Sponsors also must notify investors in instance of non-compliance of third-parties. Sponsors must have adequate policies and procedures to monitor third-party compliance with the rule. FSR Insight: The regulation provides incentive for sponsors to work with originators who have sufficient controls to meet the rule s requirements. Sponsors who rely on third-parties for compliance with risk retention will need to evaluate their ability to assess the third-parties PwC 6

7 compliance. However, it is unclear the impact to a sponsor if an originator fails to comply. Originators will be asked to provide ongoing confirmations of their compliance with the rules. 14. What are the key accounting considerations entities should evaluate when adopting the rule? There are several explicit references to GAAP in the Rule. Majority control, as it relates to a majority-owned affiliate, is defined as ownership of more than 50 percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under GAAP. Sponsors are required to calculate fair value of EHRI, using a fair value measurement framework consistent with US GAAP. To the extent a sponsor classifies the retained risk as Available for Sale or Held to Maturity, incremental analysis may be required to identify and measure any embedded derivatives. FSR Insight: The industry has been concerned that a risk retention requirement that increases the sponsor s interest in the vehicle (together with a sponsor s degree of control over the vehicle) may satisfy two legs of the consolidation analysis (i.e., power and economics). As a result, entities holding retained interests will need to evaluate their consolidation conclusions. The final rule comes at a time when the FASB is finalizing updates to its consolidation guidance, thereby increasing the uncertainty of the circumstances under which consolidation will be required in the future. Assessing the fair value of an EHRI is inherently complex, as there is often not an active market or readilyavailable information to corroborate key assumptions. Sponsors will be required to disclose assumptions and methodologies regarding fair value calculations in more granularity than typically required for financial reporting. 15. What are the restrictions on hedging, pledging, and transferring the retained risk? Sponsors are generally prohibited from transferring their retained risk to anyone other than a majority owned affiliate of the sponsors. A sponsor or its affiliates may not purchase or sell a security, or other financial instrument, or enter into an agreement with any person if: PwC 7 Payments on the instruments are materially related to the credit risk of the retained interests required to be held by the sponsor; and The security instrument, agreement, derivative or position in any way reduces or limits the financial exposure of the sponsor or majority owned affiliate to the credit risk of one or more of the particular ABS interests required to be retained by the sponsor. Sponsors are allowed to hedge interest rate risk and foreign exchange risk. While sponsors cannot hedge the credit risk of their retained interest, they can enter into a position where payments on the security to other financial instrument are based, directly or indirectly, on an index of instruments that includes asset backed securities so long as the index does not contain an interest representing more than 10% of the index and the total amount of ABS interests related to a sponsor s risk retention requirement to do not comprise more than 20% of the index. Sponsors may not hedge or transfer the retained risk for ABS until the later of a) 2 years b) the date on which the total unpaid principal balance of the securitized assets have been reduced to 33 percent of the unpaid principal balance of the securitized assets as of the date of the transaction, and c) the date on which the unpaid principal obligations under the ABS interests issued in the securitization transaction have been reduced to 33 percent of the total unpaid principal obligations of the ABS interests at closing of the securitization.

