Risk retention rules

If you’re doing a securitization under Dodd-Frank Section 941 and Regulation RR, you must retain at least 5% of the credit risk. The rule keeps sponsors from offloading all risk to investors and aligns incentives between originators and buyers.

This guide covers who’s subject to retention, the forms of retention available, the retention period, exemptions, and EU/UK parallel requirements.

Who is subject to risk retention?

The sponsor

Any “sponsor” of an “asset-backed security” is subject to the rule:

Sponsor definition:

• The entity that organizes and initiates the securitization transaction
• Typically the originator or seller of the assets
• Can be a separate entity from the originator if it “causes” the securitization

Multiple sponsors:

• If multiple entities could be considered sponsors, they can allocate retention among themselves
• Joint and several retention requirements possible

What is an asset-backed security?

The regulatory definition is broader than you might expect:

Covered:

• Term ABS (auto, credit card, mortgage, equipment)
• CMBS and RMBS
• CLOs (with important exceptions)
• Any securitization where payments depend primarily on cash flow from self-liquidating financial assets

Excluded (by definition):

• Corporate bonds
• Covered bonds (not issued in the U.S. market)
• Resecuritizations of government-backed securities only

Does your deal trigger retention?

Quick assessment:

1. Is it a securitization (transfer of financial assets to an SPV that issues securities)?
2. Are the securities dependent on cash flow from the assets?
3. Does any exemption apply (QRM, open market CLO, etc.)?

If yes to 1 and 2, and no exemption applies, risk retention is required.

Forms of retention

The rule provides flexibility in how you hold the 5% credit risk:

Horizontal (first-loss)

Hold the most subordinated tranche:

How it works:

• Retain the first-loss position (equity or residual)
• Fair value of retained interest must equal at least 5% of par value of all ABS interests issued
• The “eligible horizontal residual interest” (EHRI) absorbs losses before other tranches

Calculating the requirement:

• Determine total par value of all ABS interests
• Calculate 5% of that amount
• Retained EHRI fair value must equal or exceed the calculated amount

Advantages:

• Natural alignment (sponsor takes first loss)
• Common in traditional securitizations
• Often matches sponsor’s economic interest anyway

Disadvantages:

• Capital intensive (first-loss has high capital charges)
• Ties up sponsor capital in riskiest position
• Fair value determination requires third-party valuation

Example: $500M securitization, 5% = $25M. Sponsor retains residual interest with fair value of at least $25M.

Vertical (pari passu)

Hold 5% of each class of securities:

How it works:

• Retain 5% of each tranche issued (pro rata across capital structure)
• 5% of AAA notes, 5% of AA notes, 5% of equity, etc.
• No fair value calculation needed (par amount)

Calculating the requirement:

• For each class, retain 5% by par amount
• If $100M AAA tranche, retain $5M
• If $20M equity tranche, retain $1M

Advantages:

• Simple calculation (5% of par)
• No fair value dispute
• Lower capital charge than pure first-loss

Disadvantages:

• Harder to manage administratively
• Must hold multiple positions across the structure
• Cannot sell any portion without selling all (proportionally)

Example: $500M securitization with $400M senior, $75M mezz, $25M equity. Vertical retention: $20M senior + $3.75M mezz + $1.25M equity = $25M total.

L-shaped (combination)

Mix horizontal and vertical:

How it works:

• Combine horizontal and vertical elements
• Total retention must equal 5% of ABS interests
• Provides flexibility to optimize capital treatment

Formula: Horizontal retention % + (1 - horizontal %) x vertical % >= 5%

Example: $500M securitization. Hold $15M EHRI (3% horizontal) + 2.04% vertical of each class. 3% + (1 - 3%) x 2.04% = 3% + 1.98% = 4.98% (round up to 5%)

When to use:

• Optimize regulatory capital treatment
• Balance fair value requirements with administrative simplicity
• Address investor preferences

Representative sample

Hold a portion of the assets rather than securities:

How it works:

• Retain at least 5% of the pool’s fair value in assets
• Assets held must be representative of the securitized pool
• Same underwriting standards, similar characteristics

Requirements:

• Random selection or systematic sampling
• Representative across material risk characteristics (credit score, LTV, geography, etc.)
• Cannot cherry-pick better assets

When it works:

• Whole loan sales structures
• Situations where sponsor wants asset exposure rather than security exposure
• Less common in traditional securitizations

Documentation:

• Selection methodology must be documented
• Third-party verification may be required
• Ongoing monitoring of representativeness

The retention period

You must hold the required retention until:

The later of:

1. Two years after closing, or
2. When the aggregate unpaid principal balance of securitized assets is 33% or less of original balance

Practical implications:

• Faster-paying assets (auto, credit card): 33% threshold often hits first
• Longer-duration assets (mortgage): two-year minimum may be the binding constraint
• For revolving structures, the calculation can be complex

During the retention period:

• No hedging the credit risk of retained interests
• No transfer or sale (with very limited exceptions)
• Pledge for financing may be permitted (check with counsel)

Permitted activities

What’s allowed:

• Financing the retained position (repo, margin lending) if non-recourse to the ABS
• Hedging interest rate risk (but not credit risk)
• Transfer to majority-owned affiliates (with conditions)

What’s prohibited:

• Credit default swaps referencing the securitization or collateral
• Short positions in similar assets
• Any arrangement that transfers credit risk to third parties

Exemptions from risk retention

Not all securitizations require retention. Key exemptions:

Qualified Residential Mortgages (QRM)

What qualifies:

• Mortgages meeting the Qualified Mortgage (QM) standard under TILA
• ATR (ability-to-repay) requirements satisfied
• No negative amortization, interest-only, or balloon features
• Points and fees within limits
• Debt-to-income limits (with exceptions)

Agency-eligible:

• Loans eligible for purchase by Fannie Mae or Freddie Mac typically meet QRM
• This effectively exempts most agency RMBS

Why this matters:

• Non-QM lenders must retain (no exemption)
• Investor-purpose (DSCR) loans don’t qualify as QRM
• Fix-and-flip, bridge loans are not exempt

Qualifying Commercial Loans, CRE Loans, Auto Loans

Specific underwriting criteria provide exemption:

Commercial loans:

• DSCR minimums (varies by loan type)
• LTV maximums
• Amortization requirements
• Financial reporting covenants

CRE loans:

• LTV at or below 65% (for most property types)
• DSCR at or above 1.25x or 1.5x (depending on property type)
• Environmental assessment
• Appraisal requirements

Auto loans:

• Down payment minimums
• Loan term maximums
• DTI requirements
• Documentation requirements

In practice:

• Criteria are stringent; many portfolios don’t fully qualify
• Partial exemption if some assets qualify (blended calculation)
• Documentation burden is significant

Qualifying ABCP

Asset-backed commercial paper conduits meeting specific requirements:

• 100% liquidity support
• Intermediate SPV structure
• Sponsor retains risk at the conduit level

Government-backed assets

Exempt government programs:

• SBA 7(a) and 504 loans (government guarantee)
• USDA guaranteed loans
• Federal student loans with federal guarantee
• VA and FHA mortgage insurance

Why exempt:

• Government already has skin in the game
• Risk retention would be duplicative
• These are policy-encouraged programs

Open market CLOs

Following the 2018 D.C. Circuit decision (Loan Syndications and Trading Association v. SEC):

What the court held:

• CLO managers who purchase loans in open market transactions are not “securitizers” under Dodd-Frank
• Risk retention does not apply to open market CLOs

What qualifies as open market:

• Loans acquired through arm’s-length secondary market transactions
• No direct origination by the CLO manager
• Standard BSL CLO structure

What doesn’t qualify:

• Middle market CLOs where manager originates loans
• Transactions where manager has affiliate relationship with originator
• Structures where manager is effectively the securitizer

EU and UK risk retention

If you have European or UK investors, parallel risk retention regimes apply. Post-Brexit, these are now separate frameworks.