8 For securitizations of residential mortgages, Sponsors may not hedge or transfer the retained risk for lesser of a) seven years and b) the longer of i) five years from the closing of the securitization and ii) the date on which the unpaid principal balance of the residential mortgages issued in the securitization transaction have been reduced to 25 percent of the total unpaid principal balance of the residential mortgages at closing of the securitization. Sponsors are allowed to finance their retained interests so long as they utilize recourse financing. FSR Insight: Sponsors will face prohibitions on transferring retained interests, hedging credit risk of their retained interests, or pledging retained interests as collateral without full recourse. Therefore, we expect the retained interests to increase the size of sponsors balance sheets, especially for frequent issuers. The rule allows credit hedging as part of a broader macro credit risk hedging strategy. As a result, we expect additional interest in ABX-like indices to emerge. 16. How does the rule compare to EU risk retention? The goal of US and EU risk retention rules is consistent, align the interests of investors in, and sponsors of, securitization transactions. The US and EU rules generally require sponsors of securitization vehicles to retain economic risk in the credit risk of the securitized assets. Both US and European regulators believed aligning interests between investors and securitizers in the securitization market was critical to mitigating systemic risk. However, the regulators took different paths for achieving their goal. EU risk retention rules place the burden of compliance on investors, whereas the US rules place the compliance burden on sponsors. Specifically, an institution other than originator or original lender, shall be exposed to the credit risk for a securitization position in its trading book or non-trading book only if the originator, sponsor or original lender has explicitly disclosed to the institution that it will retain, on an ongoing basis, a material net economic interest which shall not be less than 5%. Investors will be required to hold additional regulatory capital against their investments in non-compliant securitization interests. Fair Value vs. Notional Value The size of risk retention in the EU is calculated based on the notional amount of underlying assets or issued ABS interests, irrespective of whether the sponsor retains a horizontal or vertical interest. This is in contrast to US rules where the sizing of a horizontal interest is based on fair value of the issued ABS classes. Forms of Risk Retention Both the US and EU allow for vertical and horizontal interests. However, the EU allows for a holding of a representative sample of loans, which was removed from the US rule. The US allows for an L-Shaped interest, which the EU does not allow for. Disclosure and Due Diligence US rules require sponsors to disclose certain information in connection with their retained interests. Originators issuing qualified assets must have processes and procedures for ensuring their loans are originated to qualified underwriting standards. In contrast, the EU rules place the burden of compliance and disclosure on the investor in securitization offerings. Investors subject to the risks of a securitization must demonstrate they have a comprehensive understanding of the risks associated with their investments. Investors must demonstrate they understand: PwC 8 Amount of risk retained by the sponsor; The risk characteristics of the individual securitization position and the assets underlying the position; The reputation and loss experience in earlier securitizations of the sponsor or originator for relevant asset classes; Statements and disclosures made by the originators or sponsor, about their due

9 diligence on the securitized exposures, including credit quality of assets; Where applicable, valuation methodologies and concepts supporting valuation of collateral supporting securitized assets; and Structural features which can materially impact the performance of the retained risk. Institutions shall regularly perform their own stress test appropriate to securitization positions, and must establish formal procedures to monitor the credit and performance of their risk profile on the performance of the assets underlying their exposures. Hedging, Transfer, and Financing Prohibitions According to EU rules, the net economic interest, including retained positions, interest or exposures, shall not be subject to any credit risk mitigation or any short positions or any other hedge, and shall not be sold. US rules prohibit the hedging, transfer, and nonrecourse financing of retained interests. Unlike US Rule which expires after a period of time, EU rules are indefinite. FSR Insight: Stakeholders in the international securitization markets will need to evaluate their existing and proposed business practices to ensure compliance with both sets of rules. EU based institutions investing in US based securitization offerings will need to evaluate the terms and conditions of the offerings, the disclosures provided by sponsors and the method of risk retention. Sponsors of securitization vehicles with both EU and US based investors will need to assess compliance with the EU and US rules independently. 17. How can mortgage lenders qualify for the exemption from the risk retention rule? Securities backed by high-quality collateral, such as Qualified Residential Mortgages (QRMs), are exempt from the risk retention requirements, and regulators have aligned the QRM definition with the QM standards established by the CFPB. On January 10, 2013, the CFPB issued its final rules related to Abilityto-Repay (ATR) and Qualified Mortgage (QM) rules. 1 For a mortgage to be a QM and qualify for an exemption, it generally must meet specific requirements for payment type, original maturity date, points and fees paid by the consumer, and underwriting criteria. QM loans may not have terms deemed higher risk. Examples of higher risk loans include interest only loans, negative amortization loans, balloon loans, and loans that defer principal. Generally, a QM loan s Annual Percentage Rate (APR) cannot exceed the average prime offer rate (APOR) for comparable transactions by 1.5% or more, for first liens, and may not have a maximum term exceeding 30 years. Additionally, reverse mortgages or home equity lines of credit (HELOC) do not currently qualify for QM status. To meet the specific ATR standards, lenders must consider, verify and document whether the consumer has sufficient income and assets to repay the loan, by generally considering the following eight underwriting criteria: 1. Current or reasonably expected income or assets; 2. Current employment status; 3. Monthly payment on the covered transaction; 4. Monthly payment on any simultaneous loan; 5. Monthly payment for mortgage-related obligations; 6. Current debt obligations, alimony and child support; 7. Monthly debt-to-income ( DTI ) ratio or residual income; and 8. Credit history. Eligibility for a QM loan will be based on verified current or reasonably expected income or assets and current debt obligations, alimony and child support. The monthly DTI ratio, which is based on the borrower s outstanding obligations, may not exceed 43-percent. Also, a borrower s income and associated DTI ratios must be assessed on the maximum interest rate 1 PwC 9

10 during the first five years, rather than a teaser or promotional interest rate, for all QM loans. For a loan to be eligible for QM status, the points and fees charged to the consumer cannot exceed 3-percent of the total loan amount. There are various caps allowed for loans less than $100,000. A 3-percent cap may leave little room for unanticipated costs. Adherence to the post funding cure rule is important. On October 22, 2014, the CFPB released their final rule allowing lenders to provide the cure refund within 210 days post consummation. Lenders should establish post funding audit processes to ensure compliance with the rule. FSR Insight: Depending on the sophistication of each lender s current infrastructure and supporting technology, these standards may require manual processes until an automated solution can be implemented. Manual processes will add to the compliance oversight requirements. Manual processes may also require additional training and the implementation of controls to ensure adherence to the QM and QRM standards. In addition, all documents used to underwrite the loan must be retained for a minimum of three years after the termination or payoff of the loan. These retention requirements could impact on server resource capacity and technology depending on a lender s current infrastructure. There are three new loan underwriting standards created by the rule including: QM Safe Harbor loans QM Rebuttable Presumption loans Non-QM loans QM Rebuttable Presumption loans and Non-QM loans carry increased legal risks which could result in lenders focusing on only originating QM Safe Harbor loans. Future litigation risk may be mitigated if lenders demonstrate that the loan was originated according to QM standards. Additional training for employees to understand the different lending standards should be implemented. Lenders originating QM loans will need to evaluate the impact to their platforms. Lenders should continue to evaluate fair lending risk as they would for other types of product selections by carefully monitoring their policies and practices and implementing effective compliance management systems. 18. How can Auto lenders qualify for the exemption from the risk retention rule? Auto may reduce the impact of the risk retention rule by originating Qualified Auto Loans (QAL). The Rule outlines specific consumer income, debt and transaction level requirements necessary for QAL. Key attributes include: Down payment requirement - Customers will be required to make a minimum down payment of 10% of the purchase price of the vehicle and pay the sales tax, title, license, registration, and other dealer fees at loan origination. DTI ratio - The customer s debt-to-income ratio may not exceed 36-percent based on the borrower s verified income and outstanding financial obligations. Verification of customer s income - The lender must request the borrower s pay check stub or other income documentation, usually from the selling dealership. Alternative independent verification resources may be available on-line but may not include access to all consumers, particularly those relying on selfemployment or retirement income. PwC 10