EU Securitization Regulation

Basic requirement:

• Originator, sponsor, or original lender must retain at least 5%
• Retention forms similar to U.S. (horizontal, vertical, first-loss piece, representative sample, or revolving exposure)

Key differences from U.S.:

• EU rules apply based on investor location (European investors trigger EU rules)
• Indirect compliance obligation (investors must verify sponsor retention)
• More detailed disclosure requirements
• Simple, Transparent, and Standardized (STS) designation for qualifying transactions

Investor due diligence:

• EU investors must verify that the deal has appropriate risk retention
• Must have access to retention information
• Ongoing verification required

STS designation:

• Lower capital charges for STS securitizations
• Additional criteria (simplicity, transparency, standardization)
• Third-party verification available

UK Securitization Regulation

Post-Brexit, the UK has its own framework:

Structure:

• Largely mirrors EU regulation at implementation
• UK FCA and PRA as regulators
• Separate STS designation process

Key considerations:

• UK investors subject to UK rules
• EU investors subject to EU rules
• Deals targeting both need dual compliance

Practical implications:

• Separate retention disclosures may be needed
• Consider whether same retention satisfies both regimes
• Legal opinions should address both

Structuring for EU/UK compliance

Common approaches:

• Same retention structure satisfies U.S., EU, and UK requirements
• Retention holder makes representations to investors
• Information covenant provides required disclosures

Documentation:

• Retention undertaking from sponsor/originator
• Investor verification procedures
• Ongoing disclosure obligations

Compliance documentation

Pre-closing requirements

Calculation:

• Document how you calculated the 5%
• Fair value methodology for horizontal (third-party valuation)
• Par amount for vertical
• Retain work papers

Holding structure:

• Identify retention holder (sponsor, originator, or majority-owned affiliate)
• Document any allocation among multiple holders
• Confirm holding entity meets requirements

Form ABS-15G

Filing requirement:

• File with SEC within 30 days of closing
• Even for private deals if issuer has Exchange Act reporting obligations
• Also applies if using exemption (file to claim exemption)

Contents:

• Description of retained interest
• Fair value or par amount retained
• Retention holder identity
• Exemption claimed (if applicable)

Ongoing:

• File amendments if retention changes
• Annual filing may be required for certain structures

Ongoing monitoring

Retention maintenance:

• Track that retention holder maintains position
• Document any permitted transfers
• Monitor toward 33% UPB threshold

Hedging prohibition:

• Compliance certification from retention holder
• No credit hedges during retention period
• Interest rate hedges must be documented as non-credit

When retention compliance fails

Common failures

Calculation error:

• Fair value understated
• Percentage miscalculated
• Cure: additional retention if discovered early

Prohibited transfer:

• Retention holder sold position during period
• May require repurchase or substitution

Hedging violation:

• Credit hedge put in place
• Remediation: unwind hedge, document violation

Consequences

SEC enforcement:

• Risk retention is enforceable by SEC
• Violations can result in civil penalties
• Deal may need to be restructured

Investor claims:

• Investors relied on retention representation
• Potential fraud or breach of contract claims

Remediation:

• Document the breach
• Cure if possible (additional retention, unwind hedge)
• Evaluate notification obligations
• Consult counsel on SEC disclosure

Compliance checklist

Pre-closing:

• Determine if risk retention applies to the transaction
• Identify applicable exemptions
• Calculate retention amount (5% of par or fair value)
• Select retention form (horizontal, vertical, L-shaped, representative sample)
• Identify retention holder
• Obtain fair value opinion (if horizontal)
• Document calculation methodology
• Prepare Form ABS-15G

Closing:

• Execute retention documentation
• File Form ABS-15G within 30 days
• Confirm retention interest is properly held

Ongoing:

• Monitor retention holder compliance
• Track toward 33% UPB threshold
• Verify no prohibited hedging
• Update ABS-15G as required
• For EU/UK deals, provide retention verification to investors