11 Specific borrower credit - At least a 24 month credit history. - No current 30 day delinquent trade lines. - No 60 day delinquent trade lines in the past 24 months. - No Bankruptcy, Foreclosure, Repossession or similar activity in the past 36 months. Loan term parameters - The contract may not be written at a term exceeding 72 months or at a term that would result in the vehicle s model year (age) exceeding 10 years at maturity, whichever is less. The risk retention rule may have consequences by unintentionally disqualifying creditworthy consumers from QAL status. The rule may reduce the flexibility or discretion in auto lenders targeting origination of QAL. Below are some examples of such scenarios: Self-employed Borrowers: Lenders have faced challenges verifying the income from self-employed consumers, particularly sole proprietors. Tax returns and personal financial documentation provided by these individuals may not be consistent with paystubs or W-2s. Recent Bankruptcies with Satisfactory Credit: While a bankruptcy within the last 36 months may increase subsequent default or loss risk, a broad guideline without consideration of the consumer s previous credit profile may also unintentionally disqualify some consumers. For example, a consumer with significant term loan depth over several years that had to file bankruptcy for other than a financial reason, may continue to pay most obligations through the bankruptcy period. Such an individual may actually represent a lower credit risk than others that meet just the minimum requirements of the rule. The QAL rule may have a significant long term impact on the operations of auto lenders that do not comply with the exception. Lenders will have to build up processes supported by automation similar to those described in the QM section above. The requirements for income documents, such as paystubs or W-2 s, may require a manual review function for potential fraud and DTI calculations. Consumers expect auto financing to be fast and readily available. Similarity of products and proximity of dealers to one another has made it easy for customers to simply walk to the dealership next door if they encounter resistance or issues with the sale, negotiation or financing of the vehicle. As a result, the rule may inadvertently impact QAL lender s relations with dealers if consumers are required to provide more information such as income documentation or explanations regarding their personal finances. FSR Insight: With the relative ease and availability of credit in the auto finance market, originating QALs will require a shift in industry behavior. To enact this shift, lenders may have to incentivize and educate dealers and possibly consumers. The customer experience for auto lending may more closely resemble mortgage lending as a result of increased data requests. Auto lenders will face a trade-off between risk retention and originating QALs. We anticipate few lenders will choose to originate QALs initially. 19. What should Student Loan ABS sponsors know about risk retention exemptions? Under the Federal Family Education Loan Program (FFELP), private lenders originated and owned student loans feature a federal loan guarantee. Loans meeting origination and servicing eligibility requirements defined by the Department of Education receive a federal guarantee of between 97- and 100-percent of any potential defaulted principal and interest. In July, 2010, the FFELP program was eliminated, leaving all future loans to be originated directly to borrowers through federal channels. PwC 11

12 FSR Insight: The ABS marketplace currently features FFELP and Private student loan backed securities, and each has its own nuances related to Credit Risk Retention. Private Student Loan ABS Sponsors of securitizations collateralized by private student loans will be required to comply with standard risk retention requirements. Federal Student Loan ABS Many FFELP loans were securitized, with the loans underlying the securitizations being governmentguaranteed and underwritten to government-specified parameters. The magnitude of risk retention for FFELP loans depends on the guaranty percentage of the loans in the securitized asset pool. If the securitization pool contains only loans guaranteed at 98-percent of defaulted principal and interest, then the risk retention requirement is reduced to 2-percent rather than the 5-percent requirement. If the pool contains any loans guaranteed at 97-percent, then the risk retention for the entire securitization is 3-percent. The impact of the FFELP exemption is unknown. While there have been no FFELP originations since 2010, the outstanding balance of FFELP loans remains sizable. PwC 12

13 Additional information Contacts Frank Serravalli Partner (646) Chris Merchant Principal (202) Dan Sullivan Principal (646) Additional Contacts in PwC s Consumer Finance Group Francois Grunenwald Partner (646) francois.grunenwald@us.pwc.com Douglas Ekizian Senior Manager (949) douglas.c.ekizian@us.pwc.com PwC s FSR Group brings you: A unique combination of financial reporting, advisory, tax, finance, operational readiness, process and technology, and regulatory expertise, coordinated with specialized transaction and valuation services for securitizations, structured products, derivatives and real estate assets. In-depth knowledge and valuation expertise on virtually all asset classes, including debt and equity securities, derivatives, structured notes, residential and commercial mortgages, mortgage servicing rights, commercial loans and bonds, automobile loans and leases, trade receivables, credit cards, home equity loans, equipment loans and leases, student loans, manufactured housing loans, franchise loans, hospitality and leisure real estate, timeshare receivables, and mutual fund fees. A group of subject matter specialists who provide insights into developments in the capital, credit, derivatives and real estate markets, including but not limited to consumer and corporate credit, investment banking, transaction structures, investor reporting, technology, real estate asset monitoring and management, reorganization and insolvency, forensic accounting and hospitability and leisure services. Expertise in model development and risk analysis to assess your processes for valuing financial instruments, determine robustness of financial models and perform risk analysis, including evaluating sensitivity measures and stress testing methodologies for portfolio risk. Our team is multi-disciplined and diverse. We bring a unique approach to blending and managing services in today s dynamic and fast changing markets. PwC 13

14 FSR Insights Follow us on 2014 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.